Truisms and beyond

Truisms are things that are always true. They are not particularly interesting by themselves. But if you inject a sense of behavior into some part of them, then they can become interesting. Both Keynesians and monetarists use truisms or identities as they are commonly called. An example is in order. Everyone in business knows that assets = liabilities + net worth. This is an identity; it is always true. If we know assets and liabilities, we can compute net worth, but we know nothing about the course the business is on. But suppose that we know that when net worth is high this business increases its innovation and investment. So injecting some behavior in the system may turn the identity into something interesting.

Keynesians

The big truism at the heart of the Keynesian model is the following accounting identity: GDP = C + I + G. GDP is an acronym for gross domestic product, of course. C stands for Consumption, I stands for Investment, and G stands for Government expenditures. By itself, this is uninteresting because it is always true. However, if one injects a consumption function where it is presumed that consumption expenditures are a function of GDP, then this might be interesting.

Monetarists

In contrast, monetarists are more likely to focus on the equation of exchange as their favorite accounting identity: M x V = P x Q. This equation just says that the money stock (M) times the velocity of money (V) equals the price level (P) times the real product (Q or the GDP adjusted for the price level). Again, this identity means nothing by itself, but if one had some idea about velocity, for example, it might just come alive. For example, it might be that velocity is higher when inflation is higher (that is, when the rate of change in P is higher).

It might help to do a little manipulation of the equation of exchange to see some features of the economy. For example, we can rewrite it as follows: m + v = p + q. Here the small letters stand for rates of change. So the rate of change in the money supply (m) plus the rate of change in velocity (v) must always equal the rate of change in the price level (p or the rate of inflation) plus the rate of change in real output (q).

Notice that the variables on the right hand side of the rewritten equation of exchange (p and q) are on the axes of the fundamental graph illustrated on the home page. In this graph, we see that given the rate of inflation (p) there is an upper bound on growth (g) and that this upper bound depends on the rate of inflation or deflation. This is an empirical fact. It is not a theoretical point.

Note that potential growth is maximized at somewhere around 2% inflation in the United States (one should not expect that these results apply in other countries. Notice that deflation is likely to be associated with low and negative rates of growth! Notice also that high inflation is likely to be associated with low growth. There will be much more on this later.