• Varun Mittal

The monetarist theory of inflation

As promised in my last article, this article will be about the monetarist theory of inflation. This article will contain some mathematical concepts; however, I will keep them to a minimum. The core concept of the monetarist theory is the equation below.

𝑀 ∗ 𝑉 = 𝑃 ∗ 𝑄

𝑀𝑜𝑛𝑒𝑦 𝑆𝑢𝑝𝑝𝑙𝑦 ∗ 𝑉𝑒𝑙𝑜𝑐𝑖𝑡𝑦 𝑜𝑓 𝑀𝑜𝑛𝑒𝑦 = 𝐼𝑛𝑓𝑙𝑎𝑡𝑖𝑜𝑛 𝑅𝑎𝑡𝑒 ∗ 𝐺𝐷𝑃

The left side is how much money is in the economy times by the rate at which money is spent. So, if you buy an item for $1from a grocery shop and that grocery shop worker uses the same $1 to buy an item from a vending machine, the velocity of money would be 2. It basically would be the number of times in which money has changed hands and is being used. The right side is a way of representing real GDP.

The reason why the equation works is quite simple; the left side reflects all that is spent in an economy, and the right side can represent all that is created in an economy. By the laws of supply and demand, these two must equal each other. Therefore, this can easily be used to assess how a change in monetary policy will impact inflation or GDP.

Here’s how the equation works; there are a few assumptions. Monetarism falls under classical economics; therefore, they believe that in the long run, "Q" is fixed. The LRAS of an economy is a straight vertical line if you believe the classical ideology. They also think that "V" is set. They have mathematically proved that while "V" does variate from year to year, it generally tends to hold an average value. A way to understand it can be using a modern example: During the pandemic, we stopped buying from in-person stores and instead bought from online shops. Therefore, our velocity of circulation has remained relatively the same. This is a crucial assumption. Consequently, it can be said that if you change the money supply of an economy, or increase "M", then only inflation - "P" - will change.

The monetarist theory of inflation was a key concept used in the 1960s-90s and was often what the central bank would follow. They would seek to control inflation and do so via controlling the money supply, creating or destroying money to keep it at a specific value. While no one disputes that the equation is correct, the assumptions made in this theory are often debated. The most disputed claim is over whether "V" is fixed. Classical / Monetarist economists will say yes; however other economists would argue otherwise. They say that "V" cannot be fixed as there are times where it deviates, such as during a recession where individuals spend less. They have less confidence in the economy and are less likely to spend

– this could be sustained for some time. This can be proved when looking back at the spending habits of the average person during the pandemic; they would save more if they lose their jobs. It can also be proven through recent data that the rate of velocity has fallen following the 2008 crisis, shown in the graph.

Therefore, it can be contested how much "V" can change to be "fixed" in a long-run perspective. Additionally, the concept of "Q" being fixed can also be debated. While it is not as contested as "V", it is still discussed as new/neo Keynesians say that Q can fluctuate at any given moment.

Therefore, the belief that directly changing the money supply will affect the inflation rate proportionally can be highly debated. Hopefully, this article can help you understand the impacts of printing money and the monetarist theory of inflation.

I understand this article was packed with a lot of terminology and explanation, so if you have any questions, don't hesitate to contact the economy club email. They will forward your inquiry to me.