On Money Supply and Inflation

The theory and link between Money and Inflation.

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A lot can be said about Money Supply and Inflation. Both appear constantly as reasons for certain public policies or a price of a commodity like gold or bitcoin. But let’s do a deep-dive on what they mean and the relation or lack thereof of these two variables.

Let’s get to it.

What is Money Supply?

Money Supply, in layman’s terms is the amount of money available in the economy of a country, but there is a lot of nuance in that statement and it rarely gets addressed properly. To understand what money supply means we should know how it’s measured.

Money Supply is measured with what is called monetary aggregates. These are mostly standardized by name but their formulas differ by regions. In Europe, the ECB works with the monetary aggregates M1, M2 and M3, lets go over them:

  • M1: The sum of currency in circulation and overnight deposits.

  • M2: M1, deposits with an agreed maturity of up to two years and deposits redeemable at notice of up to three months.

  • M3: M2, repurchase agreements (also known as a repo, is a form of short-term borrowing, mainly in government securities), money market fund shares (highly liquid, near-term instruments) and debt securities with a maturity of up to two years.

There are different configurations that use M0, MB, M4 and MZM, here are some links for more information on aggregates in the USA and the UK.

The Inflation Link

Inflation, the everlasting complicated love-hate relationship of every economy. When it’s not there, we want it to come. When we have too much, we want it to chill and give us some space. An the end of the day, even though psychologist might say it’s not healthy, we just want to fully control it!

Basically, inflation is a general rise in price levels over a period of time which causes each unit of our currency to have less buying power. But inflation is much more than that to an economist.

The exact nature of inflation or price increases is in constant debate by economists, The general and most prevalent idea is that prices increase because the quantity of money in the economy grows faster than its level of productivity.

But, how do we control inflation? why is it that since 2008, with all that money being pumped into the economy, we aren’t all living and dealing with hyperinflation? We will get to that. — Just a heads up, I don’t know the answer either, I’m an economist, weathermen get it right more often than we do :) —

Governments and central banks work (or should work) together with the objective of keeping these variables in check, targeting a 2-3% inflation with fiscal and monetary policies. In “normal times” when a central bank raises interest rates, consumption and investments naturally slow down, curtailing inflation. Alternatively, when central banks lower interest rates, they are incentivizing the economy to grow by making credit cheaper.

Bear in mind, every simplified explanation in economics is derived from a theory or model that, in most cases, uses the phrase “ceteris paribus”, which means "other things held constant". As we all know, life just doesn’t work that way. It’s useful for studying hypotheticals and variable relationships but when applied to the real world, more often than not, it just falls short.

Why do we want inflation at all?

Good f**king question! Every economy in the world is terrified of the word “deflation” and there’s a reason for that.

The most logical explanation for me is John Maynard Keynes “Paradox of thrift”. It basically states that personal savings are not good for economic growth and that current spending drives future growth. Ask yourself, what would anybody do if they knew prices will be lower next week? Wait and spend another day, right? That is just human nature and it drives economies into a spiral that destroys growth, investments and consumption.

Keynesian theory is the one to blame or thank for your government’s and central bank’s response of pumping money into the economy after the financial crisis of 2008 and the corona virus of 2019. Austerity (favored measure of some governments like Spain) would not work according to Keynes because a recessed economy will not produce and grow on its own when a big part of land, labor or capital are being unused. Keynes answer? Lower interest rates, buy securities, rescue “too big to fail” entities.

Keynes believed in the Circular Flow Economic Model: spending now, moves the economy, economy grows, more money to spend, etc. But remember, all these theories have a lot of “ceteris paribus” in them, even if they are not explicit. The key takeaway of the last four paragraphs is: There is a reason for governments to want a bit of inflation, which is to keep the economy away from recession, away from deflation, and keep it moving forward and upward.

Let’s move this along..

Okidoky, now that we understand what it means when we hear money supply (a monetary aggregate) and what inflation is, lets move on and dig into their relationship.

Monetarism and Quantity Theory of Money

Monetarism is a school of thought that has as a central premise that the supply of money in an economy is the main driver of economic growth.

I’m not going to go deep into monetarism, this post is already long enough, but its interesting to know that Milton Friedman challenged Keynes theory, calling it the "naive Keynesian theory" and argued "inflation is always and everywhere a monetary phenomenon".

To analyze the relationship between Money Supply and Inflation we use an equation that was developed by the famous American economist, Irving Fisher.

The quantity theory of money tells us that increases in the quantity of money tend to create inflation (P) and vice versa.

The Fisher equation:

The simplicity of this equation allows for fast conclusions, often by adding an overline above T (often substituted by nominal GDP) and V, an annotation that represents that we assume that they are constant variables. Meaning what? Our old friend, “ceteris paribus”, which would create a direct relationship between increases in money supply and inflation.

Still there are many competing theories that reject the direct relationship of M and P like the ones from Keynes or Knut Wicksell, Ludwig von Mises and Joseph Schumpeter. They all agree that increases of the quantity of money leads to higher prices but add many nuances that depend on how the M is being increased or what other variables might be taken into consideration.

I emphasize this equation because it’s often referred to in an over simplistic way, in order to promote investments with claims like “The quantitative easing or money printing euphoria will make your money worthless, buy X and protect yourself” and even though it might ring true or even be true in some cases, there is a lot to unpack and many variables to take into account before accepting such claims as correct.

The link conundrum

What if we take the velocity of money (V) into account? If it falls, wouldn’t that allow theoretically speaking, an economy to increase the money supply without creating inflation?

The St. Louis Federal Reserve tracks the quarterly velocity of money, here it is:

Pre Covid-19, the level was around 1.45, since then, the economies have adopted a expansive monetary policy. Will this generate inflation after the crisis? It didn’t happen after the last two crisis but we’ll see!

As the St. Louis Federal reserve wrote:

“So why did the monetary base increase not cause a proportionate increase in either the general price level or GDP? The answer lies in the private sector’s dramatic increase in their willingness to hoard money instead of spend it.” and “Since 10-year interest rates declined by about 0.5 percentage points between 2008 and 2013, the velocity of the monetary base should have decreased by about 0.085 points. But the actual velocity has gone down by 5.85 points, 69 times larger than predicted. This happened because the nominal interest rate on short-term bonds has declined essentially to zero, and, in this case, the best form of risk-free liquid asset is no longer the short-term government bonds, but money.” full FED article here.

Final thoughts

Beware of soundbite claims on economic variables or policies to promote investments. Remember that there’s still a discussion among leading economists on how certain monetary and fiscal measures impact economic variables, ergo, any claim suggesting that something (stock or commodity) will increase its value should be taken with a grain of salt. Especially if the pitch promises with jargon-filled phrases, much more than a hedge against inflation.

Hedge your bets, ponder claims and think long term.