How Money Supply Works
When commentators say the Fed is "printing money," what actually happens? The answer is more nuanced than it appears, and the nuance is precisely what explains why trillions in new central bank money did not always produce consumer price inflation.
The Transmission Chain
Central Bank
buys bonds from
Commercial Banks
receive reserves, can lend to
Businesses & Consumers
spend on
Goods & Services (CPI) or Financial Assets (asset prices)
The critical insight: the chain can break at any link. Reserves are not the same as deposits; deposits are not the same as spending; and spending may flow to goods, services, or financial assets in very different proportions depending on the institutional and macroeconomic context.
Quantitative Easing (QE)
In QE, the central bank purchases government bonds (and sometimes corporate bonds or mortgage-backed securities) from financial institutions. This:
- Increases bank reserves at the central bank. These are an asset of the banking system but not directly spendable by households.
- Lowers long-term interest rates through supply reduction: bond prices rise, yields fall.
- Compresses risk premia across asset classes via the portfolio balance channel (Tobin, 1969; Bernanke, 2020).
Bank reserves are not the same as money in the real economy. Commercial banks still require creditworthy borrowers willing to take on debt. After 2008, credit demand was structurally weak as households and businesses deleveraged (Mian and Sufi, 2014).
M2: The Broader Money Supply
M2 includes:
- Physical currency in circulation
- Demand deposits (checking accounts)
- Savings deposits and money market funds
- Small time deposits
M2 grew steadily after 2008, averaging roughly 6% annually, but exploded in 2020 when fiscal stimulus deposited money directly into household bank accounts. This is the critical distinction:
- QE alone: reserves accumulate in the banking system, primarily affecting financial asset prices through portfolio rebalancing.
- QE combined with fiscal transfers: money reaches consumers directly, stimulating aggregate demand and eventually CPI (Reis, 2021).
The velocity of money (V = nominal GDP / M2) fell persistently after 2008, reflecting the fact that newly created M2 was largely saved or invested rather than spent on goods and services. Only when fiscal transfers reached liquidity-constrained households did velocity stabilize and CPI respond.
The Evidence
On the U.S. Dashboard, compare:
- M2 Money Supply: note the sharp ramp starting in March 2020.
- Federal Reserve Total Assets: the Fed's balance sheet as a proxy for cumulative QE.
- CPI: consumer inflation spiked only after fiscal transfers added to QE in 2020-2021.
The correlation between Fed total assets and equity valuations is visually striking across the QE era. The correlation between Fed total assets and CPI is much weaker, until the fiscal channel activated in 2020.
The Money-Inflation Link: Regime-Dependent
The BIS (2023) found that money growth carried useful forecasting information for inflation during 2021-2023, but was much less informative during the low-inflation decade of the 2010s. This is consistent with a threshold or regime-switching model: the money-CPI link reactivates when money growth exceeds a critical level and reaches spending-constrained agents.
Benati (2009) documented a similar pattern across historical episodes: the long-run money-inflation correlation is strong, but the short-run relationship is noisy and regime-dependent.
References
- Benati, L. (2009). "Long-Run Evidence on Money Growth and Inflation." ECB Working Paper Series, No. 1027.
- Bernanke, B. S. (2020). "The New Tools of Monetary Policy." American Economic Review, 110(4), 943-983.
- BIS (2023). "Money and Inflation in the Post-Pandemic Era." BIS Annual Economic Report, Chapter II.
- Mian, A. & Sufi, A. (2014). House of Debt. University of Chicago Press.
- Reis, R. (2021). "Losing the Inflation Anchor." Brookings Papers on Economic Activity, Fall 2021.
- Tobin, J. (1969). "A General Equilibrium Approach to Monetary Theory." Journal of Money, Credit and Banking, 1(1), 15-29.