Inflation basics and understanding

Question

In some new country, there's 1 million credits in circulation, and Product X costs 10 credits. If I were to print, say, 500,000 credits and build a new swimming pool with this, how exactly would inflation increase? Why would the cost of Product X increase (to approximately 15 credits?)?

If prices and thus inflation are set by humans, then how would they know to hike up prices? Is it the increase in 'supply' of money, since whomever received some portion of the 500k stacked on top of what they already had and now they have more to spend?

Answer 1

The grey-haired "Quantity Theory of Money" is a good initial way to gain some clear understanding for inflation. This theory is just one equation,

$$PQ = VM$$ where

$P$ is the price level, $Q$ is quantity produced, $M$ is money supply, and $V$ is "velocity of money", which represents how "fast" money circulate, given the transactional technology and other institutional aspects of an economy. For example, in an economy where bank branches are interconnected by a real-time on-line system, money circulates faster compared to an economy where bank branches are interconnected only through, say, telegraph, which in turn move money faster compared to an economy where banks are not interconnected at all, and money has to move physically from one person to another.

Assume that we produce $Q=10$ pieces each at a price of $P=15$ kudos. Do we need $10 \times 15 = 150$ kudos to complete all buy-and-sell transactions? No. If velocity of money is, say $V=3$, we only need $M=50$ kudos to facilitate all transactions, because money circulates "three times around" (before the next production cycle is completed).

Now, in standard economic theory, economies are close to "full employment level of production factors" (which may allow for friction unemployment of humans, machines etc).

Now, assume we increase the money supply to $M=100$. The right-hand-side of the equation becomes $VM = 3 \times 100 = 300$. What happens to the left-hand-side? Well, since production cannot increase (because all available production factors are already employed), it has to be the Price level that will increase to $P=30 \implies PQ = 30 \times 10 = 300$.

Intuitively, buyers with more money in their hands will increase their demand (the demand schedule will shift rightwards in a diagrammatic representation), but supply won't change, because it cannot change. Suppliers will increase their prices since there is now "competition among buyers". Hence, inflation.

This is the most simple explanation about how increasing the quantity of money in a full-employment situation, will create inflation.