How To Get Off The Monetary Hamster Wheel
The impact of money on inflation arises from the interplay between money supply and money velocity. One component on its own really isn’t enough to provide the economy with the impetus needed for growth.
Consider a situation where only money supply increases, and money velocity remains low. We now know that an increase in money supply is an increase in bank loans (not reserves).
However, if banks are busy making new loans but no one in the broader economy is willing to spend the money created from these loans, nothing really changes.
All that happens is a bunch of newly created loans end up sitting on businesses’ balance sheets accruing interest, waiting to be repaid (and thus destroyed).
As such, money velocity must also rise; that is, people in the broader economy must be willing to spend money. Without the impetus of spending, money that is created but doesn’t move around the economy is not inflationary.
On the other extreme is a situation where no money is created but people can’t stop spending money, i.e. money velocity is high. This situation, barring a collapse in confidence in the currency that leads to hyperinflation, is like a hamster sprinting on a hamster wheel. The hamster can run as fast as it can, but it just won’t go anywhere.
Likewise, money can run really rapidly, and in doing so create some degree of inflation, but not really enough (again, barring the hyperinflationary scenario). As long as the banking system is not making new loans, money velocity alone cannot create growth and the “good” inflation that comes with it.
Therefore, money supply growth is what gets money velocity off the hamster wheel. Likewise, money velocity is what gets money supply growth off balance sheets and into the economy.
If economic growth is the goal, both must work together.
Of course, when growth in both money supply and money velocity is taken to the extreme, an economy can be driven into a hyperinflationary spiral.
The best and most extreme example of this is of course the Weimar hyperinflation, where indiscriminate government printing led to the population’s loss of faith in, and subsequent refusal to hold onto the currency.
Therefore, some degree of balance is required when trying to stimulate economic growth by influencing money supply and velocity. This would explain policymakers’, and some mainstream commentators’ concern over the size of the US government’s $1.9 trillion fiscal stimulus package.
Unfortunately for them, not only have they overestimated the efficacy of fiscal stimulus to households, they have also misunderstood the nature of QE (it does not work).
To top it all off, here’s a chart of M1 and M2 velocity in the USA:
M1 Money velocity has been falling pretty much unabated since the Great Financial Crisis (and M2 even longer). That’s 13 years now, with velocity hitting an at least 40 year low post Covid.
Inflation from an overheating economy really shouldn’t be the worry now, should it?
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