“Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output” (Milton Friedman).
This claim that inflation is a monetary phenomenon is based on the quantity theory of money, according to which prices vary in proportion to the money supply. This relationship is based on a mathematical identity.
M x V = P x Y or dM + dV = dP +
dY. Where M is money supply (dM are the variations in this variable), V is the
velocity of money circulation, P are prices and Y is GDP in real terms.
According to which the value of transactions carried out in an economy (understood as nominal GDP) is equivalent to the amount of money circulating in that economy (understood as the amount of money in an economy multiplied by the number of times this changes hands; i.e. the velocity of money). If we assume that the velocity of money is constant, in an economy without economic growth the inflation rate equals the rate of growth in money. Therefore, if money supply increases, there will be more money chasing the same goods, so prices will go up. Similarly, if the rate of growth for economic activity and the quantity of money is the same, prices should remain constant.
Friedman's statement has been backed by empirical evidence (especially in the U.S.), showing a positive relationship between inflation and growth in excess money supply (growth in money supply above the real growth in GDP) for a large number of countries. This relationship is strong and robust in the long term but, the relationship between both variables may weaken temporarily in the short term due to factors such as price rigidity and the velocity of money not being constant. For example, a reduction in the velocity of money in circulation would be compatible with an increase in the money supply without putting pressure on prices.
Based on the above, both the theory and empirical evidence suggest that, if growth in the money supply is greater than the actual growth in GDP, this should push up inflation in the medium term. However, in the U.S., since the start of 2012, the relationship between both variables seems to have weakened to the point of almost disappearing. On the one hand, growth in money supply has accelerated more than GDP growth while, on the other, core inflation has continued to fall.
An analysis of the effectiveness of monetary policy and specifically how it affects monetary aggregates is essential. In general terms, when a central bank offers liquidity to the banking system, either by offering long-term credit or by directly purchasing some of its assets, the monetary base increases. Monetary base is understood as the amount of liquidity provided by central banks, either in the form of currency in circulation or bank reserves deposited with the central bank.
There is no automatic rise in the money supply, however. Traditionally banks would use the liquidity provided by central banks to increase the supply of credit (Money supply is understood as the currency in circulation plus currency in its most liquid form; i.e. bank deposits.) and movements in money supply were therefore in line with those in the monetary base, ultimately leading to an increase in consumption and investment and thereby pushing up prices.
In the U.S. (and many other places) a highly uncertain environment encouraged savings and postponement of consumption and investment. On the supply side, the adjustments banks have had to carry out in order to comply with the new banking regulations (Basel III), both in terms of solvency with higher capital ratios and also in terms of liquidity, have encouraged them to be very cautious when granting loans and to hold onto a considerable buffer of liquidity.
Given this scenario, many banks have opted to use the liquidity they have received to increase their reserves with the central bank. That helps to maintain some room to manoeuvre to handle any upswings in financial tension or further regulatory requirements. With the remaining liquidity, investors looked for a more attractive return-risk combination, either in other financial assets or in other economies that were growing. A lot of the liquidity provided by central banks has therefore ended up in the main emerging economies.
In short, although the relationship between prices and monetary aggregates seems to have dwindled this is partly due to temporary factors such as those related to the supply and demand for credit. Therefore, when economic recovery takes hold, both are likely to synchronise again. It is more difficult to determine the role played by the greater integration of global financial markets, although that needs to be borne in mind when looking at effectiveness of measures.
Having said all that, there are events that disrupt supply and hence increase demand of goods/commodities. These may include: floods, storms, strikes, transit or transport disruptions or new non-tariff barriers. Some may call this as cost-push factors as opposed to demand-pull.
In Malaysia, various stimulus packages were targeted to raise domestic consumption, but its effect may not work through if people have postponed their expenditures due to uncertainty. This was in addition to monetary policy becoming more accommodative with the Overnight Policy Rate at 1.75% and a sharp increase of money supply by 4 times in 15 years (RM0.5 trillion to RM2.1 trillion – or 21% p.a. on average). That is well above GDP growth of -5.6% p.a. (2020) to 7.4% p.a. (2010) – the lowest and highest growth, respectively in the last 15 years. So, does that mean it is purely a monetary phenomenon? (Please see tomorrow’s posting).
References:
Inflation: merely a monetary phenomenon? Ariadna Vidal Martinez, Macroeconomics Unit, Strategic Planning and Research Department, CaixaBank
Statistics Dept: floods caused higher food prices, Malaysiakini, Jan 21, 2022
Understanding the factors that impact inflation (https://www. publicmutual.com.my)
Depreciation ringgit, role of middlemen likely reason for price hikes, accelerated inflation, say economists (https://malaysianow.net)
Prices aren’t going up, the ringgit is going down, K. Kathirgugan, FreeMalaysiaToday, January 20, 2022
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