Friday, February 11, 2011

The Velocity of Money

Here's a conundrum for armchair economists when it comes to monetary policy: With so many more dollars flowing into the economy, why haven't we seen inflation accelerate?

The Federal Reserve has expanded its balance sheet (the amount of liquidity in the economy) from $927 billion on September 10, 2008 to $2.47 trillion on February 2, 2011. And the Fed is pumping more money into the economy through its ongoing quantitative easing program. But the consumer price index for 2010 was a modest 1.5 percent.

The answer has to do with the velocity of money. If the definition of inflation is too many dollars chasing too few goods, then inflation is a function of the motion of the dollars. If the dollars aren't chasing the goods very hard, we won't see higher inflation.

The blog, Econobrowser
explains the phenomenon with this classic equation:


Here M is a measure of the money supply, V its velocity, and nominal GDP is written as the product of the overall price level (P) with real GDP (Y).

Yes, there are more dollars in the economy than there were before the meltdown in the fall of 2008, but these dollars haven't been moving very fast. Households experiencing unemployment or foreclosure are hoarding the few dollars they have. Those who still have jobs have been either paying down debt or building up savings. A dollar in a mattress, by definition, isn't moving very fast.

his speech to the U.S. Chamber of Commerce, President Obama noted that American corporations "have nearly $2 trillion sitting in their balance sheets." Obama wants CEOs to deploy these assets, which have been sitting doing very little, by lending, spending and hiring more. Profitable corporations have been hoarding their earnings and are still reluctant to hire new workers or invest in capital equipment. Banks that were bailed out with government funds are still rebuilding their balance sheets and have been slow to start lending again. A dollar that isn't being used to buy goods or hire workers isn't going to drive prices or wages up.


Anonymous Anonymous said...

I think inflation has been restrained because employers have been very good at keeping wage inflation down, even negative, so sellers cannot command the price increases they would like to.

Perhaps that is simply a different way of understanding MV = PY.

Americans have a cultural memory of inflation in the 70s and 80s as a very bad thing. But investors are always happy for goods to be inflated, as long as wages are not inflated too.

In the 1970s there was commodity inflation, which was then offset by wage inflation, driven by collective bargaining. That is why it was so imperative (to Reagan) that he break the unions - to begin a cheap-labor regime where commodities could float up while wages remained suppressed.

That cheap-labor regime did not really bear fruit for business until the GWB administration, when commodity inflation gradually resumed but real wages were flat.

6:44 AM, February 18, 2011  

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