Controlling Inflation Is Simple We Simply Control The Money Supply

Word Count: 1986 |

“Controlling inflation is simple, we simply control the money supply”. What do you think of this opinion?

This opinion expresses the monetarist’s stance, emphasizing the power of the Central Bank policy to control the economy by preserving the stability of the financial markets. This, in effect means maintaining an equilibrium between the supply and demand for money. Money, when used as a technical economic term is defined as: the stock of assets readily available to make transactions. Currency held by people is the asset with the greatest ease of transaction, and it constitutes one measure of money (C). However, there are also a multitude of deposits and bonds that have varying degrees of liquidity. Therefore, there are three further measures of money M1, M2 and M3 which include deposits and bonds depending on what counts as ‘readily available’, for that context. The measure referred to in this discussion will be M1, which is currency plus demandable deposits.

This essay starts by explaining the model which forms the basis of the the monetarist’s opinion, which gives it some justification. However, empirical evidence showing disparity between inflation and money supply, hence reducing this view’s credibility. The essay identifies its two major flaws. Firstly, the failure to recognise variation in other factors which influence the supply of money and are beyond the Central Bank’s control, namely, the banks’ and consumers’ behaviour. Secondly, and perhaps more crucially, the assumption that demand for money remains constant is simply too great to be justified. Significant fluctuations in the demand for money do occur, and inflation is affected by both supply and demand of money. Hence, monetary policy does not have full power over inflation.

The monetarist’s point of view is the outcome of the quantity theory of money, a model showing the relationship between quantity of money, price of goods and income level. It starts off assuming a simple money demand function, where money demand is dependent upon level of income. The reasoning behind this assumption is that as people have more income, they will be consuming more. In this case, they will desire to hold more money to ease the high number of transactions they carry out.

(M/D)d = kY
Supply of money= M/P

Where M= quantity of money, and P= price level. For stability in the financial markets,

M/P= (M/D)d = kY

k is then substituted for 1/V. V is the velocity with with money is exchanged. Therefore if k was high (ie there was a high real income balance for every dollar of income) then a lower velocity is required for the same net spending in the economy. Therefore,


Y can be defined in terms of a production function. Therefore, the quantity theory assumes that V remains constant, and there is no growth in the factors of production and technology. When V and Y are not changing, then it follows that a 1% change in M (supply of money) will result in a 1% change in P (and a change in prices is by definition, inflation). It further assumes that the Central Bank has full control over the quantity of money (M), and hence we arrive at the statement posited in the title of the essay. An increase in the supply of money above the demand would result in a decrease in the value of the currency. An increase in the price, therefore, results in inflation.

Control of money supply does lie in the hands of the Central Bank to some extent, as it has the sole authority to print off currency. Theoretically, if it could always match money supply with money demand, then inflation could be controlled. This is true to some extent, as shown by three mechanisms of control of money supply used by the Central Bank. Firstly, it can purchase and sell bonds to the government, in what are known as open market operations, hence increasing or decreasing the quantity of money in the circulation. Secondly, it can place a requirement on banks to have a minimum reserve deposit rate. In other words, it places a limit on the amount of its deposits that a bank can loan out. Since the system of fractional reserve banking results in the multiplication of the quantity of money in the economy, placing a limit on the amount that governments can loan out would also limit the money multiplier. Finally, it can alter the discount rate at which it offers loans to banks. These loans enable the bank to loan out a greater part of its deposits while still fulfilling minimum reserve deposit rates. By making these loan rates more expensive, the Central Bank can encourage banks so keep a greater proportion of their deposits in reserves, again, reducing the multiplier effect.

If one looks at some empirical data, for example, the comparison of M2 growth, and inflation in the United States from 1970 to 2000 , it appears as though the relationship between inflation and money supply does hold in the long term. However, in the short term, there no longer remains a close correlation between the two variables. If the model of the quantity theory of money was true then there should be no reason for this discrepancy to exist. There are assumptions that have been made in coming to such a conclusion that distort the reality of the models’ outcomes. One such assumption is the complete control of the Central bank over money supply. A closer look at a model of money supply shows that it is affected by the behaviour of consumers and the banks, in addition the policies of the Central Bank.

