Wednesday, December 10, 2008

Money Supply and Inflation in US

I have seen many blogs point to the huge increase in the US monetary base and conclude that the US will soon experience hyperinflation and a collapse in the value of the dollar. The graph for US money supply looks pretty dramatic. Never before have the Federal Reserve been increasing the monetary base so rapidly. This year, the growth of M2 has reached double figures. So why did the US see a FALL in prices last month?

Chart of U.S. Money Supply Growth

The link between Money Supply, inflation and National Output has become increasingly tenuous over recent years

Velocity of Circulation.

Money Supply doesn't just depend on the amount of money printed (monetary base). It depends on the velocity of circulation - how many times it changes hand. The problem is that the velocity of circulation is falling faster than the Fed can increase the monetary base. The velocity of circulation is falling because of the recession - rising unemployment, falling investment and falling consumption - People are hoarding cash and not spending it.

This is why many economists argue the increase in the monetary base is absolutely necessary to avoid a deflationary spiral. See: What Would Keynes do at Economists view

Financial Changes

Measuring the money supply is difficult because of evolution in the financial sector mean measures of the money supply are always changing. The Federal Reserve of bank of New York outline various reasons why money supply statistics are misleading to the state of the economy

Does this mean we can publish as much Money as we Want?

No, if the money supply does increase too much, then it will cause inflation. The problem is that it is quite difficult to actually know how much the money supply needs to increase. But, with the US economy facing most serious recession for a long time, the Fed are right to be more concerned about potential of deflation than inflation.

There is a danger the Fed could overshoot and create too much, but, at the moment this is not happening. Inflation is the least of our worries at the moment.


Anonymous said...

Thanks for clearing that up :) There's a lot of ambiguity running through the bloggosphere nowadays...

Tejvan Pettinger said...

Thanks Sander.

I have to say, high inflation is quite possible. The Fed are really walking a narrow line. It will be interesting to see how it develops in 2009.

At the moment, I do not subscribe to the inevitability of hyperinflation that some economic commentators are arguing with a certain evangelical fervour.

Anonymous said...

Same old Keynsian propaganda on the need to inflate the money supply because people are hoarding money. We had a speculative bubble (driven by easy money and stupid govt policies), prices must reflect this fact (be allowed to fall to levels from which investors can "see" clearly their market worth. Only then will true productive growth will occur. Economices grow through innovation and productivty not by printing money. Remember prices reflect information-when asset or captial prices don't make sense (i.e. govt is printing money), banks dont' loan, investors don't spend. We have been lucky that the rest of the world is more corrupt than we are but there will be a day when China will let their currency float and then the days of people buying our debt will be numbered.

Fredrik said...

Nice one!
I learned some new stuff that I did not previously know.

So printing money may be necessary in some circumstances.
But isn't it the case that printing money will always have the result of inflating money long term?

Anonymous said...

Please correct me if I'm wrong.

Money supply does not depend on the velocity of money. It is the velocity of money that is defined as a ratio of the nominal GDP to money supply.

Anonymous said...

Wrong analysis.

Inflation after money printing only inflates good, services, and assets bought with the money.

So the question is: Where does the money go?

The answer is: What prices are raising? Check Wall Street. Shares and values are rising better than ever. There is the new money. They are getting richer.

Also the money is flowing out to buy oil, and commodities. The rest of the world suffers inflation. Oil, food and commodities prices are raising.