Title: Inflation: A Supply Side Analysis

Authors: Saurav Kalita, Mohbubur Rohman.

Institution: Assam University, Silchar, Assam.

Corresponding Author: Saurav Kalita, Email-

myself.saurav.kalita@gmail.com, Phone No: +91-8402811478

Address: Vill: Irongmara, Pin No-788011, Dist: Cacher, State: Assam

Abstract:

Inflation, a phenomenon which is associated with the rise in price level

due to increase supply of money unaccompanied by demand for money.
It is a situation which is familiar to everyone irrespective of their area of
specialization. But from an economic point of view, it has deeper effect
than what is seen in market. Our main objective in this paper is to show
its deeper effect on demand for money. How an initial rise in money
supply can cause the decline in demand for money in total is our matter
of concern in this paper. For this purpose, we have reviewed the most
basic quantity theories of money starting from classicalist to post-
Keynesian and we have interlinked the different versions of these theories
to find the cause effect relationship between them. The cause was inflation
which we found in Fisher’s theory due to exogenous rise in money supply
and effects were found in the following theories to establish our position
of an inverse relationship between money supply and demand for money.

Keywords: Inflation; Quantity theory of money; Cambridge equations;

Demand for money

Introduction:

Inflation, a general concept which is very familiar within almost all

spectrum of people regardless their area of specialization. From
economics to physics, from physics to literature, everyone is familiar with
the term inflation. A simple definition of inflation is to merely rise in price
level in the economy. Products become costlier, services become more
expensive, a simple thoughts regarding inflation. But, from an economist
point of view it is much more than a mere rise in price level. In a more
economic terminology we can define inflation as a change in the value of
money or the purchasing power of money. If we go by the Crowther
(1941) words “The value of anything depends on the relationship between
the demand for it and the supply available. Money is an expectation only
in that changes in its value do not show themselves in fluctuations of any
one price but of all prices together. An increase in the demand for money,
unaccompanied by any increase in the supply of money, will lead to an
enhancement of its value-that is, to fall in the general price level.
Similarly, an increase in the supply of money, without an increase in the
demand for it, will lead to a fall in its value, that is a rise in the general
price level”. So, if we summarize his words we can simply say that
inflation is a situation which arises due to the more money in existence
than demanded. In our paper we will try to explain mostly the supply side
influence of money which resulted inflation in the economy and how it is
related with the demand side aspect of money. We believe on the words
of Hoover, 2001, who argued that the issue of causality in
macroeconomics has been debated extensively and part of that debate has
attained philosophical undertone. The cause and result of the quantity
theory of money has been debated and researched mostly by two school
of economics one is led by University of Chicago, prominently following
the path of Milton Friedman and the other by Keynes mostly known as
Keynesian comprising economist from Harvard University, Cambridge,
Massachusetts and Cambridge University, Cambridge, the United
Kingdom. We will follow their path to show our objective that an
increase in inflation level is inversely related to demand for money or the
people preference to hold money in this paper. We will do the same cause
and effect relationship by reviewing the most basic quantity theories of
money starting from classical to monetarist views. We will try to show
how an initial rise in price level can influence different motives of people
to hold money through the different derivations done by these economists.
We have not cross checked our conclusion by any empirical evidence but
we believe that there is a huge scope of empirical analysis to prove our
model which is beyond the scope of this paper. We welcome research and
extensive analysis to prove the inverse relationship between inflation and
demand for money or people preference to hold money.

The Model:

Dated back to 1911, the famous book which gave a new intuition on the
present theory of inflation “The Purchasing Power of Money” by
American Economist Fisher with a famous equation

MV=PT

Where M is the amount of money supply, V is the velocity during the

same period, P is the price level and T is the volume of trade during the
said period in case of T we can use Q as real GDP.

