Saturday, January 24, 2009

Money Supply Causing Concern With Future Inflation

Having an understanding of the Quantity Theory of Money (QTM) will provide one with an understanding why some strategist are concerned about future inflation. The factor in the QTM that is holding back inflation at the moment is the fact the "velocity" of money has declined substantially. So what is the Quantity Theory of Money?

The QTM is based:
"directly on the changes brought about by an increase in the money supply. The quantity theory of money states that the value of money is based on the amount of money in the economy. Thus, according to the quantity theory of money, when the Fed increases the money supply, the value of money falls and the price level increases."
The chart below depicts the relationship between the variables that comprise the QTM equation.

quantity theory of money chart
The value of money is ultimately determined by the intersection of the money supply, as controlled by the Fed, and money demand, as created by consumers. The above chart depicts the money market in a sample economy. The money supply curve is vertical because the Fed sets the amount of money available without consideration for the value of money. The money demand curve slopes downward because as the value of money decreases, consumers are forced to carry more money to make purchases because goods and services cost more money. Similarly, when the value of money is high, consumers demand little money because goods and services can be purchased for low prices. The intersection of the money supply curve and the money demand curve shows both the equilibrium value of money as well as the equilibrium price level.

The quantity theory of money is based directly on the changes brought about by an increase in the money supply. The quantity theory of money states that the value of money is based on the amount of money in the economy. Thus, according to the quantity theory of money, when the Fed increases the money supply, the value of money falls and the price level increases (emphasis added).
This depiction of the the QTM is a bit simplistic. The one factor that also must be considered is the velocity of money. Velocity is the rate at which money changes hands. The relationship between velocity, the money supply, the price level, and output is represented by the equation:
  • M * V = P * Y where
  • M is the money supply,
  • V is the velocity,
  • P is the price level, and
  • Y is the quantity of output.
  • P * Y, the price level multiplied by the quantity of output, gives the nominal GDP.
This equation can thus be rearranged as V = (nominal GDP) / M. Conceptually, this equation means that for a given level of nominal GDP, a smaller money supply will result in money needing to change hands more quickly to facilitate the total purchases, which causes increased velocity.
The equation for the velocity of money, while useful in its original form, can be converted to a percentage change formula for easier calculations. In this case, the equation becomes (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in output). The percentage change formula aids calculations that involve this equation by ensuring that all variables are in common units.

The velocity equation can be used to find the effects that changes in velocity, price level, or money supply have on each other. When making these calculations, remember that in the short run, output (Y), is fixed, as time is required for the quantity of output to change.

What is the effect of a 3% increase in the money supply on the price level, given that output and velocity remain relatively constant? The equation used to solve this problem is (percent change in the money supply) + (percent change in velocity) = (percent change in the price level) + (percent change in output). Substituting in the values from the problem we get 3% + 0% = x% + 0%. In this case, a 3% increase in the money supple results in a 3% increase in the price level. Remember that a 3% increase in the price level means that inflation was 3%.

In the long run, the equation for velocity becomes even more useful. In fact, the equation shows that increases in the money supply by the Fed tend to cause increases in the price level and therefore inflation, even though the effects of the Fed's policy is slightly dampened by changes in velocity. This results a number of factors. First, in the long run, velocity, V, is relatively constant because people's spending habits are not quick to change. Similarly, the quantity of output, Y, is not affected by the actions of the Fed since it is based on the amount of production, not the value of the stuff produced. This means that the percent change in the money supply equals the percent change in the price level since the percent change in velocity and percent change in output are both equal to zero. Thus, we see how an increase in the money supply by the Fed causes inflation.
So as the above examples states, this 3% increase in money supply would cause a 3% increase in inflation. The key assumption is velocity and output are relatively constant. Recent velocity though has actually decreased as noted in the below chart, thus the immediate concern about deflation.

(click to enlarge)

current money supply and velocity January 2009
When velocity does increase, however, the impact to inflation will be magnified due to the large increase in the money supply. Keeping an eye on money supply and velocity going forward will provide insight into an improving economy (GDP) and equally important, potentially higher inflation. These trends can be reviewed at the St. Louis Federal Reserve's Monetary Trends report. A key will be the Fed's ability to withdraw this excessive supply from the financial system before it causes significantly higher inflation.

Source:

Quantity Theory of Money
http://www.sparknotes.com/economics/macro/money/section2.rhtml

Obama’s Economic Challenge: The Velocity of Hope (PDF)
Fidelity Investments
By: Dirk Hofschire, CFA
January 16, 2009
http://personal.fidelity.com/products/pdf/obamas-challenge.pdf


2 comments:

Brian said...

Good economics lesson! THanks for posting.

Anonymous said...

tnx for posting! i was relieved by my studies about inflation and money supply...