Some thoughts on the Austrian business cycle

 

That's what I said.  Of course all the Austrians have written theory opposing Keynes' views.

 I'm sure I read Economics in One Lesson. Whatever. :)

Donald Lingerfelt:

leonidia:

But even if you accept the "equation of exchange" MV=PQ as valid (which I don't because P is indefinable), there is nothing here which tells you anything useful. If M is constant and V increases, it doesn't follow that P increases. 

 

Sorry, I totally disagree.  If V increases, demand must increase which causes the tendancy for prices to rise.  Your example of a binary economy doesn't apply to the situation. 

How on earth can you make this claim?  What rationale do you use to justify the assertion that if the number of transactions increase in a given period of time that prices will rise?  Price is determined by supply and demand.  The rapidity of transactions has nothing to do with it.  Demand is not determined by "velocity" and "velocity" has no influence on demand.

leonidia:

How on earth can you make this claim?  What rationale do you use to justify the assertion that if the number of transactions increase in a given period of time that prices will rise?  Price is determined by supply and demand.  The rapidity of transactions has nothing to do with it.  Demand is not determined by "velocity" and "velocity" has no influence on demand

 

I said, demand increases if V increases almost by definition (and M remains the same).  You said it yourself, price is a function of supply and demand and if demand increases then prices will tend to rise.  However, prices do not rise uniformly over the whole economy, it rises in areas where M and V rise first.

I am very Austrian btw.  The Mises, Rothbard, Hayek, etc views are the most accurate model of economic science there is, it is without serious challenge from any of the other schools from an intellectual and practical point of view.  My views are not inconsistant with the Austrian viewpoint.  Reisman goes into this at length in his book and lectures.

Donald Lingerfelt:

demand increases if V increases almost by definition (and M remains the same)

No!  You are making a fundemental mistake. But if you're a devotee of Reisman, whose views are not entirely consistent with other Austrians, I can see why you're making it. 

An increase in the velocity of money is an increase in the amount of money changing hands in a given period of time. But this does not necessarily imply an increase in demand over supply.  Ever watched a stock market crash?   The total amount of money spent increases significantly, but prices fall. Why?  Because there are more sellers than buyers.  Demand falls. The "velocity of money", in this case, increases despite falling demand and falling prices because falling prices are more than offset by an increase in the number of transactions.  

Logically, an increase in the "velocity of money" can be caused by either 1) an increase in the number of transactions or 2) an increase in price or 3) any combination of the two.  But an increase in price is neither a necessary requirement nor a consequence of velocity. An increase in the number of transactions alone is sufficient.  It is not necessary for demand to increase more than supply. And when you look at the economy as a whole, the fallacy becomes even clearer.  Because how do you define demand in this sense?  Demand for what?  Demand for everything?  Demand only counts when you have the ability to pay, and how are you to pay unless you sell something first. So if demand for some goods increases, the supply of other goods must increase also, which is just a roundabout way of saying that more transactions occur. The "velocity of money" tells us nothing useful about overall "demand", or prices.

MV=PQ is a useless concept.  Ditch it.

You've made two errors in your statements:

leonidia:

Ever watched a stock market crash?   The total amount of money spent increases significantly, but prices fall. Why?  Because there are more sellers than buyers.  Demand falls. The "velocity of money", in this case, increases despite falling demand and falling prices because falling prices are more than offset by an increase in the number of transactions.

 

Yes, demand in the stock market falls as does the price as supply outpaces demand considerably.  However, the stock market cannot be compared to the consumer market at all.  In the stock market, all participants are entrapeneurs who buy and sell, while in the consumer market, everyone only buys (for consumption).  Demand for stock issues are based on the future returns, while in the consumer market the item purchassed is the value desired.  The two markets are not the same.  Yes, the velocity increases during a crash and the price drops due to panic selling.  This has nothing to do with the real world buying and selling. 

leonidia:

Logically, an increase in the "velocity of money" can be caused by either 1) an increase in the number of transactions or 2) an increase in price or 3) any combination of the two.