This is the basic equation of equilibrium which is demand for money is

equal to the supply of money. Here, MV which is the demand for money
and PT which is the supply of money. The demand for money in this sense
replicates the expenditure of the economy and supply of money replicates
the revenue or sell of the economy. Fisher, in his theory assume ceteris
paribus, V and T are constant in the long run. So, if V and T are constant
then any rise in money supply will be proportionate to the rise in price
level. There was a unitary elasticity between money supply and price
level. So, it is simple rise in money supply will rise general price level
which resulted inflation. Several reasons may be attributed for the rise in
money supply but these are exogenous reason and the money supply is
controlled by the Reserve Bank. We will not go deeper in to the analysis
of rising money supply in to the economy. But, from the Fisherman
perspective it is clear that rise in money supply will cause proportionate
increase in general price level and resulting inflation since V and T are
assumed to be constant. Now if we look to the Cambridge Version of
quantity theory which is basically attributed to Marshall, Pigou,
Robertson and Keynes, can be reflected properly by the words of
Marshall, “In every state of society there is some fraction of their income
which people find it worthwhile to keep in the form of currency; it may
be a fifth, or a tenth, or a twentieth. A large command of resources in the
form of currency renders their business easy and smooth, and puts them
at an advantage in bargaining, but on the other hand it locks up in a barren
form resources, say, in extra furniture; or a money income if invested, in
extra machinery or cattle”. Thus the Cambridge economist held the view
that people would like to have a certain fraction of their real income in the
form of ready cash to meet their day to day transactions and for providing
security with certainty. Here, the views of Fisher and Cambridge differs.
Fisher assumed money only as a medium of exchange. It had no role to
play other than that. Thus, the neutrality aspect of money reflected from
the Fisherian view, while Cambridge viewed money as an asset or store
of value. In Cambridge view, the demand for money comprised of
transaction motive and precautionary motive. They had attempted to show
the relationship between demand for money and supply of money by
formulating cash balance equations known as Cambridge equations.

The Marshallian cash balance equation is expressed as

M=kY

Where, M indicates total money supply, Y stands for aggregate real

income and k stands for fraction of real income held by the people as ready
cash. Prof. Pigou further developed this equation by adding the concept
of purchasing power of money or value of money, which he denoted by
P. The purchasing power of money means the degree of command money
can have on goods and services. It is inversely related with the price level
and supply of money. Actually there is a rectangular hyperbolic
relationship between money supply and purchasing power of money. The
simplest form of Pigou’s equation is as follows

P=kR/M

Where, P represents the purchasing power of money, R represents the

aggregate real income, k represents the fraction of money people held as
ready cash and M represents money stock or supply of money. In
equilibrium demand for money is equal to the supply of money.

From the above equation it is clear that P or the purchasing power of

money is directly related to k or holding of money and indirectly to price
level and money supply. This indicates that an increase in money supply
will lead to fall in people demand for money for transaction and
precautionary motives. But this relationship is not proportional. Sometime
the degree of elasticity greater than one and sometime it is less than one
depends on the behavior of the person concerned. Robertson version also
tell the same story but with a different flavor. His equation is

P=M/kT

Where, P is now price level, M is supply of money, T is the annual volume

of trade as Fisher assumed and k is the proportion of income people held
with them as ready cash.

If we go to the Keynesian, version of liquidity preference then we find

that Keynes has just extended the Cambridge version and included
speculative motive as an addition for people’s demand to hold money.
Keynes talked about three motives of holding money—

Transaction motive, Precautionary motive and Speculative motive. The

first two motives are positively related to income but the last one is
negatively with interest rate. Here he incorporated the term “bond” for
people wish to have money in speculative purpose. A rise in interest rate
will reduce the bond price so people will desire less money to have for
this purpose and vice versa.

Now we want to go forward and discussed about post-Keynesian view in

the theory of demand for money with an aim to support our model to show
an inverse relationship between inflation or rise in price level with
demand for money in total.

