The future of monetary policy?

Over the last year, the Covid pandemic has caused a shock to the global economy with ramifications that will be felt for years. During the same period of time, the federal government has issued $6 trillion in stimulus packages designed to keep the economy, and country, functioning. But where did that money come from?

Within economic circles, Quantity Theory is widely accepted as the primary method to explain how new money introduced in an economy affects prices within that economy. Simply put, the prices of goods are directly related to the amount of money in circulation. As more money is printed, prices go up, as money is retired (or taken out of circulation), there is less money in the economy and prices fall. Quantity Theorists also believe that the amount of money in circulation is directly proportional to the price of goods; double the money, double the prices.

For argument's sake, assume that Quantity Theorists are correct. US GDP (gross domestic product) in 2020 was about $21 trillion (the overlap in stimulus packages and years can get complicated so for the sake of simplicity I will use rough estimates), the $6 trillion in stimulus money accounts for about 28.5% of the entire GDP for 2020. This equation gets even more complicated when considering that most 'money' in circulation is not actual printed bills. The Federal Reserve estimates that there about $1.5 trillion of notes in circulation and the rest is digital. Basically this all adds up to an extremely complex equation that not even the most brilliant mathematical minds and economists cannot come up with a solution that satisfies everyone. Let's assume that Quantity Theorists are correct and since there has been $6 trillion of new currency injected into the economy and therefore, there will be a corresponding increase of prices of goods eventually adding up to $6 trillion. Theoretically, this means that there will be a 28.5% increase in the price of goods in the coming years; this translates to massive inflation.

Recently, both Treasury Secretary Janet Yellen and Chairman of the Federal Reserve Jerome Powell have downplayed concerns about inflation as a result of the stimulus packages with Powell recently stating during a hearing, "We’ve been living in a world of strong disinflationary pressures for the past quarter century. We don't think a one-time surge in spending leading to temporary price increases would disrupt that". Yellen similarly explained that there are tools that can be used by the government to control the rise of inflation over the coming years.

Inflation in the US in 2019 was 1.8%. Even if it took 5 years to realize the impact of the stimulus packages, US consumers could expect to see about a 3X increase in the rate of inflation over that time period, that is if Quantity Theorists are correct. However, Quantity Theory, while widely accepted, is not the only theory that exists that could explain how new money will affect the economy, prices and inflation.

Recently a new theory, called Modern Monetary Theory (MMT) has emerged and the proponents of MMT hope that it will be the solution to the fiscal concerns of the Federal government. Rep. Alexandria Ocasio-Cortez has been at the forefront of the MMT movement, telling Business Insider in January that MMT "'absolutely' needs to be 'a larger part of our conversation'”. MMT, as the name suggests, is a new approach to monetary policy and it's proponents hope that it will be able to jumpstart the economy and get people back into the workforce through government spending. Furthermore, they believe that this might be accomplished without the usual accompanying rise in inflation. As Dr. Mike Walton of NC State explained the theory in a recent article, "MMT says if the government spending financed by newly created money makes the economy more productive – thereby leading to faster economic growth and more jobs and income – then the inflation rate won’t rise. In addition, a larger economy will make debt payments more affordable for the federal government."

While MMT sounds like a nice theory, it has been widely criticized by leading economists and other experts. Deficit spending runs counter to most established economic theory, but that is exactly what is happening. Like it or not, MMT looks like it is going to be tried. Within a few years the soundness of the theory will have been tested and it's viability as monetary policy will be established. Hopefully mainstream economic theory is wrong and with the massive government expenditures that have taken place and (with talk of further stimulus packages) will likely continue, inflation will be kept to a reasonable rate. It seems likely that an increase of inflation is imminent. That, by itself is not the main concern, the primary fear of economists is that inflation will become rampant and with it a devaluation of the US currency. As the Covid vaccine becomes more widely available and the US economy comes fully online, the monetary policies brought about by the pandemic will be realized, along with the benefits and detrimental aspects of those policies.