Quantity Theory of Money
Quantity Theory of Money
The quantity theory of money (QTM) refers to the proposition that changes in the quantity of money lead to, other factors remaining constant, approximately equal changes in the price level. Usually, the QTM is written as MV = PY, where M is the supply of money; V is the velocity of the circulation of money, that is, the average number of transactions that a unit of money performs within a specified interval of time; P is the price level; and Y is the final output. The quantity theory is derived from an accounting identity according to which the total expenditures in the economy (MV ) are identical to total receipts from the sale of final goods and services (PY ). This identity is transformed into a behavioral relation once V and Y are assumed as given or known variables.
The QTM dates back to sixteenth-century Europe where it was developed as a response to the influx of precious metals from the New World, and in this sense it is one of the oldest theories in economics. Nevertheless, only in the writings of the late mercantilists does one start to find theoretical statements that justify the connection between M and P. David Hume (1711–1776) argued that assuming a case of equilibrium, an expansion in M (for example, through the discovery of new gold mines) would make a group of entrepreneurs richer, and their rising demand would increase the prices of products, thereby increasing the income of another group of entrepreneurs whose demand would increase the price level even further, and so forth. These chain effects at some point die out, and their end result would be the restoration of equilibrium, albeit at a higher price level. Hume and the mercantilists did not back up their claims by developing a theory of value and distribution; for them, the QTM was explained either mechanically or through the operation of competition.
In contrast to Hume, for classical economists the QTM became a constituent component of their theory of value and distribution. Invoking Say’s Law of markets, according to which output can be taken as given, and assuming that V is also given for it is determined by the customs of payments and the institutional arrangements of society, it then follows that proportional changes in M will be reflected in P and vice versa. David Ricardo (1772–1823) in particular reversed the usual causal relationship of the QTM arguing that changes in P lead to changes in M and not the other way around. The idea is that the value of gold (money) is a kind of a numéraire for all other prices, which means that if the quantity of money becomes more abundant because of the rise in productivity of gold mines (because of the discovery of new gold mines or technological change), it follows that the price of gold falls and, therefore, the prices of all other commodities rise. Alternatively, if total output increases, the subsequent scarcity of money raises its price above the normal level, and the excess profits in gold production lead to the expansion of supply, thereby reducing the price of gold, which returns to its normal level, and equilibrium is restored at a higher price level. Thus, the normal price of gold is what actually determines the quantity of money in circulation. Consequently, the difference between Ricardo and the mercantilists is that the arrow of causality runs from P to M and, therefore, the quantity of money is endogenously determined—that is, it is determined within the economic system.
The quantity theory continued in the writings of the neoclassical economists, with the issue of exogeneity predominant in the work of Irving Fisher (1867–1947). The so-called Fisher’s equation of exchange (1911) can be stated as follows: MV + M’V’ = PT, where M is currency and M’ is demand deposits; V and V’ are the respective velocities; and T stands for total volume of transactions and not only of final goods. Another interesting development is that associated with Knut Wicksell (1851–1926), who stressed the endogenous character of the money supply, which is responsible for the variations in the price level. The advent of Keynesian economics in the 1930s rendered the QTM of minor importance, and it was used only for the determination of nominal magnitudes of real variables.
According to Keynesian analysis the quantity of money could not affect the real economy in any direct way but only indirectly through variations in the interest rate. In contrast, a characteristically different view has been expressed by economists at the University of Chicago. More specifically, Milton Friedman (1912–2006) claimed that money matters and is responsible for almost every economic phenomenon. In fact, Friedman argued that the major economic episodes in U.S. economic history—from the Great Depression of the 1930s to the inflation of 1970s—could be explained through variations in money supply. During the mid- to late 1960s the appearance of stagflation and the rejection of the usual Phillips curve were registered as a blow against Keynesian economics and facilitated the acceptance of monetarism and its establishment as a school of economic thought with significant appeal. Friedman not only showed the inadequacy of Keynesian economics to deal with stagflation but he also proposed an explanation based on the concept of the natural rate of unemployment— that an expansionary economic policy affects the economy only in the short run, while in the long run the economy returns to the natural rate of unemployment but this time with higher inflation.
Friedman and the monetarists express the QTM in terms of growth rates, which means that they consider as a given, in the beginning at least, the velocity of money circulation, and thus that the growth rate of money supply influences the growth rate of nominal output identified with the nominal gross domestic product (GDP), that is, the product of the real GDP times the general price level. Later, when Friedman introduced the notion of natural unemployment, it could be argued that in the long run, at least, the real GDP is equal to full employment GDP, which corresponds to the level of natural unemployment, and thus the growth rate of GDP is known in the long run. Consequently, in the long run the growth rate of the money supply—to the extent that it exceeds the growth rate of the real GDP—increases the growth rate of the price level, that is, the rate of inflation.
