With so many countries carrying out various forms of quantitative easing (money printing) in order to stimulate economic growth, many are asking why it is we don’t have high rates of inflation. The answer lies with money velocity. This article explores what money velocity is, and why we don’t yet have high inflation.
As I’ve discussed previously, it is a common misconception that inflation is rising prices. The truth however, is that rising prices are merely a symptom of inflation and not the cause. The cause of inflation is an increase in the supply of money and credit.
When you increase the amount of money and credit in an economy, e.g. through quantitative easing, but don’t increase the amount of goods and services, you end up with too much money chasing too few goods. As a result the price of those goods and services will sooner or later begin to rise.
It takes more than just newly created money to create inflation. It also requires what is known as money velocity.
Money velocity refers to the rate at which money changes hands within an economy. More specifically the velocity of money is the average frequency with which a unit of money is spent in a specific time frame.
Money velocity is a key component in both inflation and deflation because these phenomena are not purely functions of how much money is in the system. They are also functions of how fast that money is moving through the system.
When banks are lending, businesses are borrowing, and consumers are spending, money changes hands quickly and money velocity is high. Conversely, when banks are not lending, and businesses and consumers are saving or paying off debt rather than taking on new debt, money does not change hands quickly and money velocity is slow.
Inflation then, doesn’t come purely from an increase in the supply of money, you also need sufficient money velocity to spur a general and persistent increase in the price of goods and services. If you don’t get that velocity, and the newly created money doesn’t move through the system, there is no reason for prices to rise.
The bottom line
Today, governments around the world are printing money in order to spur economic growth and prevent a period of deflation. However the vast majority of the new money is just sitting in the banks, and as a result money velocity is subdued, and because the newly created money is not making it’s way out into the wider economy, inflation is also subdued.
At 247Bull, we believe that in the coming months central bankers will become much more aggressive and that they will try more and more radical ways to create inflation. That’s because of the options available to them, inflation is by far the most politically palatable one for escaping the global debt trap. As a result of these radical steps, inflation isn’t likely to stay subdued for long.
For more details on how I see the next few years playing out, read The Big Picture: How the next few years might look.