John Lock, an English philosopher in the 17th century, initially suggested a banking standard, and his vision created a paradigm shift between the obsolete barter system and purchasing power equality of money in consumers’ mindsets.
Inflation and Quantity Theory of Money
It would be prudent first to understand the Quantity Theory of Money (QTM) and its relation to inflation. Essentially, QTM is a theory that can be the primary cause of changes to money’s purchasing power. What QTM primarily derives is that any effect on the price of money, such as deflation percentage, interest rates, etc., is primarily determined by the currency in circulation.
When money supply shows an increasing trend as opposed to money demand, which is less, the consumer has to withstand the worst price increase of commodities. In other words, purchasing power falls. If the money supply decreases and money demand rises, the purchasing power also climbs, and regular prices fall. To put it simply, an increase in money supply and a decrease in money demand are related, and therefore the rate of inflation increases.
Secondly, QTM suggests any monetary policy impact by a central bank, which could be a change in Cash Reserve Ratio (CRR), discount rate, or Open Market Operations (OMO), which will primarily affect the inflation preceded by the desired price level. To put it simply, this is a cause-and-effect relationship, where the money is an active variable, and the price level is the passive-dependent variable.
Review of the QTM and its assumptions
Initially, teething issues did come into play while determining the QTM on how to create a much more plausible association between money supply and demand. Therefore, it became imperative to formulate a simple equation, i.e., P=V + M – Y, where (P) denotes Inflation rate, and V, M, and Y as the growth rate of money output, velocity, and stock (currency in circulation). Any change between money supply and demand, whether it be minimal and substantial, it is bound to affect the rate of money growth and consequentially the inflation rate.
Primarily the notion behind this theory is that the velocity and growth rate of money will remain constant. An increase in currency in circulation will have no influence as such on Real Gross Domestic Product (GDP) growth in the long run.
A good amount of practical findings of the QTM considers the velocity and growth rate of money as a constant variable. However, on the contrary, the postwar US data reveals the velocity of money is a hypothetical concept by considering it as a constant variable. Instead of pretentious that the velocity of money is a constant variable, we can rework the above equation of QTM to V= P + Y – M, allowing changes and directly affecting inflation, output, and money.
The relationship between money growth and inflation
In addition to the above, we can also divert our perception in determining the scope of money. If we use US data, we can easily discover that the accumulated “nominal output plus and stock market capitalization” is narrowly associated with the currency in circulation, which in turn supports one of the pivotal propositions by Milton Friedman. Thus, we can conclude that the monetary policy must keep a close watch on the money supply factor to foil the end-users and asset price inflation.
There is sufficient realistic data that supports the hypothesis that growth in the money supply will affect the end consumer and the price of products and goods.
Objectives and tools of the Fed’s monetary policy
Central banks governing the conduct of the economic policy of the central reserve bank in an environment, which is prone to low inflation, needs a close look. Controlling inflation and price is viewed as one of the pivotal questions facing central banks worldwide. By re-engineering and efficient regulatory framework, including transparency and freedom from socio-political influences, central banks worldwide have largely achieved their directive.