Inflation: the word of the year in the United States economic sector. It’s certainly ruling headlines, and has lately been the particular focus of a podcast series entitled “Marketplace”, hosted by Kai Ryssdal. On December 10th, Marketplace released an episode digging into the macroeconomic phenomenon, entitled “The Big Picture on Wholesale Inflation”. In the episode, Risdall notes the status of inflation in the United States and the effect that the Covid-19 pandemic has had on the wealth held by citizens. This information – in particular, the current status of inflation and how we’ve arrived at this point – can be more profoundly understood by examining the Quantity Theory of Money (hereafter “QTM”). This essay will provide an explanation of the economic cycle which led us to the present state of inflation by referencing the QTM and the actions of the United States Federal Reserve in regard to interest rates.
In the podcast, Ryssdal notes that inflation is “falling but still high” – this is a good sign for the Federal Reserve, which has been aiming to reduce the high rate of inflation for the past few months by increasing interest rates. Ryssdal also mentions two more key pieces of information: first, that the pandemic programs initiated by the U.S. government caused an overall increase in the amount of money held by households, and second, that those households who held extra savings (due to those programs) are now rapidly spending that money, which contributes to the high inflation rate.
To understand how we got here – and hopefully where we’re going in the future – we must first understand the QTM. Written in equation form as MV = YP, the QTM holds four variables: Money Supply (represented by M), Velocity (V), Real Output/Real GDP of a country (Y) and finally Price Level (P). Each variable is distinct in nature but together they interact to determine the actions and qualities of a nation’s economy. Money Supply refers to the quantity of money that’s available in the economy, which in the United States, is generally influenced by the policies of the Federal Reserve and the Federal Open Market Committee. The Velocity variable refers to the velocity of money, which measures how quickly dollars will change hands throughout the economy in a given period; it is also a variable which generally remains steady over time (as a note, due to its ability to remain relatively constant, it has little effect on inflation). The third variable, Real Output/Real GDP, concerns the production level within an economy. Like velocity, this is a variable which remains relatively stable year to year. Lastly, there is the Price Level, which indicates the overall status of the costs associated with consumption.
Inflation didn’t just magically rise; it was caused by a chain of events beginning with the increased amount of money present in American households. The higher money supply allowed more spending, which increased the demand in the economy. However, increased demand doesn’t translate to increased production levels (as the Y variable representing Real Output remains steady), so prices must rise. An economy’s price level has an inverse relationship with the value of money: the higher price levels are, the lower the value of each individual dollar is. Since each dollar is then worth less, price levels must again increase to compensate for the lost value. This illustrates a cycle of inflation, where prices increase, the value of the dollar decreases, causing prices to increase even more and dollar value to continue decreasing.
Unfortunately, many economists argue and many politicians worry that aggressive inflation has slightly destabilized the American economy. The Fed’s course of action in ending this cycle has been to increase interest rates in an effort to stop the cycle at its source by decreasing the available money supply. This would lower demand, which lowers price levels, which increases the value of the dollar and finally slows – and hopefully lowers – inflation. Their actions have been working, as noted in Marketplace, with the inflation rate falling in the past few months. This is a good sign for the Fed, and represents a positive outlook for the future stability of the United States economy.
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