I Deny (the significance of) MV = PY
By Arnold Kling
Orthodox monetarists attributed such shocks to declines in the rate of monetary growth, whereas traditional Keynesians blamed declining autonomous expenditures. Both of these sources are captured in the well known equation of exchange: MV = Py, in which MV (money times its velocity) is equivalent to aggregate demand, and Py represents nominal GDP, the product of the price level and real output. In other words, a fall in velocity (V) is equivalent to a Keynesian fall in autonomous expenditures, which can happen only if people in the aggregate are holding (or hoarding) more money. Although this basic truth is sometimes overlooked in the recent debates over fiscal policy, in which economists replay (often with far less theoretical sophistication, despite greater mathematical pizzazz) the forgotten Keynes versus the Classics controversies, a negative shock to aggregate demand must involve either (a) a decline in the money stock’s growth rate or (b) an increase in the demand for money.
I am going to take on the paragraph quoted above. Keep in mind that this has very little to do with Hummel. He speaks for the vast majority of professional economists. I am sure that one blog post is not going to be sufficient to change anyone’s mind. But I have to start somewhere.Basically, I am going to attack MV = PY. Even though it is obviously true. It is an identity. It is true even if M stands for Marbles, Manatees, M&M’s, or Mackerel. If the supply of mackerel goes up, and nominal GDP stays the same, then a monetarist (mackeralist?) says that the velocity of mackerel went
up down and a Keynesian says that people are hoarding mackerel.
What mackerel and money have in common is that they are both stores of value. What is different about them is that money is a standard unit of account, but mackerel are not.
The unit of account function means that a decline in the value of money is by definition an increase in the price level. The price level is an average price of goods and services, using money as the unit of account.
But people want money as a convenient store of value (and medium of exchange). So, if the government is behaving itself, the prices of most goods and services in monetary terms do not change very much from day to day. If the government is not behaving itself, and it is trying to fund a massive deficit by printing money, then we get the phenomenon of too much money chasing too few goods. Money starts to lose its appeal as a store of value. This is hyperinflation.
However, if we go back to the case where the government is behaving, then the quantity of money is more like the quantity of mackerel. It is just one more quantity out there. People who go to their farms, factories, and offices every day do not care about how much money is in circulation, any more than they care about how many mackerel have been caught this week. Ordinary businesses set prices and make decisions based on what they saw in their markets yesterday and what they expect to see there tomorrow.
The Federal Reserve can manipulate some market interest rates by printing money and using it to buy securities. If it buys massive quantities of mortgage securities by printing dollar bills, it can lower the interest rate on those securities. In theory, the Fed could do this by exchanging mackerel for mortgage securities just as well as by exchanging money for mortgage securities.
However, I am not sure how long they can keep it up. At some point, market participants will think, “The Fed is not going to keep buying these things forever. When they stop buying, the price will fall.” And such thinking will dampen prices (raise interest rates) today. The longer the Fed fights the market, and the more government keeps spending on other stuff, the greater the likelihood that too much will be financed by printing money, and we will have hyperinflation. As long as we know that the Fed is afraid of hyperinflation, then it has a limited supply of money, just as it would have a limited supply of mackerel.
Suppose that the Fed had decided to print a lot more money at some point last year. The Scott Sumner thesis is that this would have raised nominal GDP. In my view, the fall in nominal GDP was due to the fact that real GDP had to fall. Real GDP had to fall, because the economy was beginning a Great Recalculation. The Great Recalculation was mostly due to the end of the housing bubble and the shrinking of the financial sector. It was probably exacerbated by the panic generated by Paulson and Bernanke. I do not see how the Recalculation was helped by the bailouts, which were huge transfers from future U.S. taxpayers to current large creditor institutions, including many overseas. I do not see how the Recalculation would have been helped by the Fed suddenly printing a whole lot more money. In terms of MV = PY, I see PY as largely outside of the Fed’s control–the P part was determined by the combination of habit and gradual adjustment in the Great Recalculation, and the Y part was determined by the frictions involved in the Great Recalculation. So if we could rewind the tape to some time in 2008, hold everything else equal, and have more M, I think we would see essentially a 100 % offset in V. Just as we would if M stood for mackerel.