MV = Py
So, as evidence that I’ve never taken a true macroeconomics course, today was the first time I’ve ever seen this equation…
M – Monetary base
V – Velocity of money
P – Price level
y – Real GDP
People have asked my how I can claim the Fed/Treas are inflating when P and y are decreasing, and it’s all about V…
So I saw this comment over at Econlog today, and it deserves a response:
MV=Py, so V’s decreased lately caused by decreasing P and y. If we feed M steroid, how sure are we that y will go up more than P?
I think that’s backwards. V is decreasing which is CAUSING the decrease in P and y. It’s not the other way around.
V, in my limited understanding of the world, appears to be pretty closely act as the debt-fueled consumption loop we embarked on during the housing bubble. Asset prices rose, so we took on debt against those assets, used it to bid up prices, causing asset prices to rise, causing more debt, etc etc. V was expanding, and that expansion fueled huge increases in P and y.
When the housing bubble burst, the credit markets (V) went with it. Housing dropped. The Dow dropped. Oil dropped. Housing was demand-driven, but the drop in oil prices was far too large to be attributed to demand destruction. With M being (relatively) constant, and y being (relatively) constant, the two most mobile factors were V and P, and I think the drop in V caused the drop in P, not the other way around.
So the commenters question — “if we feed M steroids”, what will happen? — seems to assume that V is a minor factor, not a major factor, in the equation. I think this is exactly backwards, as V is far more mobile of a factor than M.
And that belies that point that we’ve started feeding M steroids, but haven’t seen the resultant rise in P or y yet! As fast as the Fed/Treas is trying to increase M, V is dropping faster. But if V is a very mobile — rather than sticky — factor, once it increases to a more normalized level acting on a much larger M suggests that P will explode.
This, anyway, is how I see this playing out. The Fed/Treas is setting the stage for hyperinflation, and once the economy starts to gather up “confidence” it will be too late to stop it. But, again, I’m not an economist — and although I felt like I understood the concepts at stake — today was the first time I’ve ever seen this equation. So if anyone can possibly assuage my fears, please tell me why.