# Why Hyperinflation Is A Myth (And What It Means For Gold Prices)

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by: Macro Investor

I previously wrote an article on what the latest GDP report says about gold prices. My conclusion was that unless it is a one time glitch, lower GDP growth will be bearish for gold prices. This would be the case even in the face of a sharp increase in money supply, as the velocity of money has kept dropping. It became amply clear from the comments on the article that it was not apparent to the readers how money velocity drops negates increase in money supply, and hence results in the low inflation environment that we are in right now, and how lower GDP growth will in turn make this situation worse.

I am therefore writing a follow up article explaining how money supply, velocity of money, and price inflation are all linked, using the standard Quantity Theory of Money. Hopefully this article will make it clearer why despite a large infusion of money into the US system by the Feds, inflation has been low.

First, what is the Quantity Theory of Money?

In its modern form, the quantity theory builds upon the following definitional relationship.

Lots of jargon there, so let's first explain the left hand side of the equation with an idealized example. We have two terms on the left hand side, M, which is the money supply, and V, which is the velocity of money.

M is simple to understand - it is the aggregate money supply in the economy held by all the actors who are engaging in buying and selling transactions. But what is V? In the simplest terms, velocity of money is the ratio between total monetary transaction to the total monetary base.

Let's say there is a closed economy with a fisherman, a tailor, and a doctor. Let's say the total monetary base is $60, with each person starting with$20. The fisherman sells $20 of fish to the doctor, and buys$20 worth of clothing from the tailor. The tailor in turn gets his annual checkup done at the doctor, paying $20. So, everyone ends with the same$20 in the end. The total transaction of $60, and the total monetary base is also$60, so the velocity of money in this case is 1.

Let's say now the doctor buys clothing from the tailor next for $20, the tailor uses that$20 to buy fish, and the fisherman gets his annual checkup for $20 in turn. Now, there has been another$60 in transactions, even though the total monetary base is still fixed at $60. Now total transactions is$60+$60=$120, and velocity of money is 2.

Let's now explain the right hand side of the equation. P is the price of goods and services, and Q is the quantity of goods and services consumed. Let's say the price of fish is $20/fish, the price of clothing is$20/shirt, and the price of medical checkup is $20/visit. Then, in both the round trip transactions, one shirt, one fish, and one medical checkup exchanged hands. Putting in all together.$60 (NYSE:M) * 2 (NYSE:V) = $20 (NYSE:P) * 2 (Q, shirts) +$20 (P) * 2 (Q, fishes) + $20 (P) * 2 (Q, visits) This is the basics of modern monetary economics. How can this model be used to predict price inflation? Imagine that the total monetary base increases to$600 instead of $60. Imagine also that the velocity of money remains unchanged at 2. Finally, imagine that the quantity of goods and services consumed remain unchanged at 2 fishes, 2 shirts, and 2 medical checkups. Then, for the above equation to hold, the price of a fish, a shirt, and a medical visit has to go up to$200. In other words, there will be 1000% price inflation from 1000% increase in the money supply, ceteris paribus. This is what most people are afraid of. The Federal Reserve has sharply increased the money supply in the country, so according to the Quantity Theory of Money, we should see hyperinflation any time now.

However, inflation has been low. Most hawkish commentators have interpreted this as either an error in calculation (inadvertent or deliberate) or a delayed effect. What they have been missing, however, is that the Quantity Theory of Money doesn't work in a vacuum. When M changes, V and Q do not always remain constant as in the above stylized example. They often change with M, thus putting little to no pressure on P. That's what has happened in the USA.

Let's see this with real numbers. Over the past 5 years, M2 Money Supply (M) has grown 36.4%. At the same time, M2 Velocity (V) has dropped 18.7%. Hence, the product of the two (M*V, or the left hand side of our equation) has only grown by 10.8% over the past 5 years, or ~2% on average every year.

What has price inflation been in the past 5 years? It has fluctuated between 5% to -2%, and on average has been ~2%/year, exactly what the Quantity Theory of Money would have predicted.

This is why inflation has been low in the USA despite major monetary injection by the Fed. It has to do with velocity of money. So, why has velocity of money dropped? Again, let's go back to our idealized example.