HowTo: the Quantity Theory of Inflation. Or, China’s idiosyncratic monetary policy at work again.

The Velocity of Money is how many times the same money must circulate to purchase everything. We don’t have a dollar for every dollar’s worth of Good or Service, out there. You spend a dollar, then the store-owner spends the dollar, then the second store-owner spends it.

Hence the Velocity of Money: $V=\frac{PQ}{M}$, where M is the money supply and PQ is Price x Quantity, or GDP.

The Quantity Theory of Inflation, following this, runs thus:

1. If M = PQ the price level is stable (no inflation)
2. If M > PQ the price level is increasing (inflation)
3. If M < PQ the price level is decreasing (deflation)

For the Quantity Theory of Inflation, Velocity is assumed to be constant and stable: since $Delta V = 0$ it drops out of the equation. Assuming that Prices are an increasing function of the Money Supply, we have inflation: too much money. Hence, during a boom period, too much money results in inflation. The Wikipedia link offers some of the criticism of the theory (such as its assumption that the Money Supply is exogenous – not at all the case these days, when we have credit-based, rather than properly Fiat, Money).

And that’s inflation. This is why our central banks bump around the Money Supply: their prime directive (sorry – too Robotics-ish?) is price stability. China’s approach? Go straight for the prices.

Prime Minister Wen Jiabao responded Wednesday to growing public anxiety about inflation by announcing that China would freeze energy prices in the near term, even as international crude oil futures have topped \$100 a barrel.

The move to hold down prices came as inflation hit an 11-year high in China. A recent nationwide public opinion survey found that “rising prices of consumer goods” ranked as the top public concern, followed by income inequality and corruption.

The freezes, announced on the government’s main Web site, followed a meeting of the State Council, led by Wen on Wednesday, to revise policies on price controls. Prices of oil products, natural gas and electricity will be frozen in the near term. Rates for public water bills also will be frozen, as will the cost of public transportation tickets.

This is becoming a fashion for the Party: they froze prices last year (calling into question just how near-term this measure is going to be). Fortunately China is no Iran: they can probably keep it up for a good long while, although the distortion this will have in their markets will be significant (demand for gasoline a big one).

Distortions are clearly not that big a concern for the Party: they’re openly working to dampen their bulk of iron ore demand, during negotiations over the benchmark price. And by ‘dampen’, I mean their macroeconomy (such as it is dampenable at all).

China is pushing the same outcome, though – these pressures (on the prices of oil and food) are exogenous. China can have inflating prices, or shortages. They seem to be going with the latter. The question for us is which serves our needs (that long march of freedom and democracy, remember?) best? I’m not a fan of this approach – it’s more destabilising than mere inflation and, what is worse, the distortions extend outwards into foreign investment, real or potential. Slowing that down only slows down China’s movement towards market-based systems, political (non-corrupt) devolution, etc.