# Classical Theory of Inflation - Money Supply, Money Demand and Prices

In every textbook, website I read when talking about the classical theory of inflation, I see the diagram below which depicts the value of money, prices etc. This one below is from Spark notes (https://www.sparknotes.com/economics/macro/money/section2/) or Mankiw (chapter 28 Money, growth and inflation).

These sources all go through a shift in the MS to the right to demonstrate inflation. No problem with that conceptually. Makes sense.

But what about the demand curve? If the demand curve SHIFTS to the right (due to a thriving economy and an increase in transactional demand for money) and the central bank keeps the money supply the same, the result would be deflation? An equilibrium with lower prices than before. i.e. A higher point on the supply curve (see my doodle below).

It would seem that no source considers a shift in the demand curve like any other S & D diagram. And I can't rationalise it for myself.

It seems totally counter intuitive. Could anyone explain the logic of this model when it comes to shifts in the demand curve (keeping money supply fixed).

• How could deflation occurs if it's clear from the graph that the price level increases? May 3, 2021 at 5:09
• According to Mankiw et. al. the price level is on the right hand side and inverted. So the move from P1 to P2 is a lowering of the price level i.e. deflation. The problem I have is that Mankiw doesn't deal with a shift in the demand curve in the textbook and if you start thinking about what would cause a shift in the demand curve it leads to something like: increased demand for money (shifting demand curve right) will lead to deflation.
– Food
May 3, 2021 at 5:39

If the demand curve SHIFTS to the right (due to a thriving economy and an increase in transactional demand for money) and the central bank keeps the money supply the same, the result would be deflation?

Yes, this would result in deflation ceteris paribus. In fact Mankiw Macroeconomics 8ed also mentions that in passing on pp 335, but you are right it does not explain intution.

The intuition is that if money demand shifts to the right and money supply is fixed that means that each individual unit of money will have higher value (e.g. this is equivalent to standard supply and demand model - fix supply of houses, increase demand for houses and you get that they have both higher value and price in equilibrium). Increase in value of money means that purchasing power of money increases which decreases the price level. New equilibrium interest rate will be higher because interest rate is essentially a price at which you can obtain money from banking sector (I am oversimplifying a bit to give you an intuition). Consequently, shift in money demand to right will increase interest rate, value of money and lowers a price level.

Conversely, if demand shifts to the left and money supply is fixed the value of each unit of money will drop, the interest rate drops as well and price level increases.

In addition, it is not true that no source discusses this. It is true Mankiw focuses on money supply in his Macroeconomics, but in Blanchard et al Macroeconomics an European Perspective there is whole sub-chapter that focuses just on change in money demand (see chapter 4.2 pp 62).

• Thanks you for the detailed answer. Yes you're right my "no source" comment was a little flippant. What I meant was "after 2 hours of google I have yet to find a reasonable explanation in language that I understand"!
– Food
May 18, 2021 at 12:21