The monetarist theory of demand-pull inflation is based on the quantity theory of money. According to the quantity theory of money, increases in the supply of money, given its velocity, lead to increases in the total money expenditure.
Assuming full employment, the increased demand will pull prices higher. Thus, according to the monetarists, inflation is a monetary phenomenon.
The monetarist theory can be studied with respect to static and dynamic conditions:
(i) In a static economy, with a given level of output, according to the equation of exchange: MV = PT, increases in the supply of money (M) alone are responsible for increases in the price level (P), assuming the velocity of money (V) constant ; P increases in the same proportion as M increases. Thus, the rate of inflation is given by
ADVERTISEMENTS:
P = M
That is, the rate of change of prices (P) is proportionate to the rate of change of money supply (M). Since M is a policy variable, the rate of inflation also becomes policy determined.
(ii) In a growing economy, real national income (Y) is increasing over time due to the operation of various growth factors. Again, in such an economy, the real demand for money will also be growing over time.
According to the Cambridge equation of the quantity theory of money (i.e., M = KPY), the rate of growth of real demand for money will be equal to the rate of growth of real national income because the income elasticity of demand for money is necessarily unity.
ADVERTISEMENTS:
The growth rate of real demand for money tells us the rate at which new money can be absorbed in the economy at constant prices.
The excess increases in the stock of money will lead to increase in prices and will become inflationary. Thus, for a growing economy, the rate of inflation is given by P = M – Y
That is, the rate of increase in prices (P) is proportionate to the excess rate of increase in the supply of money (M – Y).