Money is the stock of assets used for transactions. It serves as a store of value, a unit of account, and a medium of exchange. Different sorts of assets are used as money: commodity money systems use an asset with intrinsic value, whereas fiat money systems use an asset whose sole function is to serve as money. In modern economies, a central bank such as the Bank of Canada is responsible for controlling the supply of money.
The quantity theory of money assumes that the velocity of money is stable and concludes that nominal GDP is proportional to the stock of money. Because the factors of production and the production function determine real GDP, the quantity theory implies that the price level is proportional to the quantity of money. Therefore, the rate of growth in the quantity of money determines the inflation rate.
Seigniorage is the revenue that the government raises by printing money. It is a tax on money holding. Although seigniorage is quantitatively small in most economies, it is often a major source of government revenue in economies experiencing hyperinflation.
The nominal interest rate is the sum of the real interest rate and the inflation rate. The Fisher effect says that the nominal interest rate moves one-for-one with expected inflation.
The nominal interest rate is the opportunity cost of holding money. Thus, one might expect the demand for money to depend on the nominal interest rate. If it does, then the price level depends on both the current quantity of money and the quantities of money expected in the future.
The costs of expected inflation include shoeleather costs, menu costs, the cost of relative price variability, tax distortions (such as the disincentive to save and invest), and the inconvenience of making inflation corrections. In addition, unexpected inflation causes arbitrary redistributions of wealth between debtors and creditors.
During hyperinflations, most of the costs of inflation become severe. Hyperinflations typically begin when governments finance large budget deficits by printing money. They end when fiscal reforms eliminate the need for seigniorage.
According to classical economic theory, money is neutral: the money supply does not affect real variables. Therefore, classical theory allows us to study how real variables are determined without any reference to the money supply. The equilibrium in the money market then determines the price level and, as a result, all other nominal variables. This theoretical separation of real and nominal variables is called the classical dichotomy.