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Excess demand is not merely the result of people wanting more: they must also have more money with which to buy, thus driving prices up. For society in general (consumers, businesses and governments) to be spending more money, there must be more money in circulation – the money supply must rise. Any period of rapid inflation is accompanied by rapid increases in the money supply. And, as we have seen, the growth of the money supply is controlled by the Bank of Canada, which is ultimately responsible to the federal government. Thus, the key factor underlying the rate of inflation – the money supply – is in the final analysis determined by the federal government. In determining its monetary policy, however, the Bank of Canada is not concerned solely with combating inflation. In particular, we have seen that increases in the money supply (easy money) can be used during recessions, to reduce unemployment. While easy money policies can help to lift the economy out of recession, there is a danger that the government will boost the money supply too quickly and/or for too long a time. Of course, this will result in a new surge of inflation, but only after a time lag.

Experts in the monetary aspects of economics say that if the money supply is increased excessively rapidly, inflation will probably begin to increase after about a year and will continue to work its way through the economy for another two years more. Thus, while rapid increases in the money supply may look like a good idea to a government faced with a recession and high unemployment, they are all too likely to cause a much worse inflation problem in the future. An excellent example of this was in Canada, where rapid increases in the money supply in 1972, 1973, and 1974 led to a very serious wave of inflation in 1973 and beyond. Following this experience, the Bank of Canada undertook to keep the rate of increase of the money supply within specified limits.

Generally then, the level of aggregate demand for goods and services is the key factor underlying the rate of inflation. Generally, inflation tends to be most severe during economic booms, when demand is high, and less severe during recessions, when demand is sluggish.

The growth rate of the money supply is, over time, the single most important determinant of the inflation rate.

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