The Inflation Puzzle (Part 1)


I wanted to continue the discussion with the question that ended the previous post: if shadow banking was effectively expanding the money supply, then why did it not cause inflation, and more importantly now that the Federal Reserve is replacing the missing shadow money with real money (i.e. Fed deposits), why has this not caused a surge in inflation?

I think it’s important to go over the naïve reasoning why it’s generally thought that an increase in money supply should cause inflation: as prices are determined by supply and demand, when money supply increases the relative value of money decreases in comparison to real goods, which translates into an overall increase in prices.

There are two key assumptions behind this seemingly simple reasoning that go a long way towards explaining why the monetary expansion did not cause notable inflation:

  1. The distribution of money over different parts of the economy does not change even though the overall supply changes.
  2. The velocity of money does not change.

If the first assumption is false, then the naïve reasoning fails because the newly created money does not chase the same goods as before.  Inflation is necessarily measured with respect to a specific weighted basket of goods, dominated by a rather small set of consumer goods (food, housing, fuel, healthcare, etc.).  While having a single number is a useful shorthand, really there is no single number that can capture the global price evolution of the entire economy.  Our reliance on such an inherently limited measure obscures important price phenomena including the effects of monetary stimulus.

I would argue that in some sense, inflation did occur during the lead-up to the Financial Crisis: the housing bubble was a reflection of the same phenomenon that underlies inflation, namely too much money chasing too few goods.  What’s different from our usual notion of inflation is that the price increases overwhelmingly affected a single sector of the economy and so did not drag the entire basket of prices up.  Furthermore, the price increase did not drag up wages because people were largely paying for housing with credit rather than wages, unlike in “normal” inflation where wages would have to go up to match increased prices.  Because wages did not go up quickly, it was unlikely that other goods would increase in price because consumers did not have additional nominal purchasing power to pay more for them.

I’ll add thoughts later on about how this has developed since the crisis.  Hint: it’s pretty much the same story, just look at the stock market and the real estate market (again!).


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