How can an inadequate money supply affect the rate of inflation?
Prices can change based on the relationship between spending and production.
In the macroeconomy, since income is equal to spending, prices can also be seen to change based
on the relationship between income and production sold.
At the present time we are used to having nominal incomes steadily increasing just because society
has gotten used to the fact that it will need to keep increasing. Having spending and incomes keep
increasing, for the same amount of production, causes prices to keep increasing. If the spending
increase goes into paying for the same things (i.e., the same amount of labor, goods, services or
desired outcomes) in the same proportions, then that spending increase has nothing to do with any
increase in production or change in standard of living. This spending increase is the result
of inflation, where more nominal spending is required to pay for the same amount and types of
products.
It is possible however for some of the increased spending to go to paying for more products, either
more of the same items or new items not previously being purchased, or it could just be paying for
items that are more expensive presumably because they are of higher quality. If that is the case
then the increased spending is related to increased production, not inflation.
If we have determined that we have increased production, by increasing the amount, quality, and
variety of production items, that increased production could have two types of causes. It can be
caused by more people working to produce things,
that is, population increase, or it could be related to increased production
per worker, also known as increased productivity. If we look at the equation income equals price
times transaction (Y=P✱T), changes in spending and income could be caused either by changes in
average price or change in the number of transactions, but likely it is contributed to by both. The
change in the amount of spending could be a result of inflation or it could result from an increase in
the quantity, quality and variety of product purchased, that is, increased production. It is hard to
attribute all the specifics as to what part of increased spending is related to inflation and what part
is related to increased production. While that may be true I think it is an accurate comment to say
that our current economy exhibits both a baseline inflation
and a steady increase in production. It is further reasonable to assume that increased
production results from a combination of both increased population and increased productivity.
If you think about it, if we have increased production then the rate of spending increase
must exceed inflation. If we are in a situation where we have a baseline inflation, that means that
prices are increasing regularly on the same type and quantity of product is being purchased on the
whole. That means total spending and income increase at the same rate as inflation. If additional
product is going to be purchased, in terms of increased quantity, quality and variety, the increase in
spending and income
must not just match the inflation rate, it must exceed the inflation rate.
This must be true, or one of two things will happen, either the rate of inflation will be decreased, or
extra production will not be able to be sold, or some combination of the two. If extra product is not
sold, its continued creation will not be supported.
For just inflation, without an increase in production, average price (P) increases but the amount of
transactions (T) stays the same. In that case, increased spending goes totally into P, i.e., increased
prices, which is inflation. If the spending increase has to pay for increased prices on transactions to
purchase the same quantity and type of items, and it also has to pay for purchases of extra stuff as
well, then both P and T increase. If that is the case, all the spending increase cannot go solely into P,
it also goes into T. Therefore, IFthe same spending increase is paying for increases
in both P and T, P cannot increase as much, meaning the rate of increase in prices, inflation, is
decreased. That is why I say, if inflation rate is going to remain at a given baseline rate, we must
increase total spending, (and therefore total income), by the rate of inflation plus the rate of
production increase.
Production can increase due to increases in the number of workers caused by population
increases, in which case though total spending will increase more than inflation, spending per
person may not. If production goes up solely because more people are involved in the economy,
average income per person may not go up, or it could even go down, relative to inflation.
Production can also increase due to increase in productivity. Productivity is the amount of
production per worker. If increased productivity is the cause of increased production, the amount
of spending per person would be expected to increase relative to inflation. If total spending goes
up, to pay for extra production due to productivity increases, the average per capita income will go
up as well, relative to inflation.
Increased productivity affects not only our standard of living and quality of life, but also the amount
of spending required to pay for the extra production. Although not all of the extra production will
need to be, or is expected to be sold, certainly a good portion of the extra output will need to be
sold or it will not be produced. If we have an economy where inflation and increased production
and productivity are normal features, it is not possible to support this economy if nominal
spending, the actual amount of spending in dollars, just keeps pace with inflation.
In the book, Enlightened Capitalism I discuss in detail how, realistically, the only way to have a
successful growing economy is to have nominal MEDIAN incomes be increasing at a rate faster
than inflation, and likely have to eventually keep pace with inflation plus productivity increases.
Let us look more formally at the relationship between inflation and the size of the money supply.
Income is defined as M✱V. The nominal size of the money suppIy M time the average number of
times each unit of the money supply is used for spending during the given tme period V (velocity of
money).
If income is increasing steadily and if M is held fixed, then V will have to keep going up. In
“Enlightened Capitalism” I discuss how and why it is reasonable to assume that there are limitations
to how high V can go, and if we approach that level, spending increases will slow, and eventually
stop.
Income (spending) also equals P✱T. T represents the amount of transactions, i.e., each piece of
production that is sold. Let us say, for simplicity sake, we break up all the product being sold into
units of equal value, so that each transaction is selling an equal amount of product in terms of
value. T is the total number of these units sold.
I mean for product to be interpreted in the most general possible way to include anything people
might spend to acquire.
For example, if our original total production in one year is broken up so we have 100 units of the
same value to be sold, then T equals 100. But if in a later year we double the amount of production
to be sold, then T would equal 200. The value of T correlates to the inflation adjusted buying
power of a given amount of spending and income. Defining T this way simplifies our analysis. From
the expression P✱T if T stays constant and spending keeps increasing then the average price P of
transactions will have to increase. That is inflation. As the limitations on V are reached spending
and income increases slow and eventually stop. Since spending equals P✱T, and since T is
constant, price P increases will also have to slow and eventually stop. What this shows is that for a
given money supply M, and a constant amount of product being sold, eventually, when one
approaches the limit on velocity V we reach a point where inflation slows and eventually stops. That
is what happens when production and number of transactions remains unchanged.
What happens if M continues to remain constant, but production does not stay constant, that is
production keeps increasing. Generally, in today’s economy we we expect production to keep
increasing, both because of population increases and productivity increases. That would mean
there would be more pieces of production sold and T would increase. If we were not at the limit of
velocity of money V, then average price P could continue to rise even as T increases. Eventually
when the velocity of money V reached its limit, for a constant money supply, M✱V could not
increase further, and the product P✱T also would not be able to increase further, because total
spending Y = M✱V = P✱T. In that situation if T kept increasing due to production increases, the
average price P would not only have to stop increasing, it would actually have to start
decreasing. That is deflation. In an economy with increasing production, If, in an economy where production is increasing, we never increased the money supply M, we
would eventually reach a point where we would have deflation. I discuss deflation in another
answer.
https://www.quora.com/Can-an-economy-with-deflation-maintain-its-level-of-growth/answer/Daniel-Bright-13
