At least one thing is true about economics: everyone has an opinion about it. CNBC has program after program and tens of thousands of hours of tape of people sitting at a table debating

current events in the economy and what it means for markets. However, most people lack a good framework for thinking about economics. As the first post in my series on growth and inflation,

I’d like to motivate our discussion by reviewing some basic concepts and introducing the variables a play. Doing this now will provide a solid foundation to build off of as we move onto more

complex topics in later posts. We’ll start off with a discussion of some common intuitions about how growth, inflation and money work and then proceed with a deep dive into how the economic

“the Fed just cut interest rates, I should look into refinancing my mortgage.”), the more critical element is the money supply. There is a common belief that when the government prints money

or spends excessively (i.e. big budget deficits, lots of debt), then inflation is bound to rise. I wouldn’t go so far as to say this is the misconception, but there’s a lot more to the

story that warrants our consideration. The basic formula for linking money and economic output (think GDP) is as follows: MV = PY Where: * M = Money Supply * V = Velocity of Money * P =

Average Price Level * Y = Quantity of goods and services This formula is not a theory. Rather, it is a basic fact that no economist would dispute. However, it is a little abstract so let’s

break-down each variable and then give a simple example. Money Supply (M): The money supply is the amount of money currently in circulation. This includes the money you have in your

checking, savings, and wallet. Some might say that this is an overly restrictive definition of money and I would agree, but for now let’s keep it simple. Velocity of Money (V): The velocity

of money is simply the number of times that a money is spent. If I pay you $1 for ice cream and you then spend that $1 on gas and then the gas station deposits that $1 at their bank and

doesn’t spend it again then the velocity is 2; that same dollar was spent twice. Average Price Level (P): This is the average price/cost of a basket of goods. For example, if we put all good

and services produced in the US into a basket (10 oranges, 1 TV, 2 baseball tickets, 8 pairs of shoes, 4 tanks of gas, etc.) and tracked the price of that basket each year this would be the

average price level. This is what the Consumer Price Index (which is closely followed by investors and policy makers) attempts to measure. Quantity of Goods (Y): This is the amount (in

units) of goods and services produced. Remember that basket of goods? Well, Y is that basket. It’s the number of items of each type made each year. Let’s do a quick example to make this

concrete. Suppose the money supply is $1000 and the velocity of money is 2. If there are 100 identical goods in the economy and they each cost $20 then we can quickly see that the formula

balances out: MV = PY 1000*2 = 100*20 2000 = 2000 Very simple. We can now propose some changes to this formula to see how the variables react. We began this discussion by talking about the

money supply, inflation and the common belief that a change in the money supply will inevitably lead to inflation. Let’s see if this is true. Suppose that the Fed prints more money (like

they are doing now) and increases the supply from $1000 to $2000. If the velocity of money stays constant at 2 and the quantity of goods remains at 100, then what happens to the price level?

MV = PY 2000*2 = 100*P 2000/100 = P P = $2 We observe that the price level increased from $1 to $2. Recall that inflation is simply the percentage change in the price level. So, for our

simple example inflation is 100%; the price level doubled! What we observe is that an increase in the money supply did lead to inflation (indeed, very high inflation). We see that there is

definitely a plausible logic in the notion that an increase in the money supply will lead to runaway inflation. This example is very stylized and the Fed would never double the money supply

in one year, but suppose the increase were only 10%, this would still be a devastating level of inflation and is currently within the realm of possibility. However, notice the assumptions

that were made to reach our conclusion: a constant velocity of money and a constant quantity of goods. These are pretty restrictive assumptions, if either or both of them had been different

then we’d reach a much different conclusion regarding inflation. AN ECONOMIC PUZZLE IN REAL-TIME Drawing from our formula and the exercise we did above, let’s take a look at some real-world

variables and see how they stack up. First is the M2 money stock. This is one of several monetary aggregates the Fed compiles and is generally seen as the broadest measure of the current

money supply. https://fred.stlouisfed.org/graph/?g=r1MX We see that the M2 money stock has tended to rise pretty steadily with a few random jumps…except for very recently. In the past few

weeks we observe a very pronounced increase the money supply. In fact, if we zoom in (you can use the slider on the graph to change the window) we notice that the money supply has increased

from approximately $15.5T on February 24 thto almost $17T by April 13 th. Remember that 10% increase we talked about? Well, there it is. Next, is the velocity of the M2 money stock; how many

times M2 is spent annually. This graph paints a complicated picture. The M2 Velocity was more or less constant from about 1960 until about 1990. We then observe a pronounced surge in

velocity from 1990 until 2000 followed by precipitous decline, and we have experienced a downward trend ever since. In fact, velocity was at an all time low in Q4 of 2019 at ~1.4; down about

25% from the 1960–1990 average. This basically means that consumers and businesses aren’t spending money like they once did and dollars aren’t changing hands nearly as often. Furthermore,

pay attention to the shaded gray regions which indicate periods of recession. We are certainly in a recession as of this writing. What do you think will happen to the velocity when 30% of

the economy is shut down? https://fred.stlouisfed.org/graph/?g=qRkO Third, is the Consumer Price Index (CPI) which tracks the average price of our metaphorical basket of goods. Again, the

CPI does not represent a specific price in dollars, but rather is an index that represents how much that basket costs relative to the same basket in another year. So, while it is not

directly translatable to our formula it still gives a pretty good picture of how prices have developed through time. We can see that there is a more pronounced slope to the graph from 1965

to 1980 coinciding with the high inflation that characterized that period, but since then it has been rising pretty steadily indicating a stable inflationary environment. Additionally, like

the graph of velocity, CPI tends to decline during recessionary periods implying a general drop in the price level. https://fred.stlouisfed.org/graph/?g=r4i8 Finally, let us consider the

Quantity of Goods. Now, there isn’t a single good measure of the quantity of “things” produced in the economy so we can’t measure Y directly. Typically, we would refer to the value of the

things produced (PY rather than Y). However, because we do have a good measure of how the price of goods has changed over time, then we can use the current price index to “deflate” PY and

recover a reasonable measure Y; still denoted in dollars, but “constant” dollars such that the inflationary component has been removed. This takes the forms of converting between nominal and

real GDP. Below is the graph of real GDP. https://fred.stlouisfed.org/graph/?g=r4i9 Real GDP, much like CPI, has some subtlety. Overall the graph has tended to increase steadily over time

with prominent declines during recessions. Furthermore, we observe that the growth rate has slowed in recent years. For example, the growth rate has decreased from an average of ~3.5% over

the period of 1980–2000 to an average of ~2.2% since 2010. So, while we continue to make “more things” than ever before, the rate at which the number of things increases has slowed; Y is

getting larger but more slowly. INFLATION AND REALITY The takeaway from all of this is that there are some very complicated dynamics at work when it comes to implementing our simple formula

and drawing conclusions about the likely path of inflation. The Fed is currently printing a lot of money (increasing M), but we also have to contend with a declining velocity (decreasing V).

Furthermore, in the immediate term, real growth is going to decline dramatically (big drop in Y), but even beyond that there’s still a general slowdown in Y that we’ll have to reconcile. In

addition, what we have failed to discuss is historical precedent and the big picture trends at work in the US economy. In the posts to follow we’ll broaden our scope and introduce 3 key

themes to our formula: 1) potential GDP, 2) quantitative easing and 3) globalization/automation. Until next time, thanks for reading! -Aric Lux. _Originally published at

__http://lightfinance.blog__ on April 28, 2020._