Monetary inflation is a sustained increase in the money supply of a country (or currency area). Depending on many factors, especially public expectations, the fundamental state and development of the economy, and the transmission mechanism, it is likely to result in price inflation, which is usually just called "inflation", which is a rise in the general level of prices of goods and services.
There is general agreement among economists that there is a causal relationship between monetary inflation and price inflation. But there is neither a common view about the theoretical exact mechanisms and relationships, nor about how to measure it exactly in reality. This relationship is also constantly changing, within a larger complex economic system. So there is a great deal of debate on the issues involved, such as how to measure the monetary base and price inflation, how to measure the effect of public expectations, how to judge the effect of financial innovations on the transmission mechanisms, and how much factors like the velocity of money affect the relationship. Thus there are different views on what could be the best targets and tools in monetary policy.
However, there is a general consensus on the importance and responsibility of central banks and monetary authorities in setting public expectations of price inflation and in trying to control it.
- Keynesian economists believe the central bank can sufficiently assess the detailed economic variables and circumstances in real time in order to control monetary policy in detail. These economists favor monetary policies that attempt to even out the ups and downs of business cycles and economic shocks in a precise fashion.
- Followers of the monetarist school think that Keynesian style monetary policies produce a lot of overshooting, time-lag errors and other unwanted effects, sometimes making things even worse. They doubt the central bank's capacity to analyse economic problems in real time and its ability to influence the economy with correct timing and the right monetary policy measures. So monetarists advocate less intrusive and complex monetary policies, like inflation targeting or a constant growth rate of money supply.
The monetarist explanation of inflation operates through the Quantity Theory of Money, 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 the 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 money on the foreign exchange market thus applying downward pressure on the exchange rate. This may cause imported inflation.