Wednesday 14 November 2018

Why Did U.S. Inflation Remain Benign With QEs?


Inflation is typically described as a persistent increase in general price level such as the consumer price index. As mentioned in an earlier article, Milton Friedman holds the view that “inflation is always and everywhere a monetary phenomenon”.

Monetarists and Keynesians have two competing explanations on aggregate money demand. Monetarists think that stability of income velocity of money (V) is important. Keynesians disagree with this notion. The Quantity Theory of Money (QTM) suggests the following equation:

MV = PQ

M stands for money (M2); V stands for velocity of money (rate at which people spend money); P stands for general price level and Q stands for quantity of goods and services produced. Based on the above, holding money velocity constant and if money supply increases at a faster rate than real economic output (Q), the price level (P) must increase to make up the difference.

If we follow this view, then inflation in the U.S. should be 31% per year between 2008 and 2013 (according to Federal Reserve Bank of St Louis, September 2014). Why? Because money supply grew at an average pace of 33% per year and output growth averaged just below 2%.

So why did inflation remain persistently below 2% between 2008 and 2013? The issue has to do with velocity of money. If money velocity declines rapidly in an expansionary monetary policy, it can offset any increase in money supply and lead to deflation rather than inflation. In the U.S., the monetary base increase did not cause a proportionate increase in general price level of GDP because of a dramatic increase by the private sector (including banks) to hoard money instead of spending it. And why did they hoard? A possible answer is a combination gloomy economic outlook after the financial crisis and a dramatic decrease in interest rates. So people rather hold money or invest in equities – the Dow above 25,000. And inflation remains rather benign for now.


This Photo by Unknown Author is licensed under CC BY-SA-NC

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