| The implication of the assumption of a constant velocity
of circulation of money is that people spend money out of their checking
accounts at the same rate regardless of the state of the economy. This
does not seem reasonable. For example, in a recession some people will
become unemployed. It is pretty obvious that many people cut back on their
expenditures (eat at home, no visits to the movie theater, etc) after losing
a job. But this implies that they spend their money less rapidily, and
hence that velocity declines. Conversely, in a boom, it is more reasonable
to assume that velocity rises. |
| So what implications does this have for the theory of
inflation? The basic classical theory is that inflation is caused by fluctuations
in the money supply, because P and M have a proportional
relationship to each other. Booms and recessions are caused by fluctuations
in Y, which themselves are caused by shocks in the labor market
(so the classical theory goes). |
| Now consider the quantity theory equation, MV=PY.
Rearrange this to get |
| P=(V/Y)M. |
| In a recession, V goes down as we have argued.
But Y also goes down, so the ratio V/Y may go up,
down, or stay more or less the same. If the movements in V and Y
are more or less the same magnitude, then the proportional relationship
between M and P is preserved even in booms and recessions.
In practice, however, we would not expect movements in V and Y
to always cancel each other out, so the quantity theory of money can only
be expected to be an approximate theory of inflation. |