Monetary inflation
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Monetary inflation is the term used by some economists of the monetarist tradition and Austrian economists, to differentiate direct inflation in the money supply (or debasement of the means of exchange) from price inflation which they view as a result or necessary outcome of the former. Originally "inflation" was used to refer simply to monetary inflation, whereas in present usage it often refers to price inflation.[1]
The description of the actual mechanism and relationship between price inflation and monetary inflation varies according to each school, but there is overall agreement among them that there is a cause and effect relationship between supply and demand of money and prices of goods and services measured in monetary terms. Although the system is complex and there is a great deal of argument on how to measure the monetary base or how much factors like the velocity of money affect the relationship, and even more disagreement on what is the best monetary policy, there is a general consensus on the importance and responsibility of central banks and monetary authorities in affecting inflation.
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[edit] Quantity theory
The monetarist explanation of inflation operates through the Quantity Theory of Money, MV = PT where M is Money Supply, V is Velocity of Circulation, P is Price level and T is Transactions or Output. As monetarists assume that V and T are determined, in the long run, by real variables, such as the productive capacity of the economy, 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. Also, the increase in the demand for labour resulting from higher demands for goods and services will cause a rise in money wages and unit labour costs. 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.
[edit] The role of the Central Bank and Fractional Reserve Banking
The Austrian School defines inflation simply as an increase of the money supply and argues that inflation, so defined, always and everywhere leads to a higher nominal price level, as the real value of each monetary unit is eroded, loses purchasing power and thus buys fewer assets and goods and services.
Given that all major economies currently have a central bank supporting the private banking system, almost all new money is supplied into the economy by way of bank-created credit (or debt). Austrian economists believe that this bank-created credit growth (which forms the bulk of the money supply) sets off and creates volatile business cycles (see Austrian Business Cycle Theory) and maintain that this "wave-like" or "boomerang" effect on economic activity is one of the most damaging effects of monetary inflation.
Austrian economists therefore regard the state-sponsored central bank as the main cause of monetary inflation, because it is the institution charged with the creation of new currency units, referred to as bank credit. When newly created bank credit is injected into the fractional-reserve banking system, the credit expands, thus enhancing the inflationary effect.[2]
An alternative view focuses on the role of monetary inflation as a source of government finance. Increasing the money supply is one of the three means by which it can fund its activities, the other two being taxing and borrowing.[3] Therefore, the actual cause of inflation is government's need to create new money.[4]
