💾 Archived View for gmi.noulin.net › mobileNews › 3913.gmi captured on 2023-12-28 at 19:36:00. Gemini links have been rewritten to link to archived content

View Raw

More Information

⬅️ Previous capture (2023-01-29)

➡️ Next capture (2024-05-10)

-=-=-=-=-=-=-

What Is the Quantity Theory of Money?

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