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Guest article The comeback of the money supply

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Guest article The comeback of the money supply

Unlike the Bundesbank, M3 no longer plays a role in the ECB’s thinking. I show why you should look at them again.

The comeback of the money supply as an inflation indicator began shortly after the outbreak of Corona at the beginning of 2020. At that time, the growth of the money supply M3, which includes cash, sight deposits, time deposits, savings deposits and other near-money investments, accelerated. Inflation increased from spring 2021 and was already five percent at the end of the year, well above the ECB’s two percent target before Russia invaded Ukraine and raw material prices shot up. If one had looked at the money supply, the inflation forecast for 2021 and 2022 would have been much better, one shows Study by the Bank for International Settlements (BIZ).

Monetary supported surge in demand

There are good reasons why the money supply warned in advance about high inflation. After the outbreak of Corona, the ECB bought government bonds from the banks on a large scale and credited them with the equivalent values ​​in their ECB accounts. The banks used this money to buy new government bonds from the finance ministers. The finance ministers transferred the income in the form of Corona aid to the accounts of companies and citizens, which caused the M3 money supply to rise sharply. When the recipients spent billions of dollars in state aid, the government-fueled demand met with a sharp decline in the supply of goods due to the lockdowns. The imbalance between demand and supply, fueled by the ECB in monetary terms, caused inflation to rise like in the textbook.

The good performance of the money supply during the pandemic was no coincidence. In times of high inflation, there is regularly a close connection between money supply growth and inflation. This can be seen for the USA, Italy and many other countries well into the 1980s.

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The data confirm the quantity theory of money, according to which the more the growth in the money supply exceeds the growth in the supply of goods, the higher the inflation. When the money supply increases faster than the supply of goods, too much money chases goods and prices rise.

Why the money supply didn’t work well in the years before Corona

The fact that the connection between money supply growth and inflation became looser in many countries from the mid-1980s onwards and only existed in the very long term does not refute the quantity theory of money.

Victim of your own success: After more and more central banks switched to a stability-oriented monetary policy from the end of the 1970s, they gradually brought inflation under control. More and more citizens believed the central banks’ promise that they would ensure price stability in the long term. Inflation expectations were firmly anchored. Inflation no longer played a role in people’s minds. Unions were less likely to strike for higher wages because their members were not worried about inflation if prices temporarily rose a little more. Because wages only rose moderately, companies kept prices low. In short: inflation was consistently low. However, if the inflation rate hardly fluctuates and is only moved by random influences, there is no statistical connection between inflation and money supply growth.

Increasing role of the investment motive: When inflation is low, so are bond interest rates. Holding largely interest-free bank deposits, which are part of the M3 money supply, always cost less in the sense that the lost interest income from holding bonds was low. The opportunity cost of holding money fell. Investors used an increasing proportion of the money supply for investment purposes rather than for potentially inflationary purchases of goods. This weakened the connection between money supply growth and inflation in the three decades before Corona.

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The money supply remains an important indicator of inflation

But none of this means that the connection fundamentally no longer existed. It always existed, it just slumbered for a long time. But when monetary policy is very loose and there is a negative supply shock like the pandemic, the connection comes back to life. The money supply remains an important indicator of inflation, ECB board member Isabel Schnabel recently rightly said in a statement Network. It’s a shame that most of her colleagues see it differently.

Blog posts on the topic:

Roland Vaubel (Uni Mannheim, 2023): The ECB is disoriented because it ignores the money supply

Uwe Vollmer (University of Leipzig, 2023): On the decline of “monetary analysis” in the Eurosystem’s monetary policy strategy

Roland Vaubel (Uni Mannheim, 2020): Inflation today is the result of excessive money supply growth in 2020

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