To build the model, some definitions must firstly be clarified:
The monetary base, (B) is the total number of pounds held in reserves (R) and as currency by individuals (C).
The money supply (M) is the sum of (C) and demand deposits (D).
Reserve –deposit ratio (rr) is the fraction of deposits that banks hold in reserve.
Currency- deposit ratio (cr) is the fraction of demand deposits that people hold as currency.

If the monetary base, and money supply are divided by each other, and the formula are rearranged, you end up with the formula:
M= (cr+1/ cr+rr) B

Therefore, it is in fact B, the monetary based that the Central Bank has full control on. But cr and rr are not fully in the Bank’s control. Although the Central Bank places a minimum rr, and can encourage or discourage banks to take loans at discounted rates, it is powerless to stop banks from deciding to hold extra reserves, or refrain from taking loans. Beyond placing a limit, the Central Bank cannot control the business policies of banks. This in turn affects the money multiplier (cr+1/ cr+rr) and hence the quantity M. Furthermore, the cr could be highly variable and unpredictable, in contrast to what the original quantity theory of money assumes. For example, financial innovations and new facilities making it easier for people to withdraw and access their money will result in a lower ratio. A simple example is the use of the credit card, where people prefer to keep that money in a bank instead of as currency, but don’t lost ease of transaction. Given constant developments, it is difficult to predict the aggregate effect of many individual cr changes on M. Hence, it is possible that money supply can fluctuate outside the central bank’s control and therefore it is not a ‘simple’ matter to control it, and therefore control inflation.

Even if we grant however, that the Central Bank has considerable, if not complete control on money supply, it still does not allow it to control inflation. The key reason is that inflation depends on the relationship between the supply and demand of money. According to Blanchard, the unpredictable fluctuations in the demand for money in the short run are the key reason for the lack of correlation between money supply and inflation. The simple model of money demand as a function of interest and income, does not explain these fluctuations. However, Baumol Tobin model, which emphasizes money as a medium of exchange is more realistic, because it also takes into the account the cost incurred from extracting currency from the bank. The less currency one holds, the more often this cost will be incurred. Therefore, the optimum amount of money that an individual keeps is when the costs of going to extract the money from their account is equal to the benefits of keeping that sum in the bank to gain interest.

By keeping the money in the bank one gains: iY/2N
where N represents the number of times one goes to the bank.
(in words, one gains the interest on the proportion of the income that you would have withdrawn from the bank)
So if the costs from going to the bank are F, and this is equated to the benefit, it results in the following formula:

N = (iY/2F)1/2
Instead of defining N simply as demand for currency, this model can be extended to the demand for monetary assets over non monetary assets, where i is the difference in gain between the two assets, and F is the cost of transferring money from the non monetary to monetary asset.

The reason why this model is helpful is that it is immediately clear that in the short term F is higher variable. For example, a rise in real wages will increase F, because a person’s wage represents the opportunity cost of the time that an individual spends on getting money from the bank, or organising the transfer between the two types of assets. Alternately, the rise of internet banking makes transfers between monetary and non monetary funds much easier, reducing F. So, for a particular individual, their demand for money might change due to them installing broadband, because they their access to their accounts was suddenly improved! When an individuals’ demand for money is modelled on such microeconomic terms, then it is immediately clear why it can fluctuate unpredictably.

