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Wednesday, December 8, 2010

The Reason That Quantitative Easing Won't Cause Massive Inflation

I think that a lot of people who expect that quantitative easing of the amount the Federal Reserve is currently engaging in will lead to a large outbreak of inflation is that they assume that monetary velocity is a constant. We know that, empirically, it is not. If velocity was a constant, increases in money supply would lead to matching increases in nominal GDP, which, if not supported by gains in real output, would lead to a corresponding increase in the price level.

However, in the current environment it appears that the damage to monetary transmission mechanisms was so severe that large increases in money supply simply just sit around and don't actually make their way into the economy. The same thing happened in Japan after their real estate collapse where no amount of easy money policies would cause inflation.

The above chart is related to M1, but here is an alternative measure (MZM) which includes a broader measure of money supply.

Japan had a similar case during its slide into deflation:

This is the nature of a liquidity trap in that no increase in money supply will help because all that will happen is that velocity will continue to drop as there is no demand for money. If velocity drops by amounts sufficient to offset the increase in money supply, no inflation will occur. As of right now, this pattern seems to be holding.

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