INTEGRAL ECONOMICS

The Economic Philosopher’s Stone

Daniel O'Connor | Integral Ventures, LLC

As we explore the implications of the Equation of Exchange,

I think we have to conclude that its descriptive and
prescriptive powers are largely illusory.
The Economic Philosopher’s Stone
Daniel O'Connor | Integral Ventures, LLC
Few discussions of monetary policy take place
without at least implicitly invoking the famous
Equation of Exchange, a popular economic model
attributed to Irving Fisher, but with roots dating
back to David Hume and John Locke.1 The Equation
of Exchange can be presented as follows:
MxV=PxO
where M is the money supply, V is the velocity of
circulation of this money, P is the average price
level, and O is the quantity of output, or actual
goods produced.
At first glance, the Equation of Exchange seems to
reveal some compelling causal relationships to help
explain what’s really happening in the economy.
Being a simple formula with four interdependent
variables, we should be able to solve for each in
terms of the others, thereby generating a variety of
insights to guide our analyses of monetary policy as
well as the various elements of economic
growth. But as we explore its implications more
carefully, I think we have to conclude that its
descriptive and prescriptive powers are largely
illusory.
As we explore the implications
of the Equation of Exchange,
I think we have to conclude that
its descriptive and prescriptive
powers are largely illusory.
Central to any discussion of monetary policy is the
variable P, the average price level, whose rate of
change is popularly known as inflation when
positive and deflation when negative. Measuring
and monitoring P allegedly allows the Federal
Reserve to manage M, the money supply, whose
rate of change is understood by economists, via the
Quantity Theory of Money, a derivative of the
Equation of Exchange, to determine the average
price level.
For example, if we want to know the rate of price
inflation, we can try to solve for P over time and
then compute the percentage change in P from one
year to the next:
P=MxV/O
Thus, the average level of prices, P, is equal to the
money supply, M, times the velocity of circulation,
V, divided by the total output of the economy, O.
It sounds so logical and precise.
Page 1
Now, the only thing we have to do is develop
measures of M, V, and O.
We know that we can get the first variable M, the
money supply, from the Federal Reserve’s published
reports.
But what about V?
Well, the Fed also publishes an estimate of V based
on the following equation:
V = GDP / M
Given that we can observe and measure GDP, the
gross domestic product, as well as M, the money
supply, then we can solve for V, the velocity of
circulation, thereby giving us the second variable
we need to determine P, the average price level.
Brilliant.
Now if we insert this new model of V into the
equation for P, we get the following:
P = (M x (GDP / M)) / O
This cumbersome equation can then be simplified
because the Ms in the numerator cancel each other
out. Thus, by striking out the two Ms, we’re left
with:
P = GDP / O
So the average price level equals the GDP, which
we know we can get from the government's
published reports, divided by O, the total output of
the economy.
In our effort to solve for P, this leaves us with one
remaining variable: O, the total output of the
economy. So what is this total output, O?
The answer suggests itself when we recognize that
the GDP used by the Fed in its velocity equation is
what the government refers to as Nominal GDP, or
the GDP statistic before adjusting to remove the
effects of price inflation, which we have been
referring to as changes in P.
So, O must be associated with the Real GDP that,
according to the government, indicates the level of
economic output independent of the effects of any
price inflation that might be manifesting in the
economy.
Thus, we can clarify the above equation as follows:
P = NGDP / RGDP
where NGDP is Nominal GDP and RGDP is Real GDP.
I won’t digress to prove the mathematics, but this
equation can be transformed into another powerful
equation:
P^ = NGDP^ - RGDP^
where the change in the average price level, P^, is
roughly equal to the change in NGDP, denoted as
NGDP^, minus the change in RGDP, denoted as
RGDP^.
Simple translation: Price inflation(deflation) is
roughly equal to the difference between the growth
in Nominal GDP and the growth in Real GDP.
Makes intuitive sense, right?
But is the government's Real GDP statistic a valid
measure of O, the level of economic output
independent of the effects of any price inflation that
might be manifesting in the economy?
Stepping back from the reported statistics, recall
that in the Equation of Exchange, O refers to the
actual, that is nonmonetary, output of the
economy. In other words, the total amount of
shoes, cars, computers, etc. produced in a particu-
lar period of time.
This is the real wealth that we create each year
with all our hard work. After all, the only value in
money is in its capacity to buy real goods that help
satisfy whatever real demands we have. O is an
expression of all these real goods created in any
given year (or any other chosen period of time).
Theoretically, we could catalog everything that was
produced each year, but we could never add up all
these different goods to generate a meaningful
aggregate statistic. After all, what is the sum of 1
billion pairs of shoes plus 16 million cars plus 58
million computers? A big pile of stuff, that's what.