Furthermore, and most importantly, the whole concept and measurement of money demand depends on the traditional macroeconomic assumption on a clear distinction between non monetary and monetary assets. The former consist of assets which are both a store of value and a medium of exchange (eg, a checkable deposit), whereas the second category are assets that are simply stores of values (eg, a fixed term bond). However, recent financial innovations have resulted in a vast variety of deposits that have the benefits of long term deposits, but can also be accessed on short notice, blurring the distinction between these two categories. Non monetary assets that have acquired some of the liquidity of money, making them attractive substitutes for money. The ease of switching from one to the other has drastically reduced F, the costs of transferring, and therefore the distinctions between the various measures of money supply have been distorted. It poses difficulties for matching the supply of money to demand when in fact it is not clear at what level it would be optimal to measure demand!

In conclusion, the quantity theory of the money is indeed valuable in describing a direct relationship between the quantity of money in the economy and inflation. However, it is also obvious that inflation depends on both supply and demand of money. It would indeed by easy to control inflation by controlling the supply of money to match its demand, and this is seen generally in the long run. However, it is not possible to match the supply of money to short term fluctuations in demand which arise from the increasing liquidity of non-monetary assets, and changing transferring costs of non monetary to monetary assets. Moreover, the Central Bank does not have complete control over money supply, because it can only influence the decisions of banks and individuals to a certain extent. How much banks decide to keep in reserves and how much of their incomes individuals decide to keep as currency are other highly variable factors which result in the short term discrepancy between inflation and money supply.

You May Also Find These Documents Helpful

Allegory Of American Pie By Don Mc Lean

Ask anyone what was the defining moment in the rock history of the 1960s was and all you will get is a one word answer: Woodstock. The three day rock festival that defined an era was only one of many music festivals of the '60s. But Woodstock has come to symbolize, "an era of peaceful, free- loving, drug- taking hippie youth, carefree before harsher realities hit..." (Layman 40). The Woodstock festival ended a century filled with many metamorphoses of rock'n'roll, from the era of pop music to the rebirth of folk music to the invention of acid rock. But some cynics say that rock'n'roll died with the death of Buddy Holly before the 60s even began. One such person is Don McLean. The poet behind the haunting epic song about the death of 'danceable' music, McLean wrote the ever popular song, "American Pie" (appendix 1). The most important song in rock'n'roll history, "American Pie", is the song about the demise of rock'n'roll after Buddy Holly's death and the heathenism of rock that resulted. Although McLean himself won't reveal any symbolism in his songs, "American Pie" is one of the most analyzed pieces of literature in modern society. Although not all of its secrets have been revealed, many "scholars" of the sixties will agree that the mystery of this song is one of the reasons it has become so successful- everyone wants to know the meanings of its allegories. Proof of "American Pie's" truth lies in the allegory of the song. Many People enjoy the song but have no idea what it means- Who is the Jester? What is the levee? When the deeper story is found, the importance of the song is unearthed. "American Pie" is not only a song, it is an epic poem about the course of rock'n'roll...

Carl Orffs Philosophies In Music Education

While Carl Orff is a very seminal composer of the 20th century, his greatest success and influence has been in the field of Music Education. Born on July 10th in Munich, Germany in 1895, Orff refused to speak about his past almost as if he were ashamed of it. What we do know, however, is that Orff came from a Bavarian family who was very active in the German military. His father's regiment band would often play through some of the young Orff's first attempts at composing. Although Orff was adamant about the secrecy of his past, Moser's Musik Lexicon says that he studied in the Munich Academy of Music until 1914. Orff then served in the military in the first world war. After the war, he held various positions in the Mannheim and Darmstadt opera houses then returned home to Munich to further study music. In 1925, and for the rest of his life, Orff was the head of a department and co-founder of the Guenther School for gymnastics, music, and dance in Munich where he worked with musical beginners. This is where he developed his Music Education theories. In 1937, Orff's Carmina Burana premiered in Frankfurt, Germany. Needless to say, it was a great success. With the success of Carmina Burana, Orff orphaned all of his previous works except for Catulli Carmina and the En trata which were rewritten to be acceptable by Orff. One of Orff's most admired composers was Monteverdi. In fact, much of Orff's work was based on ancient material. Orff said: I am often asked why I nearly always select old material, fairy tales and legends for my stage works. I do not look upon them as old, but rather as valid material. The time element disappears, and only the spiritual power remains. My...

