18 Sep 2020 19:04 IST

Excess money supply may not cause inflation

Recent history suggests that the fiscal and monetary stimulus is unlikely to increase prices for consumers

The Reserve Bank of India has injected money into the economy at a record pace to fight the global recession triggered by the coronavirus pandemic. The market participants are expecting more in stimulus from both the central bank and the government.

The infusion of money into the financial system has renewed concerns for rising inflation. Supply shocks have driven up prices for some goods over the past few months. Yet, as recent history suggests, inflation is likely to stay low for a long time as we are witnessing record-high unemployment around the globe and subdued consumer spending.

Economic stimulus and inflation

So now the question arises, how will a huge economic stimulus affect inflation? Inflation refers to an increase in the prices of goods or services over time. One well-known measure of inflation across the globe is the Consumer Price Index (CPI). It involves the price we pay for services, goods, housing, and rent. Economists say some inflation is healthy for the economy. When the economy is growing, more consumers and businesses are spending money on goods and services. This increase in demand results in higher prices. Demand, as you can tell, is a very important factor in the outlook for inflation. Generally, when unemployment is high and consumer demand is weak, we find low inflation.

Another factor that affects inflation is commodity prices. Consumer and business expectations about prices form an important piece of the inflation puzzle. If a lot of people expect prices will rise in the future, they might spend more now, ultimately causing inflation. The level of actual inflation that we get is heavily influenced by the inflation rate that actors in the economy, such as households, businesses, consumers, workers, and investors, expect to prevail.

Too much inflation isn’t a good thing

Like many other central banks around the world, the RBI targets a four per cent yearly inflation rate (with a two per cent deviation). It means that a basket of goods which cost ₹100 this year would cost ₹104 the next year. In order to achieve the target inflation, central banks adjust their policies normally by changing interest rates, in order to achieve the four per cent inflation level. Too much inflation isn't a good thing either. As inflation rises, the money that you hold today becomes less valuable tomorrow. For example, at a 15 per cent inflation rate, the basket of goods which today costs ₹100 will cost ₹115 next year. Think of the same rise in bigger purchases. Thus, whenever the inflation rate is very high, it is very difficult to make any calculation about saving.

Because of the extended lockdowns in several parts of the country, businesses are forced to cut prices to generate demand. Lockdowns have depressed prices all over the world as consumers stay home and remain cautious about spending money in an uncertain economy. Disruptions in the global trade because of the virus has also raised prices for goods, such as medical supplies. Still, these supply shocks haven't offset the overall weak demand. Many economists and policymakers expect wages to stay low on account of high unemployment. Meanwhile, we find people limiting their spending because of the rising fears of a worsened situation.

Demand pull inflation

In order to boost the economy, the policymakers have pumped in crores of rupees into the financial system. Economic theory suggests that all this money printing could create the risk of inflation. In the words of Milton Friedman, “if there's too much money in the economy, and chasing too few goods then only prices will rise.” Friedman says, in order for inflation to rise, there are two conditions to be fulfilled. First, an excess supply of money, and the second is that the money is chasing only a limited basket of goods. This is called demand pull inflation.

Economists all over the world today believe that there's been a break in the link between money creation and inflation as the banking system has become more complex. The growth of the financial system and its diversification is one of the many reasons to reject Friedman’s theory, as it was more suited to an earlier time in history.

It's important to understand that whenever a central bank injects money, most of it isn't in the form of currency, but electronic money. It uses electronic cash to buy assets and lend to banks, injecting money into the banking system. RBI buys securities from primary dealers and banks.

Reality vs expectations

Again, the question arises, what actually happens when the RBI creates money? It strictly creates central bank reserves only held by the banking system. It is at the disposal of the banks whether they want to lend the money or not, even during an excess supply, like we are witnessing now. People may argue that governments even handed out money directly to its citizens as part of its coronavirus response. But in reality, this cash infusion still may not result in inflation as most people needed the money to meet their day-to-day payments to make up for lost income during the crisis.

Recent history suggests that all the fiscal and monetary stimulus during the pandemic is unlikely to increase prices for consumers. As we have seen in the past, the Federal Reserve bought trillions of dollars of assets after the 2008 financial crisis and inflation never surged. After the Great Recession, there was a general conviction among the public, that all the fiscal and monetary stimuli were going to result in huge inflation. As a matter of fact, a number of investors, including some very famous hedge funds, went for the gold, as it is considered as a hedge to inflation. The reality of what happened contradicted the expectations of the investors. Considering the current crisis, we must understand that there are limits to what history can teach us for the economic situation right now.

(The writer is currently pursuing PGDM in Banking and Finance from the National Institute of Bank Management, Pune. He worked with Endeavor Careers as a Content Associate in its publishing department for more than a year before pursuing a career in management.)