t o But there can also be a fundamental change in the value of money due to the law of supply and demand. If demand is fairly constant, and the supply is significantly increased from Q1 to Q2, as shown in the figure to the right, the result can be that the entire supply curve shifts to the right from S1 S 2 , a n d t h e v a l u e o f m o n e y d r o p s , f r o m P 1 t o P 2 . I f t h i s o c c u r s o v e r a s u s t a i n e d p e r i o d , the result can be a permanent change in the value of the monetary unit. An inordinate increase in the supply of money is the classic cause of inflation, and it is typically the result of a government deliberately printing additional currency in a vain attempt to create wealth. History has demonstrated over and over through the centuries that such tactics always result in inflation (a deflated currency.) +
Inflation can also be caused by a restriction in the supply of an essential commodity such as crude oil. Oil is an energy source, and energy need is pervasive in a modern economy. The high inflation rates in the US and Europe in the '80's is attributed to the oil cartel's success in limiting production and raising crude oil prices. 55
The supply and demand example explained above is a simplified model. In the real world, both supply and demand can interact in a vicious cycle. As government increases the supply of its currency in a vain attempt to create wealth, the currency falls in value, the demand for the currency decreases, which prompts the government to print even more currency to make up its loss in value, and so the cycle of increasing the supply and the fall in value of the currency repeats until the currency becomes worthless or the economy collapses into a recession.
As explained above in the Law of Supply and Demand model, the cause of inflation is generally related to an unjustified expansion of the money supply36. Money supplies are always fluctuating to some degree, because worn out currency needs to be retired from circulation and replaced with new currency, because some individuals and subgroups within a society tend to hoard currency rather than let it circulate, and because currency is held in the foreign exchange reserves of other countries.
The money supply can be increased without causing inflation only if demand increases. If demand falls, deflation can be avoided by decreasing the money supply. In the United States, the money supply is typically controlled (or attempted to be controlled) by the Federal Reserve Bank (central bank, in other countries) by varying the interest rate at which it loans money to its member banks. The theory behind this is that the Federal Reserve Bank is the sole source of its currency supply (for US dollar), and the rate of interest it charges affects the supply and demand for US dollars – if the price of borrowing increase, the demand for currency will decrease.
However, because the US dollar is the de facto international currency, and so much of it is held by foreign markets, they can have more influence on its supply or demand than the Federal Reserve Bank.