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Opinion: Anti-inflation policy is all about the money

Fighting Inflation Requires Money Supply Adjustments, Not Interest Rate Changes

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When the current inflation started, the Bank of Canada assured the public that it was caused by the temporary disruption to supply chains caused by the pandemic and would not last. But the price rises persisted and the Bank changed its mind and began raising interest rates to reduce demand for goods, services and assets and try to prevent a dreaded wage-price spiral. That the war in Ukraine disrupted key markets didn’t help.

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In contrast, academic economists known as monetarists insisted from the outset that inflation was due not to temporary supply disruptions or international tensions, but rather to an excess supply of money. created by the Bank of Canada itself. This view is based on Milton Friedman’s conclusion, after studying past inflation around the world, that “monetary policy is not about interest rates; it is about the growth of the (large) amount of money. Fighting inflation requires adjustments in the money supply, not changes in interest rates.

Canada’s money supply, measured by “M3”, increased by 32% (from $2.5 trillion to $3.3 trillion) between the second quarters of 2019 and 2022. During the same period, the country’s GDP increased by 22%. If the Bank had held the ratio of money to GDP constant, the money supply would have increased by 22% or $0.6 trillion, not 32% or $0.8 trillion, implying that the money supply excess held by the Canadian public in 2022 was approximately $200. billion.

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Since that extra $200 billion was more than Canadians needed to run their financial affairs, they disposed of it by spending it on goods, services, and assets. But all this new demand has not been accompanied by an equivalent increase in production, which would have happened under normal conditions when Canadians earned money in exchange for the production of goods and services. In fact, the Bank of Canada created this excess money supply with the stroke of a pen. The result – “more money for the same amount of goods” – led to inflation.

It’s probably counter-intuitive and it’s certainly ironic that the spending of some Canadians on lower their monetary holdings do not diminish the overall money supply. This is because the money that sellers of goods, services and assets receive becomes their own excess equity. When they in turn spend it, the excess money is transferred to another group of sellers – and so on in a vicious circle. It’s like a hot potato that no one wants to hold and that is passed around the room from person to person. Ultimately, the excess money supply is eliminated only when inflation reduces its real value or central bank operations absorb it directly.

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The Bank of Canada created the oversupply mainly in the second quarter of 2020, when M3 grew by 8%, four times its normal growth of around 2%. Why did he do this? Provide the federal government with the money it needed to provide financial assistance to needy Canadians affected by the pandemic. This explosion of public spending was justifiable on moral grounds. What was not justifiable was the Bank’s inability to reduce the money supply to non-inflationary levels after emergency relief payments were no longer needed.

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While some Canadians spent the excess money, others used it to fund a leisure time. Their withdrawal from the labor force helps to explain the labor shortage that has led to rising wages, inflation and the start of a wage-price spiral.

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Monetarists believe there is another important problem with the Bank of Canada. He cannot define nominal interest rate. But borrowing and spending are determined by real rates. If expected inflation is 8%, a seemingly high nominal interest rate of 6% actually becomes a real rate of minus 2%. You could borrow $100 at 6%, buy an asset, sell it a year later for $108, pay off the $100 loan, pay the $6 interest owed, and enjoy a net profit of $2. When real interest rates are negative, borrowing always pays off and lending becomes child’s play.

But inflationary expectations are not observable. The Bank therefore does not know which real rate implies the nominal rate which it sets. Operating in the dark in this way can cause it to set nominal rates too low, which unintentionally creates inflationary increases in demand, or too high, which risks unnecessarily reducing demand and a recession.

Canadians can only hope that the Bank of Canada’s interest rate policies will quickly bring inflation under control, despite the problems identified by monetarists. Otherwise, we expect a deeper recession, higher unemployment and weaker economic growth than necessary.

Herbert Grubel is Emeritus Professor of Economics at Simon Fraser University and Senior Fellow at the Fraser Institute.

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