During the financial crisis of 2008-09, many central banks expanded the monetary base. In some countries, the base remains high; in the United States, for instance it is roughly triple its pre-crisis level. Such an expansion, unprecedented in peacetime, has convinced many observers that a bout of high inflation will occur in the near future. That leads us to the lesson of the day:
To talk intelligently about the money supply, you must also consider the demand for money. Starting from a situation where supply and demand are in balance, the supply can triple, but if demand quadruples, money is tight. Similarly, the supply can fall in half, but if demand is only one-quarter its previous level, money is loose.
In normal times, it is a fairly safe assumption that demand is roughly constant or changing predictably, but in abnormal times, it is a dangerous assumption. No high inflation occurred in any country that expanded the monetary base rapidly during the financial crisis. Evidently, demand expanded along with supply. In fact, Scott Sumner and other “market monetarists” think supply did not keep up with demand. Similarly, nobody should be perplexed if a case arises where the monetary base is constant or even falling but inflation is rising sharply. Absent a natural disaster or some other nonmonetary event, it is evidence that demand for the monetary base is falling but supply is not keeping pace.