 

This is rediculous.  Velocity cannot rise because of an increse in price nor in an increase in the number of transactions, only in how much money is spent overall and as a factor of time.  Demand is total demand, as always.  Desire to consume is not demand unless the ability to pay is present and the deal is made.  I want a very large boat but I do not have the funds whith which to purchase it, so I have no demand.

I said that it is not a practical equation, only one which can be used to understand how money flows through society.  I don't think it is useless.  I think your arguement does not prove your point.  I am open to considering whether or not your conclusion is worth accepting, but so far you just haven't demonstrated it.

Donald Lingerfelt:

Velocity cannot rise because of an increse in price nor in an increase in the number of transactions, only in how much money is spent overall and as a factor of time. 

If more money changes hands in a given period of time, explain how this can occur without either 1)prices being higher or 2) the number of transactions being greater or 3) both.  Isn't this the basis of the equation of exchange MV=PQ?  If M is constant, we have V is proportional to P*Q.  If you accept this (and in an earlier post you said you did) then if V increases, P*Q must increase by the same amount.  However, this is a statement of the obvious.  It says "More money changes hands in a given period of time if prices rise or more goods are exchanged in a given period of time."  Big deal!   But nothing in the equation of exchange says that P must rise as a consequence of V increasing. P can remain constant or even go down, if Q increases by a sufficient amount.

You are correct, V can increase without P increasing if Q increases.  That was my point.  P does not need to increase in order for V to do so.  In what way does this make the equation valueless?

Donald Lingerfelt:

P does not need to increase in order for V to do so.

But you're not being consistent.  In earlier posts you said

Donald Lingerfelt:

If currency moves faster through society, this in itself will cause price inflation, even though the quantity of currency remains the same.

and this

Donald Lingerfelt:

Sorry, I totally disagree.  If V increases, demand must increase which causes the tendancy for prices to rise.

So it seemed like you were originally saying that if V increases, this will cause price inflation and demand must increase.  Now you seem to be saying this isn't necessarily so. 

My point is,this, and it's not trivial.  V tells us nothing about which way prices will move. And the equation of exchange reduces at best to a statement of the obvious. Please ask yourself the following questions:

1) If the amount of money changing hands in a given period of time is increasing, does this necessarily involve prices increasing? Couldn't it just imply that the number of transactions is increasing?

2) Every transaction involves a buyer and a seller.  If the number of transactions in a given period of time is increasing, doesn't this imply more goods being bought and more goods being sold?

3) If the amount of goods being bought in the entire economy increases, and the money supply is static, how are people to pay for these goods?  Don't they have to sell something else first?  

4)If more goods are bought and more goods are sold, does this say anything about which way prices will move? What does it say about demand? supply?

 

I will concede that P does not necessarily increase if V does, but that P tends to rise all other things being equal, due to demand rising.  This must be the case.  If demand rises, P must tend to rise also.  Other factors may negate the actual rise in P, but none the less, the tendancy is there.

leonidia:

1) If the amount of money changing hands in a given period of time is increasing, does this necessarily involve prices increasing? Couldn't it just imply that the number of transactions is increasing?

  I agree.

leonidia:

2) Every transaction involves a buyer and a seller.  If the number of transactions in a given period of time is increasing, doesn't this imply more goods being bought and more goods being sold?

 

Of course.

leonidia:

3) If the amount of goods being bought in the entire economy increases, and the money supply is static, how are people to pay for these goods?  Don't they have to sell something else first?

 

They are reducing savings, or of course they must somehow raise their own sales revenues.  They can do this by working more hours or increase sales, but this is obvious with the given of increased V.

leonidia:

4)If more goods are bought and more goods are sold, does this say anything about which way prices will move? What does it say about demand? supply?

