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.
Green, Roy. 1982. Classical Theories of Money, Output, and Inflation. New York: St. Martin’s.
Quantity Theory of Money
Quantity Theory of Money
The quantity theory of money, in its most unsophisticated form, holds that the price level is proportional to the quantity of money, and that the causation runs from the quantity of money to the price level, so that any increase in the quantity of money results in a proportional increase in the price level. Many educated people with a casual understanding of the quantity theory of money believe this unsophisticated statement of the theory to be the theory itself, although few first-rate monetary economists of the last two centuries would wholeheartedly agree.
The modern quantity theory is more properly understood as a theory of the demand for money, which asserts that money demand is a demand for real money balances, and that that demand is a stable function of a few variables, including (but not limited to) income and nominal interest rates. For expositional simplicity, we will proceed as if the demand depends only on income and the nominal interest rate, although economists have cataloged various other potential arguments. The money-demand function is thought to be increasing in income, and decreasing in the nominal interest rate. However, the unsophisticated form only holds as a short-run proposition if income and interest rates are entirely independent of money and the price level. Preexisting nominally denominated commitments—long-term wage contracts, formal or informal price setting agreements among firms, debt contracts—constitute one important mechanism (though not the only one) that can make income and the interest rate depend on money and prices. The quantity theory does not predict, by itself, the extent to which changes in the money supply end up influencing prices, income, or interest rates. That depends on the rest of the general equilibrium model in which the quantity theory is imbedded. Any conclusion depends in part on the neoclassical assumptions regarding price flexibility.
Practical application of the quantity theory is seldom an easy matter. What, for instance, is the relevant money supply? The problem has two dimensions: assets and measurement. In principle, which assets are money, and which are not? In modern times, are checking deposits money? Savings deposits? Treasury bills? How about credit cards? In time past, were bills of exchange money? Are other kinds of private notes money? The general rule economists have followed is that assets are money if they are a medium of exchange and extinguish (rather than delay the payment of) debt. So in modern times, checking deposits would certainly be money, treasury bills and credit cards would not be money, and savings deposits might be if they could be drawn upon in transactions, but otherwise not. There is no denying these distinctions are somewhat arbitrary, and debate on the proper way to draw the line between assets that are money and assets that are not money is never-ending.
Measurement is another problem in a great many circumstances. To take a modern example, one would imagine that the quantity of demand deposits in the United States would be known with great precision. Looking at any book of monetary statistics would reinforce that impression. However, because demand deposits are subject to non–interest-bearing reserve requirements and because those reserve requirements are effectively taxes, banks use various legal strategies to evade them. Large account holders, for instance, often have their demand deposits electronically loaned out or transferred overseas at the close of each business day so that they do not officially count as demand deposits, although they are indistinguishable from demand deposits during business hours. In earlier times, too, portions of the money supply were frequently either unmeasured, or measured badly. In the German hyperinflation of 1921–1923 for instance, many public and private organizations emitted emergency currency called notgeld, which circulated alongside the official currency, but (probably because the data are lacking) notgeld is not included in official statistics. Before the classical gold standard was abandoned during the Great Depression, large quantities of specie circulated around the world, but only the most primitive estimates exist of the quantity in circulation at any particular time and place. With inappropriate and incomplete measures of the money supply the norm, it is commonplace for people to correlate those measures with prices and then express astonishment at the weakness of the relationship.
Geographic considerations apply with great force to earlier times. For example, during the gold standard era in the late nineteenth century, much of the world used gold and bank notes and deposits denominated and convertible to gold as money. The supply and demand for money within the gold currency area (along with the rest of the relevant economic model) would (in principle) determine the price level within the gold currency area. A small open economy – late nineteenth century Belgium, for example, would essentially be at world prices in the gold currency area, abstracting from transportation charges. If Belgian banks had exogenously issued additional convertible bank notes, the Belgian price level would still be world prices within the gold currency area. The increase in bank notes, it is true, would increase the total money supply within the entire gold currency area, although (given Belgium's small size) the percentage increase in the total money supply of the currency area would be fairly trivial. Thus it might serve to increase prices minutely throughout the entire currency area. Every country outside Belgium would find that at the higher prices they no longer had quite enough money for their purposes, whereas the Belgians (who had only the diluted increase in prices, but the full impact of the increase in the money supply) would find themselves with more than they needed. The result would be that Belgium would export money (in the form of gold, unless Belgian bank notes circulated abroad) to the rest of the gold currency area until the supply of money in Belgium and the rest of the gold currency area had adjusted to the new price level.
Formulated in its twentieth-century form during the 1920s by Irving Fisher, the Quantity Theory of Money posits that price levels are a function not only of the amount of money in circulation in an economy but also of the rapidity with which it circulates. Famously expressed as mv=pt, it equates quantity (m) and velocity (v) to prices (p) and the total of all transactions (t). Believers regard it as generally applicable; skeptics deride it as a simple truism without any explanatory value or, at best, only useful during periods of extreme inflation.
Dornbusch, Rudiger. Open Economy Macroeconomics. New York: Basic Books, 1980.
Fisher, Irving. The Purchasing Power of Money: Its Determination and Relation to Credit Interest and Crises. New York: Macmillan, 1931.
Mishkin, Frederic S. The Economics of Money, Banking, and Financial Markets. New York: Addison Wesley, 2003.
Ricardo, David. "The High Price of Bullion, A Proof of the Depreciation of Bank Notes, 1810–1811." Reprinted in The Works and Correspondence of David Ricardo, vol. 3, ed. Piero Sraffa. Cambridge, U.K.: Cambridge University Press, 1966.
Thornton, Henry. An Enquiry into the Nature and Effects of the Paper Credit of Great Britain, ed. F. A. Hayek. Fairfield, NJ: Augustus M. Kelley, 1978.
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