Quantity Theory of Money

The Quantity Theory of Money seeks to explain the factors that determine the general price level in an economy. According to this theory, the supply of money directly determines the price level.

The Quantity Theory of Money refers to the idea that the quantity of money available (money supply) grows at the same rate as price levels do in the long run. When interest rates fall or taxes decrease and the access to money becomes less restricted, consumers become less sensitive to price changes and, thus, will have a higher propensity to consume. As a result, the aggregate demand curve will shift right, thus shifting up the equilibrium price level.

In monetary economics, the quantity theory of money (QTM) states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply. For example, if the amount of money in an economy doubles, QTM predicts that price levels will also double. The theory was originally formulated by Polish mathematician Nicolaus Copernicus in 1517, and was influentially restated by philosophers John Locke, David Hume, Jean Bodin, and by economists Milton Friedman and Anna Schwartz in A Monetary History of the United States published in 1963.

The theory was challenged by Keynesian economics, but updated and reinvigorated by the monetarist school of economics. 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. In mainstream macroeconomic theory, changes in the money supply play no role in determining the inflation rate as it is measured by the CPI, although some outspoken critics such as Peter Schiff believe that an expansion of the money supply necessarily begets an increase in prices in a non-zero number of asset classes. In models where the expansion of the money supply does not impact inflation, inflation is determined by the monetary policy reaction function.

Alternative theories include the real bills doctrine and the more recent fiscal theory of the price level.

Exchange Equation

To better understand the Quantity Theory of Money, we can use the Exchange Equation. The equation enables economists to model the relationship between money supply and price levels. The exchange equation is:

M*V = P*Q

Where:

M: Refers to the money supply

V: Refers to the Velocity of Money, which measures how much a single dollar of money supply spend contributes to GDP

P: Refers to the prevailing price level

Q: Refers to the quantity of goods and services produced in the economy

Holding Q and V constant, we can see that increases in the money supply will cause price levels to increase, thus causing inflation. The assumption that Q and V are constant holds in the long run as these factors cannot be influenced by changes in the economy’s money supply.

The theory provides a quick overview of monetarist theory, which states that changes in the current money supply cause fluctuations in overall economic output; excessive growth in money supply causes hikes in inflation.

Demand for Money

The Exchange Equation can also be remodeled into the Demand for Money equation as follows:

Md = (P*Q)/V

Where:

Md: Refers to the demand for money

P: Refers to the price level in the economy

Q: Refers to the quantity of goods and services offered in the economy

V: Refers to the Velocity of Money

In the formula, the numerator term (P x Q) refers to the nominal GDP of a country. Moreover, the equation provides another take on the monetarist theory as it relates GDP to the demand for money (contrary to Keynesian economists, who believe that interest rates drive inflation).

The value of money, as revealed by the money market, is variable. A change in money demand or a change in the money supply will yield a change in the value of money and in the price level. Notice that the change in the value of money and the change in the price level are of the same magnitude but in opposite directions. An increase in the money supply is depicted. Notice that the new intersection of the money supply curve and the money demand curve is at a lower value of money but a higher price level. This happens because more money is in circulation, so each bill becomes worth less. It takes more bills to purchase goods and services, and thus the price level increases accordingly.

The quantity theory of money is based directly on the changes brought about by an increase in the money supply. The quantity theory of money states that the value of money is based on the amount of money in the economy. Thus, according to the quantity theory of money, when the Fed increases the money supply, the value of money falls and the price level increases. In the SparkNote on inflation we learned that inflation is defined as an increase in the price level. Based on this definition, the quantity theory of money also states that growth in the money supply is the primary cause of inflation.

Limitations:

This theory has been criticised on several grounds:

(i) Inoperative below Full Employment:

It is alleged that the quantity theory of money comes into its own only during period of full employment of resources. Assuming con­stancy in V, V’, T, Y, etc., a change in money supply will bring about a change in price level. During the period of full employment, T or Y remains unchanged. During such a time, even if money supply rises, T or Y will not change.

On the other hand, price level will rise. But, in reality, full employment of resources is a rare possibility. What we find in reality is unem­ployment or underemployment of resources. During underemployment an increase in money supply will tend to raise output level and, hence, T, but not P. So, quantity theory of money breaks down when resources remain at full employment.

(ii) V, T, etc., do not Remain Fixed:

Secondly, in a dynamic economy V, V’, T, the ratio of M to M’ never remain constant. In such an economy, a change in any of the variables may cause a change in price level, even if money supply does not change. In this sense, these are not independent variables, although the authors of this theory assumed quantity of money as independent of other elements of the equation.

(iii) It is Identity, That is, Always True:

Thirdly, Fisher’s equation is an identity. MV and PT are always equal. In fact, the quantity theory of money is a hypothesis and not an identity which is always true.

(iv) Aggregate Demand/Expenditure, and not M, Influences Price Level:

Fourthly, Keynes argued that price level in an economy is not influenced by money supply. The im­portant determinant of money supply is the income level and the total expenditure of the country. According to Keynes, an increase in money supply is tantamount to an increase in effective demand.

After attaining the stage of full employment, an increase in effective de­mand which is the sum of consumption ex­penditure, investment expenditure and gov­ernment expenditure (i.e., C + I + G) will raise the price level, but not proportionately.

(v) Too much Emphasis on Money Supply:

Fifthly, change in price level is caused by vari­ous factors, besides money supply. For exam­ple, an increase in cost of production has an important bearing on the price level. For in­stance, an increase in wage rate following a revision in the pay scale of employees or an increase in the price of raw materials (say, hike in the price of petroleum products) will definitely push the price level up, whether the economy stays on or below the full employ­ment level. The quantity theory attaches too much importance on money supply.

(vi) M Influences P via Interest Rate:

Sixthly, the classical theory establishes a direct and proportional relationship between money supply and price level. Critics say that the relationship is not a direct one. Fisher ignored the influence of the rate of interest on the price level. Supply of bank money or credit money is influenced largely by the interest rate.

It is argued that the increase in money supply first affects the rate of interest which influences total output and price level in the ultimate analysis.

The casual relationship is: Change in the stock of money → change in interest rate change in investment → change in in­come, employment and output → change in general prices.