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Inflation Is Best Explained by This Underrated Economic Theory

Where theories get tried out.
Where theories get tried out. (Photographer: Kevin Dietsch/Getty Images North America)

Currently the most underrated theory in economics is the so-called Quantity Theory of Money. It has been out of fashion for a long time, and even Federal Reserve Chair Jerome Powell has said that a strong money-price connection has not held for at least 40 years. Nonetheless, on closer examination the quantity theory does a reasonable job of explaining much of recent economic history.

In its simplest form, the quantity theory states that MV = PT. That is, the quantity of money multiplied by its velocity of circulation encapsulates all relevant transactions. (Money, velocity, prices and transactions are the respective terms in that equation.) More substantively, the quantity theory suggests that it is useful to think about the “M” in this equation — the money supply — as an active causal variable for macro policy.

Consider the recent spurt of 8% to 9% inflation in the US. The simple fact is that M2 — one broad measure of the money supply — went up about 40% between February 2020 and February 2022. In the quantity theory approach, that would be reason to expect additional inflation, and of course that is exactly what happened.

The quantity theory has never held exactly, one reason being that the velocity (or rate of turnover) of money can vary as well. Early on in the pandemic, spending on many services was difficult or even dangerous, and so savings skyrocketed. Yet those days did not last, and when the new money supply increase was unleashed on the US economy, there were inflationary consequences.

This is consistent with one of the longest-standing truths of economic history, from the inflationary episodes of ancient Rome to the French Revolution to Weimar Germany. In retrospect, America’s current inflation troubles should not have been a surprise.

One reason the quantity theory fell out of favor is that the Fed increased bank reserves significantly following the financial crisis of 2008. By mid-2010, the Fed had increased reserves to the banking system by $1.2 trillion, in comparison with about $15 billion in the years just before the crisis. Yet inflation stayed below 2%, and during early parts of the crisis it fell.

On closer examination, that episode does not refute the quantity theory. The theory leaves room for the possibility that declines in velocity — which also can be called increases in the demand to hold money — can counteract increases in money supply. Along those lines, the Fed started paying interest on bank reserves, which led banks to hold most of the new surge in reserves. The Fed’s policy was thus more of a capitalization of the banking system than a truly expansionary monetary policy.

It is true that one earlier quantity theory advocate, Nobel laureate Milton Friedman, placed too much stress on the stability of money demand. So Friedman’s theory did not apply too well to the 2008-2010 period. But the more general version of the quantity theory held up fine.

So what might a quantity theorist say about the current situation?

One obvious point is that, for all the Fed’s talk to the contrary, current monetary policy remains expansionary. If you look at interest rates, the recent Fed funds rate has been hovering in the range of about 2.5%. Many T-Bill rates are in the range of 3% to 4%. You can debate which is the appropriate measure of price inflation (core inflation? overall inflation? median inflation?), but under any sensible standards these interest rates are still negative in real terms. The Fed just isn’t doing that much to choke off borrowing.

A brighter sign is M2 growth, which was 5.3% year-over-year in July 2022. With 2% economic growth, that is consistent with inflation of a little more than 3%, assuming changes in monetary velocity do not intervene. Better yet, M2 growth rates have been falling consistently, from almost 14% in August 2021.

One way of thinking about all this data is that the US is likely to be converging on lower inflation rates — but that interest rate policy is overrated in its efficacy. That perspective follows naturally from quantity theory tools.

Some analysts stress that lowering the rate of inflation requires big changes in fiscal policy. That is usually true for bankrupt nations, which have to print money to pay the bills. But for solvent nations such as the US, this is not necessary.

I predict rates of price inflation will fall significantly over the next three to five years without a very dramatic change in the US’s overall fiscal position. If I am correct, it is worth noting, that will represent a triumph for the Quantity Theory of Money.

More From Bloomberg Opinion:

• Nobody Knows How Long Inflation Will Last: Niall Ferguson

• Inflation Surprises Are Bad Even When They’re Good: Jonathan Levin

• The Fed’s Messaging Needs an Upgrade: The Editors

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the blog Marginal Revolution. He is coauthor of “Talent: How to Identify Energizers, Creatives, and Winners Around the World.”

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