East Coast Economics

The Quantity Theory of Money – V (Part Two)

with 4 comments

This is a visual addendum to my earlier post about inflation vs. deflation and the quantity theory of money.  As a reminder, Friedman postulates that inflation is caused by an increase in the money supply; the quantity theory of money in its simple form states that the amount of money in an economy multiplied by its velocity equals the real value of goods in the economy times the price level, or M*V = P*Q.  So an increase in the money supply, ceteris paribus, should result in an increase in price levels.

As I noted last month, the US monetary base has recently seen drastic increases.  We haven’t seen rising inflation, though, because all the additional money that the Fed has been printing is getting soaked up by banks upping their reserves.  FT Alphaville’s Stacey-Marie Ishmael posted an impressive chart yesterday showing this decrease in the velocity of money.

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You can find the original here.  And if you’re sifting through the FT Alphaville archives, also take a look at the hyperinflation scenario that Morgan Stanley sees as a (not highly likely, but realistic) possibility.

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Written by eastcoasteconomics

February 10, 2009 at 7:54 pm

4 Responses

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  1. It seems to me that if the US government eats up all the bad assets and loans from the US Banks and borrows everything from China and other foreign banks. Then allow hyperinflation to occur for a few years. Then the loans essentially become worthless, and the US can then repay the loans using worthless money. Similarly loans for businesses and mortgages would similarly become worthless. May not be a completely bad thing for those who are prepared for such a scenario.

    Of course nobody would want to lend to the U.S. anymore, unless they were dependent on the U.S. like China is.

    shua

    February 14, 2009 at 2:33 pm

  2. What shua says is true, but that is only looking at the positive side of hyperinflation (essentially defaulting on government debt without actually calling it that).

    The negative side is that the buying power of the US population will be next to nothing. This means no more cheap imported goods from China, no more cheap technical labor from India, no more cheap natural resources (which, I assume will start to trade in a different currency if the USD experiences hyperinflation).

    Buying power is one of the key reasons why it is in our nation’s interest to have a strong dollar. Hyperinflation will not lead to a strong dollar.

    capitalkid

    February 17, 2009 at 5:58 pm

  3. And yet this low buying power may be what the US needs. If the US citizens cannot buy products from China and India due to low buying power, the US will have to produce its own products which would seem cheap to other countries as well. Then US industries would start to grow…. maybe….

    shua

    February 19, 2009 at 1:26 am

  4. shua, that’s actually a very interesting perspective. I can’t help but wonder if you’re right.

    The free-trader in me says that without-a-doubt china has a comparative advantage in manufacturing so how in the world could it be beneficial if the US were to engage in protectionist manufacturing policies. However, I think that comparative advantage only becomes apparent in the event that the US engages in world trade (I could be wrong here, this claim should be further investigated). Without trade, and without foreign currency exchanges, you may very well be correct in implying that the US could grow to be self-sustainable. However, in any long-term scenario involving a global economy, I think you’d agree that strong buying power is essential for economic stability.

    capitalkid

    February 20, 2009 at 9:34 pm


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