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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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Let's say the central bank doubles the money supply to $2,000,000. If the velocity of money is still 12, then the GDP would grow to $24,000,000. That would be a good thing, wouldn't it?

The answer is no, because only 20% more goods are produced from the two new businesses. There's a relationship between production and price. Each business would now sell $200,000 per month or double their previous sales, which they'd spend on goods and services that had only grown by 20%. They'd start to bid up the price of the goods they want, and inflation would set in. Think of the 1970s.

So, our mythical bank decides to boost the money supply by only 20%, which allows the economy to grow and prices to stay the same. Smart. And if only it were that simple.

Let's assume 10 million businesses, from the size of Exxon (XOM) down to the local dry cleaners, and a population which grows by 1% a year. Hundreds of thousands of new businesses are being started every month, and another hundred thousand fail. Productivity over time increases so that we're producing more "stuff" with fewer costly resources.

Now, there's no exact way to determine the right size of the money supply. It definitely needs to grow each year by at least the growth in the size of the economy plus some more for new population, and you have to factor in productivity. If you don't, then deflation will appear. But if the money supply grows too much, then you've got inflation.

And what about the velocity of money? Friedman assumed it was constant. And it was, from about 1950 until 1978 when he was doing his seminal work. But then things changed. Let's look at two charts, the first from Stifel Nicolaus Capital Markets.

Here we see the velocity of money for the last 109 years. The left side of the chart shows the velocity of money using both M2 and M3 (measures of the money supply).



Notice that the velocity of money fell during the Great Depression. And from 1953 to 1980, the velocity of money was almost exactly the average for the last 100 years. Lacy Hunt explained that the velocity of money is mean reverting over long periods of time. That means one would expect the velocity of money to fall over time back to the mean or average. Some would make the argument that we should use the mean from more modern times since World War II, but even then, mean reversion would mean a slowing of the velocity of money (V), and mean reversion implies that V would go below (overcorrect) the mean. However you look at it, the clear implication is that V is going to drop. In a few paragraphs, we'll see why that's the case from a practical standpoint. But let's look at the first chart.

Y=MV

And then let's go back to our equation, Y=MV. If velocity slows by 30% (which it well has in terms of M3 -- and it's down more than 15% in terms of M2) then money supply (M) would have to rise by that percentage just to maintain a static economy.
No positions in stocks mentioned.

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