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# Why We're Facing Deflation

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## How velocity, money supply, and currency-printing affect the economic environment.

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Now let's dig a little deeper. Y, or nominal GDP, can actually be written as Y=PQ, that is, GDP is the Price paid times the total Quantity of goods sold. Therefore, since Y=MV, the equation can be written as MV=PQ. But the point is that Price (P) is tied to the velocity (V) of money. You can increase the supply of money, and if velocity drops you can still see a drop in the P, or inflation.

Now, let's complicate our illustration just a bit, but not too much at first. This is very basic, and for those of you who will complain that I'm being too simple, wait a few paragraphs, please. Let's assume an island economy with ten businesses and a money supply of \$1,000,000. If each business does approximately \$100,000 of business a quarter, then the gross domestic product for the island would be \$4,000,000 (four times the \$1,000,000 quarterly production). The velocity of money in that economy is four.

But what if our businesses got more productive? We introduce all sorts of interesting financial instruments, banking, new production capacity, computers, and so forth, and now everyone is doing \$100,000 per month. Now our GDP is \$12,000,000 and the velocity of money is 12. But we haven't increased the money supply. Again, we assume that all businesses are static. They buy and sell the same amount every month. There are no winners and losers as of yet.

Now let's complicate matters. Two of the kids of the owners of the businesses decide to go into business for themselves. Having learned from their parents, they immediately become successful and start doing \$100,000 a month. GDP potentially goes to \$14,000,000. But, in order for everyone to stay at the same level of gross income, the velocity of money must increase to 14.

Note: If the velocity of money does NOT increase, that means (in our simple island world) that on average, each business is now going to buy and sell less each month. Remember, nominal GDP is money supply times velocity. If velocity doesn't increase and money supply stays the same, GDP must stay the same, and the average business (there are now 12) goes from doing \$1,200,000 a year down to \$1,000,000.

Each business now is doing around \$80,000 per month. Overall production on our island is the same, but is divided up among more businesses. For each of the businesses, it feels like a recession. They have fewer dollars, so they buy less and prices fall. They fall into actual deflation (very simplistically speaking). So, in that world, the local central bank recognizes that the money supply needs to grow at some rate in order to make the demand for money "neutral."

It's basic supply and demand. If the demand for corn increases, the price will go up. If Congress decides to remove the ethanol subsidy, the demand for corn will go down, as will the price.

If the central bank increased the money supply too much, you'd have too much money chasing too few goods, and inflation would rear its ugly head. (Remember, this is a very simplistic example. We assume static production from each business, running at full capacity.
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