Post Reply  Post Thread 
Pages (2): « First [1] 2 Next > Last »

Money Growth Does Not Cause Inflation!

Author Message
Helsworth
Heathen
****


Posts: 8,854
Words count: 1,597,963
Group: Super Moderators
Joined: Nov2008
Status: Offline
Reputation: 146
Experience: 859
Glory Points: 260
Medals: 11

Post: #1
Money Growth Does Not Cause Inflation!

Money Growth Does Not Cause Inflation!
by John T. Harvey

Source: http://www.forbes.com/sites/johntharvey/...inflation/

It is conventional wisdom that printing more money causes inflation. This is why we are seeing so many warnings today of how Quantitative Easing I and II and the federal government’s deficit are about to lead to skyrocketing prices. The only problem is, it’s not true. That’s not how inflation works. Hence, this is yet another of the false alarms being raised (along with the need to balance the budget) that is preventing us from doing what we need to do to recover from the worse recession since the Great Depression.

Explaining inflation would be much simpler if not for the need to first spend so much time debunking the popular view. But, that’s the way it is. And so, let me start with the “money growth ==> inflation” view. This is based on the equation of exchange:

MV = Py

where M is equal to the supply of money, V the velocity of money (or the average number of times each dollar bill is spent), P the average price of goods and services, and y the total quantity of all goods and services sold during the time period in question. Thus, if there were 100 goods and services that sold for $10 each (on average), then that means a total of $1000-worth of transactions took place. Were there 200 one-dollar bills in this economy, then it must be that each was used 5 times (hence the “velocity” of money, or how fast they were spent again).

MV = Py
200 x 5 = 10 x 100

It is important to note here that the above is not the least bit controversial. No economist disagrees with the basic equation MV=Py. The arguments arise when additional assumptions are made regarding the nature of the individual variables. For example, this is what is assumed in the “money growth==>inflation” view:

M: That which is money is easily defined and identified and only the central bank can affect it’s supply, which it can do with autonomy and precision.

V: The velocity of money is related to people’s habits and the structure of the financial system. It is, therefore, relatively constant.

P: The economy is so competitive that neither firms nor workers are free to change what they charge for their goods and services without there having been a change in the underlying forces driving supply and demand in their market.

y: The economy automatically tends towards full employment and thus y (the existing volume of goods and services) is as large as it can be at any given moment (although it grows over time).

Now let’s go through an example, recalling the mathematical example from above:

MV = Py
200 x 5 = 10 x 100

Consider the assumptions made regarding each of the variables. P can’t change on it’s own, y is already as large as it can possibly be given current technology and resources, and V is constant. Only M can change in the short run and it must therefore logically be the starting point of any fluctuation we introduce. Furthermore, according to our assumptions, the central bank has the power to (for example) double the money supply at will. In Milton Friedman’s example from “The Optimum Quantity of Money,” a helicopter is used to accomplish this. Now what happens?

MV = Py
400 x 5 > 10 x 100

There is clearly a problem here which could be solved in one of three ways (assuming we don’t just lower M back to 200): 1) y could rise to 200, but of course it can’t because it’s already at its maximum; 2) V could fall to 2.5, but it is constant (something Friedman takes pains to emphasize in the original article); or 3) P could rise to 20. It is of course the third that proponents of the “money growth==>inflation” view say will occur.

MV = Py
400 x 5 = 20 x 100

Equality again!

Let me reemphasize why this is the only logical outcome. We have assumed that y and V are constant. Friedman says that y is constant at the level associated with the natural rate of unemployment, while V is indirectly related to agents’ demand for cash. When people want to hold more cash, V, the rate at which they spend cash, naturally falls, and vice versa. But, Friedman further specifies that V is relatively constant and so, therefore, is the demand for cash. Thus, when the central bank raised the supply of cash from 200 to 400, this meant that people were holding more cash than they wished to have in their portfolios. The Fed had created a situation in which the supply of money (newly raised) exceeded the demand (still at the original level). The result was that people, in the language of the “money growth==>inflation” view, rid themselves of excess money balances by spending that cash. They hoped to buy more goods and services but since, in aggregate, more did not exist, they only bid up their prices: money growth led to inflation.

