Inflation
Inflation is most certainly the result of increasing the money supply. Think about monetary policies. When the Fed increases the money supply through its open market operations, changing the reserve ratio, and changing the interest rate. This does close the recessionary gap, but it can lead to an inflation. This is the same for deflation. If the money supply decreases, the inflationary gap will be closed, but price level will decrease.
Demand Pull Inflation
Demand-pull inflation is caused by an increase in consumer demand. It happens when AD shifts to the right with consumers spending more. When this happens, the price level increases, but real GDP also increases. This demand-pull is also thought to be caused by too much government deficit spending, because government spending usually drives up AD.
Seen in the graph above, AD1 shifts to the right to AD2, increasing both price and real GDP. This is also known as the inflationary gap, and it is corrected through long-run adjustment and contractionary fiscal or monetary policies.
Cost Push Inflation
Cost-push inflation happens when production is decreased (or input costs increased, thus decreasing amount of production). This can be caused by labor or natural resource shortages as well or natural disasters. Anything that disturbs production and decreases supply is though to be cost-push inflation.
With this type of inflation, supply shortages happen, leading to AS1 (short-run in this case) shifting to the left to AS2. This drives price level to increase but real GDP to decrease. This is a bad example of inflation because it's a little harder to fix.
Wage-Price Spiral
This is the worst case scenario. It's just a self-perpetuating spiral where demand rises and supply goes down. Imagine if everyone wants to buy more of everything but the supply of everything keeps going down due to a bad hurricane or earthquake? Basically, in this case, demand-pull and cost-push are working together, which is the worst case with inflation.
Since everything is now at higher prices, it's reasonable that everyone would want higher wages to be able to afford those high costs. This would cause prices to go up even more because it's more expensive to produce now with higher wages. This will lead to more inflation, then higher prices of everything, then higher demand for wages, then higher production costs, then inflation... It just keeps going.
As seen in the graph, we have a double shifter. AD is shifting to the right, while SRAS is shifting to the left. As a result, real GDP is unchanged, but we still have an increase in price level.
Inflation due to Changes in the Money Supply
Inflation can also happen due to the changes in money supply. Remember, the Federal Reserve is in charge of the money supply. So everytime they increase or decrease the money supply, price level can be indirectly affected.
MS, meaning money supply, was increase by the Fed. Consequently, the interest rate and quantity of money increased. This indirectly leads to an increase in price, thus inflation.
Theory of Monetary Neutrality
An increase in money supply increase price level almost proportionately, including the price of labor. This will then increase the cost of production, but it will also increase revenue because selling prices are higher. So the firms will not produce more or less, they'll keep it the same way. That's same with the number of employees as well.
This goes to households as well. Households will not buy more stuff. Yes, their wages and salaries have risen, but the price of groceries have also risen too. This means that families won't buy another carton of milk. Instead, they'll buy the same number of eggs as they did before inflation. So what does this all mean?
It means that a change in money supply actually has no affect on the economy. Only dollar values are changed, but nothing else. That's the theory of monetary neutrality.
The Theory of Monetary Neutrality is the nice way of saying money doesn't matter
Quantity Theory of Money
The equation for the quantity theory of money is M x V = P x Y.
- M stands for the money supply (usually M1)
- V stands for the velocity of money
- P stands for price
- Y stands for real output (sometimes T), or GDP
So, the quantity theory of money is the money supply times the velocity of money equals the price level times the real output. So at a constant velocity and GDP, an increase in the money supply will lead to a proportional increase in prices. This is known as the quantity theory of money. It's the idea that inflation is proportional to the growth rate of the money supply. If you think about it, it's true when you look at the equation. Velocity of money is the average times a dollar is spent and re-spent in a specific period of time. It's how fast a (for example) $1 bill moves from one person to the next. If you tend to stash all your cash and never use it, the velocity of money is slow. If you spend it as soon as you receive it, velocity is fast.
Ex: So let's assume the money supply is $40, and it's used to purchase 10 products with a price of $20 each. Calculate the velocity of money.
$40 x V = $20 x 10
$40V = $200
V = $200/$40
V = 5
Frequently Asked Questions
What is the quantity theory of money and how does it work?
