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The counterintuitive relationship between money growth and inflation




While on the subject of commodities, monetary policy, and inflation, I thought I would update this chart that compares M2 growth (M2 being arguably the best measure of money) and consumer price inflation. What strikes me in this chart is the strong tendency of these two lines to move in opposite directions. For example, M2 growth surged from 1995 through 1999, yet inflation fell; very slow M2 growth from 2004 through 2006 was accompanied by rising inflation; M2 growth plunged in 2009, yet inflation surged.

My explanation for this is that money velocity is what is really at work behind the scenes. M2 is typically called a measure of money supply, but it really is a better measure of money demand. When M2 growth slows, it is because money demand is slowing and money velocity (money velocity being the inverse of money demand) is rising. Rising velocity makes a given amount of money support a higher level of prices. Rising velocity is also indicative of a phenomenon in which people try to reduce their money balances in favor of owning more things, and that is a classic symptom of inflationary psychology.

So the fact that M2 growth has been almost zero over the past six months, and only 2% over the past year is both encouraging and troubling at the same time. That's because it means that the velocity of money has turned up sharply, and that in turn is helping to fuel more spending and higher prices.

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