Monetarist theory is a concept that, in an extremely simple description, posits that the money supply is a key driver of economic growth, inflation, and the business cycle. Given the massive increase in the money supply as a source of stimulus to combat the COVID downturn and the subsequent bout of inflation we are currently working through, there is some very recent real-world support for the framework.
I don’t really have an opinion about monetarist theory or, more broadly, any theory about what drives what because I typically find the world too complicated to even have a clue about what’s going to happen tomorrow. However, there is one particular formula popular amongst monetarists that is extremely useful as a tool for thinking through potential outcomes for a given economic scenario. It goes as follows: MV = PQ.
M stands for the money supply
V is the velocity of money
P represents the price of things
Q is quantity of goods and services
Theoretically, this equation has to be true. That’s because, V can be broken into its ratio of nominal GDP divided by the money supply, so MV is really just nominal GDP. And, PQ is basically the change in prices (essentially, inflation) times real GDP, which is nominal GDP. Both sides cancel each other out if you do some algebra.
If we are basically just saying two things are the same thing with some mathematical mumbo jumbo, then why is this formula useful? The reason is, if we have three of the four variables, we can figure out what the fourth will be.
Let’s take an example. Suppose we want to know what is going to happen with inflation. All we need is a forecast for the money supply, real GDP, and the velocity of money.
We don’t even have to put numbers to it. If we know that the money supply is going to grow faster than average and GDP is going to be about normal with a relatively consistent money velocity, we would expect inflation to rise.
We could make it even simpler and assume what might happen in a situation where things are relatively constant and one variable changes. If there is a slowdown in the growth of the money supply, then inflation has to go down or real GDP must go down. Alternatively, the velocity of money could go up and keep those things the same.
One super interesting relationship that comes from this is the interaction of economic growth and inflation. Often, people think about the economy “overheating” in the sense that growth starts picking up so fast that inflation will also pick up. But, if we assume the money supply and money velocity stay the same then it is actually the opposite - more growth leads to lower inflation!
It’s also the case then that less growth leads to higher inflation. If we think about our current situation of fading stimulus slowing down forward economic growth…that’s not a good sign for coming inflation. That’s part of the reason why there are expectations for a slowdown in the money supply. But, with a slowdown in the money printer we would expect an impact to economic growth.
So, the whole situation is kind of messy when you start moving around a lot of variables - not an enviable position for those who have to make the tough decisions and try to steer the economic ship, so to speak.
The complexity also invites the potential for error. That’s why it’s important not to create problems of your own doing and, while no one responsible will readily admit it, maybe the money printers running so hot for so long created (or at least exacerbated) a bit of an inflationary problem that now is going to be a lot less fun to fix than it was to create.
I say all of this not as an expert. I’m just using the useful MV = PQ tool to make an educated guess on some potential future scenarios. Hopefully you find it useful for your own thinking when it comes to potential what-if scenarios for the future!
Have a question you want to ask or a topic you’d like to see covered? Let me know!
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