08 November 2023
Over the last few years, the economic headlines have been dominated by inflation and differing economic performances. While we will all have heard of monetary supply, inflation and the redistribution of wealth, how are these interconnected?
In simple terms, monetary supply is the total of currency and liquid assets in the country's economy at any moment. This includes everything from cash in circulation to bank deposits and other liquid assets, which can be converted into cash relatively quickly. Central banks use cash in circulation and short-term debt instruments such as treasuries to increase or reduce monetary supply. So, how does monetary supply impact inflation?
As we have seen in recent times, trying to control inflation is no easy task with so many different variables, many of which are out of the control of governments and central banks. However, there is a direct link between monetary supply and inflation, although there may be other issues to consider.
Central banks dictate the base rate - the interest they pay banks and financial institutions for their funds held on deposit. It is also the rate for the loan of government money to banks and financial institutions to part fund their lending activities. If the rate for banking deposits and lending facilities is low, this discourages banks and financial institutions from holding funds on deposit while encouraging them to increase lending to businesses and consumers.
This, in turn, filters through to increased consumer demand, which, if higher than the availability of goods and services, leads to upward pricing pressure.
The easiest way to reduce monetary supply is to increase the base rate. This encourages banks to deposit funds with the central bank but discourages them from borrowing, thereby reducing consumer/business lending. Reducing the level of funding available to businesses and consumers will reduce demand. Productivity won't necessarily slow as quickly as monetary supply, leaving an excess of goods and services, prompting price weakness.
While there are many challenges when looking to control inflation via monetary supply, one of the main issues is the time lag. As we have seen with the recent fight against inflation, it can take months for the full impact of interest rate movements to be felt in the supply/demand ratio, even if monetary supply can change relatively quickly.
It is very easy for central banks to continue to either increase or reduce base rates without giving time for historic changes to have an impact. When the impact does come, it can cause significant volatility in the economy, with the effect of more recent interest rate changes storing up yet more issues. Is this why many central banks decided to “take a breather” with their policy of interest rate rises to tackle inflation?
One of the significant impacts of inflation is wealth redistribution. Recent data from the World Economic Forum shows that since 2020, the top 1% have acquired two-thirds of the $42 trillion in “new wealth”. So how does this work?
As they say, wealth is not created; it is just redistributed, an expected impact of high inflation. While there are many technical ways of looking at this issue, this is a simple example of how it works:-
Inflation: 10%
Household income: £30,000
Assets: Zero
In this situation, to maintain their spending power, the household income would need to rise to £33,000. Therefore, without any increase in income their spending power is reduced by £3000. While inflation would also increase the value of assets, with no assets held by this family, there is no benefit.
Inflation: 10%
Household income: £100,000
Assets: £6 million
To maintain the same level of spending power, the household income for family B would need to increase to £110,000. If we assume this is not possible then they are £10,000 worse off due to inflation. However, with £6 million in assets, as a consequence of inflation, this would be worth £6.6 million. The net benefit is an increase in wealth of £590,000 against a loss of £3000 in spending power with family A.
Using the concept that wealth is transferred, not created, for family B to benefit by £590,000, this would need nearly 200 family As to suffer.
While we have simplified many of the issues above, this does give you an idea of how monetary supply impacts inflation, which then leads to the redistribution of wealth. It is also worth noting that rising inflation will tighten household budgets amongst the poorest in society, with many eventually going under. The financial losses of those going under are redistributed to those further up the food chain. In theory, the more hard-hitting the recession, the greater the level of wealth redistribution in the higher echelons.
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