The Investment Scientist

The Key Macroeconomic Equation All Investors Should Know

Posted on: June 22, 2022

I learned this “Quantity of Money” equation during my Oxford program and it has greatly helped me understand Fed’s actions and their implications.

In this equation, M stands for the total supply of money.  This variable is controlled by the Fed, the only institution in our land that can create money out of thin air. V stands for velocity of money, or the speed with which money changes hands. This variable represents the level of economic activities. For instance, in an economy that is locked down, V would drop substantially. 

On the other side of the equation, P is the price level of not just goods and services, but also labor and assets that produce goods and services. If the price of goods and services increases too fast, that’s high inflation, and that’s what the Fed is trying to control now. Of course investors (workers) love it when the price of assets (labors) increases. Q represents the total quantity of goods produced, services provided and assets created. One can also call it the real economic output.

At the onset of the pandemic, the economy was locked down, either voluntarily or by government order, thus V dropped substantially. If M were held steady, this would have caused P (prices of all things) and Q (real economic output) to also drop substantially. When prices of all things drop (P goes lower) and the economy shrinks (Q goes lower), people would instinctively hold on to their money and not spend it. This would have, in turn, lowered V further, causing a spiraling feedback loop of V (economic activities) and P (prices of all things) and Q (real economic output) all going down. That’s why the Fed had to announce a massive money printing initiative, basically saying they would increase M massively. This was done to arrest the negative spiral leading to a total collapse. 

So yes, we certainly can blame the Fed for causing this inflation, but they did rescue us from an economic collapse. I will give them that much credit.

Their announcement (unlimited money supply) in March of 2020 changed expectations. At least for me, I knew asset prices, which are part of P, would not drop further. That’s why when you read my Pandemic series, I was quite confident at the moment that asset prices would rebound. 

In my future articles, I will write about why we have high inflation now, what the Fed is doing and how that will affect asset prices, using the guidance of the same equation.

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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