Johann Sebastian Bach Biography

Throughout the history of music, many great composers, theorists, and instrumentalists have left indelible marks and influences that people today look back on to admire and aspire to. No exception to this idiom is Johann Sebastian Bach, whose impact on music was unforgettable to say the least. People today look back to his writings and works to both learn and admire. He truly can be considered a music history great. Bach, who came from a family of over 53 musicians, was nothing short of a virtuosic instrumentalist as well as a masterful composer. Born in Eisenach, Germany, on March 21, 1685, he was the son of a masterful violinist, Johann Ambrosius Bach, who taught his son the basic skills for string playing. Along with this string playing, Bach began to play the organ which is the instrument he would later on be noted for in history. His instruction on the organ came from the player at Eisenach's most important church. He instructed the young boy rather rigorously until his skills surpassed anyone?s expectations for someone of such a young age. Bach suffered early trauma when his parents died in 1695. He went to go live with his older brother, Johann Christoph, who also was a professional organist at Ohrdruf. He continued his younger brother's education on that instrument, as well as introducing him to the harpsichord. The rigorous training on these instruments combined with Bach?s masterful skill paid off for him at an early age. After several years of studying with his older brother, he received a scholarship to study in Luneberg, Germany, which is located on the northern tip of the country. As a result, he left his brother?s tutelage and went to go and study there. The teenage years brought Bach to several parts of Germany where he...


Michelangelo was pessimistic in his poetry and an optimist in his artwork. Michelangelo?s artwork consisted of paintings and sculptures that showed humanity in it?s natural state. Michelangelo?s poetry was pessimistic in his response to Strazzi even though he was complementing him. Michelangelo?s sculpture brought out his optimism. Michelangelo was optimistic in completing The Tomb of Pope Julius II and persevered through it?s many revisions trying to complete his vision. Sculpture was Michelangelo?s main goal and the love of his life. Since his art portrayed both optimism and pessimism, Michelangelo was in touch with his positive and negative sides, showing that he had a great and stable personality. Michelangelo?s artwork consisted of paintings and sculptures that showed humanity in it?s natural state. Michelangelo Buonarroti was called to Rome in 1505 by Pope Julius II to create for him a monumental tomb. We have no clear sense of what the tomb was to look like, since over the years it went through at least five conceptual revisions. The tomb was to have three levels; the bottom level was to have sculpted figures representing Victory and bond slaves. The second level was to have statues of Moses and Saint Paul as well as symbolic figures of the active and contemplative life- representative of the human striving for, and reception of, knowledge. The third level, it is assumed, was to have an effigy of the deceased pope. The tomb of Pope Julius II was never finished. What was finished of the tomb represents a twenty-year span of frustrating delays and revised schemes. Michelangelo had hardly begun work on the pope?s tomb when Julius commanded him to fresco the ceiling of the Sistine Chapel to complete the work done in the previous century under Sixtus IV. The overall organization consists of four large triangles at...

Oscar Wilde

Oscar Fingal O'Flahertie Wills Wilde was born in Dublin Ireland on October 16, 1854. He is one of the most talented and most controversial writers of his time. He was well known for his wit, flamboyance, and creative genius and with his little dramatic training showing his natural talent for stage and theatre. He is termed a martyr by some and may be the first true self-publicist and was known for his style of dress and odd behavior. Wilde, 1882 His Father, William Wilde, was a highly accredited doctor and his mother, Jane Francesca Elgee, was a writer of revolutionary poems. Oscar had a brother William Charles Kingsbury along with his father's three illegitimate children, Henry, Emily, and Mary. His sister, Isola Emily Francesca died in 1867 at only ten years of age from a sudden fever, greatly affecting Oscar and his family. He kept a lock of her hair in an envelope and later wrote the poem 'Requiescat' in her memory. Oscar and his brother William both attended the Protora Royal School at Enniskillen. He had little in common with the other children. He disliked games and took more interest in flowers and sunsets. He was extremely passionate about anything that had to do with ancient Greece and with Classics. Wilde during school years In 1871, he was awarded a Royal School Scholarship to Trinity College in Dublin and received many awards and earned the highest honor the college offered to an undergraduate, the Foundation Scholarship. In 1874, he also won the College's Berkley Gold Medal for Greek and was awarded a Demyship to Magdalen College, Oxford. After graduating from Oxford, Oscar moved to London with his friend Frank Miles, a well-known portrait painter of the time. In 1878 his poem Ravenna was published, for which he won the...

