Question

Professor Milton Friedman argues that 'inflation is everywhere, purely and solely a monetary phenomenon'. Discuss

Answer 1

This claim that inflation is a monetary phenomenon is based on the quantity theory of money, according to which prices vary in proportion to the money supply. This relationship is based on a mathematical identity, according to which the value of transactions carried out in an economy (understood as nominal GDP) is equivalent to the amount of money circulating in that economy (understood as the amount of money in an economy multiplied by the number of times this changes hands; i.e. the velocity of money). If we assume that the velocity of money is constant, in an economy without economic growth the inflation rate equals the rate of growth in money. Therefore, if money supply increases, there will be more money chasing the same goods, so prices will go up. Similarly, if the rate of growth for economic activity and the quantity of money is the same, prices should remain constant. Friedman’s statement has been backed by empirical evidence, also showing a positive relationship between inflation and growth in excess money supply (growth in money supply above the real growth in GDP) for a large number of countries. This relationship is strong and robust in the long term but, the relationship between both variables may weaken temporarily in the short term due to factors such as price rigidity and the velocity of money not being constant. For example, a reduction in the velocity of money in circulation would be compatible with an increase in the money supply without putting pressure on prices. Based on the above, both the theory and empirical evidence suggest that, if growth in the money supply is greater than the actual growth in GDP, this should push up inflation in the medium term. However, since the start of 2012, the relationship between both variables seems to have weakened to the point of almost disappearing. On the one hand, growth in money supply has accelerated more than GDP growth while, on the other, core inflation has continued to fall. Below we look at the main factors that lie behind this decoupling between monetary aggregates and prices in the last few years. In this respect, an analysis of the effectiveness of monetary policy and specifically how it affects monetary aggregates is essential. In general terms, when a central bank offers liquidity to the banking system, either by offering long-term credit or by directly purchasing some of its assets, the monetary base increases. There isno automatic rise in the money supply, however. Traditionally banks would use the liquidity provided by central banks to increase the supply of credit and movements in money supply were therefore in line with those in the monetary base, ultimately leading to an increase in consumption and investment and thereby pushing up prices. However, the considerable increase in the monetary base occurring over the last few years has not led to a similar increase in the money supply (see the table). The factors limiting the growth capacity for credit can be found both in its demand and supply.