Economics Stack Exchange is a question and answer site for those who study, teach, research and apply economics and econometrics. It only takes a minute to sign up.
Sign up to join this community
To my understanding classical economic theory tells us that inflation occurs when the money supply is increased faster than the economic growth.
Lately there has been a sharp rise in the rate of money supply, but GDP has not increased the last year:
M2 money supply and GDP for USA
However there has been no corresponding inflation (consumer price index) increase:
M2 money supply and CPI for USA
Why is this? Does the money accumulate somewhere, if so where?
This is because classical economic theory absolutely does not say that:
inflation occurs when the money supply is increased faster than the economic growth.
Even in most basic 101 models inflation depends on variety of factors. Inflation is determined by changes in price level which in turn depends on what the money market equilibrium is. This is given by equation of exchange (See Mankiw Macroeconomics pp 87) as:
$$MV=PY \implies \ln P = \ln M + \ln V− \ln Y$$
Where M is the money supply, V velocity of money, P price level and Y output. In the log-linearized version the effects of right hand side variables can be interpreted as % changes.
Even in this most simplest model your statement "inflation occurs when the money supply is increased faster than the economic growth" would only hold if velocity of money would be constant but in real life it is not. As you can plainly see from the data provided by Fed the velocity of money dropped drastically since the 90s which offests most of the increase in money supply during that period.
Lastly, the model above is still just the most simplistic 101 textbook money market model. In more realistic and complex models there are more variables that matter. For example, inflation expectations are absolutely crucial. Inflation will not move drastically if inflation expectations are well anchored (e.g. see Castelnuovo et al 2004; Kose et al 2019 or Lejsgaard & Grothe 2014 and sources cited therein for more info on the concept).
In addition, as famously shown by Krugman (1998) what matters is not just the actual change in money supply or other quantities but what are peoples expectations about changes in money supply and so on. An increase of money supply that is not credible to be permanent and expected to be quickly reversed will have no effect on inflation as if it would never even happen. Furthermore, Krugman also showed that when nominal interest rates are at zero lower bound (ZLB) even large monetary expansion won't necessary be inflationary. The reason for that is that if you would want to go significantly below ZLB the peoples will strictly prefer to hold cash and any increase in money supply will be completely offset by drop in velocity of money.
There are also further nuances to this but full overview of modern scholarship on this topic would be well beyond scope of SE answer. I recommend you to have look at Monetary Theory and Policy by Walsh or Woodford Interest and Prices and sources cited therein for state of the art models and more information on the matter.
The question, as I understand it, is about the reconcilliation of classical theory of inflation with empirical reality. Put in those terms, it's very interesting the concluding question:
"Does the money accumulate somewhere, if so where?"
The very possibility for money to accumulate somewhere is a serious problem for economics. In fact, it's attributed to M. Kalecki the claim that "economics is the science of confusing stocks and flows". The inability of handle with stocks or, put in other way, the need to balance flows, has puzzled mainstream economics long ago --neccessary balance of flows is, for example, the root of the so-called Say's law--.
Krugman --quoted in other answers to this question--, for example, has reckoned his inability to understand the role of money creation in the purchasing power creation (see here or here), due to the unability or lack of will to handle with stocks.
But the fact is, if you take into account the existence of stocks, for example of money, --as you do in the question-- the possibility of hoarding eliminates any difficulty considering more money supply not automatically meaning effective demand, nor the oppossite. Ashtoundingly simple.
You can read more on these issues googling for "stock-flow consistency".
When you say there has been a sharp rise in the money supply I will assume that you are referring to the period since 2020 March. The CPI does not include home prices and stock prices, which have increased significantly. The CPI includes consumption items and services and rent. In retrospect it appears that it was easy enough to increase the quantity of virus protecting masks and food delivery services and data bit moving services along with the increase in demand. If both increase together there is not necessarily inflation. Liquid fuel and flights and hotel stays experienced price decreases.
Money has been accumulating in deposits at the Fed and the Fed is paying interest. In addition to that there are deposits at banks that do not have accounts at the Fed so those amounts would be in addition to what is in this graph.
Currency in circulation has also increased. If it changes hands it can still be said to have been accumulated by the set of all entities that are not the Fed.
FRED graph called Velocity of M2 Money Stock shows that the money stock M2 does not hold a constant ratio to flow of nominal GDP:
https://fred.stlouisfed.org/series/M2V
This article Money, Credit, and Velocity (May 1982) makes statements concerning velocity of money that may be inaccurate when considered over long periods of time, however, it accurately describes some realistic features of money and credit markets:
https://files.stlouisfed.org/files/htdocs/publications/review/82/05/Money_May1982.pdf
In contemporary market economies, the money supply grows through two types of credit transactions: the central bank creating deposits (money) and bank reserves by buying government securities, and depository institutions creating deposits (money) from increased reserves by granting loans.
Of course, not all credit extensions entail monetary expansion. There are three distinct sources of credit extension: (1) bank and non-bank depository institution’s (commercial banks, savings and loans, credit unions, mutual savings banks); (2)non-depository financial intermediaries (finance companies, investment banks, brokerages, insurance companies); and (3) sellers of goods (retail and trade credit).
In the first case, a depository institution lends money to a borrower who in turn uses these funds to purchase goods or repay debts; the credit extension entails monetary expansion of purchasing power because it consists of checkable deposit expansion. During the last three decades, loans by such depository institutions have accounted for between 35 and 50 percent of the annual total of credit market funds extended to the non—financial sector. Alternatively put, more than half of the credit extended annually in U.S. financial markets does not entail deposit expansion.
In the second case, a non—depository institution (e.g., a consumer finance company) issues the credit or buys the accounts receivable of a credit—issuing seller. The latter method of credit extension is called factoring, and non—depository institutions fund this activity by either selling debentures directly or by acting as an agent for a depository institution. Under either method, the extension of credit does not entail an expansion of deposits but a reallocation of existing deposit holdings.
Finally, in case three, credit may be extended directly by the seller of goods and held as accounts receivable. Often this credit is financed by the sale of commercial paper issued by the seller/credit—issuer (e.g.,firms with their own financial subsidiaries such as Sears or General Motors). In these instances, whether the firm holds its own accounts receivable, factors its accounts receivable or sells commercial paper, the extended credit represents an increase in purchasing power not created by checkable deposit expansion.
This article argues that capital gains transactions, for assets that were produced in the past and not measured as part of current nominal GDP, should not count as income and do not count in nominal GDP:
https://taxfoundation.org/should-capital-gain-be-considered-income/
The Bureau of Economic Analysis (BEA), one of the principle statistics reporting agencies for the U.S. economy, does not include capital gains or losses in their National Income and Products Accounts (NIPA), from which GDP is calculated. The BEA reasons: “Capital gains and losses are not included in NIPA measures, because they result from the revaluation and sale of existing assets rather than from current production.” In other words, a change in the sale price of an asset does not add or subtract from the goods and services produced in the United States today.
When banks offer credit to purchase assets in the secondary market these transactions would tend to increase bank credit, and M2 money stock, but would have no impact on the income NIPA describes as the nominal GDP. There are many transactions that would tend to increase or decrease M2 that are not coupled in any way to the current flow called the nominal GDP.
If aggregate demand is driven at the margin by market credit and government policies then inflation or deflation are caused by complex credit and money market activities, in primary and secondary markets, also coupled with central bank policies and fiscal policies. Then the Velocity of M2 Money Stock would simply be a ratio V = GDP/M2 calculated as a residual outcome of the complex financial system.
