Monday, July 04, 2011

Does Money Supply Growth Necessarily Cause Economic Growth?

Though there has been some anomalies suggesting otherwise, such as the latest ISM manufacturing survey, most U.S. economic indicators suggest serious economic slowdown from what was already a weak recovery.

Yet money supply growth during the latest year has been relatively high during the latest year, largely because of QE2. Given the role that Austrian and Monetarist theories place on money supply in determining cyclical fluctuations, how is it possible for economic growth to slow down even as money supply growth increases?

Well, first of all, money supply is not the only factor influencing the economy. A lot of other factors, including money demand, demography, tax- and [government] spending policies, foreign business cycles etc. also influence economic growth. Saying that money supply changes could affect short-term changes in the short term is certainly not the same thing as saying that money supply changes is the only thing affecting economic growth and that there should therefore be a perfect empirical correlation. It's sort of how the things you eat influence your weight, but that doesn't mean that there will be a perfect correlation between eating habits and weight, because other factors, primarily genetics and the amount of exercise also influence weight.

And secondly, it is not certain that an increase in money supply will, even in the short term, boost economic growth. It will, if the conditions described in Austrian business cycle theory is applicable. But it might also be the case that it simply bids up prices in general, or the prices of largely imported commodities. If that is the case, then higher money supply growth could lower, and not increase, even short-term economic growth, as for example Zimbabwe experienced during its recent hyperinflation.


Blogger Ralph Musgrave said...

The US monetary base has approximately doubled over the last two years or so: largely explained by QE as you rightly point out. And the latter simply consists of giving rich people cash in exchange for their government debt. These people can be expected to purchase shares so as to pare down their excess holdings of cash, but there is no reason to suppose they’ll go on a spending spree, which WOULD promote economic growth. Reason is that QE has little effect on private sector net assets – assets of the rich in particular.

It would be totally different if exactly the same money supply increase came about as a result of the government / central bank machine simply printing money and spending it: here, private sector financial assets WOULD increase, and I would expect demand to increase. And the effect would be even more dramatic if the extra money is channeled into the pockets of poorer rather than richer citizens.

Re the idea that a money supply increase might “simply bid up prices in general”, this would happen if the economy were at capacity, but inflation shouldn’t be exacerbated too badly given excess unemployment.

Finally, it’s important to distinguish between central bank created money and commercial bank created money. An increase in the former, if it results in an increase in private sector net financial assets ought, to repeat, raise demand. In contrast, commercial bank created money is the RESULT of increased economic activity, or a result of increased demand for loans taken out with a view to engaging in economic activity.

9:30 AM  
Blogger stefankarlsson said...

Ralph, I disagree with your comments. First of all, QE2 hasn't reduced cash holdings (The broad and narrow measures of that, Currency and M1, has quite to the contrary in fact increased at double digit rates since QE2 began), but it has increased the asset values of the rich as stock prices have increased (That is a key reason why QE2 has increased inequality).

And secondly, inflation often increases even with high unemployment. The most extreme example is Zimbabwe during its hyperinflation yeras, but there are several other examples of stagflation, and QE2 was indeed such an example with accelerating inflation even as employment to population ratio was unchanged.

And thirdly, commercial bank created money can in fact create short-term boosts to growth, that is in fact what ABCT is all about.

10:10 PM  
Blogger Benjamin said...

Here is one angle I have not seen pursued.

Okay, in the 1960s and before, trade (including labor and capital flows) was not that big in the US economy.

Now, our borders are entirely porous, goods, services, capital and labor flow freely.

So we print a bunch of money here, and demand goes up, but supply easily goes up, as capital, labor, goods and services pour in.

Real money supply growth just boosts output, as the whole globe is unlikely so suffer from shortages.

As to recent history, the banks are not lending. Some say stop paying interest on reserves is a good idea.

Increasing interest rates in general,m however, is likely inducing fever in a patient suffering from anemia.

12:29 AM  

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