Money Aggregates, Debt, Pent-Up Demand, and Inflation: Evidence from WWII

The COVID-19 pandemic produced a massive decline in U.S. consumption in 2020 and swift fiscal and monetary policy responses. After growing at a rather steady 5 percent rate for decades, the money supply (M2) increased 25 percent over the past year alongside unprecedented fiscal support, raising some inflation concerns. Concurrent with the reopening of the economy as vaccines roll out, this article derives some lessons from the U.S. experience during and after WWII. The debt-to-GDP ratio increased from 40 percent to 110 percent because of the war effort. Most of it was financed by Fed debt purchases, through a de facto yield curve control that held down short- and long-term interest rates. The money supply doubled in size, but inflation was muted during the conflict as private consumption demand was severely restrained: factories were fully devoted to the rearmament effort, food was rationed, and residential construction was practically prohibited. Households’ saving boomed as a result. After the war, swift pent-up consumption demand culminated in a short-lived spike in inflation from 2 percent to 20 percent in 1946–47, which quickly returned to 2 percent in 1949. Contractionary monetary and fiscal policies, along well-anchored low inflation expectations inherited from the Great Depression, appeared to have contributed to rapid disinflation. I also discuss the experiences of Japan and Europe in recent decades.