Opinion
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Guest Column
A wonkish look at why inflation is high and might remain so | Column
Too much money is sloshing through the economy.
Published Nov. 26, 2022

M x V = P x T

Where M is the amount of money in circulation.

V is the velocity of money, which is the average number of times a dollar changes hands in a year. Higher V implies higher economic activity and vice versa.

P is the average price level of goods and services in the economy.

T is the real output of goods and services in the economy during the year as measured by real gross domestic product, or GDP.

If you switch these variables around you get:

P = (M x V)/T

This identity holds true at all times, so percentage changes in these variables also have to equate. The math is a bit complicated, so I will not go into the details.

Using this formulation, let’s determine what happened during the pandemic first, and then the past 20 years during which M — the money supply — expanded rapidly.

The money supply grew by 24.8% in 2020 and 12.8% in 2021. Look at the graph of M over time, notice the steep spike in 2020 followed by a milder spike in 2021.

In spite of the 24.8% increase in M, inflation was a low 1.2% in 2020. Why? Because V — the velocity of money — declined 21% from about 1.4% in 2019 to 1.1% by the end of 2020.

Moving on to 2021, the money supply increased by 12.8% and the velocity of money declined by 0.8%. Real GDP grew by 5.7%. The inflation rate was 4.7%. Inflation increased because the increase in the money supply was far greater than the decline in the velocity of money.

For the first six months of 2022, the money supply declined by 0.4%, the velocity of money increased by 2% and real GDP declined by 2.5%. So, the formulation estimates inflation at 4.6 % over the first six months of the year.

Looking at the Money, Velocity and GDP chart, between 2002 (when spending increased to finance the Afghanistan and Iraq wars) and the end of 2019 (just prior to the pandemic) the money supply grew by 183%, the velocity of money declined by 28%, and real GDP increased by 44% respectively. Note that the increase in money supply was more than four times the increase in real GDP. Such a huge discrepancy would typically lead to high and sustained inflation — too much money chasing too few goods — except that the velocity of money declined significantly, which kept inflation low. The velocity of money was low because many did not spend their money at the rate they had in the past. So, the Fed kept pumping money into the economy to prop it up.

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The middle column shows that between 2020 and mid-2022, the money supply grew 15 times greater than real GDP. The last column in the table shows that between 2001 and mid-2022, the money supply grew six times greater than real GDP.

America is drowning in excessive liquidity. The supply of money has grown many times greater than the real output of goods and services. Way too much money has been pumped into the economy over the past 20 years, which is a recipe for high and sustained inflation.

Pumping a massive amount of money into the economy was required to counter a decline in the velocity of money. It was a short-term fix for the economy but with dire consequences for the long term. A declining velocity of money kept inflation low in the past. But the party has ended. The number of times a dollar changes hands in a year started to increase in 2022 which has led to higher inflation, which in turn could lead to those dollars changing hands even faster in the future because, in anticipation of high inflation, consumers will spend at a faster rate.

The Fed is compelling the money supply to decline by raising interest rates, which will lead to a recession. It seems that they will continue to raise rates to decrease the money supply which could keep the economy in a recession well into 2023.

Moving on to T, which is real GDP (the size of the economy), there is a significant challenge on the horizon. Real GDP growth is a function of net additions to the labor force and growth in productivity. The former has crawled to a standstill because the working population in America — ages 20 to 65 — has peaked, and productivity growth has been moderate even with technological progress.

So, some economists recommend that growth in the economy should be stimulated by increasing immigration judiciously. There are more than 11 million job openings in America. Filling those jobs will go a long way in stimulating economic growth, which would lower inflation.

It is going to take a while to bring inflation down because it will take time to wring the excessive liquidity out of the system. Furthermore, supply constraints with food and energy because of the war in Ukraine, bottlenecks because of China’s draconian COVID shutdowns, and housing shortages because of burdensome regulations primarily in blue states such as New York and California is not helping to keep inflation in check.

Because of the excessive amount of liquidity, an inflation target of 2% is not workable without creating a prolonged recession, according to The Economist. A target between three and four percent is suggested.

Inflation rates were around 3 percent or higher between 1970 and 2010. An inflation target between 3 and 4 percent is well within the realm of recent history. Wringing the excess liquidity out of the economy will take some time.

Murad Antia, now retired, taught finance at the Muma College of Business, University of South Florida.