Japan and the Velocity of Money

On 27^th August 2010, the Japanese government released data which showed that the core consumer price index, a weighted basket of goods which excludes volatile food prices, had fallen by 1.1% in July from a year earlier – the 17^th straight month of decline. This decade-long trend of falling consumer prices has happened despite the government’s efforts to prevent the deflationary spiral.

In the wake of the recent results, the Bank of Japan (BOJ) is mulling over whether to return to quantitative easing (which involves flooding markets with extra cash under a liquidity target) – a policy which had little effect in tackling deflation in the early 2000s before it was terminated in March 2006. Simply pumping cash into the economy didn’t work then and won’t work now as consumers look to defer purchases in expectation of lower prices in the future. Rock-bottom interest rates of 0.1% (the benchmark rate) have been equally unsuccessful in shaking off deflation. Clearly increasing the money supply has failed.

The quantity theory of money states that:

M*V = P*Q

where M is the money supply, V is the velocity of money, P is the price level, and Q is an index of the real value of final expenditures. Of these terms, three are fairly self-explanatory though the definition of the ‘velocity of money’ may need some clarification. The velocity of money is the average frequency with which a unit of money is spent in a specific period of time – the number of times a unit of money changes hands in, say, a year. The question for the Japanese government is how to increase the value of P.

As increasing M (money supply) has failed to cause inflation, by this equation, the government is left with two other options – to decrease Q or to increase V. It is quickly obvious why reducing Q to cause inflation is a bad idea. Given that P*Q can be defined as the nominal value of output, reducing Q would reduce output. While this may lead to higher prices in the short run as the supply curve shifts inwards, in the (slightly) longer run, lower output would mean lay-offs which, in turn, would cause the demand curve to shift inwards as well – causing the price level to fall once more.

Because decreasing Q is out of the question, Japan’s only remaining option is to increase the velocity of money (also known as the velocity of circulation). In order to increase the velocity of circulation in an economy, there must be a strong multiplier effect – in other words, there must be as little leakage as possible from the flow of money within the country. One of the most significant ways in which money is leaked out of a country is through imports. It follows that Japan must try and reduce imports. An extremely strong yen, which hit 15-year highs this week, is therefore ominous for the Japanese government as it reduces the competitiveness of exporters and makes imports more affordable, helping to keep overall prices low. It is extremely important that Japan reduces the value of the yen in order to channel consumers’ money away from imports and towards domestically produced goods – spurring a multiplier effect.

Decreasing the value of the yen should, according to the quantity theory of money, help increase the velocity of money and hence, cause healthy inflation. However, in the long term, a structural change involving the reduction of inequality may be needed to keep imports in check. Inequality in Japan is higher than in India (Source: Gini coefficients, CIA World Factbook 2010), meaning that there are plenty of rich Japanese who probably love imported goods. Taking some money away from the upper echelons and diverting it to the poor (who would save little and spend on domestically produced goods) may be the best way to go in the long run.

Deep Vaze

28/8/2010