MV=PY is alive and well

With the Federal Reserve increasing the monetary base, we look at the basic equation of the Quantity theory of Money which many economists use to expect hyper-inflation...

MV = PY

M = money supply
V = Velocity of money
P = Price level of goods and services
Y = Real value of total goods and services transacted

We can modify the equation...

%∆M + %∆V = %∆P + %∆Y

Does the left side of the equation really equal the right side in actual data?

For the most part, the two sides have been close. But the most important to see is the most recent data since the crisis. The equation has been holding very well.

 So why does M2 money supply work so well in the equation? The M2 money supply is basically the money in circulation apart from reserves that banks hold with the Federal Reserve. Those reserves never enter the economy to influence prices & inflation... which change due to money demand for goods and services.

M2 has been growing at 6% to 7% since the beginning of 2013. That is good normal growth. The velocity though has been falling since 2011.

Why has velocity been falling? Well, we know that money is simply moving slower through the economy. Transactions are done less frequently with the money that people have. People are more careful in their consuming. Thus we see that real output and inflation are muted.

The basic story is that people need to feel more secure with the money that they have. They need more income stream. Labor share needs to rise.

Comments

[AB]

Why does MV = PY? Because V is only defined as PY/M. V has no other tangible definition. If you disagree, then please show me how you can determine V independently. I thought this was common knowledge. I am disappointed that you would write something like this.

[Steve Roth]

Not your best post.

1. There are no plus signs in the MV=PY equation. Where'd that come from?

2. M2 velocity is effectively zero relative to M2 level. Ditto CPI vs GDP.

So you're showing M2 growth versus GDP growth. Not much light there. Says nothing about MV=PY.

Try playing with it using household net worth as M. Gets pretty interesting.

[JimH]

"The M2 money supply is basically the money in circulation apart from reserves that banks hold with the Federal Reserve. "

I have been wondering if M2 included those bank reserves with the FED.

Very interesting that Velocity is still going down, even though M2 is only growing normally. This touches on something that we had discussed before. I believe that lower income earners are much more likely to spend their income and therefore contribute more to Velocity.

Why are you using Velocity of M2 + M2? Scaling for the graph?

[Edward Lambert]

AB,
As you say, V spits out of PY/M. Why does that discount V? It is a logical deduction.
Milton Friedman was wrong when he said velocity was constant. That created trouble. So now we know that velocity can change and how.

[Edward Lambert]

Hi Steve,
The plus signs come with percent changes. So I use percent over year change, just like an inflation rate is the percent change over the last year.
But MV=PY can also be written as %∆M + %∆V = %∆P + %∆Y. If the right side changes by 4%, the left side has to too.

But the velocity of M2 has not been zero. It has been changing yearly by over -2% for 3 years now.
That is not interesting?

[Edward Lambert]

Hi Jim,
I use the percent changes because it is just easier to see how the equation works using FRED graphs.
So you think velocity is low because money is being distributed to higher income earners? That is interesting.

[AB]

Edward,
"... we know that velocity can change and how."

Okay, if you could independently define V, that would prove me wrong. I don't think the economy works that way and any attempt results in a ptolemaic model. But, I am open minded.

[Edward Lambert]

AB,
Take an economy where nothing changes... real output, money supply in circulation, new investment, productive capacity, utilization of labor and capital... all that stays the same. Also the velocity of money has a ratio of 2. Inflation is 0%.
Now what would happen if all of a sudden real GDP starts to rise 2% continuously because of increased productivity?
Holding velocity constant, inflation would go to -2% continuously in order for the money supply to circulate to buy the increased quantity of goods and services.
But what if you have price stickiness and prices do not drop. Then velocity will have to grow by 2% continuously.
The likelihood is that you will see some price declines and some increases in velocity due to falling prices. So price stickiness causes changes in velocity.

Ultimately if inflation is to stay at 0%, you may end up with velocity increasing 1%, and the money supply increasing 0.5% (not 1% since money supply is half of nominal GDP).

So velocity is part of the dynamics of inflation.
If velocity gets pushed too high due to a lack of money supply, the economy experiences friction in its transactions. It would be better to inject more money in order to bring velocity into a comfortable zone.

It goes back to the idea of homeostasis which allows life to exist. Physiology has a certain rhythm that optimizes bodily functions. If you speed up a rhythm, you risk optimal homeostasis and sickness.
Such is the case of velocity. A velocity of 10 is much too high. You are forcing people to move money too fast in order to meet nominal GDP demands. A velocity of .5 is much too low. You are not letting people do enough transactions to express their demands. Money is sitting idle.
According to the graph at this link...
http://research.stlouisfed.org/fred2/graph/?g=Po0

The normal velocity is around 1.75. In the 20 years before the crisis, velocity was running over 2. That tells me that incentives were forcing people to move money too much. The result was bubbles and the like.
It is more sustainable to have a velocity over 1 and less than 2. Why?
You at least want all money to move once. Also you do not want money to move more than twice as that increases debts too much. People all of a sudden do not have the money to keep up with high velocity spending so they borrow.

Velocity tells an important part of the overall picture.

[AB]

EL,

Correct me if I am wrong, but your longer form description still defines V as PY/M. You have not said anything about how V is independently established.

PY and M are the only independently observable values. The fact that PY/M fluctuates so much tells me that there is not a strong relationship between PY and M.

-AB

[Edward Lambert]

AB,
V has meaning.
When V is less than 1, you have money that does not enter into transactions. There would be too much money.
When V is more than 2, there are distortions from policies that try to move money faster. Output becomes inflated over natural trends.

PY/M is just V. Yet, V does not fluctuate tremendously. Even the Fed seeks stability in P.
Once you have well-anchored expectations of P due to Fed credibility, then MV respond more to changes in Y.

PY is nominal output.
MV is nominal money flow.

A key aspect of controlling M is to obtain an optimal V between 1.5 and 1.8.

It is no problem that V cannot be measured directly. We can still deduce it. There are other variables that are obtained by deduction... like capacity utilization.