The History Of Greek Theater

Theater and drama in Ancient Greece took form in about 5th century BCE, with the Sopocles, the great writer of tragedy. In his plays and those of the same genre, heroes and the ideals of life were depicted and glorified. It was believed that man should live for honor and fame, his action was courageous and glorious and his life would climax in a great and noble death. Originally, the hero's recognition was created by selfish behaviors and little thought of service to others. As the Greeks grew toward city-states and colonization, it became the destiny and ambition of the hero to gain honor by serving his city. The second major characteristic of the early Greek world was the supernatural. The two worlds were not separate, as the gods lived in the same world as the men, and they interfered in the men's lives as they chose to. It was the gods who sent suffering and evil to men. In the plays of Sophocles, the gods brought about the hero's downfall because of a tragic flaw in the character of the hero. In Greek tragedy, suffering brought knowledge of worldly matters and of the individual. Aristotle attempted to explain how an audience could observe tragic events and still have a pleasurable experience. Aristotle, by searching the works of writers of Greek tragedy, Aeschulus, Euripides and Sophocles (whose Oedipus Rex he considered the finest of all Greek tragedies), arrived at his definition of tragedy. This explanation has a profound influence for more than twenty centuries on those writing tragedies, most significantly Shakespeare. Aristotle's analysis of tragedy began with a description of the effect such a work had on the audience as a "catharsis" or purging of the emotions. He decided that catharsis was the purging of two specific emotions, pity and...

Scholarship Essay About Goals

Ever since I was a young kid I have always been interested with aircraft. I was so curious of how airplane's fly. I remember taking my toys apart to see how it works. As a kid I wanted to go to the airport to watch the airplanes land and fly and pondered how this happens. Other kids wanted to go to the amusement places. As I grew older I became more and more interested in aircraft and the technology behind it. I always involved myself with aviation early on. I read books and magazines on aviation, took museum tours, built model airplanes. When I was younger my father would take me to aircraft repair facilities where I would watch in great fascination. In my teens, went up to the military bases and befriended many soldiers involved with aircraft and asked them numerous questions. I got to meet many aeronautics engineers and borrowed their old textbooks and read them till the wee hours of the morning. As technology improved with information superhighway, I logged on the web. Stayed up for hours and hours searching through web pages and web pages of information about aircraft and technology. I started my elementary school in the Philippines, then we moved to U.S. and continued my high school education and graduated. Enrolled at the CCSF to pursue my college education and now I am in the 2nd year in CCSF taking aeronautics. My goal now is to obtain my AS degree from the City College of San Francisco (CCSF) so I can transfer to a University and get a Bachelors degree and to continue for my Masters degree in Aeronautics Engineering. I will strive hard to reach the peak level of my career which is a Professor and hopefully to be an aeronautic professor so...

