Economics: Why Is Inflation Shrinking?

 (Drivebycuriosity) - Inflation is shrinking (chart above cnbc). This is going on for a while, but has been mainly ignored by pundits & media. Now they pay attention, but they still don`t get the cause.

The answer is easy, it is the shrinking money supply.

 

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                    Helicopter Money Gone

The high inflation rates were caused by a flood of money in the past. In 2020 & 2021 the US government flooded the economy with stimulus checks in the value of trillions of dollars (American Rescue Plan), supported by massive bond purchases by the Federal Reserve.

The government money landed directly on the bank accounts of the Americans, blowing up the money volume M2 (bank notes & coins & deposits at banks). Milton Friedman described this as helicopter money (cato ).

As a result in 2020 & 2021 the US money supply M2, the engine of the inflation, jumped 40% (image below). The money deluge met a constrained supply of goods & services partly because of Covid19. It is no surprise that prices had to increase so much (marginalrevolution).

 

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"Inflation is caused by too much money chasing too few goods and services", noticed the economists at fisherinvestments. "It is no surprise that prices increased so much", commented Tyler Cowen, Professor at George Mason University (marginalrevolution).

 

                     Causal Connection

The causal connection between money and inflation is known since the 16th century at least. Nicolaus Copernicus described already in the year 1522 how "too much money" causes inflation. Copernicus` "quantity theory of money" is based on observations: 

Early in the 16th century Spain conquered today`s Latin America and looted the silver stocks. The Spaniards send the precious metal to Europe where is was printed into coins and used as money.

 As a result the European money volume jumped, meeting a restrained supply of goods (agriculture, hand works) &  services. The flood of money raised suddenly the demand for scarce goods & services and caused a jump of the price level.

Elaborated studies by Milton Friedman, Karl Brunner, Allan Meltzer and many other economists (known as Monetarists) described already in the 1960s how and why the inflation rate follows the growth rate of money with a time lag (causal connection).

The monetary growth already peaked in February 2021 (with plus 27%). Since then the monetary growth rates have been falling and turned negative in December 2022.  

In the recent months the money volume has been shrinking! In September M2 dropped 3.6% YoY.  "We have never seen money taken out of the economy like this in our history" ( twitter.com).

 

 

                The Pull Of Money

It might be helpful to recall Calculus. The inflation rate is the change of the price level: First Derivative. The change of the inflation rate is the Second Derivative. 

Since inflation follows the growth of money, the inflation rate (growth rate of prices) will follow the pull of the shrinking money volume and the inflation rate will continue to drop.

If we believe calculus inflation will continue to shrink in the coming months and maybe turn into deflation next year.