Inflation affects the real economy in two specific areas: it can harm economic efficiency, and it can affect total output. We begin with the efficiency impacts:-
Inflation impairs economic efficiency because it distorts prices and price signals. In a low inflation economy, if the market price of a good rises, both buyers and sellers know that there has been an actual change in supply and/or demand conditions for that good, and they can react appropriately. By contrast in a high inflation economy, its much harder to distinguish between changes in relative prices and changes in the overall price level.
Inflation also distorts the use of money. Currency is money that bears a zero nominal interest rate. If the if the inflation rate rises from 0 to 10% annually, the real interest rate on currency falls from 0 to -10% per year. There is no way to correct this distortion. As a result of the negative real interest rate on money, people devote real resources to reducing their money holdings during inflationary times. They go to the bank more often. Corporations set up elaborate cash management schemes. Real resources are thereby consumed simply to adapt to a changing monetary yardstick rather than to make productive investments . Effect of GDP on Money Supply
Money supply and GDP do not automatically affect each other, but Money Supply can affect GDP depending on monetary policy; the expressed intention in economic management is to monitor the money supply to allow transactions to take place. Therefore, if money supply is severely restricted it is likely to affect the GDP: i.e.: reduce the volume of transactions . The GDP can only increase the demand of money... and transactions will stall if that demand is not met. GDP is also inadequate as a measure of real production, because it does not truly represent production, but it is a statistic of dollar value of all transactions that have taken place. A comparison of the two statistics maybe valuable after the fact to examine the difference in growth ratio, to maybe predict near term inflation, if money growth was too much larger than GDP.
Money is NOT increased as a result of greater ability to produce, but it is increased intentionally to attempt to allow the greater ability potential to materialize. Money supply affects GDP by making transactions more efficient. You don't need to find someone to trade with to get what you want, everyone takes money. The more of it there is, the larger this effect becomes.
GDP affects money supply through the banking system. When growth is high, banks make additional loans and expand the money supply. The Federal Reserve also has something to do with it, but the dynamic aspects of money supply rest with the banking sector.
The Effect of Inflation On Monetary Transmission
Having examined the building blocks of money, we now describe the monetary transmission mechanism, the route by which changes in the supply of money are translated into changes in output, employment, prices and inflation. The Reserve Bank is concerned about inflation and has decided to slow down the economy. There are five steps in the process:-
• To start the process, the Reserve Bank takes steps to reduce bank reserves. Reserve Bank reduces bank reserves primarily by selling government securities in the open market. This open market operation changes the balance sheet of the banking system by reducing total bank reserves.
• Each dollar reduction in bank reserves produces a multiple contraction in checking deposits, thereby reducing the money supply. Since the money supply equals currency plus checking deposits, the reduction in checking deposits reduces the money supply.
• The reduction in the money supply increases interest rates and tightens credit conditions. With an unchanged demand for money, a reduced supply of money will raise interest rates. In addition the amount of credit (loans and borrowing) available to people will decline. Interest rates will rise for mortgage borrowers and for businesses that want to build factories, buy new equipment, or add to inventories. Higher interest rates tend to reduce asset prices (such as those of stocks, bonds, houses) and therefore depress the values of peoples' assets.
• With higher interest rates and lower wealth, interest sensitive spending-especially investment, tends to fall. The combination of higher interest rates, tighter credit and lower wealth tends to reduce investment and consumption spending. Businesses will scale down their investment plans, as will state and local governments. For example, higher interest rates may lead airlines to stretch out their purchases of new aircraft. Similarly consumers may decide to but a smaller house, or to renovate their existing one, when rising mortgage interest rates increase monthly payments relative to monthly income. In an economy increasingly open to international trade, higher interest rates may raise the foreign exchange rate depressing net exports. Hence, tight money will raise interest rates and reduce spending on interest sensitive components of aggregate demand.
Finally, the pressures of tight money, by reducing aggregate demand, will reduce income, output, jobs and inflation. The aggregate supply and demand analysis shows how a drop in investment and other autonomous spending may depress output and employment sharply. Furthermore, as output and employment fall below the levels that would otherwise occur, prices tend to rise less rapidly or even to fall. Inflationary forces subside.
The money supply is ultimately determined by the policies of the Central Bank. By setting reserve requirements and the discount rate, and especially by undertaking open market operations, the Central Bank determines the level of reserves, the money supply and short term interest rates based on the Inflation rate and the GDP figures. Inflation rates and GDP figures have a direct impact on the money supply since their increase and decrease determines the level of circulating money in the system as and when required by the Central Bank. Banks and the public are cooperating partners in this process. Banks create money by multiple expansions of reserves; the public agrees to hold money in depository institutions.
Through our regression analysis we have come to conclude that both GDP and Inflation rate have a significant impact on the changes in money supply observed over a period of 15 years in this project work. The regression values are highly significant in explaining the relationship between the dependent and independent variables.
Thus, we conclude that macroeconomic factors like GDP and Inflation rate have a considerable impact on money supply.
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