The quantity theory of money is the simple identity MV = PY. M = money supply, V = velocity (how fast money circulates), P = price level, Y = real output. The theory (used in the AP CED) assumes V is stable and, in the long run, Y grows at its natural (full-employment) rate. So if M grows faster than Y, P must rise—inflation is a monetary phenomenon (EK POL-3.A.1, POL-3.A.3). In growth-rate form: %ΔM + %ΔV = %ΔP + %ΔY. With %ΔV ≈ 0 and %ΔY = potential output growth, %ΔP (inflation) ≈ %ΔM − %ΔY. Example: if money grows 8% and real output 3%, inflation ≈ 5%. This expresses monetary neutrality and the classical dichotomy (money affects nominal variables, not long-run real output). For exam review, see the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH) and more unit resources/practice questions (https://library.fiveable.me/ap-macroeconomics/unit-5 and https://library.fiveable.me/practice/ap-macroeconomics).
How do I calculate money supply using the quantity theory of money formula?
Use the quantity theory formula MV = PY. If you need M (money supply), rearrange: M = (P × Y) / V Where P = price level (nominal), Y = real output, and V = velocity of money. On growth rates (what the CED emphasizes): growth rate of M ≈ inflation rate + growth rate of real output − growth rate of V. If velocity is stable and the economy is at full employment (so Y grows at its long-run rate gY), then inflation ≈ growth rate of M − gY. Quick numerical example: if P = 120 (price index), real Y = 2000, and V = 5, then M = (120 × 2000)/5 = 48,000. For AP prep, you should be able to rearrange MV = PY and compute M, V, P, or Y from given values—practice these types on the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH) and with problems (https://library.fiveable.me/practice/ap-macroeconomics).
I'm confused about why printing more money causes inflation - can someone explain this simply?
Printing more money causes inflation because more dollars are chasing the same amount of goods. The quantity theory of money (MV = PY) makes this clear: M = money supply, V = velocity, P = price level, Y = real output. If V and Y are roughly constant (especially at full employment), an increase in M leads almost directly to an increase in P. Example: if the Fed doubles M and V and Y don’t change, P will roughly double—that's 100% inflation. In AP terms: this shows inflation is a “monetary phenomenon” and demonstrates monetary neutrality in the long run (money growth affects nominal variables like P, not real output Y). Extreme cases (seigniorage from rapid money printing) cause hyperinflation (e.g., Weimar). For practice with MV = PY and exam-style problems, check the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH) and more practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
What's the difference between short run and long run effects of increasing money supply?
Short run: An increase in the money supply raises aggregate demand (AD shifts right). With sticky wages/prices, real output and employment rise above full-employment (you get a short-run boost in Y) and the price level rises too. This is why expansionary monetary policy can fight recession in the short run. Long run: Money is neutral—once nominal wages and expectations adjust, real variables return to their long-run values (output = full-employment Y). The only lasting effect is a higher price level (inflation). According to the quantity theory (MV = PY), sustained faster money growth leads to a higher inflation rate. So short run: higher Y and P; long run: only higher P (inflation), real output unchanged. For AP prep, know the language (monetary neutrality, MV=PY) and be ready to draw AD/SRAS/LRAS adjustments. Review Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH) and practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
How do I use the equation MV = PQ to solve for different variables?
MV = PY (also written MV = PQ) links the money supply (M) and velocity (V) to nominal GDP: price level (P) times real output (Y). To solve for any one variable, rearrange the equation and plug in the others: - Solve for P: P = MV / Y. Use this when you know M, V, and real output; it gives the price level (inflation implications). - Solve for Y (real output): Y = MV / P. Use this to find real GDP given nominal spending. - Solve for M: M = PY / V. Use this to find required money supply for a target P or Y. - Solve for V: V = PY / M. Velocity is just nominal GDP per dollar of money. Quick example: M = $500, V = 4, Y = 200 → P = (500·4)/200 = 10 (price index). On the AP exam you may be asked to calculate M, V, P, or Y from data (Topic 5.3). For more practice and step-by-step examples, check the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH) and extra problems (https://library.fiveable.me/practice/ap-macroeconomics).
Why doesn't changing the money supply affect real output in the long run when we're at full employment?
