The Flinchum File
Thoughtful Economic Analysis and Existential Opinions

A Little Algebra . . .

05/12/2020

One way to estimate the size of our economy is this:  GDP equals the average number of transactions each year times the average price of transactions.  (GDP = TP)
Another way is this:  GDP equals money supply times the velocity of money.  (GDP = MV)  The velocity of money is the number of times a dollar is spent each year.

That means:  TP = MV

It is assumed that both the average number of transactions (T) and the velocity of money (V) remain constant, with certain exceptions.  That means any change in P or M will mirror an increase in the other.

In the last seven weeks, money supply (M) has increased a whopping 19%.  That suggests the average price per transaction will go up 19%, which would be mega-inflationary.  Nonetheless, the latest CPI shows deflation of 0.8% last month.

Fortunately or unfortunately, during this economic collapse, the normally predictable number of transactions (T) and the velocity of money (V) decreased, as consumers quit spending.  The question is whether the increase in M will compensate for the decrease in T or V.  It is clear that GDP will decrease this quarter and probably next quarter as well.  Once the GDP turns positive, the Fed has the tricky job of decreasing our money supply.  If they decrease it too slowly, we will have inflation.  How much inflation will depend on how slowly they decrease money supply.

One important side effect of this increase in money supply is that it also powers the stock market, at least in the short term.  The stock market will absorb excess money supply, at least temporarily, until such time as P, T or V increase.

The President likes to denigrate the Fed, but I am very thankful for them.  The Fed has never increased money supply so rapidly, and I’m very thankful they did!

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