GDP, Money Supply and Inflation

GDP, Money Supply and Inflation:

The following chart is a scatter diagram showing the relationship between money supply and inflation:

From the above chart it is evident that as money supply increases then the inflation rate increases, the relationship between the two variables is summarized by the regression model that states that Y = 0.1359 + 0.5673 X, where Y is the inflation rate and X is money supply, this model can explained by stating that if the money supply level is equal to zero and we hold all other factors constant then the level of inflation will be 0.1359, further if we hold all other factors constant and increase the level of money supply by one unit then the level of inflation will increase by 0.5673. For this discussion therefore increasing money supply will definitely increase inflation in the economy. Using this model we can predict the expected inflation rate for 2006 and this will need us to use the level of money supply to determine inflation, we assume that money supply will be 10 then the inflation level will be as follows:

Y = 0.1359 + 0.5673 (10)

Y = 5.8089

This is a rise in inflation in 2006 while the level of inflation was 2.7 in 2005.

For this reason therefore there is need to reduce money supply in the year 2006 in order to check inflation, this is because if the money supply maintained at 10 then inflation will rise, for

GDP, Money Supply and Inflation

this reason the money supply level should be reduced.

The following chart shows the GDP level over the years:

From the above chart it is evident that there has been a decline in the level of GDP, this decline can be attributed to the reduction in investment following the decline in investor confidence, an increase in investment means that the GDP level will also increase while a decline in investment will mean that the GDP level will decline, for 2006 it is evident that there has been a decline in GDP.

FED actions:

The following diagram shows the aggregate supply and aggregate demand curves:

The above diagram shows the aggregate demand and aggregate demand curve, aggregate demand in this case is equal to C + I + G, in order to improve the declined GDP level as discussed above then there is a need to increase consumption, investment and government spending in the case of a closed economy, for this reason therefore there is need for the federal reserve to increase investment which can be done by reducing lending rates, this means that interest rates should be reduced in order to increase investment which will in turn increase the GDP level.

From our above discussion regarding the relationship between money supply and inflation then the Federal Reserve should increase money supply at the expense of experiencing high inflation, therefore the federal reserve should be a ware that reducing interest rates will increase investment which will in turn increase GDP, however the inflation rate is expected to rise and this can be reduced by the use of monetary policies when investor confidence has been acquired.

GDP, Money Supply and Inflation

## References:

Phillips Hardwick (2002) introduction to modern economics, Prentice hall publishers, New York