Modeling Inflation Using a Non-Equilibrium Equation of Exchange

Abstract

Inflation is a change in the prices of goods that takes place without changes in the actual values of those goods. The Equation of Exchange, formulated clearly in a seminal paper by Irving Fisher in 1911, establishes an equilibrium relationship between the price index P (also known as "inflation"), the economy's aggregate output Q (also known as "the real gross domestic product"), the amount of money available for spending M (also known as "the money supply"), and the rate at which money is reused V (also known as "the velocity of circulation of money"). This paper offers first a qualitative discussion of what can cause these factors to change and how those causes might be controlled, then develops a quantitative model of inflation based on a non-equilibrium version of the Equation of Exchange. Causal relationships are different from equations in that the effects of changes in the causal variables take time to play out-often significant amounts of time. In the model described here, wages track prices, but only after a distributed lag. Prices change whenever the money supply, aggregate output, or the velocity of circulation of money change, but only after a distributed lag. Similarly, the money supply depends on the supplies of domestic and foreign money, which depend on the monetary base and a variety of foreign transactions, respectively. The spreading of delays mitigates the shocks of sudden changes to important inputs, but the most important aspect of this model is that delays, which often have dramatic consequences in dynamic systems, are explicitly incorporated.macroeconomics, inflation, equation of exchange, non-equilibrium, Athena Projec