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The Quantity Theory of Money equation states there exists a direct relationship between the price levels of services and goods traded and the quantity of money in any economy. According to the Equation, when the amount of money in circulation goes up by twice its original figure, the prices of services and goods also double. The effect of the doubling in both the amount of money in circulation and the price levels of service and goods is inflation. The result of inflation is that the consumer is left to bare the most burden as he pays double for the same amount of services and goods. The equation can be simply stated as MV=PT where the variables representing, M; Money Supply, V; Velocity of Circulation, P; Average Price Level and T; Volumes of Services and Goods transacted (ManKiw, 2008). The quantity of money equation implies that the quantity of money in circulation is based on in determining the money value thus forming a monetarism cornerstone. From the equation, it is clear that a rapid increase in the supply of money results to a rapid inflation increase. The increase of money surpassing the economic growth results to inflation because of the excess amount of money expected to finance the minimal production of services and goods. Hence monetarists are in agreement that a rapid increase in the distribution of money can lead to rapid fix boost to the economy that is already staggering so as to increase its production. In the long run, however, the monetary policy effects remain blurry.
In the Banana Republic vs. US FED figure, the phenomenon illustrated by the X and Y axis are the money index verses recession indicating the declining purchasing power of the dollar (ManKiw, 2008). Monetarists can be considered to have failed in their key recommendation while refereeing to the constant growth in money supply. However, they are credited for succeeding to advocate the manipulation of money supply as having the powerful consequences which are in some ways harmful to the economy. The existing monetary authorities appreciate the limitations associated with the monetary policy. The Federal Reserve on its part watches over the economy keenly and gathers a lot of information on the economy state before making any major action towards monetary action. Hence monetarists did not completely fail as they at least succeeded in adding caution on the monetary policy (ManKiw, 2008).
Inflation targeting is a strategy used by the monetary policy and makes use of the existing public announcement on targets concerning official quantitative on the rates of inflation covering one or multiple times horizons. This is achieved by the explicit acknowledgement of stable inflation that is low in relation to the monetary policy as its main aim in the long run. When New Zealand passed the Reserve Bank Act in the year 1989, it became the first nation to set its strategies towards inflation targeting (ManKiw, 2008). Since that time, many other central banks have joined in the inflation targeting trend but most of them based on the New Zealand model.
Demand pull refers to a situation in which the demand for any service or good increases to a point where the price of that item is forced to increase until it reaches a new supply demand curve equilibrium. Cost push on the other hand refers to a situation where the price of a certain good and service have to be increased as a result of the increased cost of producing the product or service (ManKiw, 2008).
Inflation on the Y axis on the government spending graph tends to stabilize when the country is not facing recession thus the graph assumes a downward trend. The Philips curve essence is that there exists a trade off that is short lived between inflation and unemployment. This because the falling unemployment trend might result in increased inflation while inflation fall might only occur when unemployment is allowed to rise. If the government thinks of cutting on employment rate, it could settle for an aggregate demand increase, however, this will lead to inflationary implications in the product markets and labor. The Stagflation model came up as a result the soaring inflation in US in the 1980’s when inflation rates rose to a record 12 percent while unemployment doubled its original figure to settle at 9 percent (ManKiw, 2008). The inflation had been caused by the oil prices that had quadrupling, rapid increase in the prices of basic raw materials and also the lifting of the wage and price controls that were imposed by the government during the Vietnam era. The rates worsened as they increased as a result of doubling of the petroleum prices doubling. The stagflation was come as a surprise as the country had a rich historical data on both high unemployment and high inflation rates thus regarded as mutually exclusive events (ManKiw, 2008).