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Exponential Money Growth

November 2, 2011

In recent decades the broad money supply (e.g. UK M4) has been growing much faster than nominal GDP. (No this is NOT because of inflation because nominal GDP, as opposed to real GDP, has inflation left in it.) Why is this?

Some Money Reform enthusiasts – and I stress some – claim that this is a mathematical consequence of our current fractional reserve system of banking. When money is created as debt, they claim, there is only enough money to repay the principal but not the interest; therefore the money supply must grow exponentially. This is a fallacy because the interest payments eventually flow back into the economy, and because if loans are being paid back faster than new ones are extended, the supply of credit (essentially money) is reduced. By not recognising this, these enthusiasts damage their case.

The true explanation is almost as simple, though it has been a puzzle to orthodox economists. Economists talk about the phenomenon as the ‘velocity decline’. The ratio GDP divided by the broad money supply has been taken as a rough measure of the velocity of money, which is the number of times per annum that money turns over. Historically over centuries the velocity has fluctuated around a figure of about 2.5 times per annum. In recent decades the velocity has steadily declined and is now well below unity. Basically the decline has arisen from the explosion in the volume of purely financial transactions that are not captured in GDP – see for example [Turner 2010]. GDP is an attempt to measure in monetary terms the flow of goods and services in an economy without double counting. It does not include the buying and selling of existing assets such as land, housing, stocks and shares and a host more. This has been realised by a number of people, Werner’s explanation [Werner 2005] is the clearest and most convincing explanation that I have seen, and probably the first. To handle this Werner seeks to partition the supply of money between that used in the real economy and that used for speculation in existing assets – see my post ‘The creation and allocation of credit’.

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