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August 16, 2012

Monetarist Equation: What Happens When Real Numbers Are Put In?

In a previous article, we discussed the components of the monetarist equation and what it told us about the financial crisis.

In short, M*V = P*Q, where M is the money supply, V is the velocity (or speed) that money moves through the economy, P is the price index (or inflation), and Q is the real GDP.

We decided to take this equation a step further and enter real economic numbers into each variable and see what it tells us.  The statistics we choose were M2 supply (for M), M2 money velocity (for V), CPI Index (for P), and Real GDP (for Q).  M2 Money supply and Real GDP were divided by one trillion to index our equation to a lower number.  Money velocity was presented as is, and CPI was divided by 100.

Keep in mind as we do this analysis with these four statistics that we do not expect them to equal each other out.  The reason being that any number of statistic combinations could be used for each variable.  What we were looking to do was assign a coefficient variable to the higher side of the equation.  The more steady that variable holds, the more true the equation.  If you're confused, don't worry, we're going to get into the numbers now, and hopefully, that angle will present a clearer picture.

Here's what we found when we combined M*V on one line and P*Q on another line.

We can see the relationship, however, it appears that the gap between the two lines widens over the years.  Also, it's important to note that the deflationary push during the financial crisis did not have as much of an impact on monetary supply or velocity.  So, this is where the coefficient, or as we call it, the differential comes into play.  We want to see if there's a common multiple that when multiplied by M*V, it equals P*Q.  From a mathematical standpoint, the equation would look like:

x(M*V) = P*Q, where x is our differential variable.

Here's what we found:

So, from 1987 to 2000, our variable slowly increased.  This meant that inflation and real growth outpaced monetary supply and speed.  From 2000 to 2007, our variable held steady at 1.95.  From 2000 to 2007, the monetarist equation held true for our economy.  However, the credit crisis and points since have shown the greatest degree of volatility.  What caused the change in 2000?  We're really not sure, but one thing is clear, for the past 12 years our economy has become more dependent on monetary growth as an input to economic growth.

Let's take this differential chart and magnify in to 2006-2012.

It appears as if the monetary side of the equation showed distress before the growth side.  But, once the growth side became distressed, it fell faster and further than the monetary side.  This chart is clearly not an overwhelming endorser of quantitative easing, however, if the Federal Reserve is seeing what we are seeing, they may think that the monetary base is once again becoming weak, and therefore requires more stimulus.  We, however, believe that if that is the case, it is because of distortion created by the Federal Reserve.

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