What explains our current inflation? An increase in the money supply or something else?

Money supply is still hampered by practical problems but might offer insights into how spending boom lifted prices

See Inflation Surge Earns Monetarism Another Look: Money supply is still hampered by practical problems but might offer insights into how spending boom lifted prices by Greg Ip of The WSJ. Excerpts:

"The money supply had a poor record of predicting U.S. inflation before last year thanks to conceptual and definitional problems that haven’t gone away.

On the other hand, contemporary models that predict inflation based on economic slack, such as high unemployment, didn’t do that well in the past year."

"there is no single definition of the money supply. The narrowest is the monetary base, the money the Fed creates directly: bank notes and “reserves,” electronic money the Fed issues to commercial banks when it buys an asset. A wider definition, M1, includes demand deposits at commercial banks. Over the years, financial innovation has allowed a growing array of investments to be treated as money such as certificates of deposit and money market mutual funds, which are included in broader measures such as M2. In 2008, the Fed was allowed to pay interest on reserves, making them functionally equivalent to Treasury bills. Treasury debt and short-term IOUs such as commercial paper are also treated by some analysts as money.

These innovations ruptured the relationship between nominal (that is, unadjusted for inflation) demand and money-supply measures that central banks targeted, such as M1, causing them to abandon their use. Broader measures such as M2 fared a bit better than M1, but it, too, sent false signals in 2001 and 2008, reaching double-digit growth as inflation fell."

"In 2008, during the financial crisis, the Fed began buying bonds as federal deficits ballooned. Conservative economists and Republican lawmakers warned the Fed this would “risk currency debasement and inflation.”

But inflation stayed low. This showed that while central banks could create money, they couldn't force businesses or households to spend it. In other words, velocity, the link between money and spending, kept changing, which made the quantity theory of money of little use for predicting inflation."

"Economists agree that over the long run, money growth tracks inflation. But you don’t need that to diagnose an inflation problem. Suffice to watch inflation itself, Columbia University economist Michael Woodford wrote in 2007."

"Not surprisingly then, economists didn’t pay much attention when annual M2 growth soared to 27% in early 2021 as stimulus checks and borrowing spurred by low interest rates flooded bank accounts with cash. In retrospect, though, this was a sign of soaring nominal income. Jason Furman, an economist at Harvard University who served in the Obama administration, argued in a recent academic journal article that inflation in 2021 is best explained by stimulus that dramatically raised nominal income, which, through the fiscal multiplier process, generated an explosive rise in nominal demand. That rise in demand exceeded what the economy could supply on such short notice, especially given disruptions caused by Covid-19. The gap between excess demand and constrained supply showed up as sharply higher prices."

Since inflation is a rise in the general price level, it is caused by either an increase in demand or a decrease in supply. The article suggests, especially at the end, that we got too much demand as the money supply went up.

The quantity theory of money the article refers to has to do with. Here is an excerpt from my lecture notes.

We start with the Equation of Exchange.  It is

MV = PQ

That is, M times V equals P times Q   

M = the money supply (how much money is in the economy)

V = the velocity of money

V = how fast money is spent (how many times a year is a dollar spent)

P = the price level, measured by something like the CPI (the price of all goods)

Q = the quantity of all goods produced in a year

MV = PQ = GDP

This is because the GDP is total spending in the economy in a given year and is also because GDP is the price of all goods times the quantity of all goods. And since the total spending has to be the number of times all dollars are spent (MV), the MV = PQ = GDP must be true.        

But Monetarists the also assume that

 

V is stable

Q is stable

That is, they don’t change very easily. V has changed over time but the Monetarists say it is because the technology has changed to allow people to spend money more quickly (credit cards, debit cards, ATMs) and that year-to-year changes in V are small. But Keynesians say that even small drops in V (velocity) can hurt the economy. The Monetarists also assume that Q is stable around the full-employment GDP.

BOTH ASSUMPTIONS ARE CONTROVERSIAL AND HIGHLIGHT THE DIFFERENCE BETWEEN THE Monetarists AND Keynesians. How and why these two groups differ over proper economic policy is discussed more below in Part 4.

Since MV = PQ, then P = MV/Q

And since Monetarists assume that V and Q are stable, then if M increases, P must increase. That is, trying to help the economy by increasing the money supply will only cause higher prices.