This is this standard view. It makes for a great lecture in an intro or even intermediate macro class and I’ve done it many times (in fact, I just did it this week in my summer course). But the problem is that after the course is over, people only remember this:

increase M ==> increase P

What they don’t recollect are all the assumptions we made to get there! And not only are some questionable, they are downright inconsistent with other lectures we make in the very same class.

Take for example y. One need only look out the window to see that it is not currently at the full-employment and therefore maximum level. Hence, given this scenario:

MV = Py
400 x 5 > 10 x 100

there is no reason that this could not lead to the rise in y shown below as those spending their “excess money balances” actually cause entrepreneurs to raise output to meet the new demand:

MV = Py
400 x 5 = 10 x 200

This is, of course, the goal of the government deficit spending that so many economically-ignorant people are trying to stop right now.

In addition, there is a great deal of evidence that the velocity of money IS NOT constant. As one would expect, it tends to decline in recessions when people do, in fact, want to hold more cash. Hence, if we assume that the central bank undertakes the above policy during such a period (as we see today), the final result might be this:

MV = Py
400 x 2.5 = 10 x 100

Or it could be some combination of a rise in y and a fall in V–this would make perfect economic sense. Notice how the process of making the initial assumptions of this approach more realistic is making it far from certain that a rise in M leads to a rise in P, particularly during an economic downturn.

But that’s not the worst of it. There is actually a much more fundamental problem with the “money growth==>inflation” approach. Recall the original assumptions for M:

M: That which is money is easily defined and identified and only the central bank can affect it’s supply, which it can do with autonomy and precision.

What is “money” in a modern, credit-based financial system? Is it that stuff you carry in your pocket, the 1′s and 0′s of the electronic entries in your bank account, the available balance on your credit card, your checking account, your savings account? In practice, this question is so difficult to answer that economists actually offer several possible definitions, just in case! Suffice it to say that for present purposes, the idea that we can precisely identify the current “supply of money” in our economy is suspect. This by itself causes problems for operationalizing the above equation.

To make matters worse, the financial sector can create and destroy money without direct action by the central bank. Every time a loan is made, the supply of money increases. The bank is creating money out of thin air, with only a fraction of the total necessary to have already been in the vault as reserves. And when loans are repaid or there are defaults, the supply of money contracts. Hence, the private sector has a great deal of control over M.

But perhaps the real nail in the coffin of the “money growth==>inflation” view is this: the phenomenon that Milton Friedman identifies as key to the whole process, i.e., the excess of the money supply over money demand, cannot happen in real life. The irony here is that something else we already cover in the intro macro class makes this evident. How is it that the Federal Reserve increases the money supply? Remember that Friedman used a helicopter–indeed, he had to, for there was no other way to make the example work. This wasn’t just a simplifying device, it was critical, for it allowed the central bank to raise the money supply despite the wishes of the public. However, that can’t happen in the real world because the actual mechanisms available are Fed purchases of government debt from the public, Fed loans to banks through the discount window, or Fed adjustment of reserve requirements so that the banks can make more loans from the same volume of deposits. All of these can raise M, but, not a single solitary one of them can occur without the conscious and voluntary cooperation of a private sector agent. You cannot force anyone to sell a Treasury Bill in exchange for new cash; you cannot force a private bank to accept a loan from the Fed; and private banks cannot force their customers to accept loans. Supplying money is like supplying haircuts: you can’t do it unless a corresponding demand exists.

The bottom line is that the “money growth==>inflation” view makes perfect sense in some alternate universe where all those assumptions regarding the variables DO hold, but not here, not today, not in the United States of America in 2011. That’s not how it works. It’s a damn shame, I know, because it’s so simple and intuitively appealing and it would make controlling inflation really simple. But, if we are to develop useful policies then we need a model better suited to the way the modern financial system works.

There’s no reason to throw the baby out with the bath water, so let’s retain the equation. However, we need new assumptions with respect to M, V, P, and y:

M: A precise definition and identification of money is elusive in a modern, credit-money economy, and its volume can change either with or without direct central bank intervention. In addition, the monetary authority cannot raise the supply of money without the cooperation of the private sector. Because central banks almost always target interest rates (the price of holding cash) rather than the quantity of money, they tend to simply accommodate demands from banks. When private banks communicate that they need more reserves for loans and offer government debt to the Fed, the Fed buys it. It’s the private sector that is in the driver’s seat in this respect, not the central bank. The central bank’s impact is indirect and heavily dependent on what the rest of the economy is willing to do (which is, incidentally, why all the QE and QE II money is just sitting in bank vaults).