This is my point whole in this discussion.  Prices will tend to rise with the increasing demand, regardless of the change in the money supply.  However, a positive change in the money suppy will tend to increase velocity as well, because consumers will have more to spend and because if they see prices starting to rise they will attempt to maximize their value retention by getting rid of it more quickly.  This is encouraged by lower interest rates which generally occurs at the same time. 

If supply increases as well, this may negate the price increase, but if it does not, prices should rise.  The rise in V says nothing about supply, only that cunsumers have decided for some reason to increase consumption.

 

Donald Lingerfelt:

I will concede that P does not necessarily increase if V does, but that P tends to rise all other things being equal, due to demand rising.  This must be the case.  If demand rises, P must tend to rise also.

  Yes, of course. 

Donald Lingerfelt:

This is my point whole in this discussion.  Prices will tend to rise with the increasing demand, regardless of the change in the money supply. 

The price of an individual good will rise if the demand for that good increases, but if the money supply is static,  this simply means that the demand for some goods will increase and the demand for others will decrease, and these changes are simply a reflection of consumer's subjective preference. Of course, if the consumer's time preference changes, then the overall demand for goods can change.   But you seemed to be saying that velocity had something to do with influencing demand, which it doesn't.

Velocity tells us nothing about demand, nor does it tell us anything about which way prices will move. It can't because it's not an independently defined variable. Velocity is simply a measure of the rate at which money changes hands, but it is defined by the very same variables that you claim are influenced by velocity.  If we want to measure velocity, we first have to look at the prices at which goods are exchanged and then multiply that by the rate at which these goods are exchanged.  That's the only way we can know what velocity is. So we can't then turn the argument around and claim that velocity tells us anything useful about price. It doesn't because we've measured it using price.  We've defined velocity in terms of price, so it cannot tells us anything we don't already know about price. Compare this with a famous equation from the physical world.  Force=mass*acceleration.  All three variables are independently defined.  We can measure them independently. We can use different instruments to measure force and mass and acceleration, and we can prove empirically that the relationship between these things is true.  It's not true simply by definition.  We can use it for its predictive value. If we know just two of the variables we can predict what the third is. Thus the equation tells us something valuable. 

Looking again at the problems with the equation of exchange.  MV=PQ.

1)  V is not an independently defined variable.  It is defined as the sum of each individual p*q, so it cannot tell us anything that we don't already know about P or Q

2) P cannot be defined at all.  You cannot average the unit price of dissimilar goods, because they have no common denominator. Therefore it is illigetimate to quantify an overall price level. Prices exist only for each individual good. 

3) The terms on either side of the equation are not equivalent.. On the left, we have money*money/time.  On the right, we have money/unit * unit/time (reduces to money/time).

Donald Lingerfelt:

However, a positive change in the money suppy will tend to increase velocity as well, because consumers will have more to spend and because if they see prices starting to rise they will attempt to maximize their value retention by getting rid of it more quickly.

A positive change in the money supply will cause a general rise in prices, and this may well cause an increase in velocity, but it's not the velocity that's causing the increase in prices.  It is true that in an inflationary environment, consumers will avoid holding large cash balances for fear that the purchasing power of their money will diminish. This is what exacerbates price inflation during a hyperinflation. The demand for money to hold becomes less and thus the purchasing power of money diminishes almost to zero, leading to a mad scramble to get rid of money and a rush to hold real goods. But the velocity of money isn't the cause, it's the effect of higher prices. Now if more transactions occur in a given period of time, then this will speed prices to their equilibrium position faster, but neither the rate at which money changes hands nor the rate at which goods change hands influence what the equilibrium prices will be.

