Money Supply and the Inflation Rate

February 2008

Dear Editor,

   I found your web site as I was doing some in depth research on inflation. In looking at the CPI published by the Federal Reserve Bank of Minneapolis

you'll notice three columns. The column on the right shows the "Annual percent Change (Rate of Inflation)" which appears to be the one you publish on your web site.

 However, if you do the math and take the years 2006 & 2007 as an example, you'll see that in 2006 the CPI (center column) was 201.6.

If you then add 2.9% (right column) you get 207.3 (center column) for 2007. The column on the right merely reflects the percentage of change over the previous year and is not the true inflation we're having.

According to the Atlanta Fed:  
In the year 2000, we had $571 billion  in  circulation. Today we have $820 billion. See New York Fed : 

In 7 years time the money supply grew by at least $249 billion. That's a 43.6%. At the very least that's a 6.2% annual "rate of inflation" (43.6% \ 7years = 6.2%).

Even if you start at $571 billion in the year 2000, and add the 7 percentages in the right column ("rate of inflation") to each succeeding  year, you only come with $610.46 billion.

There is more to the CPI than meets the eye. As it turns out the FED has a base line for money creation and as near as I can tell it's about $16.5 billion annually. The annual average (column 2) for 2008 is 215.6. Take this as a percentage multiplier: $16.5 billion (Annual Base Line) multiply it by 2.156 (percentage multiplier) =  $35.57 billion new money annually. We are right on track this year. Bear in mind that the base line goes up every decade and has been since 1913.

Webster's New World Dictionary (1957) defines inflation as follows: 2. an increase in the amount of currency in circulation, resulting in a relatively sharp and sudden fall in it's value and a rise in prices: it may be caused by an increase in the volume of paper money issued or of gold mined.

The fact is, price increases at the gas pump are a symptom of inflation, and so instead of  placing the blame where it belongs (on Congress & the Fed) we end up blaming the businesses of America.

   You'll notice that it took about 110 years to create $3.148billion (1800 to1910 see Atlanta Fed above). That's an average of about $28 million per year. Moving forward to June of 2000, $242.737 billion  was created from June 30, 2000 to Feb. 2008. That's an average of about $34.188 billion per year!

That's a 1,221% increase in the amount of money that was being created annually just 98 years ago.

Your "Inflation Calculator" bears this out. The Federal Reserve Note is worth just 4 cents on the dollar. The two things that drive the proper growth in the money supply are the growth of the population and the creation of wealth. Neither one of these can justify the staggering amount of money that is being created and that is currently in circulation. We are in fact having hyperinflation here in the U.S.

I'd be interested to here your thoughts on this subject.

L. Ripplinger
 

Dear Mr. Ripplinger,

 That is a very thoughtful question. 

You are right that the increase in money supply is the real cause of inflation.  See our articles:

What is the Real Definition of Inflation?

What is Inflation?

Inflation Cause and Effects

What is Deflation?

However, you can’t just take the increase in money supply  and transfer it to an equivalent inflation rate.  The reason can be seen in a simple example I have used in several articles.   

A simple example is that of an island with ten people on it and each person has $1. and one item for sale (10 items total). Simple mathematics tells you the average price for each item would be $1.

Now suppose you wanted to make everyone richer so you gave each one another dollar. There are still only 10 items for sale but now there is $20 to spend so the average price would now be $2  This means the price doubled, so no one is any richer because they can still only buy one item with their $2. 

So it becomes obvious that increasing the money supply will increase the inflation rate. So one would think that simply tracking the money supply would allow you to easily forecast the inflation rate. 

 However, there are a variety of definitions of "money supply" so forecasting becomes more difficult.  To make matters worse  recently the government stopped tracking one measure of the money supply see Good-bye M3.

Forecasting is also made more difficult by the fact that we have a world wide economy now. The available money supply can be affected by a wide variety of things from as far away as China.  For instance our forecast would be radically affected if China were to decide one day to dump the billions of U.S. dollars it is currently holding as reserves. 

Imagine increasing the quantity of available dollars (money supply)  by a Billion dollars overnight simply because China decided it would rather hold Yen or Euros. In today's economy that is a distinct possibility.

Another reason you can’t just track the money supply is that if our island with $2 commodity prices doubled the quantity of goods available, prices would be back to $1.00 each so you also have to factor in Gross Domestic Product (GDP).

 You state that, "In 7 years time the money supply grew by at least $249 billion. That's a 43.6%. At the very least that's a 6.2% annual "rate of inflation" (43.6% \ 7years = 6.2%)." 

During that time the "official" inflation rate increased by 25.05% see our Inflation Calculator from January 2000 through January 2008.

So at first blush, there appears to be a major discrepancy between 25% and 43%.  However, you have to subtract the increases in Gross Domestic Product (as mentioned above) and any capital that has been removed from circulation.

Now this doesn't mean burned or destroyed. It means not available for purchasing goods within the US.  In this case a major source of a decrease in the money supply in the U.S. is the Billions that are held as reserves by foreign governments (i.e. China and Saudi Arabia, etc.) and the currency that circulates in countries that have adopted the Dollar as their own currency (i.e. Panama and Ecuador). This makes calculating the inflation rate strictly based on money supply extremely difficult.

However, I do agree with you that the official Bureau of Labor Statistics numbers probably underestimate inflation.  But, I also disagree with other sites that say our inflation rate is in the 15% range.  Some items may be increasing at that rate but others like Computers, GPS, and other electronics are actually declining at higher rates than that. My first computer cost $3000 twenty years ago. Now you can buy one 100 times faster with features I couldn’t have dreamed of for about $500 (an 83.3% decrease).

 So my "best guess" is that the average inflation rate is somewhere in between.

 For a more in depth discussion on the reliability of the government numbers, See my article What is the "Real" Inflation Rate?

 Tim McMahon, editor

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