Quantity theory of money In monetary economics, the quantity theory of money is the theory that money supply has

a direct, proportional relationship with the price level. The theory was challenged by Keynesian economics,[1] 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,[2] followers of the School of Salamanca, Jean Bodin,[3] 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 wa stated by John Stuart s Mill[4] who expanded on the ideas of David Hume.[5] The quantity theory was developed by Simon Newcomb,[6] Alfred de Foville,[7] Irving Fisher,[8] and Ludwig von Mises[9] in the latter 19th and early 20th century, and was argued against by Karl Marx.[10] The theory was influentially restated by Milton Friedman in response to Keynesianism.[11] Academic discussion remains over the degree to which different figures developed the theory.[12] For instance, Bieda argues that Copernicus's observation Money can lose its value through excessive abundance, if so much silver is coined as to heighten people's demand for silver bullion. For in this way, the coinage's estimation vanishes when it cannot buy as much silver as the money itself contains []. The solution is to mint no more coinage until it recovers its par value.[12] amounts to a statement of the theory,[13] while other economic historians date the discovery later, to figures such as Jean Bodin, David Hume, and John Stuart Mill.[12][14] 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.[15] 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 PT is the price level associated with transactions for the economy during the period

T 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 V is the velocity of money in final expenditures. Q is an index of the real value of final expenditures. As an example, M might represent currency plus deposits in checking and savings accounts held by the public, Q real output (which equals real expenditure in macroeconomic equilibrium) with P the corresponding price level, and the nominal (money) value of output. In one empirical formulation, velocity was taken to be the ratio of n national et product in current prices to the money stock.[16] 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 d not oes require that a change in the money supply would change the value of any or all ofP, Q, or . For example, a 10% increase in M could be accompanied by a 10% decrease in V, leaving unchanged. The quantity theory postulates that the primary causal effect is an effect of M on P. A rudimentary version of the quantity theory The equation of exchange can be used to form a rudimentary version of the quantity theory of the effect of monetary growth on inflation.

If V and Q were constant, then:

and thus

where t is time. That is to say that, if V and Q were constant, then the inflation rate (the rate of growth of the price level) would exactly equal the growth rate of the money supply. In short, the inflation rate is a function of the monetary growth rate. Less restrictively, with time-varying V and Q, we have the identity

which says that the inflation rate equals the monetary growth rate plus the growth rate of the velocity of money minus the growth rate of real expenditure. If one makes the quantity theory assumptions that, at least in the long run, (i) the monetary growth rate is controlled by the central bank, (ii) the growth rate of velocity is purely determined by the evolution of payments mechanisms, and (iii) the growth rate of real expenditure is determined by the rate

of technological progress plus the rate of labor force growth, then while the inflation rate need not equal the monetary growth rate, an x percentage point rise in the monetary growth rate will result in an x percentage point rise in the inflation rate. Cambridge approach Economists Alfred Marshall, A.C. Pigou, and John Maynard Keynes (before he developed his own, eponymous school of thought) 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 (Md = M), Y 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.[17] Quantity theory and evidence As restated by Milton Friedman, the quantity theory emphasizes the following relationship of the nominal value of expenditures PQ and the price level P to the quantity of money M:

The plus signs indicate that a change in the money supply is hypothesize to change nominal d expenditures and the price level in the same direction (for other variablesheld constant). Friedman described the empirical regularity of substantial changes in the quantity of money [18] 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 Q than the price level P in (1) but with much variation in the precision, timing, and size of the relation. For the longrun, there has been stronger support for (1) and (2) and no systematic association ofQ and M.[19] Principles The theory above is based on the following hypotheses: 1. The source of inflation is fundamentally derived from the growth rate of the money supply. 2. The supply of money is exogenous. 3. The demand for money, as reflected in its velocity, is a stable function of nominal income, interest rates, and so forth. 4. The mechanism for injecting money into the economy is not that important in the long run.

