Question

Does increasing money supply necessarily lead to higher inflation? Explain the theory and consider your arguments in light of the response of central banks to the Great Recession of 2007-2008.

Answer 1

Generally, it is assumed that an increase in the Money supply leads to a rise in the inflation rate.

But this does not hold always. If the economy is below the full employment level, then an increase in the money supply would drive up the output and employment levels without causing the rise in the inflation rate or there is a marginal rise in the inflation rate.

During the great recession of 2007-2008, the aggregate demand was too low, thus, when Fed increased money supply, there was rise in output and employment without causing a rise in the price level or price rise was insignificant.

When economy reaches the full employment level, the increase in the money supply would full get reflected on the price level only.