Clearly, they are incommensurable without some
common denominator.
Therefore, because O cannot be quantified, it is not
a valid, independent variable for this mathematical
Equation of Exchange. It cannot be observed or
measured all by itself, the way we can observe and
measure M and NGDP.
What to do?
Perhaps we can rearrange the original equation to
solve for O, as follows:
O=MxV/P
We’ve already determined that M and V are
available in the Fed’s published reports, and we’ve
seen that V = NGDP / M. So we can insert this new
ratio into the equation to yield this:
O = (M x (NGDP / M)) / P
Look familiar? Canceling the Ms in the numerator,
we’re left with:
Page 2
O = NGDP / P
Now that’s no better than P = NGDP / O.
We’re basically chasing our tails here, trying in vain
to calculate both P and O from a single known
variable, NGDP, which is the only observable,
measurable, valid indicator of total output.
In our mind’s eye, we can appreciate that NGDP
might be the mathematical product of some
tangible yet incommensurable mountain of goods,
O, multiplied by some average price level, P. But we
cannot observe either of these in the natural world.
They simply do not exist.
In our mind’s eye, we can
appreciate that NGDP might be the
mathematical product of some
tangible yet incommensurable
mountain of goods, O, multiplied by
some average price level, P.
But we cannot observe either of
these in the natural world.
They simply do not exist.
Now at this point someone must be thinking that
we can estimate P more directly via the statistical
analysis that yields the various inflation rates
published by the government, whether it's the
familiar Consumer Price Index or the GDP Deflator
(which, incidentally, is NGDP / RGDP).
But this approach side-steps a very important
problem: If we cannot observe or measure or
deduce in any quantitative way one of the two
variables that is supposed to be a component of
Nominal GDP, then we cannot, by definition,
observe, measure, or deduce the other variable. We
may convince ourselves that we can, but we really
cannot.
It may sound a bit too definitive for some, but if
NGDP is supposed to be the product of P x O, and O
is a completely fictitious aggregate statistic, never
to be observed in nature other than as a catalog of
distinct products that cannot be added together,
then P must also be a fictitious aggregate statistic,
never to be observed in nature other than as a
catalog of distinct prices that cannot be validly
separated from the distinct products to which they
have been associated through unique acts of
market exchange. Simply put: if no independent O,
then no independent P.
Thus, with the help of the deceptively rigorous
Equation of Exchange, I come to the logical, if
somewhat disappointing, conclusion that there
really are no valid, independent measures of price
inflation and real output, despite the very great
importance of these economic constructs.
I come to the logical,
if somewhat disappointing,
conclusion that there really are
no valid, independent measures of
price inflation and real output,
despite the very great importance
of these economic constructs.
Perhaps I am missing something.
But it seems as though the only real GDP is what
the government calls Nominal GDP and what the
government calls Real GDP is not a real statistic at
all, but rather something conjured up in order to
convey the deceptive notion that we can still enjoy
robust growth in output despite even more robust
growth in money supply by virtue of the logical
impression that low velocity of circulation can
somehow "absorb" excess monetary inflation,
resulting in low price inflation whose reasonably
accurate independent measurement can be deduct-
ed from a reasonably accurate measure of Nominal
GDP growth to yield a reasonably accurate measure
of Real GDP growth.
Daniel O'Connor is the managing director of Integral
Ventures, a strategy consultancy committed to foster-
ing more innovative and sustainable ways of doing
business. He has been a pioneer in the development of
integral praxis in business and economics, having
authored numerous articles and essays in this
emerging field.
email: daniel@integralventures.com
website: www.integralventures.com
Page 3
And most people fall for this story when journalists
and economists simply parrot the government's
press releases that summarize statistics for
carefully manipulated price inflation and carefully
conjured real output. And then the Fed adds to the
confusion by highlighting the relatively low inflation
statistics together with the relatively strong growth
in Real GDP as if this were proof positive of the
benign nature of its shockingly high monetary
inflation.
In terms of the Economic Philosopher's Stone, the
Equation of Exchange, it seems that the only robust
aggregate statistics we can use are the money
supply, which is tracked very carefully by the Fed,
and nominal output, which is reported as Nominal
GDP. And when money supply has been increasing
at a higher rate than nominal output over the
course of many years, we need to be very
concerned about what that implies for both the level
and the sustainability of real output, the real wealth
of nations.
This March 2005 work is licensed under a Creative Commons
Attribution-Noncommercial-No Derivative Works 3.0 License.
1
Wikipedia. (2005). “Equation of Exchange.” Wikipedia.
http://en.wikipedia.org/ wiki/Equation_of_exchange. Retrieved
March 4, 2005.
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