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Money supply-side deflation

From a monetarist perspective, deflation is caused primarily by a reduction in the velocity of money or the amount of money supply per person.

A historical analysis of money velocity and monetary base shows an inverse correlation: for a given percentage decrease in the monetary base the result is a nearly equal percentage increase in money velocity. This is to be expected because monetary base (M), velocity of base money (V), price level (P) and real output (Y) are related by definition: M V = P Y. However, 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.

In the early history of the United States, there was no national currency and an insufficient supply of coinage. Banknotes were the majority of the money in circulation. During financial crises, many banks failed and their notes became worthless. Also, banknotes were discounted relative to gold and silver, the discount depended on the financial strength of the bank.

In recent years changes in the 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. More recently Alan Greenspan cited the time lag as taking between 12 and 13 quarters. Bonds, equities and commodities have been suggested as reservoirs for buffering changes in the money supply.