Monday, February 19, 2007

Beavis, Butthead, and the Quantity Theory of Money

Today I covered one of my favorite topics of Econ 102, Principles of Macroeconomics. We have begun discussing monetary policy and the Federal Reserve. This is the point at which I can allow Beavis and Butthead to demonstrate the Quantity Theory of Money.

When I was in college, my grandparents came to visit, and one day at the breakfast table my grandmother wondered aloud, "Why doesn't the government just print more money and give it to everyone? Everyone would be rich." Beavis and Butthead could help her to understand why this can't work.

In the episode of Beavis and Butthead entitled "Candy Sale", our heroes get candy bars from "Mr. Candy" (voiced by David Spade). Mr Candy tells them to sell candy bars for $2 each in order to raise money for the school. Beavis and Butthead are not excited about the prospect of selling candy bars, but they dutifully try to sell one to Mr. Anderson, their neighbor. He is not interested until Butthead offers a price of $1. Beavis matches the offer, and Mr. Anderson buys a candy bar from each of them. They have sold their first candy bars.

Butthead now has $1, and let's suppose he has 19 candy bars left. Beavis also has $1, and 19 candy bars. Here's where the episode gets clever: Butthead asks to borrow $1 from Beavis, and Beavis reluctantly agrees. Now that Butthead has $2, he offers to buy a candy bar from Beavis. Beavis agrees. Butthead eats the candy bar. Now Beavis offers Butthead $2 for a candy bar. Butthead agrees. Beavis eats the candy bar.

They go back and forth, trading the $2 to each other for candy bars. The next day in class they reveal to Mr. Candy that they have sold all their candy bars. He is delighted, but when he learns they have only $2 to show for it, he becomes furious. He threatens to harm the students, so Coach Buzzcut intervenes and beats up Mr. Candy.

What is the lesson to be drawn from this? Beavis and Butthead have demonstrated what economists call the velocity of money. The velocity of money is the number of times a dollar is spent, in order to purchase all the goods and services in an economy. It is a part of the equation of exchange, which is typically written:

MV=PY

M is the money supply. V is velocity. P is the price level, and Y is real GDP. IN the case of Beavis and Butthead, it is:

$2 * 38= $2 * 38

They have $2, which must be spent 38 times to buy all the candy bars in their little endowment economy.

This equation looks simplistic, but it is actually very important in the real world. In reality, the velocity of money is stable (i.e., fairly constant) over time. Let's also assume GDP is fixed. This means that any increase in M, the money supply, must lead to an increase in P, the price level. We call such an increase in the price level inflation. That is, the ultimate cause of inflation is almost always an increase in the money supply, which is controlled by the Federal Reserve. Some countries have had very rapid increases in money supply, such as postwar Germany, and as a result they get very high inflation. The Fed increases money supply slowly, so we get low inflation.

In the case of Beavis and Butthead, we can imagine what would happen if they were given $4 instead of $2. They might adjust to this by having each dollar go back and forth fewer times (i.e., velocity could rise). Alternatively, they might bid up the price of candy bars to $4 each. What will not happen, however, is an increase in candy bars--the extra money cannot summon more candy bars into existence, just as an increase in money supply in the U.S. cannot (in the long run, anyway) lead to a permanent increase in GDP.

To answer my grandmother's question, the reason the government doesn't just print enough money to make us all rich is that we would run out and spend the money, driving up the prices of goods and services, leaving us no better off. We'd have more money, but the things we buy will be more expensive, so we'd just be running in place.