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The Quantity theory of money is the idea that an increasing money supply (& particularly base money–cash and reserves supplied by the Fed) has a direct relationship with prices.

The idea is used by some to suggest that Government spending is useless because it will only increase prices.  The other way it is used is by suggesting that the Federal Reserve buying assets from the private sector (Treasuries, Mortgage backed securities, etc) will be inflationary because banks will use the increased reserves to lend more, leading to additional credit and therefore increased prices.

Both of these ideas are false.

Over the past couple of years, base money in the economy has more than doubled, increasing the cries of talking heads that massive inflation is coming.  But as yet, we’ve not had (much)  inflation.

As usual, I’ll leave the technical work to others, see here and here.

A simple example should suffice.  Let’s say you are a car manufacturer who got caught in the downturn with a little too much inventory.  Typically you like to keep about 50 cars on hand to give consumers some choice in style and price.  But when the downturn hit, your inventory doubled to 100 cars.  Now a few years in from the crisis and you’ve managed to work your inventory down to about 70 cars.  The monetary base has doubled, government spending has increased but you still have excess inventory on your lot, so increasing prices is a non-starter.

The reason for this is two-fold:  1.  Just because banks have extra reserves on hand, doesn’t mean they are going to lend more money.  If they can’t find qualified borrowers, or if people are already indebted and don’t want to borrow, then banks can’t or won’t lend.  2.  If too many people are trying to save their incomes, then the velocity of money through the economy slows down and less is spent on goods and services and just ends up in savings accounts or paying down existing debt.

The bottom line is that inflation is ultimately and everywhere a capacity issue.  If there is little excess capacity in the economy, prices will increase.  If there is too much slack among goods and services, it doesn’t matter how much money or liquidity the Government pumps into the economy, prices won’t increase.  

With 9.0% unemployment and incomes decreasing, significant inflation is nowhere in sight.



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