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Tuesday, August 23, 2011

Why is there no hyperinflation?

Okay, we've had warnings ever since early 2009 about the prospect of a breakout of massive inflation due to a massive increase in the monetary base.  The logic, such as it is, goes something along the lines of:

1. Monetary velocity is a constant
2. The Fed has increased the monetary base substantially
3. Nominal GDP will rise substantially, but real GDP won't
4. The difference will be taken out on us in inflation

If you believe the first step of this sequence, that all follows.  If you double the amount of money in the system and everyone still does everything in the same way, meaning consumption patterns in terms of unit quantities don't change and production also does not, prices should approximately double.  However, the way money is "made", through bank lending, has been a broken mechanism as the demand for credit is very weak.

So, as the Fed has dramatically increased money supply, nothing much has happened.  All that has happened is that monetary velocity has collapsed (left scale is velocity, right scale is monetary base in billions):


Velocity is about a third of what it was during the period just preceding the crisis while the monetary base has approximately tripled.  With the banking sector still sick and consumers still deleveraging, this situation will not change soon.  A strong increase in money supply is a necessary (in most cases), but clearly not a sufficient ingredient for inflation.

1 comment:

  1. No way. What if velocity changes?

    ReplyDelete