Steve Bain

The Quantity Theory of Money

The Quantity Theory of Money is another topic in macroeconomics that stirs up controversy between the different schools of thought. For those economists who veer towards a more classical or monetarist point of view, it is an indispensable part of their whole philosophy of economics.

Having its foundations in classical economics, it should come as no surprise that the starting assumption for the theory is that the economy is operating at the long-run equilibrium point where unemployment is at its natural rate and there is no spare capacity to increase economic output without incurring an increase in the price level.

The Equation of Exchange

The purpose of the quantity theory of money is to establish a link between the money supply and the price level in an economy. The most common expression of the theory is known as the 'equation of exchange', and is written in the form:

MV = PY

In this simple equation:

  • M is the money supply
  • V is the velocity of money
  • P is the price level
  • Y is economic output

In words the equation means that: the money supply, multiplied by the number of times it is spent in the economy over the course of a year, is equal to the total output of the economy in that year multiplied by the price level. This is simply an accounting identity.

The key part of the controversy relates to the nature of V, the velocity of money, which measures the rate at which the money supply is spent over that year.

Keep in mind that this is a long run model, and that we assume a starting position of equilibrium with unemployment at its equilibrium rate i.e., at the NAIRU level. Under these circumstances it is reasonable to consider Y in the equation above to be stable. 

The quantity theory of money argues that V is also stable, and this is the controversial part of the theory. Opponents argue that this is simply not the case. For an in-depth review of this particular bone of contention, please refer to my article about the Velocity of Money.

With both V and Y stable in the equation above, it is clear that the only variable left that can influence the price level is the money supply. Any increase in the money supply cannot permanently increase economic output, or reduce unemployment, and will simply lead to rising prices i.e. higher inflation.

There may, of course, be some temporary boost in the short term from this or any other type of expansionary demand management policy, but ultimately only the price level is affected. In other words, the quantity theory of money supports the notion of the neutrality of money, at least in the long-run. For an explanation of how this process would work itself out, please see the second half of my page about the NAIRU. 

A further complication arises with M in that it only refers to the money supply circulating in the newly produced goods/services market. The broader money supply is divided between this market and the market for assets (e.g., existing durable goods, land, property, and investment in financial assets like saving accounts, commodities, stocks, and shares).

Monetarism and the Quantity Theory of Money

With Keynesian economics falling from grace in the 1970s after a supposedly stable aggregate supply proved to be anything but stable after the oil price increases at that time, Monetarism came to the forefront of economic policy. This was largely headed by Milton Friedman and one of the key elements of his approach included a revival of the quantity theory of money.

Using empirical analysis of historical economic data Friedman showed that periods of high inflation had always been associated with prior periods of high money supply growth, and that changes in velocity of money had been relatively stable in the long-run, only changing slowly over longer periods of time. Velocity can, of course, change sharply in the short-run.

In the short-run, changes in velocity are usually led by changes in the money supply, but in the opposite direction. For example, if the money supply were to double, velocity would half in the beginning and then gradually increase as consumers gradually increase their spending.

The velocity of money in the newly produced goods market is directly linked to the demand for money in the financial assets market. Keynesians, with their Liquidity Preference Theory, insist that the broader demand for money relates only to interest rates and their affect on the demand for financial assets. Higher interest rates make saving and investment in financial assets more rewarding, and so more money is diverted to that market instead of the market for newly produced goods. This is covered in my article about the Monetary Transmission Mechanism. 

The monetarists, on the other hand, prefer the Loanable Funds Theory as an explanation of the demand for money, and that theory is not limited to changes in demand for financial assets alone, with the implication that any increase in the money demand would more readily increase demand for goods too, and directly increase pressure for prices to rise. Furthermore, the monetarists generally hold that the demand for money in the newly produced goods market is inherently more stable in the short run than the Keynesians suggest, and put much more emphasis on the Permanent Income Hypothesis.

In addition to his convincing arguments in favor of a relatively stable velocity of money, at least in the long-term, Friedman points out that the supply of money can be very volatile. This is an inherent problem with any fractional reserve banking system, because the high-street banks are able to create vast amounts of credit in a short period of time via the money multiplier.

Conclusion

As with so many of the conflicts of opinion between different economic schools of thought, much depends on the starting assumptions.

Keynesians gained popularity at a time when high unemployment was the key economic problem, and their theories are built on policies to boost economic output on the assumption that there is spare capacity in the economy to create more jobs and permanently increase the employment rate.

Monetarists gained the upper hand at a time when high levels of inflation were proving that any spare capacity in the economy had been exhausted, and that the older Keynesian ideas were flawed.

Both of these schools of thought may be more or less appropriate depending on the economic circumstances of the day, and both have flaws regardless.

I do believe that the correct starting point for economic analysis should be one of long-run equilibrium, and for that reason the monetarists naturally appeal more to my own philosophy. For this reason, I do see plenty of value in the quantity theory of money, and I think that its critics have badly misrepresented it.

At the same time, as we approach the culmination of decades of economic mismanagement, it has to be acknowledged that our economies are far away from long-run equilibrium and this will grossly distort the functioning of all our economic models in the years ahead.

The main challenge to the quantity theory of money in normal times relates to the short-term stability, or instability, of the velocity of money, so be sure to check that article out for a fuller understanding.


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