Mainstream economists have argued that the large scale quantitative easing conducted by central banks in recent years - so-called printing money - would be inflationary. They based their predictions on the Classical Quantity Theory of Money which links the growth of the money stock to the inflation rate (too much money chasing too few goods). The fact that inflation has not accelerated sharply indicates that this mainstream economic theory should be discarded.
Answer: False
The answer is False.
The question requires you to: (a) understand the Quantity Theory of Money; and (b) understand the impact of quantitative easing in relation to Quantity Theory of Money (QTM).
The short reason the answer is false is that quantitative easing has not significantly increased the aggregates that drive the alleged causality in the QTM - that is, the various estimates of the "money supply".
So the point is that the period we are discussing is not a true test of the QTM, which for other reasons is largely inapplicable as a theory of inflation in a modern economy.
The QTM which in symbols is MV = PQ says that the money stock times the turnover per period (V) is equal to the price level (P) times real output (Q).
The QTM assumes that V is fixed (despite empirically it moving all over the place) and Q is always at full employment as a result of market adjustments.
In applying this theory mainstream economists and commentators are thus denying the existence of unemployment. The more reasonable mainstream economists admit that short-run deviations in the predictions of the Quantity Theory of Money can occur but in the long-run all the frictions causing unemployment will disappear and the theory will apply.
If V and Q fixed, then changes in M are associated with changes in P by construction - which is the basic Monetarist claim that expanding the money supply is inflationary. The causality the Monetarists invoke is to say that monetary growth (with no further capacity in the economy to expand output) creates a situation where too much money is chasing too few goods and the only adjustment that is possible is nominal (that is, inflation).
One of the contributions of Keynes was to show the Quantity Theory of Money could not be universally correct. He observed price level changes independent of monetary supply movements (and vice versa) which changed his own perception of the way the monetary system operated. In other words, something else was driving these price movements.
Further, with high rates of capacity and labour underutilisation at various times (including now) one can hardly seriously maintain the view that Q is fixed.
There is usually scope for real adjustments (that is, increasing output) to match nominal growth in aggregate demand. So if increased credit became available and borrowers used the deposits that were created by the loans to purchase goods and services, it is likely that firms with excess capacity will respond by increasing output, in order to maintain market share.
The mainstream have related the recent non-standard monetary policy efforts - the so-called quantitative easing (QE) - to the Quantity Theory of Money and predicted hyperinflation will arise.
They have to invoke the mainstream concept of the money multiplier to link the QE to inflation through the Quantity Theory of Money. In other words they think that increasing the level of bank reserves (QE) has to be inflationary because they think the increased reserves will flood the economy with money (spending).
Mainstream economics courses mislead their students into believing that there is a direct relationship between the monetary base (including reserves) and the money supply.
Students are familiar with textbook explanations a bank is alleged to "loan out some of its reserves and create money". As I have indicated several times the depiction of the fractional reserve-money multiplier process in these mainstream textbooks exemplifies the mainstream misunderstanding of banking operations. Please read my blog - Money multiplier and other myths - for more discussion on this point.
The idea that the monetary base (the sum of bank reserves and currency) leads to a change in the money supply via some multiple is not a valid representation of the way the monetary system operates.
The reality is that the central bank does not have the capacity to control the money supply. We have regularly traversed this point. In the world we live in, bank loans create deposits and are largely made without reference to the reserve positions of the banks. The bank then ensures its reserve positions are legally compliant as a separate process knowing that it can always get the reserves from the central bank if other sources fail.
The only way that the central bank can influence credit creation in this setting is via the price of the reserves it provides on demand to the commercial banks.
QE involves the central bank buying assets from the private sector - government bonds and high quality corporate debt. So what the central bank is doing is swapping financial assets with the banks - they sell their financial assets and receive back in return extra reserves.
The net financial assets in the private sector are in fact unchanged although the portfolio composition of those assets is altered (maturity substitution) which changes yields and returns.
In terms of changing portfolio compositions, quantitative easing increases central bank demand for "long maturity" assets held in the private sector which reduces interest rates at the longer end of the yield curve. These are traditionally thought of as the investment rates.
This might increase aggregate demand given the cost of investment funds is likely to drop. But on the other hand, the lower rates reduce the interest-income of savers who will reduce consumption (demand) accordingly.
How these opposing effects balance out is unclear but the evidence suggests there is not very much impact at all.
But this increased lending (if it happened) would not be the result of banks having more reserves. Rather it was because lending rates had fallen and more credit-worthy borrowers were willing to seek credit. In times of recession, confidence among prospective borrowers is low and so the demand for loans is weak, irrespective of the price of credit.
However, mainstream economists think that the demand for loans is weak in recession because the banks lack reserves and assert that by providing those reserves, QE increases the capacity of the banks to make loans. That is a major misrepresentation of the way the banking system actually operates.
Banks do not operate like this. Bank lending is not 'reserve constrained'. Banks lend to any credit worthy customer they can find and then worry about their reserve positions afterwards. If they are short of reserves (their reserve accounts have to be in positive balance each day and in some countries central banks require certain ratios to be maintained) then they borrow from each other in the interbank market or, ultimately, they will borrow from the central bank through the so-called discount window. They are reluctant to use the latter facility because it carries a penalty (higher interest cost).
The point is that building bank reserves will not increase the bank's capacity to lend. Loans create deposits which generate reserves.
So in saying that the answer to the question is false, we are not giving a green light to the validity of the QTM, which should be abandoned as theory of inflation in a modern economy.
The fact that large scale quantitative easing conducted by central banks has not caused inflation does not provide a strong refutation of the mainstream QTM largely because QE has not impacted on the broader monetary aggregates.
In other words, the 'test' of the QTM wasn't properly constructed.
The QTM is unreliable for other reasons. Even if the money supply rises, firms will likely respond to the rising nominal spending by increasing output. And that is separate from the shifts in velocity (V) that also occur.
A properly constructed validation of the QTM would require inflation to accelerate every time the money supply increased. That doesn't happen.
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