Does MV=PT explain the recent inflation upswing?

As the lockdown from Covid ended there was the predicted increase in prices. Although supply-side shocks tend to be temporary, the demand side is more permanent. Expansionary fiscal (increases in Government spending) and monetary (low interest rates) policy were responses to what was seen as almost another great depression. Once economies opened up after Covid this accumulation of cash was unleashed on the market and it drove prices up sharply – see graph from the IMF.

Between December 2020 and 2023 the CPI in the US and EU went up by approximately 18%, UK 21% and in New Zealand 18.9%. The target is normally around 6% and if you take the previous 3 years from December 2017 to 2020 the total change is 5.3% in New Zealand. Linked to this rise in inflation is the increase in broad money M3 – between Q4 2019 and Q4 2020 If you look at the ratio of broad money (M3) to GDP rose 15% in the EU, 17% in US, 20% in Japan and 23% in the UK.

This lends itself to to the quantity theory of money and the monetarist explanation of inflation through the fisher equation.

M x V = P x TM = Stock of money
 V = Income Velocity of Circulation
 P = Average Price level
 T = Volume of Transactions or Output For example if M=100 V=5 P=2 T=250.   Therefore MV=PT – 100×5 = 2×250. Both M x V and P x T are equivalent to TOTAL EXPENDITURE or NOMINAL INCOME in a given time period. To turn the equation into a theory, monetarists assume that V and T are constant, not being affected by changes in the money supply, so that a change in the money supply causes an equal percentage change in the price level.

According to Bruegel (Papadia and Cadamuro) money does not help in forecasting inflation when it is stable. When central banks are close to the target of 2% inflation, money has no forecasting power with respect to future inflation. But when inflation is volatile, as in post Covid-19, it does help in forecasting inflation – see graph below from BIS. Overall, while, in contrast to the quantity theory of money, there is no constant relationship between money and inflation, in unsettled monetary and inflation conditions monetary developments do provide information relevant to inflation.

According to Martin Wolf in the FT, although demand was a significant cause of the inflationary conditions it does not mean that expansionary fiscal and monetary policy was an oversight, as weaker demand would have imposed large economic and social costs. Central banks targeting inflation have survived (just) two tests – GFC and Covid but more shocks are imminent.

Sources:

Lesson from the great inflation – Martin Wolf – FT 4-9-24Does money growth help explain the recent inflation surge? BIS Bulletin 26 January 2023

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