Tuesday, May 9, 2017

Money Supply and Inflation

New car, caviar, four star daydream
Think I'll buy me a football team
--Pink Floyd

Frank Shostak discusses the relationship between money supply growth and inflation. In the 'olden days,' inflation was defined in terms of money supply--not prices. Growth in money supply that exceeded productivity growth was considered inflationary.

While the definition of inflation has since shifted toward a focus on price-related outcomes, shouldn't the relationship between money supply and modern 'measures' of inflation such as the consumer price index (CPI) be straightforward? After all, more money chasing a set amount of goods should raise prices, right?

As Shostak notes, not necessarily. One thing that could cloud the relationship is change in productivity. As productivity improves, prices naturally decline. Thus, it is possible that in an era of improving productivity that growth in money supply may translate into higher prices.

Stated differently, higher prices from more money in circulation could be offset by lower prices from productivity gains.

It is also possible that popular measures of price inflation such as the CPI might not capture the effects of money supply growth. Since the credit collapse, for example, much of the growth in money supply engineered by central banks around the world has been confined to the banking system. The effect has been a surge in prices of financial assets rather than in prices of consumer goods.

What is safe to conclude is that growth in money supply distorts prices and generally makes them higher than they would be otherwise.

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