In recent years, especially following the global pandemic, China's economic landscape has undergone a fascinating transformationDespite a rise in the broad monetary supply, measured as M2, the expected correlation between this increase and economic growth seems to be lackingMany are puzzled as to why inflation remains low while the supply of money swellsThis creates a significant conundrum for economists and policymakers alike, particularly as the principles of monetary theory suggest otherwise.

The famous economist Milton Friedman asserted that "inflation is always and everywhere a monetary phenomenon." While this adage rings true in many instances, the current situation in China calls into question its universalitySince 2022, M2 growth has accelerated from 9% at the end of 2021 to 12.4% in April 2023. This may appear impressive at first glance; however, when compared to the unprecedented M2 growth rates in Western countries during the pandemic, where figures soared above 20%, China's increase seems more tempered.

Curiously, even as money supply expands, indicators of inflation in China are trailing downwards

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In April 2023, the Consumer Price Index (CPI) rose by only 0.1% year-on-year, representing a notable decline from a peak of 2.7% in September 2022. Similarly, the Producer Price Index (PPI) experienced a significant drop of 3.6% in the same month, reflecting a remarkable downturn from its zenith in October 2021. Thus, one is compelled to examine why an increase in money supply does not translate into sustained inflation.

Traditional economics teaches us that an uptick in money supply should correlate with a rise in either real economic activity or price levelsThe basic equation MV = PQ illustrates this relationship, where M is the money supply, V represents the velocity of money, P signifies the price level, and Q denotes the quantity of goods and services producedYet, in China's current economic milieu, this relationship appears disrupted, raising questions about the underlying dynamics at play.

In 2022, M2 grew by 11.8% while nominal GDP only increased by 5.3%. This widening gap has further stretched to 7.7% in the first quarter of 2023. Such discrepancies prompt inquiries about the fate of this newly minted money

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If conventional economics holds, why isn't there a more pronounced impact on either GDP or inflation?

One possible explanation lies in the delayed transmission of monetary policy to the real economyEconomic recovery patterns can influence how quickly injected capital circulates within the economyAccording to the money quantity equation, a lack of robust economic growth and subdued inflation point toward a declining velocity of moneyObservably, China's velocity of money has been on a slow decline, exacerbated by the pandemic's fallout on households and businesses.

Moreover, the notion of whether more money truly equates to enhanced economic activity is ripe for discussionThe money quantity equation oversimplifies the complexity of real-world economies by neglecting influential factors such as the absorption of money by financial markets—as a portion of newly minted money may not reach the physical economy but rather flow into financial instruments.

Examining the funds generated in recent years suggests they haven't necessarily found their way into financial markets

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The Shanghai Composite Index, which stood at 3,640 points at the end of 2021, has since dropped below 3,300, and transaction volumes on the Shanghai and Shenzhen Stock Exchanges have diminishedSimilarly, the real estate market, traditionally a significant avenue for money injection into the economy, saw transaction numbers plummet in 2022, with total sales declining by 26.7% compared to the prior year.

The lag in money transmission to the real economy could contribute to the observed misalignment between monetary trends and economic indicatorsPast economic recovery phases typically relied heavily on infrastructure spending and real estate to generate rapid economic and inflationary responsesThe current economic upswing, however, leans predominantly on consumer recovery post-COVID, a process that moves at a slower pace.

A deeper concern stems from the dynamics of money velocity itself

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The money quantity equation emphasizes that money needs to circulate actively within the economy for growth to occurIf the velocity of money decreases, the actual funds effectively permeating the economy could lag behind the apparent increases in M2. By historical standards, China’s money velocity has steadily decreased since 2018, down from 0.5 to 0.45 in 2022, indicating a wider gap between available funds and their utility in stimulating economic output.

This decline indicates that fewer funds enter the real economy than the monetary aggregates suggestSince this trend of diminishing money velocity has persisted for the last several years, it implies that even as M2 grows by 12%, the genuine increase in money impacts economic activity is potentially falling below 7%. As a result, the narrative surrounding excessive money supply leading to inflation becomes muddled.

Why has the velocity of money notably declined? Economic analyst Ren Zepin identifies several profound factors: a weakening of income expectations, disparities in income structure, heavy debt burdens that have driven precautionary saving behaviors, reluctance from businesses to expand production, slow government investment turnover, and diminishing appetite for financial investment.

Reports from China's financial institutions highlight this diminishing money flow's cyclical nature

Traditional circuits involving corporate investments generating household income, which then fuels consumption and business revenues, are stallingWhen one segment of this economic cycle faces obstacles, overall velocity slows, exacerbating the challenges facing economic growth.

The inability of funds to circulate throughout the economy has significant implicationsDespite favorable conditions for corporate financing, business-led expansion remains muted without a corresponding rise in consumer spending to support ongoing business activities.

Looking ahead, the question of how to break from this cycle persistsIncreasing monetary supply, while a straightforward approach, can superficially resemble past strategies that sparked inflationary responsesFor instance, the United States similarly increased its money supply in response to economic crises but faced significant inflationary pressures in subsequent recovery phases.

Alternatively, seeking ways to enhance the velocity of money and stimulate economic activity presents a more sustainable approach