EYE ON ECONOMICS: Velocity of Money and Inflation in the United States. May 29, 2015

Transcription

1 EYE ON ECONOMICS: Velocity of Money and Inflation in the United States May 29, 2015

2 CERC is a nonprofit corporation and public-private partnership that provides our clients with objective research, marketing and economic development services. Our mission is to provide services consistent with state strategies, leveraging Connecticut s unique advantages as a premier business location. Produced by the CERC Research Department: Alissa DeJonge, V.P. of Research Carmel Ford, Research Analyst Matthew Ross, Economist

3 Velocity of Money and Inflation in the United States Although the economy has recovered considerably since the recession, inflation in the United States has remained low. The US economic recovery started to pick up significantly in 2012 in terms of gross domestic product and job growth, however since then inflation has averaged about 1 percent, which is well below the US Federal Reserve s annual inflation growth target of 2 percent. For some time, it was even thought that the US would fall victim to deflation, which most agree should be avoided. The lack of inflation appears to be perplexing given the unprecedented level of money supply, or high powered money, injected into the economy to stimulate aggregate demand by the US Federal Reserve s quantitative easing program. Referencing Milton Friedman from the Monetarist school of thought, inflation is always and everywhere a monetary phenomenon. In other words, the huge increase in money should have proportionately impacted inflation. In fact, evidence of this phenomenon has appeared throughout the world, especially in developing countries. During the 1980s, Latin American countries in particular took on the practice of printing money to cover huge deficit and debt burdens, which led to inflation and hyperinflation (Figure 1). Although not displayed on the graph below, Brazil had one of the highest average inflation rates during this time period (613 percent). Figure 1: Average Money Supply and Inflation Growth ( ) R² = Average Inflation Growth Average Money Growth 1 Number of observations = 114 countries.

4 However, based on the modern monetarist definition of the quantity theory of money, money supply is not the only variable impacting inflation. According to this identity model, the velocity of money also plays a role: Money Supply (M) x Velocity (V) = Price Level (P) x Output (Y) MV = PY Previously, it was thought that the velocity of money, which is typically defined as how rapidly money change hands in the economy, was constant and predictable over time. However, it is now widely accepted that velocity can change over time and can be unpredictable. In fact, in the United States the velocity of money has changed significantly (Figure 2). In the post- recession recovery, velocity spiraled downward significantly, reaching historically low levels 2. From a monetarist perspective, this decrease in velocity helps to explain why inflation has not increased given the substantial increase in the money supply by the US Federal Reserve. Figure 2: The Velocity of M2 3 in the United States ( ) VELOCITY OF MONEY Post- recession Source: World Bank, usinflationrates.com, CERC calculations The decrease in the velocity of money has been on the minds of policymakers. Austan Goolsbee, former chairman of President Obama s White House Council of Economic Advisers, was quoted as saying We re simply not going to get inflation until velocity gets back to something normal. 4 Some believe that velocity has been decreasing because real interest rates, which impact the money supply, have been near zero percent. The interest rate environment provides an incentive to hoard 2 The- Economy/2014/September/What- Does- Money- Velocity- Tell- Us- about- Low- Inflation- in- the- US 3 M2 is defined as a measure of money supply that includes cash and checking deposits (M1) as well as near money. Near money" in M2 includes savings deposits, money market mutual funds and other time deposits, which are less liquid and not as suitable as exchange mediums but can be quickly converted into cash or checking deposits /the- recovery- and- the- speed- of- money

5 cash, rather than invest in instruments that are not as liquid as cash. For example, many banks have chosen to hold money in reserves beyond what is required, rather than lending because they most likely perceive it to be risky. To provide perspective, according the Federal Reserve Bank of St. Louis, the ratio of currency in circulation to bank reserves was approximately 0.46 in August 2014, while in August 2007 (pre- recession) was 100. Banks are definitely holding on to money, thus affecting velocity. While putting together this analysis, we inserted actual data into the quantity theory of money model to see if it would match or come close to actual inflation. The model can be altered to show percent changes in each variable: % Δ P = % Δ M - % Δ Y + % Δ V Figure 3 shows the results. It appears that current inflation levels make sense based on the model. Although the predicted model does not exactly match actual inflation, it shows that inflation is low. Based on this it is likely that velocity is playing a role in inflation levels. It is important to note that the quantity theory of money model is more effective when analyzing inflation over the long- term, rather than the short- term as prices are sticky in the short- term. This means that prices of goods and services do not change immediately to reflect price level changes in the broader economy. Of course, in addition to evaluating inflation from a monetarist perspective, it is important recognize other factors affecting inflation, such as current deflationary pressure originating from oil price decreases. This type of deflation is often categorized as the only good type of deflation. Figure 3: Actual and Predicted US Inflation Using the Quantity Theory of Money Model ANNUAL PERCENT GROWTH 10% 9% 8% 7% 6% 5% 4% 3% 2% 1% 0% Actual Inflation 3.1% 3.3% 1.7% 3.4% 1.6% Predicted Inflation 2.5% 4.1% 2.7% 1.5% % Source: World Bank, usinflationrates.com, CERC calculations