I have been puzzled recently by the apparent lack of a cause and effect between the recent increases in US money supply and the CPI-U inflation rate.
So I went googling.
I was surprised to find out that I wasn’t the first person to notice this.
"July 1993 … Chairman Greenspan added, “The historical relationships between money and income, and between money and the price level have largely broken down, depriving the aggregates of much of their usefulness as guides to policy. At least for the time being, M2 has been downgraded as a reliable indicator of financial conditions in the economy, and no single variable has yet been identified to take its place.”
from: The Money Supply - FEDERAL RESERVE BANK of NEW YORK
I am glad I don’t make my living keeping up with the latest in monetary policy…
And it certainly appears that the Chairman is correct to date. Japan has been living with this disconnect for 20 years, and in the US there doesn’t appear to be any connection between money supply and inflation as measured by the CPI-U.
So, my friends, what evidence exists that growing the money supply in today’s world economy will cause significant inflation?
The quantity theory of money states that the following equation holds:
M * V = P * Y
where:
M is the money supply
V is the velocity of money (basically how fast people spend money)
P is the price level
Y is real aggregate output
The standard assumption has been that V is constant. If that’s true, then if the growth in the money supply outstrips growth in output, the price level must rise(i.e. there must be inflation). What central banks like the Fed have been grappling with is the fact that V has not been constant. When things turn bad, people get scared and hold onto money rather than spending it, and V drops. The central bank can keep increasing the money supply but if the recipients of that money don’t spend it nothing changes.
Increasing the money supply is certain situations can definitely lead to inflation. Zimbabwe is a recent, if extreme, example of that.
Most of the money the fed has creates sits idly in the form of excess reserves in the accounts of it’s member banks. According to the current issue of Bloomberg Business week (if I read the chart correctly) it’s over $1 trillion. It hasn’t caused inflation because it has never been introduced into the economy in the form of new loans. Therefore the velocity measurement never applied to this huge chunk of cash.
Add to that the fact that velocity (which I’m assuming is the same thing as observed money multiplier as reported by the St. Louis fed here)is not constant as you can see from the data presented there. Currently it is less than one and has been so for well over a year.
Zimbabwe is clearly an extreme example of exactly what happens when money supply grows faster than the economy in a “closed” system. Your example is quite good.
I would like to add to the discussion. First by limiting the discussion to the US dollar. Only because each currency is unique and the US $ is important in the world.
I would like to propose the idea that the key reason the world and the US economy is working as it does is due to the specific relationship between China and the US. China keeps their currency tied relatively tightly to the dollar. That is, even as the US creates additional dollars, their buying power in China is relatively constant. This has consequences for the rest of the world as well as the US. If Saudia Arabia wants to buy televisions, they buy (like the rest of the world) TVs made in China. To do that they take the dollars they earn from selling oil to the US and pay China at the relatively constant rate fixed by the Chinese government. So while there are a lot more dollars floating around, the buying power of those dollars has remained relatively constant. Hence, low inflation. So, low inflation in the US is in part, but only in part, due to the efforts of the Chinese. Who are doing this entirely for their own reasons. If they let their currancy float freely, their manufacturing base will suffer. So far, the US and Chinese interests coincide. This of course can’t continue forever, but for the next few years, I don’t see it drastically changing.
And of course this isn’t the only reason. Certainly the Gov’t created a lot of money. But at the same time, trillions of dollars have disappeared from the economy with the collapse of the housing market. People seem to forget that rising housing prices has exactly the same effect as the Gov’t printing money. Homeowners re-financed and created new money. While the Gov’t may have created more money than the housing bubble took away, the collapse of the financial markets and the decision by banks to hold much of the new money instead of lending it out means that the simple growth in the money supply has been balanced to a large degree by these effects.