In the last video, we learned the quantity theory of money and its corresponding identity equation: M x V = P x Y
For a quick refresher:
•M is the money supply.
•V is the velocity of money.
•P is the price level.
•And Y is the real GDP.
In this video, we’re rewriting the equation slightly to divide both sides by Y and explore the causes behind inflation. What we discover is that a change in P has three possible causes – changes in M, V, or Y.
You probably know that prices can change a lot, even over a short period of time.
Y, or real GDP, tends to change rather slowly. Even a seemingly small jump or fall in Y, such as 10% in a year, would signal astonishing economic growth or a great depression. Y probably isn’t our usual culprit for inflation.
V, or the velocity of money, also tends to be rather stable for an economy. The average dollar in the United States has a velocity of about 7. That may fall or rise slightly, but not enough to influence prices.
That leaves us with M. Changes in the money supply are the driving factor behind inflation. Put simply, when more money chases the same amount of goods and services, prices must rise.
Can we put this theory to the test? Let’s look at some real-world examples and see if the quantity theory of money holds up.
In Peru in 1990, hyperinflation came into full swing. If we track the growth rate of the money supply to the growth rate of prices, we can see that they align almost perfectly on a graph with both clocking in around 6,000% that year.
If we plot the growth rates of the money supply along with the growth rates of prices for a many countries over a long stretch of time, we can see the same relationship.
We’ll wrap-up the causes of inflation with three principles to keep in mind as we continue exploring this topic:
•Money is neutral in the long run: a doubling of the money supply will eventually mean a doubling of the price level.
•“Inflation is always and everywhere a monetary phenomena.” – Milton Friedman
•Central banks have significant control over a nation’s money supply and inflation rate.
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