V: The velocity of money is, indeed, related to people’s behavior and the structure of the financial system, but there are discernable patterns. It is not constant even over the short run.

P: While it is true that factors like production bottlenecks can be a source of price movements, the economy is not so competitive that there are not firms or workers who find themselves able to manipulate the prices and wages they charge. The most important inflationary episode in recent history was the direct result of a cartel, i.e., OPEC, flexing its muscle. Asset price bubbles can also cause price increases (as they are now). The key here, however, is that P CAN be the initiating factor–in fact, it has to be, since M can’t.

y: The economy can and does come to rest at less-than-full employment. Hence, while it is possible for y to be at its maximum, it most certainly does not have to be.

A number of scenarios can be described based on this more realistic alternative and it would be nice to go through each. Unfortunately, as I suggested above, the big problem with this topic is that it takes to long just to reject the popular view! So, I’ll avoid the temptation to write a book here and offer just a quick example (maybe a future post can go over some other interesting possibilities).

As already mentioned, the most important inflationary episode in post-WWII history was that during the 1970s and early 1980s. From 1968 through 1972, consumer price inflation averaged 4.6%. Over the next ten years it was 7.5%. What happened? What caused this sudden and dramatic acceleration in prices? Did the Fed accidentally print too much money? As already explained, that can’t happen–you simply can’t raise the money supply above the demand. M did rise, however, and largely proportionally to the increase in P. This is a much more realistic story of those events.


As the price of oil skyrocketed, so costs of production rose for many, many US businesses. Because there is a lag between purchasing inputs and selling output, most firms have to borrow money (working capital) to bridge the gap. As the ripple effect of the OPEC price increases moved throughout the economy, the demand for cash by these businesses rose. Quite reasonably, private banks and the Fed did what they could to accommodate. These were fair requests on the part of US entrepreneurs. Loans were extended and government debt sold by the private sector to the central bank. This raised the supply of money. Therefore, the rising prices led to an increase in the supply of money and not the other way around. QE, QE II, and the federal government deficit cannot by themselves cause inflation.

And this is how it really works, at least until the Fed starts using helicopters for monetary policy.


https://www.patreon.com/SerbanVCEnache

This post was last modified: 25.11.2013 18:00 by Helsworth.

25.11.2013 17:58
Find all posts by this user Quote this message in a reply
Winston957
Senior Member
*


Posts: 268
Words count: 27,893
Group: Basic
Joined: Jan2013
Status: Offline
Reputation: 7
Experience: 7062
Glory Points: 155
Medals: 12

Post: #2
RE: Money Growth Does Not Cause Inflation!

I don't know where I exactly should post this. It's not directly linked to the inflation topic, but I think here it fits best:

http://blogs.telegraph.co.uk/finance/amb...should-it/

It seems UK- central bank intends to expand monetary base and keep it on a higher constant level.

Maybe they read this about "helicopter money"?
http://www.interdependence.org/resources...operation/

Winston

12.03.2014 18:44
Find all posts by this user Quote this message in a reply
Helsworth
Heathen
****


Posts: 8,854
Words count: 1,597,963
Group: Super Moderators
Joined: Nov2008
Status: Offline
Reputation: 146
Experience: 859
Glory Points: 260
Medals: 11

Post: #3
RE: Money Growth Does Not Cause Inflation!

Evans-Pritchard suggests that increasing rates tempers inflation. This is not true. QE alone does not facilitate deleveraging. It's just a swap operation. No new net asset creation happens.
I don't think going off of QE is that "dangerous" as Pritchard and others paint it. When households already seek to deleverage, keeping interest rates low won't help to revive the economy. Nor will it give rise to inflation.
Using monetary policy to "deal" with a recession is like trying to cut a tree with a blunt axe.
QE is essentially useless for the economy as a whole.


https://www.patreon.com/SerbanVCEnache

This post was last modified: 12.03.2014 19:22 by Helsworth.

