Inflation is as logical as 1 = 2

6 points by duschang27 14 years ago | 6 comments

Acording to Quantity Theory of Money, MV = PT.

M is Money Supply.

V is Velocity of Circulation.

P is Price level.

T is Transactions or Output.

Assuming that V and T are determined, or fixed, P must increase as M increases.

Economists call this "inflation"...

But the logic seems flawed

For one, V cannot be determined. Think about the impact of Visa, eBay or Amazon. And of course, the hyper circulation via mortgage derivatives.

Also, T is ill defined. The output of certain resources, such as precious metal, may be constrained, But we cannot ignore the renewable ones. Especially because they are postivily correlated with M. You know, the concept known as investing

So would someone please show me otherwise? Or it's going to get really depressing...

ra 14 years ago |

The formula aside, I thought that inflation was actually calculated by charting the price deltas of a 'standard basket of goods' [1] [2].

In which case, assuming that Output can be measured with a reasonable degree of consistency (economic output of a nation) and assuming that money supply is controlled, then V can be calculated. More importantly V can be used as an instrument to control inflation.

I guess the complications come from the side effects of manipulating V, and increasingly (especially for non-US countries) the impact of foreign economic factors.

Also the measurement of inflation has a built in delay (eg: you measure the aggregate inflation of the previous quarter) which can be problematic if inflation is changing.

I am not an economist, but this is how I understand things.

[1] Depending on who is calculating inflation, sometimes these prices are seasonally adjusted.

[2] I somewhat oversimplify things. See http://www.rba.gov.au/publications/confs/2009/ravazzolo-vahe...

achompas 14 years ago |

Before going any further, I should point out (as a former economist-in-training) that the relationship between money supply and prices is not understood well. The Quantity Theory of Money is a theory in the truest sense of the word, and has been challenged by other schools of thought.

With that said, the equation's main point is that prices grow proportionally to money supply if velocity and transactions are also proportional to one another. As you've stated, we cannot measure V and T, so we're not sure of the relationship between prices and money.

There's really no reason to fret, though. As someone who helped with research at the Federal Reserve Board, I can tell you that research into this area is thriving, and our understanding of the relationship between money and prices constantly evolves.

ich 14 years ago |

You are basically right. That's what makes the job of the federal reserve bank so hard. They need to measure V and T, which you rightly point out is not easy, and then they need to adjust M to keep P stable. And as you further rightly point out they only control a small part of M, i.e. the amount of cash. It basically works by the Reserve Bank having a good guess at V and T and then adjusting the cash rate hoping that it will encourage banks to adjust their general loan rates accordingly and thus having a significant enough impact on M.

duschang27 14 years ago | |

But doesn't the federal reserve uses Consumer Price Index(CPI) to measure P. Looking at how CPI is measured, it doesn't seem like it has a strong correlation with M. Cost is directly related to M, but price is not. Under these circumstances, doesn't it encourage merchants to artificially up the sales price to maximize their profit, regardless of the cost?

duschang27 14 years ago | | |

and if the fed tries to lower the value of dollars to counter act this, wouldn't it ultimately dilute the profit of those who maintained the lower price? Thus starting the vicious cycle of price hikes

astrodust 14 years ago |

Why can't 1x = 2y?