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Can MV=PT solve credit crisis for BoE?

March 5, 2009

Britain could begin a telling exercise in classical monetary theory on Thursday as the central bank gets set to test a newly minted policy of “quantitative easing”.

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.

Comments

Had this chrisis occurred 20 years ago Quantative easing would have quite possibly worked and worked quickly. Problem is, it is not just the banks that lend money these days though the Govt is focusing soley on the banks and therefore missing a major part of the problem.

Posted by nick | Report as abusive
 

It is extremely critical that we have a widely-used and regularly-published measure of velocity (by currency). Operating without a measure (that can be evaluated historically) creates the same problems for central banks today that they faced in the Great Depression: a dearth of information. At that time, the U.S. Federal Reserve kept interest rates perpetually too high which, of course, prolonged the misery.If we had a clearer idea as to how much money supply has to be increased to offset the velocity loss (and get our economies back to full employment), we could determine whether current global efforts are sufficient.When a recovery does return, the inflationary pressures may become intense very quickly – and at that time, central banks will need to have an idea as to scale (and speed) of their efforts to cut the money supply.Is anyone working on a good measure to publish regularly (and historically)?This is critical!!

Posted by Michael Labrat | Report as abusive
 

no

Posted by tom sopp | Report as abusive
 

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