Dude, Where’s My Inflation?
From time to time, Austrian economists, goldbugs, and other economists on the saner end of the spectrum warn of the inflationary dangers of modern central bank policies. The most famous case of this was Bob Murphy’s bet with David Henderson that the Federal Reserve’s policies after the financial crisis of 2008 would result in high, i.e., double digit inflation. Unfortunately for Murphy, he lost this bet, and, more generally, the much-dreaded (or in the case of central banks, much-hoped-for) inflation has so far failed to materialize. This is true both when one looks at the official inflation measures and even when one consults alternatives such as shadowstats. What explains this apparent failure of Austrian commentators?
In order to understand the problem, it is necessary to get clear on the basics of the discussion. The Austrian point is that increases in the money supply—the old definition of inflation—must eventually result in a rise in the prices of all goods, what is nowadays meant by inflation. However, most official inflation measures, notably the Consumer Price Index, show only a slight increase. And while alternative measures usually show a higher rate of increase, even these are far from proportional to the increase in the money supply. Now, while the construction of any index measuring the change in consumer prices is arbitrary (as explained by Dr. Karl-Friedrich Israel here), it is surely not completely out of line with everyday experience; while prices on consumer goods do generally go up, it is usually not by more than a few percentage points per year.
Monetary experts counter the claims of those of us who think that increases in the money supply will necessarily result in inflation by arguing that this is not necessarily so; reverting to the equation of exchange, MV=PT, they say that an increase in the money supply need not be inflationary if it simply counters a decline in velocity—indeed, if the increase does not completely make up for the decline in velocity, they will even claim that an expansionary monetary policy increasing the supply of money in existence, is in fact a tight monetary policy since total spending in the economy declines.
We thus have a twofold problem before us: Why is expansionary monetary policy not reflected in increasing price inflation? And is it true to say that money is tight if an increase in M does not completely offset a decline in V? We will answer the second question first.
What Causes a Collapse in Velocity?
Why does the velocity of circulation change and suddenly decline, as it for instance did in the aftermath of the 2008 financial crisis? While the equation of exchange is a poor stand-in for monetary theory (I have criticized it here, and other, more able economists have done so here and here), it does point at a real phenomenon. That is to say, velocity is simply the variable introduced to equate the money supply with total spending. Therefore, if V declines while the money supply stays the same or increase
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