The link between Money Supply and Inflation

Readers Question: When would an increase in the money supply not result in an increase in inflation?

In a simplified form.

  • Increasing the money supply faster than the growth in real output will cause inflation. The reason is that there is more money chasing the same number of goods. Therefore, the increase in monetary demand causes firms to put up prices.
  • If the money supply increases at the same rate as real output, then prices will stay the same.

Simple example

money-supply and inflation

  • In 2001, the output of widgets increases 20%. The Money supply increases 20%. Therefore, the average price of a widget stays at £0.50 (zero inflation)
  • In 2002, the output of widgets increases 16.6% and money supply also increases 16.6%. Prices stay the same and the inflation rate is 0%
  • However, in 2003, the output of widgets increases 14% but the money supply increases 42%. WIth the money supply increasing faster than output, there is a rise in nominal demand. In response to this rise in demand, firms put up prices and we get inflation.

Examples of increased money supply causing inflation

This link between the money supply and inflation can be seen in many historical cases.

US Confederacy 1962-65. During the Civil war, the Confederacy of southern states found itself short of finance (it could only raise 46% of the cost of war from taxes and bonds) so it increased the printing of money to pay for materials and soldiers. However, with economic output falling, this caused inflation of 700% in the first two years of war and reaching a peak of over 5000% by the end.

German Hyperinflation 1923. In the aftermath of the First World War, Germany faced high reparation payments. To meet these demands, the government started printing more money – so that firms could continue to pay workers. This led to an explosion in the inflation rate. By the end of 1923, printing money had got out of hand, and the economy experienced hyperinflation.

Zimbabwe 2008. Zimbabwe found itself in a similar situation. High government debt, falling output and a need to print money to stave off a short-term crisis. This printing of money led to hyperinflation of an estimated 79,600,000,000% in Nov 2008. A daily inflation rate of 98%

Diagram showing how increased money supply translates into inflation

LRas-inelastic-rise-ad-ms

 

In other words, if the money supply grows at the same rate as real output we maintain the same price level.

Why increasing the money supply does not always cause inflation

1. Growth of real output same as growth of money supply

supply-side-policies

Suppose the money supply increased by 4%. In a simplified model, this would lead to an increase in Aggregate Demand (AD) of 4%. If AS (productive capacity) also increased by 4%, then the price level would be unaffected. In other words, the growth of money supply is absorbed in the increase in real output.

2. Hard to Measure Money Supply.

Sometimes the money supply is hard to calculate and is constantly changing. Large increases in the money supply are often just due to changes in the way people hold money. For example, an increase in credit card use may cause an increase in th broad money supply M4.

3. Velocity of Circulation

MV=PY

The quantity theory of money equation assumes that an increase in M causes an increase in P. However, this assumes that V(velocity of circulation) is constant and Y is constant.

However, in practice, it is not as simple as this equation assumes. There are often variations in the velocity of circulation.

A good example is in a recession, the stock of money may rise 5%, however, people will be making fewer transactions and therefore the velocity of circulation will fall. This explains why quantitative easing (increasing the money supply) did not cause inflation between 2009 and 2016.

4. Keynesian view – Liquidity Trap

In a recession, there is spare capacity in the economy. Therefore, an increase in the money supply, merely helps to get unemployed resources used in the general economy. Therefore, in the case of a recession, increased money supply is unlikely to cause inflation.

In a liquidity trap, interest rates fall to zero but this doesn’t prevent people saving. In this situation, there is a fall in the velocity of circulation and this can cause deflation. In this situation, increasing the money supply will not necessarily cause inflation.

liquidity-trap-ms-demand-for-money

For a start, increasing the money supply doesn’t reduce interest rates any further.

Summary of Link Between Money Supply and Inflation

  • In normal economic circumstances, if the money supply grows faster than real output it will cause inflation.
  • In a depressed economy (liquidity trap) this correlation breaks down because of a fall in the velocity of circulation. This is why in a depressed economy Central Banks can increase the money supply without causing inflation. This occurred in the US between 2008-14
  • However, when the economy recovers and velocity of circulation rises, increased money supply is likely to cause inflation.

Quantitative Easing and Inflation

Quantitative easing led to a big increase in the monetary base

US monetary base

The Federal Reserve created money to buy bonds from commercial banks. Banks saw a rise in their reserves.

However, commercial banks didn’t really lend this money out. Therefore the growth of the broader money supply didn’t change much

What happened is that commercial banks merely oversaw a rise in their reserves

The US inflation rate was largely unaffected by this increase in the monetary base. Stripping out volatile cost-push factors (food and fuel), core inflation remained below the 2% inflation target

us inflationSource: US CPI

Further Reading

28 thoughts on “The link between Money Supply and Inflation

  1. Well i think you were right in saying that all the money that was printed is kept in the banks for now. But what happens when the banks start lending again. What happens when this money starts to change hands in the economy. The answer is simple inflation.However, the people who are doing this are not the ones who have to worry about it as by the time this mess is sorted out and the banks start lending again they will all be out of office. On the other hand, those who will be in office at the time will have no other choice by to suck this money out of the economy and the result will be a dramatic increase in interest rates that would probably leave the economy crippled. Think Paul volker and the sluggish growth rates of the early 1980s. Now, no one knows exactly how interest rates will need to rise or how sluggish the economy would be. This is not to say that QE was a bad idea. QE was probably the only way out. However, this is just to say that QE has a price and sooner or later those countries that engaged in QE will need to pay that price. The only way to see whether or not this price was worth paying is to wait until these economies start functioning again.

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