In monetary economics, the quantity theory of money states that money supply
has a direct, proportional relationship with the price level. For example, if
the currency in circulation increased, there would be a proportional increase
in the price of goods. The theory was challenged by Keynesian
economics, but updated and reinvigorated by the monetarist school of economics.
While mainstream economists agree that the quantity theory holds true in the
long run, there is still disagreement about its applicability in the short
run. Critics of the theory argue that money velocity is not stable and, in the
short-run, prices are sticky, so the direct relationship between money supply
and price level does not hold. Alternative theories include the real
bills doctrine and the more recent fiscal theory of the price level.
Origins and development of the quantity theory
The quantity theory descends from Copernicus, followers of the School of
Salamanca, Jean Bodin, Henry Thornton, and various others who noted the
increase in prices following the import of gold and silver, used in the coinage
of money, from the New World. The “equation of exchange” relating the
supply of money to the value of money transactions was stated by John Stuart
Mill who expanded on the ideas of David Hume. The quantity theory was developed
by Simon Newcomb, Alfred de Foville, Irving Fisher, and Ludwig von Mises in
the late 19th and early 20th century. Henry Thornton introduced the idea of a
central bank after the financial panic of 1793, although, the concept of a
modern central bank wasn't given much importance until Keynes published "A
Tract on Monetary Reform" in 1923. In 1802, Thornton published "An Enquiry
into the Nature and Effects of the Paper Credit of Great Britain" in which he
gave an account of his theory regarding the central bank's ability to control
price level. According to his theory, the central bank could control the
currency in circulation through book keeping. This control could allow the
central bank to gain a command of the money supply of the country. This
ultimately would lead to the central bank's ability to control the price
level. His introduction of the central bank's ability to influence the price
level was a major contribution to the development of the quantity theory of
money. Karl Marx modified it by arguing that
the Labor Theory of Value requires that prices, under equilibrium conditions,
are determined by socially necessary labor time needed to produce the
commodity and that quantity of money was a function of the quantity of
commodities, the prices of commodities, and the velocity. Marx did not reject
the basic concept of the Quantity Theory of Money, but rejected the notion that
each of the four elements were equal, and instead argued that the quantity of
commodities and the price of commodities are the determinative elements and that
the volume of money follows from them. He argued...
John Maynard Keynes, like Marx, accepted the theory in general and wrote...
Also like Marx he believed that the theory was misrepresented. Where Marx
argues that the amount of money in circulation is determined by the
quantity of goods times the prices of goods Keynes argued the amount of money
was determined by the purchasing power or aggregate demand. He wrote
In the Tract on Monetary Reform, Keynes developed his own quantity equation: n =
p(k + rk'),where n is the number of "currency notes or other forms of cash
in circulation with the public", p is "the index number of the cost of
living", and r is "the proportion of the bank's potential liabilities held in the
form of cash." Keynes also assumes "...the public,(k') including the
business world, finds it convenient to keep the equivalent of k consumption in
cash and of a further available k' at their banks against cheques..." So long
as k, k', and r do not change, changes in n cause proportional changes in p.
Keynes however notes... Keynes thus accepts the Quantity Theory
as accurate over the long-term but not over the short term. Keynes remarks that
contrary to contemporaneous thinking, velocity and output were not stable but
highly variable and as such, the quantity of money was of little
importance in driving prices. The theory was influentially restated by
Milton Friedman in response to the work of John Maynard Keynes and Keynesianism.
Friedman understood that Keynes was like Friedman, a "quantity theorist" and that
Keynes Revolution "was from, as it were, within the governing body", i.e.
consistent with previous Quantity Theory. Friedman notes the similarities
between his views and those of Keynes when he wrote...
Friedman notes that Keynes shifted the focus away from the quantity of money
and put the focus on price and output. Friedman writes...
The Monetarist counter-position was that contrary to Keynes, velocity was not a
passive function of the quantity of money but it can be an independent
variable. Friedman wrote: Thus while Marx, Keynes, and Friedman
all accepted the Quantity Theory, they each placed different emphasis as to
which variable was the driver in changing prices. Marx emphasized
production, Keynes income and demand, and Friedman the quantity of money.
Academic discussion remains over the degree to which different figures
developed the theory. For instance, Bieda argues that Copernicus's
observation amounts to a statement of the theory,
while other economic historians date the discovery later, to figures such as Jean
Bodin, David Hume, and John Stuart Mill. Historically, the main rival of the
quantity theory was the real bills doctrine, which says that the issue of
money does not raise prices, as long as the new money is issued in exchange for
assets of sufficient value. Equation of exchange
In its modern form, the quantity theory builds upon the following definitional
relationship. where
is the total amount of money in circulation on average in an economy
during the period, say a year. is the transactions velocity of money,
that is the average frequency across all transactions with which a unit of money
is spent. This reflects availability of financial institutions, economic
variables, and choices made as to how fast people turn over their money.
and are the price and quantity of the i-th transaction.
is a column vector of the , and the superscript T is the transpose operator.
is a column vector of the . Mainstream economics accepts a
simplification, the equation of exchange:
where is the price level associated with
transactions for the economy during the period
is an index of the real value of aggregate transactions.
The previous equation presents the difficulty that the associated data are
not available for all transactions. With the development of national income and
product accounts, emphasis shifted to national-income or final-product
transactions, rather than gross transactions. Economists may therefore
work with the form where
is the velocity of money in final expenditures.
is an index of the real value of final expenditures.
