# Is money supply inflation? Perhaps not

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noodlydoo
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Joined: Feb 4 2009
Posts: 13
Is money supply inflation? Perhaps not

Dear Chris,

In Chapter 10 of the crash course, you subscribe to the theory that
inflation is ALWAYS a consequence of increased money supply chasing the
same number of goods. I'm sitting here with my father in law (a banker)
who argues that you and others are off base, based on the equation that P x
Q = M x V (where P is price, Q is quantity, M is money supply and V is
velocity). Having studied math, I must say that he in does in fact make a
clear and compelling argument that inflation is SOMETIMES a monetary
phenomenon, but, not always. You are not taking into consideration supply, quantity or
velocity.

I've read MANY arguments from various sources that inflation is based as a
(money) supply issue, which historically I bought into, but now no longer
makes sense. Having studied this issue, I would be very interested in your
response, as much of your course is predicated on the assumption that
inflation is ONLY a money supply issue.

Why aren't we considering other reasons for price increases.

Farmer Brown
Joined: Nov 23 2008
Posts: 1503
Re: Is money supply inflation? Perhaps not

If M is money supply, then what is Q (quantity) supposed to be?  Is that the quantity of the product in question?  Also, is V (velocity) in this equation supposed to be GDP divided by M (money supply)?

SkylightMT
Status: Silver Member (Offline)
Joined: Sep 30 2008
Posts: 125
Re: Is money supply inflation? Perhaps not

It might be a semantic thing.

There's two types of inflation: Economic, and monetary.

Economic inflation is a rise in the general level of prices of goods and services in an economy over a period of time.

Monetary inflation is a disproportional increase in the monetary supply, which usually results in the above.

It should be noted that Austrian economic theory does not believe there is a difference between the two.

Anyway, as I understand it, M (the money supply) does not react to V (velocity) at a 1 to 1 ratio. So, if there are small decreases in the velocity of money (e.g. we little people start putting money in our mattresses) it can be offset by printing a little extra money. But if twice as many people start stuffing their cash in mattresses, you have to print more than twice as much money (you need a bigger increase in M to offset a smaller decrease in V).

In our current economy, velocity has slowed down mainly due to banks decreasing lending. They are stuffing their mattresses with cash, so to speak, in BIG amounts. So the fed is printing madly. But if the banks start lending again, suddenly hugely increasing velocity, there will be no way the feds can pull that extra currency back in time to prevent huge inflationary processes from taking over. Printing money while also trying to get the banks lending again is very dangerous.

mred
Status: Bronze Member (Offline)
Joined: Apr 8 2008
Posts: 96
Re: Is money supply inflation? Perhaps not

noodlydoo,

You should also get a taste of the
opposing view. A sample is here:
Money and Inflation: The Tendency to Deny Reality

The article closes with the reasonable
observation:

“Inflation, as this term was always
used everywhere and especially in this country, means increasing the
quantity of money and bank notes in circulation and the quantity of
bank deposits subject to check. But people today use the term
"inflation" to refer to the phenomenon that is an
inevitable consequence of inflation, that is the tendency of all
prices and wage rates to rise. The result of this deplorable
confusion is that there is no term left to signify the cause of this
rise in prices and wages. There is no longer any word available to
signify the phenomenon that has been, up to now, called inflation. …
As you cannot talk about something that has no name, you cannot fight
it. Those who pretend to fight inflation are in fact only fighting
what is the inevitable consequence of inflation, rising prices. Their
ventures are doomed to failure because they do not attack the root of
the evil. They try to keep prices low while firmly committed to a
policy of increasing the quantity of money that must necessarily make
them soar. As long as this terminological confusion is not entirely
wiped out, there cannot be any question of stopping inflation.”

