Based on classic economic theory, Monetary Theory states that prices for goods and services within the wider economy will only rise if the amount of money within the economy increases over and above any increases in the levels of production and output. With a greater amount of money chasing a lesser amount of goods and services, the price of those same goods and services must consequently rise as a result. This is known as the Quantity Theory of Money, which is expressed by the following equation:

Where:

P is the general price level of consumers’ goods,
DC is the aggregate demand for consumers’ goods,
SC is the aggregate supply of consumers’ goods.

Developed by the American economist Milton Friedman in the 1970’s, the Quantity Theory of Money posts that as the money supply increases, total spending rises as does the aggregate demand for goods and services. Because of this, Monetarist economists believe that the only cause for inflation within a growing economy is an increase in the total money supply – caused primarily by loose or accommodative monetary policy as pursued by the central bank. Because of this, Friedman is widely quoted as saying that “inflation is always and everywhere a monetary phenomenon”.

What this implies is that controlling rising prices levels depends on both monetary and fiscal restraint, which means the government must maintain a delicate balance between not making it too easy to borrow, nor borrowing to excess itself. Therefore, monetarist economists emphasize the need to control government budget deficits, interest rates, and economic productivity in order to minimize the likelihood of ‘cost-pull’ inflation feeding through into the economy.

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