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2012-03-19 12:03:25
May 02 2010 | Filed Under Economics , Financial Theory , Students
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 recognize 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 money s marginal
value.
The Theory s Calculations
In its simplest form, the theory is expressed as:
MV = PT (the Fisher Equation)
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 Market 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 criticized, 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 organization.
The theory assumes an economy in equilibrium and at full employment.
Essentially, the theory s assumptions imply that the value 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.
by Reem Heakal