Decreasing Inflation Rate, but Increasing Money Supply ?

By Asseged Major

How Central Bankers Reduce Inflation 

​Central Bankers Combat inflation by causing Money Supply to be reduced. As the economics saying goes, inflation is “too much money, chasing too few goods.” Central Bankers will reduce the supply of money available, so it causes less money available in the economy to purchase goods, in response accumulated inventory builds up of unsold goods for producers, producers will respond by reducing the prices of those goods so they can get rid of them and sell them. There are lag effects of Central Banks interest rate policy on the Economy, and not a perfect relationship with the Money Supply. But essentially higher interest rates overall will reduce the Money Supply in the Economy.

Inflation & Money Supply

In figure (1) Chart below, all of the countries except for China and Japan and just recently Brazil, have been conducting restrictive monetary policy and raising interest rates. As you can see in the chart comparing “Peak Inflation in 2022” Column with “Current - Nominal Inflation 2023” Column, All the countries listed have reduced inflation from the Peak Inflation Levels in 2022, and most by a very significant amount. 

Figure 1 ( Money Supply Growth vs Inflation Rate )
(Note : Yellow Highlight are Countries with Higher Money Supply Growth with Decreased Inflation Rate)

(Data : ceic.com, tradingeconomics.com, theglobaleconomy.com)

​Looking at “Money Supply Growth” column in Figure 1 Above, only 5 Countries/territories out of 14 Total Countries/territories have reduced their  “Money Supply Growth” currently from 1 Year Ago. The 5 Countries and territory that have reduced their “Money Supply Growth” are USA (-3.70 %), Euro Zone (-2.10 %), Germany (-1.90 %), UK (-3.10 %), Switzerland (-10.35 %). The rest of the countries/territories have experienced an actual increase in Money Supply, even though nearly all those Countries Central Banks have been raising interest rates for over a Year. ( In Figure 1 Yellow Highlight indicates Countries with Increased Money Supply (YoY), and Decreased Inflation (YoY). )  

Higher Interest Rates, but still Higher Money Supply ?

So why has Money Supply actually increased in those countries, while the Central Banks in those countries have been raising interest rates, which causes the Money Supply to decrease ? It is mainly due to the Private Sector increase in Loan amounts in the economy. The Central Bank with higher interest rates can affect the Loans Market, but they can’t directly stop Banks and Finance Companies from giving Loans. If Banks and Finance Companies continue to increase the Loan amounts, it will increase the Money Supply in the system. When a Loan is given by a Commercial Bank or Finance Lender, it will eventually be deposited in the banking system, which leads to an increase in excess reserve for a bank, in which that bank can create another loan, which this cycle continually repeats,  which causes a Money Multiplier effect,  where the actual Money Supply increases in the Financial System. The relation can be shown by observing the money supply growth and private sector loans amounts in the economy. 

​For example, Australia had an increase in 1 year change of Money Supply Growth of 3.86 % as of July 2023. Looking at Figure 2, shows the Private Sector Total Loans Amount in Monthly Periods for Australia, in Australian Dollars. Australia Private Sector Loan Amounts monthly have grown Increasingly in this same time period, as its Money Supply Growth. 

Figure 2 : Australia Private Sector Loans in Billions (AUD)

Opposite Case – US Economy 

​The opposite case is for the US Economy. The US Economy had a decrease in 1 year change of Money Supply Growth of -3.70 % in July 2023. Looking at Figure 3, it shows the Private Sector Total Loans Amount has been decreasing in the US Economy during the same time. As is what would be expected from Higher Interest Rates from a Central Bank, and a decreasing Money Supply. 

Figure 3 : ​USA Private Sector Loans in Billions (USD)

If Money Supply is Increasing in these Countries, than how is Inflation Decreasing ? 

The next question is if Money Supply is increasing in these Economies, how come inflation is decreasing ? Economic theory suggests it is likely due to the decrease in the Velocity of Money in those economies. The Velocity of Money is the turnover rate of a currency in the economy. In other words, how many times the currency is being transacted for purchases/sales in the economy. It is a measure of consumers and businesses willingness to spend money in the economy. The higher the velocity of money, the more likely the Economy will increase in GDP Growth, the lower the velocity of money, the more likely the Economy will decrease in GDP Growth. This relationship is explained in the Equation of Exchange, 

In the Equation of Exchange,  MV = PY 
M = Money Supply
V = Velocity of Money
P = Prices
Y = Real Output (Real GDP)

For the scenario where in an Economy there is an increase in Money Supply, and still experience a decrease in inflation (Prices) like most of the countries that was shown on in Figure 1, this would mean in the Equation of Exchange, (M) Money Supply value would increase, and (P) Prices value would decrease, for the Equation of Exchange to hold true, this would mean (V) Velocity of Money would have to decrease. For simplicity’s sake of using basic numbers, look at the following, 

Example of an Economy, when the Money Supply Increases, and Inflation (Prices) Decreases, using the “ Equation of Exchange ” 

Equation of Exchange 
MV = PY

Initial Economy - Time Period 1  
MV = PY 
6(2) = 3(4)      
​
In Time Period 2 , the Economy Money Supply (M) has increased to 8, and the Prices (P) has decreased to 2, and Real GDP ( Y ) has increased to 4. In order for the Equation of Exchange to hold true, meaning for both sides of the Equation to equal each other (MV=PY), than Velocity of Money (V) must decrease in value mathematically. Look below, 

Economy in Time Period 2
MV = PY 
8V =  2(5)
8V = 10 
V= 1.25 ,   
the Velocity of Money (V) is lower here in Time Period 2 than Time Period 1 (1.25 < 2 ) 

MV = PY 
8(1.25) = 2(5) 
        10 = 10 ,
Hence, Both Sides Equal each other (MV=PY), the Equation of Exchange Holds True.

