Quantity theory of money: definition, formula, criticisms
- The quantity theory of money states that an increase in the money supply will cause the same increase in inflation.
- The concept has been around since the early 16th century and was popularized in modern economics in the 1960s.
- The principle underlying the theory is found in the quantitative easing policies of the Federal Reserve and other central banks.
The quantity theory of money holds that the price of goods and services is directly related to the money supply of an economy. Renaissance astronomer and mathematician Nicolaus Copernicus formulated the idea in the 1500s. American economists Milton Friedman and Anna Schwartz revitalized it in the mid-20th century.
Quantity Theory of Money Proposition
Before diving into the quantity theory of money, it is useful to review a few terms:
- the amount of money is the money supply, or the total amount of readily available funds – including cash, coins, and bank account balances – circulating in the economy. The money supply sometimes has a close relationship with key economic variables, such as nominal gross domestic product (GDP) and the price level. When this happens, it supports the claim that the money supply determines price levels and long-term inflation.
- the price level is the average cost of goods and services in an economy. The Consumer Price Index (CPI) is the most widely used measure in the United States. It weights the average change in what consumers pay for a representative basket of goods and services over time. The US Bureau of Labor Statistics releases new numbers every month, which investors use to gauge inflation, and the Federal Reserve uses them to help calibrate monetary policy.
- Inflation refers to the general increase in the prices of goods and services over time in an economy. Inflation occurs when everything becomes more expensive (not just a few items in the grocery store), so the cost of living also tends to increase. Inflation decreases the value of money and purchasing power, which means your money doesn’t go as far as it used to. The opposite of inflation is deflation.
“The quantity theory of money simply states that an increase in the money supply will lead to the same increase in inflation, all other things being equal,” says Dan North, chief economist at Allianz Trade. “A doubling of the money supply will lead to a doubling of inflation.”
Of course, certain events can lead to an increase in the prices of certain commodities. For example, a hurricane in the Gulf of Mexico can drive up prices at the gas pump, or a drought in the Midwest can make wheat more expensive. But the quantity theory of money postulates that medium prices should not rise as long as appropriate monetary policy controls the money supply.
Quantitative theory of monetary formula
Monetarism is a macroeconomic theory that holds that governments can achieve economic stability by controlling the money supply. the
and other central banks have done this through a policy known as quantitative easing, which involves buying large numbers of long-term securities on the open market to increase the money supply and encourage loans and investments.
Hermann Simon, founder and honorary chairman of Simon-Kucher & Partners, asserts that the quantity theory of the monetary equation is “at the heart of quantitative easing and monetarism”.
Here is the equation:
“M is the quantity of money. V is the speed at which money flows through the economy. P is the price level. And T is the number of transactions,” Simon explains.
It is nicknamed the Fisher equation after the American economist Irving Fisher, who discussed the quantity theory of money in his 1911 book, “The Purchasing Power of Money”.
Money velocity is the number of times a unit of currency is spent on goods and services over a period of time. If the velocity of money increases, it means that more transactions are taking place in the economy and vice versa. The numbers can help determine whether consumers and businesses are saving or spending their money.
How is the quantity theory of money applied?
To understand how the quantity theory of money works, Luke Tilley, chief economist at the Wilmington Trust, offers an example:
“Imagine a simple economy with 100 people producing and consuming a single type of good,” says Tilley. “[The economy] can earn 100 per year with his labor and capital. And this saving has $100. The economy produces 100 units per year, which are each sold once (V=1) for $1 each (P=$1). It seems very simple.”
However, things start to change if the money supply increases. “If you inject another $100 into the economy by giving each person $1, they all want to buy another unit of the good, so they’re going to raise the price,” Tilley says. “But because the economy’s labor and capital level hasn’t changed, it can’t do any more. The new dollars push the price to $2. Nothing has really changed except that prices are higher and the economy has experienced inflation.”
The example above “is a concrete description of Friedman’s famous statement that inflation is always and everywhere a monetary phenomenon,” says Tilley. “The Fed (and other major central banks) have largely embraced this theory. For the Fed, it’s included in its long-term goals and strategy statement. It’s not as clear to the non-economist, but they say something along the lines of “Over the long term, monetary policy is the only thing that can affect inflation.”
Certainly, monetary policy is a balancing act.
“If the Fed provides too much money, you get inflation,” says Allianz Trade’s North. “If the Fed doesn’t provide enough money, you get deflation and a slowing economy with rising unemployment. The Fed’s mandate is to balance inflation and unemployment.”
Who developed the quantity theory of money?
Copernicus, perhaps best known as the father of modern astronomy, is credited with formulating the quantity theory of money in the early 16th century. Copernicus believed that the money supply was the main determinant of prices.
“We, in our slowness, fail to realize that the dearness of everything is the result of the cheapness of money,” wrote Copernicus. “For prices rise and fall according to the state of the currency.”
Over the years, the quantity theory of money has been reaffirmed by philosophers John Locke, David Hume and Jean Bodin. Eventually, Friedman and Schwartz formalized and popularized the theory in their 1963 book, “A Monetary History of the United States, 1867-1960”.
Criticisms of the quantity theory of money
Of course, like all economic theories, not everyone agrees with the quantity theory of money. Keynesian economists – who believe that maximum economic performance can be achieved through government intervention and militant stabilization, not by changing the money supply – are among its biggest critics.
Critics argue that changing the money supply is not effective in influencing economic growth.
North points to the Fed’s moves to increase the money supply and lower interest rates when the pandemic brought parts of the economy to a virtual standstill. As the economy rebounded, officials stuck with those policies for too long, leading to a spike in inflation two years later, he says.
“Too much easy money for too long is the classic formula for inflation and tears,” says North.
Critics also argue that the velocity of money is not stable, so the relationship between money supply and price levels is not constant. For example, Tilley explains that production is a difficult moving target to pin down given the ever-changing nature of how business and labor interact.
“The way labor and capital work together (productivity) is constantly changing and difficult to track,” says Tilley. “The so-called velocity of money can be described conceptually. Perhaps it is increasing or decreasing because debit cards or other technology make it faster and easier to exchange dollars . But to me, the V is just a by-product of the equation. It’s not very helpful.”