Classical Theory of Inflation and Money Growth pt 1

This topic explores the relationship between money growth and inflation through the lens of the Classical Theory of Inflation.
Other schools of thought in macroeconomics mentioned include:
- Keynesian Economics
- Neoclassical Economics
- Monetarist Economics
- Supply-side Economics
The Classical Theory is a long-run theory. This distinguishes it from the Keynesian view, which primarily focuses on the short-run.
Historically, John Maynard Keynes argued against the classicalists, but they were fundamentally analyzing different time frames.

A fundamental concept in this theory is the inverse relationship between the general price level and the value of money.
Price Level ( $P$ ): When prices rise, people must pay more for the goods and services they purchase.
Value of Money ( $\frac{1}{P}$ ): When the price level rises, the value of money falls, meaning each individual dollar buys less than it did previously.
If the price level falls, each dollar buys more, and the value of money rises.
In mathematical terms, value and price level are inverses: if price level is $P$ , the value of money is $\frac{1}{P}$ .

Money Supply ( $MS$ ):
- This is set by the Federal Reserve (the Fed).
- Because it is externally determined by the central bank, the money supply curve is represented as a vertical line on a graph until the Fed decides to change it.
Money Demand ( $MD$ ):
- This refers to the amount of money people "want" or, more accurately, "need" to hold on their person or outside the banking sector.
- This is not total wealth, but the liquid money kept in houses or wallets.
- When the price level $P$ rises, the quantity of money demanded rises. This occurs because more currency is required to buy the same amount of goods and services.
- When the price level $P$ falls, the quantity of money demanded falls.
- Consequently, the price level is the primary factor that causes movement along the money demand curve.

The classical theory uses a specific graph layout to analyze equilibrium:
- It is shaped like a "box without a top."
- Horizontal Axis: Represents the Quantity of Money.
- Left Vertical Axis: Measures the Value of Money ( $\frac{1}{P}$ ), scaling from high (at the top) to low (at the bottom).
- Right Vertical Axis: Measures the Price Level ( $P$ ), scaling from low (at the top) to high (at the bottom).
The Curves:
- The money supply ( $MS$ ) is vertical.
- The money demand ( $MD$ ) is a downward-sloping curve. As the price level increases (moving down the right axis), the quantity of money people must hold increases.
Equilibrium:
- Equilibrium is found at the intersection of the $MS$ and $MD$ curves.
Market Adjustments:
- If the price level is too high, people demand more money than is supplied; prices will eventually decline to return to equilibrium.
- If the price level is too low, more money exists than people need to hold; prices will increase to return to equilibrium.

If the Federal Reserve increases the money supply, the effects are clearly visible on the graph:
- The vertical $MS$ curve shifts to the right ( $MS_1$ to $MS_2$ ).
- This shift results in a higher quantity of money available in the economy.
- As a result, the equilibrium value of money $\frac{1}{P}$ falls.
- Simultaneously, the equilibrium price level $P$ rises.
Therefore, when an increase in the money supply makes dollars more plentiful, it results in an increase in the price level, making each dollar less valuable.

This theory is the cornerstone of the classical model.
It states that the amount of money available in the economy determines the price level.
It further states that the rate at which the money supply grows determines the inflation rate.
The Mechanism of Inflation:
- If the Fed injects more money than people "need" to hold at current prices, people will try to get rid of the excess money.
- People get rid of excess money by spending it on goods and services or by using it to buy bonds and making bank deposits (which are then loaned out further).
- This increased demand for goods and services—while supply remains the same—causes prices to rise according to basic supply and demand principles.
- Prices continue to rise until the economy reaches a new equilibrium where the higher prices necessitate holding more money.

Question: Why would someone want to "get rid" of money? Wouldn't you always want more?
Response: In this context, "getting rid" of money doesn't mean throwing it away or burning it. It means people do not want to hold excess cash on their person when they could spend it or invest it. When people have more cash than they need for their current transactions (due to a supply increase), they spend it on goods and services. This collective spending increases demand, which drives up the overall price level (inflation).