Is Increasing the Money Supply Deflationary?

Is that even a question? Yes, it turns out; but a stupid one. I have never ever encountered an argument that increasing the supply of money, such as through QE, is deflationary, until I came across arguments from Stephen Williamson, a vice-president at the St. Louis Fed, that QE and zero nominal interest rates are deflationary.

Now when it comes to interest rates one should never reason from a price change. If conditions are so bad in the economy that the interest rate that would equalize savings with investment is negative, then yes, a 0% nominal interest rate target is contractionary, and potentially deflationary. And in order for nominal interest rates to be near zero in the long run there must be deflation, because the long run real return on investments, even safe ones, is positive. But that does not mean lowering interest rates causes the deflation. In order for people to frequently cart around umbrellas in the long run, there must be frequent rain.

Anyway, on to the dumber part: towards the end of last year Williamson made the argument, according to a mathematical model he drew up, that increasing the money supply would be per se deflationary. How? Here’s how he puts it without math:

Savers who hold assets care about the rates of return…different assets have different rates of return. Risk can explain some of that…[the] other factor is liquidity.

We can all understand that currency is more liquid than T-bills, in the sense that no one accepts T-bills in retail transactions, but currency is widely accepted. However… T-bills could be more liquid than currency in particular uses. For example …use as collateral in overnight repurchase agreements.

Ignoring risk, (which he spells out but I’m cutting down for space)

if the rate of return on asset A is higher than…asset B, then part or all of the explanation for this is that asset A is less liquid...In other words, the two assets can carry liquidity premia…with the liquidity premia on asset B being higher.

Given demand, an increase in the supply of available assets will cause the rates of return on all assets to go up, so as to induce savers to hold those assets.

In finance that’s another way of saying the price decreases when supply increases (higher rate of return reduces the net price savers pay for the investment).

A conventional open market purchase is basically a swap of money for short-term government debt. Under conventional conditions, the rate of return on short-term government debt is higher than the rate of return on money (the nominal interest rate is positive) 

Given that currency and U.S. Federal debt is considered essentially risk free that should be entirely due to different liquidity premia, with cash being more liquid. 

think about what happens in a liquidity trap… where the rates of return on money and short-term government debt are the same. The nominal interest rate is zero. Further, the rate of return on both of these assets is equal to minus the inflation rate.

Thus…the liquidity premia on money and short-term government debt are the same, and positive. 

What happens if there is an increase in the aggregate stock of liquid assets…? This will in general reduce liquidity premia on all assets, including money and short term debt.
Think supply and demand, given a demand for liquidity, more supply means a lower price for it. 

 Since the liquidity payoffs on money and short-term government debt have gone down, in order to induce asset-holders to hold the money and the short-term government debt, the rates of return on money and short-term government debt must go up. That is, the inflation rate must go down. Going in the other direction, a reduction in the aggregate stock of liquid assets makes the inflation rate go up.

What!? How? Why? How? How does one even make that leap? That’s just an equation of what it would take for an increase in money supply to be offset by an increase in money demand. It’s not economic reasoning at all; it’s what would happen if a calculator tried to be an economist.

Money is unique among assets, its value is 1 over the price level, or the value of goods and services it can be traded for. If you increase the supply of money without changing the value of goods or services it can be traded for, then the value of a unit of money must go down (inflation) proportionate to the increase in supply; it’s the monetary system that has value, not the specific quantity of money.

Why would individuals require deflation to hold extra money as Williamson says will happen, and how would that occur? In the simple model, as Professor Nick Rowe points out, the “quantity of money demanded is a positive function of the price level and a negative function of the expected rate of inflation.” As in the more inflation the more money one needs to perform the same transactions. The more expected inflation, the less money one wants to hold because it will lose its value faster. Williamson seems to be assuming that the price level can’t respond, so only deflationary expectations can cause adjustment.

Here’s how it really works: in the long run the price level increases by the same proportion as the money supply (inflation) and people require/demand more cash to perform the same transactions. The value, or price, of money falls, and the quantity demanded increases. 

And in the short run? Individuals aren’t required to hold that extra money, they don’t want to hold it, they value its liquidity relatively less because there is more of it. But society as a whole must hold the extra money, because no one’s gonna destroy it. So people spend the money to get rid of it, without needing to be any better off wealth wise. They may spend the money by investing it for example, or banks by loaning it. Nominal interest rates may fall as it's easier to borrow. Demand increases, but in the long run prices adjust and nothing has changed but the price level.

Also here’s a graph showing money supply growth and inflation from 1960 - 2000 produced by Marcus Nunes using Robert Barrow's 2008 macroeconomics textbook. Guess it’s just a mistaken correlation huh.