Monetarism making a comeback?

By Amol Agrawal

Monetary policy is understood as an economic tool that adjusts money supply and interest rates of a nation to achieve macroeconomic stability in a country. Needless to say, money is central to monetary policy. However, over the last 30 years, it has been marginalised in the formulation of monetary policy. Now, due to recent developments, it is staging a comeback, and we need to understand this recent turn of tide in monetary policy.

Post WW-II, the focus was on fiscal policy as countries tried to restructure their economies. Monetary policy, despite its importance, remained in background. The high inflation of 1970s put the spotlight on monetary policy.

Milton Friedman was central to this pivotal shift from fiscal policy to monetary policy. Drawing insights from the works of Scottish philosopher David Hume, Friedman pointed that money growth eventually leads to inflation. Thus, it was very important that monetary policy and central banks create only so much money as what helps the economy grow. Anything more or less will lead to high or low inflation.

The next objective was to measure money supply, as without measurement, one cannot work on Friedman’s ideas. By the middle of the 20th century, money was not just limited to currency notes and coins but also deposits created by banks, post offices, and other entities. Accordingly, economists categorised measures of money as M1, M2, M3, etc, based on liquidity. M1 typically comprised currency and highly liquid deposits, M2 comprised M1 and less liquid deposits and so on. Each country had its own monetary aggregates, as these were called, and measures depending on the banking system and banking products.

Central banks adopted a framework called monetary targeting where they targeted a particular measure of money supply to control inflation. After some initial successes, the monetary targeting framework did not work as per expectations. The main reason was that the targeted money supply measure never really captured the supply of money in the economy. Further, financial innovations meant that some new forms of money were not being measured. Former Governor of Bank of Canada Gerald Keith Bouey famously said, “We didn’t abandon monetary targets, they abandoned us.”

The search for a new monetary policy framework led to development of inflation targeting (IT) in early 1990s, where the central banks targeted inflation and used interest rates and not money supply. Under IT, monetary aggregates were sidelined. Monetary policy did not have any role for money! Only European Central Bank kept focusing on monetary aggregates, but that too came down over time.

From early 1990s to 2008, inflation trended lower and the success was attributed to IT and globalisation. From 2008 to 2020, the central banks in developed economies faced a new problem of having to generate higher inflation as inflation was lower than the targeted 2%. Even if price inflation remained low, few economists wrote on how asset inflation was high, and this was mainly because of money growth.

The tide of inflation changed once again post the pandemic and Russia-Ukraine war. Inflation touched record-high levels—last seen in the 1970s and 1980s—when monetary targeting was adopted. Central banks increased policy interest rates significantly. Some economists attributed the high level of inflation to the easy monetary policies post 2008.

This reversal of inflation tide and relative failure of IT central banks has brought the attention back to money. Bank for International Settlement economists, in an article, argued that there is a strong link between money growth and inflation during high inflation episodes. By looking at money growth, there would have been an improvement in central banks’ inflation forecasts. Isabel Schnabel of ECB highlighted how money growth still matters for inflation, especially when inflation is driven by supply shocks. The Governor of the Czech central bank has also spoken on how money matters for measuring inflation.

What do above trends and discussions imply? Just that we should never really dismiss core economic ideas. They come back in different forms. The role of money in inflation is one such core economic idea. However, ongoing digitalisation makes the older problem of measuring money even more difficult. Since the time money was discarded, money has transformed from physical to digital. We are already seeing how digitalisation has transformed the way we receive and pay money. Clearly, for money to make a proper comeback, it has to be measured properly and the earlier monetary aggregates need reworking.

What does the above mean for India? India has also transitioned from monetary targeting to inflation targeting. The RBI still computes monetary aggregates, but these do not carry much importance. The year 2023 marks the 25th anniversary of the committee which last measured monetary aggregates, under chairmanship of YV Reddy. To begin with, RBI could study the role of money in India’s inflation and properly measure monetary aggregates.

(The author teaches at Ahmedabad University)