When the economy’s at full employment (potential output), real output is determined by real factors—resources, technology, and institutions—not by money. The quantity theory (MV = PY) shows this: if velocity (V) and real output (Y) are fixed in the long run, a rise in money supply (M) raises the price level (P) proportionally, so you get inflation, not more real GDP. This is monetary neutrality / the classical dichotomy (CED EK POL-3.A.2 and EK POL-3.A.3). On the AP exam you should be ready to show this with AD/AS or MV=PY work: money shifts AD and raises PL in the long run while LRAS (Yf) stays unchanged. For a targeted review, see the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH) and more practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
What happens to inflation when the Federal Reserve increases the money supply too quickly?
If the Fed increases the money supply too quickly for a sustained period, inflation rises—sometimes a lot. According to the quantity theory of money (MV = PY), when money growth outpaces real output growth (Y) and velocity (V) is stable, the price level (P) must rise: long-run inflation ≈ money growth rate (CED EK POL-3.A.3). At full employment extra money doesn’t raise real output in the long run (monetary neutrality, EK POL-3.A.2); it just raises prices. Rapid money growth can create an “inflation tax” on holders of money and, in extreme cases, hyperinflation (e.g., Weimar) (EK POL-3.A.1). On the AP exam you may be asked to explain this with MV = PY or an AD/AS graph (Topic 5.3). For a focused review, see the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH), the Unit 5 overview (https://library.fiveable.me/ap-macroeconomics/unit-5), and extra practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
I don't understand velocity of money - what does it actually measure?
Velocity of money measures how many times, on average, a dollar is used to buy final goods and services in a year. Formally V = PY/M (nominal GDP divided by the money supply). Think of it like turnover: if people spend money fast (high V), each dollar supports more transactions so a smaller money supply can still produce the same nominal GDP; if V falls, money sits idle and you need more money to get the same spending. In the quantity theory (MV = PY) the growth rate of M plus growth of V determines nominal GDP growth; when V is stable, faster money growth → faster inflation (EK POL-3.A.3). On the exam you might use V to solve for P, M, or Y from MV = PY. For extra practice, see the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH) and more practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
How do I know if a country's inflation is caused by monetary policy or other factors?
Short answer: check the money growth rate against inflation using the quantity theory MV = PY. If money supply growth minus real output growth ≈ the inflation rate (when velocity is stable), inflation is likely monetary. Example: if M grows 10%, real GDP grows 2%, and V is stable, inflation ≈ 8%. Steps to diagnose: - Measure money supply growth and inflation over the same period. - Check real output: if economy’s at full employment (no big output gap), money growth should show up mainly as inflation (monetary neutrality). - Look for supply shocks: big rises in oil or food prices, or disrupted supply, point to cost-push inflation (not primarily monetary). - Check velocity and expectations: collapsing velocity or rising inflation expectations can change the relationship. - Use graphs (AD/AS and MV=PY) to show whether AD shifted (monetary/demand) or SRAS shifted (supply/cost-push). AP free-response expects these visuals and explanations. For review and practice on this topic, see the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH) and practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
What's the relationship between money growth rate and inflation rate in the long run?
In the long run, money growth determines inflation. Using the quantity theory MV = PY (M = money supply, V = velocity, P = price level, Y = real output), take growth rates: ΔM + ΔV = ΔP + ΔY. If velocity is stable (a standard long-run assumption) and the economy is at full employment so real output grows at its normal rate, then the inflation rate (ΔP) ≈ money growth (ΔM) − real output growth (ΔY). In the special case where real output growth is zero, inflation ≈ money growth. This reflects monetary neutrality and EK POL-3.A.3: sustained rapid increases in the money supply cause inflation; changes in M don’t affect real output in the long run (EK POL-3.A.2). For AP practice, be ready to use MV=PY algebraically and with a graph (AD/LRAS) on FRQs (see Topic 5.3 study guide: https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH). More practice problems at (https://library.fiveable.me/practice/ap-macroeconomics).
Can someone explain why deflation happens when money supply decreases?
