Hidden Secrets of Money - Currency vs Money

[Madison320]

M0 being cash only covers a small fraction (one tenth) of all money so its impact on price inflation is minimal. Velocity is much more important- that is how quickly money turns over. High velocity means lots of money chasing goods and services which is likely to lead to higher prices. Velocity right now is very low which is why we are seeing low price inflation. Cash is the basic unit but velocity is the multiplier- it has more power than the basic unit does by itself. In a hyperinflation, velocity aproaches infinity.

But what CAUSES velocity to increase?

 

[Zippyjuan]

People's demand for goods and services. They aren't spending money much right now. If they are spending lots of money on things, the velocity is higher. The Fed looks at GDP and the money supply.

Chart of velocity:

http://research.stlouisfed.org/fred2/series/M2V

The velocity of money is the frequency at which one unit of currency is used to purchase domestically- produced goods and services within a given time period. In other words, it is the number of times one dollar is spent to buy goods and services per unit of time. If the velocity of money is increasing, then more transactions are occurring between individuals in an economy.
The frequency of currency exchange can be used to determine the velocity of a given component of the money supply, providing some insight into whether consumers and businesses are saving or spending their money.

 

[Madison320]

M0 being cash only covers a small fraction (one tenth) of all money so its impact on price inflation is minimal. Velocity is much more important- that is how quickly money turns over. High velocity means lots of money chasing goods and services which is likely to lead to higher prices. Velocity right now is very low which is why we are seeing low price inflation. Cash is the basic unit but velocity is the multiplier- it has more power than the basic unit does by itself. In a hyperinflation, velocity aproaches infinity.

Meanwhile here is what M0 has been doing:
http://research.stlouisfed.org/fred2/series/CURRENCY

I didn't realize there was such a big difference between M0 and the Monetary Base. I'm assuming the reason is that most of the newly printed money is owned by the banks but held at the federal reserve and this money is not counted in M0. If that's the case the monetary base is more important than M0 because that newly printed money at the fed will eventually get out in circulation.

 

[Zippyjuan]

I didn't realize there was such a big difference between M0 and the Monetary Base. I'm assuming the reason is that most of the newly printed money is owned by the banks but held at the federal reserve and this money is not counted in M0. If that's the case the monetary base is more important than M0 because that newly printed money at the fed will eventually get out in circulation.

That is a common mistake. The Monetary Base is M0 (currency) PLUS bank reserves. You are right- it could potentially end up in circulation but right now there just isn't the demand for that money so it is sitting in vaults- either at the banks themselves or the Fed. Usually excess reserves are close to zero. Whether the eventually declining monetary base leads to price inflation will depend on how quickly the reserves get pulled out and spent (once again, our old friend velocity will be a factor). If velocity is low and the base declines slowly, the impact on price inflation will be small. If there is a sudden surge in demand for money (the economy suddenly booms), then it will drain quickly and put a lot more upward pressure on prices.

 

[Madison320]

People's demand for goods and services.

That's a vague, meaningless answer. How can you predict an increase in "People's demand for goods and services"? This is why Keynesians can't predict things.

Suppose you have two similar countries, each with their own fiat currencies. Country A decides to double its monetary base. Country B leaves its monetary base unchanged. An Austrian economist predicts prices will rise sharply in country A. The Keynesian economist will scratch his head and say he has no idea what's going to happen, it depends on the velocity of money or animal spirits and there's no way to predict that.

 

[Zippyjuan]

The more things I want to buy, the more money I am going to use. Money in my bank account has zero impact on price inflation- it isn't competing against other dollars for goods and services driving up their prices. Not until I start spending it. The more quickly I spend money, the more money is moving around faster- hence higher velocity. The less people are spending, the lower the velocity. No- you can't accurately predict what people's demand for goods and services will be in the future but you can measure how much people are spending today and try to guess.

Suppose you have two similar countries, each with their own fiat currencies. Country A decides to double its monetary base. Country B leaves its monetary base unchanged. An Austrian economist predicts prices will rise sharply in country A. The Keynesian economist will scratch his head and say he has no idea what's going to happen, it depends on the velocity of money or animal spirits and there's no way to predict that.

True- but no other economists- including Austrians- can look at monetary base and say that inflation will be "x" in the future either. As I pointed out, it depends on how quickly the base gets distributed into the economy. Doubling the base does not necessarily lead to doubling of prices.

