Quora Question: Money – Inflation Relationship

I recently answered the following question on Quora:

How is it that the United States has tripled the money in circulation over the last five years, but inflation is only at 2 percent?

This is a great question, and there’s a lot to be said on this issue.

For starters, let’s look at the Equation of exchange:

M * V = P * Y

Where P is the price level, Y is real GDP, M is the money supply and V is the velocity, the average amount of times the average dollar trades hand per year.

Change in P is called inflation (or deflation), and change in Y is called growth.

Tautologically, the left and right hand side of this equation have to equal each other. The amount of dollars that trade hands in a period of time has to equal the dollar value of all goods and services traded in a period of time.

From this framework, you asked why M can greatly increase without P greatly increasing. The answer is some combination of Y increasing and V decreasing (although mostly the latter, in this case). Velocity has tremendously fallen since the Great Recession started.

What does that mean in real terms? Suppose you had $100 in cash. Suppose you accidentally burned half of it. For your one-person economy, M just got divided by two.

Suppose that instead you buried $50 in the backyard and promised yourself to not find it for ten years. For your one-person economy, V just got divided by two.

Until you dig up your $50, it is as good as gone from the macroeconomy. In the short term, an decrease in velocity greatly lowers the price level.

This isn’t a new idea. David Hume made this point in the 1700’s in his essay Of Money: “If the coin be locked up in chests, it is the same thing with regard to prices, as if it were annihilated.”

That’s exactly what has happened in the U.S. since 2008. For example, here’s a graph of Excess Reserves banks hold at the Fed.

Before 2008, the highest spike is to $19 billion (shortly after 9/11). By the end of 2008, it was at $767 billion, and is currently at over $1.5 trillion. Banks have buried over a trillion and a half dollars in the back yard of the Fed. Based on the equality we discussed earlier, this will result in (/is the result of) a combination of the following factors, all else held equal:

  1. An increase in M
  2. A decrease in P
  3. A decrease in Y

Why did velocity drastically decrease in late 2008? This is where serious economists start to disagree with each other. I’m just a kid with a keyboard, so I shouldn’t speculate.

In the comments, someone called me out. “That’s a lot of words for ‘I don’t know.'” I responded:

I want to be very precise about what is known and what is not known. We know that there is not a direct relationship between changes in the quantity of money and changes in the price level unless all else is held equal. All else was not held equal in 2008.

Personally, I think the decrease in velocity was caused by a combination of two factors: a decrease in confidence in the financial system and the fed instituting a policy of paying interest on excess reserves. I can’t prove the second factor was a big deal. Some economists I respect (like Scott Sumner at Bentley) believe that. Many don’t. That’s up for debate. The stuff I posted above is not.