Monetary Theory

This chapter presents a contemporary and easy to understand version of the quantity theory of money. It explains how the theory provides a simple explanation of how and why inflation occurs, and the ways in which monetary policy is used to influence the economy. The chapter tries to set these debates in the broader context of whether the costs of trying to conduct complicated monetary policy outweigh the benefits. In doing so, it highlights some of the ways in which inflation can generate false signals that can induce managerial errors. Whilst it is impossible to fully distinguish between false and true signals, an awareness of the difference can be a major source of competitive advantage. ‘Inflation’ can be used by economists to mean different things, so it is important to be clear about what is being ‘inflated’. The chapter also examines how macroeconomic variables relate to each other.