monetary inflation - quantity theory

The Monetarist explanation of inflation operates through the Fisher equation.

M.V = P.T

M = Money Supply                  V = Velocity of Circulation

P = Price level                         T = Transactions or Output

As Monetarists assume that V and T are fixed, there is a direct relationship between the growth of the money supply and inflation. The mechanisms by which excess money might be translated into inflation are examined below.

Individuals can also spend their excess money balances directly on goods and services. This has a direct impact on inflation by raising aggregate demand. The more inelastic is aggregate supply in the economy, the greater the impact on inflation.

The increase in demand for goods and services may cause a rise in imports. Although this leakage from the domestic economy reduces the money supply, it also increases the supply of pounds on the foreign exchange market thus applying downward pressure on the exchange rate. This may cause imported inflation.

If excess money balances are spent on goods and services, the increase in the demand for labour will cause a rise in money wages and unit labour costs. This may cause cost-push inflation.  

The Bank of England no longer sets targets for the growth of the money supply but it keeps a close eye on the rate at which consumer credit, bank lending and cash in circulation is rising as a guide to future trends in consumer demand and retail price inflation