INM MAGAZINE VOLUME 8 | FEBRUARY 2016
#Economics
DEFLATION & DISRUPTION
KUSHAGRA JAIN
Institute of Management, Nirma University
Batch – (2014-16)
M
ost economic theories that attract a large
and devoted following are sooner or later
victims of their own success. The quantity
theory of money is a good example. This theory is
the basis for a school of economics known as
monetarism, which has had a powerful inuence on
central banking since the 1970s.
In its simplest form, the quantity theory of money
says that money supply times the velocity of money
equals nominal GDP. Velocity is just a measure of
how quickly each printed dollar turns into a dollar of
goods or services.
If everyone stays home and leaves their money in
the bank, velocity is zero. If people go shopping,
and those who receive the money spend it too, then
velocity grows.
Fisher in the 1920s and continuing through Milton
Friedman in the 1970s, believed that velocity was
constant.
Using these inputs of 3% real growth, price stability
and constant velocity, monetarists concluded that a
slow, steady increase in the money supply — just
enough to accommodate real growth — would
produce maximum real growth with no ination or
deation. This is central bank nirvana.
Of course, reality is messier than the theory implies,
and there are leads and lags in the response to
monetary policy. Real growth could be higher or
lower than 3% for certain periods. But the basic idea
that steady monetary growth could produce steady
economic growth was taken as gospel by Friedman
“In its simplest form, the quantity theory of
money says that money supply times the
velocity of money equals nominal GDP.
Velocity is just a measure of how quickly each
printed dollar turns into a dollar of goods or
services.”
Nominal GDP is the gross dollar value of goods and
services. It is broken into two parts. One part
represents real value and the other represents
ination or deation.
Figure 1
As a simple mathematical equation, the theory is
written as M * V = P * Q, where M is money supply, V
is velocity, P is a price index and Q is real GDP.
Most economists agree that long-run potential
growth in a developed economy such as the United
States is about 3%. They also agree that price
stability is a desirable goal and that neither ination
nor deation should play much of a role in spending
and investment. Monetarists, starting with Irving
and his followers.
There was only one problem with this neat, tidy
monetarist theory. Like a lot of economic theories, it
worked better in the faculty lounge than in the real
world. In particular, one of the core assumptions —
that velocity is constant — turns out to be false.
As Figure 1 above shows, velocity varies widely over
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