Think of the quantity equation MV = PY. If velocity (V) and real output (Y) are roughly fixed in the long run (especially at full employment), a decrease in the money supply (M) must be matched by a decrease in the price level (P). That fall in P is deflation. In other words, money growth (or shrinkage) drives nominal variables: when M falls faster than needed, there’s less money chasing the same goods, so prices drop. Short-run caveat: if the economy isn’t at full employment, a drop in M can temporarily reduce real output (so P might not fall as much), but in the long run monetary neutrality means the main effect is on P (EK POL-3.A.1 & EK POL-3.A.2). Example: if M falls 5% and V and Y are constant, P falls ~5% → 5% deflation. For AP prep, be ready to show this with MV=PY and an AD/AS graph (short-run AD shifts left, long-run output unchanged)—see the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
How do I calculate the growth rate of price level using quantity theory?
Use the quantity equation MV = PY. Take growth rates (percent changes) to get: %ΔM + %ΔV = %ΔP + %ΔY, where %ΔP is the inflation rate. Solve for inflation: %ΔP = %ΔM + %ΔV − %ΔY. On the AP, you usually assume velocity is constant in the long run (%ΔV = 0) and the economy is at full employment so %ΔY = long-run real growth (gY). That gives: inflation ≈ money growth − real GDP growth. Example: if money supply grows 8% and real output grows 3%, inflation ≈ 8% − 3% = 5%. Show your work on the exam: write MV = PY, take percent changes, substitute numbers, and state any assumptions (constant V, full-employment output). For a quick review, see the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH) and try practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
Why do economists say inflation is always a monetary phenomenon?
Because in the long run prices move when the amount of money in the economy changes. The quantity theory of money (MV = PY) shows this: with velocity (V) and real output (Y) roughly fixed at full employment, increases in the money supply (M) raise the price level (P). So sustained inflation comes from money growing faster than real output—that’s monetary neutrality and the “inflation is a monetary phenomenon” idea in the CED (EK POL-3.A.1, POL-3.A.3). Extreme cases (Weimar hyperinflation) and everyday effects (inflation tax, seigniorage) illustrate how governments finance spending by creating money, which raises P. For AP you should be able to explain this with MV=PY, note that money changes don’t affect real output in the long run, and practice problems on this topic are in the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH). For extra practice, visit the Unit 5 overview (https://library.fiveable.me/ap-macroeconomics/unit-5) and the 1000+ practice questions (https://library.fiveable.me/practice/ap-macroeconomics).
What does it mean when they say changes in money supply have no real effects in the long run?
It means of all things money can change in the long run, only nominal variables (like the price level or inflation rate) change—real variables (real GDP, real wages, employment) don’t. That idea is called monetary neutrality or the classical dichotomy and is tied to the quantity theory MV = PY. If Y is at full-employment (fixed in the long run), a sustained increase in M raises nominal spending (PY); with Y fixed, P must rise (inflation). So long-run money growth determines inflation (EK POL-3.A.3) but not real output (EK POL-3.A.2). Short run is different: sticky wages/prices let changes in M temporarily affect real output and unemployment. For AP practice, be ready to show this with MV=PY and AD/AS graphs and use the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH) and extra practice problems (https://library.fiveable.me/practice/ap-macroeconomics).
I'm studying for the AP exam - when do I use quantity theory vs other inflation models?
Use the quantity theory (MV = PY) when you’re analyzing long-run inflation—especially when the economy is at or near full employment and velocity is relatively stable. In growth-rate form: %ΔM + %ΔV = %ΔP + %ΔY. If %ΔY ≈ 0 (full employment) and %ΔV is stable, then long-run inflation ≈ money growth. That’s the AP “inflation is a monetary phenomenon” result (EK POL-3.A.1, EK POL-3.A.3). Use other models for short-run or demand/shock-driven inflation: - AD–AS / SRAS: when prices, wages, or expectations are adjusting and output gaps exist (short-run tradeoffs). - Phillips curve: to connect current inflation and unemployment (short run, expectations matter). - Money demand / liquidity preference: when velocity changes matter, interest-rate effects are important, or you’re explaining nominal interest changes (Fisher equation). For the exam, draw AD–AS or Phillips-curve graphs for short-run questions and use MV=PY (or its growth-rate form) for long-run numerical/calculation items. For targeted review, see the Topic 5.3 study guide (https://library.fiveable.me/ap-macroeconomics/unit-5/money-growth-inflation/study-guide/USZZBsqEAKh5xNFM4fRH) and practice problems (https://library.fiveable.me/practice/ap-macroeconomics).