Sunday, November 22, 2009

Inflation vs. the Money Supply

Real quick, then I must bolt.

If you increase the money supply by 5% and you produce 5% more stuff inflation will be 0%.

If you increase the money supply by 5% and produce 0% more stuff, inflation will go up by 5%

If you decrease the money supply by 5%, but produce no more stuff, you get deflation of 5%.

This is not an opinion, this is a mathematical fact. If you print off more money and produce less (like we are today) you will have inflation. It's an unavoidable law of economics.

However, economies are not simple entities nor machines that work like clocks and why you have this disagreement that more money will not trigger inflation vs. will. So allow me to explain a couple things;

1. Just because you print off money NOW doesn't mean it will IMMEDIATELY trigger inflation. The chart below shows us IN GENERAL when the M2 money supply was increasing at a higher rate we had inflation. When we stopped printing money in the 70's, inflation came back under control.

2. A person will observe that we increased the money supply rather rapidly during the dotcom bubble, which did not trigger inflation. However that inflation is measured by the "CPI" and does not include investment assets such as stock market bubbles and housing bubbles. If those were included in the CPI you would see the correlation again.

3. Obamaites will immediately point out that inflation has turned to DEflation even though we've increased the money supply again.

Don't worry my friends. Give it time to permeate. Give it time.


PeppermintPanda said...

I have argued in the past that there are analogous laws within economics to the famous laws of thermodynamics. While I haven’t come up with good phrasing for any of the laws, the amount of money in an economy is directly proportional to the total value of goods and services produced by that economy; and money can neither be created nor destroyed without changing the total value of goods and services produced by an economy.

Now, attempting to create money without increasing productivity does not (necessarily) result in a proportionate level of measured inflation because inflation statistics are manipulated; and no one includes investment-assets into inflation statistics. Most asset bubbles are the direct result of a loose monetary resulting in people borrowing money to invest, and the increase in investment dramatically over-values an asset; and the resulting (deflationary) crash is just the system rebalancing itself.

Milton Hayek said...

Those Obamaites would be revealing their ignorance of the limitations of the CPI statistics. We are not experiencing deflation, i.e., the devaluation of money, we are simply seeing the effects of supply and demand during a recession.

I think Sowell's Basic Economics has the best explanation I've seen of what's wrong with the CPI.

Econmom said...

Are you taking velocity into account? What about the deflationary effects of a credit crunch? What about the deflationary effects of more and more cash being used for debt service instead of circulating through the system? Inflation is more money chasing fewer goods. I would argue that since aggregate demand is severly depressed, and aggregate supply has not yet caught "down" with decreasing demand, we are entering a period of deflation. Now, of course, if the Chinese start dumping treasuries, you will be right. But until then, deflation, not inflation is our biggest problem. Do I think the Government should be "printing" money and expanding to stop this? No. We must let it happen, as it is a healthy over-supply clearing mechanism that will ultimately keep markets free.

Ryan Fuller said...

MV=PQ, Captain. Don't forget V. :)

Anyway, Econmom pretty much nails this one.

I wrote about this phenomenon on my MySpace blog back in mid 2006. And predicted a recession triggered by a wave of housing foreclosures, but what do I know?

geoih said...

What does production have to do with inflation? Increase the money supply and you cause inflation, no matter how much is (or isn't) produced. Increasing prices are a symptom of inflation, not a measure of it.

Captain Capitalism said...

No, no, I know, velocity duly noted. I am saying there is "deferred" velocity. Does that make any sense?

Anonymous said...

Fuller, no one cares about your EMO myspace ranting... If they did, the housing market would not have collapsed.

Econmom said...

I understand the concept of deferred velocity, but what would be the trigger that would get the flow pumping? Consumer and corporate debt levels are still extemely high. In addition, the FRB can pull cash out of circulation through the banks if it so chooses. (I know that would be politically unfeasible, but it is possible.) You will be right if aggregate supply recovers quickly. I just don't think this will be the case.

Anonymous said...

Peppermint is on the right track here. As they say in driver's ed class, you can break the laws of men, but you can't break the laws of physics. The laws of economics lie somewhere between these. You can appear to break the laws of economics for a while, but eventually they snap back into place, usually giving you a slap on the schnozz in the process.

Inflation has only one cause: government, that is to say, politicians. Those same politicians will try to misdirect your attention with loud and frequent condemnation of all and sundry villains: greedy capitalists, oil sheiks, speculators, saboteurs, illegal immigrants, global warming, resource depletion, the phases of the moon. When you hear it start, remember that that the real criminal is standing before you pointing his finger at these others.

Anonymous said...

Captain Capitalism, as an economist, I'm wondering what your thoughts are on 's lastest post: Behold, Inflation Cometh. The author says in order to address the debt, the government must induce inflation.

Ryan Fuller said...

"Fuller, no one cares about your EMO myspace ranting... If they did, the housing market would not have collapsed."

Emo? How so? I didn't mention my feelings once, or complain about how hard things are for me, or proclaim my love for Dashboard Confessional or Hot Topic or whatever it is emo kids are doing these days.

I pointed out that the CPI is a bad measure of inflation. This isn't a revolutionary notion, although it is rather less acknowledged than would be ideal. I also pointed out that if loans go bad, it'll cause a mess for the rest of the economy.

Is it emo if you're right?

geoih said...


And I thought this was a blog about reality. May I suggest you all (re)read your Mises.

Ryan Fuller said...

Geoih, don't be stupid.

MV=PQ can be proven without resorting to empiricism and Austrian writing is loaded with claims tying the price level to the money supply, so I don't see where your Austrian indignation is coming from.

Having spent more than my fair share of time at, I can say I've got a pretty good grasp of what sort of thing raises Austrian hackles, but watching one get miffed at MV=PQ is certainly a first.

PeppermintPanda said...

I’m sure someone will correct me if they disagree, but I would say introducing inflation as a way to lower debt (and get out of economic trouble) is kind of like burning down your house to collect the insurance money to stave off bankruptcy. In theory, if you assume nothing goes wrong with your plan, it may work out great; but in reality there are multiple highly probable outcomes which are a far worse problem than the one you’re trying to resolve.

Unfortunately, it seems like in order to become someone who can dictate economic policy you have to have given up all attachment to reality; and I’m fairly certain that if a theoretical model can justify high inflation as a resolution to the current economic problems the Federal Reserve will inflate the currency.