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Deflation in the Quantity Theory of Money Essay

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Updated: Aug 15th, 2020

Introduction

The relationship between inflation, money growth, and consumer or producer prices has in the past few decades played an important role in monetary theory and policy not only in the United States but also globally (Bagliano & Morana 2).

Although inflation has been described in the literature as a monetary phenomenon, it is becoming increasingly important for analysts to assess the drivers of deflation particularly against the backdrop of recent revelations that the United States Federal Reserve is likely to hamper economic recovery by undershooting its own 2 percent inflation rate (Wolfers par. 1). The present paper analyzes the recent revelations using the quantity theory of money and concludes that the United States Federal Reserve can reverse the anticipated deflation tide by increasing the amount of money circulating in the economy, which in turn will prompt an equivalent percentage rise in the prices of various goods and services.

Summary of Event

A recent article appearing in The New York Times raised fears that the economy could be headed for a deflationary rut not only due to the perceived misalignment between inflation expectations and actual inflation, but also because of the fact that the Federal Reserve’s inflation target of 2 percent is unattainable in actual sense (Wolfers par. 1-6). Although the news article talked about how individuals and analysts can use derivatives to understand new perspectives on inflation expectations, its importance in this analysis is nested on how it discussed the dynamics of the money market in terms of not only tracking the anticipated level of inflation, but also providing justifications on “the risks that inflation might be too high, too low or just right” (Wolfers par. 3). The subsequent economic analysis is firmly grounded in these assertions.

Economic Analysis

Available economic scholarship demonstrates that “any exploration of the relationship between money and inflation almost necessarily begins with a discussion of the venerable quantity theory of money” (McCallum & Nelson 3). The quantity theory of money (QTM) can be described to an average reader as a simple theory that seeks to associate the inflation rate with the growth rate of the money supply through calculating the rate at which money circulates or the number of times the average dollar bill changes hands in a given time period, otherwise known in the economic domain as velocity (Mankiw 105).

In the news article, the author advanced the idea that the United States might be exposed to prolonged periods of deflation and its attendant negative economic consequences due to falling consumer prices (Wolfers par. 11). QTM can be used to demonstrate that the expected deflation will be as a result of slower growth rate of the money supply, leading to a higher velocity quotient.

QTM is increasingly associated “with the equation of exchange, MV = PY, where, M, Y, and P respectively denote measures of the nominal quantity of money, real transactions or physical output per period, and the price level, with V then being the corresponding monetary velocity” (McCallum & Nelson 3).

Synthesizing this equation makes it easier to understand why normal economic growth requires a certain amount of money supply growth in transactions and also why excessive growth in these transactions may trigger inflation. In the context of the news article, the falling prices and subsequent anticipations of deflation (instead of inflation) can therefore be attributed to lack of sufficient money supply growth in transactions, probably due to the fact that the American economy is in a recovery mode.

Indeed, it has been demonstrated in the literature that “a one-to-one proportionality between changes in the steady-state money growth rate and the rate of inflation in the long-run is commonly regarded as an explanation of inflation grounded in the quantity theory of money” (Bagliano & Morana 2).

This means that monetary growth rate is directly associated with the rate of inflation, further lending credence to the assertion made in this analysis that a slow money supply growth rate may be directly responsible for slowing inflation in the United States and putting the economy on the brink of deflation. To achieve the anticipated inflation target of 2% as suggested in the news article, the United States Federal Reserve must therefore increase the amount of money in the economy, which in turn will trigger an equal percentage rise in the prices of products and services.

Conclusion

This paper has employed the QTM to provide responses to the various questions and issues raised in the news article about the possibility of the United States slipping into deflation. Although the author of the news article raised valid issues, it has been demonstrated that the anticipated deflation is as a result of slower growth rate of money supply, and that a rise in the prices of products and services can be achieved by enhancing the amount of money in the economy. However, more analysis using various economic models is needed to understand why enhancing the growth rate of money supply does not necessary lead to sustained economic development.

Works Cited

Bagliano, Fabio and Claudio Morana 2004. Inflation and Monetary Dynamics in the US: A Quantity-Theory Approach. Web.

Mankiw, N. Gregory. Macroeconomics. New York NY: Worth Publishers, 2013. Print.

McCallum, Bennett and Edward Nelson 2010. . Web.

Wolfers, Justin. “A Prediction Market for Inflation, or Deflation.” New York Times. 2015. Web.

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