Mathematically, the LM curve is defined by the equation / = (,), where the supply of money is represented as the real amount M/P (as opposed to the nominal amount M), with P representing the price level, and L being the real demand for money, which is some function of the interest rate and the level of real income.
Since the rate of growth of money (dM/M=m) is equal to inflation (p) (assuming, for simplicity, that the rate of growth of output y is zero), we get: Seignorage t = p t (M t /P t ) = Inflation Tax. In other terms the inflation tax is equal to the inflation rate times the real money balances held by private agents.

MONEY SUPPLY SPECIAL REPORT

Practical Measurement and Analytical Uses of Money Supply in Assessing Inflation

An increase in the money supply (M S) causes an increase in the real money supply (M S /P $) since P $ remains constant. In the diagram, this is shown as a rightward shift from M S ′/P $ to M S ″/P $. At the original interest rate, real money supply has risen to level 2 along the horizontal axis while real money demand remains at level 1. The equation simply states: M x V = P x Y. Where M = the money supply, usually the M1. V = the velocity of money. P = the price level. Y = real output, or real GDP. Velocity is the number of times the average dollar is spent to buy final goods and services in a given year. Velocity can be. . The Theory of Liquidity Preference We assume that the supply of real money balances (M/P) is fixed by the Central Bank. Money Supply = M./P. where M. is determined by the Central Bank and P is fixed at P. Remember IS/LM is a short-run model and so we assume that prices are fixed. This assumption means that the supply of real money balances does not depend on the interest rate r.

Issue Number 44

August 3, 2008

__________

Overview

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Excess supply of a commodity or product usually is reflected in downside pressure on its price, and the same is true for money. Excessive supply of money leads to its debasement, to a decline in its value that otherwise is known as inflation. Where money supply generally is an underpinning of economic activity, it also is the ultimate determinant of prices and inflation. At present, near-record high annual growth in the broadest U.S. money measure M3 is suggesting a significant inflation problem in the year ahead.

The most common question raised by SGS readers in the last year has been along the lines of: 'You are predicting rising inflation because of higher M3 growth, but what about this analysis that claims the lack of growth in the monetary base (or M1, or the Austrian Money Supply [a.k.a. True Money Supply], or some concocted measuring adding in commercial paper) is suggesting deflation.' Sometimes the question is posed in terms of the high level of credit defaults/losses collapsing money supply and causing deflation. Most recently, questions have shifted to: 'How can there be inflation during a recession?' Those points will be addressed in various sections of the report.

Many of the questions raised have been based on legitimate analyses, but there also is a diehard deflationist camp out in the markets and on the Internet grasping at whatever straws can be found in order to dismiss the current inflation threat. An example that comes to mind is the argument that the collapsing commercial paper market should be counted in money supply (if so there are a number of other instruments that should be included, and the numbers would not be collapsing). Such reminds me of Federal Reserve Chairmen Ben Bernanke and Alan Greenspan touting the lowest inflation rate they could find (the core PCE deflator), irrespective of its lack of relevance for consumers, in order to demonstrate how well consumer inflation has been contained by the Fed.[1]

The following money supply analysis explores the nature of monetary theory, and why — with different degrees of success — its key components cannot be meaningfully measured in today’s economy. While M3 is not the perfect money measure, it is the broadest and best practical measure that currently is available, although no longer from the Federal Reserve.

The push for developing new money measures has resulted from the apparent breakdown in traditional relationships between money and measures of the broad economy and inflation. The problem is neither the money measure nor monetary theory, but rather meaningful redefinitions and the gimmicking of inflation and the GDP/GNP measures that have altered the apparent relationships.

The general analysis also looks at how there can be inflationary recessions and hyperinflationary great depressions, though the emphasis here is on the money relationship to inflation, not to economic activity (previously discussed in the SGS newsletters of March 2006 and May 2007).

Various money measures are compared, and I explain my preference — indeed the necessity — for using the broadest money measure available as an indicator of future inflation. While money supply measures M2 and M3 have a fairly strong correlation, the broader M3 provides the most comprehensive picture of what is happening to money in the system. That said, the behaviors of the various other measures of the money supply are not at all inconsistent with the inflation signals currently being generated by strong annual M3 growth.

We have a number of clients who use money supply estimates in their financial modeling and analyses. As always, comments and questions are invited through the feedback available at the Contact Us tab at www.shadowstats.com or by e-mail to johnwilliams@shadowstats.com.

Monetary Theory

[Much of the material in this and the 'Inflationary Contractions' sections was published in the Flash Update of July 10, 2008.]

Discussion on inflation and deflation in the financial markets, the financial media and as generally discussed in the SGS newsletters usually centers on price changes in goods and services as traditionally measured by the CPI survey. Such, however, is not the same measure of price changes as encompassed in general monetary theory, where the relationship between money supply and inflation commonly is expressed as:

M x V = P x Q

In the preceding equation, M is the money supply. V is the velocity of money, as measured by the number of times the money supply turns over in a year, relative to the economy as reflected in nominal (not-adjusted for inflation) gross national product (GNP), where V = GNP/M. GNP is the broadest measure of U.S. economic activity and encompasses the more popularly reported gross domestic product (GDP).

In turn, nominal GNP = P x Q, where P is some measure of GNP deflator (prices/inflation) and Q represents some measure of physical quantity/volume, or a real (inflation-adjusted) GNP, as a measure of economic output.

So, the P, or inflation measure here, effectively is the GNP deflator, the change in which is a broader inflation measure than the CPI, since it covers costs of consumption for businesses, government and net exports, in addition to the costs of consumer spending on goods and services. In terms of the other variables, the price equation is:

Real Money Supply M P