Is economic growth inflationary? Many economic and political commentators think so. Nick Timiraos of the Wall Street Journal, for example, writes that “easier financial conditions [loose monetary policy] stimulate spending and economic growth.” Some monetary policymakers agree. Mr. Timiraos later describes the views of a Fed official who “prefer[ed] to find a rate level that restricted economic growth enough to lower inflation.”
This is a two-part argument: Loose monetary policy causes prices and total spending to increase, which in turn causes economic growth. While I dispute that we should think about monetary policy in terms of interest rates, I agree that loose monetary spending causes prices and total spending (nominal income, NGDP) to rise. But it does not follow that higher inflation is associated with greater economic growth. In fact, the opposite is true: Economic growth puts downward pressure on prices, all else being equal.
Let’s start with the equation of exchange, MV=PY. The money supply (M) multiplied by its average rate of turnover (V) equals nominal GDP (PY). Nominal GDP is itself the product of the price level (P, the inverse of the dollar’s purchasing power) and real GDP (Y, actual goods and services). In growth rates, this becomes gM+gV=gP+gY. When nominal income growth (gP+gY) is positive, it must be the case that the money supply is growing (gM>0), that money is changing hands faster (gV>0), or both.
There are two ways to model looser monetary policy. If the Fed is printing more money, gM will rise. If the Fed lowers interest rates by cutting interest paid on reserves, money turnover will increase, implying gV will rise. Either way, nominal income (gP+gY) goes up, too. But what’s the balance between inflation (gP) and economic growth (gY)?
In the short run, gY may increase. Businesses will observe sales growth. Laborers will see their nominal wages rise. The increase in nominal spending makes producing look more attractive. But this effect is temporary. Once the economy discovers the monetary origins of the boom, things will start to cool off. In the long run, gY depends on productivity. If we want to produce more real goods and services, we need to get better at turning inputs into outputs. One way to do this is to acquire more labor, capital, and natural resources. A better way is to come up with new ideas: better recipes for turning inputs into outputs. These can be complemented by investments in human capital, which make a given labor supply more productive. Notice that none of these factors depend on money, interest rates, or inflation. It is all about the supply side of the economy. We can’t consume goods and services that haven’t been produced.
The long-run effect of looser monetary policy is higher inflation (gP), not higher economic growth (gY). This is an important result in economic theory. You can’t make a nation richer by printing money. The best you can do is prevent the economy from falling into a recession caused by a spike in liquidity demand (fall in gV). Keeping the economy along its trend growth path, however, is not the same thing as setting the growth path itself. Monetary policy isn’t about economic growth.
Given supportive supply-side policies (moderate taxes, predictable regulation, and a general legal environment supportive of private property and freedom of contract) innovation will cause growth to rise independently of monetary policy. In the growth-rates version of the equation of exchange, higher productivity manifests as faster real output growth (gY) without any corresponding change in money growth (gM) or velocity growth (gV). But the equation still must balance: gM+gV=gP+gY. Thus, if gY rises while gM and gV stays the same, it must be the case that gP falls. At minimum, economic growth is disinflationary. And if the productivity increases are big enough, it may even be deflationary!
We have nothing to fear from supply-side disinflation or deflation. This is the benign effect of comparatively less money chasing comparatively more goods and services. A general slowdown in price hikes sends a valuable signal: Money goes further because the economy is more productive.
The conventional wisdom is wrong because it neglects the supply side. If your theory of monetary policy begins and ends with aggregate demand, you’ll mistakenly think growth is inflationary. A realistic appraisal of the determinants of economic productivity shows that growth eases, not intensifies, pricing pressures.
This doesn’t mean that economic growth is a strategy for fighting inflation, of course. We should want more growth regardless of what’s happening to gP. Nevertheless, it’s important we should get the basic economic relationships right when discussing monetary policy. Economic growth isn’t inflationary. Journalists and central bankers should stop saying otherwise.