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January 26, 2009

MV = Py

by Brad Warbiany

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.

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  1. Neither am I an economist but I tend to agree with your conclusions here. I’ve always felt a pit in my stomach not only when “V” decreases but when “V” is being discussed. Why? It’s somwhat of a wild card. No one can figure out all the variables affecting “V” much less how to control them.

    I dare say what is going on and why no one can figure it out is that less and less money is moving more and more quickly covering up the how bad the underlying economic damage truly is; economic flows are turning to glue – akin to narrowing of the arteries in the human body.

    The whole economy and tax system is essentially hyper vertically integrated and leveraged. Everything is loss leader or a depreciating asset. In the currnet finance structure – long term loans are never repayed only rolled over and funded with short term loans. Now short term money will be tied up in long term infrastructure projects and govt debt service as well. We are about to have very very little money circulating.

    How long can this nonsense continue?

    I fear your fears of the eventual cataclysmic release of the building inflationary pressure are actually understated.

    Hope that cheers you up.

    Comment by Persnickety Curmudgeon — January 26, 2009 @ 2:39 pm
  2. If your hypothesis were correct, we would have seen the velocity drop BEFORE the economy collapsed. You should ask why the credit market collapsed, which will lead you back to factors on the other side of the equation not having been where they should have been to justify where credit was. Cf. chapter 24 (The Assault on Saving) of Hazlitt’s Economics in One Lesson for a nontechnical but eminently clear discussion of the underlying idea.

    Comment by Miko — January 26, 2009 @ 3:17 pm
  3. The nation’s V was dropping before the economy collapsed, example: rate of home sales was in decline. The price of stuff was going up, but as oil went up, driven miles went down. People didn’t increase their spending as energy prices went up; they cut back. That’s a stable V for staples. The larger purchases, new homes and cars, were in a clear slide. It’s easy for me to say this now, but the numbers were there. Sales were low. GM and Ford were burning money in 2007 and 2008.

    I know there was strong demand for iPods and such, but you could buy an iPod for the price of a week of gas ($80 for me). If you simply didn’t drive as much, carpooled, or played hooky, you could easily afford a new iPod.

    Hawaii tourism took a hit. In 2007, there was a 7% decline (if I recall correctly). 2008 had a 17% decrease on average across the islands. Vacations are a big V factor, with thousands of dollars spent in one week’s time, a decline of 7% will make a noticeable dent in the GDP.

    Comment by Paul — January 26, 2009 @ 4:23 pm
  4. I should suffix by stating that I’ve never taken a class in macroeconomics. My definition of terms may not be technically correct, so I’m going for the overall cohesion of my argument.

    Comment by Paul — January 26, 2009 @ 4:26 pm
  5. Miko,

    I’ll have to sit down and read that chapter… I read Economics in One Lesson a few years ago, so I don’t recall this section.

    My initial reaction, though, is the same as Paul’s. The prices of certain asset classes dropped (which caused the negative delta-V), but the general price level didn’t fall until V started moving. I.e. houses were dropping like a rock, but it wasn’t until the subprime crisis really hit that this expanded to the general price level (which is P).

    If I’m blatantly wrong, let me know.

    Comment by Brad Warbiany — January 26, 2009 @ 4:48 pm
  6. No one can figure out all the variables affecting “V” much less how to control them.

    Like others, I have never taken a macro class. However, I don’t know if this fact ought to concern as much as someone who claims that they have figured out all of the variables or how to control them. How does that saying go? The best thing that a person can ever know is that they don’t know everything?

    Comment by Justin Bowen — January 27, 2009 @ 10:54 am
  7. Justin – Velocity of Money to me means the same money being spent simultaneously in different places and different times and returned before it is missed – it is much more of a multiplier than fiscal or monetary policy proper – perhaps even bank deposits, credit cards and other leverage.

    I think this is 10,000 pound gorilla in the room no one speaks about and why so many smart people can’t figure this thing out.

    How many people have already spent next years tax refund, and done so on credit too; put up their house which is declining in value as collateral for another loan in anticipation of future gains in equity? That money is spent and someone else realizes a profit and someone else gets a wage which they spend or invest and maybe sell forward their receivables so they can qualify for a credit line to purchase more business equipment for anticipated future business. On top of this the government has already booked and and likely spent tax receipts on transactions yet to occur, spent that and borrowed to do so. The Govt loves it because at every transaction the government gets it’s cut – even if the transactions are made essentially with IOU’s in the first place.

    If the first transaction defaults everyone may not get paid but they may still show the transactions as “collectible” and borrow and spend against them in many cases – especially the Treasury, which may also tax them.

    Comment by persnickety curmudgeon — January 27, 2009 @ 4:37 pm
  8. All you need to know to understand our current situation is this quote from Human Action, by Ludwig von Mises:

    There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only where the crisis should come sooner as the result of a voluntary abandonment of further credit expansion, or later as a final and total catastrophe of the currency system involved.

    The other fatal flaw of all of our wonderful economic thinkers and advisors, is they seriously believe that our problems lie in lack of consumption by the consumer, instead of a lack of saving and investment, which are the real problems.

    Buy gold, one coin at a time, with a goal of leaving the stash for your son and his sons, etc. I call it ancestral planning. Our currency may not go to zero on our watch, but make no mistake about it, it is going to zero.


    Comment by Jack Stevison — February 2, 2009 @ 4:43 pm

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