Inflation is, once again, a monetary phenomenon
15 March 2023
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The inflation of 2021-22 was a result of mistakes in monetary policy, not – as often claimed by government and central bank officials – the result of series of external shocks beyond the control of the UK authorities. Official explanations attribute the surge in inflation during and after the pandemic to factors such as the shift in demand from services to goods and the consequent shortages of items like electronic chips or cars; widespread problems with supply chains; or the war in Ukraine which triggered a surge in energy and food prices.
This official analysis is wrong because countries such as China, Japan, and Switzerland – which all suffered similar disruptions to their supply chains and similar changes in relative prices – have generally avoided inflation, subsequently experiencing only small increases in their overall price level. The distinguishing feature of policy in these economies in contrast to the UK and other inflation-plagued economies is that monetary growth remained under control.
There is a strong case for saying that inflation should primarily be attributed to the Bank of England and the excessive monetary growth that its Monetary Policy Committee (MPC) initiated from March 2020.
I argue first, that the Bank of England’s existing approach fails to ensure that policy remains consistent with the avoidance of either inflationary or deflationary conditions. Second, I propose an alternative monetarist framework which ensures that excess (or inadequate) money growth is not permitted in future.
Monetary policy failure during the pandemic can be linked to the Bank of England’s aggregate demand/aggregate supply (AD/AS) framework together with the MPC’s neglect of broad money growth.
A major problem with the AD/AS framework is that it is not sufficiently quantifiable to be tractable. Ideally, we would want a framework that enabled MPC members to be able to see clearly if policy was too tight or too easy. Instead, estimates of either aggregate demand or aggregate supply are simply too vague to offer good guidance for policy decisions.
Some theoretical tools that underpin the AD/AS approach suffer from similar problems of inadequate precision. Two notable examples are the output gap and the Phillips curve. The result is that MPC members vote for raising, lowering, or keeping Bank rate unchanged without adequate quantitative input as to how effective their decision is likely to be.
These problems are compounded by the MPC’s focus on interest rates as the key measure of the stance of monetary policy the MPC. Interest rates are unreliable as a measure of the stance of policy. I would argue, like Irving Fisher and Milton Friedman, that current interest rates are a result or symptom of past monetary growth, not solely a driver of future monetary conditions – except in the very short term.
An alternative way to operate monetary policy would rely on the quantity theory of money. It can be shown that there is a stable medium-term relationship between broad money growth (M4 to 1997 and M4x thereafter) and the growth of nominal GDP, and that the income velocity of circulation for M4x (i.e., the ratio of nominal GDP to broad money) has a stable downward trend.
Inflation outcomes could be significantly improved by shifting from trying to steer the economy using interest rates and occasional episodes of Quantitative Easing/Tightening to reliance on the relative stability of income velocity as a means of managing aggregate demand. Since aggregate demand is equivalent to nominal GDP, in turn the product of broad money and the value of income velocity, broad money growth could be managed so as to achieve the inflation target by generating an appropriate level of nominal GDP.
Three factors would need to be taken into account in managing broad money: the annual average expected real GDP growth rate, the trend value of income velocity (which is easily calculated from past records), and the inflation target.
Based on past data for the UK, maintaining broad money growth in the range 4-6% p.a. would be optimal, but short-term deviations in a wider range such as 2-8% p.a. could be tolerated. Since the relation between money and inflation is a medium term one, it would be a mistake to make a fetish of trying to hit a monetary growth target month by month.
John Greenwood’s analysis is developed more fully in his article ‘The monetary policy strategy of the Bank of England in 2020-21: An assessment’ in the latest issue of Economic Affairs. Journal subscriptions are available at
https://ordering.onlinelibrary.wiley.com/Lite/Subs.aspx?doi=10.1111/(ISSN)1468-0270&ref=1468-0270
This official analysis is wrong because countries such as China, Japan, and Switzerland – which all suffered similar disruptions to their supply chains and similar changes in relative prices – have generally avoided inflation, subsequently experiencing only small increases in their overall price level. The distinguishing feature of policy in these economies in contrast to the UK and other inflation-plagued economies is that monetary growth remained under control.
There is a strong case for saying that inflation should primarily be attributed to the Bank of England and the excessive monetary growth that its Monetary Policy Committee (MPC) initiated from March 2020.
I argue first, that the Bank of England’s existing approach fails to ensure that policy remains consistent with the avoidance of either inflationary or deflationary conditions. Second, I propose an alternative monetarist framework which ensures that excess (or inadequate) money growth is not permitted in future.
Monetary policy failure during the pandemic can be linked to the Bank of England’s aggregate demand/aggregate supply (AD/AS) framework together with the MPC’s neglect of broad money growth.
A major problem with the AD/AS framework is that it is not sufficiently quantifiable to be tractable. Ideally, we would want a framework that enabled MPC members to be able to see clearly if policy was too tight or too easy. Instead, estimates of either aggregate demand or aggregate supply are simply too vague to offer good guidance for policy decisions.
Some theoretical tools that underpin the AD/AS approach suffer from similar problems of inadequate precision. Two notable examples are the output gap and the Phillips curve. The result is that MPC members vote for raising, lowering, or keeping Bank rate unchanged without adequate quantitative input as to how effective their decision is likely to be.
These problems are compounded by the MPC’s focus on interest rates as the key measure of the stance of monetary policy the MPC. Interest rates are unreliable as a measure of the stance of policy. I would argue, like Irving Fisher and Milton Friedman, that current interest rates are a result or symptom of past monetary growth, not solely a driver of future monetary conditions – except in the very short term.
An alternative way to operate monetary policy would rely on the quantity theory of money. It can be shown that there is a stable medium-term relationship between broad money growth (M4 to 1997 and M4x thereafter) and the growth of nominal GDP, and that the income velocity of circulation for M4x (i.e., the ratio of nominal GDP to broad money) has a stable downward trend.
Inflation outcomes could be significantly improved by shifting from trying to steer the economy using interest rates and occasional episodes of Quantitative Easing/Tightening to reliance on the relative stability of income velocity as a means of managing aggregate demand. Since aggregate demand is equivalent to nominal GDP, in turn the product of broad money and the value of income velocity, broad money growth could be managed so as to achieve the inflation target by generating an appropriate level of nominal GDP.
Three factors would need to be taken into account in managing broad money: the annual average expected real GDP growth rate, the trend value of income velocity (which is easily calculated from past records), and the inflation target.
Based on past data for the UK, maintaining broad money growth in the range 4-6% p.a. would be optimal, but short-term deviations in a wider range such as 2-8% p.a. could be tolerated. Since the relation between money and inflation is a medium term one, it would be a mistake to make a fetish of trying to hit a monetary growth target month by month.
John Greenwood’s analysis is developed more fully in his article ‘The monetary policy strategy of the Bank of England in 2020-21: An assessment’ in the latest issue of Economic Affairs. Journal subscriptions are available at
https://ordering.onlinelibrary.wiley.com/Lite/Subs.aspx?doi=10.1111/(ISSN)1468-0270&ref=1468-0270
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