curiousspring
New member
Introduction: There has been a lot of discussion as to the increase in money supply and inflation. Most seem to think that an increase in M2 inevitably leads to inflation in prices of goods and services. This couldn't be further from the truth. There was previously a strong correlation between the two up until 1990. From then on, the correlation has reversed and is negative. There is now a much stronger relationship between increases in the money supply and decreases in the velocity of money, meaning that money is not moving through the economy as it once did. This means that increases in the money supply are not getting spent. And as we all know, money must be spent to cause inflation. This is why economists are not overly concerned about the recent rapid rise in the money supply causing inflation.
So here are the four easy charts:
TLDR: Increasing the money supply does NOT lead to inflation in products and services like it once did. It now results in a lower velocity of money, more savings and higher asset prices.
So here are the four easy charts:
- This first chart shows the correlation between the adjusted money supply and inflation. The M2 money supply is adjusted by subtracting real GDP. This amounts to the excess money beyond what is needed to grow real GDP. This has the strongest correlation with inflation. Inflation is measured by the implicit GDP price deflator, which measures the actual items that were spent in the year vs. a previous year's base price. You can use PCE or CPI, but the relationship is very similar. (Also I'm using an 8 year moving average because this gives the strongest correlation between the two variables. The correlation is very weak in concurrent periods, and gets a little stronger using 2 and 4 year moving averages.) You can see from this chart that the correlation was very strong from 1968, the first year of the 8 year moving average, through the end of 1990. R = 0.95 and R^2 = 0.90. This indicates that 90% of changes in inflation can be explained by the changes in the adjusted money supply. This strong relationship has lead the general public to believe that the two variables are inherently related: That is, that the expansion of the adjusted money supply inevitably leads to inflation.
- The second chart shows the correlation from 1991-2021. You can clearly see that the relationship reversed. R= -0.50 R^2 = 0.25. This indicates that the rate of inflation decreases as the adjusted money supply increases. It shows a moderate to weak relationship in which the increase in the adjusted money supply explains about 25% of the decrease in the rate of inflation. This can probably be explained by the fact that the money supply has seen its largest increases in periods when the economy was in recession and prices were falling. Needless to say, you can see that the former relationship between these two variables does NOT exist anymore and hasn't for 30 years!
- This third chart shows the relationship between changes in adjusted money supply and changes in the velocity of money from 1960-1990. The velocity of money is the frequency of monetary transactions in the economy. You can clearly see that the relationship is negative, as the adjusted money supply increases, the number of transactions decreases. R = -0.63 R^2 = 0.40. This indicates that 40% of the decrease in the velocity of money can be explained by the increase in the adjusted money supply. This is a moderately strong relationship.
- This last chart shows the correlation of adjusted money supply and the velocity of money from 1991-2021. R= -0.98 R^2 = 0.97. This indicates the strengthening of the relationship between increases in adjusted money supply and decreases in the velocity of money. You can clearly see that the more money that is pushed into the economy the less frequent that money gets spent.
TLDR: Increasing the money supply does NOT lead to inflation in products and services like it once did. It now results in a lower velocity of money, more savings and higher asset prices.