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Velocity Matters

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An accounting identity does not indicate the direction of causation. Not ever.

I’ve been caught out on this a few times myself, usually when I am trying to deduce something useful from national accounting equations. But I’m merely a writer. People actually involved in the formulation of policy should know better.

Here’s an attempt by people who should know better to try to infer the direction of causation from an identity. On the St. Louis Federal Reserve’s blog site is this post by Yi Wen and Maria Arias. It purports to show that the reason why three rounds of QE in the US have failed to raise inflation is because the velocity of money has collapsed. And they then come up with some reasons why velocity has collapsed, though sadly no ideas about what to do about it.

Their argument is based on the familiar Quantity Theory of Money:

MV = PY

where M is the monetary base M0, P is the price level, Y is real GDP, and V is the velocity of money. Sometimes real economic output Q is use…