It is conventional wisdom that
printing more money causes inflation. The only problem is, it is not
true. That is not how inflation works. 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 note 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 B$10 each (on
average), then that means a total of B$1000 - worth of transactions took
place. Were there 200 one-dollar notes 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 its 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 not change
on its 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 or in our case our AMBD 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; or
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 AMBD 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 Government 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. But the problem is that after the lecture is
over, people only remember this:
increase M ==> increase P
What
they do not 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 (Note:
currently unemployment rate in Brunei is 3.7 percent). 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 AMBD undertakes the above policy during such a period (as we
see today in some countries), 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 is 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 current 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 AMBD. 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 Government 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 was not just a
simplifying device, it was critical, for it allowed the AMBD to raise
the money supply despite the wishes of the public.
However,
that can not happen in the real world because the actual mechanisms
available are AMBD purchases of government debt such as sukuk from the
public, AMBD loans to banks through the discount window, or AMBD
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 sukuk in exchange for new cash; you cannot force a private
bank to accept a loan from the AMBD; and private banks cannot force
their customers to accept loans. Supplying money is like supplying
haircuts: you can not 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
this world in 2011. That is not how it works.
There
is 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 (in some countries) 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 central bank or AMBD, the central bank
buys it. It is the private sector that is in the driver’s seat in this
respect, not the central bank or AMBD. 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
done in the USA is just sitting in bank vaults and that is why the US
economy is still in the doldrums’).
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!
