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What Is the Connection between Money Supply and Price Level?

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  • Written By: Esther Ejim
  • Edited By: Kaci Lane Hindman
  • Last Modified Date: 12 September 2016
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The relationship between money supply and price level lies in the fact that the amount of money in circulation in an economy has a direct impact on the aggregate price level. This is mainly because an abundance of money leads to an increase in demand for goods and services, while a scarcity of money has the opposite effect. In economic terms, this effect is explained by the quantity theory of money, which states that the amount of money in supply in an economy has a direct bearing on the price level.

A simple way of looking at the relationship between money supply and price level is to consider the fact that consumers will only spend when they have something to spend. That is to say that when there is a lot of money in the economy, people will have more to spend. This increase in demand also causes a corresponding increase in the price level. Excess liquidity leads to a situation in which a lot of cash will be vying for an often limited supply of goods. This causes the money to gradually lose its value, which consequently leads to price increases.

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Economists rely on the relationship between money supply and price level as one of the indicators of the state of the economy. When there is a rise in the aggregate price, one of the chief factors responsible is too much demand caused by consumers having easy access to money. The response of the government to this is often to introduce monetary or fiscal policies meant to restrict the ease with which consumers can obtain money, including bank loans and various types of credit. One method by which the government can restrict access to money is through increases in general interest rates.

The effect of this restriction further illustrates the relationship between money supply and price level, because this maneuver usually forces the price level to drop. When the central bank of a country increases the interest rate, consumers may find the conditions attached to obtaining money to be either too prohibitively expensive or too rigorous, as other banks tighten their lending policies in response to the interest rates increase. As a consequence of the lack of easy access to funds, consumers tend to become more conservative in their spending habits, leading to a drop in the demand for goods and services. The consequence of a reduction in demand is an accompanying drop in the prices of goods and services.

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Chmander
Post 3

In connection to all this, the economy and gas prices are an example. Years ago, gas prices were much lower, sometimes even costing around two dollars. However, with the money supply in the economy (or lack of it), the gas prices have skyrocketed. It really makes me wonder how things will be in the next ten years.

RoyalSpyder
Post 2

@Hazali - I agree with you. Also, based off of my experience, this isn't just the case for video games and systems, but many new products that are released in stores. You do give some good tips as well, especially in reference to the price drops. It's usually best to wait a few years till the crowds die down before purchasing your item. That way, you can avoid the first year rush.

Hazali
Post 1

In relation to money supply and price level, you see this all the time with video games and their respective systems. For example, have you ever noticed that when a gaming system is first released, the prices range from four to five hundred dollars? However, as the years go on, the prices begin to drop, making the systems more affordable to some. One reason why the price is so high is because when a system is first released, there are many people who want to buy it, and the companies also need to make plenty of money off these sales. However, when the sales begin to drop, that's why prices drop as well.

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