INTEGRAL ECONOMICS

The Economic Philosopher’s Stone

Daniel O'Connor | Integral Ventures, LLC

As we explore the implications of the Equation of Exchange,I think we have to conclude that its descriptive andprescriptive powers are largely illusory.

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The Economic Philosopher’s Stone

Daniel O'Connor | Integral Ventures, LLC

Few discussions of monetary policy take placewithout at least implicitly invoking the famousEquation of Exchange, a popular economic modelattributed to Irving Fisher, but with roots datingback to David Hume and John Locke.

The Equationof Exchange can be presented as follows:M x V = P x Owhere M is the money supply, V is the velocity of circulation of this money, P is the average pricelevel, and O is the quantity of output, or actualgoods produced.At first glance, the Equation of Exchange seems toreveal some compelling causal relationships to helpexplain what’s really happening in the economy.Being a simple formula with four interdependentvariables, we should be able to solve for each interms of the others, thereby generating a variety of insights to guide our analyses of monetary policy aswell as the various elements of economicgrowth. But as we explore its implications morecarefully, I think we have to conclude that itsdescriptive and prescriptive powers are largelyillusory.Central to any discussion of monetary policy is thevariable P, the average price level, whose rate of change is popularly known as

inflation

whenpositive and

deflation

when negative. Measuringand monitoring P allegedly allows the FederalReserve to manage M, the money supply, whoserate of change is understood by economists, via theQuantity Theory of Money, a derivative of theEquation of Exchange, to determine the averageprice level.For example, if we want to know the rate of priceinflation, we can try to solve for P over time andthen compute the percentage change in P from oneyear to the next:P = M x V / OThus, the average level of prices, P, is equal to themoney supply, M, times the velocity of circulation,V, divided by the total output of the economy, O.It sounds so logical and precise.Now, the only thing we have to do is developmeasures of M, V, and O.We know that we can get the first variable M, themoney supply, from the Federal Reserve’s publishedreports.But what about V?Well, the Fed also publishes an estimate of V basedon the following equation:V = GDP / MGiven that we can observe and measure GDP, thegross domestic product, as well as M, the moneysupply, then we can solve for V, the velocity of circulation, thereby giving us the second variablewe need to determine P, the average price level.Brilliant.Now if we insert this new model of V into theequation for P, we get the following:P = (M x (GDP / M)) / OThis cumbersome equation can then be simplifiedbecause the Ms in the numerator cancel each otherout. Thus, by striking out the two Ms, we’re leftwith:P = GDP / OSo the average price level equals the GDP, whichwe know we can get from the government'spublished reports, divided by O, the total output of the economy.In our effort to solve for P, this leaves us with oneremaining variable: O, the total output of theeconomy. So what is this total output, O?The answer suggests itself when we recognize thatthe GDP used by the Fed in its velocity equation iswhat the government refers to as Nominal GDP, orthe GDP statistic before adjusting to remove theeffects of price inflation, which we have beenreferring to as changes in P.So, O must be associated with the Real GDP that,according to the government, indicates the level of economic output independent of the effects of anyprice inflation that might be manifesting in theeconomy.Thus, we can clarify the above equation as follows:P = NGDP / RGDPwhere NGDP is Nominal GDP and RGDP is Real GDP.

As we explore the implicationsof the Equation of Exchange,I think we have to conclude thatits descriptive and prescriptivepowers are largely illusory.

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I won’t digress to prove the mathematics, but thisequation can be transformed into another powerfulequation:P^ = NGDP^ - RGDP^where the change in the average price level, P^, isroughly equal to the change in NGDP, denoted asNGDP^, minus the change in RGDP, denoted asRGDP^.Simple translation: Price inflation(deflation) isroughly equal to the difference between the growthin Nominal GDP and the growth in Real GDP.Makes intuitive sense, right?But is the government's Real GDP statistic a validmeasure of O, the level of economic outputindependent of the effects of any price inflation thatmight be manifesting in the economy?Stepping back from the reported statistics, recallthat in the Equation of Exchange, O refers to theactual, that is nonmonetary, output of theeconomy. In other words, the total amount of shoes, cars, computers, etc. produced in a particu-lar period of time.This is the real wealth that we create each yearwith all our hard work. After all, the only value inmoney is in its capacity to buy real goods that helpsatisfy whatever real demands we have. O is anexpression of all these real goods created in anygiven year (or any other chosen period of time).Theoretically, we could catalog everything that wasproduced each year, but we could never add up allthese different goods to generate a meaningfulaggregate statistic. After all, what is the sum of 1billion pairs of shoes plus 16 million cars plus 58million computers? A big pile of stuff, that's what.Clearly, they are incommensurable without somecommon denominator.Therefore, because O cannot be quantified, it is nota valid, independent variable for this mathematicalEquation of Exchange. It cannot be observed ormeasured all by itself, the way we can observe andmeasure M and NGDP.What to do?Perhaps we can rearrange the original equation tosolve for O, as follows:O = M x V / PWe’ve already determined that M and V areavailable in the Fed’s published reports, and we’veseen that V = NGDP / M. So we can insert this newratio into the equation to yield this:O = (M x (NGDP / M)) / PLook familiar? Canceling the Ms in the numerator,we’re left with:O = NGDP / PNow that’s no better than P = NGDP / O.We’re basically chasing our tails here, trying in vainto calculate both P and O from a single knownvariable, NGDP, which is the only

observable

measurable

valid

indicator of total output.In our mind’s eye, we can appreciate that NGDPmight be the mathematical product of sometangible yet incommensurable mountain of goods,O, multiplied by some average price level, P. But wecannot observe either of these in the natural world.They simply do not exist.Now at this point someone must be thinking thatwe

can

estimate P more directly via the statisticalanalysis that yields the various inflation ratespublished by the government, whether it's thefamiliar Consumer Price Index or the GDP Deflator(which, incidentally, is NGDP / RGDP).But this approach side-steps a very importantproblem: If we cannot observe or measure ordeduce in any quantitative way one of the twovariables that is supposed to be a component of Nominal GDP, then we cannot, by definition,observe, measure, or deduce the other variable. Wemay convince ourselves that we can, but we reallycannot.It may sound a bit too definitive for some, but if NGDP is supposed to be the product of P x O, and Ois a completely fictitious aggregate statistic, neverto be observed in nature other than as a catalog of distinct products that cannot be added together,then P must also be a fictitious aggregate statistic,never to be observed in nature other than as acatalog of distinct prices that cannot be validlyseparated from the distinct products to which theyhave been associated through unique acts of market exchange. Simply put: if no independent O,then no independent P.Thus, with the help of the deceptively rigorousEquation of Exchange, I come to the logical, if somewhat disappointing, conclusion that therereally are no valid, independent measures of price

In our mind’s eye, we canappreciate that NGDP might be themathematical product of sometangible yet incommensurablemountain of goods, O, multiplied bysome average price level, P.But we cannot observe either of these in the natural world.They simply do not exist.