High inflation can prompt people to reduce their money holdings, potentially causing the money supply to rise and inflation to rise. Which outcome best describes this sequence?

• A. Decrease; Increase
• B. Increase; Increase
• C. Increase; Decrease
• D. Decrease; Decrease

Answer: (B)

When inflation is high, money loses value quickly, so people want to hold less cash and other liquid balances. That drop in money holdings means money demand falls. If the overall money stock hasn’t contracted by the same amount, banks have more funds they can lend, and through the lending and deposit creation process they can increase the money supply. A larger money supply, with prices still adjusting upward, tends to push the price level higher, fueling even more inflation. So the best description of the sequence is that money holdings decrease first, and the resulting lending expansion raises the money supply, which then raises inflation.