 

[Madison320]

That is a common mistake. The Monetary Base is M0 (currency) PLUS bank reserves. You are right- it could potentially end up in circulation but right now there just isn't the demand for that money so it is sitting in vaults- either at the banks themselves or the Fed. Usually excess reserves are close to zero. Whether the eventually declining monetary base leads to price inflation will depend on how quickly the reserves get pulled out and spent (once again, our old friend velocity will be a factor). If velocity is low and the base declines slowly, the impact on price inflation will be small. If there is a sudden surge in demand for money (the economy suddenly booms), then it will drain quickly and put a lot more upward pressure on prices.

Your logic is out of whack. You are saying that as long as printed money SLOWLY enters circulation, and the velocity of money is SLOW, we won't have price inflation, therefore printing money does not cause price inflation. Just because some other factors may offset the effect of printed money, doesn't mean that printed money does not cause prices to rise. That's like saying if the current speeds up it won't cause your canoe to float downstream faster because you can start paddling upstream.

Plus we are not talking about some tiny little expansion of the monetary base that could easily be offset by other factors. We're talking about gigantic increases. And they are still on going.

 

[Madison320]

True- but no other economists- including Austrians- can look at monetary base and say that inflation will be "x" in the future either. As I pointed out, it depends on how quickly the base gets distributed into the economy. Doubling the base does not necessarily lead to doubling of prices.

OK, so the Austrian predicts prices will double while the Keynesian has no idea. Prices go up by 80%. I'll stick with the Austrian model.

 

[Zippyjuan]

The money supply hasn't really expanded yet despite actions by the FED. For money to impact prices, it needs to be circulating. The extra money is mostly still at the banks. If it comes out of the monetary base slowly, that is the exact same thing as far as the economy is concerned as the money supply growing slowly. IF the money is all released in six weeks it will impact the economy significantly differently than if it takes six years to release it. Prices will rise more dramatically in the former and more slowly in the latter case.

 

[Seraphim]

Yes Zippy, they ARE spending.

The key is that they are spending on DEBT SERVICE.

Since debt= currency, when paying down debt you destroy currency in circulation. It does not go towards "goods and services" which are what velocity of money measures are built around.

Who woulda thunk it that in a money=debt system, over indebtedness would lead to a collapse in velocity?

It's pretty straight forward.

People's demand for goods and services. They aren't spending money much right now. If they are spending lots of money on things, the velocity is higher. The Fed looks at GDP and the money supply.

Chart of velocity:

http://research.stlouisfed.org/fred2/series/M2V

 

[Zippyjuan]

OK, so the Austrian predicts prices will double while the Keynesian has no idea. Prices go up by 80%. I'll stick with the Austrian model.

Austrians don't predict numbers on price inflation rates- only that inflation will occur.

 

[RAAVAN]

Rightly said if money is kept in secret, currency will increase but the value of currency will be decreased.

 

[Seraphim]

No, the opposite.

Money/currency taken out of circulation withdraws it from the supply and increases the value of the remaining stock.

Rightly said if money is kept in secret, currency will increase but the value of currency will be decreased.

 

[Madison320]

I think we overcomplicate this topic. If you print huge amounts of money it's like standing on the beach with a tidal wave coming. You might think you have all kinds of reasons why the tidal wave is not going to hit you (velocity of money,holding the money in reserve,etc), but it's all wishful thinking.

 

[helmuth_hubener]

But what CAUSES velocity to increase?

People's demand for goods and services.

Also, people's demand to hold money. The demand-level for money affects the price of money even more strongly and directly than the demand-level for goods.

Suppose you have two similar countries, each with their own fiat currencies. Country A decides to double its monetary base. Country B leaves its monetary base unchanged. An Austrian economist predicts prices will rise sharply in country A.

No, an Austrian economist would not predict that. An Austrian economist could only say that *all else equal*, if everything else is held constant, then yes: an increase in the money supply will result in a decrease in the price of that money, and that this will (eventually) result in the prices of other products being higher than they would otherwise have been, priced in terms of money (not necessarily up [much less "sharply"], just higher than otherwise). The problem is, all else is never equal. There are many variables involved. Supply of money is a critical factor, yes, but also:
demand to hold money,
demand to purchase goods,
supply of goods,
changes in time preference,
etc.

The prices of goods may go down or stay the same, as they did in the 1920s: despite massive monetary inflation going on, there was no price inflation, because a rapid rise in productivity outpaced the inflation. So in the 1920s, supply of money rapidly increased, and demand for money probably stayed about the same, but supply of goods rapidly increased as well (due to increased productivity). All together, these factors resulted in price levels being flat.