Thus in order for Money Supply to Increase to 8, and Inflation to Decrease, where Prices to Decreased to 2, the Velocity of Money had to Decrease to 1.25, in order for the Equation of Exchange to hold True. In this scenario regardless how much Prices (P) decrease, Velocity of Money (V) would always decrease. In Sum, this mathematical expression shows Inflation Decreased, even while Money Supply Increased, and it is due to the Decrease in the Velocity of Money. 

The Velocity of Money would decrease regardless if the Real GDP (Y) increased or decreased. The only caveat is if the Real GDP (Y) level equaled or exceeded the Money Supply level, in that case the Velocity of Money would stay constant or actually increase. For instance, in this example, if Real GDP (Y) equaled 8 or Higher, then Velocity of Money would be constant or increase, look at following, 

MV = PY 
8V =  2(9)    *Note : Here  Real GDP (Y) = 9, the Real GDP (Y) > (M) Money Supply
8V = 18 
V= 2.25 ,   
The Velocity of Money Increased higher in Time Period 2 ( 2.25 > 2 ),  because Real GDP (Y) is higher than Money Supply (M), (8 < 9) . 


If Theory followed into practice, as long as the Real GDP (Y) does not equal or exceed the Money Supply level, than this would explain for Most of the Countries in Figure 1, where they experienced a Increase in Money Supply,  But still a Decrease in Inflation, which is likely due to a Decrease in Velocity of Money. Also most of the countries that experienced this had a Positive Real GDP (Y), which fits this example scenario.   

​Example (Canada Economy) : Inflation Decreasing, Velocity of Money Decreasing 

​An Example is Canada, where its Real GDP Level is below the Money Supply Level, and it has experienced a Increase in its Money Supply Growth and a Decreasing Inflation Rate (YoY). As of of July 2023 Canada Real GDP is 2.2 Trillion Canadian Dollars, this is lower than the Money Supply in Canada at 2.4 Trillion Canadian Dollars. In other words the Money Supply Value exceeds the Real GDP Value currently in Canada. Look below at Figure 4.

Figure 4 : ( Canada Real GDP vs. Money Supply)   

(Data : tradingeconomics.com)

Canada Money Supply Value is Greater than its Real GDP Value

2.2 Trillion < 2.4 Trillion

          Real GDP < Money Supply

Y < M

​​At the Same Time as of July 2023 Year to Year Money Supply Growth increased 2.60 %, and its Inflation Rate is at 3.3 %, which has decreased from its recent Peak Inflation Rate of 8.1 %, and at the same time in which Velocity of Money has been decreasing, Look at Figure 5. 

Figure 5 : Canada - Velocity of Money

(Data : moody's analytics, theglobaleconomy.com)

Example (US Economy) : Inflation Decreasing, Velocity of Money Increasing ​

In Contrast to Canada, in the US Economy, the US Real GDP Value is higher than the Money Supply Value. As of September 2023, the US Real GDP Value is $ 22.4 Trillion, and the Money Supply is $ 20.7 Trillion, Look at Figure 6.  

Figure 6 : ( USA Real GDP Value vs. Money Supply)

(Data : tradingeconomics.com)

USA Real GDP Value is Greater than its Money Supply Value 

​22.4 Trillion > 20.7 Trillion 

          ​Real GDP > Money Supply 

​Y > M

​Unlike Canada and including the 10 other countries, the US Economy Money Supply Growth has decreased, and the actual Velocity of Money is increasing. Looking at  Figure 7, since the 3rd Quarter of 2021, the Velocity of Money has been increasing for the US Economy. The Velocity of Money has increased from below (1.16) to currently (1.32). The Increase in Velocity of Money has led to an increase in spending in consumption, which  increases Real Output (Y) in the US Economy, as Real GDP Growth continues to grow in 2023. As of September 2023, US Money Supply Growth decreased (-3.61 %), and Inflation Rate of 3.7 %, which is a decrease from its recent peak of 9.1 % .  The US Economy has experienced a decrease in Money Supply and Prices, while an increase in Velocity of Money, and Real GDP Growth.                                                

Figure 7 : ​US Economy - Velocity of Money 

​(Data : Federal Reserve Bank of St. Louis, fred.stlouisfed.org)

​Disclaimer : 
Paraimbal, LLC is a registered CTA & CPO ( Commodity Trading Advisor and Commodity Pool Operator ) with the CFTC (Commodity Futures Trading Commission) and NFA Member. This content is for informational purposes only. This information is of the opinion of Paraimbal, LLC and Asseged Major. This information is not mean’t to be investment advice. This is not a offer to participate a futures trading program, or securities.