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Thursday, November 11, 2010

Another Reason Why Inflation Isn't Coming Courtesy of Milton Friedman

MIilton Friendman is best known (among economists not political pundits) for his quantity theory of money i,e, monetarism:

from Wikipedia
he equation of exchange can be used to form a rudimentary version of the quantity theory of the effect of monetary growth on inflation.
P=\frac{M\cdot V}{Q}.
If V and Q were constant, then:
\frac{d P}{P}= \frac{d M}{M}
and thus
\frac{d P/P}{d t}=\frac{d M/M}{d t}
t is time.

which says that the inflation rate equals the monetary growth rate plus the growth rate of the velocity of money minus the growth rate of real expenditure. If one makes the quantity theory assumptions that, at least in the long run, (i) the monetary growth rate is controlled by the central bank, (ii) the growth rate of velocity is purely determined by the evolution of payments mechanisms, and (iii) the growth rate of real expenditure is determined by the rate of technological progress plus the rate of labor force growth, then while the inflation rate need not equal the monetary growth rate, an x percentage point rise in the monetary growth rate will result in an x percentage point rise in the inflation rate.

Looking at thiese charts(from the great website  it seems clear to me Friedman would not be looking at the prospect of future inflation. There is no velocity to money. Unfortunately it also may mean that the economiy is in a " liquidity trap" and the fed's easing will do little to help the economy (which doesnt mean  it's not worth a try)

 Here(immediately below)  is the "V" from the equation

and here (immediately above) is the "M"

here is money supply and inflation expectations via the tips/conventional bond spread (excuse the scan from the FT). . Note that M2 (money in circulation) hasn't changed even as the monetary base M1 increased. The Fed can only move M1 M2 reflects whether or not the banks sit on the money or lend it out creating a multiplier of wages and consumer spending. M2 creates spending an potentially inflation. Money sitting in the vault and not circulating can't create inflation (or jobs).

a nice article on the deflation vs inflation argument is here

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