In the long run, inflation is driven by how fast the money supply grows. The quantity theory of money explains why. Use the calculator to see how money growth turns into inflation, then use the AD–AS graph to see why extra money raises output only in the short run.
The equation of exchange is M × V = P × Y. In growth rates it becomes %ΔM + %ΔV ≈ %ΔP + %ΔY. Solve for %ΔP and you get the inflation rate.
M = money supply, V = velocity (how many times each dollar is spent per year), P = price level, Y = real GDP. P × Y is nominal GDP.
A one-time increase in the money supply shifts AD right. In the short run, output and prices both rise. In the long run, wages and price expectations catch up, SRAS shifts left, and only the price level stays higher. Dashed grey lines show the starting position.
Total spending (money times how often it is spent) equals nominal GDP (prices times real output). It is always true as an accounting identity.
If velocity is stable and real GDP is set by real resources, then faster money growth must show up as a higher price level. More money chasing the same goods means higher prices.
In the long run, changes in the money supply change only nominal variables (prices, nominal wages, nominal GDP). Real GDP, unemployment, and the real interest rate return to their long-run levels.
Nominal values are in current dollars. Real values are adjusted for inflation. Money can change nominal values forever but changes real values only temporarily.
Classical economists argue wages and prices are flexible, so money affects only prices. Keynesians stress that sticky wages let money affect output in the short run. AP uses both: short run is sticky, long run is flexible.
High inflation erodes purchasing power, hurts savers and lenders when it is unexpected, raises menu and shoe-leather costs, and makes planning hard. Many central banks aim for about 2%, not 0%, to leave a cushion against deflation.
The time frame in the question decides the answer. Read for words like "in the long run" or "after the economy adjusts."
| Event | Short run | Long run |
|---|---|---|
| One-time increase in the money supply | AD shifts right. Real GDP ↑, price level ↑, unemployment ↓ | SRAS shifts left. Real GDP back to full employment, price level higher |
| One-time decrease in the money supply | AD shifts left. Real GDP ↓, price level ↓, unemployment ↑ | SRAS shifts right. Real GDP back to full employment, price level lower |
| Money supply grows faster every year | Inflation starts rising; output may rise briefly | Inflation rate rises by about the same amount as money growth |
| Money supply grows at the same rate as real GDP (V stable) | Little change | Stable prices, about 0% inflation |
| Expected inflation rises because of money growth | Nominal interest rates rise (Fisher effect) | Real interest rate unchanged; nominal rate = real rate + expected inflation |
AP-style multiple choice. Pick an answer to see the explanation.
The vocabulary for topic 5.3. Read the list, flip through flashcards, or quiz yourself. For every term in the unit, see the Unit 5 terminology guide.