 

[helmuth_hubener]

Your logic is out of whack. You are saying that as long as printed money SLOWLY enters circulation, and the velocity of money is SLOW, we won't have price inflation, therefore printing money does not cause price inflation. Just because some other factors may offset the effect of printed money, doesn't mean that printed money does not cause prices to rise. That's like saying if the current speeds up it won't cause your canoe to float downstream faster because you can start paddling upstream.

Plus we are not talking about some tiny little expansion of the monetary base that could easily be offset by other factors. We're talking about gigantic increases. And they are still on going.

There are other gigantic and powerful factors which can completely offset the money supply increase and then some. There are 6 or 7 or so billion people in the world. That's a lot of people. If even just 20% of those people decide "Hey, I think I'm going to go buy and hold 100 more dollars because my demand for money has increased, or my skepticism of my own government has increased" that can completely undo whatever the Fed has done to the point there could be massive price deflation!

You use a canoe. That massively discounts the role of the other factors. It's a motor boat. We as Austrians believe in the law of supply... and demand! Supply is only one side of the equation. You have to remember demand.

During the 1990s, the monetary base expanded outreageously! Overwhelmingly! Yet there was no price inflation to speak of, because people all across the world -- from the Russian Mafia to the Pakistani businessman -- started buying up and holding dollars at a much higher rate. So it cancelled out.

 

[helmuth_hubener]

I think we overcomplicate this topic.

Including demand in your thoughts when considering a phenomenon that follows the law of supply and demand is not overcomplicating your thinking.

Not thinking about demand when considering a phenomenon that follows the law of supply and demand is oversimplifying the matter.

You will not be able to account for reality with such a halfway understanding.

 

[Henry Rogue]

The money supply hasn't really expanded yet despite actions by the FED. For money to impact prices, it needs to be circulating. The extra money is mostly still at the banks. If it comes out of the monetary base slowly, that is the exact same thing as far as the economy is concerned as the money supply growing slowly. IF the money is all released in six weeks it will impact the economy significantly differently than if it takes six years to release it. Prices will rise more dramatically in the former and more slowly in the latter case.

This makes sense to me and in my opinion bolsters the Austrian notion that the early users of new RFNs gain wealth while the later users lose wealth.

Of course the Fed eliminated the keynesian liquidity trap, for velocity to happen, it needs some where to flow. You can't pour water through a plugged pipe. Looks to me like the Fed created its own problems. Keynesian economic manipulation proves to be its own undoing.

 

[Madison320]

There are other gigantic and powerful factors which can completely offset the money supply increase and then some. There are 6 or 7 or so billion people in the world. That's a lot of people. If even just 20% of those people decide "Hey, I think I'm going to go buy and hold 100 more dollars because my demand for money has increased, or my skepticism of my own government has increased" that can completely undo whatever the Fed has done to the point there could be massive price deflation!

Sure there are a lot of other factors that influence price, but they are usually temporary and they don't all trend in one direction like monetary inflation.

If these "theories" on massive deflation are correct, why hasn't there been any cases of major deflation in the entire history of fiat currencies?

I'm leaning the other way. I'm afraid that the combination of enormous amounts of dollars being held by foreigners plus the fact that they can unload those dollars electronically, could result in massive hyperinflation.

 

[Zippyjuan]

Sure there are a lot of other factors that influence price, but they are usually temporary and they don't all trend in one direction like monetary inflation.

If these "theories" on massive deflation are correct, why hasn't there been any cases of major deflation in the entire history of fiat currencies?

I'm leaning the other way. I'm afraid that the combination of enormous amounts of dollars being held by foreigners plus the fact that they can unload those dollars electronically, could result in massive hyperinflation.

Theoretically possible but highly unlikely. The countries holding the US Treasuries are doing so because they believe they have some value. If they dump them, they collapse the very value they were holding. That hurts them as well. And if our trading partners (like China and Japan- our two biggest foreign holders) decide to dump, they drive down the value of the dollar relative to their currency which makes their exports to the US incredibly expensive and our exports to them incredibly cheap so they lose export sales to the US and even domestic sellers lose sales to imports from us- a double whammy on their economy. Their actions would hurt themselves more than us. We would face higher prices of imports but that would encourage domestic production to increase.

Note- there hasn't been any cases of major deflation on non-fiat currencies either aside from during recesssions.