Inflation is a Monetary Phenomenon, But This Isn’t Inflation

There has been much talk recently about the potential inflation on the horizon given the unprecedented movement of the Federal Reserve of increasing the monetary base through quantitative easing. The talk has predominantly surrounded the substantial increase in the monetary base. However, increases in the monetary base are not sufficient to cause inflation. Like discussion of other markets, we must consider both supply and demand conditions.

Milton Friedman famously quipped, “inflation is always and everywhere a monetary phenomenon.” Friedman was undoubtedly correct. However, recently a few seem to have taken this claim to mean something different entirely. Namely, that any increase in the money supply necessarily causes inflation. This is something that Friedman himself did not believe.

In his restatement of the quantity theory of money, Friedman pointed out that the quantity theory is primarily a theory of money demand. Specifically, quantity theorists view the level of real money balances as more important than the nominal quantity of money. Thus, if at any point in time people have chosen to hold some level of real money balances that they deem optimal, an increase in the nominal money supply will leave these individuals with a larger level of real money balances than they wish to hold. These individuals will then necessarily try to reduce their holdings of nominal money balances such that their real money balances fall back to their optimal level (perhaps by increasing spending). Unfortunately, as a group, they will not be able to do so because every person’s spending is another person’s receipt (or income). Initially output will increase and gradually prices will rise until the level of real balances falls back to the optimal level.

Given this discussion, it should not be difficult to understand why I prefer a monetary equilibrium framework. What’s more, it should be apparent that what causes inflation is not an increase in the money supply, but rather an excess supply of money.

Ultimately, the question at hand is whether the current increases in the monetary base imply that there is an excess supply for money. If so, inflation is on the horizon. If not, we need not fear inflation.

Personally, I do not believe that the recent increases in base money imply that there is an excess supply of money. There are a couple reasons for this belief. First, it has been well-known — at least among monetarists — since Clark Warburton’s influential work that the peaks in the time series variables important for quantity theorists follow this order: (1) money, (2) output, and (3) velocity. The implication here is that declines in velocity (increases in the demand for money) are an accentuating feature of the business cycle. In other words, after output begins to fall, the demand for money increases. As our previous discussion of monetary equilibrium implies, this creates an excess demand for money, which results in falling output and prices — thereby exacerbating the previous decline in output.

Second, the money multiplier has declined drastically. In fact, the money multiplier for M1 remains below 1. This means that for every increase of $1 in base money, the money supply (as measured by M1) increases by less than $1. In order to determine the cause of the decline in the M1 multiplier, we should first discuss its components. The money multiplier for M1 consists of the currency-to-deposit ratio, the required reserve-to-deposit ratio, and the excess reserve-to-deposit ratio. An increase in any of these ratios implies that the money multiplier will fall. The required reserve ratio is set by the Federal Reserve and has not changed. Thus, the decline in the M1 multiplier must be the result of changes in the currency-to-deposit ratio and the excess reserve ratio. As previously mentioned, the demand for money often increases during the downturn in the business cycle. What’s more, financial crises often induce a flight to quality in which individuals abandon risky investments for safe investments such as bonds or cash. The increase in cash balances increases the currency-to-deposit ratio.

The largest cause of the decline in the money multiplier, however, is the result of the increase in the level of excess reserves. What’s more, this increase in excess reserves can be directly attributed to the fact that the Federal Reserve started paying interest on excess reserves late last year. In doing so, the Fed essentially reduced the opportunity cost of holding excess reserves thereby giving banks the incentive to hold more reserves on their balance sheets. This is why our friend Scott Sumner not only supports eliminating the interest payments on excess reserves, but prefers that the Fed impose a penalty on those who hold reserves above the required level.

Ultimately, the money multiplier (M1) has fallen from around 1.6 prior to the recession to .93 as of June 17. At the beginning of January 2008, the monetary base was roughly $848 billion. Given that money multiplier, this would suggest that M1 was around $1.356 trillion. Thus, given the current money multiplier, this would suggest that the monetary base would have to be about $1.458 trillion today to maintain the same money supply — an increase of roughly 72%. Given that we are currently in a recession, this suggests that the Fed wants to increase the money supply rather than simply maintain the earlier level. Given that the monetary base is about 90% higher than it was at this time last year, this would suggest that the Fed is expansionary, but hardly over-expansionary given the circumstances surrounding money demand.

With that being said, the Fed must be careful and begin pulling money out of the economy when this demand for base money subsides and the money multiplier begins to rise again. A failure to do so would result in a substantial period of inflation. However, at the current time, the evidence suggests that the massive increase in the monetary base is justified by the increase in the demand for base money. Thus, the increase is in the monetary base doesn’t suggest that massive inflation is on the horizon … yet.

(In the future, I hope to post on how the Fed can prevent finding itself in such a precarious situation in the future, but this is clearly enough for now.)

11 responses to “Inflation is a Monetary Phenomenon, But This Isn’t Inflation

  1. The quantity theory of money sounds sensible until you start asking what exactly counts in ‘M’, what happens to prices when checking accounts and credit cards are introduced, and what happens to prices in Mexico when Mexicans start trading with dollars. The backing theory of money does not suffer from these flaws, is supported by the empirical work of Sargent, Smith, Bomberger, Makinen, Calomiris, etc., and also explains that the recent explosion of base money will not be inflationary, since it was accompanied by a comparable explosion of the Fed’s assets.

  2. Good post and good info. If you haven’t come across him yet, may I suggest you look up Steve Keen’s blog and, in particular, his post titled: The Roving Cavaliers of Credit
    http://www.debtdeflation.com/blogs/2009/01/31/therovingcavaliersofcredit/

    I am sure you’ll find what Steve has to say about monetary creation to be interesting and, maybe, surprising.
    Thank you for posting

  3. I would define inflation simply as a growth in the money supply. I prefer not to look at formulas or the M1 or the CPI to gauge anything. The question you have to ask is: How long is China (And every holder of dollar reserves) going to keep those dollars off of the market? No matter what the Fed does they cannot control the flow of dollars back into the market. If dollars come back into the market only the US is going to stem the tide. The money contraction in the US would be severe and kick off another recession.

    I beleive China to be cutting long term contracts for resources in dollars. They know they have a wasting asset that they need to use. What tells me this?
    -China is the world’s largest gold producer and the central bank is sucking it all up to get their reserves into the same league as other Western economies
    -China is gradually putting the yuan out for settlement
    -They almost bought Rio Tinto!
    -They are apolitical in their economic transactions. No regime to brutal, no dictator to cruel to prevent China form doing business with them.
    -China is buying/stockpiling resources. and they are increasing their own strategic oil reserves
    Everything they are doing suggests they are preparing for an economic expansion.

    Volcker raised rates above 20% when we owed mostly 30 year bonds to ourselves. How high would rates have to go to stave of inflation when the world starts spending dollars? Inflation is not a question of economics but of domestic and geo-politics.

    “With that being said, the Fed must be careful and begin pulling money out of the economy when this demand for base money subsides and the money multiplier begins to rise again. ”

    If Bernanke does not have the discipline to raise rates now how could he do so when it is politically untenable to do so? When he still has an administration trying to prop up the economy with consumer spending? When they are still trying to prop up the housing market?

    All I see are years of high interest rates.

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  9. Cornelius kuzorli yao

    When money supply growth exceed the growth rate in the economy for a period of time.

    • Cornelius kuzorli yao

      It might be that the velocity is declining. But when there is excess money with increasing velocity, there is inflation…

  10. Thank you for an informative summary..but is infation always monetary.lets discuss

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