MonetaryPolicy,Money,andInflation.pdfVIP

FRBSF ECONOMIC LETTER 2012-21 July 9, 2012 ? Monetary Policy, Money, and Inflation BY JOHN C. WILLIAMS Textbook monetary theory holds that increasing the money supply leads to higher inflation. However, the Federal Reserve has tripled the monetary base since 2008 without inflation surging. With interest rates at historically low levels and the economy still struggling, the normal money multiplier process has broken down and inflation pressures remain subdued. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Western Economic Association International on July 2, 2012. I’m very pleased to be in such eminent company, especially that of my former advisor at Stanford, John Taylor. And I’ll begin my presentation with a reference to another pathbreaking monetary theorist. Milton Friedman (1970) famously said, “Inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output” (p. 24). We are currently engaged in a test of this proposition. Over the past four years, the Federal Reserve has more than tripled the monetary base, a key determinant of money supply. Some commentators have sounded an alarm that this massive expansion of the monetary base will inexorably lead to high inflation, à la Friedman. Despite these dire predictions, inflation in the United States has been the dog that didn’t bark. As Figure 1 shows, it has averaged less than 2% Figure 1 over the past four years. What’s Inflation more, as the figure also shows, % surveys of inflation expectations 5 indicate that low inflation is anticipated for at least the next ten 4 years. 10-year 3 forecast In my remarks, I will try to reconcile mone