The Quantity Theory of Money: A New Restatement
Leading economist Professor Tim Congdon calls for a shift in the Bank of England's approach to controlling inflation.
By Tim Congdon, Chairman of the Institute of International Monetary Research
Most economists failed to anticipate the high inflation in 2022 following the Covid-19 pandemic. This resulted in a delayed response from the Bank of England in the United Kingdom and the Federal Reserve in the United States.
A handful of economists correctly predicted the inflationary threat as early as June 2020 by monitoring the growth in the money supply.
As measured by ‘Broad Money’, the money supply grew by over 15% between February 2020 and February 2021.
The Bank of England should focus on 'Broad Money' — a measure of money including virtually all bank deposits — to control inflation.
A timely new book from the Institute of Economic Affairs, a free market think tank, explains why most economists and central bankers were caught off guard by the cost of living crisis in 2022. This comes as the Bank of England could cut interest rates tomorrow (20 June 2024) for the first time since March 2020.
During the Covid-19 pandemic, it was widely believed that inflation would decrease and prices might even decline. Professor Tim Congdon, Chairman of the Institute of International Monetary Research, was one of the few economists who foresaw the inflationary threat as early as June 2020.
In his new book, The Quantity Theory of Money: A New Restatement, Congdon argues that many economists misunderstood the causes of inflation by neglecting a crucial factor: the quantity of money circulating in the economy.
Congdon specifically criticises the Bank of England’s ‘New Keynesian Model’, which uses interest rates – and only interest rates – in the monetary part of the forecasting exercises in which they predict inflation. This model caused Monetary Policy Committee members to mistakenly warn of deflation throughout 2020 and fret about insufficient stimulus.
The Committee overlooked the inflation dangers inherent in the rapid expansion in the money supply, arising largely from the Bank of England’s large asset purchases (or Quantitative Easing [QE]). An early warning sign that surplus cash artificially boosted asset prices was that the FTSE 100 hovering near record levels by January 2021, despite the pandemic's devastating impact on the economy and company profits.
According to Congdon, central bankers aiming to control inflation should analyse 'Broad Money,' a measure of money balances that includes virtually all bank deposits. The principle that the money supply influences inflation is well-established and is commonly known as the Quantity Theory of Money.
“The main propositions of the quantity theory are fundamental to any analysis of the relationship between money and inflation in the 2020s," writes Congdon. “Its central message accords with the laws of supply and demand. If too much money is created, its value will fall, whereas – if an economy becomes short of money – its value will rise.”
Congdon stresses the importance of maintaining monetary equilibrium for price stability, arguing that broad money growth should be aligned with the growth of nominal GDP to prevent inflation or deflation.
This book underscores the urgency for policymakers to reassess monetary policy to avoid repeating past errors.
Book author and Institute of International Monetary Research Chairman Professor Tim Congdon said:
"Flawed models – and bad monetary policy decisions based on those models – were made by central bankers and other policymakers in 2020 and 2021, as they responded to the Covd-19 medical emergency. This led to a serious and unnecessary flare-up in inflation. I was almost alone in late March 2020 in forecasting that central banks' reaction to Covid-19 would lead to an explosion in money growth and a consequent big jump in inflation.
“Economists failed to identify the inflation risk because of their obsession with interest-rate-only macroeconomics (such as three-equation "New Keynesianism"). It is high time for a fundamental shift in economic thinking. There has been a foolish and myopic focus on interest rates. We need a more comprehensive understanding of the powerful impact of money - meaning the quantity of money, nowadays dominated by bank deposits - on our economy and society."
Read a copy of The Quantity Theory of Money: A New Restatement.
Congdon emphasises the "monetary equilibrium," a state where the amount of money people wish to hold equals the actual money supply. When the money supply exceeds the desired level, people will try to spend the excess, leading to increased demand for goods, services, and assets. This excess demand puts upward pressure on prices, causing inflation. Conversely, when the money supply falls short of the desired level, people reduce spending, demand and potential deflation.
Earlier proponents of the quantity theory, such as economists Irving Fisher and Milton Friedman, emphasised base or narrow money, which only includes the most liquid components (currency in circulation and demand deposits). Congdon, by contrast, argues that broad money (also including savings deposits, time deposits, and money market funds) is the most relevant measure for understanding the money-inflation relationship as it better captures the total amount of money available for spending and investment.
In June 2020, Professor Congdon co-authored Inflation: The Next Threat?, which warned that central bank stimulus and monetisation of emergency government spending would unleash inflation in 2021 or 2022.
In April 2021, the IEA’s Shadow Monetary Policy Committee wrote to the Financial Times warning that excessive money growth was on course to cause inflation: Letter: BoE must end its asset purchases to avoid stoking inflation.
Director of the Institute of International Monetary Research Damian Pudner explained The critical role of ‘broad money’ for the IEA Blog.
IEA Economics Fellow Julian Jessop wrote for The Spectator in 2023 explaining how Broad Money has influenced inflation in the UK: Is printing too much money the real cause of inflation?
When rates are low, credit should be tight, and vice versa. Sorted, and/as the very opposite of monetary policy ever since going off the gold standard.
The supply of goods and services is more important I think than the supply of money, so goods which can be rapidly produced tend to increase in supply when more money is available. Goods in Short supply or controlled supply will rocket in price, housing, gold etc. and recently Russian gas. This last has been rapidly replaced by other sources so inflation has fallen. The other important factor is CONFIDENCE. which unmeasurable, but would you prefer Argentine Pesos or US dollars, both are in massive deficit. To counter lack of confidence Argentina has to pay massive interest.