Richard Duncan quotes
Longer excerpt from The New
Depression (taken from my Kindle highlights, so the excerpts aren’t
necessarily the paragraphs I have put them in below, and there may be things in
between that I didn’t highlight).
[Irving] Fisher reasoned that the velocity of money, its rate of turnover,
depends on “individual habits” and “technical conditions” and has no
discoverable relationship with the quantity of money. “It will depend on
density of population, commercial customs, rapidity of transport, and other
technical conditions, but not on the quantity of money,” he wrote.
He also explained that the impact of a change in the quantity of money on the
volume of trade (T) only lasts during a transition period.
He described the dynamics of the transition period as follows. An initial
increase in the quantity of money (M) causes the price of goods sold by the
business community to increase more quickly than the rate of interest they are
required to pay to finance the production of those goods. That results in
higher profits for businessmen. The improvement in profits prompts businesses
to borrow and invest more, thus producing a pickup in the volume of trade (T).
Sooner or later, however, interest rates begin to increase due to rising
inflation. Eventually, interest rates catch up with the increase in prices,
thereby causing profit margins to contract again. At that point, the business
community realizes it has been too optimistic about profits. Consequently,
businesses stop borrowing and investing, so the volume of trade (T) contracts
This is essentially a clear and simple explanation of the business cycle, or
the credit cycle, as it is sometimes called. While the transition period lasts,
the increase in the volume of trade (T) produces a temporary increase in PT
(real GDP), followed by a bust in which both the volume of trade (T) and real
GDP contract again. At the end of the process, GDP is only higher in nominal
terms because of the increase in the price level (P ).
Fisher was convinced that the duration of the transition period (or business
cycle) would always be short-lived because there would always be a limit as to
how much the quantity of money (M) could expand.
In 1912, the legal requirement for banks to hold liquidity reserves against
their deposits and the legal requirement for the Fed to hold gold to back the
paper currency it printed both limited the “further expansion of deposit
currency” (i.e., money). Both those constraints have long since been removed.
As discussed in Chapter 1, the
banks no longer are required to hold meaningful liquidity reserves and the Fed
does not back its Federal Reserve notes with gold. That means the amount of credit
that can now be created is practically infinite and that the transition period
during which the volume of trade (T) (and GDP) can expand is much longer than
when Fisher wrote The Purchasing Power of Money. The implications of this
change are enormous.