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MV=PT

Irving Fisher was probably the most popular economist of the early
twentieth century. That said, a popular economist is a bit like a
monogamous rock star or a wild and crazy accountant or a Victoria Secret
model without breast implants! Everything is relative!

In 1911 he came up with the "Equation of Exchange" concept. That equation


was MV=PT, where M was representative of the amount of money, V
equaled velocity, P was price and T represented transactions.

A landmark theory, many people consider the equation to this day to be the
single most important mathematical description of economics. Others
downplay its significance or find it mildly useful. It helps their case that
Irving was quoted as proclaiming just before the crash of 1929, "Stock
prices have reached what looks like a permanently high plateau". Needless
to say his finances suffered in a significant way. He was also the first
president of the "American Eugenics Society". These folks have strong
beliefs on selective breeding, the human kind that is!

Since we are concerned with how this equation could be applied to


monetary policy, whether "Fiat" or fixed, we can solve for M or Money by
dividing both sides by V or velocity.

M= PT/V

Money equals price times transactions divided by velocity. Now, the most
common problem people have with Irving's formula is with V. If we omit V
entirely, we come up with an equation that is hard to argue with.

M=PT

The amount of money equals the number of transactions times the price.
Barring theft, fraud or force, we should be able to accept this as a basic
truth.

Fisher's definition of V was the total expenditures for a time period, usually
a year, divided by the average amount of money in circulation for the same
time period.

Another practical definition for V or Velocity is the number of times that it


takes the Money Supply to circulate before the total output or PT, of the
economy is purchased. Whoever was following the greenbacks around to
prove that one should be given an extra star! A valiant effort to say the
least!
One good argument against any variation of V at all, is that at any moment
in the economy, all money is being used at all times. Money, aside from that
in your wallet or under the mattress is used and reused constantly and
essentially always has the same velocity. Is it possible V could represent the
"extent" of credit? And what about the present situation, with gobs of
money being injected, is it just that the number of transactions is
decreasing or is the overall "speed" dropping?

A simple solution for this example is the use of V as the "factor" in this
equation. Since, for the context of our discussion, we know M or money and
we know the amount of transactions and the price, V can be determined. It
can represent the "phantom" or missing element. We could even perceive it
as the "human" element. All the numbers are in, the results are not the
same, V is the directional or determining force. A bit of mystery won't hurt
too badly!

In our "Fiat" world, M can be altered and is altered, at any time by the
actions of our Government. The policies and actions of the Federal Reserve
and the Treasury determine the level of M. The Treasury, by issuing
Securities, can introduce "outside" money to our economy, if they receive a
foreign buyer. As you can imagine, this is an intricate web, and extremely
hard to trace in a world market. Kind of like, "what goes around comes
around". We can be certain though, except for rare instances, over time the
money supply is increasing.

P=MV/T

When the value for M is made greater, the hope is that the number of
transactions will increase or the Velocity will fall or a combination of the two
will occur. As you can see by the equation above where we solved for P or
Price, there isn't a lot of room to wiggle. If these results don't come to pass
nor reach the extent needed to balance the change in M, then P increases.
Even if this policy is successful, the possibility of price inflation looms on the
horizon. The economy has been stimulated by "false" capital, an influence
outside the usual realm of supply and demand of labor, resource or actual
capital. Unless there was previously a significant overproduction with a
corresponding slowdown in the demand for labor, inflation will be the usual
result. This is all without considering "monetary inflation" which is the loss
of value of the currency because there is more of it in circulation.

Often, the reason given for the dismissal of a "fixed" currency is the limits or
constrictions it places on an economy. We have seen what a variable M
does to Irving's equation, does a fixed value M place restrictions on output?
If we set M as a constant amount, any increase in T must coincide with a
decrease in P or an increase in V to maintain the equation. On the working
side of the equation, prices must fall or the velocity must increase or both,
when more transactions occur in an economy with a fixed currency. As the
economy grows, prices can actually experience downward pressure, money
is constant but gains value because there are more goods and services or
commodities represented by the same amount of currency! Fixed M doesn't
limit the economy; the economy limits or multiplies the value of M without
changing the amount.

This isn't to say that prices can't inflate and/or transactions can't fall or
velocity won't slow with fixed currency. What it is saying is that what
happens in the economy directly affects the value of money without any
change in the amount. That is, how we use our labor to craft resources to
meet the needs of our daily lives determines the value of the medium of
exchange [money]. When the economy grows in a healthy way, we all share
in the profit as our currency becomes stronger and is able to purchase
more.

The "Fiat" system in the best light would be hard pressed to offer us this
combination. The basic idea behind money creation is to bring the future to
the present. By entering a greater amount of M into the system now, we are
attempting to jump ahead to a point in the future of the economy where
greater output has already been reached. This is basically an attempt to
experience the benefits without doing the work required. Although beyond
the scope of this discussion, it should be noted that because this method of
monetary control is a "directed" method, the benefits or the resulting
drawbacks can and are directed by whoever is controlling the release of
monies to wherever in the economy they deem worthy of the good effects
or whoever is deserving of the bad effects.

In relation to the M=PT/V equation perhaps the biggest difference between


a "Fiat" monetary system and one based on a fixed value is which side of
the equation we deem the most vital. The "Fiat" policy stresses the
importance of the left side of the equation, using different, almost always
increasing amounts of M to attempt to determine the outcome of the right
side. With a fixed system, the results that the economy provides us on the
right side of the equation determine the value of the left.

