How money supply affects inflation

Source: How money supply affects inflation | The Herald 29 OCT, 2019

How money supply affects inflation

Beaven Dhliwayo Features Writer
In its July monthly economic review report, the Reserve Bank of Zimbabwe said sustained high inflation remains a real threat after Zimbabwe’s annual broad money supply soared 81 percent to $17 billion in the 12 months to July 2019 driven by growth in foreign currency accounts classified as transferable deposits.

This scenario is likely to maintain the heat on inflation, at a time prices also track exchange rate dynamics, which reached 175,5 percent by June this year from 5,39 percent in September 2018.

While money supply should at least track production (in tandem with the growth of the economy), Zimbabwe registered a 3,5 percent growth in 2018, but is projected to shrink between 3 and 6 percent this year, making high money supply growth highly inimical to inflation stability or even decline.

There is need to break this down and possibly find solutions to end the inflationary heat which many ordinary Zimbabweans are failing to keep up with.

In an interview with The Herald, chief economist at Equity Axis, a financial research firm, Respect Gwenzi, said money supply typically entails the collective levels of liquidity in an economy and for purposes of inflation it is normally base money (highly liquid) which fuels inflation.

“Base money is banks deposits held by the central banks as reserves added to currency in general circulation,” he said. “Once Government, through the central bank, sells its Treasury Bills in the open market to banks and other similar institutions, money supply expands and this has been the case with Zimbabwe over the last five years.

“The Government has deliberately sought to fund its budgetary deficits through selling its securities to the public and the net effect has been an expansion in money supply.”

Gwenzi said in July alone, money supply grew by over $2,7 billion from June levels and this growth means more ZW$ chasing lower or stable US$ balances.

“Worryingly, our US$ deposits base has been coming off and in July fell for the second consecutive month by a double-digit figure,” he said. “What then happens is that when money supply (ZW$) goes up against falling US$ balances, there is pressure on the exchange rate.”

What it implies is that the Zimbabwean market, which remains dollarised in practice, adjusts prices accordingly, and that is inflation.

But this is a longer route to inflation.

The simpler route is that once money supply goes up, there are higher liquidity levels in the economy to inspire increased demand for goods and services.

This deduction has a weakness in the current environment because consumers are already hard pressed and income levels very low such that increases in prices are not being matched by salary adjustments and worsened by purchasing power erosion.

Globally, there are several methods that are used to control inflation and some work well while others have negative effects.

For instance, controlling inflation through wage and price controls can cause a recession and loss of jobs. In this scenario, Treasury should implore what economists term a contradictory monetary policy.

The objective of a contractionary policy is to lessen the money supply within an economy by decreasing bond prices and increasing interest rates.

Subsequently, this helps shrink spending because with little money in circulation, those with money will want to save it, instead of spending it.

Moreover, this means that there is less available credit, a factor that can also reduce spending.

Zimbabwe should aim at reducing spending as it is vital during inflationary periods because it halts economic growth and, in turn, the rate of inflation.

The second instrument required to halt the abnormal inflation is to increase reserve requirements on the amount of money banks are legally required to keep at hand to cover withdrawals.

The more money banks are required to hold back, the less they have to lend to consumers. If they have less to lend, consumers will borrow less, which will decrease spending.

More importantly, Treasury should reduce money supply growth which is the reason for high inflation in the country.

There is need for the Government to directly or indirectly reduce the money supply by enacting policies that encourage reduction of the money supply.

This can be achieved by way of calling in debts that are owed to Government and also increasing interest paid on bonds so that more investors will buy them.

The latter policy raises the exchange rate of the local currency due to higher demand and, in turn, increases imports and decreases exports.

Such policies will reduce the amount of money in circulation because money will be going from banks, companies and investors pockets and into the Government’s pocket where it can be controlled as to what happens to it.

This is important to avoid what happened in 2008.

High Government debt, falling output and a need to print money to stave off a short-term crisis led to hyperinflation in November 2008.