Post coronavirus: putting more V in MV=PT

Governments around the world introduce unprecedented fiscal stimulus packages to compensate those who have been impacted by the enforced lockdown. In New Zealand Finance Minister Grant Robertson announced a $12.1 billion stimulus package to support New Zealanders and their jobs from the global impact of COVID-19 – the largest in the world on a per capita basis. The money is hopefully going to bring as many businesses back from the brink of closure but the crucial aspect of this injection is that it actually does stimulate demand and generate additional spending. Businesses that survive this pandemic and open their doors again will need the demand side of the economy to do its bit.

Demand side

The lockdown has badly affected the demand side of the economy and it won’t revert back to the way it away was overnight. Will people venture back into areas with large crowds – bars, restaurants, hotels etc? It is essential that demand makes a return in order to inject some inflation into the economy. But with such uncertainty consumers will want to put off a lot of non-essential purchases. Many economists are also concerned with the “output gap.” — the difference between what the economy could produce and what it was producing. The solution to this output gap, particularly one caused by collapsing economic demand, is to invest in infrastructure projects and give consumers cash. If consumers don’t spend then the government should step-in and spend on their behalf to create the demand necessary to return the economy to some sort of normality. One indicator that we shouldn’t be worried at present is inflation – in theory such a stimulus should create inflationary pressure – the 1970’s yes but today this is less likely when you look at the velocity of circulation.

Velocity of circulation of money is part of the the Monetarist explanation of inflation operates through the Fisher equation:

M x V = P x T

M = Stock of money
V = Income Velocity of Circulation
P = Average Price level
T = Volume of Transactions or Output

For example if M=100 V=5 P=2 T=250.   Therefore MV=PT – 100×5 = 2×250. Both M x V and P x T are equivalent to TOTAL EXPENDITURE or NOMINAL INCOME in a given time period. To turn the equation into a theory, monetarists assume that V and T are constant, not being affected by changes in the money supply, so that a change in the money supply causes an equal percentage change in the price level.

However when the velocity of money is falling, monetary policy which would otherwise cause inflation doesn’t seem to do so. The velocity graph (USA) above shows that you need to go back to 1949 to find a time when it was lower than today, and it was actually rising rapidly after the postwar lows. Remember that this graph was before the Covid-19 lock down. Velocity needs to increase at rapid rate to cause any inflation.

We have no idea of how the future is going to unfold because we have never seen anything like this before – to quote Rogoff and Reinhart – This time it is definitely different.

Source: Thoughts from the from line by John Mauldin

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