Saturday, July 24, 2010

Bush tax cuts and the Quantity Theory of Money

The Bush tax cuts are set to expire, and it doesn't look like the Obama administration will intervene to extend them. I think this is a mistake.

The Quantity Theory of Money states:
where

MV=PQ

M is quantity of money.
V is the velocity of money in final expenditures.
Q is an index of the real value of final expenditures.
P is price

As an example, M might represent currency plus deposits in checking and savings accounts held by the public, Q real output (which equals real expenditure in macroeconomic equilibrium) with P the corresponding price level, and the nominal (money) value of output. In one empirical formulation, velocity was taken to be “the ratio of net national product in current prices to the money stock”.

Thus far, the theory is not particularly controversial, as the equation of exchange is an identity. A theory requires that assumptions be made about the causal relationships among the four variables in this one equation. There are debates about the extent to which each of these variables is dependent upon the others. Without further restrictions, the equation does not require that a change in the money supply would change the value of any or all of P, Q, or . For example, a 10% increase in M could be accompanied by a 10% decrease in V, leaving unchanged. The quantity theory postulates that the primary causal effect is an effect of M on P.
The postulation is wrong. V changes dramatically with propensity to spend, or not spend. Not spending is the same as "saving".

Those with low incomes have very little discretion in their ability to spend or not spend. They need to spend most of their income every week just to get by. Those with high incomes have more discretion in their ability to spend or not spend. Their savings rates are much higher. Moreover, if you look at after tax consumption, you'll find that inequality is much lower than pre-tax income. This is due to transfer payments, progressive taxes, and the difference in saving.

The Bush tax cuts operate at the Federal income level, and therefore can only impact those with high incomes, as Federal Income taxes are primarily paid by high income households. Therefore, an increase in the tax rate at that segment may have the largest impact on their propensity to save, and therefore V.

This recession is primarily caused by a fall in V that has not been made up by an increase in M. Fed actions have changed the composition of M, but not its quantity. The increase in quantity has come from fiscal deficits.

4 Comments:

OpenID Ohm said...

"Therefore, an increase in the tax rate at that segment may have the largest impact on their propensity to save, and therefore V."

The story does not end there. When the additional tax collected is spent by the Govt and put in the hands of the "Those with low incomes have very little discretion in their ability to spend or not spend. They need to spend most of their income", by your own framework, that increase V way beyond the decrease you are pointing to.

The other thing that impacts V upwards is a fall in P (as you noted, the inter-causality between the 4 factors is not represented in the equation).

11:31 PM  
Blogger winterspeak said...

Every act of Government spending is money creation. Every act of taxation is money un-creation. The Govt does not need to tax Peter to pay Paul in a fiat currency regime.

7:38 AM  
Blogger Ohm (Ώ) said...

'Govt doesn't need to tax Peter to pay Paul in a fiat currency regime': Agree.


However, as you well noted in another blogpost, the one constraint on Govt in creating new money is to not create so much as to get intolerable inflation. So taxing Peter does increase the safe-quantum of money that Govt can bring to the hands of the Pauls who are struggling for or in their jobs-incomes, and who will spend forth more of this money than the Peters would.....And that can, of course, take two people to begin quarreling on ideological (as opposed to econological) grounds!


But the One thing that is emerging from this blogpost, and subsequent discussion, is that there is little point in the USG simply expiring the tax cuts for the Wealthy and then saving it -- that would shrink the economy as it would give a demand loss and nothing to counterbalance it. As much as is incrementally collected from the expiring tax breaks will need to be pumped back in into the right hands to get a net positive impact on demand....more is better until intolerable-inflation point is reached.

4:05 PM  
Blogger Lord Keynes said...

On the flawed quantity theory, see here:

http://socialdemocracy21stcentury.blogspot.com/2010/07/quantity-theory-of-money-critique.html

1:04 AM  

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