With CPI inflation remaining above 8% over the past year and average gas prices rising above $5.00 per gallon, policymakers are trying to identify the source of the rapid increase in the price level in order to determine how rapidly to raise interest rates to combat inflation. There are two views to describe the inflation that we are experiencing. One view puts most of the blame on pandemic-related factors, including reduced production during the pandemic, supply chain challenges, the war in Ukraine, and corporate greed. The second view is that monetary factors, including the Federal Reserve maintaining low interest rates during the pandemic and large stimulus payments that sent cash directly to consumers and businesses are the primary culprit.
To sort out how much each factor is contributing to inflation, it is helpful to return to a simple theory of the price level. The quantity theory of money begins with a simple accounting identity that relates prices and money. The equation states that:
M * V = P * Y
Here M is the quantity of money in circulation, and V is the velocity of money or how many times each dollar is used for transactions in a given time period. The left-hand side of the equation describes the total value of purchases made in the economy. P denotes the aggregate price level, and Y is real gross domestic product (GDP), so the right-hand side of the equation is nominal gross domestic product or the value output produced in a given year at current prices.
This identity can help separate the two views on inflation described above. In the first view, the increase in the price level is generated by reductions in Y, holding M and V constant. The second view says that growth in M is primarily to blame for the rapid increase in inflation that we have observed. We can look at data on nominal GDP and money supply to assess the role of monetary factors in the current price increases.
First, we can examine the growth of nominal GDP. Figure 1 plots the annual percentage change in nominal GDP over time. The chart shows that while there was a sharp decline in GDP during the pandemic recession, GDP growth recovered rapidly and has remained above pre-pandemic levels since the second quarter of 2021. This rapid recovery has meant that nominal GDP has been above its previous trendline since late in 2021. In contrast, after the 2008 financial crisis, GDP growth recovered slowly and never went higher than its pre-trend.
If the monetary explanation for inflation is not playing a role, we would expect nominal GDP to remain fixed so that higher prices are offsetting declines in real GDP. Hence, the fact that nominal GDP has been elevated after the pandemic suggests that increases in the money supply from the stimulus packages are an important factor in current inflation.
We can also look directly for evidence of how the money supply has changed during the pandemic. Figure 2 is a plot of annual percentage changes in M2, which is a prominent measure of the money supply that includes currency, checkable deposits, savings deposits, and shares in money market funds. The plot shows that the growth rate of M2 surged during the pandemic and has remained elevated. Given the quantity theory of money, the rapid growth in money supply can translate directly into higher prices.
Finally, we can consider the velocity of money. When using the quantity theory of money to imply a close relationship between the quantity of money and the price level, it is typically assumed that the velocity of money is constant. While velocity is not measured directly, the implied velocity can be computed by dividing the level of nominal GDP by the average value of M2 over the quarter. This is plotted in Figure 3. While the figure does not contain additional information from what is in the previous graphs, we see that since the implied velocity has been declining, increases in velocity are not generating higher prices. One may also worry that if velocity returns to pre-pandemic levels that may cause further increases in the price level.
While the figures highlight that monetary factors have played a role in the observed rates of inflation that we have experienced, they do not imply that other pandemic-related factors were unimportant. Indeed, high food and energy prices from the war in Ukraine may keep inflation from declining quickly in the coming months. However, the second figure shows that the rate of growth in the money supply has been returning rapidly toward pre-pandemic levels. If this trend continues, inflation will hopefully begin to decline soon.
