Money Supply And Inflation

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There are various statistics used to track each country's currency in circulation. The main ones that most people reference are the following:

  • M0: The total of all physical currency, plus accounts at the central bank that can be exchanged for physical currency.
  • M1: The total of all physical currency part of bank reserves + the amount in demand accounts ("checking" or "current" accounts).
  • M2: M1 + most savings accounts, money market accounts, retail money market mutual funds,and small denomination time deposits (certificates of deposit of under $100,000).
  • M3: M2 + all other CDs (large time deposits, institutional money market mutual fund balances), deposits of eurodollars and repurchase agreements.

When we talk about inflation, the actual definition of it involves an expansion of the money supply. Somewhere along the line inflation seems to have been refined as price increases, but it is technically due to the increase in the supply of money. Yes, price increases go hand in hand with monetary inflation, but they are the result of inflation, not inflation itself.

The money supply metrics, particularly M3, give great insight into the amount of inflation being injected into an economy. To understand that, you need to understand how pricing ultimately works. The following is a really simple example of the Quantity Theory of Money (which basically says that prices track inflation in the money supply).

Let's say we have an economy with two people in it. Each person has two dollars, and also two cookies. In the total economy there are four cookies, and also four dollars. The only thing you can buy with dollars is cookies (which would make Cookie Monster wicked happy), so each person is happy to set the price of a cookie to be a percentage of the total economy: in other words, each cookie is worth one dollar.

Now say in CookieVille that the Federal Cookie Reserve chairman decides to print more money, and injects four more dollars into the economy. We now have an economy with eight dollars, but only four cookies. So the price of each cookie has now doubled to two dollars a cookie.

By simply expanding the money supply, the Federal Reserve has the power to influence the price levels, causing them to go up as the monetary supply increases. This leads to price inflation (prices go up), which makes it harder for most people to live. If you have savings in the form of cash, your purchasing power goes down since it takes more money to buy the same items. Conversely, you now have more money (even though it technically can purchase less), so people with debts are able to retire their loans faster. In summary, inflation benefits people with debts at the expense of people with savings.

Remember, you can't create real value out of thin air. Inflation causes wealth to be silently transferred from savers to debtors. So when the Federal Reserve prints money to buy its debt, it's really paying for that debt by stealing a portion of the wealth from all of that country's citizens. Effectively that makes it a silent tax.

Alan Greenspan wrote these words in 1966 regarding inflation (my emphasis):

In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value. If there were, the government would have to make its holding illegal, as was done in the case of gold. If everyone decided, for example, to convert all his bank deposits to silver or copper or any other good, and thereafter declined to accept checks as payment for goods, bank deposits would lose their purchasing power and government-created bank credit would be worthless as a claim on goods. The financial policy of the welfare state requires that there be no way for the owners of wealth to protect themselves.

This is the shabby secret of the welfare statists' tirades against gold. Deficit spending is simply a scheme for the confiscation of wealth. Gold stands in the way of this insidious process. It stands as a protector of property rights. If one grasps this, one has no difficulty in understanding the statists' antagonism toward the gold standard.

It's no surprise then that the United States stopped publishing M3 money supply information a few years ago.

If you want to see some massive increases in money supply, check out the M3 series in a few of these beauties:

It's no surprise that people are heading to precious metals at this stage in the game. Countries are starting to become increasingly reckless with their monetary policy, and are resorting to printing more and more money in an effort to pay off their debts. Ultimately that just results in higher prices and a harder life for most people.

finance graphs inflation m3 money supply