As I said before, the Quantity Theory of Money states that the growth rate in the money supply will equal the growth rate in the prices of goods and services in an economy (inflation rate) minus the growth rate in real Gross Domestic Product. Rearranging this equation, we have:
Â
This is called the inflation equation. As we said above, although this relation does not hold for every year, it is accurate over the long run, a fact supported by the empirical evidence. To paraphrase the Nobel Prize-winning economist, Milton Friedman, inflation is always and everywhere a money supply problem (1970).
As a thought experiment, imagine an economy with a certain (fixed) money supply. You need money to buy goods and services created within that economy (the GDP). Now let’s imagine that over time the money supply grows 10% greater (rate of growth = 10%) but the goods and services do not change at all (rate of growth= 0%). Therefore, the prices paid for the fixed amount of goods and services will be bid up by 10% (rate of inflation=10 %).
For example, consider Robert Mugabe, the strongman dictator who ruled Zimbabwe for over 30 years. From 2007 to 2010, he created seismic shifts in his country’s monetary policy. Since he needed more money to run the government, to pay the military, and to buy imports, he simply ordered the Central Bank of Zimbabwe to print more money. Unfortunately, he printed so much money compared to the supply of goods and services that the rate of inflation in 2008 was over one billion percent (1,000,000,000%). As things became more expensive, the Central Bank had to print currency notes in larger and larger denominations so the residents would not have to carry money around in wheelbarrows to pay for food at the market.
In addition, Mugabe instituted poorly executed land reforms that did not help, but the root cause of the hyperinflation was printing too much money.
In 2009, so many people had lost confidence in the Zimbabwe dollar that the government had to allow the U.S. dollar and other foreign currencies to be used for payments. They also stopped printing the Zimbabwe dollar, which caused the inflation rate to drop precipitously. Even so, in 2010, it still cost 100 Billion Zimbabwe dollars to buy lunch. Eventually, the inflation rate in Zimbabwe was tamed (relatively, at least), and as of June 2019, the official inflation rate was 97.8% annually.