Inflation is typically
described as a persistent increase in general price level such as the consumer
price index. As mentioned in an earlier article, Milton Friedman holds the view
that “inflation is always and everywhere a monetary phenomenon”.
Monetarists and
Keynesians have two competing explanations on aggregate money demand.
Monetarists think that stability of income velocity of money (V) is important.
Keynesians disagree with this notion. The Quantity Theory of Money (QTM)
suggests the following equation:
MV = PQ
M stands for money
(M2); V stands for velocity of money (rate at which people spend money); P
stands for general price level and Q stands for quantity of goods and services
produced. Based on the above, holding money velocity constant and if money
supply increases at a faster rate than real economic output (Q), the price
level (P) must increase to make up the difference.
If we follow this
view, then inflation in the U.S. should be 31% per year between 2008 and 2013 (according
to Federal Reserve Bank of St Louis, September 2014). Why? Because money supply
grew at an average pace of 33% per year and output growth averaged just below
2%.
So why did inflation
remain persistently below 2% between 2008 and 2013? The issue has to do with
velocity of money. If money velocity declines rapidly in an expansionary
monetary policy, it can offset any increase in money supply and lead to
deflation rather than inflation. In the U.S., the monetary base increase did
not cause a proportionate increase in general price level of GDP because of a
dramatic increase by the private sector (including banks) to hoard money
instead of spending it. And why did they hoard? A possible answer is a
combination gloomy economic outlook after the financial crisis and a dramatic
decrease in interest rates. So people rather hold money or invest in equities –
the Dow above 25,000. And inflation remains rather benign for now.
This
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