 

 

Leonidia,

In my opinion we are reaching a consensus here, there is only one problem left with your assessment: V can never be separated from M in this equation.  Without velocity, the money supply would just lay there having no effect on anything.  If someone buys something, there is velocity of at least one.  Money without velocity makes absolutely no change in anything, especially prices.  Granted, we can't know P for sure, only estimate it to a point (and only compare it to past versions).  It just can't be done accurately.  M is only estimable as well, but closer than P.  Even Q is not really estimable as there is the black market for both services and goods.  And lastly, V is only a concept that we have very little by way of means to estimate.  However, V can cause prices to move up or down just as much as M can.  If, for instance, individuals wished to increase their cash balances for some reason (doesn't matter why), V will decrease regardless of M.  Just after and during the Great Depression, the Fed increased M significantly with little effect because the banks would still not lend for fear that the reserve requirements would rise and cause them to go bankrupt.  And this along with the public's distrust of the bankiing system (rightfully so) caused V to decline, and thus slowed the economy even though the money supply tripled. 

I contend that V in inseparable from the equation regardless of our ability to determine it. 

Donald,

I'm sorry to have to disagree with you, but I don't think we are reaching a consensus.  We seem to have a fundamental difference of opinion here.  V doesn't tell us anything of value about the real world because it is defined solely in terms of P and Q (or more precisely the sum of p*q).  Since V is not an independently defined variable, the relation between V and it's defining terms is therefore a tautology and the true statement "V is proportional to P and Q" is an analytic proposition.  Analytic propositions do not tell us anything about the real world. Furthermore, Austrian economics is based upon propostions deduced from the axiom of action, which is an a priori synthetic proposition.  The equation of exchange is not deduced from the axiom of action. It is an attempt to apply a mathematical formula to human action, which is a grave mistake.  Unlike in the physical world of natural science, human beings aren't governed by time-invariant universal constants like the acceleration due to gravity or the speed of light.  Human beings make decisions based on preferences which vary over time, and from person to person. For this reason, the only valid way to discover how human beings act is to deduce propositions from a priori knowledge that come from inner reflection on the nature of man, not from empirical data. The equation of exchange is not so deduced.  It is a crude (and mathematically inconsistent) attempt by the logical positivists to explain empirical data.  As an Austrian, I categorically reject such methodology. 

You have made some very good points, most of which I agree with.  I never said the we could predict human action using this formula.  I see it as merely an observational tool to find out what people actually did in the past.  Should we jettison a tool merely because it does not find its derivation from the axiom of action?  A change in V only indicates that individuals have done something different than they did in the past, and we can theorize why that that may have happened.  Why does an increase in the money supply cause a change in the price level different from the percentage change in the money supply?  It must be because they wish to acquire their new desired level of cash holdings.  A change in their desired cash level is caused by various factors (change in interest rates, change in the money supply, anticipation of change in inflation levels, etc), and they either spend faster or slower depending on their newly acquired desire for cash holdings.  A change in V is the vehicle by which this takes place.  By your logic, we must not even look at the money supply because it is an analytic quantity.  We are stuck with real world ideas and materials whether we like them or not.  Without dealing with "things", economics becomes a useless academic exercise.  We may not want to deal with the real world, but we must.  Why would we even talk about a change in the money supply? Or a change in individual choices?  Or rising unemployment?  These are real world events that we must deal with, and our desire to remain "pure" is without substance.  To say that humans increase their desire to change their rate of spending is one of those events that, while real and observational, should be ignored, is to neglect an important part of our science.  Recently I listened to a lecture on Mises.org of Dr. Solerno discussing the business cycle and he made several observations concerning  the change of the rate of saving and spending for the purpose of attaining their newly desired level of savings.  How can we not take this into account?  [Fundamentals of Economic Analysis: A Causal-Realist Approach, lecture 10, Banking and the Business Cycle]

I guess we'll just have to agree to disagree.

Leonidia,

You may be suprised to hear that I am going to conceed the point.  After reviewing HA and ME&S and reading some of my other texts, I am now convinced that you are correct.  I still don't know exactly how we can ignore the fact that money moves faster in some instances than in others, but I will continue to study the question. I apologise for being so stubborn.