Thursday, June 06, 2013

Money Supply Inflation and Economic Growth

After having discussed the basics of Money supply and Inflation, it is essential to discuss growth based on our model of money supply. At the moment, we are assuming there are no imports/exports. Let us refer to our equation:

Now using this equation it is clear that there are only three ways of creating growth in the economy. First two are obvious. First, increase "n" or number of products available in the economy. Thus, when new products and services are discovered we have growth. Secondly, by increase "Q" by increase of  population since when number of people increase, the total product consumed also increases thereby leading to growth. These are obvious and let us call them basic growth. It is the third that is interesting.

Increase in Q or Quantity by increasing Purchase intensity
Purchase intensity means the amount of product "i" one person buys. When the purchase intensity increases the demand goes up and leads to growth. But the beauty is it is "purchase" and not "consumption". Thus, even hoarding will also create growth. Now this seems silly when you relate it to goods but relate it to assets and things start looking quite different. We will term them differently, one we will call Asset building and other we will call asset hoarding.

Asset building is excess creation of assets than required or justified by future demand of such assets. Such asset building also creates demand if asset creation involves economic activity i.e. leads to increase in "n" or modifies the "PI" of existing goods as a consequence. Thus, if some one buys homes and blocks them, you have demand since other products related see increased consumption (steel, cement, wood, etc.) *(Refer Note)

Asset hoarding is of different type, say buying mines and mineral deposits, hoarding leads to inflation and not to real growth. This type of asset hoarding works on Pi and thus does not contribute to real growth. Concurrently, asset hoarding of this nature, ties up money supply reducing its velocity.

QE and growth
It is clear that QE is effective when it triggers basic growth or asset building even though such asset building may be excess. (Refer Note 2). If QE leads to asset hoarding then it does not lead to growth but leads to inflation. 

  1. There is slight technicality here, homes though termed as assets can also be termed as consumption goods. But the principle is applicable for all assets that influence n or PI.
  2. Technically, the difference is "how much excess". Some excess is allowed but major excesses leads to depressing of long term demand and as such creates a drag. Essentially, asset building prepones the future demand.