Circus Circus Enterprises Case Studies

Executive Summary: Circus Circus Enterprises is a leader and will continue to be in the gaming industry. In recent years, they have seen a decline in profit and revenue; management tends to blame the decrease on continuing disruptions from remodeling, expansion, and increased competition. Consequently, Circus has reported decreases in its net income for 1997 and 1998 and management believes this trend will continue as competition heightens. Currently the company is involved in several joint ventures, its brand of casino entertainment has traditionally catered to the low rollers and family vacationers through its theme park. Circus should continue to expand its existing operations into new market segments. This shift will allow them to attract the up scale gambler. Overview Circus Circus Enterprises, Inc founded in 1974 is in the business of entertainment, with its core strength in casino gambling. The company?s asset base, operating cash flow, profit margin, multiple markets and customers, rank it as one of the gaming industry leaders. Partners William G. Bennett an aggressive cost cutter and William N. Pennington purchased Circus Circus in 1974 as a small and unprofitable casino. It went public in 1983, from 1993 to 1997; the average return on capital invested was 16.5%. Circus Circus operates several properties in Las Vegas, Reno, Laughlin, and one in Mississippi, as well as 50% ownership in three other casinos and a theme park. On January 31,1998 Circus reported net income of 89.9 million and revenues of 1.35 billion, this is a down from 100 million on 1.3 billion in 1997. Management sees this decline in revenue due to the rapid and extensive expansion and the increased competition that Circus is facing. Well established in the casino gaming industry the corporation has its focus in the entertainment business and has particularly a popular theme resort concept....

Effect Of Civil War On American Economy

The Economies of the North and South, 1861-1865 In 1861, a great war in American history began. It was a civil war between the north and south that was by no means civil. This war would have great repercussions upon the economy of this country and the states within it. The American Civil War began with secession, creating a divided union of sorts, and sparked an incredibly cataclysmic four years. Although the actual war began with secession, this was not the only driving force. The economy of the Southern states, the Confederacy, greatly if not entirely depended on the institution of slavery. The Confederacy was heavily reliant on agriculture, and they used the profits made from the sale of such raw materials to purchase finished goods to use and enjoy. Their major export was cotton, which thrived on the warm river deltas and could easily be shipped to major ocean ports from towns on the Mississippi and numerous river cities. Slavery was a key part of this, as slaves were the ones who harvested and planted the cotton. Being such an enormous unpaid work force, the profits made were extraordinarily high and the price for the unfinished goods drastically low in comparison; especially since he invention of the cotton gin in 1793 which made the work all that much easier and quicker. In contrast, the economical structure of the Northern states, the Union, was vastly dependent on industry. Slavery did not exist in most of the Union, as there was no demand for it due to the type of industrial development taking place. As the Union had a paid work force, the profits made were lower and the cost of the finished manufactured item higher. In turn, the Union used the profits and purchased raw materials to use. This cycle...

Evaluation Of The Effectiveness Of Trade Embargoes

Although I am a strong critic of the use and effectiveness of economic sanctions, such as trade embargoes, for the sake of this assignment, I will present both their theoretical advantages and their disadvantages based upon my research. Trade embargoes and blockades have traditionally been used to entice nations to alter their behavior or to punish them for certain behavior. The intentions behind these policies are generally noble, at least on the surface. However, these policies can have side effects. For example, FDR's blockade of raw materials against the Japanese in Manchuria in the 1930s arguably led to the bombing of Pearl Harbor, which resulted in U.S. involvement in World War II. The decades-long embargo against Cuba not only did not lead to the topple of the communist regime there, but may have strengthened Castro's hold on the island and has created animosity toward the United States in Latin America and much suffering by the people of Cuba. Various studies have concluded that embargoes and other economic sanctions generally have not been effective from a utilitarian or policy perspective, yet these policies continue. Evaluation of the effectiveness of Trade Embargoes Strengths Trade embargoes and other sanctions can give the sender government the appearance of taking strong measures in response to a given situation without resorting to violence. Sanctions can be imposed in conjunction with other measures to achieve conflict prevention and mitigation goals. Sanctions may be ineffective: goals may be too elusive, the means too gentle, or cooperation from other countries insufficient. It is usually difficult to determine whether embargoes were an effective deterrent against future misdeeds: embargoes may contribute to a successful outcome, but can rarely achieve ambitious objectives alone. Some regimes are highly resistant to external pressures to reform. At the same time, trade sanctions may narrow the...