Today's lesson, the equation of exchange

In today's Senate confirmation hearing, Treasury Secretary Timothy Geithner talked about how restoring the banking system could require spending "trillions of dollars." The result of such a large scale increase in the money supply is that inflation will occur due to the formula known as the Exchange of Equation. This formula, MV=PQ states that the number of dollars in circulation(M) times the number of times they change hands in a year(V) is equal to the average price of all goods sold during the year(P) times the number of goods sold during the year(Q). By definition velocity is relatively constant and only moves greatly during a recovery or a depression when people are afraid to spend money.

Using this formula, by increasing the money supply X dollars means that those X dollars are spread out by the percentage change in the money supply equalling the percentage change in price. The previous statement presupposes that Q is unchanged or drops, which is likely given the economic slowdown occurring. As a result, those trillions of dollars in new spending will end up translating into fractions of dollars and cents on goods to spread out the increased money supply over the goods produced and sold in the country. (If Q increased it would be simple arithmetic to find if P rose or fell by having %(delta)M=%(delta)P+%(delta)Q) A little inflation is a given in an economic system because goods are scarce so over time the value should rise do to increasing marginal costs to produce.

When the money supply greatly increases relative to GDP growth, however that is when problems occur. When that happens the costs of doing business increase faster than a firm can deal with so people get laid off or their real wage falls.