Money supply / Money velocity / Inflation relationship

benjamen

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Fisher equation:
M*V = P*Q

M is the total money supply (how much fiat currency the central bank produces)
V is the money velocity (how fast money circulates in the economy)
P is the average price of all good and services sold in a year (inflation)
Q is the quantity of all goods and services sold in a year (GDP is usually used as a proxy)

Resulting equation to quantify money velocity:
V = (P*Q)/M
Money velocity slows down as GDP falls. Less things are being purchased to move money around.
Also, the velocity slows down as money supply increases. It takes more transactions or higher prices to move bigger and bigger piles of cash around.
Not suprisingly, in a time of slow GDP growth and huge money supply growth, our current money velocity is amazingly low.

Different form of the Fisher equation:
% change in M + % change in V = % change in P + % change in Q

in English:
Change in the Money Supply + Change in the money velocity = Change in inflation + Change in GDP

To find expected change in inflation: change in money supply + change in money velocity - change in GDP

Usually, this breaks down into the government relying on strong GDP growth to prevent money supply growth from causing huge inflation.

If you look at the current situation, money supply is way up, money velocity is way down, and GDP is flat. This gives us a fun situation where we are pouring new money into the system without a whole lot of inflation (at least for now) due to a big drop in money velocity.

Going forward, even assuming we pull out of the recession into a relatively normal GDP growth scenario and stop printing money like it is going out of style, GDP will pick up some and money velocity should take off. In this scenario you have flat money supply growth (flat to inflation), small increase in GDP growth (small push down to inflation), and a large increase in the money velocity (large push up to inflation). Essentially, if we actually straighten out economy and monetary policy it will cause a painful inflationary period.

Alternatively, if we continue on our current path of printing money like mad and the economy limping along, GDP will be flat, money velocity really can't fall much further, and money supply increases eventually add up enough to start causing some really bad inflation.
 
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pmbug

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Most of the new money is being invested back with the Fed, so that's keeping the velocity down. The Fed peeps think they are smart enough to withdraw that money as needed when the ecomony (GDP/inflation) picks up.

Knowing just how much pressure to apply. It's easy, right? What could possibly go wrong?

 

ancona

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When I think of the "excess reserves" held by the "banks" and what happens if inflation is really ignited, I have nightmares. There is now a truly insane amount of liquidity sloshing around in the world just waiting for an opportunity to chase a little beta.
 
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