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Has the Relationship Among Money Supply, Inflation, and Exchange Rates Broken Down Forever?

By Frances Coppola

“Inflation is always and everywhere a monetary phenomenon,” the economist Milton Friedman so famously said. True to Friedman’s doctrine, the Federal Reserve’s approach to controlling inflation involves adjusting the money supply to maintain inflation at or near its target of 2 percent per year, which Fed Chairman Jerome Powell dubbed “pi-star” (π*).1 But since the Great Recession, the relationship between money supply and inflation appears to have broken down. The Fed put an additional $4.2 trillion into the economy but inflation has been persistently below pi-star. In the “new normal” world, is deflation, not inflation, the principal risk facing the U.S. economy? And if so, what does this mean for the dollar’s exchange rate?

The Quantity Theory of Money


One equation the Fed uses to help it make monetary policy decisions is the Quantity Theory of Money. It’s written mathematically as “MV = PY,” where M is the quantity of money in circulation; V is the velocity, or speed, at which that money changes hands; P is the general price level; and Y is economic output (GDP). V has until recently been assumed to be constant.


If P is rising faster than 2 percent per annum, this can mean there is too much money in the economy for the level of economic output—colloquially, there is “too much money chasing too few goods.” So, the Fed reduces M in order to bring down inflation. But what exactly is M, and how can the Fed adjust it?


The money, M, that circulates in the economy is mostly created by banks when they lend, not by the Fed. So, to maintain inflation close to pi-star, the Fed influences the rate at which banks create money by controlling the Federal Funds Rate, which is the rate at which banks lend reserves to each other. The idea is that if banks have to pay more to obtain reserves to fund their lending, they will raise interest rates on loans to customers. This will dampen demand for loans and hence reduce the quantity of new money being created. If less money is created, then as long as GDP growth holds up, inflation is likely to fall.


To raise the Federal Funds Rate, the Fed sells securities for dollars, thus withdrawing dollars from circulation. To reduce it, the Fed buys securities for newly-created dollars, thus increasing dollars in circulation. These actions are known as “Open Market Operations.”


Since dollar markets are international, the Fed’s Open Market Operations also influence the dollar exchange rate. Increasing the Federal Funds Rate tends to raise the dollar exchange rate; reducing the Federal Funds Rate tends to lower it.


Where Has All the Inflation Gone?


Quantitative Easing (QE), also known as “Large-Scale Asset Purchases” (LSAPs), can be regarded as very large-scale Open Market Operations. Between 2008-2014, the Fed put $4.2 trillion of new money into the U.S economy by buying U.S. Treasury bonds and agency mortgage-backed securities from banks and investors.


Many people, including economists at the Fed, expected this enormous infusion of money to create inflation. Some even thought it would cause hyperinflation and the collapse of the dollar. But QE did not create hyperinflation, or even much in the way of any inflation. Despite three rounds of QE since the Great Recession, the Fed has struggled to raise inflation to its 2 percent target. And although the dollar’s exchange rate fell a bit when QE started, and did not start to rise until the Fed announced the end of QE in December 2013, the dollar did not collapse.


The Fed is not the only central bank that has struggled to raise inflation despite creating huge amounts of new money with QE. The European Central Bank (ECB) and the Bank of Japan have also been unable to raise inflation to target. The Bank of England exceeded its inflation target during its second round of QE, but this was largely due to oil price rises: core inflation, which excludes volatile items such as oil, remained subdued. Like the Fed, these central banks found that QE depressed their currency exchange rates but did not cause currency collapse. It now seems clear that QE does not significantly raise inflation and only has a limited effect on exchange rates.


