Question

Explain the relationship between money supply and prices.

Answer 1

Instructions: Explore the type of relationship (positive or negative) between money supply and prices.

Explore the role of central banks in regulating the supply of money in an economy

Solution: Let us explore the relationship between money supply and prices in general.

It has been observed that there is a positive relationship between money supply and prices.

It means that when the money supply in an economy increases, the prices of most goods and services (called the general price level) increases and vice-versa. When the money supply in an economy decreases, the general price level falls.

The increase in general price level is also referred to as inflation.

Now that we know about the positive relationship between money supply and prices, let us learn more about the role of the central bank to regulate the money supply in an economy.

The central bank has to regulate or control the money supply to keep a check on the rate of inflation (which is the rate of increase in the general price level).

For example, if the inflation rate is too high, the central bank would reduce the money supply which in turn would decrease the rate of inflation.