Economics

Economics 101 tells us that one way to measure the Gross Domestic Product (GDP) is to multiply the money supply by the velocity of money. The money supply used for this formula is cash, checking accounts and savings accounts and is called M3. The velocity of money means how many times each dollar is spent. Let’s say I pay a painter to paint my porch $100 and he uses $80 to buy paint and the paint store spends $20 to stock the paint. My original $100 has turned into $200 and the velocity of money is 2. If there is 700 billion in the money supply (M3) then MV = 1,400 billion and that equals GDP.

Recently in the news there has been a lot of discussion about Quantitative Easing (QE). The Federal Reserve Bank also known as the Central Bank last year had QE1 and this year QE2. The Fed adds money to the account of large banks and they in turn use this to purchase Fed bonds. The bank gets the money at zero interest and buys bonds that pay 3 or 4% interest. As long as that is all that is done the money supply does not increase so the threat of inflation is not increased. However banks are allowed to create money. If the banks instead of buying Fed bonds would loan this money out then the money supply would increase. This happens because banks are only required to hold 10% in reserve to cover their loans. It works like this. The bank gets $100 from the Fed and then it loans out $90 and the money supply increases by $90. Up to this point the banks have not been loaning since they prefer the 3% no risk return from the Fed as opposed to a higher risk to a private party. When the economy recovers from this slump and the banks start lending to business then the money supply will increase rapidly and inflation will follow.