Due proportions of money to trade and inflation

Abstract

There is a rather old idea called: "due proportions of money to trade" (DPMT) which may help economists increase their understanding of inflation "quality" when it is described in relation to the simple "quantity equation of exchange" (QEE). The reason that a certain minimum amount of money is necessary to circulate goods is that in the short run, the income velocity of money is assumed capable of increasing only a finite amount; a maximum value of V exists during any given period of production. Let M be (nominal money stock), V (income velocity), P (general price level or price index), Q (real GNP), and YM (nominal GNP). From the QEE (MV = PQ = Y~): V= Q/(M/P). Hence, the proportion of trade in relation to money varies directly with V; a maximum value for V in the short run means that the proportion of trade in relation to money is also maximized or that the proportion of money in relation to trade is minimized. This short run maximum V value determines a "minimum" or a "due" proportion of money to trade. Velocity can be regarded as a measure of the "work" that a given quantity of money can do; when it has reached a maximum with downwardly rigid prices, only an increase in the money supply which lowers V can once more facilitate the trade of goods. This argument was mentioned by Professor Friedman in a 1958 article published by the Joint Economic Committee of the U. S. Congress [Reprinted in: M. Friedman, Optimum Quantity of Money and Other Essays, Chicago, Aldine, 1969 p. 174]. Many "monetarists" have taken up this argument in their rationalization of increases in M rather than V as one of the leading causes of short run inflation. An increase in V means that the existing money supply is spent more rapidly and that there is an independent lowering of money demand; perhaps because inflation is already occuring. But if V is already maximized, the money authority is "forced" to accommodate the borrowing public by allowing M to increase and simultaneously to lower V (increase the proportion of money to trade). IfMincreases at the "right" speed, it will mainly cause Q to increase and little inflation; but, if an "'overreaction" occurs to Vapproachingits maximum, then part of the M increase will be inflationary. Such a situation constitutes a tack of proper discretionary control over M by the money authority and it is an argument for automatism. However, if the public's changing spending habits caused inflation with a resulting V increase, there would be little to be done by the authority short of credit controls.