I’m pulling this one out of the AMA section because it’s a common question I see. Reader Oshe asked about the Equation of Exchange otherwise known as MV=Py, where M is the quantity of money, P is the price level, Y is total output and V is velocity, or the number of times that a dollar is used to purchased goods and services. He asks how useful this equation and if its assumptions are valid. I don’t think so.
First off, we should be clear that the Equation of Exchange isn’t used by many economists these days. The old school Monetarists who relied on this sort of thinking are largely gone. This is the result of many erroneous assumptions in the theory that the empirical data simply doesn’t support.
That said, we can’t deny MV=Py. After all, this is just a tautology. You can’t debunk it. But you can poke serious holes in the assumptions that go into it. So, what are some of those erroneous assumptions?
1) MV = Py is only useful if V is constant. In this world V = Py/M. And if V isn’t constant then it can basically be fudged to mean whatever you want. So, if P is 1, Y is 1,000 and M is 10 then V has to equal 100. If you were an old school Monetarist then you would say that doubling M will double P because P=MV/y or P=((20*100)/1,000)=2. But what if P doesn’t double for some reason? Well, then you can just say V went down. In other words, the demand for money increased. It’s like voodoo economics. The equation can mean whatever you want it to. That’s not very helpful.
2) The bigger problem in the Equation of Exchange is that it doesn’t define money accurately. “Money” in this model generally refers to the Monetary Base or Central Bank money. So, if you were applying an old school Monetarist sort of view then you’d have used this equation to conclude that QE would cause sky high inflation. In fact, we saw this sort of analysis all over the place in recent years. But the problem is that “money” is a really complex thing in a modern economy. It is not merely Monetary Base, cash, coins or even deposits. Money, as I’ve described, exists on a scale of moneyness and different things meet the properties of money in different instances. So, trying to peg “money” as Central Bank money is misleading at best and totally erroneous at worst.
In short, the Equation of Exchange is a very limited description of how the quantity of money actually impacts the economy and prices. And that’s primarily due to some broad theoretical assumptions that make it a lot less useful than many people think.
Mr. Roche is the Founder and Chief Investment Officer of Discipline Funds.Discipline Funds is a low fee financial advisory firm with a focus on helping people be more disciplined with their finances.
He is also the author of Pragmatic Capitalism: What Every Investor Needs to Understand About Money and Finance, Understanding the Modern Monetary System and Understanding Modern Portfolio Construction.