Tuesday, June 04, 2013

About Money Supply and Inflation

A lot of times we discuss money supply and possible inflation it can cause and wonder why it doesn't cause that inflation. So here I attempt to explain what happens with money supply and when inflation happens and when it doesn't.

Here is the modified Money supply equation.


M = Money supply
V = Velocity of Money
P = Price of good (product or service) "i"
Q = Quantity of good (product or service) "i" sold
n = Total number of goods
M*V = Money Momentum

Explanation of the equation - ideal money supply
The Money Momentum must be equal to economic activity in the country. In any given period, there is a change in the total number of goods available (i.e. "n") in the economy, there is change in quantity of available goods sold (i.e. Q) in the economy and there is change in the velocity of money (i.e. "V") in the economy). Central banks must consider all these variables to tweak Money supply (i.e. "M") and if done successfully there will be no change in the price of the goods (i.e. "P").

Real Economic growth
Real economic growth, from layman perspective, refers to growth in the products and services produced by the economy. When the price of the goods increases but the quantity produced does not it does not imply real economic growth but refers to inflation. In our equation, real economic growth comes only from the following two ways:
  1. Increase in Q for various goods: Thus, if suddenly more people start going to their hair-dressers to get their hair done up then you will have economic growth.
  2. Increase in number of goods available in the economy: If total number of products in the economy increases then there is economic growth. For example, when telephone was invented, it lead to new products and services being made available to the consumers which would be economic growth.

What is inflation and deflation
When there is no increase in the price of goods then we have no inflation. Conversely, when the price of goods drops then we have deflation. Thus so long as the variable P in above equation remains the same we have neither inflation nor deflation.

What is velocity of money?
In layperson language, Velocity of money is number of times money changes hands. Thus, if $100 was paid by one person to A, then A to B who paid to C and who, lastly, paid to D, then velocity will be 4 within that period. 

Because of velocity, in any given period many more people feel they have money than actual money in the system. In above example, 4 people were able to conduct their transactions each worth $100 while in reality there was only one $100 bill floating in that economy.

So why do economist want to increase money supply?
Generally, during crisis, the velocity of money decelerates abruptly as people want to hold on to the money they have. This reduces the Money Momentum drastically leading to collapse of demand and therefore slowdown. 

To prevent this, central bankers pump in money to compensate the loss in velocity thereby holding the prices level in the economy up. This stabilizes the economy and pacifies the participants. In the current crisis too, US Fed has increased Money supply exponentially as seen in alongside figure (from St. Louis Fed from business insider).

The question really is whether the increase has compensated the change in velocity or not. The answer is slightly more complicated.

What Fed did
Let me interpret the Fed actions using our Money supply equation. Let the Money supply M has been split into two components and let us assume MA is usual money supply while MB is what Fed added post crisis. 

Ideally, the left hand side should have looked like (MA+MB)*V to have the maximum effect. However, Feds action created amounts to splitting the above equation to something like this:

Note that each type of money supply has its own velocity component to it. The Fed policy and the mechanism they used kept the VB very close to zero but not exactly equal to zero. Naturally, it has miniscule impact on the whole economy. Therefore there is no inflation.

  1. In reality, economists cannot measure Velocity and it is the variable that is calculated. In principle, that is wrong. Velocity does not adjust itself and is independent variable depending on psychology, mood, history etc. What really happens is economists tend to guess the change in velocity. Their guesses tend to be wrong and we end up with changes in prices. Milton Friedman believed that we should err on the side of inflation (slight) rather than deflation.
  2. It is also incredibly difficult to estimate the right hand side of the equation. If one really does go through the fine-print we realize that it is all guesswork on RHS too. The key as an expert once told me is to have consistent guesswork so that changes are almost correctly perceived. Now whether the guesswork is consistent or it has been tweaked a bit here and there has tremendous implication about what the central bankers should do.
  3. This post has been adapted from my book "Subverting Capitalism and Democracy".