Money and inflation

We saw above that:

Of the two components of GDP, GDE is the largest by a long margin in most countries. And of the two components of GDE, C is the largest by a long margin in most countries. Thus C can be seen to be the chief driver of GDP growth. This gives rise to the adage the consumer is king. Alfred Marshall, a celebrated economist of the past, spoke of the sovereignty of the consumer. For example, in the US consumption expenditure makes up roughly 80% of GDP.

In Figure 1 we illustrated the relationship between M3 and GDP growth. Let's take this a little further. There is a celebrated identity in economics relating to the role of money (a product of the fine mind of Irving Fisher in the early twentieth century) referred to as the quantity theory of money:

MV = PT.

Put simply, over a period (say, a year) a change (A) in the money stock, AM, times the change in its velocity of circulation, AV (which generally is a stable number), is equal to the change in prices, AP (i.e. inflation), times the change in the total of economic transactions adjusted for inflation, AT (i.e. AGDP). Thus, assuming V to be stable, an increase in M will give rise to an increase in nominal GDP. Nominal GDP = actual GDP as measured at current prices, that is, not adjusted for inflation (real GDP x inflation = nominal GDP). If there is no inflation it means that the increase in M is fully translated into an increase in GDP. Basically, this says that M growth plays a major role in driving additional economic output and the welfare of the country and its people.

It is an elegant and beautiful feature of the modern monetary system - because it means that funds are always available for new consumption and business projects (C + I). Money creation provides the fuel for economic growth. However, and this is critical, it is only elegant if money creation growth is carefully managed, and this is the formidable task of the central bank. If it is not prudently managed, it transmutes into a monster in the form of inflation, which can be a destructive force in terms of economic growth and employment. Thus in terms of the identity MV = PT, a small increase in M can lead to an equivalent increase in real GDP, while a massive increase in M can lead to an equivalent change in P, or even to a larger increase in P and a decline in real GDP.

What actually happens when M increases at a high level? As we know, underlying an increase in the demand for loans is an increase in the demand for goods and services. If demand is high, and local industry cannot meet supply, local prices will rise (AP+), and the exchange rate will fall. Foreign goods will become cheaper / local goods will become expensive, imports will rise, exports will fall, and the TAB will deteriorate. If M rises further and extensively, the vicious circle will be exacerbated.

If money creation is left unchecked, and is a consequence of a government debt trap (when government borrows from the banking sector to pay interest), and if it borrows from the central bank, the consequences are profound.

The worst inflation monster the world has experienced is 7 000 000 000 000 000 000 000% pa (7 sextillion % pa) in Zimbabwe in 2008. The previous record was 41 900 000 000 000 000% pa in Hungary in 19463. In the Zimbabwean case GDP growth during the hyper-inflation period was negative every year and the unemployment rate grew to over 90%. The cause was massively excessive money creation.

The largest denomination bank note in the history of the world, for 100 quintillion pengo, was issued in Hungary in 1946. The largest denomination bank note with zeros printed on its face is the Zimbabwean 100 trillion dollar note (see Box 1), issued in 20 094. Prior to the issue of this note, thirteen zeros had been lopped off the bank notes (three in August 2006 and ten in August 2008). Following the issue of this note another twelve zeros were lopped off, making it equal to 100 Zimbabwe dollars.5

Box 1: largest denomination bank note (with zeros)

largest denomination bank note (with zeros)

The monster side of money was also seen by the developed world in 2008 / early 2009, when the "credit / banking / sub-prime crisis" was at its peak. To a large degree this crisis had its genesis in the excessive creation of money by the credit granted to the many US sub-prime borrowers by the US banks, which led to an artificial and unsustainable boom. It also clearly demonstrated the fact that banks are inherently unstable, and therefore require rigorous regulation by government authorities. It may come as a revelation to young readers that the bank failures seen in this period is not a new phenomenon; history is littered with banking / credit crises and bank failures.

 
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