Monetary Supply and Inflation: Debunking Keynesian Myth and Considering Modern Insights

Is the increase in money supply a clear predictor of inflation, as suggested by Keynes? Often, there is a misconception that money supply growth automatically leads to inflation. However, as we explore this topic, it becomes evident that the relationship between the two is multifaceted and highly nuanced.

Keynesian Theory vs. Modern Economic Insights

John Maynard Keynes suggested that an increase in the money supply would lead to higher inflation. However, in the modern era, numerous economists argue that this premise is overly simplistic and often incorrect. The dynamics behind the relationship between monetary supply and inflation are more complex than a straightforward cause-and-effect in many cases.

Complexity of Inflation Prediction

There is no straightforward method for predicting inflation. Factors such as money supply growth, interest rates, and economic expectations all play a role but do not guarantee a direct relationship. For instance, it is entirely possible for the money supply to be in decline for most of a year while inflation remains persistently high.

The best predictor of future inflation, as noted by many economists, is past inflation. This means that even if the money supply significantly increases over an extended period, such as 14 consecutive years, inflation may still opt to remain low. This underscores the importance of historical trends in economic forecasting.

Keynesian Misconception in Modern Context

Common misconceptions about Keynesian theory may stem from outdated economic paradigms. In the pre-computer era, economic forecasts were often based on observational data rather than rigorous analysis. However, in today's data-driven environment, any incremental change in interest rates can be virtually meaningless. Therefore, the expectations of economists based on past trends need to be updated with current data and analytical tools.

Modern Economic Insights

One significant insight from recent economic publications is that sometimes, the expansion of the monetary supply does not immediately drive inflation. This is due to several key factors:

1. Excess Production and Supply Dynamics

During periods of excess production and supply, the influx of new money may not lead to price increases. Manufacturers and retailers might absorb the additional funds to finance investments in production capacity or to weather economic downturns. This ensures that inflationary pressures are lessened for a period.

2. Debt Repayment and Asset Investment

Another critical factor is that the newly created money is often being used to repay existing debt, not to purchase goods and services that are typically included in inflation indices. Debt repayment does not contribute to inflation, as it merely shifts funds from one party to the other. Additionally, the new money is often being used to invest in assets, which are not part of the inflation measurement. Therefore, the effect on inflation can be invisible in the short term.

3. The Role of Pandemic and Uncertainty

The ongoing global pandemic has introduced a significant variable to the economic equation. Uncertainty around the pandemic has led to a reluctance to spend on major items, which further dampens inflationary pressures. Initial periods after the pandemic, when stimulus measures expand the money supply, might not show immediate inflationary effects due to this hesitation to spend.

Looking Ahead: Future Inflation Trends Post-Pandemic

Despite the current uncertainties, there are indicators of increasing inflation. These include factors such as shortages in supply chains, labor shortages, and the aforementioned pent-up demand due to the pandemic. These factors will eventually work through the system and be reflected in inflation data. As vaccination rates rise and pandemic-related concerns subside, we are likely to see a significant increase in spending, which will be reflected in higher inflation rates over the coming months.

The key takeaway is that while an increase in money supply can contribute to higher inflation, there are numerous complex factors at play. Economic policymakers must consider these dynamics carefully to develop effective strategies for managing monetary policy.

Conclusion

Monetary supply and inflation remain interrelated but not in the simple cause-effect relationship posited by Keynesian theory. Instead, they are influenced by a myriad of factors including production levels, debt repayment, asset investments, and the economic context of global events such as the pandemic. Understanding these interactions is crucial for making informed economic decisions and forecasting future trends.