What Causes Inflation and Deflation?

Economist Milton Friedman once said that inflation is “always and everywhere a monetary phenomenon”—a case of too much money chasing too few goods. This is basically true, in the sense that overall price levels are about the accessibility of money (and credit) versus the number of items in the economy that it can be used for (goods, services, and assets). In a sense, inflation and deflation are about the desirability of holding real assets versus pieces of paper, and how that changes over time.

Like many one-phrase descriptions of the economy, however, Friedman’s statement can be misleading. It is just not as simple as it sounds. Many financial and political pundits have been pounding the table recently about a great inflation in our future, based on the idea that the Federal Reserve Bank has “printed money” when it enlarged its balance sheet, and this means that there is too much money “out there.” Certainly, many other countries have created inflation and even hyperinflation by “printing money,” but to understand why future inflation is not nearly as certain as it sounds, we need to examine how inflation and deflation come about.

Inflation and Deflation as a Change in Supply and Demand

A basic principle of economics is that price levels in a market economy are set by the interaction of supply and demand. So prices can change in response to either demand or supply factors, and this is what those focused on Friedman’s statement often miss. For example:

• For Inflation:
◊ Increased aggregate demand tends to push prices upwards.
◊ Increasing materials, capital, and labor costs push prices upwards.
• For Deflation:
◊ Reduced aggregate demand tends to push prices lower.
◊ Increased productivity/reduced input costs typically lowers prices.

The money supply (i.e., cash plus available credit) connects to this dynamic mainly through effects on total demand. When it is easier to acquire money or credit, people and businesses are likely to spend more and more easily. But if economic productivity does not rise in line with increases in overall demand, prices will rise, creating inflation. In general, it helps for central banks to keep the money supply growing in line with (or sometimes just a little bit faster than) the overall economy.

Note: There is a secondary effect on prices, which is that a looser money supply can reduce costs on the supply side when previous credit conditions have critically restricted the ability of businesses to invest in needed productivity or capital improvements. We often see this dynamic in emerging markets. If freer credit enables businesses to restructure and produce goods and services more efficiently, making credit more available can actually lower prices and deflate them by reducing supply costs. This tends to be smaller than the effects of credit on aggregate demand, however, and so interventions targeting this effect are often better handled by fiscal policies such as subsidies or tax rebates rather than broader monetary strategies.

But What About That “Money Equation”?

The “money printing inevitably means inflation” argument often is often said to be “proven” by the equation of exchange, often called “the money equation.”

MV = PY

This equation says that the money supply (M) times the “velocity” of money (V) equals the general price level (P) times the real output of the economy (Y). This equation is true by definition. Why? Because the “velocity” of money is simply defined to be PY divided by M. Effectively, all the uncertainty in how M, P, and Y interact gets squeezed into this variable called “velocity,” which we will interpret in a moment.

The argument that money printing leads to inflation is based on the idea that if the money velocity and real production stay constant, then any increase in the money supply will translate one-for-one into an equivalent increase in prices. If just the velocity stays constant, inflation is simply the percentage growth in the money supply minus the percentage growth in real GDP, and this guides the idea of keeping money supply in line with Y.

But what is “velocity,” exactly? It is basically the willingness and speed with which the average person spends their money on something. Economics instructors describe it as the “number of times the average dollar (or other currency) enters someone’s hand and gets spent again over a year.” The faster the velocity of money, the more spending on “stuff” happens in a year. In fact, over a given time period:

MV = PY = (Aggregate Demand) = (Aggregate Supply)

“Velocity” is where the economy’s animal spirits hide in this seemingly scientific equation. If times are good, credit is easy, incomes (or asset values) are growing, and danger seems far away, people will spend freely and velocity will be high. But when jobs are insecure, the ability to pay debts uncertain, credit difficult or seemingly more dangerous, and political outcomes both relevant and unclear, people and businesses will spend only what they must and will be very careful (taking their time to decide) about spending more. As a result, velocity will collapse.

“Money Printing” Is Not Always Inflationary

When money velocity plummets because people and businesses are scared to spend any more than they absolutely must, additional credit and money can be created (“printed”) without inflationary effects. Looking at the equation: If V drops, then M should rise to compensate, or else either P or Y will suffer. Indeed, given that declining velocity will provoke either recession or deflation (and the deflationary cycle we warned about in an earlier post), or both, it is responsible—indeed crucial—for a central bank like the Fed to offset these threats by expanding money and credit. This is especially true early on in the process, before long-term malaise and consumer desperation kicks in and proves hard to eradicate.

Hyperinflation is almost always the result of excessive money printing, usually because a government with insufficient revenues chooses or becomes forced to make up the difference by printing currency to pay expenses. But what many armchair analysts forget is that not all monetary expansions end in inflation, and at moments where fear and/or credit constraints make people afraid to spend, “printing money” can be an essential part of responsible policy, provided it is done with caution.

The key point is that drivers of inflation and deflation can come from many sources. Too much money and credit relative to goods and services is almost always the end result of inflation, but creating money does not always cause it.

Rampant money printing when the money velocity is high is the formula for hyperinflation, and hyperinflation itself drives up the velocity of money because people and businesses in hyperinflationary times tend to spend their money as rapidly as possible so as not to have it lose value in the interim. Printing money when velocity is falling or has fallen substantially is not inflationary—indeed, it is downright responsible to do so—as long as the money can be removed from the economy if and when velocity starts to recover.

This post sets out some of the causes of inflation and deflation, and how they may be linked to money supply, real growth, and animal spirits (via “velocity”). In our next blog post, we will build on this to understand options available to policy makers, and the rationale for pursuing policies like low interest rates, quantitative easing, and the like.

Disclosures & Disclaimers

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