12.03.2014 19:19
Find all posts by this user Quote this message in a reply
Winston957
Senior Member
*


Posts: 268
Words count: 27,893
Group: Basic
Joined: Jan2013
Status: Offline
Reputation: 7
Experience: 7062
Glory Points: 155
Medals: 12

Post: #4
RE: Money Growth Does Not Cause Inflation!

does he? I didn't read it like that. I don't see him mentioning any causality between inflation and QE. But right, it doesn't give rise to inflation.
So, I (like very often) agree with you.

But inflation is not the point I wanted to make here (therefore it's maybe the wrong thread). The interesting point (at least for me), is that it became clear that the CB accepts a broader monetary base "forever" (it't not exactly forever). And thats real life, no theory.

It's interesting to me, since I think it means the CB also sees no harm to the economy or to inflation in doing so. For me that's a surprise. Not in the analysis, but in CB's monetary policy. Maybe they start to suspect that something is going fundamentally wrong, and just see no other option….?

12.03.2014 20:20
Find all posts by this user Quote this message in a reply
Helsworth
Heathen
****


Posts: 8,854
Words count: 1,597,963
Group: Super Moderators
Joined: Nov2008
Status: Offline
Reputation: 146
Experience: 859
Glory Points: 260
Medals: 11

Post: #5
RE: Money Growth Does Not Cause Inflation!

Winston957 Wrote:
It's interesting to me, since I think it means the CB also sees no harm to the economy or to inflation in doing so. For me that's a surprise. Not in the analysis, but in CB's monetary policy. Maybe they start to suspect that something is going fundamentally wrong, and just see no other option….?

I agree with your suspicion. It's certainly something new for western governments. Politicians don't look at other countries, even if they are big (like Japan)... to learn from their past experiences. Hell, politicians aren't concerned at all about understanding economics. They just operate like drones. National budgets ought to be balanced. Inflation is bad. And everything in between is a juggle and trade-off between selling and ousting various government programs and legislation projects.
Everyone's concerned about athletes taking drugs, when alcohol and tobacco combined kill more than half a million people every year in the US. Yet the "war" is being fought on marijuana, food stamps, unemployment benefits, and on the average tax payer.
Anyways, I digress...

It takes a while for people to adjust to a new/non-traditional policy, until they get it that it doesn't bring in financial armageddon. Japan's parliament and its CB are not concerned about stupid bullshit like sovereign default or inflation/hyperinflation. Like the western governments are. And it's a lot easier to implement unconventional monetary policy, because CBs are treated as separate from the executive. Thus, the board in charge of monetary policy makes its own policy. A change in fiscal policy, on the other hand, is a lot harder to implement.
And by the gods, the cyber austrian-libertarians are so active and loud in spewing apocalyptical revelations about the future and most especially, the near future. Slavery! Slavery! Default! Default! Turn to gold! Turn to gold! Arm yourself! Take up arms! The big bad government is robbing you every time it delivers welfare, every time it decreases the interest rate! We know all about inflation! Inflation is the greatest evil in the world! Governments trying to reduce the unemployment rate are EVIL, for they intervene in the (otherwise holy/pure) market!
And the zealots go on and on and on...

My monetary/fiscal policies would be simple. A permanent zero nominal interest rate, plus a combination of reducing fiscal drag and increasing fiscal stimulus according to the country's needs in order to achieve full employment and price stability. Also, I'd eliminate the practice of issuing public debt completely. In order to control short-term interest rates in the market, the government would simply pay the difference between the target rate and the market rate to achieve its desired rate overnight.


https://www.patreon.com/SerbanVCEnache

This post was last modified: 12.03.2014 20:54 by Helsworth.

12.03.2014 20:41
Find all posts by this user Quote this message in a reply
Snorunt30
Senior Member
*


Posts: 360
Words count: 54,477
Group: Basic
Joined: Dec2010
Status: Offline
Reputation: 7
Experience: 269
Glory Points: 100
Medals: 1

Post: #6
RE: Money Growth Does Not Cause Inflation!

Helsworth Wrote:

Winston957 Wrote:
It's interesting to me, since I think it means the CB also sees no harm to the economy or to inflation in doing so. For me that's a surprise. Not in the analysis, but in CB's monetary policy. Maybe they start to suspect that something is going fundamentally wrong, and just see no other option….?

