ly equal percentage increase in money velocity [10]. This is to be expected because monetary base (MB), velocity of base money (VB), price level (P) and real output (Y) are related by definition: MB * VB = P * Y. However, it is important to note that the monetary base is a much narrower definition of money than M2 money supply. Additionally, the velocity of the monetary base is interest rate sensitive, the highest velocity being at the highest interest rates [10]. p> Changes in money supply have historically taken a long time to show up in the price level, with a rule of thumb lag of at least 18 months. Bonds, equities and commodities have been suggested as reservoirs for buffering changes in money supply [13].
2.2 Credit deflation
In modern credit-based economies, a deflationary spiral may be caused by the central bank initiating higher interest rates, thereby possibly popping an asset bubble. In a credit-based economy, a fall in money supply leads to markedly less lending, with a further sharp fall in money supply, and a consequent sharp fall-off in demand for goods. The fall in demand causes a fall in prices as a supply glut develops. This becomes a deflationary spiral when prices fall below the costs of financing production. Businesses, unable to make enough profit no matter how low they set prices, are then liquidated. Banks get assets which have fallen dramatically in value since their mortgage loan was made, and if they sell those assets, they further glut supply, which only exacerbates the situation. To slow or halt the deflationary spiral, banks will often withhold collecting on non-performing loans. This is often no more than a stop-gap measure, because they must then restrict credit, since they do not have money to lend, which further reduces demand, and so on.
2.3 Scarcity of official money
When structural deflation appeared in the years following 1870, a common explanation given by various government inquiry committees was a scarcity of gold and silver; although they usually mentioned the changes in industry and trade we now call productivity. However, David A. Wells (1890) wells notes that the U. S. money supply during the period 1879-1889 actually rose 60%, the increase being in gold and silver, which rose against the percentage of national bank and legal tender notes. Furthermore, Wells argued that the deflation only lowered the cost of goods that benefited from recent improved methods of manufacturing and transportation. Goods produced by craftsmen did not decrease in price, nor did many services, and the cost of labor actually increased. Also, deflation did not occur in countries that did not have modern manufacturing, transportation and communications [14]. p> In economies with an unstable currency, barter and other alternate currency arrangements such as dollarization are common, and therefore when the 'official' money becomes scarce, commerce can sti...
