Monday, June 25, 2012

Velocity of Money

In this post I am looking at some real data for the Equation of Exchange.

The orange line is the velocity of money scaled by 5000 so it can be on the same graph as the other data.  The red line is a measure of the quantity of money.  The blue line is these two things multiplied together.   The green line is a measure of inflation scaled so it can compare to the blue line.

The velocity of money has been trending down since 1980 and is now the slowest in the data available. If we multiply the velocity of money times the quantity of money it roughly matches the price level. If the velocity of money starts going up the price level can go up faster than the quantity of money, which is what happened in the 1970s.

Since the recession started the velocity of money went down sharply and the quantity of money went up sharply.   So far the slower velocity of money has compensated for the increased quantity of money so that inflation is not bad.   This will not last.  The velocity of money is at the lowest level recorded and can not keep going down.  Once it stops going down or starts up then inflation will pick up.

Hussman has shown that lower interest rates lower the velocity of money and higher interest rates increase the velocity of money.  So once inflation picks up and the fed has to try to fight inflation by raising rates it will have the problem that raising rates increases the velocity of money which causes inflation.  This is why it is "hard to put the inflation genie back in the bottle".