Intro: The link between inflation, the money supply, and real GDP growth is complicated by changes in the demand for people to hoard money, something which has become loosely known as velocity. Increases in the money supply may not necessarily be inflationary if people are willing to hold onto the money as a store of wealth.
In theory, if the definition of inflation is too much money chasing too few goods, then inflation should be able to be predicted by the difference in the growth rate between money supply and real GDP growth. However, in reality the equation rarely, if ever holds. One issue is in defining money itself and as we have illustrated previously (see The Importance of Money Supply in Driving Inflation) this should be extended to include government liabilities such as bonds. Another issue relates to the demand for money.
Individuals can chose to buy goods and services today or hoard the money and buy goods and services in the future. If people on aggregate wish to draw down their cash balances and purchase more goods and services today, attempts to do this will act as an inflationary force. (This is often known as an increase in velocity as it is thought that people spend the money that they have faster. In reality, the speed at which transactions take place is irrelevant, what matters is that people are reducing their willingness to hoard and increasing their willingness to spend.) As a result, prices can rise even in the absence of a rising money supply if people simply become more eager to spend the money they already have.
Demand for money, or the willingness of individuals to hoard, is a major factor explaining why strong real GDP growth in developed markets can often be inflationary despite the direct disinflationary force of increased goods and services. It can also help explain why emerging markets have higher rates of inflation on average.
Why Strong Growth Can Often Appear to be Inflationary
During periods of strong economic growth, factors such as improving economic confidence and rising asset prices can cause people to reduce their demand for money (add in chart of SPX vs Breakevens) as the need for precautionary cash hoarding is reduced. As the chart shows, the positive short-term correlation between equity prices and market-driven inflation expectations largely reflects this dynamic. Over the long term, strong growth is a deflationary force owing to the greater availability of goods and services, but over shorter cycles the impact of reduced money demand can dominate.
Why Emerging Markets Tend to Have Higher Inflation Rates
In contrast to most developed markets, emerging markets almost always experience higher inflation at times of economic weakness. One main reason for this is that in addition to the direct impact of slower real GDP growth on inflation, there is a behavioural impact whereby a history of high inflation causes a self-fulfilling prophecy. If people are accustomed to rising inflation during times of economic weakness, they will tend to reduce their hoarding and buy goods to anticipate prices rising. Alternatively, they may decide to hoard dollars or gold in anticipation of their currency weakening. As a result, prices will tend to rise. It is sometimes the case that inflation rates rise even amid rising real GDP growth and in the absence of rising money supply growth. The only possible explanation for this is that money demand is falling.