Inflation: Making The Complex, Simple – Part 2

<< Read Part 1: Inflation: Making the Complex, Simple 

Before progressing, it is worth revisiting Stoking The Embers of Inflation, a paper we wrote with Brett Freeze in 2018. At that time, the money supply was declining, and we argued, contrary to popular thinking, it might generate more inflation. In the months that followed, annual CPI rose to 2.90%, the highest level since 2012. Today, we argue a sharply rising money supply may not generate much inflation.

Confused? 

In Part 1 we wrote: “The truth lies in the supply and the demand for money. Unfortunately, the supply of money gets the headlines, while its demand is an afterthought.”

This article’s underlying theme, and the one described in depth in the article mentioned above, is the Monetary Exchange Equation. The equation explains how money supply and monetary velocity determine price trends.

Supply Demand Curves

Economists use supply-demand curves to visualize how a shift in the supply and/or demand for a good affects prices. As shown below, reducing the production of goods shifts the supply curve to the left. Since demand remains constant in this case, the price rises (P1 to P2). The example is Econo-speak for “the less of something there is, the more its worth.”

Inflation, Inflation: Making the Complex, Simple &#8211; Part 2

The cost of beef, factory capacity, labor prices, and thousands of other factors influence the supply of Big Macs. Its demand curve shifts with the prices of other goods, wages, tastes, and many other factors.

Federal Reserve actions and, equally important, the demand for debt and the banks’ willingness and ability to lend greatly impact the supply of money. All money starts as debt. As such, new debt increases the money supply while debt defaulted upon decreases the supply.

The demand for dollars, also known as velocity, is driven by the aggregate desire to save or spend money. Velocity is essential in determining prices and yet is most often neglected. To better understand velocity, we recommend reading: The Fed’s Inconvenient Truth: Inflation is M.I.A.

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