Quantity theory of money
In monetary economics, the quantity theory of money states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply. 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. In such models, 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.
Origins and development
The quantity theory descends from Nicolaus Copernicus, followers of the School of Salamanca like Martín de Azpilicueta, 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 was not 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,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, 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.
The quantity theory of money preserved its importance even in the decades after Friedmanian monetarism had occurred. In new classical macroeconomics the quantity theory of money was still a doctrine of fundamental importance, but Robert E. Lucas and other leading new classical economists made serious efforts to specify and refine its theoretical meaning. For new classical economists, following David Hume's famous essay "Of Money", money was not neutral in the short-run, so the quantity theory was assumed to hold only in the long-run. These theoretical considerations involved serious changes as to the scope of countercyclical economic policy.
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.
Fisher's equation of exchange
In its modern form, the quantity theory builds upon the following definitional relationship.where
Mainstream economics accepts a simplification, the equation of exchange:
where
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
where
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/ 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.
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
Criticisms
criticized the quantity theory of money, citing the notion of a "pure credit economy".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 the price level was not strictly determined by the 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".
In his book The Denationalisation of Money, Friedrich Hayek described the quantity theory of money "as no more than a useful rough approximation to a really adequate explanation". According to him, the theory "becomes wholly useless where several concurrent distinct kinds of money are simultaneously in use in the same territory."