The news seems to be more of the same, so I thought I would take a little time and explore the topic of money supply. Doesn’t that sound exciting :-).

A lot of silly things get said on the news and having a deeper understanding of this subject will help you filter some of those out. It will also help you understand why both prolonged low inflation and then sudden high inflation are in our future (IMHO). Since this tends to be a bit cerebral, please leave a comments on any parts that are unclear.

Imagine a world with two entities trading back and forth. One produces water and the other food. Entity F buys 1 water every month for $1 from entity W and entity W buys 1 food for $3 from Entity F once every quarter.

How much money does this economy need to operate? $3, which will get passed back and forth. The GDP of this economy is $24 ($12 of water and $12 of food). So the velocity of money is $24/$3 = 8.

Now what happens if both entities double their production and consumption? GDP doubles to $48. And if the money supply stays at $3, then prices will drop in half (i.e., entity F will buy two waters once a month for $0.50 each). So if we want price stability the money supply needs to increase with GDP (i.e., double to $6 in this case).

There is an alternative to doubling the money supply however. If both entities also made their supply and demand more frequent (e.g., every half month for 1 water and every one and half month for 1 food) then the original $3 would still be sufficient, but the velocity of money would have increased from 8 to $48/$3=16 (i.e., doubling).

So the doubling of the velocity has the same effect on pricing as the doubling of the money supply. And halving the velocity would have the same effect as halving the money supply.

Now imagine that you are the central banker and you can increase or decrease the money supply but you don’t directly control the velocity of money (it is the entities in the economy who control that). You realize that not only must you anticipate how much GDP will grow, but you must also guess how the velocity of money will change. Any any errors you make will put pressure on pricing up or down (which will feedback into affecting GDP and velocity). And like balancing a ball on a long stick, once you guess badly, it becomes very hard to get back to a stable position.

Hopefully you being to see how difficult a job the central banker has in this respect. In my next money supply post I will talk about our reserve banking system and how derivatives made the central bank’s balancing act even harder.