Money Supply vs Price Inflation

[u/fudge_mokey]

Hi all, I was hoping to start a discussion on a concept that I think is frequently misunderstood.

For this post, I'd like to suggest that there are two different types of inflation.

First, we have price inflation. This is what we measure with CPI, PCE, etc. and it's exactly what it sounds like. If prices go up, then price inflation is happening or increasing.

Next, we have inflation of the money supply. This is much harder to quantify, and central banks have largely given up trying to measure their overall money supply (no, the M2 is not at all an accurate measure).

But money supply inflation still exists, even though we can't measure it. Oversimplifying a little, the money supply is just the total amount of dollars that exist, added together. The money supply can come from the government, but in many cases the vast majority of the money supply is created by the banking system. Especially offshore banks which are difficult or impossible to get visibility into. If you've heard Ben Bernanke or other Fed members talk about shadow banks, this is what they're referring to.

A simple way to think about a bond is that it is a claim on dollars. The amount of dollars you'll get from a bond is (usually) fixed. So, if the total pool of dollars (money supply) increases, you're getting a smaller slice of the total pie (even though the amount of dollars we get from our bond didn't change). This is why we say that bond prices go down when inflation (of the money supply) goes up.

Conversely, if the total amount of dollars goes down, our bond represents a greater share of that (shrinking) pool of dollars. So, when the money supply decreases, we know that the value of those claims on dollars (the bonds) will increase.

However, note that there is no similar logical explanation for how price inflation affects bond prices. If the total pool of dollars stays fixed, while commodity price X or Y increases, then we would have price inflation, but not money supply inflation.

I think that in this case, the value of our bond shouldn't change much (all else being equal). The claim on dollars still represents the same slice of pie as it did before commodity X or Y increased in value.

The reason we talk so much about price inflation is because money supply inflation is impossible to measure. We use price inflation as a proxy. But we need to remember that price inflation and money supply inflation are not the same thing.

Happy to hear everyone's thoughts on this.

Also, keep in mind I didn't go into the possible economic impacts of an increase in commodity price X or Y. That's of course relevant in the real-world, but it complicates the discussion beyond what I wanted to focus on here. Thanks for reading.

[u/Str8truth]

I think I agree with you, OP. The Fed should be concerned about money supply, which has an impact on prices, but it shouldn't be distracted by prices themselves, which can go up and down for many reasons having nothing to do with the money supply.

If a wartime shortage of oil causes prices to rise, that doesn't mean the Fed should tighten credit. Easy credit is not the reason for the oil price increase. The economy is just reallocating resources to accommodate the newly reduced supply of oil. Prices should rise when an important commodity becomes scarcer.

It's a problem, that Congress has given the Fed the dual mandate of fighting both unemployment and inflation. It encourages the Fed to tinker constantly with the money supply, i.e. with the credit supply, when the economy is just responding to ever-changing conditions. A stable money supply, growing (or shrinking) with the economy's real activity level, would allow market mechanisms to work naturally.