A Monetarist Revival? The Relationship between Money Supply and Inflation
Updated: Dec 30, 2022
The recovery from the COVID-19 pandemic has been a very turbulent one. With advanced and developing economies struggling with high inflation rates, Economists have been scrambling to solve the inflation puzzle. The current consensus amongst policymakers seems to be the notion that rising costs have been the key component behind high inflation. Unfortunately for Central Bankers, the tools at their disposal make a monetary response to rising costs dismal. Yet, despite this, CBs such as the Federal Reserve, and Bank of England, have all risen their base interest rates to combat rising CPI inflation rates. This indicates that policymakers do have a concern over possible demand-pull pressures such as ones originating from high nominal wage growth that is currently occurring as a product of tight labour markets. However, the historical evidence shows that there is a much stronger correlation between the supply of money broadly defined and inflation rates rather than the base interest rate. Furthermore, with interest rates being at record lows during the start of the pandemic, there is dwindling room for policymaking as negative interest rates can yield disproportionate costs relative to benefits as cheap credit can prop up inefficient economic activity. As such, the following column will introduce the case for the importance of the supply of money broadly defined when implementing Monetary Policy measures.
With Monetary Policy being the manipulation of interest rates and money supply, historically, economists & policymakers have focused on these aspects when judging a Central Bank’s ability to steer economies away from recessions. And for a good reason, historically, first, the money supply, money aggregates, have been a critical factor in causing or preventing economic crises. For example, in the 1930s, a string of bank runs/failures occurred as the Federal Reserve failed to increase liquidity in the banking system. During this period the quantity of money fell by a third, and as such, approximately a third of banks failed. (Friedman, Goodhart and Wood, 2002a) In other words, a lack of monetary stimulation led to a liquidity crisis within the US. Conversely, during the COVID-19 pandemic, interest rates within modern economies such as the UK, US, and Eurozone, were at a record low. (Bank of England, 2021) (BBC, 2022) (Trading Economics, 2022) These interest rates should be a key focus for monetary policy decisions for two reasons. First, manipulation of interest rates has a direct influence on broad money growth and NGDP due to the transmission mechanism. When interest rates fall, the cost of borrowing, and, the cost of servicing debt declines, making the creation of private money through loans more attractive as banks can do so at a cheaper cost, and, to more customers as economic agents are incentivised to take on more debt. Second, with interest rates being at historic lows, there is less room for manoeuvre available as there are many dangers associated with negative interest rates. These include the propping up of inefficient zombie companies, and, a fall in industrial investment as firms will be forced to allocate more capital into pension funds to keep them solvent. (IIMR, 2019) This means that at first, for Central Banks, it seems that due to historically low policy rates, policymakers have little legroom when responding to crises. However, alongside these historically low rates during the pandemic, economies also recorded the largest money aggregate stimulus via QE. (Figure 1) indicates sufficient room for manoeuvre for policymakers as for the Federal Reserve, there are more than $30 trillion in US Treasuries and mortgage-backed securities in circulation, (Sumner, 2020) and, there is no theoretical limit on the amount of money that can be created by Central Banks. (Congdon, 2021) Furthermore, there seems to be a historic correlation between the quantity of broad money in the economy, and, money velocity. (Friedman, Goodhart and Wood, 2002b) As such, this has been followed by inflation rates that are at historic highs. (Figure 2) Hence, there is a clear historic correlation between a lack of aggregate money manipulation yielding liquidity crises such as in the US, and, an overstimulation of such money supply growth leading to inflationary crises today. These trends stress the importance of focusing on monetary aggregates when looking at monetary policy decisions compared to interest rates as failure to do so can yield severe unintended consequences.
Bank of England (2021). Our response to Coronavirus (Covid-19). [online] www.bankofengland.co.uk. Available at: https://www.bankofengland.co.uk/coronavirus.
BBC (2022). Eurozone raises interest rates for first time in 11 years. BBC News. [online] 21 Jul. Available at: https://www.bbc.co.uk/news/business-62240730.
Congdon, T. (2021). Can Central Banks Run out of ammunition? the Role of the Money‐equities‐interaction Channel in Monetary Policy. Economic Affairs, 41(1). doi:10.1111/ecaf.12444.
Friedman, M., Goodhart, C.A.E. and Wood, G.E. (2002a). Money, Inflation and the Constitutional Position of the Central Bank. [online] Institute of Economic Affairs, pp.75, 76. Available at: http://www.iea.org.uk/sites/default/files/publications/files/upldbook202pdf.pdf.
Friedman, M., Goodhart, C.A.E. and Wood, G.E. (2002b). Money, Inflation and the Constitutional Position of the Central Bank. [online] p.77. Available at: http://www.iea.org.uk/sites/default/files/publications/files/upldbook202pdf.pdf.
IIMR (2019). Geoffrey Wood: Will Negative Interest Rates Revive the Interest in the Quantity Theory of Money? [online] www.youtube.com. Available at: https://www.youtube.com/watch?v=_KTRMOqjfAU.
Sumner, S. (2020). There Is No Substitute for Monetary Policy. [online] Mercatus Center. Available at: