Does printing money cause inflation?
By Bodh Maathura
The COVID-19 pandemic locked the world indoors, dragging down economic growth across the world. The World Bank forecasts a 5.2 percent contraction in global GDP in 2020. Governments and Central Banks worldwide stepped in with agendas to restart their economies. Sri Lanka was successful in countering COVID-19, as it took the necessary measures in a timely manner to contain the spread of the virus. The island was able to open up its economy much sooner than its neighbors.
In an effort to tackle both the pandemic and the economic crisis that was looming, the Central Bank of Sri Lanka proactively used monetary policy tools to support both the fiscal sector and the private sector. This was done through a series of rate cuts and money being printed to support the fiscal need to fight COVID-19. This created some tension among economists in the country, who came out shouting warnings of hyperinflation and a currency crisis. This created fear among the public and mistrust towards the Central Bank.
Is printing money bad?
To answer this question, one must first identify the reason why money printing flashes a red warning among people. Anyone who has sat for a macro-economic lecture, at some point would have heard, ‘increase in money supply causes inflation to rise. As a matter of fact, anyone who has heard of high inflation rates would connect it to the excess money supply. Let’s dive deeper into the theory behind this norm.
The Quantity Theory of Money (QTM)
The Quantity Theory of Money is a theory connecting money supply and price levels of an economy. The theory was popularized by economists Milton Friedman & Anna Schwartz after the publication of their book, “A Monetary History of the US, 1867-1960” in 1963. According to the book, if the amount of money in the economy doubles, the price levels of that economy will also double (inflation). Their work influenced both monetarists and policies of Central Banks around the world. American economist Fisher created an equation to better depict the variables of the Quantity Theory of Money. Its simplest form is shown below.
M*V = P*T
M: Money supply
V: Velocity of money (the number of times money changes hands)
P: average price levels of an economy
T: The volume of goods and services traded during the given time period
The equation of exchange is a mathematical expression of the quantity theory of money. In its basic form, the equation says that the total amount of money that changes hands is equal to the nominal GDP of an economy. Monetarists add some assumptions about the variables in this model.
Constant velocity of money
Velocity is assumed to be constant and is not influenced by changes in the quantity of money. The velocity depends on exogenous factors like population, trade activity, habits of people, etc. These factors tend to be stable and change slowly over time. Thus, velocity is concluded to remain constant.
Constant Volume of Trade
The total volume of trade or transactions is also assumed constant and is not affected by changes in Q and M. T is viewed as independently determined by factors like natural resources, technological development, and population. These factors are outside the equation and change over a long period of time.
Price Level is a passive factor
Price levels are affected by other factors of the equation, but it does not affect them.
Money is a medium of exchange
The monetarists assume that money is only a medium of exchange to facilitate transactions. It is not hoarded or held for speculative purposes.
Taking this assumption into account, an increase in money supply (M) is able to only increase the variable P, as the other two variables V and T are constant. This allows economists to draw the conclusion that an increase in money supply will cause higher inflation rates. However, before blindly accepting this conclusion, the assumptions must be tested to observe if they hold in the real world.
Firstly, the velocity is assumed to be constant and changes over a very long period of time. But the data shows that people’s spending behavior changes with the economic growth levels of the economy. For example, household saving levels increase at a time of recession. According to the US Bureau of Economic Analysis, data shows the private savings rate in the US rising to as much as 33.5 percent in April 2020 amid the peak of the pandemic. Figure 1 shows the changes to the personal rate of savings in the US. The rates are highly volatile and are affected by changes in the economic outlook. These changes to spending patterns directly affect the velocity of money, making it highly volatile and tending to be lower during recessions when people save.
Figure 1. U. S. Personal Savings rate
Secondly, let us consider the assumption made on the volume of goods and services trades, which is assumed to be constant in the short run. However, with globalization and countries having a variety of trade partners to fulfill their demand, one cannot hold T to be constant even in the short run. The injection of money into the economy will be an indicator for manufactures and service providers that future demand will increase, therefore they will plan to increase production in the future. Furthermore, the world is advancing in technology and innovation at a much faster rate, producing larger quantities and making supply much more elastic. These facts prove that T is not constant but can move to output levels that are demanded by the economy.
In the real world, Velocity and the volume of goods and services traded are not constant. An increase in money supply by a central bank during a time of economic slowdown would not necessarily cause inflation. As M increases, V has fallen because fewer people spend money. This will balance off the left side of the equation of exchange. Further, the money injected should be used by the private sector to increase production levels in the future, bringing prices down.
The untold story of hyperinflated Zimbabwe
Let us move away from theory and observe how inflation and money supply relate in the real world. “Wheelbarrow of cash to buy a loaf of bread” – This is a famous phrase used to show the effects of hyperinflation. One of the most famous examples of this is Zimbabwe. In its peak month, the inflation rate was estimated at 79.6 billion percent month-on-month and 89.7 sextillion percent year-on-year in mid-November 2008. The second-highest hyperinflation of a currency since post World War 2 Hungary. The country was forced to redenominate the Zimbabwean Dollar three times starting in 2005. and finally, abandon the currency in 2009. All this catastrophe is said to be caused by the excess printing of money. But was excess money printing the only cause of this tragedy? This must be questioned before labeling money printing as evil.
Zimbabwe is a country located in the African continent and was once known as the ‘Bread Basket of Africa’. A nation rich in gold, platinum, diamonds, and other minerals, it was a target of the British colonizers. The black majority of Zimbabwe was able to regain control of the country in 1980, under elected president Robert Mugabe. The nation had close to a decade of stable economic growth and peace. In 1998, Zimbabwe entered the Second Congo War which drained millions of dollars from the economy. The Zimbabwe government printed money to finance its military involvement in the Democratic Republic of the Congo, including higher salaries for army and government officials. The war, mixed with a period of drought had a huge toll on the economy. This was followed by land reforms evicting more than 4,000 white farmers and redistributing land to black farmers with no experience, which led to the fall of productivity.
The land reforms of 2000, carried out by the government, bled the agricultural sector which was one of the main contributors to GDP and foreign exchange in the country. This led to a serious food shortage which resulted in cost-push inflationary pressure to increase as people started looking at imported goods and black markets to fulfill their daily supplies. The government kept printing more and more money through this period which drove prices even further till the currency was considered worthless. The downward trajectory of the economy which started in 1998, can be seen through figure 2, depicting the GDP of Zimbabwe between 1990 and 2010.
The country also faced many international sanctions and its credit lines from the IMF and the World Bank were cut off during this period. A combination of war and mismanagement of economic resources led to Zimbabwe overprinting money to finance its daily fiscal needs (most of which were pocketed by government and army officials). This led to its currency experiencing hyperinflation that led the country to poverty.
Bank of Japan’s fight against deflation
Let us now draw our attention to a more stable economy – Japan. This East Asian nation is the third-largest economy in the world in terms of GDP. It also has one of the highest levels of the broad money supply as a percentage of GDP standing at 252% in 2018. However, the country has had a long period of relatively low inflation and even deflation in some years. In a measure to tackle this deflation of prices, the Bank of Japan proactively cut interest rates to zero and put the money printers to work, dropping helicopter money over the economy in the hope of increasing inflation. A cash injection of ¥400 trillion was pumped into the Japanese economy over a period of five years to slay deflation and kickstart growth. To date, the Japanese economy experiences low levels of inflation. Figure 3 shows broad money supply as a percentage of GDP increasing over time, while figure 4 shows inflation rates remaining low over the same time period (2008-2018). This contradicts the monetarist view of increasing the money supply causing higher inflation. An increase in money supply will not necessarily cause price levels to increase as other economic factors will come into play and balance off the change.
Broad Money Supply vs. Inflation
Building further on this argument, countries with high levels of broad money as a percentage of GDP tend to have low levels of inflation. This can be seen through the table, showing the relation between money supply and inflation of the countries with the highest levels of broad money and lowest levels of broad money (as % of GDP). Countries having the highest levels of broad money tend to have relatively low levels of inflation. This can be observed by the L shape formation on the graph where the horizontal axis depicts broad money and the vertical axis depict inflation. Lebanon, having the highest level of inflation at 6% is a country known for geopolitical tensions affecting economic growth. The highest level of inflation in the sample can be seen by DR Congo, Liberia, and Uzbekistan at 29.27, 23.6, and 17.5 percent respectively. These three countries have been experiencing extreme levels of poverty, mismanagement of the economy, and external and internal political tension for the past few decades. The three nations also have some of the lowest levels of broad money as a percentage of GDP. The data shows that the level of the money supply is not the main cause for inflation, but factors such as geopolitics and macro-economic trends of the economy play a role.
Let us observe how the quantity theory of money has played out in Sri Lanka. Figure 6 charts broad money increasing over time as figure 7 shows inflation fluctuations of the same time frame. The data establishes the norm of the real world we observed prior, where money supply and inflation do not have a co-relation. The inflation rate movement is not affected by the increase in money supply but by other economic factors. Over time, output levels have increased in the economy, allowing price levels to stay relatively stable over time, therefore, debunking the Quantity Theory of Money put forward by the monetarists’ school.
As the COVID-19 pandemic paused the world economy, the US Federal Reserve (once the preacher of the Quantity Theory of Money) injected more than $ 2.3 trillion in the hope of reawakening the US economy. This exceeded the relief measures taken by the Fed in the 2008 great financial crisis. Printing money, once labeled radical and insane, maybe the only way of stimulating the economy towards a growth trajectory. The Central Bank of Sri Lanka was following the path set by Central Banks of developed nations, who now see the Quantity Theory of Money as an unrealistic, textbook model of economics. It is fair to conclude that a country with a stable macro-economic outlook has the monetary tool of injecting to be used to stimulate growth in an economy. The island must maintain a certain cap on the level of money injected while making sure this cash ends up in the hands of efficient private and public entities that are able to increase the future productivity of the economy. In conclusion, the following arguments debunk the myth that printing money to stimulate the economy results in high inflation.
Disclaimer: Published in the July/August 2020 Edition of BiZnomics Magazine.