Quantity Theory of Money – you can’t have your cake and eat it

I blogged on this topic last year but I thought it appropriate to look at it again especially I have just completed it with my NCEA Level 2 class and about to start the topic next week with my CIE A2 class. – it refers to Unit 4 of the CIE A2 Economics course and the Inflation topic at NCEA Level 2. Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:

M x V = P x T

M = Stock of money
V = Income Velocity of Circulation
P = Average Price level
T = Volume of Transactions or Output

For example if M=100 V=5 P=2 T=250.   Therefore MV=PT – 100×5 = 2×250
Both M x V and P x T are equivalent to TOTAL EXPENDITURE or NOMINAL INCOME in a given time period. To turn the equation into a theory, monetarists assume that V and T are constant, not being affected by changes in the money supply, so that a change
in the money supply causes an equal percentage change in the price level.

The speed at with which money goes around the circular flow is a significant indicator as to the economic activity of an economy. Money’s “velocity” is calculated by dividing a country’s quarterly GDP by its money stock that quarter – the bigger GDP is relative to the money supply, the higher the velocity.

Recessions – dampen the velocity by increasing the attractive of a store of value. People tend to save rather than spend. E.G. The Great Depression and the GFC. See graph for US velocity of money.

Covid-19 – with the closure of a lot of businesses and people worried about job security personal savings increased to 33.6% of disposable income. Also consumers didn’t have the money to spend.

The stimulus measures and the glut of dollars could cause problems once the consumer confidence starts to become prevalent. Inflation will inevitably rise again – which is not a bad thing considering the threat of deflation that we are currently experiencing. But the major concern is if the increase in spending spirals out of control with high inflation. It seems that central banks want the velocity of money to increase to kick-start the economy but they will need to consider how to control it if it gets above the ‘speed limit’. “You can’t have your cake and eat it”.

The concern now is that inflation is at very high levels around the world caused by both supply and demand issues. Velocity of circulation is increasing but also major supply chain problems and still expansionary monetary conditions – low interest rates – are contributing to higher prioces.

The table shows the global problem of inflation. The OECD area climbed to 7.2 percent in January 2022 – the highest level in the area since February 1991. In the US inflation has risen to 7.5% – main cause being petrol up 40% and cars/truck up 40.5%. In New Zealand the CPI is 5.9% above the 1-3% target range. The outlier is Japan who has had deflationary concerns for a number of years.

Source: Why money is changing hands much less frequently – The Economist 21-11-20

Sign up to elearneconomics for multiple choice test questions (many with coloured diagrams and models) and the reasoned answers on Quantity Theory of Money Immediate feedback and tracked results allow students to identify areas of strength and weakness vital for student-centred learning and understanding.

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