If we leave the scope of both Economics and Mathematics and look at things
a bit more philosophically, we might come up with another outlook. What is
more important to us, what we do everyday to make our lives what they are
or money? Do we value our labor and the natural world and how we bring
the two together to survive, enjoy and create what we call our economy or
do we grant the dollar excessive power over our lives? The choice seems
simple, what does it take for us to be allowed to make that choice?

What is Monetarism?

"Inflation is always and everywhere a monetary phenomenon" is an often


quoted line from Milton Friedman, a Nobel Prize winning economist and
foremost thinker on monetarism. It does provide us with some clues as to
the underlying debate on the subject.

Monetarism is the belief that changes in the quantity of money in circulation


in an economy is a determinant of the level of national income. We can
think of national income as gross domestic product, the value of output in
an economy over a given period of time.

The argument is not so much about whether money supply does in fact act
as a determinant of national income - most economists would agree that it
has a role to play but on the extent to which changes in the money supply
impact on national income. Keynesians would believe that changes in the
money supply will take some time to work through to national income
whilst monetarists believe it is likely to happen far more quickly. The
importance of this distinction is in the implications it has for policy makers.

Task 1

Assume that there was a high level of unemployment in the economy. You
are charged with devising a policy to reduce the level of unemployment.

Why is an awareness of the speed with which a policy instrument like


monetary policy works through to the economy important in your decision
making?

This difference manifests itself in the appropriate policy that is to be


focused on in dealing with economic problems. Keynesians believe that
fiscal policy, changing government income and expenditure, is a more
effective means of dealing with problems such as inflation and
unemployment. Monetarists believe that monetary policy should be the
primary weapon in dealing with these problems.

The Equation of Exchange

Why do monetarists believe in the power of monetary policy? In simple


terms, their views stem from a statement called the equation of exchange.
The equation of exchange is often cited as being a truism - it is obviously
true. The extent to which it can be claimed to be a theory is thus debatable.
To be an effective theory, it has to have some predictive value.

The equation of exchange, or the Fisher equation, named after its founder
Irving Fisher in 1911, states the following:

MV = PT

• M is the money supply, the amount of money available in the economy


for transactions. Let us assume that M = 500
• V is the velocity of circulation. The velocity of circulation refers to the
number of times the stock of money changes hands in purchasing
transactions over a period of time
• P is the price level
• T is the number of transactions

P x T is referred to as nominal income. Let us assume that nominal income


is £1 billion. That could mean 1 billion 'goods' produced and sold at £1
each, or a million 'goods' sold at £1,000 each, or 100 million 'goods' sold at
a price of £10 each, or indeed any other combination of price and quantity.

How is that nominal income purchased? It is purchased by using the notes


and coins (let us assume that 'money' is notes and coins for the moment)
in circulation and the number of times it changes hands depends on the
price that each good is sold for. The two sides of the equation, therefore,
are just a different way of saying the same thing. The amount of goods
produced and the value of those goods must be the same as the amount of
money available and the number of times it was used to purchase that
output!

From Equation to Theory

Fisher then made some important assumptions that gave the equation
some predictive qualities. The velocity of circulation was assumed to be
relatively stable over a period - let us say it has a value of 50. In other
words, the stock of money in circulation (500) changes hands 50 times to
buy the output of the economy.

Now let us assume that we want to find the price level. Assume that we
know that the number of transactions in the economy is 200. What is the
price level? A bit of simple arithmetic gives us the answer:

• MV = PT
• 500 x 50 = p x 200
• 25,000 = 200p
• P = 125

This tells us that the average price of each good that changed hands was
125. Now assume that there is some boost to the money supply - perhaps
due to the government printing more notes or the discovery of new
reserves of gold. M now rises to 600 as a result. Remember that the
velocity of circulation is assumed to be stable. We might also further
assume that the number of transactions or the output of the economy is
also relatively stable, or at least only rises by a small amount over time.
Assume that T rises to 205. What now happens to the price level?

• MV = PT
• 600 x 50 = p x 205
• 30,000 = 205p
• P = 146.3

In this example, the price level has risen by 17.04%. What has been the
cause of this rise in the price level? The rise in the money supply! The
money supply increased by 20% but the output of the economy (the
number of transactions) increased by only 2.5%.

When we have built in these assumptions, it seems fairly obvious that the
money supply has an impact on the price level or inflation. Concern over
the rate at which the money supply grows, therefore, might be of concern
to policy makers charged with controlling inflation.

When we look at the statement issued by the Bank of England after the
Monetary Policy Committee (MPC) raised interest rates by a quarter point to
5% in November 2006, we can see that the rate of economic growth was
around 2.6%. However, the MPC reported that 'credit and broad money
growth remain rapid' - in other words, the money supply was increasing
rapidly.

M is the money supply which includes currency and bank deposits


available to the public.

V is the velocity of money. Essentially this says how quickly the


money supply is turned over. For example, if the money supply is M
and monetary transactions totaling M occurs in 1 month then the
money supply turns over 12 times per year so V=12/year

P is the price level.

T is the real value of aggregate transactions.

So MV = PT means that the total transactions at the current price


level is equal to the total money stock multiplied by how often it is
turned over.

Imagine the money supply is $1 billion and the velicity is 12/year so


then $1 billion is spent 12 times per year so a total of $12 billion is
spent.

Now imagine there are 120 million transactions during the year.
Then the average price of these transactions must be $100 since
120 million times $100 = $12 billion.