There are many theories about inflation that are more or less meaningful. Some economists see inflation as a result of cost pressures. If costs rise in the supply chain, companies pass them on until the effect is reflected in general price increases.
Others, notably the Keynesians (economists who see aggregate demand as the determinant of output and employment), emphasize fluctuations in demand and rely on how they are managed.
Still other economists point out that the inflation rate is not being measured correctly and, above all, the rising prices of assets – especially real estate – should be included in the measurement of inflation. And then there are those who attach importance to globalization and deglobalization and demographics.
Each of these inflation theories has worked in the past, but not always. This also applies to a theory that has lost much of its influence in recent decades: monetarism. According to the economic concept, an increase in the money supply due to an expansive financial policy alone causes inflation. Expectations play a crucial role in modern theories.
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Critics of the money supply theory of inflation rightly emphasize that the correlation between the growth of the money supply and the inflation rate has decreased significantly in recent decades.
Inflation: Renaissance of Monetarism
In addition to a significant decline in the velocity of money in circulation, this is due to the factors of globalization and demographics and the aspect of the significantly increased lending to acquire assets. The other theories were just better.
2020 may have been the year in which monetarism began a renaissance. Anyone paying attention to the development of the broad money supply could see that inflation would return more vigorously and more sustainably.
At its peak, the M2 money supply in the US grew at an annual rate of 27.5 percent. M2 includes cash in circulation and overnight deposits at commercial banks (M1) as well as time deposits and savings deposits.
In the euro zone, M2 growth was significantly lower at 11.5 percent, but still more than twice as high as in previous years. That money fueled demand, which combined with supply-side problems was bound to lead to higher inflation.
What happens now? The rates of monetary growth have fallen significantly since the beginning of 2022. This suggests that inflation rates will soon peak and that we will return to normal values.
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Of course, as with any forecast, there are risks. It may take longer for the money overhang to be reduced, further supply shocks are imminent. However, the latter are more likely to endanger the economy than give inflation a further boost.
The central banks, which laid the foundation for inflation, risk further slowing down an economy that is already in a downturn.
More: What is inflation? Definition, examples, meaning