Inflation and Economic Development

The relationship between inflation and monetary policy can probably be discussed most conveniently by referring to the classical ‘equation of exchange’, developed by Irving Fisher in 1911 and explained in thousands of elementary economics texts. The quantity of money in an economic system multiplied by its velocity (the number of times one unit of money changes hands during some period of time) must be equal to the total transactions taking place during that period multiplied by the average price per transaction. This definitional relationship, the Fisher Equation, MV = PT, does not say anything about causality; by the definition, a change in any of the four variables could cause a change in one or more of the other three. This elementary point is often ignored by ‘theorists’ of various persuasions. Some economists may argue that increases in the money supply will tend to be offset by exactly proportional declines in velocity — thus, ‘money does not matter’, the strict Keynesian view. For others, velocity is a constant, in other words, total transactions in the economy do not change by very much in the short run, and a strong causality running from money growth to the price level is postulated, the so-called monetarist position or ‘classical view’. According to Fisher himself, a 10 per cent increase in the supply of money will, on average, lead to the same 10 per cent rise in the general price level, but few other economists today would argue that the relationship is a direct and proportional one.