Money on the move

How quickly do we spend?

The West today worries that prices will fall unexpectedly, discouraging production.  But deflation is no problem for Kazakhstan, which benefits by the bane of the West, expensive oil.  In Kazakhstan, prices on average have been rising about 6% to 8% per year since its recovery from the financial crash of 2008-9.  At times, monthly “headline” inflation has exceeded 20%, often due to food prices in the short run.  The resulting uncertainty is not good for business.

The central bank, the National Bank of Kazakhstan, periodically avers that it will contain inflation.  Indeed inflation here has been lower than in Russia, for whatever that’s worth.  But an inflation rate of 8% is about four times higher than the one often recommended by economists.  Can the National Bank reduce inflation?

Conservative economists note that the higher the money supply, the higher the prices.  Suppose that Kazakhstan’s economy produces only one product, a pint of kefir each year.  Then increasing the money supply from 200 to 400 tenge will double the beverage’s price. 

The inflation in this example is temporary, since the price will stabilize at 400 tenge.  But monetarists point out that continual increases in the tenge supply may sustain inflation if they exceed the rate of increase in production.  To avoid long-run inflation, the money doctors prescribe a diet for the National Bank:  Cut back on those high-fat tenge. 

In Kazakhstan, the annual rate of growth in “broad” money – cash, checking and savings accounts, called “M2” – has thankfully fallen since the bubble days of 2006, when it was 78%. But it remained at 13% and 15% in 2010 and 2011, according to the International Monetary Fund.  These rates were roughly double the output growth rates in those two years. 

This “tough love” argument is alluring, but it assumes a simple link between the tenge supply and the price level (which is the price of a typical bundle of products).  If money supply rises by 16% and output by 6%, then the price level will rise by 10%.  So cut back the increase in tenge to something like 6%.  But this assumes that we can forecast output.  If production actually rises by 16%, then no inflation will occur.

Safe at any speed?

More unsettling is an assumption that central banks rarely discuss with the public.  It concerns the rate, or “velocity,” at which people spend a tenge.  Suppose that the money supply is 1 trillion tenge.  If velocity is 3, then each tenge is spent 3 times per year.  Annual spending is 3 trillion tenge.  If velocity suddenly rises to 6, then spending will double and may well push up prices.  To calculate the money supply that will avoid inflation, the central bank must forecast velocity as well as output.

At one time, it was fashionable to assume a constant velocity.  People will always spend a typical tenge three times per year, so we need not worry that an unexpected change in velocity will gum up the forecast.  This supposition was common shortly after the American economist Irving Fisher had popularized velocity in 1911.  Alfred Marshall, an English economist (and teacher of Keynes), explained in 1923 that velocity was stable because spending habits are slow to change.

Some macroeconomists still assume a constant velocity, at times for reason.  A rate of turnover in bank deposits was fairly constant in Britain from 1920 to 1940, reported J. S. Cramer.  But most economists now recognize that velocity may depend on the interest rate.  When bonds pay off at higher rates, people will buy them more quickly, increasing the rate at which money turns over.  Thus, in reality, velocity is volatile. 

In Kazakhstan, the velocity of cash and checking accounts (“M1” money) has halved since 2002, from 4 to 2, according to one study.  This may relate to a fall in interest rates, or it may express a new reluctance to spend that would not bode well for the country in the event of another global recession.  In any event, fluctuations in velocity over the course of a year have nearly tripled since 2008. 

Forecasting the “right” money supply may be harder for the National Bank than classical monetarists might claim.  Perhaps the Bank should provide a range of forecasts (for example, from 1 to 2 trillion tenge) rather than just one value.  –Leon Taylor, tayloralmaty@gmail.com

Notes

1.  The IMF defines M2 money as “the sum of currency outside banks, demand deposits other than those of the central government, and the time, savings, and foreign currency deposits of resident sectors other than the central government.”  I use end-of-year estimates.

2.  The velocity rate reported by Cramer was measured as the ratio of debts to account balances, excluding money markets.  It ranged from 15 to 20.

         

Good reading

Alfred Marshall.  Money, credit and commerce.  Prometheus Books.  2003. 

Ana Lucia Coronel, Dmitriy Rozhkov, Ali Al-Eyd, and Narayanan Raman.  Republic of Kazakhstan: Selected issues.  IMF.  2011.  Discusses inflation and food prices.   

J. S. Cramer.  Velocity in circulation.  In John Eatwell, Murray Milgate, and Peter Newman, eds., The New Palgrave: Money.  Norton.  1989.

Irving Fisher, assisted by Harry G. Brown.  The purchasing power of money: Its determination and relation to credit interest and crises. Macmillan.  1911.

References

Murat Alikhanov and Leon Taylor.  An algorithm for estimating the volatility of the velocity of money.  Working paper, Munich RePeC archives.  2013.  The source of the estimates of velocity in Kazakhstan used above.

International Monetary Fund.  International financial statistics.  Online.