Did the Reserve Bank's money printing cause inflation? The bank says it's complicated

This is a sophisticated article so it is good to see it in the public prints. It omits mention of two important facts.

1). The banks initially got the new money. So what did they do with it? No mystery. They almost gave it away as low interest housing loans -- which rocketed up real estate prices, including rents. So that was a HUGE blow to the cost of living.

2.) Due to the lockdowns, there was a HUGE loss of available goods and services. There were far fewer goods and services for ANY money to buy. There was a big new mismatch between demand and supply. So what was available came at an increased price. So that too greatly increased the cost of living.

So between those two things, The increased money supply WAS largely responsible for inflation. It was not the only factor. Bad weather and Mr Putin also played a part in their own way

Do you remember how the Reserve Bank printed a huge amount of money in the pandemic? Have you been wondering if it's responsible for the inflation we're seeing?

The RBA says it's a complicated question to answer, and it's trying to encourage people to think more deeply about money itself. Here's what that means.

The bond-buying program

In late 2020, the RBA began buying hundreds of billions of dollars worth of government bonds.

It was an emergency stimulus measure. The program ran from November 2020 to February 2022, and saw the RBA buy $281 billion of federal, state and territory government bonds.

Last week, the RBA published a review of the program which found it broadly helped to support economic activity during the crisis.

However, there were a few passages near the bottom of the review that were very interesting.

They had to do with money printing.

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See, the RBA's bond buying was an exercise of "money printing" because the bank was creating money to buy the bonds.

To be more precise, it was waiting for Treasury to sell the government bonds to authorised investors (ie institutional banks), then it would buy the bonds from those banks.

And when it bought the bonds, it would pay for them by simply electronically crediting the accounts that those banks had at the RBA.

For example, let's say the RBA bought $100 million worth of bonds from a particular bank.

It would say to that bank, 'Here you go, we've gone to the computer and added an extra $100 million to your exchange settlement account. Thanks for the bonds."

The RBA's act of money printing clearly increased the supply of money in Australia. But the RBA says it didn't have a significant impact on the overall supply of money. What does that mean?

Well, think of what qualifies as money.

Money comes in many different forms. It comes in the form of currency (notes and coins), and savings deposits, and term deposits, and a bunch of others.

Consider what happens when you withdraw currency from an ATM: the value of your currency holdings increases, and the value of your deposit holdings decreases, but the stock of "broad money" in the economy doesn't change.

So, when we talk about an increase in the supply of money, we need to be clear about what type of money is increasing, and how that's impacting the overall supply.

And we also need to know if the extra supply of money is actually being spent, or if it's being stashed in savings accounts or under peoples' beds where it won't be adding to inflation.

It won't add to inflation if it's not being used to buy anything. Which brings us back to the RBA's bond buying.

The Quantity Theory of Money

In the RBA's review of its bond purchase program (BPP), it's defended itself against accusations that its "money printing" is largely responsible for the inflation we're experiencing now.

It says some people have been drawing on a theory popularised by Milton Friedman that links inflation to the rate of growth of the money supply.

According to that theory, if you assume money circulates in the economy at a constant rate (ie a constant "velocity"), then a large increase in the money supply, owing to the bond-purchase program, would lead to a sharp increase in inflation.

But the RBA says the world's not that simple. Why? Because the "velocity" of money isn't stable, for one. It's been falling for decades in Australia, and it crashed in the pandemic when people couldn't leave their homes and there were fewer opportunities for money to circulate in the economy. That's why the RBA began buying bonds in the first place, to push more money into the system.

Now, you get the velocity of money by dividing nominal GDP by broad money.

Broad money, as the name implies, is the broadest measure of money that includes every type of money in the economy (I've produced a table below that shows the different types of money).

Eagle-eyed readers may notice that, according to the graph above, the velocity of money has actually picked up a little recently.

That suggests broad money has started circulating through the economy at a faster pace, after lockdowns ended.

Wouldn't it follow from that, with so much extra money in the economy and with people starting to spend that money more quickly, inflation would obviously be picking up?

Well, again, the RBA says it's not that simple. It says its bond purchase program only significantly increased a particular kind of money, and we need to understand how that type of money can be spent.

"While inflation has increased following the bond-purchase program, it is not clear that this can be explained by the Quantity Theory," the RBA review says.

"Different components of the money supply can move independently over time. "While the bond purchase program led to a sharp increase in exchange settlement (ES) balances and thus 'base' money, the increase in the broader money supply, which is relevant for nominal expenditure in the economy, was not as large," it says.

So, what exactly is "base" money?

The RBA makes a distinction between different kinds of money depending on how accessible the money is.

If you're able to get your hands on the money quickly to spend it, it's considered "liquid."

For example, the cash in your pocket is extremely liquid, but the money in your term deposit isn't as liquid because it can take time for you to gain access to it.

That's why central banks categorise money into different "monetary aggregates" to reveal what type of money is in an economy, and who has access to it.

That's the category of money that experienced a sharp increase in supply from the RBA's bond-buying program.

When the RBA bought the government bonds from banks in the secondary market, it credited the banks' ES accounts which are held at the RBA, and those balances, which are a form of money, fall into the category called "money base."

As you can see from the table above, the value of the entire supply of "money base" money was $550 billion in July.

In February 2020, it was worth $116.2 billion. So, the supply of that specific category of money has increased by $433.8 billion since the pandemic began. Meanwhile, the supply of broad money - which captures all money in the economy - has increased by $624.3 billion.

That means the increase in base money accounted for 70 per cent of the increase in the economy's entire money supply during the pandemic.

And crucially, that "base" money wasn't put into the deposit accounts of individuals who could freely spend it. It was initially put into the ES balances that large financial institutions held with the Reserve Bank.

It was up to those institutions how they spent it. They could try to lend it to other people, or they could try to invest it in other assets, or they could use it to buy their own bonds, or whatever.

And it's not like they can collectively rush out and spend it all at once, keeping other things equal, because they still have to satisfy their liquidity requirements with the regulator.

In other words, the financial system is complicated. According to the RBA, it's wrong to simply assume that its money printing was a big driver of this inflation.


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