In my last memo, I discussed how inflation could be disastrous for an economy, especially creditors/savers when left to its own devices. In this memo, I will explain the cause-effect relationships between money supply and the price level based on my study of economies that have experienced high rates of inflation.
First, we need to distinguish the difference between the increase in the price of some things, which is not necessarily inflation, and the increase in the price of all things as an aggregate, which is price inflation. If gasoline prices go up 5% in a year while other things available for purchase stay relatively stable, then there may be a supply/demand issue that has caused the price of gasoline to increase in price.
The idea that buyers and sellers determine the price of all things is largely inaccurate. For example, if a seller of a product raises the price of that product, every dollar more a buyer spends on that product is a dollar less they can spend on something else. Unless, of course, someone provides more dollars. An increase in the money supply will allow for aggregate price inflation. If the supply of money stays the same and the price increases for one product, an amount equal to the price increase for that product must come from a decrease in the price of other products.
The following equation determines the price level:
Let me explain with a simple example. Let’s assume an economy had only two products gasoline and food; the total money supply was $100, the holders of money prefer to spend $100 per day (Velocity), and they demand one unit of gasoline and one unit of food each day, the price of one unit of gasoline and food would be $50. Suppose the money supply stays the same ($100) and the price of one unit of food is raised to $60. In that case, the price of one gasoline unit must fall to $40 because the money supply stayed the same ($100) and the velocity of money (how many times money is spent per unit of time) stayed the same. The only way you can see an aggregate increase in price is if the supply of money increases in aggregate or if money velocity increases. If the money supply increased to $110 and the demand for each product stayed the same at one unit per day, then the increase in the price of food would not impact the price of gasoline.
The velocity of money is equally as crucial as the money supply. We, as consumers, don’t have control of the money supply, but we do have control of the velocity of money. When we have money in our pocket (or bank account), we have a choice to spend it or to save it. If we decide to spend only $50 per day in the above example, we cut the velocity variable in half. If there are still only two products, then the price would fall from $50 for each product to $25 per product.
If you study the above equation and the example. You may be questioning my statement that buyers and sellers don’t determine the overall price level, i.e., whether there is persistent inflation or deflation. Your argument may stem from the variable, Money Velocity. If we determine money velocity, then we would directly impact the price level. This is true, and theoretically, if the money supply stayed the same and we doubled the money velocity while the total supply of things available for sale stays the same, then the price level should double. To understand this better, let’s define the “total supply of all things available for sale.”
To most economists, the total supply of things for sale is represented by GDP (Gross Domestic Product) produced during a given period of time. This is inaccurate. Using GDP alone disregards all the existing capital wealth of a nation. You can essentially spend your money on two competing kinds of “things.”
You can spend your money on currently available goods and services, i.e., GDP, or
You can spend your money on existing property, including land, used goods, and all kinds of paper property such as stocks and bonds.
The second category is entirely outside the GDP and represents the nation’s wealth. Most of us think of category two as investments, but to an economist, investment means creating new capital assets. For simplicity, we will label the two things you can spend money on as “GDP” and “Investments.” Therefore, there are two distinct money supplies and velocities of money, one for GDP and one for Investments; however, there is no barrier between the markets other than the psychology of people. Each market must follow the law of prices separately, which means the prices in that market must be higher if the quantity of money or velocity of money rises. Since there is no barrier between the two markets, anyone can take money from the stock market, purchase a new vacation home, then later sell the house, and invest the money back into the stock market. The two markets must obey the law of prices separately, and they must also abide as an aggregate. When the net money moves from one market to the other, prices must fall in the first and rise in the second if money supply and velocity stay the same.
When studying inflation and the impact on economies, it becomes apparent that the first sign of inflation shows up in capital markets, especially the stock market. At the same time, prices, as it pertains to GDP, stay relatively stable. This makes sense when we consider that the holder of excess money has three options, A. purchase more GDP products/services, B. hold on to the money longer than usual, C. invest the money in the capital markets. In every economy that I have studied, excess money supply first finds its way into capital markets, causing prices to rise in that market. Over time and since there is no barrier between the two markets, money begins to move from capital markets into the GDP market, causing prices in the capital markets to fall to near their real value and GDP prices to rise. This only occurs if the money supply does not increase further after the initial increase. One man’s price inflation is another man’s capital gains.
Let’s look at an example involving both the GDP and the investment market, each with its own money supply. They both have a $100 money supply, making the total money supply equal to $200. We will assume velocity and the quantity of things to purchase remain constant. If the money supply doubles to $400 and all the additional money ($200) moves to the investment market initially, the price of investments will triple, not double. The GDP market prices will remain unchanged. In reality, investment prices tend to go up even further because of an increase in velocity in the investment market due to speculation. Money will eventually find its way back to the GDP market as there will always be the “partypooper” that takes his capital gains and purchases GDP products. There will always be that business owner selling GDP products that see the price appreciation in the investment markets and wants to take his piece by raising his product’s prices. If the money supply does not increase further, investment prices will begin to move closer to their real value while GDP prices rise as money flows from the investment market to the GDP market.
Suppose the economy in the above example is lucky and excess money is redistributed proportionally between the two markets. In that case, the GDP market’s prices will double while the investment market’s prices fall from three times their original level, down to double their original level. This is precisely the scenario that occurred in Germany from 1920-1921. The money supply doubled; the stock market tripled before losing a third of its value just as domestic prices began to rise.
Many cause-effect relationships make up inflation. Relationships between how much money is in circulation and how much money people want to hold for liquidity, with what people choose to spend their money on, and how confident they are in stable prices or the economy’s health. I could not possibly cover all examples of each cause-effect relationship related to inflation in a single memo, but I can simplify all the cause-effect relationships into a simple equation.
Income growth – Productivity growth = Inflation
If you take the growth rate of all the income in an economy (all wages earned, investment income, and now in 2021, money printed and sent out to citizens) and subtract the growth rate of all things that are produced or services provided, plus the growth rate of all things that are available for purchase (property, stocks, bonds, etc.) you will arrive at roughly the inflation rate.
Unfortunately, predicting the inflation rate over the next year or two is nearly impossible since a couple of the variables (money velocity and the value of all things for sale) are only known after the fact. Even if we get the estimates correct, inflation can lay dormant for extended periods, slowly building up pressure until it finally makes itself known. There are also reasons that increases in money supply with all other variables remaining constant will not cause inflation, such as loss of incomes and/or credit. The increase in money supply is used to fill the gap, such as in the wake of the 2008 financial crisis.
I could continue writing about inflation variables such as currency depreciation, but this memo is already getting a little wordy. I hope that you find this information educational or at least interesting and your understanding of inflation is slightly better than before.
All my best,
Brandon VanLandingham, CFA, CMT
This newsletter contains general information that is not suitable for everyone. The information contained herein should not be construed as personalized investment advice. Past performance is no guarantee of future results. There is no guarantee that the views and opinions expressed in this newsletter will come to pass. Investing in the stock market involves gains and losses and may not be suitable for all investors. Information presented herein is subject to change without notice and should not be considered as a solicitation to buy or sell any security Investment advisory services offered through Perissos Private Wealth Management an Oklahoma Registered Investment Advisory.
