The Equation of Exchange says:
- = Money supply
- = Velocity of money
- = Price level
- = Real GNP
When you first introduce the punchbowl, as the Fed buys bonds or lends to banks cheaply the money supply goes up and the interest rates go down which makes the velocity of money also go down (as seen in the graph above). The lower velocity of money can largely compensate for the increased quantity of money so that the price level does not change too much. It seems like free money has no downside and the central bank has amazing powers.
- However, if you try to withdraw the punchbowl the interest rates also go up, increasing the velocity of money. This increased velocity of money compensates for the reduced money supply so you have the pain of higher interest rates but still get the inflation. It can seem like "inflation is out of control" and the central bank is powerless. This makes for a difficult time for a central bank. It can take a very strong leader and a recession to really get inflation under control.
However, the velocity of money can also go up because of inflation. So if they don't take the punchbowl away you can get inflation because of the increasing money supply and also from the increasing velocity of money. In bad cases this can develop a positive feedback loop and really get out of control.
- John Hussman has a graph showing how extreme the current conditions of low interest rates, high money supply, and low velocity of money are:
- Even a tiny move from 0.125% to 0.25% in the fed funds rate would imply a similar move in 3-month treasuries, which the above graph indicates will cause a large increase in the velocity of money. By the equation of exchange, a large increase in the velocity of money will increase the price level and inflation.