Sunday, August 29, 2010

Tracing excess money in the economy!

The post below about Friedmand's claim regarding inflation being always a monetary phenomenon has already introduced the question of this post. Let me restate still: when the money supply in an economy increases, where does it go and thus what effects does it have?

Insofar as 'inflation' in Friedman's claim is restricted to consumption goods and does not include changes in the prices of assets such as real estate and equity stocks, the above claim though true is only half-accurate. While the only explanation of inflation is increase in money supply, not all increases in money supply cause inflation. Inflation as a phenomenon is the subset of all the effects of increased money supply. Why is this important to highlight? That is because monetary policy decisions would be faulty if it is assumed that any expansion in money supply will eventually lead to inflation for sure.

Hence the need to trace the money. To be more precise - increased money supply. The mechanisms of increase in money supply are not directly controlled by one entity. There are several participants who respond to not only the regulatory fiat of the central banks but also the market realities of credit and money markets. Hence it is difficult even for the central banks to directly control money supply - they are probably the biggest influencers but that is that. Let us consider the simplest example of growth in money supply. The central bank reduces interest rates and the demand for money goes up. The banking system starts to lend out more. The multiplier comes into picture and the total amount of money in the economy goes up. This happens through a combination of extension of more credit, higher incomes, more projects and so on. This is expected to push the prices of the goods and services up. Herein lies the catch.

The prices of goods and services will increase if the increased money supply has found its way to the wage earning individuals AND they have decided to use most of their increased nominal wages for higher consumption. Both of these assumptions are valid only ocassionally. Also there co-occurance is another matter of debate. The first assumption is not trivial. Increased money supply reaches spending individuals directly through retail credit and indirectly through the negotiations for higher wages in labor intensive industries. The elasticity of retail credit to price of money remains to be evaluated. Also the frequency of wage changes in labor intensive industry needs to be ascertained. For the second assumption, one needs to be cognizant of the further stratification of incomes and thus find out which income groups the increased money supply is going to. The savings rate tends to rise very sharply at some point in the income spectrum of the middle class. Increased money supply to individuals above this level would typically not increase their consumption by much - and in effect will divert the money into asset markets.

The excess money in the hands of individuals who are not very keen to spend most of it eventually finds its way into asset markets through debt, equity or real estate. This should have very limited direct impact on the prices of goods and services. On the other hand, the asset prices are likely to move up. Which assets move up in particular will depend on the risk perceptions prevalent in the economy then. The regulators then need to watch out for the asset price inflation as much as the goods and services inflation. The former can adversely affect the economy by introducing a random variable in future monetary policy decisions. More on that later.

Another noteworthy point is the implication of monetary policies on the way we think about our wealth. While the wisdom of inflation eating into the purchasing power of one's wealth is widely discussed and agreed upon, it seems to miss the same point as above of asset price inflation. One can argue that the asset price inflation directly positively affects one's wealth. However, depending on which assets inflate by how much and how reliably and what is the balance between goods and services inflation and asset price inflation, one needs to fine tune the investment strategy in the long term.

Sunday, August 08, 2010

Friedman's claim for inflation

Milton Friedman has famously claimed once - inflation is everywhere and without exception a monetary phenomenon. Many have agreed, many have disagreed and a small subset on either side have understood. I don't know which group i belong to!

In theory, it is quite straightforward to understand that if the money supply in the economy is growing at the same rate as the output, the average price level in the economy will be constant - zero inflation. Hence any economy wide price increase has to be attributed to the prevalence of more money than that is needed to buy all the goods and services produced. The issue becomes perpelxing when one thinks of the so-called supply side inflationary shocks. If the oil price goes through the roof, prices of most things tend to go up. This is also easy to understand and in fact to see in practice. What happens to money supply in this case? As in, if money supply were constant and the price of a key commodity went up due to supply side issues, what explains the resultant inflation?

One can go back to first principles and device a thought experiment. Say a closed economy has wheat as the primary commodity and a host of manufactured goods and services. For simplicity let us assume that the economy is not growing in real terms and has constant money supply. Hence one can effectively point to the total amount money in the market (including notes, coins and bank deposits). Now if the wheat harvest of one year turns out to be quite bad and the stocks dwindle. The demand for wheat has remained same and hence by the laws of supply and demand, the price of wheat will go up. Insofar as there is no change in the money supply, one would expect a deflationary pressure on the price of other commodities. As in the haircuts and electricity should become cheaper since more money is now being sent the way of purchasing wheat. Would it happen in real life? If not, where would the excess money to pay for more wheat come from?

In a real life scenario, there might be a linkage to the asset markets and credit generation. Ultimately money supply is primarily affected by the rate of credit growth in the economy. If the supply shock leads to change (effectively increase) of the credit in the economy, it can lead to inflation through a forced change in money supply. Forced in the sense that it comes from outside the monetary policy controller of the economy (central bank). In this sense Friedman may be right in the final observation - it is through the money supply route that the supply shocks also get to increase inflation. But the statement has been often abused by monetary policy critics who directly translate that statement into a blame for all inflation onto monetary policy. That is clearly not the case.

One can only say that supply side or demand side, inflation comes through increase of money supply. Not always can the increased money supply be attributed to the monetary policy. However only active monetary policy can quell the increased money supply.

Another important factor in considering the impact of money supply on inflation is the growth rate in asset markets. It is not only goods and services that are purchased with money. Equities, bonds and real estate are as well. Hence the linkage of money supply to inflation is not complete without understanding the balancing figures of asset price changes. More on that later.