Today, my part-rant, part-lecture will be on the topic of people who think that the dollar needs to be 'strong' in order for America to be successful, and that any 'weakening' of the dollar is automatically a bad thing.
I'm sure you all know if you're this kind of person.
Anyways. This group of people generally hold to two separate but related beliefs - that inflation is bad, and that any devaluation of the dollar against other currencies is bad. I will cover both topics separately.
Before talking about inflation, a little equation, for those of you not in the know: MV = PQ. This equation is a short and absolutely correct statement relating to inflation and the GDP.
(Wikipedia page for Quantity Theory of Money.)
M stands for the amount of money currently in the economy. V stands for velocity, or the number of times the average dollar changes hands.
(Page for the economic concept of money supply, for reference below.)
P stands for the average price of goods. Q stands for the total quantity of goods produced.
Assuming that we look at the equation over the span of one year PQ is equivalent to the gross domestic product, or GDP. Thinking about it, MV must equal PQ, because the amount of things bought must, by the very nature of transaction, be equivalent to the amount of money times the average number of transactions that each quantity of money goes through.
Now, imagine we have a growing economy. This means Q is increasing over the course of one year. To balance the equation, one of the following must happen:
1) The total amount of money in the system increases.
2) The velocity of money increases.
3) Prices decrease.
Velocity is generally held to be very inelastic, so the possibility of velocity accounting for all of the change in Q is very unlikely in a growing economy. This is backed up by plenty of empirical evidence that I will not go into here. Hopefully you can trust me on this one.
Decreasing prices seems like a good thing, but this phenomenon, deflation, is often considered one of the worst possibilities
We are then left with number one being the best possible case out of the three. If we release additional money into the economy as the economy grows, we can keep prices stable and everyone will be happy. Right?
Not quite. This isn't the whole picture, because we've ignored an important factor - what causes growth?
In the American economy, growth is spurred by investment. Investment increases the amount of money now at the cost of less money in the future. Conversely, you could think of it as moving money from M3 or M2 to M1, at the cost of some loss to friction; this would increase V temporarily, rather than M, at the cost of M in the future.
(The second would be the case if you include M2 and M3 amounts in your M, which is not usually the case. Those counts usually only include M1.)
In either case, growth now calls for a current increase in M (or V) but a future decrease of M that is greater than the current increase. Because of the inelastic nature of V (outside of borrowing when you take into account all money, as above), to balance the equation, something needs to occur on the other side when we lose M in the future.
As Q can only increase by growth, and more increase in Q would require more investment, leading to an even greater decrease in the future, the only possibility is that, in the future, prices will decrease as a result of growth.
The most efficient method of balancing this out is to increase M by more than growth. In fact, when an economy has constant, steady growth, increasing M by enough to increase P at the same rate as Q is the correct move, as it will balance out the amount of money in the system in the future, therefore ensuring that prices will not drop - again, a much worse problem than moderate inflation.
(Wikipedia page on deflation, and why it's so bad.)
So there you have it, folks! Inflation is an integral part of a healthy, growing economy. Understanding this is very important, as it also helps you to understand one of the main purposes of the Federal Reserve - ensuring that the growth of the money supply is at the correct level.
And this has been significantly longer than I wished it to be, so I'm going to stop now. I'll cover the other half of my pet peeve tomorrow or the next day. Thanks for reading, and I hope you learned something.
No comments:
Post a Comment