Home > Economics > Inflation – Part 2

Inflation – Part 2

In part 1 I (hopefully) illustrated the point I was trying to make, which is that a low stable and predictable rate of inflation is actually preferable to a no inflation state, primarily because it encourages consumption and give policy makers some space in which to influence the economy. I’m sure the libertarians and free-market dogmatists will object, but I will have to leave that discussion for another time. In this post, I want to discuss the money supply and it’s effects on inflation. It will probably get more technical later in the post, however I’m sure you can follow along with some simple algebra and I will try to explain everything in laymen’s terms as much as possible. I’ll also try to pretty this post up with some charts.

Let’s begin with the money supply. The money supply is the amount of money (in the US, dollars) that is available for the private sector to use. This includes all cash (paper and coins)  in circulation, all money sitting in demand accounts (demand is the technical term for checking accounts) and most savings accounts, money market accounts, money market mutual funds, and short term CD’s. You can think of it more simply as any type of account that you could convert into cash relatively easily without have to “sell” something.

The Classical Picture

The classical picture of how the money supply is determined is called the “money multiplier” and goes something like the following. Banks acquire or borrow federal reserves from the Fed. Then, through fractional reserve banking they can lend out more than they have. In the US the fractional reserve requirement is 10%. That means banks only have to have 10% of what they loan out. Using this methodology, the banks loan out 10 times (1/10%= 10) the amount of reserves they have. So the reserve amount times 10 equals the money supply. The government controls the supply of reserves, therefore the government controls the money supply. If the government spends more than it taxes then the amount of reserves in the system increases therefore increasing the money supply. You could take it one step further and say that increasing the money supply produces inflation, therefore deficit spending produces inflation.

The Real Deal

As you can probably guess, I’m going to explain to you why most of the preceding paragraph is wrong. First, let me start with fractional reserve banking and the money multiplier. In reality, the order is completely reversed. Banks make as many loans as they think they can service profitably. Then, they go borrow reserves to meet their reserve requirement. Let me say that again to hit the point home. Banks are not reserve constrained. They make as many loans as they want, then go get the required amount of reserves. This totally destroys the money multiplier model. The main source of fluctuation in the money supply are supply and demand of bank loans, not government spending. Someone needs to want to borrow money and the banks must find them credit worthy enough to loan to. Here is a chart that shows reserves (called M0) and the money supply (called M2) over time. notice how the big spike in reserves in 2008 did not produce a large spike in the money supply. Also notice here that the money multiply is not a constant number and is most definitely not 10 as our money multiplier model would suggest.

Before we move on, I want to point out that government deficits do have an impact on the money supply, however the main driver is the demand for private loans, not government spending. I’m not going into great detail on how government spending increases the money supply because, as I’ll show in a few minutes, the money supply is only one relevant part of the inflation equation.

Quantity Theory of Money

The quantity theory of money is best defined by the equation (remember I said there was going to be algebra) MV = PQ. M is the stock of money (what we’ve been calling the money supply). V is the velocity of money, which is a measurement of how many times money changes hands. P is the price of money which is our measure of inflation. Q is national output, in dollar terms.

Let’s put that into some easier to understand English. Lets start with the right side of the equation. P times Q. This is the measure of output in money terms. It is measured by GDP. Since P is our measure of inflation, Q on its own can best be thought of as inflation adjusted GDP which we call real GDP. The left side of the equation can be thought of as the supply of money times the amount of time that money changes hands. Let me do an example in real numbers.

Say I have $10. I pay you the $10 to mow my yard. Now you have $10 and I have $0. Next, you pay me $10 to cook you dinner. Now I have the $10 back and you have $0. Assume that this goes back and forth say 5 times total, each time we exchange the $10 for real goods or services. At the end of the trades, I have the $10 and you have $0. However, if we were to measure the GDP of our 2-person economy it would be $50 because that is the value of all the goods and services that were produced. In terms of our quantity theory of money equation, $10 (M) times 5 (V) equals $50 (P*Q). In this simple example we’ve ignored inflation for now.

When you hear someone talking about how increasing the money supply will cause inflation, here is the logic they are espousing: If V and Q are constant, then increasing M will increase P. That is, if you assume that velocity and real GDP are constant, then increasing the money supply will cause inflation. The astute observer will notice right away that we’ve just made 2 huge unwarranted assumptions. Why should we assume that velocity or real GDP is constant. The only way that is true is if you are in an economy operating at full efficiency. The truth is that velocity and real GDP are very inconstant. Here’s a chart of velocity as measured by nominal GDP divided by the money supply (M0). It might not look like it changes alot since it bounces around between 1.6 and 2.1, however that is a 31% swing.

So What?

So how can you see increases in the money supply without seeing inflation? Simple, you just do some algebra. we want to increase M without increase P, therefore we can only let V or Q move. We don’t really have much direct control of V, so lets focus on Q. Remember Q is real GDP. It is the measure of how many real goods and services are produced adjusted for inflation (P). So, if our increase in M leads to an increase in Q, there is no increase in P. Put in English, if the increase in the money supply leads to the creation of more goods and services, there is no inflation. Inflation only occurs if that extra money is trying to buy the same amount of goods.

Since I work at a shoe retailer, lets discuss this in terms of shoes. If more people had more money which they wanted to use to buy shoes. Shoe prices would only go up if we were currently producing the maximum number of shoes that we can produce. However, this is definitely not the case. We could produce a lot more shoes at the same price than we are currently producing. If more people wanted to buy shoes we wouldn’t raise the prices, we would just sell more shoes. We might be tempted to raise prices, however if our competition kept their prices flat, we would lose business to them. It is in our best (profit) interest to sell more shoes at the same price up to the point where we can’t produce any more shoes for that price. Beyond that point, there are inflationary concerns because now we’d have to invest in more manufacturing facilities.

How is this applicable to the current economy?

The economy currently is suffering from a lack of aggregate demand. This is just a fancy way of saying that suppliers have the capacity to produce quite a bit more than people are currently willing to buy. In this situation, it is possible to inject money into the economy to stimulate demand without causing inflation. The stimulus package didn’t produce any inflation (contrary to what some folks would have you believe) and the main reason you didn’t hardly see any positive benefits from it, was that it wasn’t big enough. Here’s a chart of inflation vs. the government budget deficit. Where’s the hyper-inflation from the huge deficit? If you said, “there wasn’t one,” you win the prize.


Let take a few seconds to just summarize the main points.

  1. The money multiplier model of the money supply is wrong.
  2. The main cause of an increase in the money supply is demand for private loans, not government spending.
  3. Increasing the money supply is only inflationary if it doesn’t produce more real output (i.e. if you are already at maximum capacity).
  4. If you make unwarranted assumptions, you can make algebraic equations support anything you want.

In my next post I will discuss competition, unless I think of something better.

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