By Satyajit Das, author of Extreme Money: The Masters of the Universe and the Cult of Risk (Forthcoming in Q3 2011) and Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives – Revised Edition (2006 and 2010)
Quantitative easing (”QE”), the currently fashionable form of voodoo economics favoured by policymakers in the US, is primarily directed at boosting asset values and creating inflation. By essentially creating money artificially, central bankers are seeking to return the world to stability, growth and prosperity.
The underlying driver is to generate growth and inflation to enable the problems of excessive debt in the economy to be dealt with painlessly. It is far from clear whether it will work
QE is designed to create inflation, at least just at the correct level. Given that one of the objectives of central banks is to keep inflation under control, it is ironic that they now want to create more inflation. Higher inflation would reduce the value of debt. Inflation may also induce more consumer spending, as people accelerate purchases, anticipating higher prices in the future.
The ability of QE to generate inflation relies on Milton Friedman’s observation that “inflation is always and everywhere a monetary phenomenon.” The quantity theory of money holds that the supply of money multiplied by velocity (the rate at which it circulates) equals nominal income, the product of real output and prices. Increasing money supply increases nominal income, boosting real output and/ or prices.
The role of money supply in inflation and economic activity is complex. Cause and effect is uncertain – does money supply influence nominal income or does nominal income affect velocity and the demand for and thereby the supply of money? Central banks control the monetary base, a narrow measure of the money supply made up of currency plus the reserves that commercial banks hold with the central bank. The relationship between the monetary base, credit creation, nominal income and economic activity is unstable.