As an example, might represent currency plus deposits in checking and savings
accounts held by the public, real output with the corresponding price
level, and the nominal value of output. In one empirical formulation, velocity
was taken to be “the ratio of net national product in current prices to
the money stock”. Thus far, the theory is not particularly
controversial, as the equation of exchange is an identity. A theory
requires that assumptions be made about the causal relationships among the four
variables in this one equation. There are debates about the extent to which
each of these variables is dependent upon the others. Without further
restrictions, the equation does not require that a change in the money
supply would change the value of any or all of , , or . For example, a 10%
increase in could be accompanied by a change of 1/(1 + 10%) in , leaving
unchanged. The quantity theory postulates that the primary causal
effect is an effect of M on P. Cambridge approach
Economists Alfred Marshall, A.C. Pigou, and John Maynard Keynes associated with
Cambridge University, took a slightly different approach to the quantity
theory, focusing on money demand instead of money supply. They argued that a
certain portion of the money supply will not be used for transactions; instead,
it will be held for the convenience and security of having cash on hand. This
portion of cash is commonly represented as k, a portion of nominal income. The
Cambridge economists also thought wealth would play a role, but wealth is often
omitted for simplicity. The Cambridge equation is thus:
Assuming that the economy is at equilibrium, is exogenous, and k is
fixed in the short run, the Cambridge equation is equivalent to the equation
of exchange with velocity equal to the inverse of k:
The Cambridge version of the quantity theory led to both Keynes's attack on
the quantity theory and the Monetarist revival of the theory.
Quantity theory and evidence As restated by Milton Friedman, the
quantity theory emphasizes the following relationship of the nominal value of
expenditures and the price level to the quantity of money :
The plus signs indicate that a change in the money supply is hypothesized to
change nominal expenditures and the price level in the same direction.
Friedman described the empirical regularity of substantial changes in the
quantity of money and in the level of prices as perhaps the most-evidenced
economic phenomenon on record. Empirical studies have found relations consistent
with the models above and with causation running from money to prices. The
short-run relation of a change in the money supply in the past has been
relatively more associated with a change in real output than the price level in
but with much variation in the precision, timing, and size of the
relation. For the long-run, there has been stronger support for and and no
systematic association of and . = Principles=
The theory above is based on the following hypotheses:
The source of inflation is fundamentally derived from the growth rate of the
money supply. The supply of money is exogenous.
The demand for money, as reflected in its velocity, is a stable function of
nominal income, interest rates, and so forth.
The mechanism for injecting money into the economy is not that important in the
long run. The real interest rate is determined by
non-monetary factors:. = Decline of money-supply targeting=
An application of the quantity-theory approach aimed at removing monetary
policy as a source of macroeconomic instability was to target a constant,
low growth rate of the money supply. Still, practical identification of the
relevant money supply, including measurement, was always somewhat
controversial and difficult. As financial intermediation grew in
complexity and sophistication in the 1980s and 1990s, it became more so. To
mitigate these problem, some central banks, including the U.S. Federal
Reserve, which had targeted the money supply, reverted to targeting interest
rates. Starting 1990 with New Zealand, more and more central banks started to
communicate inflation targets as the primary guidance for the public. Reasons
were that interest targeting turned out to be a less effective tool in
low-interest phases and it did not cope with the public uncertainty about future
inflation rates to expect. The communication of inflation targets helps
to anchor the public inflation expectations, it makes central banks
more accountable for their actions, and it reduces economic uncertainty among
the participants in the economy. But monetary aggregates remain a leading
economic indicator. with "some evidence that the linkages between money and
economic activity are robust even at relatively short-run frequencies."
Criticisms Knut Wicksell criticized the quantity
theory of money. John Maynard Keynes criticized the
quantity theory of money in The General Theory of Employment, Interest and
Money. Keynes had originally been a proponent of the theory, but he
presented an alternative in the General Theory. Keynes argued that price level
was not strictly determined by money supply. Changes in the money supply
could have effects on real variables like output.
Ludwig von Mises agreed that there was a core of truth in the Quantity Theory,
but criticized its focus on the supply of money without adequately explaining
the demand for money. He said the theory "fails to explain the mechanism of
variations in the value of money". Paul Krugman gave empirical evidence
that the quantity theory of money does not operate when an economy is in a
liquidity trap, and that even tripling the money supply in that situation had
no measurable effect on prices. See also
= Alternative theories= Benjamin Anderson
Fiscal theory of the price level Real bills doctrine
References Further reading
Fisher Irving, The Purchasing Power of Money, 1911
Friedman, Milton. “quantity theory of money”, The New Palgrave: A Dictionary
of Economics, v. 4, pp. 3–20. Abstract. Arrow-page searchable preview at John
Eatwell et al.(1989), Money: The New Palgrave, pp. 1–40.
Laidler, David E.W.. The Golden Age of the Quantity Theory: The Development of
Neoclassical Monetary Economics, 1870-1914. Princeton UP. Description and
review. Mises, Ludwig Heinrich Edler von; Human
Action: A Treatise on Economics, Ch. XVII “Indirect Exchange”, §4. “The
Determination of the Purchasing Power of Money”.
Humphrey, Thomas M., The Quantity Theory of Money: Its Historical Evolution and
Role in Policy Debates. FRB Richmond Economic Review, Vol. 60, May/June 1974,
pp. 2-19. Available at [SSRN: http:ssrn.com/abstract=2117542]
External links The Quantity Theory of Money from John
Stuart Mill through Irving Fisher from the New School
“Quantity theory of money” at Formularium.org — calculate M, V, P and
Q with your own values to understand the equation
How to Cure Inflation from Aplia Econ Blog