Why is deflation a likely short-term of an increase in M2?

The year-on-year growth in M2 — a broad measure of US money supply — has rocketed this year due to the efforts of monetary and fiscal policymakers to reduce the economic damage caused by the pandemic. Although the severity of the shock makes deflation the most likely short-term outcome, Mr Wilson argued that there is now a “greater likelihood for inflationary pressures to build”. Source: Financial Times, August 10th, 2020.

What fact in macroeconomics explain deflation being the most likely short-term outcome of an increase in M2? A reference would be appreciated. Thank you.

1 Answer

None, you are misreading the passage. The paragraph does not say that increase in M2 will lead to deflation.

As the paragraph clearly states the deflation is most likely because of the severity of the 'shock'. Shock here is not the increase in the money supply it is the recession. Fall in real output is deflationary.

According to standard textbook equation of exchange (see for example Blanchard et al Macroeconomics an European perspective) price level $$P$$ is given by:

$$P=MV/Y$$

where $$M$$ is money supply, $$V$$ velocity and $$Y$$ output. This equation is an oversimplification as in more advanced models also expectations of these variables and other factors play a role (see Romer's Advanced Macroeconomics or Krugman (1998)), but for this question more complex model would arguably be an overkill.

As the equation shows price level (change of which gives you inflation) increases with $$M$$ but also decreases with $$Y$$. The article in the Financial Times simply states that although $$M$$ increased considerably deflation is still expected due to the fall in $$Y$$ (i.e. the shock).

• Right on. I didn't see the shock was being referenced. The references have been very nice. Thank you! (For the record, the simplified model seems to be given in chapter 8 of Blanchard et al. and further discussed in chapter 10.) – user12406990 Aug 13 at 4:51