The State of Monetarism - What Causes What?

What Causes What?

Why might the Bank of England print more notes? Would it be in response to a rise in the demand for cash to spend or because spending has increased and people need more cash? One of the biggest problems facing monetarism is the importance of causality. Monetarism holds that an increase in the money supply above the growth rate of the economy leads to inflation. It does this because if the money supply increases it leads to more spending which creates inflationary pressures. How does such a theory get developed in the first place?

In very simple terms, we could look at instances where there has been a boost to the money supply and then look at what has happened to prices after this rise in the money supply. If prices rise, this suggests that the two are linked. Common sense would suggest that if there is more money swilling round in the economy then that would lead to a rise in spending. We know from basic supply and demand analysis that if demand rises, prices will rise (assuming supply remains fairly constant).

What we are outlining here is cause and effect. Economics is a social science. The science bit is tagged onto the subject because economists would like to give the impression that they base the generation of theories in the subject on some form of scientific basis. Sophisticated analysis of statistics and the use of econometric models might give some convincing explanations of cause and effect.

In reality, the correlation between two variables is less easy to determine. Take the following cases to illustrate this point:

Case 1

Every year around the 25th December, I get some presents left for me at my house. At the same time, there is a significant increase in the number of Santas that are around. Clearly, the two are related. The rise in the number of Santas is directly responsible for the presents I get left, as we all accept that Santa Claus brings presents for Christmas.

Or is it that the number of Santas increases because there are more presents that need delivering? Which causes which? Is it more Santas delivering more presents or more presents requiring more Santas?

A young girl sitting on Santa's knee

The increase in the number of Santas in December correlates strongly with the number of presents received - or is it the other way round? Copyright: Roger Kirby, from stock.xchng.

Case 2

In one region of the country, there is a sudden increase in the number of new babies born. At the same time, wildlife naturalists observe that there is an increase in the stork population in that same area. The conclusion? Storks bring babies and that is why there was a rise in the birth rate in the area.

These two examples are obvious and extreme examples of the problem that monetarism has had to confront. Does an increase in the money supply feed through to a rise in the level of national income, or is the rise in the level of national income the cause of the rise in the level of the money supply?

The problem is that although one event follows another, we cannot assume that the first event causes the second. If a measure of the money supply is observed to rise at the same time (or an accepted related time period) as a rise in national income, does that mean that money causes income? It could do, but could it also be the case that the rise in income has caused the money supply to rise?

The relationship between the two, however plausible they might seem, might not be related at all. The relationship between the number of storks and the number of babies born is patently the result of some form of old wives tale that has developed and has no basis in fact. Could the relationship between the money supply and income be the same?

The problem of identifying the nature of the relationship between changes in the money supply and income levels has been a difficulty that has not been easy to prove through empirical observation and study. There might be some sort of reverse causality to that which the Fisher equation, for example, was suggesting in relation to the money supply and inflation. If prices rise, the authorities accommodate the extra spending that might have caused it by expanding the money supply rather than the other way around.

Task 4

  • Can you think of other relationships in economics where it might be difficult to identify the causal relationship between the two? Explain what the two types of causality might be.
  • How do you think that economists might discover whether there was any relationship between the two?

Use the information from the link relating to the trend for broad money from Task 3. Look at the trend for GDP and inflation over the same time period. Can you see any evidence of a relationship between the two? (You will need to consider the impact of time lags in your analysis).

You can get some hints about how to compare data from Biz/ed's 'Key Economic Data' resource.

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