We want to focus on the Baumol-Tobin approach wich is also known as

the “Inventory Theoretic Approach” where Baumol held the view that it
is not only Speculative demand which has an inverse relationship with
rate of interest but also the transaction motive. His theory is related with
the opportunity cost of holding money in the form of cash for day to day
transaction purposes. If an individual holds money in the form of idle cash
for meeting out day to day transaction then he forgoes the income he
would have to earn if he stashed them in bank or in other forms like
treasury bills, bonds etc. But there is also cost of keeping money in other
forms except than the ready cash. Because in the meantime he has to
convert those non ready form of cash in the form of ready cash which
involves certain amount of transaction cost. So the main argument of
Baumol is to combine his optimum portfolio of cash and bonds subject to
the minimum total cost. For this purpose, in his theory he minimizes the
total cost and gave his equation in the form of

𝑀 𝑏𝑌
=√
2 2𝑖

Here, M is the demand for money for transaction motive, Y is the total
income, b is the fixed rate of transaction cost and I is the rate of interest.
This formula is also known as “square root rule”. Here, he argued that
income elasticity of transaction demand for money is less than
proportionate, i.e., ½, if income increases by 1 percent, transaction
demand for money increase by ½ percent, similarly less than
proportionate relationship between interest elasticity of money demand,
i.e., -1/2, if interest rate increases by 1 percent, demand for money
decreases by ½ percent. Thus Baumol refuted Keynesian view and
postulated his argument of inverse relationship between interest rate and
transaction motive for the demand for money. Thus, we can see an inverse
relationship between interest rate and transaction demand for money.
Now going back to Fisher equation which held the view of a propionate
positive relationship between price level and supply of money means an
increase in the supply of money will lead to proportionate rise in the price
level. And again the Cambridge version which postulated an inverse
relationship between k and price level, means a rise in money supply
which leads to rise in price level leads to fall in k which comprises
transaction and precautionary motives. Now return to the square root
formula says that transaction motive is inversely related with the interest
rate. Therefore, fall in k or transaction motive to hold money leads to rise
in interest rate by less than proportionate. And as Keynes in his liquidity
preference held the view of an inverse relationship between interest rate
and speculative demand for money, shows rise in interest rate which is
due to transaction motive as discussed earlier in Inventory Theoretic
Approach will lead to the fall in speculative demand for money. So total
demand for money which is the combination of all three motives for
demand for money will decline as a rise in price level or inflation. It is a
cause and effect relationship through different version of quantity theory
of money. The cause was due to the exogenous rise in money supply
which resulted increase in price level means inflation and effect can be
traced out by different version of the theories given by noted economist
and ultimately fall in total demand for money. But this relationship is not
proportionate. We have termed it supply side analysis because we have
shown by reviewing different versions of the quantity theories of money
how inflation due to increase in money supply can ultimately fall demand
for money.

Conclusion:

In this paper we have tried to give our intuition of an inverse relationship

between inflation and demand for money in total through the supply side
analysis by reviewing the basic theories of quantity of money. We have
interlinked the Fisher theories with Cambridge version and Keynes along
with the post-Keynesian version of the quantity theory to derive our result.
We believe that it is not a theory in new but something to derive from the
old ones which was lying hid in different aspect of quantity theories. We
first analyzed the Fisherian version of quantity theory to show the basic
form of inflation then we went through the Cambridge version to show its
effect on different motives of people to hold money or simply demand for
money then we went through Keynes theory of liquidity preference as our
objective to show extended effect of inflation on total demand for money
through the post-Keynesian view mainly by Baumol theory of Inventory
Approach. And finally interlinked all the causal effect to derive an inverse
relationship between inflation and demand for money. We have already
said that it is just a simple model combing cause and effect of different
models without empirically testing the viability of the model. The
empirical test is beyond the scope of the paper but we welcome authors
for empirical testing to prove our model.

References:

Barro, R.J. (1976), “Recent Developments in Monetary Theories”,

Journal of Monetary Economics, 133-167.

Chirichiello, G. (1994), “Macroeconomic Models and Controversies”,

The Macmillan Press.

McCallum, B.T. and Goodfriend, M.S. (1986), “Money: Theoretical

Analysis of the Demand for Money”, Federal Reserve Bank of Richmond,
Working paper 86-3.

McDonald, J.F. (2016), “Rethinking macroeconomics”, Routledge.