Thursday, August 26, 2010

Money Supply, Velocity and Economic Growth

A great deal has been written recently about the fact that the Fed's effort to provide for more liquidity in the financial system has really not produced much growth as bank's are holding the liquidity in excess reserves.

From The Blog of HORAN Capital Advisors

The importance of this has to do with the Quantity Theory of Money (QTM) which describes the interplay of nominal GDP, money supply and velocity. I wrote on this topic in early 2009 in a post titled, Money Supply Causing Concern With Future Inflation.

Recently though, the velocity of M2 and the YOY percentage change are showing increases. As the below charts do show, it is not uncommon for velocity to take some time to pick up following an economic recession.

From The Blog of HORAN Capital Advisors

From The Blog of HORAN Capital Advisors

As I noted in my post in 2009, 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. In the QTM, velocity is assumed to be constant in the short run since it is not easy to manipulate. If the above equation holds and output is not quickly changed, prices will rise. Additionally, a rise in prices multiplied by an unchanged output will result in higher GDP. The question is whether or not there is demand for the output.

At HORAN Capital Advisors, we do believe the consumer demand side of the equation is being restrained for a number of reason, the uncertain regulatory environment, consumer deleveraging and high unemployment to name just a few. At HORAN we are cautiously optimistic that higher velocity is being realized and will lead to higher nominal GDP via an upward pressure on prices. GDP growth is likely not to be strong near term, but growth nonetheless.

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