A Business Encyclopedia

Monetarist Theory of Inflation

Definition: The Monetarist Theory of Inflation asserts that the general price level rises only due to the increase in the supply of money, but not proportionally.

The monetarist theory of inflation relates to the work of Milton Friedman, who tried to revive the classical monetary theory (price level rises with a proportionate change in the supply of money) in a modified form. According to him, inflation is always and everywhere is a monetary phenomenon and can be produced more rapidly with an increase in the quantity of money than the increase in output. Although, he believed that prices rise due to the increase in money, such increase is not proportionate.

The classical economist, especially Irving Fisher proposed that the increase in the stock of money is the sole cause of inflation and rise in the price is proportional to the money supply. He had explained this through an equation given below:



P = MV/T

MV = money supply = currency X velocity of money
P = general price level
T = Total number of transactions (Sale and Purchase)

This clearly shows, that the price level (P) increases proportionately with the increase in the money Supply (MV), the total number of transactions (T) remaining constant. This proposition is not acceptable to the modern monetarists and does not agree with the proportional increase in the price level.

Thus, the monetary theory of inflation asserts that price rises only due to the increase in the money supply, but there is no proportional relation between the supply of money and the general price level.

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