Relationship between money supply and the inflation Essay

Relationship between money supply and the inflation - Essay Example However, when the government securities are purchased from the market, central bank actually inject money into the market thus increasing the money supply in the economy. (Mankiw, 2008) Another important method through which money supply can be controlled in the economy is the adjustment in the discount rate. Discount rate is the interest rate at which central bank lends to other banks and is also serves as the primary rate in any economy. When discount rate is increased, central bank therefore invariably makes it difficult for the households and firms to obtain the obtain money at relatively cheaper rates thus making borrowing costly. A decrease in the discount rates otherwise because by reducing the rate, central bank makes it easier for the firms and the households to borrow money easily. (Sloman, & Garratt.2010). Inflation and money supply Inflation is an increase in the general price level in the economy and signifies a reduction in the purchasing power of the money. Normally in flation is measured through a consumer price index where the prices of a fixed basket of goods and services are compared with the prices of the same basket of goods and services at a give base year. An increase in the prices as compared to the base year therefore is considered as an increase in the inflation and hence erosion in the purchasing power of money. A decrease in the purchasing power would mean money would buy fewer things. (Krugman & Wells, 2009) According to the classical economics, an increase in the money supply actually does not result into an equal increase in the aggregate demand for goods and services. As such any change in the money supply will... This paper outlines the relationship between aggregate money supply and the growth of the real GDP and overall level of prices in the economy. One of the central debates in monetary economics rests upon the neutrality of money and whether money can actually result into the development of price increase or not. This debate is also based on the notion that the central bank of a country actually does not have any role in contributing towards the economic growth because money actually remains neutral and does not result into the growth. Moreover, it is argued that the higher money supply can result into higher prices and thus if money supply is increased, it will create inflation in the economy and will hurt the real economic growth. This is because of the fact that higher inflation level decreases the purchasing power of money quickly. In order to achieve objectives of the economic growth and price stability, central bank adapts different tools and techniques which help it to control the money supply in the economy. One of the most commonly used methods is the open market operations under which central bank actually purchases or sells the government securities in the market. Another important method through which money supply can be controlled in the economy is the adjustment in the discount rate. According to the classical economics, an increase in the money supply actually does not result into an equal increase in the aggregate demand for goods and services. Classical economists also argue in such situation an increase in the money supply would result into inflation. At the full equilibrium level, a positive change in the money supply would result into inflation and the negative growth rates.