RE:The long and variable lag More and more people should follow Milton Friedman advice. His quote that Monetary Policy works with long and variable lags is a classic one.
- increase money supply, then 12-24 months you get inflation plus some real economic growth as people spend more. In other words, the money velocity increases as well.
In general, gdp tends to follow the growth rate in the money supply. The money supply has now contracted by ~ 5% y/y and if money velocity remains constant, gdp will decrease by 5%. This is what the quantity theory of money teaches us.
MV = PT
M= money supply
V= velocity of money
P = price level (inflation)
T= real gdp
P*T = nominal gdp
Here is something to think about.
Nominal gdp in the last 12 months has increased by 6.97%. Money is contracting at a rate of about 5% per year. If gdp decreases by 5%, and inflation is to return to 2%, then real gdp would have to be 0%. Here is why.
the quantity theory of money equation can be written the following way:
delta M + delta V = delta P + delta T
"delta" refers to the changes or differences in growth rates.
delta V =0
Lhs of the equation decreases by 5% so rhs has to decrease by 5%. If gdp is ~7% then it must decrease by 5% according to the quantity theory of money. Keep in mind velocity is held constant. That is, delta V = 0
1) Best case scenario:
The price level returns to ~ 2% in one years time and real gdp =0% (no recession)
2) recession scenario:
The price level returns to ~ 3% and real gdp = -1% I.e, a recession
3) really bad recession scenario:
The Fed continues to hike rates, the money supply contracts at a greater rate, and real gdp is -1%/-2% over the next 12 months.