Money and inflation: Loose connections | Print Edition – The Sunday Times, Sri Lanka


Money and inflation: Loose connectionsView(s): An interesting question that has been raised is related to “illegal money”, and its connection to money supply and inflation.We will take up this question too.The concepts We have already clarified the concepts of “money” and “money-printing” which have been largely misunderstood and misinterpreted among the public.Money is not the…

Money and inflation: Loose connectionsView(s): An interesting question that has been raised is related to “illegal money”, and its connection to money supply and inflation.We will take up this question too.The concepts We have already clarified the concepts of “money” and “money-printing” which have been largely misunderstood and misinterpreted among the public.Money is not the notes and coins in our pockets, and money-printing is not printing notes and minting coins.Money is defined in terms of various monetary aggregates.It includes cash in circulation plus various types of bank deposits.Depending on which types of bank deposits are included, there are differences in monetary aggregates too.

Bank deposits also perform the task of money in an economy so that they should be part of the money stock.

In addition, it is noteworthy that bank deposits create bank loans, and bank loans create more deposits in the banks – the process known as “deposit multiplication”.Money-printing is injecting “fresh money” to the economy which can be measured using different concepts of monetary aggregates.The strong (long-run) relationship between money stock and the general price level has been well-established in the minds of academics, policy makers, politicians and even the general public.Accordingly, an increase in money stock (money supply) above and beyond the required level of real GDP growth is inflationary.The students, learning macroeconomics and monetary economics, know the famous statement of the pioneering monetarist in the second half of the 20th Century, Milton Friedman who in 1963 said: “Inflation is always and everywhere a monetary phenomenon”.In a literal sense, he is right in saying this because inflation has something to do with losing the purchasing power of money.But the statement is often used to depict the relationship between money and inflation.Strange outcome It is quite bizarre to note that this relationship has weakened over the years.

During the period after the US financial crisis in 2008-09, advanced countries printed money on a massive scale without experiencing a corresponding higher inflation.The Federal Reserve Bank (Fed) of the US has increased its reserve money stock from less than US$1 trillion to over $6 trillion, just within 13 years.The reserve money stock (designated as M0) is the “monetary base” of a country, which refers to the quantity of cash plus bank reserves deposited at the Central Bank.If we resort to a broader measure of money stock such as M2, the money stock in the US economy has increased from $8 trillion to $22 trillion during the same period.

This definition of the monetary aggregate is defined as cash in circulation plus the bank deposits in current and savings accounts.

This increase in money in the US economy is massive, compared with money growth prior to that.The annual US inflation rate that remained around 3 – 4 per cent, declined further during the period after the US financial crisis.The story is similar in the European countries.

For instance, in the Euro area, reserve money stock increased from less than EUR1 trillion in 2008 to more than EUR6 trillion in 2022.But the average inflation rate that remained around 2 per cent, further declined to around 1 per cent, showing even deflationary pressures in some of the years.Going unconventional There was a time that the central banks were targeting money stock and not the interest rates in order to deliver the desirable inflationary outcome of the monetary policy.This policy too has changed towards the interest rates; in both the US and the Euro area as well as many other countries around the world, the policy rates were seen reaching zero level.

What do we expect by lowering policy rates as such? It makes credit cheaper, thereby stimulating aggregate demand to maintain financial stability avoiding deflation.Apparently, credit became cheaper, but there was no inflation, neither was there stimulated economic growth.

With no more room to cut down policy rates, the Fed as well as the central banks in Europe and some other countries like Japan, turned to more unconventional policies; the well-known among these was the large-scale asset purchases known as “quantitative easing” (QE) programme.As a result of open market operations, quantitative easing programmes and other elements of loose monetary policy measures, banks’ reserve money grew significantly.The banks’ balance sheets showed a growing share of reserves as a percentage of their total assets.Weakening link Even though a little complicated, from the above case what I wanted to explain is that the link between money and inflation is not as strong as we used to think of it.This link has become weakened over time so that its historical strength doesn’t seem to hold timelessly.

As we have discussed last week, while money stock influences prices through its impact on aggregate demand, its reverse causation is also true; accordingly, aggregate demand, which rises or falls for various reasons other than money, and hence influences money too.

This is where the question of illegal money or corrupt money can come into the picture.Practically, such money cannot be a big share of a country’s money stock.But nevertheless, technically such money can influence aggregate demand through consumption or business spending; accordingly, aggregate demand influences money demand on the one hand and price level on the other hand.If we are talking about illegal money that enters the legal financial system of a country, which is called “money laundering”, this raises bank deposits and loans.

Once it enters the formal financial system, it is part of the money stock.Crypto currency The innovation of crypto currency presents another complication within the global monetary system.There are over 1000s of crypto currency varieties in circulation in the world today.As we know, money and payments in the world operates through the banking system, which in the case of crypto currency is replaced by a computer-based technological development called “blockchain” technology.In other words, transactions in crypto currency do not require the mediatory role played by the central banks or the commercial banks, but by the millions of computers worldwide.But the irony is that it can shape the aggregate demand through consumer spending or business spending.And as we have already said, changes in aggregate demand can influence formal money stock on the one hand.When crypto currencies are traded with bank money – either cash or bank deposits – then they can alter the money stock on the other hand.

In Sri Lanka Given the complexities in the modern monetary systems and the presence of “two-way” relationships among the monetary variables, the money-inflation link does not appear to remain all the same timelessly and universally.

In fact, the Central Bank of Sri Lanka too has acknowledged it as follows: “…amid a weakening relationship between money supply and inflation, the role of monetary targets as a nominal anchor became uncertain and also complicated the Central Bank’s communication strategy, causing the Central Bank to upgrade its monetary policy framework.” As per the above quotation from the Central Bank website, the “weakening relationship between money supply and inflation” has been noted at policy level.Accordingly, the Central Bank’s monetary policy approach has shifted away from targeting monetary aggregates as the nominal anchors towards a direct inflation-targeting.During the two-year period in 2020-2021, in Sri Lanka too the reserve money (M0) increased by a staggering Rs.372 billion, and the consolidated money stock (M2b) by Rs.3024 billion.The question is whether it is the only reason for the subsequent hyperinflation in a crisis-ridden economy where demand and supply conditions started moving erratically.(The writer is Emeritus Professor of Economics at the University of Colombo and can be reached at [email protected] and follow on Twitter @SirimalAshoka). has you covered with quality used or brand new [cars for sale]( that are budget friendly yet reliable! Now is the time to sell your old ride for something more attractive to today’s modern automotive market demands.Browse through our selection of affordable options now on before deciding on what will work best for you!.

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