The FRED graph above, which tracks broad money in the U.K. over the past 172 years, makes it look like the Bank of England has let the money supply go completely out of control since 1970. But not so fast! Two important effects are at play here. The first is the power of compounding: Any statistic that increases at a constant rate will look like it is accelerating, especially if the sample period is long. That’s why FRED graphs offer the option of taking the natural logarithm, as shown in the second graph, below.
If broad money had increased at a constant rate, the graph would show a straight line. That’s not the case, though, as broad money reacts to economic conditions, which is the second effect at play here. Consider that the money supply follows the general evolution of prices. Or the reverse: Prices follow increases in the money supply. In any case, we deflate broad money by the consumer price index, as shown in the third graph, below.
This new statistic is still skyrocketing. But that’s because the U.K. economy has actually grown during most of the period. In our fourth graph, show below, we divide broad money by nominal GDP, which takes into account inflation, population growth, and increases in productivity in one fell swoop. Our final statistic is less dramatic, but it still shows some sort of effect that keeps propelling broad money upward. What could it be?
Let’s stop and define what broad money actually is. As you may have guessed, it’s the broadest possible definition of money, which encompasses all forms of assets that could possibly be used for transactions: from currency all the way to savings accounts and large time deposits. (In the U.S., we call it M3.) And, as an economy becomes more financially developed, broad money grows more than what nominal GDP would account for. This is what we see here.
How these graphs were created: Search for and select “broad money United Kingdom” and you have the first graph. Use the “Edit Graph” panel to create the others: For the second, choose units “Natural Logarithm.” For the third, add a series to the line by searching for and selecting the “United Kingdom CPI” (in levels, with a long sample) and apply formula a/b. For the fourth, replace the CPI series with “nominal GDP United Kingdom.”
Suggested by Christian Zimmermann.