Question

Question 2:  

This chart shows actual numbers for the US economy since 1984. 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?

Answer 1

The theory that states that higher money growth leads to higher inflation in medium run is true but the fact that this hasn't happened in US is somewhat counterintuitive. Let's try to understand what could be the possible reasons behind this diverging movement of money growth rate and inflation rate.

Inflation is defined as the increases in the general price level in the economy, that is to say when we have to pay more dollars for the same good that we used to buy with less dollars previously. The logic behind this is as follows when FED increases the money supply the more comes into economy and when real output doesn't grow at the same rate as the money grows then there is too much money chasing few goods so the price of goods goes up, which is manifested as inflation in the economy.

But the inflation since the 2008 is very low despite huge amount of money which was pumped in the economy by FED is due to the fact that new money hasn't entered the economy, the inflation rate goes up only when the new money issued by the fed enters the market but if for some reason it doesn't doesn't enter the economy the inflation will remain unaffected. The new money issued by the fed goes to commercial banks, and most of transactions by the US citizens are done through electronic medium so the new cash sits idle in the banks which goes to the 12 district fed banks.

Another reason for the low inflation in US is the weak US economy and global economy. When the economy is growing at a good rate the demand increases and higher demand leads to higher prices. So the lower demand has helped fed to pump more money without affecting inflation in the economy. And another reason can the low crude oil prices, the low crude oil prices helps in containing inflation. When the demand in the global economy is low the price of crude oil usually stays low.

Another reasons which has contributed to the low rate of inflation in US is the ever changing labor market in United States. The labor in United States are now competing with the cheap labor of asia due to which they have bargain hard for with employers, and the wages doesn't grow as much as it is supposed to be when unemployment goes down. The same thing has happened in goods market, the suppliers are benefiting from the closely linked economies by importing cheap inputs from other parts of the world which reduces their cost of production and hence the price they charge. Which in turn keeps the inflation rase in check.

So these are the possible reasons which can be attributed to the low inflation in the United States despite high money growth.