Money Supply and Price Inflation
In essence, PPP theory predicts that changes in relative prices will result in a change in exchange rates. Theoretically, a country in which price inflation is running wild should expect to see its currency depreciate against that of countries in which inflation rates are lower. If we can predict what a country’s future inflation rate is likely to be, we can also predict how the value of its currency relative to other currencies—its exchange rate—is likely to change. The growth rate of a country’s money supply determines its likely future inflation rate.9 Thus, in theory at least, we can use information about the growth in money supply to forecast exchange rate movements.
Inflation is a monetary phenomenon. It occurs when the quantity of money in circulation rises faster than the stock of goods and services—that is, when the money supply increases faster than output increases. Imagine what would happen if everyone in the country was suddenly given $10,000 by the government. Many people would rush out to spend their extra money on those things they had always wanted—new cars, new furniture, better clothes, and so on. There would be a surge in demand for goods and services. Car dealers, department stores, and other providers of goods and services would respond to this upsurge in demand by raising prices. The result would be price inflation.
A government increasing the money supply is analogous to giving people more money. An increase in the money supply makes it easier for banks to borrow from the government and for individuals and companies to borrow from banks. The resulting increase in credit causes increases in demand for goods and services. Unless the output of goods and services is growing at a rate similar to that of the money supply, the result will be inflation. This relationship has been observed time after time in country after country.
So now we have a connection between the growth in a country’s money supply, price inflation, and exchange rate movements. Put simply, when the growth in a country’s money supply is faster than the growth in its output, price inflation is fueled. The PPP theory tells us that a country with a high inflation rate will see depreciation in its currency exchange rate. In one of the clearest historical examples, in the mid-1980s, Bolivia experienced hyperinflation—an explosive and seemingly uncontrollable price inflation in which money loses value very rapidly. Table 10.2 presents data on Bolivia’s money supply, inflation rate, and its peso’s exchange rate with the U.S. dollar during the period of hyperinflation. The exchange rate is actually the “black market” exchange rate, because the Bolivian government prohibited converting the peso to other currencies during the period. The data show that the growth in money supply, the rate of price inflation, and the depreciation of the peso against the dollar all moved in step with each other. This is just what PPP theory and monetary economics predict. Between April 1984 and July 1985, Bolivia’s money supply increased by 17,433 percent, prices increased by 22,908 percent, and the value of the peso against the dollar fell by 24,662 percent! In October 1985, the Bolivian government instituted a dramatic stabilization plan—which included the introduction of a new currency and tight control of the money supply—and by 1987 the country’s annual inflation rate was down to 16 percent.10
TABLE 10.2 Macroeconomic Data for Bolivia, April 1984 to October 1985
Money Supply (billions of pesos)
Price Level Relative to 1982 (average = 1)
Exchange Rate (pesos per dollar)
Source: Juan-Antonio Morales, “Inflation Stabilization in Bolivia,” in Inflation Stabilization: The Experience of Israel, Argentina, Brazil, Bolivia, and Mexico, ed. Michael Bruno et al. (Cambridge, MA: MIT Press, 1988). Reprinted with permission.
Another way of looking at the same phenomenon is that an increase in a country’s money supply, which increases the amount of currency available, changes the relative demand and supply conditions in the foreign exchange market. If the U.S. money supply is growing more rapidly than U.S. output, dollars will be relatively more plentiful than the currencies of countries where monetary growth is closer to output growth. As a result of this relative increase in the supply of dollars, the dollar will depreciate on the foreign exchange market against the currencies of countries with slower monetary growth.
Government policy determines whether the rate of growth in a country’s money supply is greater than the rate of growth in output. A government can increase the money supply simply by telling the country’s central bank to issue more money. Governments tend to do this to finance public expenditure (building roads, paying government workers, paying for defense, etc.). A government could finance public expenditure by raising taxes, but because nobody likes paying more taxes and because politicians do not like to be unpopular, they have a natural preference for expanding the money supply. Unfortunately, there is no magic money tree.
The result of excessive growth in money supply is typically price inflation. However, this has not stopped governments around the world from expanding the money supply, with predictable results. If an international business is attempting to predict future movements in the value of a country’s currency on the foreign exchange market, it should examine that country’s policy toward monetary growth. If the government seems committed to controlling the rate of growth in money supply, the country’s future inflation rate may be low (even if the current rate is high) and its currency should not depreciate too much on the foreign exchange market. If the government seems to lack the political will to control the rate of growth in money supply, the future inflation rate may be high, which is likely to cause its currency to depreciate. Historically, many Latin American governments have fallen into this latter category, including Argentina, Bolivia, and Brazil. More recently, many of the newly democratic states of eastern Europe made the same mistake. In late 2010, when the U.S. Federal Reserve decided to promote growth by expanding the U.S. money supply using a technique known as quantitative easing, critics charged that this too would lead to inflation and a decline in the value of the U.S. dollar on foreign exchange markets, but are they right? For a discussion of this, see the accompanying Country Focus.