Thursday, December 10, 2009

Velocity Of Money

velocity has become the key driver in the entire world-wide economic crisis, so here is a quick explanation of it. Money responds to the law of supply and demand just as everything else does. If people do not want a particular currency — let's say the British pound — then the value of a pound will fall.
Sellers will demand more pounds in trade for their goods or services, and prices in Britain will rise, even if there has been no change in the supply of pounds. On the other hand, if the demand for pounds rises, the value will rise and prices will fall even if there has been no change in the supply of the currency.
Velocity is the speed at which money changes hands. When demand for the money is high, money changes hands more slowly, and velocity is low. When demand for the money is low, velocity is high. A key point is that velocity and money supply can act as substitutes for each other. A 10% rise in velocity has the same effect as a 10% rise in money supply. The biggest problem with velocity and money demand is they can turn 180 degrees overnight. If people trust the currency, and suddenly perceive some kind of big threat to their futures, money demand can shoot up. That's exactly what happened last year. The supply of dollars certainly did not go down, but when the real estate crash happened, people became so frightened they were afraid to let go of their dollars. Within a few days, money demand shot up, people stopped spending and held onto their dollars, and this had the same effect as an instantaneous deflation of the money supply. If you don't spend your money, that's the same thing as taking it out of circulation. This can instantly cause the equivalent of a sharp deflation of the money supply by 10 or 20 percent, or more.
The velocity of money is not CONSTANT. Instead, velocity changes as consumers' preferences change. It also changes as the value of money and the price level change. If the value of money is low, then the price level is high, and a larger number of bills must be used to fund purchases. Given a constant money supply, the velocity of money must increase to fund all of these purchases. Similarly, when the money supply shifts due to Fed policy, velocity can change. This change makes the value of money and the price level remain constant.

The relationship between velocity, the money supply, the price level, and output is represented by the equation M * V = P * Y where M is the money supply, V is the velocity, P is the price level, and Y is the quantity of output. P * Y, the price level multiplied by the quantity of output, gives the nominal GDP. This equation can thus be rearranged as V = (nominal GDP) / M. Conceptually, this equation means that for a given level of nominal GDP, a smaller money supply will result in money needing to change hands more quickly to facilitate the total purchases, which causes increased velocity.

Also there is a huge difference between Demand pull inflation and stagflation. Stagflation ( stagnation of economic growth + inflation in essentil cost of good & services) is a direct impact of currency devaluaion thru printing press and monetizing debt. So distinguish between inflation & stagflation and also distinguish between ASSET deflation which is credit contraction vs REAL deflation ( contraction of credit + drastic reduction in essential cost of goods & services including food, tuition cost, home & car maintenance cost, taxes, insurance,,etc).

16 comments:

  1. Kli, I see potential inflation in China. But not the USA or other Western economies. Chinese banks are forced to lend by their government. But the US/UK/EU's regulators have no such authority.

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  2. arev,

    I think you and kli are both right. The symptoms are trying to be treated but the disease is ravaging on and on. It is not just isolated to the US. China is clearly a bubble; Dubai is the first, but is certainly not the last state to melt down. In the US whole States are going up in smoke. NOBODY is dealing with all the EXCESS spending GOVERNMENTS (not consumers) are STILL doing. Until budgets are balanced, there is no way out. But what is worse than that is the catastrophic leverage the CDSs bring. I cannot see how any issuer of CDSs has or can successfully hedge against a 1,000 to 1 ($100k premium buys $10 million in coverage) bet. And I don't want to find out whether or not they did, but things are headed that way FAST.

    IF governments start to do the right thing and balance budgets through CURTAILED SPENDING, we will certainly have deflation and Depression. But even today, we see that they do not get it--with UK and Greece being prime examples.

    I think we have collapsing asset prices but rising prices in necessities--hyperstagflation. But if it gets where I think we all fear, and the probabilities continue to increase that, it is going, then we need to get beyond even gold as a solution.

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  3. Great post Kli,

    I agree that the velocity of money does have an impact on inflation/deflation. But to be quite honest, I believe you are pushing into the problem instead of the root causes of those problems.

    Problems you mentioned:

    High demand for currency = low velocity
    Low demand for currency = High velocity
    Rise of money supply = rise in velocity
    Decrease of money supply = decrease in velocity

    To be honest, you are probably right about all these problems, and I will not refute any of it.

    With regards to your statement about stagflation, "stagnation of economic growth + inflation in essential cost of good & services as a result of currency devaluation thru printing press and monetizing debt" makes little sense if you look at the whole picture.

    I agree with the first part (stagnation of economic growth) without a doubt. First tell me why you believe there will be less demand for dollars, as you portray on your thesis. As you mentioned above, the opposite occurred last year, as demand for USD increased when investors and individuals were hoarding cash. When Dubai crashed, demand for USD went up. As a matter of fact, every time the credit markets froze up, demand for dollars went up.

    Obviously depending on what your answer to question 1 is, where does the demand come from to make those essential goods and services go higher? Again, I am not arguing the price of a particular good/service.


