Inflation and the Velocity of money

Trillions were pumped into the global economy since 2008. We got numbing inequality but no inflation. Then why did we get inflation just now?

Apr 06, 2023

Since the Great Recession, Trillions have been pumped into the global economy. US Fed, ECB, PBoC, BoJ, etc., all did QE in some form or other. Despite all the money injections, we did not get inflation, nor did we get overheating economy. In fact, in 2018, central bankers were pleading, praying, and begging for inflation and growth traction. When inflationary clouds gathered around the horizon, the growth prospects were so mild that central bankers talked of letting the economy run hot for a while. Alas, the inflation prospects petered out, and growth seemed weak despite the high employment rate. At this point, COVID hit, turning the world upside down.

After COVID, suddenly, we have inflation. Central bankers now worry about runaway inflation like in the 1970s. Why? What happened?

It is all about velocity manipulation.

We do not understand and cannot measure the velocity of money, but we can infer it.

Here:

M = Money supply

V = Velocity of Money

P = Price of good (product or service) "i"

Q = Quantity of good (product or service) "i" sold

n = Total number of goods and services

M*V = Money Momentum

Explanation of the equation - ideal money supply

The Money Momentum must be equal to economic activity in the country. In any given period, there is a change in the total number of goods available (i.e. "n") in the economy, there is a change in the number of available goods sold (i.e. Q) in the economy, and there is a change in the velocity of money (i.e. "V") in the economy). Central banks must consider all these variables to tweak the Money supply (i.e. "M"), and if done successfully, there will be no change in the price of the goods (i.e. "P").

Real Economic growth

Real economic growth, from a layman's perspective, refers to growth in the products and services produced by the economy. When the price of the goods increases, but the quantity produced does not, it does not imply real economic growth but refers to inflation. In our equation, real economic growth comes only from the following two ways:

Increase in Q for various goods: Thus, if more people suddenly start going to their hair-dressers to get their hair done up, you will have economic growth.
Increase in the number of goods available in the economy: The economy grows if the total number of products or services (n) increases. For example, when the telephone was invented, new products and services were made available to consumers, which would be economic growth.

What are inflation and deflation?

When there is no increase in the price of goods, we have no inflation. Conversely, when the price of goods drops, then we have deflation. Thus so long as the variable P in the above equation remains the same, we have neither inflation nor deflation.

What is the velocity of money?

In layperson language, the Velocity of Money is the number of times money changes hands. Thus, if $100 was paid by one person to A, then A to B, who paid to C and who, lastly, paid to D, then velocity will be four within that period.

Because of velocity, in any given period, many more people feel they have money than actual money in the system. In the above example, four people were able to conduct their transactions, each worth $100, while in reality, there was only one $100 bill floating in that economy.

So why do economists want to increase the money supply?

Generally, during a crisis, the velocity of money decelerates abruptly as people want to hold on to the money they have. This reduces the Money Momentum drastically, leading to the collapse of demand and a slowdown.

To prevent this, central bankers pump in money to compensate for the loss in velocity, thereby holding the price level in the economy up. This stabilizes the economy and pacifies the participants. In the current crisis too, US Fed has increased the Money supply exponentially, as seen in the alongside figure (from St. Louis Fed)

The question is whether the increase has compensated for the change in velocity. The answer is slightly more complicated.

Fed’s Quantitative Easing was different.

Let us interpret the Fed's actions using our Money supply equation. We split the Money supply M into two components. Let us assume MA is the usual money supply while MB is what Fed added since the 2008 GFC.

Ideally, the left-hand side should have looked like (MA+MB)*V to have the usual effect. However, Feds action split the above equation into something like this:

Note that each type of money supply has its velocity component.

In the ideal case, the velocity VB should be positive and commensurate with MB (the quantum of the additional money supply). The exact mechanics of QE were designed to keep VB low so that the injection of money does not cause runaway inflation. The Fed policy and the mechanism they used kept the VB very low. Naturally, it has a minuscule impact on the whole economy. Therefore there is no inflation.

The source of Inequality is this component of MB*VB

The excess money MB had to move somewhere in the economy. It moved within the financial space and into the hands of the rich.

Money expands in the financial domain through various illiquid instruments and debt to amplify profits which then funnel into equity-linked remunerations to the hands of the ultra-rich.

The money also created inflation, just as theory predicts. However, since this MB was moving into the hands of the extremely rich, it inflated the prices of the goods and services bought by the rich. You can see prices of art, yachts, wine and other luxury goods going higher.

This MB has been driving INEQUALITY since the 2008 financial crisis.

The COVID slowdown was different.

During the COVID slowdown, the money supply was boosted too. MB was indeed increased. However, Government Stimulus was directly given to the real economy as rebates, income support etc. THAT increased MA too. This resulting increase in the money supply is what caused inflation.

The fight against inflation, though, will hurt both MA and MB. One can also argue more MB (at the hands of the rich) will be affected than MA (at the hand of general people). However, the general population will be hurt much more than the rich.

That is a topic for another time.

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