--Ludwig Von Mises

The “Quantity Theory of Money”, as
the tiny equation you presented is called, is the macroeconomics equivalent of the
drunkard looking for a lost coin under the lamp post because there is
light there, and not looking where he actually lost his coin. Why?
Think of the inherent complexity of an economic system, the diversity
of economic sectors, players... think about how when money is
injected into the economy it does not appear simultaneously
everywhere at the same time in a neutral way, but first in some
sector, then going from asset to asset, from first users of the new
money to the last users... In this ocean of complexity ask yourself
how reasonable it is to try to capture all that with the equation you
showed. Ponder about it and you can only be overwhelmed at the
absurdity of the thing. Yet, that is the state of modern
macroeconomics: total bankruptcy. Under the enticement of precision
given by the use of sometimes quite sophisticated mathematical
models, lurks an unbelievable amount of "inaccuracy", to put it mildly.

Consider also that simplistic views
like the QTM are the main instruments of a discipline that is the
main culprit of the economic disaster that is just beginning. Yet,
somehow, by continuing to use "tools" like the QTM, implicitly everyone is continuing to lend credibility to
this kind of thinking which has: been unable to predict this crisis;
been unable to explain the 2-decade Japanese recession even in light of all the
Monetarist and Keynesian arsenal that was deployed there; provided the most ridiculous rationalizations to try to justify the
“benefits” for “market efficiency” given by the derivatives
monster; been unable to explain how a multi-decade American trade deficit can be maintained
in the face of dollar devaluations and whatever other tricks they
have ... and the list goes on.

Modern macroeconomics is quite
different and opposed from the classical economics that resulted from
the intellectual tradition of the Enlightenment. Modern “theory”
would truly offend the principles of guys like Adam Smith, or Thomas
Jefferson. The thinking of these men is not obsolete, and I would
argue that is becoming more relevant by the minute.

Despite what someone might tell you,
Economics is not a science. Its ideological content is enormous and
for the good observer, obvious. When you go and try to figure these
promoted by a particular economic position or another; ask yourself
whether some view promotes centralization and statism or
decentralization and liberty. These questions are fundamental. Today,
people are so massively propagandized that they take for granted
whatever is fed to them through the TV or the words of some person
deemed an “expert”. Finally ask yourself why the particular brand
of macroeconomics that I'm saying is bankrupt has taken over major
universities, think tanks and virtually all governments. There are reasons for that, and they
have nothing to do with the “objectivity” or demonstrated power of that discipline.

Since I'm trying to give you a taste of
the opposite view, I'll add a couple more articles from the same
source. If you are the type of person that only accepts arguments “on
authority”, you can try this by F. Hayek: The Pretence of Knowledge

And finally a more extended argument
from the “classicists” against the “Keynesians” in The Misesian Case Against Keynes (I'm sorry I'm giving you stuff from only one source, but this is actually a great one-stop shopping place for these views)

Am I presenting you "science" in contrast with ... whatever modern macroeconomics is? No, but at least you should be aware of how differing ideologies present very different views about the same situation.

Going back to the beginning: the idea of "price inflation" deflects the attention from the monetary policies of the central bank, and sometimes redirects the blame to "greedy businessmen", speculators or whomever. The idea of inflation as an increse of the money supply is a clearer concept, because it decouples price fluctuations arising from supply and demand from monetary policy.  Finally, I hope that you end up discovering how under an inflationary system (which favors the banking sector only) purchasing power is being siphoned from your earnings and savings even when the "price level" remains constant. When you get to understand that last statement you'll see the kind of sham that the whole system is.

fombie
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Joined: Sep 22 2008
Posts: 16
Re: Is money supply inflation? Perhaps not
noodlydoo wrote:

Dear Chris,

I'm sitting here with my father in law (a banker) who argues that you and others are off base, based on the equation that P x Q = M x V (where P is price, Q is quantity, M is money supply and V is velocity). Having studied math, I must say that he in does in fact make a clear and compelling argument that inflation is SOMETIMES a monetary phenomenon, but, not always. You are not taking into consideration supply, quantity or velocity.

P x Q = M x V = GDP in nominal terms

Okay, that sounds reasonable. This means that if M goes up and V and Q stay the same, then necessarily P has to go up and this means price inflation. However, Q and V will react to changes in P, so the picture is not that simple.

