Economics 311
Intermediate Macroeconomics
Mark Witte
Northwestern University
MV = PY
Expansionary Fiscal Policy (G⬆ or T⬇)
But wait...how can spending change if there’s still the same amount of money in circulation?
We can use the existing money supply more intensely!
How can spending rise with the same money?
The rate at which money is spent (“velocity”) can vary.
This is a line of work most associated with Milton Friedman.
However, it is a relationship that’s been thought about for a long time.
Like this guy, back in 1517 (and others too)
Quantity Theory of Money
Nicolaus Copernicus, 1517
NGDP = Total spending in the economy
= (Price of each good)*(# of each good sold)
= P*Y
NGDP = Total spending in the economy
= (Money supply)*(# times average dollar is spent)
= M*V
V = Velocity
= Average # of times a dollar is spent in a given period
Equilibrium: M*V = P*Y
Quantity Theory of Money: Growth Rates
In levels: M*V = P*Y
But it’s more useful in terms of growth rates
Quantity Theory of Money
In levels (actual amounts):
Take derivatives with respect to time, t:
Then divide by M * V = P * Y
This puts things in growth rate terms:
(Math reminder: Multiply levels; add growth rates)
Quantity Theory of Money (M*V = P*Y)
In levels:
In growth rates:
Tautology: It must be true!
But what good is it?
Suppose we thought that in the long run that there were stable values for the growth of velocity and output:
v = 1% and y = 2%
Suppose you wanted inflation to be 2%.
How fast would you let m?
m + 1% = Inflation + 2%
Velocity has become less stable
Velocity
In levels:
In growth rates:
Velocity will change because of the “needs of trade,”
that is, higher prices and Y will mean that people need to use their money more intensely to get their shopping done.
However, velocity will also change as people become less willing to hold on to money, for example, if they expect inflation to rise sharply in the future. This process can feed on itself, which can lead to hyperinflation.
Velocity is cratering as monetary assets shoot up
Growth of velocity of M1 (currency + checkable deposits)
Velocity is cratering as monetary assets shoot up
This is monetary base = Currency + Bank Reserves
M1 = Currency in circulation + Checkable deposits
Why hasn’t this exploded inflation?
m + v = π + y
350% + -344% = 1.5% + 4.5 (I’m guessing at v here.)
Here is the growth of M1 in percentage change terms.
What’s going on? Velocity and inflation depend a lot on expectations. More on this soon.
Partly, it’s that banks are fine with holding the extra $
Banks are in a world of trouble right now, and some extra liquidity is fine with them.
And it’s not just the US
This is from April 10, 2020
Why haven’t V and inflation exploded upward?
It’s about expectations.
As this guy said it back in 1779:
“The quantity of money in circulation is certainly a chief cause of its decline. But we find it is depreciated more than five times as much as it ought to be…. The excess is derived from opinion, a want of confidence.”
Hamilton is saying that, yeah, the money supply has grown, but prices have risen way more than in proportion because people are unwilling to hold onto the money and instead try to spend it before it loses its value. So Velocity is rising quickly.
Next up….