Money and inflation
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Output supplies cannot be multiplied overnight.
It was the 5th Convocation of the SANASA Campus in Kegalle, held on March 1st. I too travelled there with Dr. Howard Nicholas who delivered the convocation speech. We had been invited to join for lunch with the Chancellor and the Chairman of the SANASA Campus Dr. P.A. Kiriwandeniya and the former Vice Chancellor of the Campus Prof. W.D. Lakshman.
I recalled the event to refer to the focus of Howard’s convocation speech on the link between money and inflation. It was only a few weeks before that Howard launched at the University of Colombo his book titled “Explorations in Marx’s Theory of Price – why Marx is still relevant for understanding the modern economy”. The book is also within the subject area of “money and money prices”. Howard has been carrying out a couple of publications including newspaper articles as well as frequent speeches challenging the conventional idea of the link between money and inflation.
After attending the Convocation ceremony at the SANASA Campus, I thought of shedding some light on this subject area – the link between money and inflation. My purpose is to unveil the complexity of the “money-inflation link” guiding you to question the one-to-one relationship between the two, rather than to oppose or support any argument.
Excess money growth
It is now deep-rooted opinion, not only among economists but also among the general public, that money-printing causes inflation. At the outset let me say that it’s not a wrong idea, because what you imagine is something like this: You have Rs.1000 in hand for which you can buy 5kg of rice at the price of Rs.200 per kg: If the money in your hand doubles, you will have Rs.2000 and can buy 10kg of rice.
In order to make it happen, rice producers must also be able to double their market supply instantly which is not at all realistic. If the amount of rice remains the same as 5kg, then doubling the amount of money in your hand will cause the prices to go up; as beginners to learn economics in the schools days, we would then say that “more money would chase after fewer goods” causing inflation.
Just imagine that you expand the above case to national level: the country has a “stock of money” as well as a “stock of output” of goods and services. The output is growing over time, which we measure using the rate of real GDP growth. If the stock of money is growing more than the real GDP growth, then “more money would start chasing fewer goods and services”. And there will be inflation!
As we all think, real GDP growth has a limit, but it is not the case with money. As we have got used to believe “money-printing” is in the hands of the Central Bank. Therefore, without any obstacle, money can be printed easily, if the Central Bank choose to do so or if the government asks it to do so. Therefore, we are overwhelmed with the idea that, in order to avoid inflation, the Central Bank should not print money above and beyond real GDP growth.
Money and money-printing
However, there are two important questions to clarify, before we dig further: The first is “what is money?” and the second “what is money-printing?” Money is not the amount of coins and notes; money-printing is also not multiplying the sacks of coins and the bundles of notes!
Under the narrow definition of monetary aggregates, the stock of money is the “amount of cash held by the public plus the current account deposits of the commercial banks”. Under its broader definitions, other bank deposits can be included resulting in higher values of the money stock.
The source of money stock is known as “reserve money” which is the amount of cash issued plus commercial bank deposits at the Central Bank. The minimum of the latter is determined by the Statutory Reserve Ratio (SRR) imposed by the Central Bank on the deposits attracted by commercial banks. At a given value for the reserve money, how much would be the stock of money is explained by “money multiplier”.
Money-printing means an injection of “fresh money” to the economy: According to one of the interpretations, it is the change in reserve money. As it is believed, changes in reserve money also lead to corresponding changes in money stock (through money multiplier). For this reason, one may also take the changes in money stock as money-printing.
Apart from these definitions, “net lending to the government by the Central Bank” is a commonly understood definition of money-printing too, because it injects fresh money to the economy directly through the Treasury. Central Bank lending to the government is a result of purchasing government securities (Treasury Bills and Bonds) by the Central Bank in the primary market. It tells that money-printing can also be interpreted as changes in the stock of government securities held by the Central Bank.
Fundamental questions!
Now we have a more fundamental set of practical questions to ponder, if we need to understand the robustness of the link between money and inflation. The first is about the link between reserve money and money stock. Sometime ago, even the central banks used to target reserve money in order to influence the money stock and, thereby to control inflation.
In economics, it is quite natural that the relationships exist in both directions. The question is whether reserve money determines money stock or money stock determines reserve money. When the prior changes in bank deposits generate cash reserves of the reserve money, then there is a reverse causation too. Accordingly, bank deposits would influence reserve money equal to or more than the amount determined by the SRR.
It leads to another question: then, who controls the stock of money. The question arises because it is not only the Central Bank, but also the commercial banks that play a major role in controlling the stock of money through their business. Bank business is generating deposits and creating loans, while loans determine deposits too (through deposit multiplication process).
Finally, it is understood from the above discussion that bank deposits and loans are the same factors that determine money stock at least partially. Then, how do we ignore non-bank commercial and retail credits which influence transactions? If money is for transaction purpose, long before money enters the equation a large part of modern transactions is determined through business credit facilities.
When all forms of transactions are aggregated together, it is called “aggregate demand” emanating from the households and businesses as well as the government. Accordingly, modern aggregate demand is determined not only by the stock of money (cash plus bank deposits), but also by non-bank business credit, all of which eventually demand the stock of money. What I want to emphasise here is that there is again a reverse causation running from aggregate demand to the stock of money, and not the other way around.
Conclusion
As it is believed in a traditional way, the stock of money (determined by reserve money) influences aggregate demand, exerting pressure on inflationary trends. What I have examined above is the existence of a multitude of influencing factors around and the possibilities for reverse causation. Accordingly, it is the aggregate demand that can also create pressure on both the demand for money stock on the one hand, and pressure on inflation on the other hand.
The link between money and inflation also weakens due to some external factors. Business cycle is one of these factors, in which inflationary pressure would subside during recessions and exacerbate during expansion times. In the recent past we have witnessed this in both advanced and developing countries.
Moreover, there is a notable distinction between advanced and developing countries in relation to the money-inflation link. Advanced countries have been printing money in a massive way since the US financial crisis in 2008-09, but without causing significant inflationary pressure.
As international monetary flows have escalated along with liberalisation policies and ICT advancement, such money from advanced countries did not create pressure on domestic aggregate demand but flooded stock and bond markets in developing countries. It is not the case of developing countries, as their currencies had not acquired an international value. My point is that money-printing may not be enough, where that money is going to land matters too.
(The writer is Emeritus Professor of Economics at the University of Colombo and can be reached at sirimal@econ.cmb.ac.lk and follow on Twitter @SirimalAshoka).
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