Economics: Inflation - What We Could Learn From Copernicus

(Drivebycuriosity) -  There is still a lot confusion about what caused the recent inflation. Apparently the Federal Reserve and many pundits don`t understand how the economy works and ignore the importance of money. The image above shows that the recent inflation wave was caused by a deluge of money ( reuters).

The causal relationship between the money supply and inflation was already recognized by Nicolaus Copernicus! The astronomer explained in the year 1517 why "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 it was printed into coins and used as money.

As a result the European money supply jumped, but the supply of goods & services did not change much. The flood of money raised suddenly the demand for scarce goods & services and caused a jump of the price level.

Copernicus`findings lead to quantity theory of money. The theory is represented by the basic formula M X V = Q X P, meaning M (money) multiplied with V (the velocity of money) = Q (available goods & services) multiplied with P (price level). The dynamical version today means M (growth rate of money supply) X V = Q (real GDP) X P (inflation rate). Since the real GDP (Q) does not change much, a sudden jump of the monetary growth rate (M) leads to a rise of the inflation rate (P). 

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

 

 (source)

                         Helicopter Money

The inflation wave of 2021 & 2022 confirms again the insights of Copernicus and the monetarists. In 2020 & 2021 the Biden government flooded the economy with stimulus checks in the value of trillions of dollars to fight the Covid19 recession (American Rescue Plan). The government checks got financed by massive bond purchases by the Federal Reserve (Quantitative Easing known as QE1,QE2 & QE3).  

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 2021 & 2022 the US money supply M2, the engine of the inflation, jumped 40%. Unfortunately the money deluge met a constrained supply of goods & services partly - partly because of Covid19. So the price level inevitably had to jump and the inflation rate (first derivation) went up (calculus).

 

 ( source)

Fortunately the money flood ended already in 2022 and the money supply shrank for a while. Since October 2023 the money volume is growing again, but only moderately. Since inflation follows the growth of money, the inflation rate (growth rate of prices) will follow the pull of the slowly growing money supply and the inflation rate will stay low.

Those who try to explain the recent inflation and ignore the role money are economic illiterate and ignorant of history.