Can MV=PT solve credit crisis for BoE?
In an effort to pump more money into the financial system and encourage banks to get lending again, the Bank of England has been given the green light to basically create more money.
It will use the electronic funds to buy short- and long-dated gilts and a host of commercial debt in the hope that that will free up other capital to the banks, allowing them to lend more.
At root, the exercise is based on MV=PT, known as the Fisher equation of exchange and a mainstay of Keynesian monetary theory.
In the equation, M is the quantity of money and V is the velocity at which it travels around the economy. P stands for the general level of prices and T equals the number of transactions performed over a given accounting period.
In theory, V and T are more or less stable, meaning that all other things being equal, the amount of money in circulation has a direct impact on prices and/or the number of transactions.
By pumping more M into the economy (or at least making more M available), the central bank is hoping that economic activity will pick up (T will increase) and the economy will be reflated (P will pick up). In theory.
The problem will come if those who have more money made available to them — the banks, commercial borrowers, companies and ultimately individuals — end up sitting on it rather than using it. That would effectively mean that V falls.
That has always been the unquantifiable in monetary theory as precisely measuring the velocity of money is extremely difficult, not to say open to interpretation.
If it works, quantitative easing will push up M, P and T and a corner may be turned in the credit crisis. Maybe. If it doesn’t, then M may go up, but V, T and P will all go on falling, causing More Very Tricky Problems indeed.