Pages

 

The Equation of Exchange Still Makes Sense

0 comments
Over at Alphaville, Isabella Kaminska is fretting over what seems to be a breakdown in the equation of exchange:
So what’s wrong with Irving Fisher’s famous MV = PT equation? Why has throwing money at the problem not affected the relationship between money and income in the equation the way it supposedly should?
Drawing on a research note by Standard Chartered, Isabella concludes the answer must be with velocity. Let me reassure Isabella that the equation of exchange still holds and that there is more to story than just velocity. As I showed in an earlier post, the way to see this is to first note that M, the money supply, is the product of the monetary base, B, times the money multiplier, m:

M = Bm.

Now substitute this into the equation of exchange to get the following (I use PY instead of PT ):

BmV = PY

Now we have an identity that says the sources of nominal spending, PY, are the monetary base, the money multiplier, and velocity. Here, V = velocity or the average number of times a unit of money is spent, P = price level, Y = real GDP, and thus, PY = nominal GDP. This accounting identity allows us to think about what causes may have been behind the the dramatic decline in nominal spending, PY. Using MZM as the measure of M and monthly nominal GDP from Macroeconomic Advisers to construct velocity (i.e. V=PY/M), the three series on the left hand side of the expanded equation of exchange are graphed below in levels (click on figure to enlarge):



The last time we saw this figure was in September 2009. I noted then that the surge in the monetary base was largely offset by decline in the money multiplier leaving velocity as the main factor pulling down nominal GDP. This doesn't seem to have changed much, though velocity looks like it has bottomed out. I also noted then that the decline in the money multiplier probably reflects (i) the problems in the banking system that have led to a decline in financial intermediation as well as (ii) the interest the Fed is paying on excess bank reserves. The decline in the velocity is presumably the result of an increase in real money demand created by the uncertainty surrounding the recession. For the sake of completeness, the below figure graphs the the right-hand side of equation (2):

0 comments:

Post a Comment

  • Greenspan's Cult of Personality... Review topics and articles of economics: Alan Greenspan was a legend in his time and there was no shortage of praise for him back then. For example, who can forget Bob Woodow's 2000 book Maestro: Greenspan's...
  • Yes Tyler, Low Interest Rates Matte... Tyler Cowen is wondering whether the Fed's low interest rates in the early-to-mid 2000s really were that important to the credit and housing boom of the early-to-mid...
  • The Eurozone Crisis: Deja Vu... Review topics and articles of economics: Randal Forsyth sees similarities between the current unfolding of the Eurozone crisis and that of the U.S. financial crisis a few years back:Just as the problem on this...
  • Charles Plosser and the Burden of F... The Economist's Free Exchange blog is shocked to hear this from Federal Reserve Bank of Philadelphia President Charles Plosser:"Since expectations play an important role...
  • Arnold Kling and Expected Inflation... Review topics and articles of economics: What do we know about expected inflation? According to Arnold Kling not much if we look to financial markets:I'm also not convinced that we can read expected inflation...
  • A Paper on Stabilizing Nominal Spen... Given the recent discussion on stabilizing nominal spending as a policy goal I found this article by Evan F. Koenig of the Dallas Fed to be interesting: The article...
  • Why The Low Interest Rates Mattered... Review topics and articles of economics: This is the second of two posts detailing why the Fed's low interest rate policies in the early-to-mid 2000s was one of the more important contributors to the credit and...
  • Why The Low Interest Rates Mattered... This is the first of a two-part follow up to my previous post, where I argued that the Fed's low interest rate policy was a key contributor to the credit and housing...
  • The Stance of Monetary Policy Via t... Review topics and articles of economics: There has been some interesting conversations on the stance of monetary policy in the past few days between Arnold Kling, Scott Sumner, and Josh Hendrickson. Part of...
  • Scott Sumner's New Best Friend:... Joseph Gagnon is calling for $6 trillion more in global monetary easing. This should not be too hard to implement since the Fed is a monetary superpower.Update: The...
 
Review topics and articles of economics © 2011 The Equation of Exchange Still Makes Sense