Money Supply and Inflation

Money is one of those things that keeps growing in an economy. There's always more of it. But money just can't grow willy-nilly, the economy forces money to multiply. Money has two problems. The first is when there is too much of it. In this case, the oversupply of money reduces its value, which means that it no longer buys as much as it used to. This phenomenon is called inflation. The second problem is when there isn't enough of it. In this case the undersupply of money causes its value to skyrocket. This phenomenon is called deflation.

Now, check out this graph I have shamelessly linked from The Economist (here). This graph measures the growth of money in Japan, the United States, the Euro Area (that part of Europe which uses the Euro as its currency) and Britain.

If you take my comments about money supply at face value, you'll probably conclude that Britain, having the greatest increase in money supply (about 13% more than it was 12 months ago), would have the highest inflation, while Japan would have the lowest.

Yet this is not really the case. Britain's current inflation rate is 2.4%, Europe's is 1.8%, the US is 2.7% and Japan's is -0.2% (source). So while there are some correlations, the highest level of inflation (the USA) has not expanded its money supply at such a high rate. Why?

It's got to do with supply and demand. One country's demand for money might be higher (or lower) than another's. This means that, in the US, an expansion in the money supply of around 6% has meant inflation of 2.7%. Yet an expansion of 11% in the European money supply has led to inflation of only 1.8%. In short, it means that some nations have, for a variety of reasons, a higher threshold than others when it comes to inflation.

And if that is the case, then it follows that some nations' economies can grow faster while keeping inflation in check than others - after all, money supply is a reflection on economic growth.

So, what can we deduce from this graph and the inflation figures?

The most obvious thing to deduce is that the drop in the value of the US Dollar has placed a restriction on US economic growth. At the same time, and as a corollary, the increasing value of the Euro has led to less restrictions on European economic growth. Therefore we can actually expect, at some level, that the growth of the European economy will come at the expense of growth in the America economy.

This is reflected in recent stats. Economic growth in the US has averaged 1.8% in the last 12 months, while it has averaged 3.0% in Europe over the same period (source).

What is interesting to me is that Japan seems to have the sort of "zero-inflation monetary policy" that I advocate. Despite their money growth being the slowest of all four, their economy has grown by 2.6% which is quite respectable compared to the US.

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