How Misunderstanding Bank Lending Affected the Quantity Theory of Money


The Quantity Theory of Money dates from the 1960s, when money moved around the economy mainly in the form of cash and checks. The speed at which money moved around the economy, V, could safely be assumed to be constant. But technological advances have made it much easier to move money around and exchange it for goods and services—and when money moves easily, it is much more prone to run. Data from the Fed’s statistical service, FRED, shows that V has become significantly more volatile since the 1960s.2


When QE first started, economists were still using a model of bank lending known as the “money multiplier.” This postulated that of each new deposit, including QE deposits, a bank would keep 10 percent as reserves and lend out the rest.3 When the Fed bought securities from banks and investors, therefore, it was thought that 90 percent of the new money it created would be lent out as new loans. This would kickstart spending and investment in the economy, bringing it out of recession and raising inflation to target. Economists did not expect the Fed to have to infuse much money into the economy: the “money multiplier” would do the rest.


But in 2014, the Bank of England released a paper which said that far from banks “lending out” deposits or reserves, they create money when they lend. The money multiplier is simply an arithmetic relationship between loans and deposits, and it is not necessarily constant.4 QE caused banks’ reserves to increase dramatically, but it did not make them lend.


And nor did cutting interest rates to zero. After the financial crisis, damaged banks simply didn’t want to lend, and damaged businesses and households didn’t want to borrow. They wanted to reduce their debts, not increase them—a phenomenon dubbed “balance sheet recession” by the economist Richard Koo.5 So, any money that came their way was saved, not spent, creating a poor economic outlook that made businesses want to hold on to dollars, not invest them for the future, in what the economist John Maynard Keynes called a “liquidity trap.”6


Consequently, although M increased, V slowed to a crawl.7 In fact, increasing M when no one wanted to borrow may itself have slowed the velocity of money.8 The fast economic growth and rising inflation that might have been expected from a large increase in bank lending simply did not materialize. Interest rates stayed on the floor, and so did the dollar exchange rate.


What Does This Mean for the Future of Inflation and Exchange Rates?


The Fed’s latest inflation forecasts show that, 10 years after the Great Recession, inflation is still likely to be below its neutral rate—pi-star.9 This is a contributory factor in the Fed’s recent decision to halt interest rate rises.10 Economists have also expressed concern that the Fed is withdrawing QE money from the economy too fast.11 Slowing down the pace of “normalization” may enable inflation to rise back to pi-star.


But there are growing concerns that inflation remains low because of structural changes in the economy. Reasons advanced include: technological changes reducing the prices of some goods; changes in the labor market that reduce workers’ bargaining power; ageing populations that prefer to save rather than spend; globalization; and entrenched expectations of low inflation.12 If this is right, then inflation may remain low for the foreseeable future, regardless of what happens to the supply of money. However, as these are factors across the entire developed world, they may not have much effect on exchange rates.



The Quantity Theory of Money says that the amount of money circulating in the economy is one factor determining the inflation rate, which in turn influences the exchange rate. But since the Great Recession, more money has circulated in the U.S. economy than ever before yet inflation remains below the Fed’s 2 percent target. It’s clear that there is no simple relationship between the quantity of money and inflation: the velocity of money is also important, and so too is the behavior of banks and people. But even more important may be structural changes in the economy that threaten to keep inflation low. In the future, “pi-star” of 2 percent may no longer be “normal.” However, as the entire developed world is experiencing unusually low inflation, this may have little effect on exchange rates.

Frances Coppola - The Author

The Author

Frances Coppola

With 17 years’ experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.


1. “Monetary policy in a changing economy,” Jerome Powell
2. “Velocity of M2,” FRED;
3. “Money Multiplier and Reserve Ratio in U.S.,” Investopedia
4. “Money creation in the modern economy,” Bank of England
5. “The World in Balance Sheet Recession,” Richard Koo
6. “Liquidity trap,” Investopedia
7. “Velocity of M2,” ibid.
8. “Velocity Matters,” Coppola Comment
9. “Inflation Forecasted to Remain Under 2 Percent in 2019,” St. Louis Fed
10. “Fed Chair Jerome Powell Says the Case for Raising Interest Rates ‘Has Weakened’,” CNBC
11. “The Fed is Tightening More Than It Realizes,” Council on Foreign Relations
12. “A Closer Look at Reasons for Low Inflation,” St. Louis Fed

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