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.

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