In fact, what Keynes has shown in his General Theory is that expectations matter more than anything else: if people think that prices will go up, they will try to change their money for something more stable, and hence V goes up and hence P goes up and inflation becomes a self-fulfilling prophecy.

The other way round, what we are seeing now is people (and even more so the banks) holding on to their money, fearing troubles ahead, so V goes down so P or Q (or both) have to go down, and if this loop feeds on itself one gets deflation.

Bernanke can control M but not V. Obama can try to influence V through government spending, but as long as he does not manage to restore trust and transparancy, the rest of the economy will not follow.

Woodman
Status: Diamond Member (Offline)
Joined: Sep 26 2008
Posts: 1028
Re: Is money supply inflation? Perhaps not
SkylightMT wrote:

...

In our current economy, velocity has slowed down mainly due to banks decreasing lending. They are stuffing their mattresses with cash, so to speak, in BIG amounts. So the fed is printing madly. But if the banks start lending again, suddenly hugely increasing velocity, there will be no way the feds can pull that extra currency back in time to prevent huge inflationary processes from taking over. Printing money while also trying to get the banks lending again is very dangerous.

I'd like to see good data to verify what's the limiting factor: the banks not wanting to lend or the borrowers not wanting to borrow.   I suspect a significant factor not as well reported is that people don't want to go into debt as much as before, certainly that's true for me, and are saving more.  This seems exactly what we should do for a more sustainable economy, instead of bubbles and collapses.

SkylightMT
Status: Silver Member (Offline)
Joined: Sep 30 2008
Posts: 125
Re: Is money supply inflation? Perhaps not

I think its a combination of both, but banks are definitely trying to bolster their reserves so they look more attractive to investors and depositors. From Investopedia:  "Financial firms that carry excess reserves have an extra measure of safety in the event of sudden loan losses or cash withdrawals by customers. This may increase the attractiveness of the company that holds excess reserves to investors, especially in times of economic uncertainty. Boosting the level of excess reserves can also improve an entity's credit rating, as measured by ratings agencies like Standard & Poor's."

I hope this link works; its a link from FRED on current excess reserves: http://research.stlouisfed.org/fred2/series/EXCRESNS

The chart doesn't say what causes the excess reserves but I think its reasonable to presume the banks are deliberately sitting on cash versus people not wanting to borrow. I think there are many companies still wanting to borrow but unable to do so. For example, Tesoro, an oil refinery a few miles south of where I live, just had massive layoffs. Tesoro borrows money from the bank to buy crude oil, processes the oil in their refinery, sells the processed oil, and repays the loan. They have been operating this way for decades. Recently the banks refused to continue their short term loans; they could not get oil, and had to layoff.

Its incredible to me how different this recession is from previous recessions in which banks didn't stockpile cash like they are now. If they ever decide to release that money in the form of lending all at once, or within a short period of time, inflation will spiral out of control.

dander2194
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Joined: Apr 20 2009
Posts: 20
Re: Is money supply inflation? Perhaps not

Hello, I am Dr. Anderon, DBA. Here is some clarity on the issue of inflation:

Milton Friedman said that inflation is always and everywhere a monetary phenomenon. This is Chris's point. If you double the money supply it is worth half as much. However, credit contraction is causing asset prices to fall while the monetary base is expanded. This is a temporary phenomena.

One reason inflation has not occurred to date is exactly because velocity of the money supply has decreased. The money in the public hands is not turning over as fast as it was a year ago. Further, the TARP funds are sitting on deposit back with the fed. In other words, the banks are not circulating the funds as evidenced by the decrease in lending activity. This may be the reason for the decrease in velocity. However, the fiscal stimulus and the Fed's monetary easing programs ARE inflationary. These funds will not sit on deposit at the federal reserve, thus, even if velocity stays the same, inflation will be the result.

Milton Friedman argues inflation is the result of monetary policy increases 3 to 18 months after the stimulus is injected. Because the fiscal stimulus and monetary easing are happening from February 2009 on, we would expect the inflation pressures to increase heading into 2010.