In lecture 2, we have defined inflation as an increase in a

price index. Now, we will present a theory of the main cause

of inflation. Why, in some periods, prices increases steadily?
Why, as we have already mentioned, in some countries there were
processes of extremely high inflation? We will see that the classical
theory of inflation emphasizes that one of the main reasons
of these processes, specifically in the long run,
is the growth in the money supply. The first thing we need to
do is to establish a relationship between the value of money
and the price level. If prices increase, it means that more
that more money is needed to buy the same quantity
of goods or, in other words, goods are more expensive in terms
of money. So, if P is a price index (like the CPI),
P is value of goods in terms of money.
More specifically, we can say that P is the average value (with
the corresponding weights) of the goods included in the basket
of the index in terms of money. Alternatively, 1 over P can
be thought as the value of money in terms of goods.
Every time that the prices index  P increases,
1 over P decreases. Every time that goods become more expensive,
the value of money decreases.The determination  of the value
of money can be analysed with a framework similar to the ones
we have used to analyse the value of all the other goods in
the economy: a market in which we have a demand
and a supply. We can graph both the money supply and the money demand
in a standard scheme of a market with the value of money
in the vertical axis and the quantity of money in the horizontal
axis. Remember that the value of money is 1 over P.
The money demand is given by the amount of wealth that the public
(households, non-financial firms and the public sector)
wants to hold in liquid form. This money demand depends mainly
on 3 variables: the price level (capital P), the interest rate (r)
and the total income of the economy (capital Y).
In topic 5 of this course we will discuss how the interest
rate and the total income of the economy affect the money demand.
So far, we will focus on the relationship between
the money demand and the price level. The price level affects the
quantity demanded of money because money is mainly a medium
of exchange. The public decides to hold their wealth in money instead
of other assets because money can be used
to buy goods and services. Hence, if prices increase,
the public will want to increase their money holdings to be able
to purchase the same quantity of goods and services.
Here, of course, we are assuming ceteris paribus, like  in microeconomics.
So, in this reasoning , both the interest rate and the total
income are kept constant. Then, higher prices,  ceteris paribus, imply
higher money  demand. So, when P increases, the value of money decreases
and the quantity demanded of money increases.
So, the money demand in our graph has a negative slope.
Regarding the money supply, we already know that, in principle, it
is controlled by the central bank. We have already learned
that the process of expanding or contracting the money supply
is not so simple because the commercial banks also play a role.
However, just for simplicitly, we will assume by now
that the center bank fully controls the money supply and that it does not
depend on the price level. Hence, in our graph the
money supply will be a vertical line. So, we have a money supply
defined by the central bank and a money demand defined by the
public. The equilibrium defines the value of money in the economy
(1 over P) and therefore, also defines the price level P.
In the example, the central bank defines a money supply of
1000 and, given the money demand,
the value of money will be 2. Hence, given that the price level
is the inverse of the value of money, the price level will be
one half. What  happens if the central bank decides to increase
the money supply? An increase in the money supply is represented
as a shift of the money supply curve to the right.
In this case, there is more money in circulation and the value of
money decreases. In our example, if the money supply increases
to 1400, the value of money in the new
equilibrium will decrease to one. In this case the price level
will be also one. Hence, the quantity of money in the economy
controlled by the central bank is the primary cause of changes
in the value of money, and therefore, of the price level in the
long run. This is the main lesson we learn from the classical
theory of inflation. Any increase in the money supply leads
to an increase in the price level in the long
run. This was the idea of the Noble Prize winner
Milton Friedman when he said that "inflation is always and everywhere
a monetary phenomenon". We will furthrer analyse the relationship
between the money supply and the price level and other macroeconomic
variables, in the next video.