Sunday, December 06, 2009

Arnold Kling's Denial Of The Relevance Of Money Supply

Arnold Kling criticizes the view that money supply affects inflation and output:

"If you believe MV = PY, then something magical happens when the monetary authority purchases bonds with money. M goes up, V is approximately constant, and so spending (PY) goes up.

Instead, I think that when the Fed exchanges money for bonds this has almost no effect on spending.

Suppose that your net worth is $100,100, of which $100,000 is in various assets, such as home equity, mutual fund shares, and checking and saving accounts. You carry $100 in cash in your wallet. One day, you wake up with $99,900 in other assets and $200 in your wallet. By how much does your spending go up? Well, if V is constant, then PY doubles. Instead, I think that V will fall by half.

Personally, I prefer to believe that my spending rate has almost nothing to do with my wallet cash. If I have a lot of cash, I can still resist buying stuff I do not want. If I have only a little cash, I have no problem using a credit card or writing a check."

The key fallacy here is of course that it isn't just cash that is money. Any asset that can be used as a means of payment is money. That is why even narrow money definitions like M1 include a lot more than cash (or "currency in circulation" as it is called in money supply statistics). And that certainly includes the amount of money available through the use of credit cards or cheques.

It is true that it is not likely that a sudden big increase in money supply will really immediately increase PY (nominal GDP) by the same amount, as the full effect of money supply on both output and prices for various reasons works with a time lag of varying length, but usually 1-2 years. Nor is it necessarily the case that PY will necessarily increase exactly as much as money supply even over a longer period of time. But Kling goes way beyond that and says that money supply has almost no effect on inflation or output at any time.

It is also true that net worth also influences spending, and that therefore when a nation's aggregate net worth rises because of higher stock and/or house prices, this will increase spending. But money still affects spending more, and rising asset prices are usually the result of previous money supply increases.