Friday, December 28, 2012

How the Conquistadors Inflated Their Economy

One day I realized I had absolutely no idea how businesses, banks, or the financial world work. That annoys me. So I read an Idiot's guide to economics from the library. The book was pretty dry, but it was a down and dirty quick guide to most of the concepts of economics. Then I started reading a macroeconomics textbook, and now I truly know the meaning of dry. One of the concepts discussed in both books was fiscal and monetary policy. An IS-LM curve (Investment-Savings; Liquidity Preference [money demand]-Money Supply) was introduced which shows how equilibrium exists between the commodity market and the money market with interest rates and income plotted out on the y and x axes respectively. But another idea was introduced which is still an odd concept to me.
And that is the velocity of money.
Simply stated, velocity is equal to the nominal GDP and divided by the money supply, or V=PQ/M. 
And MV=PQ is another way of stating the formula.
So is M=PQ/V.
I remember reading about how the Spanish discovered the Americas and brought back so much silver and gold that it caused rampant inflation for their economy. But being historians, the authors never discussed why that happened. I think the simplest definition of inflation is too much money chasing too few goods which leads to an increase in the price based off of a supply and demand curve. 
But the equation actually shows why inflation happened. Instead of Q increasing, prices increased. Although you would get a higher nominal GDP based off of higher prices, your real GDP would deflate.
So why wouldn't velocity increase with an increased money supply? Velocity is the amount of times money changes hands in the year per unit of currency. So a huge increase in money supply wouldn't necessarily correlate with an increase in velocity.
So, if that's the case, why wouldn't Q increase instead of prices with the GDP being equal to the change of the money supply and velocity of money?
I'm not totally sure, but I think if a large amount of money were flooded into an economy it would take several years of investing in order to actually raise production of goods. If the Spanish explorers were to start buying boats and farms after coming back from the Americas it might take several years before they could start growing wheat or catching a bunch of fish with a fleet. While the money supply exceeds the demand though, prices increase with inflation as a result.
Out of all of this, the takeaway is that by controlling the money supply you can attempt to control prices to prevent a rapid inflation or deflation. 
Now my head hurts.
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