The new era of money supply and its impact on policy

The empirical relationship between money and inflation has changed, writes Manmohan Singh, with Apoorv Bhargava and Peter Stella. To understand current policy challenges, we must first understand money creation
US Federal Reserve, Washington, DC
The Federal Reserve has expanded its balance sheet dramatically in recent years

The massive expansion of central bank balance sheets since 2009 in countries with well-developed financial markets has not yet led to accelerating inflation. In a recent IMF working paper, we show how the empirical relationship of various measures of money and inflation has changed. Understanding how money is created in the economy is essential if we are to understand current policy challenges for central bank and governments.

In our paper, we discuss the modern history of monetarism and its alternatives. After demonstrating that previous correlations between money and inflation in the 20th century have largely disappeared, we explain why this cannot be taken as support for an increased reliance on monetary finance (for example, quantitative easing) that creates bank reserves. Rather, we argue that rapid technological innovation in payments systems – both public and private – including in global pledged collateral markets, portends a declining demand for bank reserves.

In his 1995 Nobel prize address, Robert Lucas implied that the quantity theory of money and the correlation between money growth and inflation was one of the most empirically well-documented theories in all of economics. The premise was that a long-term relationship exists between the two variables (McCandless and Weber 1995, study from 1960–1989); the results were robust regardless of the monetary regime and  aggregate chosen. We examine the long-term correlations (minimum 10, up to 30 years) between the geometric growth rates for various measures of money and inflation in more recent years (1990–2019) for a broad set of countries. Our analysis shows a dramatic diminution in the correlation between these variables.



All correlations for the full sample and the OECD sub-sample are statistically significantly different from 1 (under the null hypothesis that their correlation with inflation is 1). This suggests that the basic premise of the Lucas remark no longer holds. Furthermore, for OECD countries, the negative correlation for M0 suggests that an increase in money supply (driven by the reserves post-global financial crisis) has been accompanied by lower-than-average inflation.

Although we have shown the problem with simple monetarist models is a secular issue, the massive expansion of central bank balance sheets since 2009 in response to low levels of inflation has accelerated the accumulation of convincing evidence with respect not only to M0 but also M1 and M2, putting to rest the archaic concept of the “money multiplier”. Indeed, in the midst of Covid, the Fed joined other central banks who had long ago reduced reserve requirements to zero. Bank reserves (part of M0) play an important role in the payments system but technological developments have enabled quadrillions of dollars, euros, and yen to be transferred every year without more than a small quantity of reserves being needed. Reserves in excess of this amount are simply deadweight on banks’ balance sheets (Singh and Stella, 2012).

Reserves suffer in comparison with Treasury securities because they can only be held by banks, cannot be used as collateral efficiently like securities and are subject to capital requirements. Treasury securities may be held by anyone residing anywhere, serve as good collateral and support global capital markets. They are also not subject to capital requirements when held by real money investors. Thus, if we compare the two instruments, beyond a minimum threshold required for payments, securities sell at a premium to reserves, are more useful in market plumbing and serve as a less costly way for the sovereign to finance itself.

The assumption that money finance as a result of QE is less expensive than bond finance for any given level of deficit spending is myopic

The key takeaway is the way money is created in the system. Overt fiscal financing through central banks carries a much higher inflationary risk compared with central bank asset purchases. The simple theoretical representations of the quantity theory of money lead to misleading analyses of the recent increase in reserves, because they fail to distinguish between money created in exchange for bonds and money created to finance higher fiscal spending. Unsustainable fiscal expenditures will be inflationary regardless of whether they are financed in the first instance with money or bonds (Sargent and Wallace, 1981).

The assumption that money finance as a result of QE is less expensive than bond finance for any given level of deficit spending is myopic, especially in an era when most advanced country government debt is being issued at near-zero interest rates. Moreover, once the central bank balance sheet expands it becomes difficult to get that genie back in the bottle, as seen from the recent experiences of the Bank of Japan, ECB, Fed and others.

Compared with QE (or QE that may never unwind), Treasury debt issuance is not only cheaper but takes place in open auction markets with secondary market signals until maturity, thereby providing discipline. Near-zero (or negative) interest rates on most developed-country medium-term debt suggests debt issuance is a superior way to finance temporary surges in expenditure such as those related to Covid-19.

The development of domestic debt markets in countries has taken a great amount of effort, but it has paid back important benefits. Many countries that suffered through extended periods of inflation in the 1970s and 1980s and subsequently made great strides to develop domestic debt markets are issuing debt rather than money to finance deficits even during the exigencies of the Covid crisis (Canuto 2020)). Given the evidence we present about the decline in the demand for bank reserves, any government strategy that relies on increasing monetary finance is swimming against tides both historical and technological.

Manmohan Singh and Apoorv Bhargava are with IMF; Peter Stella is with Stellar Consulting. The views expressed are those of the authors and should not be attributed to the IMF, its executive board, or its management.

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