Does Inflation Always Emerge When Government Decides to Increase Money Supply?

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Constant changes in the global economy raise questions about the dependence of inflation and an increase in the money supply. In economic science, at the moment there is no clear judgment as to what inflation is and its dynamics. Let’s go back a bit and recall the financial crisis of 2008, which was provoked in many respects by the development of the “financial bubble”. In response to the development of the crisis, the US Federal Reserve and the Central European Bank significantly increased the supply of money supply, which, however, did not affect the significant growth in the money supply.

How Money Supply Affects Inflation

Many expect the current increase in the money supply to cause inflation. The reason for this expectation is the supply and demand curve itself. Money is just a tool that people and companies use to purchase goods. Accordingly, if the amount of money grows faster than the supply of goods, then people and companies will be willing to pay more for what they need, which in turn will lead to an increase in prices in the markets. As a result, it is expected that more money will provide growth in demand and if the growth rate of supply volume lags, this will cause price increases.

This sounds even more logical, especially if one recalls the Christ-like example of the “price revolution”. For the first time, Western Europe faced serious inflation in the middle of the 16th century, when the number of precious metals exported by the Spaniards from the New World exceeded all reasonable limits. Then it was gold in the modern sense of the word, and since the growth in the supply of goods was much slower, this led to the depreciation of gold, that is, inflation.

Moreover, in countries with less developed economies, governments often force central banks (although monetary policy should be independent) to increase the amount of money. This is usually done to finance current budget expenditures or to increase demand. In less developed countries, this also becomes a significant cause of inflation, which over time overlaps the volume by which the money supply was increased.

Everything seems to confirm the idea that an increase in the money supply leads to inflation. However, there are several reasons why this may not happen.

When Increasing Money Supply Does Not Lead To Rising Inflation

The modern economy is much more complex than the economy of Spain 400 years ago. And in the modern economy, credit money makes a significant contribution to economic growth. The money supply includes not only real money in cash and non-cash form but also loans, mortgages, credit cards. All these types of borrowing are an important source of consumption.

Scenario #1: The money supply was increased to balance demand. Let’s consider the first version of the situation when the growth of the money supply did not cause a rise in inflation. To do this, we return to the crisis of 2008, when due to problems in the economy, most banks began to reduce the volume of loans. This led to a drop in human consumption and to compensate for this, the governments of developed countries began to flood the market with money. As a result, the growth of the money supply did not affect inflation, since it did not increase demand, but only supported it at the pre-crisis level.

Scenario #2: inflation has occurred, but consumers will not feel it. Money and credit are also used to acquire financial assets. If we analyze the correlation of money supply and stock indices, we can find a strong correlation, especially during the years of growth and the absence of crises.

S&P 500 Index and Money Supply Correlation. Source: Fred

As a result, an increase in the money supply primarily affects the purchase, value, and turnover of financial assets. The development of this practice leads to financial bubbles, that is, a significant overestimation of the prices of financial assets over their real value.

It turns out that in developed economies (USA, Japan, the European Union), an increase in the supply of money supply leads to an increase in inflation, but ordinary people do not feel it, since most of the inflation affects the price of financial assets without affecting the rise in prices for goods and services.

Globalization Effect on Inflation

Globalization also has a significant impact on reducing and containing inflation. In connection with the growth of the money supply, a part of inflation is leveled by increasing imports from countries with lower costs. It turns out that the expansion of the money supply within the country is offset by both an increase in the export of money to other countries and the import of additional goods that increase supply on the market. In such a situation, if one of the countries increased its money supply and the demand in its market increased significantly, then the price increase will not happen or will not be so significant, because with the growth in demand, foreign companies will try to fill the market with additional offers.

In conclusion

In this article I tried to make out situations where the expansion of the money supply does not lead to an increase in inflation. However, two things must be understood. First, the nature of inflation and its features have not yet been fully studied. Secondly, an increase in the money supply in developing countries will almost certainly lead to an increase in inflation, since none of the described scenarios (including the impact of globalization) has such a strong influence in these countries as in the USA, Canada, Australia, the European Union or Japan.

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