I agree with your suspicion. It's certainly something new for western governments. Politicians don't look at other countries, even if they are big (like Japan)... to learn from their past experiences. Hell, politicians aren't concerned at all about understanding economics. They just operate like drones. National budgets ought to be balanced. Inflation is bad. And everything in between is a juggle and trade-off between selling and ousting various government programs and legislation projects.
Everyone's concerned about athletes taking drugs, when alcohol and tobacco combined kill more than half a million people every year in the US. Yet the "war" is being fought on marijuana, food stamps, unemployment benefits, and on the average tax payer.
Anyways, I digress...

It takes a while for people to adjust to a new/non-traditional policy, until they get it that it doesn't bring in financial armageddon. Japan's parliament and its CB are not concerned about stupid bullshit like sovereign default or inflation/hyperinflation. Like the western governments are. And it's a lot easier to implement unconventional monetary policy, because CBs are treated as separate from the executive. Thus, the board in charge of monetary policy makes its own policy. A change in fiscal policy, on the other hand, is a lot harder to implement.
And by the gods, the cyber austrian-libertarians are so active and loud in spewing apocalyptical revelations about the future and most especially, the near future. Slavery! Slavery! Default! Default! Turn to gold! Turn to gold! Arm yourself! Take up arms! The big bad government is robbing you every time it delivers welfare, every time it decreases the interest rate! We know all about inflation! Inflation is the greatest evil in the world! Governments trying to reduce the unemployment rate are EVIL, for they intervene in the (otherwise holy/pure) market!
And the zealots go on and on and on...

My monetary/fiscal policies would be simple. A permanent zero nominal interest rate, plus a combination of reducing fiscal drag and increasing fiscal stimulus according to the country's needs in order to achieve full employment and price stability. Also, I'd eliminate the practice of issuing public debt completely. In order to control short-term interest rates in the market, the government would simply pay the difference between the target rate and the market rate to achieve its desired rate overnight.


If only I could convince the people here of this, would make so many things that much better Pfeif. (Rather hard to do so though, for the reasons you mentioned, namely they spout off what they assume as truth and cover their ears for what they don't want to hear.)


Ense petit placidam sub libertate quietem.
(By the sword we seek peace, but peace only under Liberty.)
If the opposite of pro is con, what is the opposite of progress?
Congress.
14.03.2014 19:58
Find all posts by this user Quote this message in a reply
Sato
Apex Predator
*


Posts: 55
Words count: 6,608
Group: Basic
Joined: Feb2010
Status: Offline
Reputation: 2
Experience: 217
Glory Points: 10
Medals: 1

Post: #7
RE: Money Growth Does Not Cause Inflation!

Inflation is too much money chasing too few goods.

For there to be inflation, there must first be an increase in demand for goods with the supply of goods being constant. Or a decrease in supply of goods with the demand for goods being constant.

First could be caused by the private sector not having the money needed to afford the expenses of investing to expand their businesses to supply the increased demand for their goods. Second would be caused by the private sector not having the money needed to afford the costs of production to maintain the supply to meet the demand for their goods.

This would mean that failing to grow the money supply to meet the demands of the private sector to have businesses make investments to increase the supply of the goods to meet demand would cause inflation. Or failing to grow the money supply to meet the demands of the private sector to maintain current levels of supply to meet the demand for their goods would cause inflation.

If I'm getting this right, only when there is demand for it by the private sector along with the failure of the central bank to grow the money supply does this lead to an increase in inflation. Problem has less to do with too much money, more to do with too few goods.

This post was last modified: 16.04.2014 15:23 by Sato.

16.04.2014 15:19
Find all posts by this user Quote this message in a reply
Helsworth
Heathen
****


Posts: 8,854
Words count: 1,597,963
Group: Super Moderators
Joined: Nov2008
Status: Offline
Reputation: 146
Experience: 859
Glory Points: 260
Medals: 11

Post: #8
RE: Money Growth Does Not Cause Inflation!

It's about velocity rather than quantity. If transactions are depressed, you can increase the MS by 1 trillion; and if the money velocity remains the same - people not looking to buy new stuff with that money; then you won't get inflation.
Firms become supply adjusters when there's spare production capacity to go around. Money in itself or access to credit is less of a problem; the real issue is sales. If you ask any business owner what's preventing him or her from hiring more people - the answer they're gonna give is "sales figures".
A restaurant that's packed with customers is not gonna lay off workers. And it's not gonna have difficulties in obtaining a business credit from a bank. Of course, there are contexts and contexts; but during an expansion cycle - banks aren't afraid to lend. And once more, money is endogenous. The Money Supply reacts according to the desires of the private sector. Loans create deposits.


https://www.patreon.com/SerbanVCEnache

This post was last modified: 16.04.2014 17:33 by Helsworth.

16.04.2014 17:32
Find all posts by this user Quote this message in a reply
Sato
Apex Predator
*


Posts: 55
Words count: 6,608
Group: Basic
Joined: Feb2010
Status: Offline
Reputation: 2
Experience: 217
Glory Points: 10
Medals: 1

Post: #9
RE: Money Growth Does Not Cause Inflation!

Yeah I guess businesses wouldn't have a problem with getting a loan from the bank, if their business was doing great with such high demand for their products or service. With that being the case, they wouldn't have less employment causing a problem with meeting demand.

As I think about it now, even if they couldn't this wouldn't have caused inflation or an increase in inflation. As the demand out pacing supply would been the cause of inflation. They would have to start raising prices to prevent a possible shortage before they did anything else. Getting a loan from the bank or an increase in the money supply would have nothing to do with it.

Neither credit or increasing the money supply can cause or create inflation. An increase in velocity along with an increase in quantity is needed to cause inflation. That can't happen as in an expansion cycle, quantity will increase when needed as there's an increase in velocity or there's not an increase in velocity at all. In a contraction cycle, velocity will decrease as the private sector would want to hold on to more of their money and not spend or invest.

Interesting stuff I've read and learn in the last couple days. Big Grin

This post was last modified: 16.04.2014 18:56 by Sato.

16.04.2014 18:48
Find all posts by this user Quote this message in a reply
Helsworth
Heathen
****


Posts: 8,854
Words count: 1,597,963
Group: Super Moderators
Joined: Nov2008
Status: Offline
Reputation: 146
Experience: 859
Glory Points: 260
Medals: 11

Post: #10
RE: Money Growth Does Not Cause Inflation!

Wertung
Glad you've enjoyed it. However, I must warn you - that with the knowledge of our modern fiat system - you will live a frustrated life. Becase when you'll hear the damned conventional wisdom on the radio, on the net, on the TV, on the street, and even in the family... you'll constantly feel the need to try to explain MMT to everyone; be they deficits doves or deficit hawks... Some will keep an open mind, many will call you crazy.

But there's a quote from Marcus Aurelius which I really love:
"The purpose of life is not to be on the side of the majority; but to escape the ranks of the insane."


https://www.patreon.com/SerbanVCEnache
16.04.2014 20:04
Find all posts by this user Quote this message in a reply
Pages (2): « First [1] 2 Next > Last »
Post Reply  Post Thread 

Possibly Related Threads...
Thread: Author Replies: Views: Last Post
  The real, fundamental, cause of low growth in developed economies CommieScum 2 1,282 23.04.2020 21:19
Last Post: velazquez
  Inflation is not always and everywhere a monetary phenomenon Helsworth 1 1,109 20.01.2017 04:41
Last Post: VineFynn
  The Quantity Theory of Money: A Critique Helsworth 1 971 18.01.2017 23:24
Last Post: VineFynn
  Why Positive Money is wrong, by Mike King Helsworth 2 1,565 16.07.2016 08:33
Last Post: Helsworth
  Money & the Myth of Barter Helsworth 0 1,201 09.03.2016 18:26
Last Post: Helsworth
  China Fast-Tracks $1 Trillion in Projects to Spur Growth Helsworth 7 2,232 07.09.2015 21:07
Last Post: Alexei B.Miller
  Markets got Eurozone inflation wrong! Helsworth 2 1,385 09.04.2015 21:18
Last Post: Helsworth
  How Modern Money Theory Replies to Hyperinflation Hyperventilators Helsworth 0 2,172 11.02.2015 17:45
Last Post: Helsworth
  How to turn litter into money, all about debt, deficits, and economic policy Helsworth 0 2,668 13.12.2014 21:18
Last Post: Helsworth
  Why Central Banks Should Give Money Directly to the People Helsworth 0 1,357 05.09.2014 19:28
Last Post: Helsworth

View a Printable Version
Send this Thread to a Friend
Subscribe to this Thread | Add Thread to Favorites

Forum Jump: