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Monetary inflation is the term used by economists of the monetarist, neoclassical or Austrian school of economics to differentiate the primary or direct inflation in the money supply from price inflation which they view as a result or symptom of the former. Originally "inflation" was used to refer to monetary inflation, whereas in present usage it commonly refers to price inflation.
The description of the actual mechanism varies according to each school, but there is overall agreement among them that there is a cause and effect relationship between supply and demand of money and prices of goods and services measured in monetary terms. Although the system is complex and there is a great deal of argument on how to measure the monetary base or how much factors like the velocity of money affect the relationship, and even more disagreement on what is the best monetary policy, there is a general consensus on the importance and responsibility of central banks and monetary authorities in affecting inflation. Inflation targeting is advised by followers of the monetarist school, while Austrian economics often calls for an end to fractional reserve banking and a return to some kind of gold standard.
The Monetarist explanation of inflation operates through the Quantity Theory of Money, MV = PT where M is Money Supply, V is Velocity of Circulation, P is Price level and T is Transactions or Output.
As Monetarists assume that V and T are fixed, there is a direct relationship between the growth of the money supply and inflation. The mechanisms by which excess money might be translated into inflation are examined below. Individuals can also spend their excess money balances directly on goods and services. This has a direct impact on inflation by raising aggregate demand. The more inelastic is aggregate supply in the economy, the greater the impact on inflation.
The increase in demand for goods and services may cause a rise in imports. Although this leakage from the domestic economy reduces the money supply, it also increases the supply of pounds on the foreign exchange market thus applying downward pressure on the exchange rate. This may cause imported inflation.
If excess money balances are spent on goods and services, the increase in the demand for labour will cause a rise in money wages and unit labour costs. This may cause cost-push inflation. The Bank of England no longer sets targets for the growth of the money supply but it keeps a close eye on the rate at which consumer credit, bank lending and cash in circulation is rising as a guide to future trends in consumer demand and retail price inflation.