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Macroeconomics Myths: Quantity Theory of Money & The Multiplier Effect

March 30th, 2013 by dimpledbrain

We continue our discussion from the previous post where we talked about money supply, currency devaluation and the new 21st century war called the ‘currency war’. James Rickards, author of Currency Wars described it succinctly  when he said, “Currency wars are akin to tug of war. Nothing much seems to happen on the surface. But as tension builds up underneath, it’s only a matter of time when the rope is pulled to one side or the other.” Well, it’s not word for word. Curse me for not copying it down previously.

Before that, let me digress a bit to provide some conceptual background:

(1) Macroeconomics

  • Economic policy makers can influence a country’s economies via fiscal policy and/or monetary policy. Very broadly, the former relates to using taxation and government spending while the latter deals with money supply.
  • Occasionally one may hear terms like ‘M1, M2 and M3‘ and ‘Central Bank (e.g. the Federal Reserve or Fed in the US/Bank Negara Malaysia) decided to maintain the Overnight Policy Rate (OPR) at 3.00 percent‘. These relate to manipulating supply of money to influence economic growth, i.e. monetary policy.
  • If you google ‘how does central bank control money supply’, you will get more information on this. I decided not to overly dwell into this because this is not something that you and I can do anyway.

(2) Quantity Theory of Money & Multiplier Effect

  • The link between money supply and inflation can be understood through quantity theory of money, i.e. M * V = P * Y, where M = money supply, V = velocity of money, P = price level/inflation level, Y =real GDP.
  • Velocity refers to the turn over of money, how many times the average dollar/Ringgit changes hand.
  • We talked about GDP previously (click here for the post); real GDP is merely inflation adjusted GDP. Hence nominal GDP = P * Y.
  • There is nothing special about this equation as it is intuitively correct. If I spend RM2 (M) on 5 trips (V) to the bakery to buy 10 croissants (Y) at RM1 each (P), I will spend RM10 to buy RM10 worth of goods.
  • Multiplier effect is the belief that ‘an increase in spending produces an increase greater than the initial amount spent.’ (To reinforce our understanding, there can be money multiplier via monetary policy or fiscal multiplier via fiscal policy.)

(3) So Why Didn’t the US Economic Stimulus Programme(s) Work and The Need for Quantitative Easing (QE) Infinity?

  • In short, the false belief of a constant V in Quantity Theory of Money and Multiplier Effect greater than 1.
  • It turns out my finance professor captured it perfectly when he told me, “banks will only lend you an umbrella when it’s hot and sunny, not when it’s going to rain.”
  • There is an increasing amount of empirical proof that the so called multiplier effect (that is still taught in schools) is less than 1. (click here for an external journal.)
  • The original Quantity Theory of Money developed by Irving Fisher and later Milton Friedman assumes a constant velocity, i.e. you and I will always spend our money at exactly the same rate. If I spend RM1,000 per month and I expect to lose my job next month, the theory says I will still spend RM1,000 this month.

(4) Governments’ Propaganda Tool – Influencing Velocity, V

  • James Rickards, in his book Currency Wars describes 2 such techniques i.e. (a) wealth effect and (b) fear of inflation. Wealth effect means to increase asset values especially through (i) stock price and (2) home price.
  • Ironically, fear of inflation, exactly the same argument used against Quantitative Easing programmes plays into the Fed/Bernarke’s hands. Recall from the above formula where M* V = P * Y. An increase in M will lead to an increase in P. (Y is relatively stable while V is the wild card here).
  • Given nominal interest rate = real interest rate + inflation expectation (goodness gracious, how many formulas do you want to write today?! dimpledbrain: ok, this is the last one.), if central banks keep (nominal) interest rates artificially low (say 3%) and a not-so-helpful argument that inflation is expected to go through the roof (say inflation expectation = 4%), then a negative real interest rate (3%-4% = -1%) will make borrowing money very attractive which will in turn boost spending/ investment (i.e. GDP).
  • This is the crux of the Fed’s/Bernarke’s Quantitative Easing Infinity thinking. (By the way, Paul Krugman who is Ben Bernarke’s BFF has a column in one of the newspapers in Malaysia.)
  • But, even so, printing unlimited money has not proven to work in the past. For one, it will lead to currency wars.

My key takeaways for today’s post:

(1) Understand velocity, V in the Quantity Theory of Money. V can only be manipulated/influenced but cannot be controlled. Isn’t this similar to so many things in life despite our madness trying to control them?

(2) As an individual, how do we gauge V? One technique perfected by Victor Niederhoffer is called the remaining length of unfinished cigarette. One can infer V from the general public. If good times are expected ahead, generally the public will smoke more frequently and leave longer unfinished cigarettes in the bin/ on the floor.

(3) There are many false doctrines out there. While we can debunk as many as we can find, here’s food for thought. What if the people who use the false doctrines actually believe in them? Now, that’s very scary isn’t it?



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