Over the past four years, the U.S. monetary base has grown from roughly $850 billion in the autumn of 2008 to more than $2.6 trillion at present (Figure 1). The primary driver of this expansion has been implementation of quantitative easing as the FOMC endeavored to breathe life into the U.S. economy. One question that we very often hear at presentations and in panel discussions is: "Doesn't all this extra money sloshing around in the system diminish the value of the U.S. dollar and ultimately lead to higher inflation?" There is a legitimate basis to this question in the Classical Theory of Inflation which essentially suggests that prices are a function of the money supply. The noted monetarist Milton Friedman famously observed in 1963 that "inflation is always and everywhere a monetary phenomenon."
When thinking about inflation today, economists benefit from the work of the many great thinkers over the years who have advanced the body of knowledge in our field. A complete analysis of the evolution of thinking about the relationship between the money supply and prices is beyond the scope of this paper. Suffice it to say that from Irving Fisher's Quantity Theory of Money, to John M. Keynes' Liquidity Preference Theory and Milton Friedman's Modern Quantity Theory of Money, there is no shortage of explanations for, or argument about, the sometimes esoteric relationship between money and prices.
While there remains some degree of disagreement among modern economists, the Classical Theory of Inflation which considers prices exclusively in the context of the money supply, has generally given way to a more nuanced interpretation which makes allowances for other variables. Indeed, if prices were exclusively a function of the money supply, the near tripling of the monetary base between late 2008 and 2011 should have given way to runaway inflation, but that has not nearly been the case. Barring the run-up in gas prices and a few other commodities, price growth has been in check with the Consumer Price Index (CPI) averaging nearly 2.5 percent on a year-over-year basis for the past two years. Clearly something else has to be at work. What dynamic other than money supply growth has been factoring into inflation these past two years?
The Money Multiplier and the Velocity of Money
When it comes to the impact of the growth of the money supply and the impact on prices, one major consideration is the money multiplier. If the banking system simply holds money in deposits on reserve and makes no loans, the banking system does not affect the money supply.
David Fuller's view I commend the rest of the Money Multiplier section to subscribers and I agree with most of it. Additionally, I maintain that increased competition due to globalisation has helped to keep wages down, as has technology to the extent that it reduces manning requirements for many industries.
However, Milton Friedman's theory will have its revenge in anything other than an apocalyptic outcome. And I agree with Warren Buffett when he says (I paraphrase) that the USA has come through far greater crises over the last two centuries than the shameful credit and bankster antics.
Meanwhile, when both US and global GDP growth next become synchronised in a sustained period of expansion, how could all that QE not result in some uncomfortable inflation? Subscribers who agree may wish to retain a respectable position in gold bullion.