Study partially protects the ECB
Who is to blame for the high inflation?
By Jannik Tillar
01/29/2023, 07:12 am
Higher money supply, higher inflation – it’s not that simple, as a study by the Bundesbank shows. The expansive monetary policy of the European Central Bank is therefore only partly responsible.
For many years, monetary theory seemed to contradict itself: despite persistently low interest rates and central bank expansion of the money supply, inflation rates remained low. This is paradoxical, because the so-called quantity theory actually says something else – namely that money supply growth correlates exactly with the inflation rate. If you follow the theory, the inflation rate should have risen much more sharply in the past 20 years: by around 5.6 percent per year – the average money supply growth. In fact, it was just 1.8 percent. And now that inflation has risen so much, that trend has reversed.
So is the quantity theory dead? The Bundesbank has now also investigated this question, examining the connection between the money supply and inflation in its current monthly report – and coming to a very differentiated conclusion.
What sounds like a question for nerds and gourmets is causing surprisingly lively discussions on social networks like Twitter. Many blame the European Central Bank (ECB) for the current inflation – they have printed too much money. In professional circles, the situation is hardly discussed in a more differentiated way. Some demonize more money in the market, others see fewer problems in it. The extreme form of this can be found in the “Modern Monetary Theory”, whose adherents do not completely negate the connection between the money supply and inflation, but ultimately see the state as more responsible for getting inflation under control.
In its monthly report, the Bundesbank therefore questioned itself to a certain extent: does monetary policy actually work as we assume – and how strong is the connection between the money supply and inflation? This is a highly topical question, especially in times of high inflation rates as a result of the Ukraine war. The Bundesbankers answer the question with a yes: Yes, the monetary policy measures are basically having the desired effect on the real economy – the so-called transmission process is therefore intact. For example, if the central bank raises the key interest rate, this also seeps into the real economy. However, the connection between money supply growth and the inflation rate may be smaller than the quantity theory suggests – at least there are a large number of studies that come to this conclusion.
“Money demand shock” in the first year of the pandemic
However, the connection between the money supply and inflation cannot be completely dismissed. The Corona crisis in particular is an instructive period for this. In 2020, the money supply M3 rose sharply – in addition to cash and sight deposits, it also includes certain money market paper and money market funds. In peak months, this money supply increased by up to twelve percent compared to the same period last year. In 2021 and 2022, the money supply then fell again – while the inflation rate rose at the same time. “This raises the question of a possible connection between the increase in the M3 growth rate and the inflation rate,” writes the Bundesbank.
With the help of a regression model that calculates the relationship between nine variables – such as consumer prices or the M3 money supply – the Bundesbank economists come to the conclusion that the money supply is only partly to blame for inflation. The money supply growth in 2020 is primarily the result of a “money demand shock”. To put it simply, people hoarded their money – on the one hand because they feared for their jobs. On the other hand, because they could hardly spend the money. Restaurants, hotels and parts of the retail trade were eventually closed.
People largely reduced this buffer again in 2021 and 2022. So the “money demand shock” became smaller and smaller. At some point there was even a macroeconomic demand shock because people were consuming unusually heavily. According to the Bundesbank, this spending spree was further fueled by support programs and an expansive monetary policy. At the same time, there was a supply shock from stuttering supply chains. Later came the Ukraine war and with it the exorbitantly rising energy prices. According to the Bundesbank, the expansive monetary policy was adhered to for too long, but there are other reasons.
In the long term, the development of the money supply does not play a major role as long as inflation rates are low. However, the Bundesbank points to the opposite effect, which can be seen in developing countries such as Argentina and Turkey, for example. Inflation rates there have been high for a long period of time, and many of their populations have gotten used to it. It is unlikely that something like this will happen in Germany for the time being – for this to happen, inflation rates would have to remain high for a longer period of time and remain well above the well-known ten percent.
This text first appeared in capital