quantity theory of money - Principles, Critics

A theory in economics which states that the money supply (M) × the ‘velocity of circulation’ (V) (ie the number of times a year it changes hands) must equal the price level (P) × the real volume of transactions (T): in algebraic terms, MV = PT. Monetarists have argued that inflation is therefore mainly due to changes in the quantity of money, since the velocity of circulation depends on business practices, and the real level of activity depends on supply-side factors, neither of which changes quickly. Large increases in M must therefore lead to large rises in P, ie inflation. While this is true for large changes in M, business practices do change, and a large proportion of actual transactions are in capital markets; the real level of activity is also subject to short-run variations in the trade cycle. For small changes in M, the connection with the price level is therefore very weak, and even large changes in M produce results subject to long and variable time lags.

In economics, the velocity of money refers to a key term in the quantity theory of money, which centers on the equation of exchange:

where

M is the total amount of money in circulation in an economy at any one time (say, on average during a month). V is the velocity of money, i.e., how often each unit of money is spent during the month. For example, if only 30% of goods are bought with paper or checking account balances, and if the quantity of this type of money doubled, then it might happen that the quantity of goods bought with paper or checking account balances would double from 30% to 60%, while real output of goods (and P and V) are unaffected.

Given this identity, the velocity of money can be measured as

In an early work espousing the quantity theory, velocity is defined as 'the ratio of net national product in current prices to the money stock.'

Historically, the main rival of the quantity theory has been the real bills doctrine, which says that the value of money is determined by the assets and liabilities of the money-issuing entity, rather than by the ratio of money to real GDP.

Principles

The theory is based on the following principles:

The source of inflation is always, fundamentally, derived from the money supply. Money demand determines the real money supply. If the velocity of money is given by financial institutions (such as the role of bank accounts and credit cards) and the amount of production is always at a fixed level (say, at full employment), then any increase in the amount of money leads to rising prices for the economy as a whole, i.e., inflation.

If V and Q are constant, then we can state the equation of exchange in terms of rates of growth:

the rate of growth of the money supply = the inflation rate

Critics

Critics point to several principles presented above. Money supply is endogeneous, as money is created by banks and other financial institutions in relation to a general optimism on the future return of investments. Private supply of money fluctuates in the short and long term and the central bank can only try to level off these fluctuations but has no control on the amount of supply of money. If consumers expect both a rising consumption and rising prices they tend to add to their stocks, stocks rotate faster, there are more transactions, money demand is higher, and for a given money supply, deflation happens. Expectations are hence crucially important as optimism may lead to both higher money supply and higher money demand and pessimism to both lower money supply and money demand. Private money supply often overreacts to money demand through credit booms and credit bust, just as investment overreacts variation in the demand of final goods in the real sphere, hence the central bankers must try to keep things stable and regulation of he finance industry is to be advocated. Finally, for a given money supply, inflation can happen in consumption good prices or in production good prices (assets), and this depends from the relative strenght of labor and management of the labor market.