Morningstar Magazine - October/November 2016 - 48

Strategies EXHIBIT 1 because it determines how much "liquidity" (in this case real balances) people want to hold.¹¹ Because MV = PQ, by simple algebra the demand for money is thus related to velocity as follows: V= The Velocity of U.S. Money (M2), Q1 1960-Q2 2016 M2 Velocity of M2 2.30 Q3 1997 2.20 Q L(i,Q) 2.10 Recession This means that-if the demand for real balances is proportional to real income, and logic and evidence suggest that it is-you cannot raise Q (income or real economic output) by lowering interest rates. All you will do is decrease velocity, V. A Natural Experiment This proposition was recently tested in a "natural experiment." When interest rates fell dramatically after the global financial crisis of 2008, velocity fell, too, as we can see in E X H I B I T 1 . 1.90 1.70 1.44 1960 1970 1980 1990 2000 2010 1.50 1.30 Source: FRED, Federal Reserve Bank of St. Louis. What Determines Inflation? The market-clearing condition-what must be true if markets are to clear-is: M S = P ∙ L(i,Q) If, however, the money supply is not suboptimal- St. Louis Adjusted Monetary Base M2 Money Stock Price factor-then Index for All Urban Consumers, All Items notConsumer a restraining additional money supply growth will just cause inflation; it will not increase real output. This was Friedman's insight in his 1967 presidential address, and it enabled him to forecast accelerating inflation in the 1970s, a forecast that came true. bottom of the graph, we reproduce it on a Real Gross B I T 3 , which also shows Growth larger scaleDomestic in E X H I Product annualized quarterly rates of real GDP growth.1,000 where M S denotes money supply. In other words, there must be enough money in circulation to satisfy the demand for real balances as described earlier. When this condition holds, at any given level of demand for real balances the price level moves in proportion to the money supply. So, if the money supply were to grow at some rate, that rate would become the rate of inflation. Now, what does all this theory mean for the ability of central banks or governments to manage the real economy? If there is economic growth, the demand for real balances would grow and, according to monetarism, it would be incumbent on the central bank to grow the money supply at the same rate as the economy to achieve price stability. If the money supply grows at a slower rate, the quantity of money becomes suboptimal and is a restraining factor on economic growth; then, and only then, should central banks increase the rate of money supply growth to enable the real economy to grow. E X H I B I T 2 shows the growth of two measures of the U.S. money supply (M2 and the monetary base), as well as of the real output of the U.S. Logarithmic scale economy (real GDP) and of consumer prices, over 2005-16. (The monetary base is defined as the sum of currency in circulation and reserve This time, however, after a much worse recession, 100 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 balances held by banks in their accounts with a peak-to-trough decline of 4.2% in real GDP, the best recovery year was 2015, with a 2.6% at the Fed; M2, a broader measure, also includes checking and savings deposits, certain other growth rate, and the average growth rate during the recovery period of 2009-15 was a deposits, and retail money market funds.) Because the real GDP line is hard to see at the miserable 2.1%. What went wrong? Monetary Keynesianism and the Economy Recession Quarterly Change in Real GDP (Stated as a Annual Rate) 900 800 The message of E X H I B I T 2 is that, despite massive 700 and unprecedented growth in the monetary base and much less dramatic but still substantial600 growth in M2, the economy hardly grew 500 and neither did prices. In fact, we need to study 400 E X H I B I T 3 in the context of longer-term data to see just how terrible the performance of the real economy of this period was. After severe300 recessions, growth usually rebounds sharply; for example, after the 1981-82 recession, 200 which saw a peak-to-trough decline in real GDP of 2.8%, the real GDP growth rate in the recovery year of 1984 was 7.3%. Real GDP Growth Annualized (%) 17,000 11 Friedman discusses other variables in the liquidity preference function including wealth, the division between wealth in human and nonhuman forms, and the expected return on money and other assets. In 2009 USD Billions 48 Morningstar October/November 2016 16,000 +10 +5

Table of Contents for the Digital Edition of Morningstar Magazine - October/November 2016