5. The real i terest rate is determi ed by non-monetary factors: (producti ity of capital time preference). Decli e 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. [20] 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. As a result, some central banks, including the U.S. Federal Reserve, which had targeted the money supply, reverted to targeting interest rates. But monetary aggregates remain a leading economic indicator.[21] with "some evidence that the linkages between money and economic activity are robust even at relatively short-run frequencies."[22] Criticism The theory attracted criticism from John Maynard Keynes, particularly in his work The General Theory of Employment, Interest and Money.[1][clarification needed ] Ludwig von Mises agreed that there was a core of truth in the Quantity Theory, but critici ed 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".[23] The concept of the quantity theory of money (QTM) began in the 16th century. As gold and silver inflows from the Americas into Europe were being minted into coins, there was a resulting rise in inflation. This led economist Henry Thornton in 1802 to assume that more money equals more inflation and that an increase in money supply does not necessarily mean an increase in economic output. Here we look at the assumptions and calculations underlying the QTM, as well as its relationship to monetarism and ways the theory has been challenged. QTM in a Nutshell The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. According to QTM, if the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). The consumer therefore pays twice as much for the same amount of the good or service. Another way to understand this theory is to recogni e that money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency). So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in moneys marginal value. The Theorys Calculations In its simplest form, the theory is expressed as: MV = PT (the Fisher E uation) Each variable denotes the following: M = Money Supply V = Velocity of Circulation (the number of times money changes hands) P = Average Price Level T = Volume of Transactions of Goods and Services

The original theory was considered orthodox among 17th century classical economists and was overhauled by 20th-century economists Irving Fisher, who formulated the above equation, and Milton Friedman. (For more on this important economist, see Free Mar et Maven: Milton Friedman.) It is built on the principle of "equation of exchange": Amount of Money x Velocity of Circulation = Total Spending Thus if an economy has US$3, and those $3 were spent five times in a month, total spending for the month would be $15. QTM Assumptions QTM adds assumptions to the logic of the equation of exchange. In its most basic form, the theory assumes that V (velocity of circulation) and T (volume of transactions) are constant in the short term. These assumptions, however, have been critici ed, particularly the assumption that V is constant. The arguments point out that the velocity of circulation depends on consumer and business spending impulses, which cannot be constant. The theory also assumes that the quantity of money, which is determined by outside forces, is the main influence of economic activity in a society. A change in money supply results in changes in price levels and/or a change in supply of goods and services. It is primarily these changes in money stock that cause a change in spending. And the velocity of circulation depends not on the amount of money available or on the current price level but on changes in price levels. Finally, the number of transactions (T) is determined by labor, capital, natural resources (i.e. the factors of production), knowledge and organi ation. The theory assumes an economy in equilibrium and at full employment. Essentially, the theorys assumptions imply that the val e of money is determined by the amount of money available in an economy. An increase in money supply results in a decrease in the value of money because an increase in money supply causes a rise in inflation. As inflation rises, the purchasing power, or the value of money, decreases. It therefore will cost more to buy the same quantity of goods or services. Money Supply, Inflation and Monetarism As QTM says that quantity of money determines the value of money, it forms the cornerstone of monetarism. (For more insight, see Monetarism: Printing Mone To Control Inflation.) Monetarists say that a rapid increase in money supply leads to a rapid increase in inflation. Money growth that surpasses the growth of economic output results in inflation as there is too much money behind too little production of goods and services. In order to curb inflation, money growth must fall below growth in economic output. This premise leads to how monetary policy is administered. Monetarists believe that money supply should be kept within an acceptable bandwidth so that levels of inflation can be controlled. Thus, for the near term, most monetarists agree that an increase in money supply can offer a quick-fix boost to a staggering economy in need of increased production. In the

long term, however, the effects of monetary policy are still blurry. Less orthodox monetarists, on the other hand, hold that an expanded money supply will not have any effect on real economic activity (production, employment levels, spending and so forth). But for most monetarists any anti-inflationary policy will stem from the basic concept that there should be a gradual reduction in the money supply. Monetarists believe that instead of governments continually adjusting economic policies (i.e. government spending and taxes), it is better to let non-inflationary policies (i.e. gradual reduction of money supply) lead an economy to full employment. QTM Re-Experienced John Maynard Keynes challenged the theory in the 1930s, saying that increases in money supply lead to a decrease in the velocity of circulation and that real income, the flow of money to the factors of production, increased. Therefore, velocity could change in response to changes in money supply. It was conceded by many economists after him that Keynes idea was accurate. QTM, as it is rooted in monetarism, was very popular in the 1980s among some major economies such as the United States and Great Britain under Ronald Reagan and Margaret Thatcher respectively. At the time, leaders tried to apply the principles of the theory to economies where money growth targets were set. However, as time went on, many accepted that strict adherence to a controlled money supply was not necessarily the cure-all for economic malaise.

Quantity Theory of Money

International Encyclopedia of the Social Sciences | 2008 | Copyright

Quantity Theory of Money

BIBLIOGRAPHY 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 numraire 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.