Question

Since 2008, the money supply has almost quadrupled, going from $1.4t to $5.3t. At the same time, the Real GDP (the actual amount of goods and services produced by the economy has increased by a modest 23%, equivalent to an average growth of just under 2% per year.  

We expect that a large increase in the money supply without a corresponding increase in the Real GDP would cause a very large increase in inflation. In fact, since 2008 inflation has been quite low, averaging under 2% a year.

Our Monetary Exchange equation isn’t wrong. How do you explain this apparent contradiction? What happened to keep inflation so low while the money supply went way up? I am not looking for precise numerical calculations, but rather a thorough explanation of what happened to keep inflation so low.

at Question 2: Money, Reserves and Inflation (8 points out of 20) This chart shows actual numbers for the US economy since 1984 M1 Money Supply and Excess Reserves Sain) $5.500 $5,000 $4,500 I $4,000 $1,500 $1,000 $2,500 $2,000 $1,500 $1,000 $500 1 1 686 + 0661 TAT 5861 1997 1988 TE 2661 7661 61 Sut 9661 Im 1998 4000 2001 TOOT gor 2011 TIDE FIDE PIE SIT 910 CI BIDE -Mi Money Supply Exces Reserves Source: StLouis Fed.org Since 2008, the money supply has almost quadrupled, going from $1.4t to $5.3t. At the same time, the Real GDP (the actual amount of goods and services produced by the economy has increased by a modest 23, equivalent to an average growth of just under 2$ per year. We expect that a large increase in the money supply without a corresponding increase in the Real GDP would cause a very large increase in inflation. In fact, since 2008 inflation has been quite low, averaging under 25 a year. Our Monetary Exchange equation isn't wrong. How do you explain this apparent contradiction? What happened to keep inflation so low while the money supply went way up? I am not looking for precise numerical calculations, but rather a thorough explanation of what happened to keep inflation so low. Para 2

Answer 1

Increase in Money Supply will not alwsys result in inflation, especially if the scenario is just after a recession. This can be explained by the two cases detailed below -

• Since 2008 saw a massive Financial Crisis, the economy was at its lowest. This was the point where aggregate demand was extremely low. We know that in Keynesian economics, we talk about the liquidity trap. This is the point where reduction in the interest rate increases the money supply in the economy, but it still does not increase the economic activity. Even as interest rates are low, people still prefer saving than spending, and hence, there is no increase in aggregate demand. This shows that the government can stimulate increase in aggregate supply in the economy through subsidies, but aggregate demand will still be low, and because of that, the prices will not increase even as the money supply is increased. This is seen mostly in recessionary situations when people in general have a negative outlook for the economy.
• Another approach to evaluating this would be evaluating the components of the equation -

$MV=PY$

Which is the standard equation for the qauntity theory of money. In this, we can see that keeping the Velocity of circulation (V) constant and the national output (Y) constant, an increase in the money supply (M) will increase the price level (P). But, during recessions, V is not constant. In the above scenario, we have been informed that Y and P were constant even as M increased, which can only happen if V falls. And indeed, during recessionary phases like after 2008, V would fall as people will reduce their expenditure and save more money for the uncertain future. Hence, even as M increased 4 times, V would have decreased as much, leading to P and Y being consant.