According to Keynesians the velocity of money is characterized by high volatility; consequently, changes in the supply of money can be absorbed by changes in the velocity of money with negligible effects either on output or on the price level. These arguments emphasize that the velocity of money depends on consumer and business spending impulses, which cannot be constant. A similar view is shared by economists of the neoclassical synthesis, especially in the case in which the economy is in the liquidity trap, whereby, regardless of the changes in the supply of money, the real economy is not affected at all. Changes in the supply of money are absorbed by corresponding changes in the velocity of money. Furthermore, the effect of money supply on prices may work indirectly through variations in interest rates, which in turn induce effects on aggregate demand.
The empirical evidence with respect to the effects of the money supply on the price level so far has been mixed and depends on the definitions of the money supply (narrow or broad) and the time period. As a consequence, the velocity of the narrow money supply, V 1 = GDP /M 1, for the U.S. economy has displayed a rising trend during the period 1920–1929, a falling trend during the period 1929–1946, an upward trend in the period 1947–1981, erratic behavior along a falling trend during the period 1981–1991, and an upward trend since then. The erratic behavior of the 1980s has been attributed to the deregulation of the banking industry and the appearance of new checkable accounts. Clearly, the overall movement of V 1 is associated with the long-run upward or downward stage of the economy. The results with respect to the U.S. data prove somewhat better for the monetarist argument with regard to the velocity V 2 = GDP /M 2. A closer look at V 1 or V 2 in monthly or quarterly data reveals substantial fluctuations in the short run. The variability of the velocity of circulation has been attributed, among other things, to the frequency of payments, the efficiency of the banking system, the interest rate, and the expected inflation rate. From the above it follows that the causal relationship between money supply and price level—that is, the issue of exogeneity versus endogeneity—is not settled yet and, therefore, continues to attract the attention of economists. There is no doubt that the discussion will continue in the future as economists try to understand better the interrelations of monetary and real economic variables.
SEE ALSO Economics, Keynesian; Fisher, Irving; Friedman, Milton; Hume, David; Interest Rates; Keynes, John Maynard; Mercantilism; Monetarism; Monetary Theory; Money; Money, Demand for; Neutrality of Money; Phillips Curve; Ricardo, David; Say’s Law
Fisher, Irving. 1911. The Purchasing Power of Money: Its Determination and Relation to Credit, Interest, and Crises. New York: Macmillan.
Friedman, Milton, and Anna Jacobson Schwartz. 1963. A Monetary History of the United States, 1867–1960. Princeton, NJ: Princeton University Press.
Green, Roy. 1982. Classical Theories of Money, Output, and Inflation. New York: St. Martin’s.
"Quantity Theory of Money." International Encyclopedia of the Social Sciences. . Encyclopedia.com. (April 21, 2018). http://www.encyclopedia.com/social-sciences/applied-and-social-sciences-magazines/quantity-theory-money
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Quantity Theory of Money
QUANTITY THEORY OF MONEY
According to the quantity theory of money there is a direct relationship between prices, income, and the amount of money circulating in the economy. The quantity theory was first propounded in its most basic form by French philosopher Jean Bodin (1530–1596), who observed that the large amounts of gold and silver being brought back from the New World were driving up prices across Europe. Later two British philosophers, John Locke (1632–1704) and David Hume (1711–1776), noted that when the quantity of money grew, so did purchasing power and economic activity. Thus, if a government wanted to lower prices to combat inflation, according to the quantity theory, all it had to do was decrease the amount of money in circulation. Consumers would have less money to spend, demand would fall, and prices would drop. Over the next two centuries other economists elaborated on this basic interconnection between the quantity of money, income, and prices, and until the 1930s it remained the dominant theory for explaining inflation, deflation, and the nature of business cycles.
During the 1930s the quantity theory came under attack because its opponents argued that government attempts to increase the amount of money in circulation during the early years of the Great Depression (1929–1939) had almost no affect on consumer demand. The primary opponent of the quantity theory was British economist John Maynard Keynes (1883–1946). He claimed that increasing the money supply alone would never be enough to stimulate a contracting economy. Only high levels of employment could resuscitate demand and that meant the government had to create jobs for unemployed workers if the private economy could not.
Keynes's "fiscal policy" approach to economic growth ruled the world of economics until the 1960s when a new quantity theory of money arose to take its place. Led by U.S. economist Milton Friedman (1911–), the new quantity-of-money theorists agreed with Keynes that government fiscal policy had an important role to play in stimulating the economy. However, they showed that during the Great Depression government officials had not really expanded the money supply fast enough or in large enough quantities to get the economy growing, so the Depression did not really disprove the quantity theory of money after all. Moreover, using new tools of economic research, the Friedman school of economists showed that increasing and decreasing the money supply did in fact have a direct effect on inflation and deflation.
See also: John Maynard Keynes, Milton Friedman
"Quantity Theory of Money." Gale Encyclopedia of U.S. Economic History. . Encyclopedia.com. (April 21, 2018). http://www.encyclopedia.com/history/encyclopedias-almanacs-transcripts-and-maps/quantity-theory-money
"Quantity Theory of Money." Gale Encyclopedia of U.S. Economic History. . Retrieved April 21, 2018 from Encyclopedia.com: http://www.encyclopedia.com/history/encyclopedias-almanacs-transcripts-and-maps/quantity-theory-money