    Dny

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  4. Dny,

    You asked;
    "where does the demand come from to make those essential goods and services go higher?"

    Government will increase the price of ESSENTIAL goods/services thru taxing, do not forget ESSENTIAL means people need it otherwise it would not be called ESSENTIAL. VAT tax will come to theatre near you as well. As more and more people become unemployed government has to find ways to collect revenue, that's done thru taxing. You still need food, insurance, fix car, home,,etc. You won't buy more food if you do not have a job, but what you NEED will be taxed higher to accomodate for quantity drop. They get you one way or the other.

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  5. Dny,

    The word STAGFLATION comes from STAGNATION + INFLATION, where do you think the inflation part of STAGFLATION includes,heheeee!

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  6. kli.... this one is for you, listen to the lyrics:
    http://www.youtube.com/watch?v=JChuUgio_8g

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  7. You guys are focusing on prices, which I believe is incorrect.

    I believe the root cause here is the money supply and credit. Velocity and prices are just symptons.

    We will see what happens going forward, but I just have a feeling you guys are going to be surprised.

    Dny

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  8. Dny,

    You keep saying, you guys are focusing on prices, what the fuck do you think in real world a person who lives day to day FOCUSES on. In every day life the REALITY which determines to citizens whether they are in deflation or inflation comes down to PRICE, it's REAL LIFE. If you do not CONNECT theories and concepts to REALITY which is PRICE then you MISS the whole ball of wax. The person in the street who is losing his job and his cost of living is still high, what do you think they will tell you, deflation. Start thinking in PRACTICAL terms, otherwise your argument becomes mute.

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  9. Anon, your "massive taxes on essentials" strikes me as incredibly unlikely. If essentials become more expensive as incomes continue to fall, then essentials will become the only thing people buy, at which point good luck holding a job, any job. Then it's either deflation or anarchy, which is what you get when you push on a string.

    Any major tax increase would lead to a deflationary spiral (not that we can't have one anyway), Too many people picked the same pocket at the same time. The government isn't going to stick their hand in there now because they know it's empty (you really think the bankers left anything behind for Uncle Sam?).

    We can't pay for this spending and they know we can't. They're hoping vainly that someday we can, but it sure won't be today or anytime in the next few years. Maybe next currency, even.

    Get incomes in an uptrend, then we can discuss sustainable price inflation and rising taxes. Otherwise.. nope.

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  10. Taxes already going up as Bush breaks expire and a whole new set coming with Healthcare for Everyone (at no cost). State income and sales taxes have already been raised in my state, much to the chagrin of retail. Thus the unemployment rate will not budge. There is just no good outcome or clear answers, but like another poster, I wonder what good owning gold will really do under these worst-case scenarios.

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  11. Here's an interesting paper by NY Fed researchers about why banks are holding so many excess reserves.

    http://www.newyorkfed.org/research/staff_reports/sr380.pdf

    To spoil your reading, they say excess reserves don't matter at all in banks' lending. If they want to lend, they lend and create money. Another interesting thing they say is that the money multiplier ceases to matter when the market interest rate is effectively at zero (like right now). It's on page 8 of the paper.

    We'll find out soon enough whether these Fed researchers are right.

    Also, the person above who says the price of goods and services is symptom, not the root cause. The root cause is money supply.

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  12. To steal a line from Denniger. If you think you need gold you will need lead even more.

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  13. I should have been more specific when I said "taxes" I suppose. State and local governments might try damn near anything. They're not "in the loop" on the real economic situation and they also don't have a magical printing press (yet).

    The feds won't let the states raise taxes drastically though.. They'd rather bail out the states than have incomes fall much further. We need to believe that everything's gonna be OK so we'll spend and borrow and spend and borrow. That's what yachts use for fuel. As Kliguy often says, it's all about CONfidence!

    Don't worry about paying for health care or Bush tax cuts expiring, if the worst comes to pass you're not going to be paying taxes at all. If the masses still had jobs paying well enough to care about tax rates we could afford to raise taxes, not to mention we'd be out of this mess already.

    If you say "But that can't last! What about China?!" I regret to inform you that you are correct.

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  14. Well I live in NY and we are getting "Fee'd" to death! Xtra fee's to DMV to float the MTA, Fee's added to Utility bills to cover lost Sale Tax revenue. County I live in passed 2.5% tax on all energy sources! Local Village & School Taxes are up and they will go up more next year as NYS will have less $$$ to pass down. Bush tax cuts due to expire & if they pass Health care they are gonna charge the tax FIRST! Than we all can get that GREAT coverage in 2013! IMHO Congress could care less about the consequence of it's behavior.

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  15. If anything major happens to hurt household income further, the congress will have to care about the consequences. Consequence will happen pretty much right away and it will be a depression. If the CONfidence is destroyed it means the big fish have failed, then look out below.

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  16. There's a movement to radically change California government, by getting rid of career politicians and chopping their salaries in half. A group known as Citizens for California Reform wants to make the California legislature a part time time job, just like it was until 1966.

    www.onlineuniversalwork.com

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