How Money Moves Prices

A man walks past the International Monetary Fund (IMF) logo at its headquarters in Washington, D.C., on May 10, 2018. Yuri Gripas/Reuters

Commentary

The banking crisis is there, but global inflation does not ease quickly. Breaking down the components tells clearly that the non-core components (food and energy) almost vanish while the core ones (mainly services) are still firm. This is true in most of the advanced economies, including Japan. Housing prices are generally coming down (some are in slow growth), but the transmission to housing rents and hence consumer prices are limited. This time inflation is all-rounded rather than sector (such as housing) specific. The root cause is still too much money.

Merely monetary abundance will not bring about inflation, as has been verified repeatedly by rounds of quantitative easing over the past decades. Money, by construction, is a stock. Money stuck as stock without flowing would not have any macroeconomic consequences. As money moves around, there can be a few related concepts explaining inflation. The reason for more than one concept is that the money movement is hard to observe. There are, of course, statistics recording all kinds of transactions, but seems to be no single indicator combining them.

The movement probably begins in a much earlier phase one thinks: What is money? Money directly created by the central bank is a monetary base, but the generic monetary variable used in most economic analyses (the notation M) refers to broad money. Broad money includes most kinds of deposits that can be recreated from loans: For someone who borrows (a loan) to invest or buy something, the recipient might take that money to invest or buy something else. After several rounds, some of the money might not be further used and be redeposited.

Defined this way, the first measurement of money movement originates from the above “narrow to broad” process. Money multiplier is defined by the ratio of broad (M2) to base money (M0)—some are defined by required reserve but are derived from this version—it is the first phase of movement before broad money is shaped. The multiplier measures how fast the process is.

When broad money performs its function in the aggregate market, it impacts the aggregate price and quantity via the quantity theory of money (QTM): Money quantity times money velocity is aggregate price level times quantity (or transactions), or MV = PY. Since Y is conceptually real GDP, the righthand side can be operationalized as nominal GDP. Thus, the second measure of money movement is money velocity which is the ratio of nominal GDP to broad money.

This last measure is naturally the direct measurement of how fast money flows: credit. However, the only available indicator of consumer credit measures only the consumer market.

U.S. Money, Credit and Price in YoY % Growth. April 4, 2023. Courtesy of Law Ka-chung

The accompanying chart compares all three measures over the past two decades. Calculation shows money velocity growth is most correlated to inflation (0.45) while money multiplier growth is the least (0.35). Anyway, none of them have come down meaningfully, and this is a powerful explanation for the latest sluggish downtrend of inflation.

Views expressed in this article are opinions of the author and do not necessarily reflect the views of The Epoch Times.