Eco week 21-13 // 2 April 2021
economic-research.bnpparibas.com
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EDITORIAL
AFTER DISCONNECTING, WILL MONEY SUPPLY GROWTH AND INFLATION RECONNECT?
Since the Great Recession, the monetary base in several advanced economies has seen a considerable increase, driven
by the creation of bank reserves at the central bank. Yet, contrary to what had been observed in previous decades,
this has not been followed by a significant pick-up of inflation. Following the global financial crisis, the demand of
the banking system for central bank reserves increased a lot. This was a reflection of the dire state of the economy
and money markets as well as tighter liquidity requirements. Subsequently, quantitative easing caused an increase
in reserves on the initiative of the central bank. Going forward, as the economy strengthens, money supply growth
and inflation could reconnect on the back of an increase in money velocity or faster credit demand growth. Central
banks have the tools to address this, if need be. Clearly, asset markets might be less relaxed about such a prospect.
Why has the massive expansion of central bank balance sheets in In the aftermath of the global financial crisis in 2008-2009, money
advanced economies not succeeded in lifting inflation? It’s a frequently markets were no longer functioning smoothly and many banks were
asked question that reflects a feeling that an increase in the monetary facing pressures on liquidity, so central banks reacted by supplying
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base and broader money aggregates will inevitably lead to higher abundant reserves: “the expansion in base money was instrumental in
inflation.
avoiding fire sales and a curtailment of credit with potentially severe
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consequences for the real economy” . The demand of banks for central
This view may be based on common sense: in a fiat-based monetary
system, money is created ‘out of nothing’ so when a lot of it is created
and used to buy goods, it may lead to more inflation. It could also be
based on reading about hyperinflation in the Weimar republic or, more
recently, in certain developing economies. Economists have learned at
school about Milton Friedman’s observation in 1970 that “Inflation is
always and everywhere a monetary phenomenon in the sense that it
is and can be produced only by a more rapid increase in the quantity
bank reserves did not reflect gathering strength of the economy and
credit demand, rather it was a manifestation of considerable uncertainty
about the outlook, economic weakness, a poorly functioning interbank
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market and new regulations in terms of liquidity .
US MONEY SUPPLY AND INFLATION
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of money than in output.” This was confirmed by empirical research
conducted by the 1995 Nobel Prize winner Robert Lucas: “The prediction
that prices respond proportionally to changes in money in the long run
Monetary base, y/y %
CPI, y/y % (rhs)
Money supply M2, y/y %
…
has received ample — I would say, decisive — confirmation in data
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from many times and places.”
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100
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Things have evolved since the mid-nineties and the huge increase in
the monetary base in the United States, Japan and the euro area since
the Great Recession has not been followed by a significant increase
of inflation. In explaining this disconnect, the origin of the creation
of reserves plays a key role. In normal times, the growth of central
bank reserves is determined by the demand by banks, which in turn
depends on the evolution of banks’ short-term liabilities (deposits and
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9
6
3
0
2
8
6
4
2
0
0
0
0
0
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debt securities with a residual maturity of up to two years) . For the
banking system as a whole, the growth of deposits is largely driven by
the growth of bank credit (‘loans create deposits’), which means that
the money multiplier –the ratio of broader monetary aggregates to the
monetary base– is rather stable.
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20
-3
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0 64 68 72 76 80 84 88 92 96 00 04 08 12 16 20
SOURCE: FEDERAL RESERVE, BLS, BNP PARIBAS
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.
The monetary base, also called base money, corresponds to notes and coins in
circulation and bank reserves held at the central bank.
“Base money, broad money and the APP,” ECB Economic Bulletin, Issue n° 6, 2017.
5. ECB (2017)
6. This concerns the Liquidity Coverage Ratio. Before its introduction, bank reserves more
or less corresponded to the reserves that banks were required to hold at the central
bank. Reserves held by banks at the central bank increased significantly following the
introduction of the LCR. “The objective of the LCR is to promote the short-term resilience
of the liquidity risk profile of banks. It does this by ensuring that banks have an adequate
4.
Money supply growth and inflation can reconnect but for
inflation to spin out of control, it would require central banks
to acquiesce this.
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