Inflation refers to a sustained rise in the prices of goods and services. When inflation occurs, the buying value of a currency unit erodes, meaning that a person needs more money to buy the same product. Most economists suggest there is a direct relationship between the amount of money in an economy, known as the money supply, and inflation levels. Understanding the relationship between money supply and inflation is far from easy or predictable, since inflation can easily be influenced by other factors as well.
Money supply and inflation are linked because a high quantity of money usually devalues demand for money. Imagine if everyone in a small town got a $50 US Dollars (USD) raise in salary per month. These people may have been paying $10 USD a week for gasoline, but since their raise was substantial, would now probably not mind paying $11 USD a week for gas, because it is still proportionally less than what they were paying before the raise. This is sometimes how the relationship between inflation and money supply begins, when the market can bear higher prices because money supply has gone up, yet a consumer can't buy a product for the price it was before inflation occurred because the buying power of the currency has eroded.
The relationship between money supply and inflation is explained differently depending on the type of economic theory used. In the quantity of money theory, also called monetarism, the relationship is expressed as MV=PT, or Money Supply x Money Velocity=Price Level x Transactions. The Velocity and Transactions are considered to be constants, so according to this explanation supply and prices have a direct relationship. In Keynesian theory, while there is still a relationship between money supply and inflation, it is not the only large factor that can affect inflation and prices. Generally, the Keynesian theory stresses the relationship between total or aggregate demand and inflationary changes.
Changes in money supply are often used to try and control inflationary conditions. When a region is trying to lower inflation, central banks will generally lower lending rates and increase interest. When inflation drops below a target level, these standards are generally relaxed in an attempt to stimulate the economy. Usually, countries use a federal banking system to set lending and interest limits based on economic data.
Unreserved money supply increases can sometimes lead to a condition called hyperinflation. This occurs when inflation jumps extremely high in a short period of time, though the exact definitions are somewhat variable. Economists often say hyperinflation occurs when inflation jumps 50% in a month, but other estimates are also used. Money supply and hyperinflation are linked because the condition can result from a sudden, massive pouring of money into an economy with no associated rise in production or availability of goods. If, in the first example, the townspeople got a raise of $500 USD a month, then the price of gas could suddenly multiply by many times, causing an extraordinarily high level of inflation.
