(amount of Money) x (Velocity of money) = (Prices of stuff) x (Quantity of stuff sold)
Otherwise known to econ students as MV = PQ. You can also think of it as MV = GDP, or MV = total economic activity aside from bartering. [V, or the velocity of money, means how often a dollar changes hands in a given year. Higher values mean there's more spending.]
Now, I never took an econ class in my life, and I never saw this equation until a few months ago. But it seems I'm not the only one who's been neglecting this equation. Many people in the "hard money" or Austrian camp tend to get obsessed with M, the money supply, rather than with MV. They tend to define things based solely on M, e.g.:
Inflation is best described as a net expansion of money supply and credit. Deflation is logically the opposite, a net contraction of money supply and credit. (Mish)
Inflation is an increase in the money supply. (Ron Paul)
Inflation and deflation are purely monetary phenomena.... Inflation is the very specific case of a rise in general price levels driven by an increasing money supply. If the money in an economy grows at a faster rate than the pool of goods and services on which to spend it, general prices are bid higher as a result. Only money creates inflation. (The Market Oracle)
This last blurb tacitly makes reference to the MV = PQ equation, but it pretends V is not there! If M is increasing, while Q (the total amount of goods and services) is not, then, the author concludes, in order for the equation to balance, P (prices) must increase.
This is not a fair conclusion. If V falls, it may counteract the increasing amount of money. Conversely, "Only money creates inflation" is not correct, because if V increases then inflation may result even with a constant money supply. The question is not "what is happening to M?" but rather, "what is happening to MV?"
Mr. Bernanke doesn't seem to recognize this, either:
By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.
I guess eventually, over the long haul, he may be right. But the assertion that printing money "always" generates higher spending (PQ) once again ignores V altogether. We've seen this with the tax credit stimulus that was supposed to boost the economy... it didn't work very well, because people didn't spend that money. They paid down debts or stuck it under the mattress. To take an extreme example: if V = 0, then MV= 0, no matter how fast M is increasing.
Consider Weimar Germany, where velocity of money drove inflation moreso than the total money supply did.
By the end of the war, the amount of money in circulation had increased four-fold. In view of this, the extent of inflation was less than one might have expected. The consumer price index had risen 140% by December 1918....
Some rather simplistic folks would argue that a four-fold increase in the amount of money should have resulted in a four-fold increase in prices. Such folks should recall that the equation is MV = PQ, and not M = PQ. M went up by a factor of 4, but because people do not spend much money during wars, V went down. Thus, prices were not as strongly affected as one might expect, if one is looking solely at money supply. But then the war ended:
[I]nflation resumed after the peace until by February 1920 the price level was five times as high as it had been at the armistice. Yet during this same time the amount of currency in circulation had only doubled. Prices were in fact rising much faster than the rate at which money was being printed.
Yes, because the war was over now, and people were spending again. Velocity surged, and with it, prices.
Currency collapses -- often referred to by the inapt term hyperinflation (as if it's just an extension of regular inflation, which it is not) -- primarily seem to be caused by a catastrophic swing in velocity, from very low velocity (hoarding of money) to extremely high velocity (desperate panic buying of anything of tangible value). Jim Sinclair says history proves that currency devaluations or failures arise from very bad, deflationary economies. During the bad times, people don't spend. They hoard cash.
During this pre-collapse period, governments commonly print money to pay bills, as the Fed has begun doing. They also try to goose the economy by printing money and handing it 'round, hoping to get the party started again. This doesn't work very well, because when your economy is faltering and unemployment is rising, it's hard to get people to spend any extra cash they may have been given.
But the day comes when the psychology changes. Here again I would cite Jim Sinclair, who has repeatedly said that a currency collapse is a psychological event. The madness of crowds swings the other way, from panicked hoarding to panicked buying. (In Weimar the shift was more dramatic due to massive speculation in financial markets, which rapidly turned against their currency; but this is still a psychological event.) The change happens at some very unpredictable point, at the moment when confidence in the currency is lost. Suddenly people would rather own anything but the currency. During this phase, if you go to the store and all they've got to sell is 8 toasters, then you buy 8 toasters. That's the psychology that destroys currencies.
In terms of our equation, during the period before "hyperinflation" you have an increasing M but a falling V, so you do not see major price inflation. The currency begins to fail in earnest when V turns around and begins to shoot upward. All of a sudden MV is skyrocketing, but on the other side of the equation, Q cannot skyrocket because it is subject to physical constraints. There is only so much factory space, only so many engineers, and so on, so Q must remain relatively stable. This means that P must increase in line with MV. Prices go up rapidly, which is to say, the currency rapidly loses value.
The printing of new money, and thus the larger value of M, has a multiplying effect and makes any increase in velocity worse. It also plays a role in causing loss of confidence in the first place. But it's not like there is some value of M beyond which the currency begins failing. That failure occurs when the velocity changes.
In short, it's the V that gets you.
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