Not all prices rise at the same time, nor do they rise evenly. Furthermore, the equation of exchange cannot differentiate between price changes that emanate from demand for goods and those that emanate from changes in preference for money – two effects that can produce very different results.
These unknowns are effectively wrapped up in that catch-all, velocity of circulation.
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By Alasdair Macleod, GoldMoney
The quantity theory of money and its accompanying equation of exchange are generally accepted as defining the relationship between money and prices. The equation has been expressed a number of ways, always including “velocity of circulation”, which is a variable essential to balance the equation.
Few disagree with the simple premise that an increase in the quantity of money tends to increase prices; the mistake is to try to tie the relationship mathematically, because it rides roughshod over what actually happens. Not all prices rise at the same time, nor do they rise evenly. Furthermore, the equation of exchange cannot differentiate between price changes that emanate from demand for goods and those that emanate from changes in preference for money – two effects that can produce very different results. These unknowns are effectively wrapped up in that catch-all, velocity of circulation.
Aprioristic theory tells us where the error lies. People make a choice to allocate their income between current consumption and savings for the future. The most they can do without incurring debt is spend their earnings once. In practice most income is spent on consumption, but some is put aside for savings, and those savings are lent on through financial intermediaries to businesses for investment. Savings end up being spent on capital goods and working capital, instead of immediate consumption, but they are still spent.
If there is an increase in the quantity of money it is spent by those that first obtain it, but the same rule applies: they can only spend their money once. How that increase is spent determines which prices will tend to rise. Furthermore demand for goods can change as the quantity of currency and bank credit changes and consumers can also change their preference for money by hoarding or dishoarding only marginal amounts of cash. It is these factors that govern the relationship between money and prices. Therefore, the number of times a unit of account circulates over a given time is a red herring.
The fallacies behind the equation of exchange are more fully exposed in the case of a fiat currency, which unlike gold has no intrinsic value at all. What it will buy is set by its domestic acceptability as a money substitute amongst those that use it for transactions, and by its external value in the foreign exchanges set by those that don’t. Its purchasing power boils down to a matter of confidence and nothing else; therefore velocity is meaningless.
Consider the Icelandic krona’s dramatic fall in purchasing power in October 2008. According to the equation of exchange, the sharp increase in domestic prices that followed must be the result of an expansion in the quantity of money and/or an acceleration of velocity of circulation. What actually happened was simply a collapse in the purchasing power of the krona that originated in the markets, which had nothing to do with any monetary equation.
Velocity is an invention by economists to balance an equation conjured out of their own imagination, instead of understanding that the purchasing power of today’s fiat currencies is governed solely by the confidence placed in them. And because they have no intrinsic value, the quantity theory itself is a wholly inadequate explanation of the relationship between fiat money and prices.
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As has been said before, the current monetary system based on issuance of debt-based fiat paper currency out of nothing, and passing it off as money, is an entirely corrupt and immoral system (even if it’s not illegal due to laws written to protect those bankers who issue them). It is entirely corrupt and immoral because it steals the two most fundamental treasures that all people as individuals possess–our time and our labor, or in other words, our freedom.
More like the issuance of toilet paper… wait toilet paper is worth more…
Author used the term “Aprioristic Theory” in the third paragraph. I have no idea what that means so I looked it up.
“APRIORISM—a gnoseological tendency according to which valid a priori knowledge exists (moderate apriorism), or all valid knowledge is obtained only a priori (radical apriorism); apriorism is opposed to asposteriorism or empiricism which gives experience the dominant role in cognition (a priori—a posteriori)
That didn’t help much.
EXACTLY what I was thinking before I read your last line.
No thing has intrinsic value, this is a fallacy. It comes down to supply and demand. This is called price discovery. There is nothing wrong with the concept of Fiat currency apart from the fact that paper can be created quickly, easily and cheaply. Even during the gold standard, there was more paper than the gold that it represented, there has always been a form of fractional banking. The problems are usury in nature. This is the problem. Lending money that has been created at the point of contract.
* “There is nothing wrong with the concept of Fiat currency…”
Then, why has every single fiat paper currency in the history of the world failed at some point? Does anyone really believe those who issue fiat currencies can control themselves? Or act in the interest of others rather than themselves? Gold and Silver are physical elements that are not available in infinite amounts. That fact alone is what serves to restraint borrowing and spending. It is a balance against the uncontrollable desires of the powers that be to print, tax and spend uncontrollably.
* “…there has always been a form of fractional banking.”
That is completely false. When money and currency were only physical Gold and physical Silver, the concept of fractional reserve banking did not exist, nor was it necessary. Fractional reserve banking is a scam invented by bankers and money changers. When Gold and Silver were money, history shows prices were stable over long periods of time. Inflation is a result of printing fiat currencies in excess–because they can.
The force of widespread propaganda is strong, but only a little history is needed to dispel the fallacies.
Do some research, we had gold and silver in circulation. Banks lent out more than they held, this is the essence of fractional Banking. Its why bank runs occurred and banks went under. Usury is evil, not Fiat currency. How can you have a negative of something? Its a concept that only exists in theory not actuality. There is no real value in gold, only perceived value, the reason why it works as money has nothing to do with intrinsic value. As stated value is an emergent property not fact. Bitcoins are an excellent example of a controlled resource that hold no value, they are just strings. Gold was only taken to be a standard after countries copying the British Empires successful model. Fractional banking has been around for centuries.
Here’s the summary about the relationship between money and prices.
The more money you add in circulation, the more there is inflation which is when prices go up. The more money you remove from circulation, the more there is deflation which is when prices go down. It’s all about the supply and demand! Traditionally, to calculate the price of silver per ounce in dollars for example, you divide the dollar supply by the number of ounces of silver available in the market and you’ll get the price, but today, that’s not how prices work.