Money supply and price level - the role of speed and its change

The first part is orignial comments on the article China’s economy: now the bad news, on http://www.eastasiaforum.org/ April 23rd, 2009, by Yiping Huang, Peking University and Australian National University. It should appear in association with the article on that website after moderation. See below.

Yiping's article attempts to demonstrate that 8% growth of the Chinese economy this year, though seeming a bit on the optimistic side to many, is more likely achievable than not. If it does as hoped, it will be good for the recovery of the global economy in general and a blessing to the Australian economy in particular given China is Australia's top trading partner and has underpinned the mining boom of the more recent years.

A point in the article touches the likely trend of price levels. The author argued that the key macroeconomic problem, deflation, is likely to exacerbate, contrary to many economists concerns about a potential inflation problem as a result of recent dramatic expansion of monetary base. It argues that the pessimistic view of the inflation issue would be right if the normal money supply mechanism works as usual, but it isn’t at the moment – though the quantity of money base increased, the speed of its circulation declined. So a different equation is at work now. He also argues that the rising output gap will have a downward pressure on price.

This, however, raises an important issue in managing the price level in the coming months and perhaps a couple of years. While the slowing in the speed of money circulation now may work may relieve the authority from worrying about inflation for now, the pressure is likely to be greater if and when the speed of circulation picks up and returns to its normal course sometime in the future. The difficult to predict the precise timing and its exact course will increase the pressure for the authority to do a finer job in fine-tuning monetary policy, especially given the unprecedented nature of the scale of global including China’s monetary expansion. A truly difficult and real test, but perhaps not necessarily impossible to overcome. Let’s hope so.
24/04/2009

These part(s) has been added on later on.
The speed in which money circulates in an economy is one of the factors that affect the price level. Some other important factors include: the money base, the relationships between the money base and other money supply measures, reserve capital requirement and more recently accounting methods. The recent depressional financial crisis, though likely to differ in magnitudes to other earlier financial crisis, had its course in a sudden and dramatic reduction in credit flows, most likely to be associated with a change in risk premiums and a desire to increase own capital by financial institutions and reduce credit exposures. If and when such behaviours occur, the money supply in terms of the base money normally has not changed, but there are likely to be credit crunching, causing difficulties for both businesses and consumers to access finance and/or refinance. This slows demand and reduces output, businesses are closing down and laying off employees. The economy slows down or even may decline.It is noted that a financial crisis can be caused by a variety of reasons, as history has shown. Changes in some markets like housing, equity, national reserves etc can do some damage. A sudden realisation of real risks and or an increase in perceived risks can cause panic. Speculations may cause or facilitate a change in some market conditions.