How does an increase in money supply typically affect inflation?

An increase in the money supply typically increases inflation due to the basic principles of supply and demand in the economy. When the money supply grows, consumers and businesses have more funds available to spend. This increased liquidity leads to a higher demand for goods and services. If the output of goods and services does not increase at the same rate as the money supply, it can lead to demand-pull inflation—where the demand exceeds the supply, causing prices to rise.

Additionally, with more money circulating in the economy, individuals may be more willing to spend rather than save, further driving demand. This phenomenon can also result in an expectation of rising prices, which motivates businesses to increase their prices preemptively. The combined effect of increased demand and expectations of inflation contributes to an overall increase in price levels, affirming the relationship between an increased money supply and rising inflation.

Understanding this dynamic helps explain why central banks often monitor and manage the money supply to achieve their inflation targets, aiming for economic stability.