Money Stock and Its Effect on Changes in Price Level

 

The relationship between money stock changes and price levels has been a key area of debate in monetary theories. As per the quantity theory of money, increases or decreases in money supply directly affect price levels. While some other schools of thoughts say that money stock changes might not always have a direct impact on the price level. This view challenges the idea that the money supply is the primary driver of inflation or deflation.

The quantity theory of money is a classical economic theory that links the money supply to the price level. It is based on the equation: MV=PY. According to the theory, an increase in the money supply (M) with a constant velocity (V) and real output (Y) will lead to an increase in the price level (P). This implies that changes in the money stock directly affect the price level.

There are arguments against this view; changes in the money supply do not always result in proportional changes in price levels. In this case, the velocity of money is a factor which refers to how quickly money circulates in the economy. If the velocity of money increases, the same amount of money can support a greater number of transactions, which could mitigate the inflationary effects of an increase in money supply.

Increases in money supply may not lead to inflation if the economy is expanding and real output is increasing at the same rate or faster than the money supply. In such cases, the additional money supply can be absorbed by the growth in goods and services without causing a rise in prices. For example, during periods of strong economic growth, businesses increase production, wages rise, and demand for goods and services increases. In such environments, the money supply can grow without putting upward pressure on prices, as the economy's productive capacity is also growing. This is known as the neutrality of money in the long run, where changes in the money supply only affect nominal variables like prices and wages but not real variables like output and employment. In the short run, however, an increase in the money supply can still influence demand. Again, if the economy is already at or near full capacity, price levels may rise.

Expectations of future inflation or deflation can play a significant role in determining price levels. If consumers and businesses expect prices to rise due to an increase in the money supply, they may act preemptively by raising prices or increasing wages, contributing to inflation. On the other hand, if people believe that an increase in the money supply is temporary or that the central bank will take steps to manage it, they may not adjust their prices, and inflation may not occur. This indicates that inflation expectations are just as important, if not more so, than changes in the money supply in determining the price level. If the public lacks confidence in the government’s ability to manage the money supply, even small increases in the money stock could lead to inflationary expectations and subsequent price increases.

Price levels are also influenced by supply-side factors, such as changes in the cost of raw materials, energy prices, and wages. If supply-side shocks occur - such as a rise in oil prices or a natural disaster that disrupts production - prices may increase regardless of changes in the money supply. In this case, money stock changes would not be the primary driver of inflation. As an example, the situation in 1970s can be said. The world experienced a series of oil price shocks, which led to stagflation. In such situations, an increase in money supply may not have been the primary cause of rising prices. Instead, the price of oil and other key commodities had a more direct effect.

During periods of economic uncertainty or recession, central banks may increase the money supply as an effort to stimulate the economy. However, if the economy is in a liquidity trap, where interest rates are already very low and people are unwilling to spend or borrow, increasing the money supply may not lead to higher spending or investment. In such cases, the money stock may not translate into higher demand or higher prices, as consumers and businesses hoard cash rather than use it for consumption or investment. During the global financial crisis of 2007–2008, it is observed that many economies experienced significant increases in the money supply through measures like quantitative easing. Despite the increase in money stock, price levels remained relatively stable for an extended period, as businesses and consumers were reluctant to spend due to economic uncertainty.

In an increasingly globalized economy, changes in domestic money supply might not have the same effect on domestic price levels as they once did. For example, if a country increases its money supply but faces competition from international markets with lower costs of production, the effect on domestic prices may be muted. Global supply chains, trade liberalization, and access to cheaper foreign goods can dampen inflationary pressures. Even if domestic money stock increases, the global supply of goods and services may keep prices in check.

In periods of high money supply growth, such as during the 2008 global financial crisis, inflation was relatively contained in many advanced economies despite significant increases in money supply, largely due to low consumer demand, reduced velocity of money, and cautious lending. Similarly, in Japan, despite many years of monetary expansion through programs like 'Abenomics', inflation has remained persistently low, suggesting that the relationship between money supply and price levels is not always straightforward.

The relationship between money supply and price levels is more complex than simple cause and effect, and a variety of factors must be considered when analyzing inflationary or deflationary trends in an economy. Therefore, while changes in money stock can influence price levels; but they are not the sole determinant of inflation or deflation as cited by the opposite school of the quantity theory of money.

Money is considered as a means of exchange. Whether the stock is 1 million, 1 billion, or 100 billion in unit does not matter. Regardless of the actual size of the money stock, any transaction volume in goods and services can be conducted with a given supply of money, as per other school of thoughts. A large money stock of, say 10 billion units, would lead to increase prices, while a small money stock of, say 1 billion units, would lead to low goods prices. The thoughts cited that no increase in the money supply can improve the exchange function of money. An increase in the money supply will merely dilute the effectiveness of each unit of money as a medium of exchange. In other words, an increase in the quantity of money brings no social benefit. Rather, it destroys the benefits of evenly distribution. The first recipients of the new money benefit much because they can purchase goods at unchanged prices with their newly received money. It means that early recipients of the new money benefit at the expense of the late recipients.

In an economy where the prices of goods are rising, businesses want revenues to grow faster than costs. Likewise, in a price deflation regime they ensure costs to fall faster than its revenues. As such, a firm producing goods and services as per market demand can flourish in a price inflation and price deflation regime. This also means that there is no need for a chronically rising money supply; a constant or even shrinking money supply would be just fine.

There are different theories which cannot address the problems in the real time of the pains of changes in price level. As such, it is a question to ask where the reality lies.
 

Mehdi Rahman works in the development
sector. He also writes on business
phenomena and monetary issues.