Friday, October 5, 2012

The velocity of money and inflation

Before I get in to this to any extent, let me first say that I have not drawn any conclusions nor do I have any profound insights on following. If you have been following the debate on inflation, you undoubtedly have heard one pundit or another talking about how there cannot be any inflation in the system because the velocity of money is very low and is declining.

Without getting too much into the background here, this argument stems from the equation MV=PQ, where M is the money supply and PQ is essentially productive output (Q) and price levels (P). Working a little algebraic magic yields the velocity of money (V) or V=PQ/M. As the theory goes, V and P are related and generally move in tandem. So are these pundits correct?

If this was any year prior to 1990, I would say most definitively yes. However, the apparent relationship between the velocity of money and inflation (here defined as the year-over-year change in CPI) has broken down since then. See the chart below. Prior to 1990, the change in monetary velocity and inflation appears directional the same.




Since 1990, There does not appear to be any relationship whatsoever or at the very least a tentative relationship. In fact, the following is the graph of the 10-year rolling correlation of the 1-year change in both monetary velocity and inflation, and it shows this breakdown in the relationship, beginning in or around the mid-1990's.



What does mean or signal? I am not sure. Could this be due to productivity? Potentially. The correlation again appears to have shifted in years, specifically increasing in the years beginning in between 2006 and late 2010. At the very least, I think the graphical analysis suggests the relationship between monetary velocity and inflation is more complex than what is implied.

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