The Quantity Theory of Money
Aug 31, 2019Posted by on
This week on Facebook: I have to think very hard about whether I am a monetarist or not, the answer seems to depend on how strongly I believe that the State guides its political economy by changes to the monetary supply and other forms of fiat money creation. It was an article or remark of Mervyn King in which he displayed misconceptions about money velocity, particularly with regard to quantitative easing, that first brought the Irving Fisher equation of exchange (MV=PT) to my attention. Economist vacillate over measuring Instruments in economics¹ and while I would hardly call myself an economist — I share in their vacillations.
Irving Fisher used the equation of exchange to develop the classical quantity theory of money, i.e., a causal relationship between the money supply and the price level. On the assumptions that, in the long run, under full-employment conditions, total output (T) does not change and the transactions velocity of money (V) is stable, Fisher was able to demonstrate a causal relationship between money supply and price level. Fisher’s Quantity Theory of Money
The foundation of the Fisher version was Purchasing Power of Money published in 1911, and whilst based on earlier works, (and not unique to Fisher), the original equation of exchange MV=PT, in which M denotes the total money stock, V the velocity of circulation, P the general price level, and T the total number of transactions. Fisher referred to this equation as the quantity theory and it is the causal influence of changes in the money supply to changes in the price level. By the time Mises’ book was published in 1912 The Theory of Money and Credit and later translated, it was probably mostly ignored in the contemporary economic or political thoughts about the quantity theory of money and credit².
Fisher’s book assumed that in the long run, under full-employment conditions, total output (T) does not change and the transactions velocity of money (V) is stable. The Financial Times wrote in 2009 (last Sunday’s post) that history tells us V has never been sufficiently predictable to be reliable for use in policy.
Post Fisher it took a second world war to create full employment, and it is questionable what Fisher meant in 1911 by full-employment. Post WWII there was full-employment for a short time, only to be curtailed (perhaps) by the introduction of fiat money, but certainly by the rise monetarism.
If the Bank of England does not calculate the amount of ‘money’ spent by someone on a credit card, but simply looks at the balance in a checking account (M1 money), which only reveals the monetary balance (M) left in that account. It does not reveal the velocity of circulation or the general price level of monies paid out, nor does it reveal the total number of transactions made by a credit card holder. The use of plastic cards and their relationship with money, makes the demand for money even more complex. Last week’s post stated that credit card debts are not used as a part of the State economy’s stock of money.
Although market prices are flexible and can react to deflation much better than most people realise, it is still true that our system is tragically absurd. Is Our Money Based on Debt
The videos included at end of this post³ asks and answer the question, ‘Who controls all of our money?’, by claiming that fiat money has created a debt based economy and blaming the central bank for creating this absurdity. The last article (5) gives monetarists credit for being overwhelmingly right in insisting on how much money matters in any form it is in. It also deals comprehensively with the velocity of money in the Fisher equation. It is money that is most influential in determining the purchasing power of the monetary unit and it is the quantity theory of money that is most influential in this. The use of the ‘quantity theory equation’ may make most wonder who exactly do central banks represent the interests of.
1. What Is the Quantity Theory of Money? 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.
2. Forget The Fed: It’s About Velocity! Actually, in many walks of life including financial and economic research, you can’t simply say if such and such does this, then this other thing will do that. It’s always essential to add and important caveat: “all else being equal.” The all-else caveat is vital. That, however, may be the problem. It’s so vital, we often take it for granted and forget to say it out loud. And if we stay silent for too long, it becomes easy to lull ourselves into completely forgetting about it.
4. The Financial Crisis — Responses: In the aftermath of the Crash a fresh set of problems arose: how to prevent the drying up of credit, the loss of confident investors and the reluctance of households to spend in an emergency situation to create a deep and prolonged slump and mass unemployment — as occurred in the US after the Great Crash. There are various schools of economic thought which have contended to answer this set of questions.
5. Where the Monetarists Go Wrong: It is with considerable reluctance that I criticise the monetarists, because, though I consider their proposed monetary policy unfeasible, they are after all much more nearly right in their assumptions and prescriptions than the majority of present academic economists. The simplistic form of the quantity theory of money that they hold is not tenable; but they are overwhelmingly right in insisting on how much “money matters,” and they are right in insisting that in most circumstances, and over the long run, it is the quantity of money that is most influential in determining the purchasing power of the monetary unit.
Referenced Articles Books & Definitions:
- A bold text subscript above and preceding a title below (¹·²·³), refers to a book, pdf, podcast, video, slide show and a download url that is usually free.
- Brackets containing a number e.g. (1) reference a particular included article (1-5).
- A link (url), which usually includes the title, are to an included source.
- The intended context of words, idioms, phrases, have their links in italics.
- A long read url* (when used below) is followed by a superscript asterisk.
- Occasionally Open University (OU) free courses are cited.
- JSTOR lets you set up a free account allowing you to have 6 (interchangeable) books stored that you can read online.
¹Measuring Instruments in Economics and the Velocity of Money (url/pdf): In economics, facts are hard things like numbers: measurements of unemployment, for example, or of prices or money. Numbers like these that become widely accepted within the economics community, and are used without much consideration of how they were found or made, can be considered as facts that have travelled well. Yet such facts are hard to come by.
²The (Quantity) Theory of Money and Credit (url/download): The Theory of Money and Credit (1912) is rightly regarded as a seminal book in the development of the Austrian school approach to monetary theory. We argue that Mises’ understanding of the equation of exchange differs from both of the conventional textbook versions, and warrants recognition as being a distinct contribution. After supporting this claim we discuss it in light of expectations, monetary regimes, and the micro-foundations of the quantity theory.