milton said:
With inflation- let's just say the govt was feeling jolly happy and decided to print heaps of money and give it to everyone. now there is much greater aggregrate demand and according to law of demand and supply- there is an increase in demand and extension of supply ie there will be greater price and greater quantity. now, neglecting the cost of the raw materials of ink and paper to print the money, we have just magically caused a greater supply of G&S to be available and greater GDP. how is this explained?
No thats false...
All that an increase in the money supply will do is lead to inflation.
The reason this happens is due to the following:
There is a simple equation known as the quantity theory of money which might help explain:
MV = PQ
Where
M = Money Supply (lets keep it simple and just say notes and coins)
V = Velocity of money (how many times each dollar gets used in a given period of time. For example I give you $1 for services, then you give another person that $1 for services, and they pass it on etc. So how many times this occurs is known as the velocity of money)
P = Average level of prices of goods sold (say you take every single good available on the market, and average its price - Kind of like a cpi)
Q = Total amount of goods solds sold
Now MV is equal to the total amount of notes and coins multipled by the total amount of times it gets used. By intuition you should be able to see that this would equal PQ which is the total monetary value of goods and services. So essentially the total monetary value of goods and services purchased must of course be equal to the money that was present to pay for it.
Now by your example we are increasing the money supply. With an increase in the money supply, MV becomes larger. Because this is an equation, therefore PQ must also become larger. But the question here is in order to offset the increase, does P become larger, or does Q become larger (or both?).
As someone pointed out before, Q (as in the total quantity of goods, or supply if you like) cannot really change (particularly in the short run). Assuming that we are at full capacity, we cannot simply put more goods and services into the economy.
So what happens is that P increases, and we have inflation.
What you are suggesting is that the money supply will create supply (i.e. M will actually increase Q and not P). Some keynesians would argue this is true. Perhaps below equilibrium this would happen, but where an economy is at equilibrium, then supply = demand and any change in the money supply would be inflationary.
Zimbabwe has the highest inflation in the world (over 1000%). Their central banker is a "Money Printer" which means their answer to the solution is to print more money. Obviously its failing them. Most economies pursue either a monetary targeting strategy where they pursue a steady growth in the money supply to keep Velovity constant (so change M in the MV part of the equation) in order to match PQ, whereby prices will remain constant and only output rises. Australia uses inflation targeting which is the same thing (in principle) except that we have an inflation target range of 2-3%. The advantage of an inflation target is that is a rule based policy (i.e. not discretionary). This means that there are very little inflationary expectations. It also allows central banks to categorically tackle issues such as consumer confidence. the US uses a monetary targetting strategy where theyve increased interest rates almost every month. Because we use inflation targeting we only change them every so often to keep us in the 2-3% range which is usually governed by consumer confidence.
