Intro: Inflation can be thought of as the result of too much money chasing too few goods. Increases in the money supply gradually erode the purchasing power of money, but not in a linear fashion. The bulk of global money supply is created by the private banking system, although government bond issuance also has a similar impact on inflation.
Understanding inflation is easy if you stick to simple supply and demand dynamics. As with anything else, an increase in the supply of money will tend to reduce its value over time. That is not to say that a 10% increase in the money supply will lead to a 10% increase in prices as there are many other variables such as economic growth and the demand to hold money as a store of wealth. However, as the data shows, high money supply growth tends to go hand in hand with high inflation:
Money is Created by Bank Loans or Direct Central Bank Creation
In most economies the majority of the country’s money supply and changes in it are determined by the commercial banking system. When a new loan is created, say for a mortgage, this increased the amount of money in the economy by the amount of the loan. Conversely, when a loan is paid back, the money supply is reduced by this amount.
Alternatively, a central bank can increase the money supply directly through quantitative easing, as is happening in many emerging and developed countries currently. In the process, central banks effectively create money out of nothing to purchase government bonds, resulting in a direct increase in the money supply and a reduction in the supply of bonds available in the market.
Government Bonds are also a Form of Money
One important point to note regarding the impact of money supply on inflation is that government bond issuance acts in the same manner as base money creation in terms of its impact on inflation. This is why fiscal deficits tend to be inflationary even if they do not result in increases in the main monetary aggregates. When a government issues a government bond to finance its fiscal deficit, it exchanges a piece of paper for real goods and services in the economy, just as would be the case if it printed currency directly. These bonds act as a store of value and a medium of exchange enabling greater monetary spending in the same way as currency. The Milton Friedman quote that inflation is always and everywhere a monetary phenomenon is somewhat misleading due to its omission of this key point.