In monetary economics, the quantity theory of money (QTM) states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply. The theory was originally formulated by Polish mathematician Nicolaus Copernicus in 1517, and was influentially restated by philosophers John Locke, David Hume, Jean Bodin, and by economists Milton Friedman and Anna Schwartz in A Monetary History of the United States published in 1963.
The theory was challenged by Keynesian economics, but updated and reinvigorated by the monetarist school of economics. Critics of the theory argue that money velocity is not stable and, in the short-run, prices are sticky, so the direct relationship between money supply and price level does not hold. In mainstream macroeconomic theory, changes in the money supply play no role in determining the inflation rate. In such models, inflation is determined by the monetary policy reaction function.
Alternative theories include the real bills doctrine and the more recent fiscal theory of the price level.
Origins and development
The quantity theory descends from Nicolaus Copernicus, followers of the School of Salamanca like Martín de Azpilicueta, Jean Bodin, Henry Thornton, and various others who noted the increase in prices following the import of gold and silver, used in the coinage of money, from the New World. The “equation of exchange” relating the supply of money to the value of money transactions was stated by John Stuart Mill who expanded on the ideas of David Hume. The quantity theory was developed by Simon Newcomb, Alfred de Foville, Irving Fisher, and Ludwig von Mises in the late 19th and early 20th century.
Henry Thornton introduced the idea of a central bank after the financial panic of 1793, although, the concept of a modern central bank was not given much importance until Keynes published “A Tract on Monetary Reform” in 1923. In 1802, Thornton published An Enquiry into the Nature and Effects of the Paper Credit of Great Britain in which he gave an account of his theory regarding the central bank’s ability to control price level. According to his theory, the central bank could control the currency in circulation through book keeping. This control could allow the central bank to gain a command of the money supply of the country. This ultimately would lead to the central bank’s ability to control the price level. His introduction of the central bank’s ability to influence the price level was a major contribution to the development of the quantity theory of money.
Karl Marx modified it by arguing that the labor theory of value requires that prices, under equilibrium conditions, are determined by socially necessary labor time needed to produce the commodity and that quantity of money was a function of the quantity of commodities, the prices of commodities, and the velocity. Marx did not reject the basic concept of the Quantity Theory of Money, but rejected the notion that each of the four elements were equal, and instead argued that the quantity of commodities and the price of commodities are the determinative elements and that the volume of money follows from them. He argued…
The law, that the quantity of the circulating medium is determined by the sum of the prices of the commodities circulating, and the average velocity of currency may also be stated as follows: given the sum of the values of commodities, and the average rapidity of their metamorphoses, the quantity of precious metal current as money depends on the value of that precious metal. The erroneous opinion that it is, on the contrary, prices that are determined by the quantity of the circulating medium, and that the latter depends on the quantity of the precious metals in a country;this opinion was based by those who first held it, on the absurd hypothesis that commodities are without a price, and money without a value, when they first enter into circulation, and that, once in the circulation, an aliquot part of the medley of commodities is exchanged for an aliquot part of the heap of precious metals.
John Maynard Keynes, like Marx, accepted the theory in general and wrote…
This Theory is fundamental. Its correspondence with fact is not open to question.
Also like Marx he believed that the theory was misrepresented. Where Marx argues that the amount of money in circulation is determined by the quantity of goods times the prices of goods Keynes argued the amount of money was determined by the purchasing power or aggregate demand. He wrote
Thus the number of notes which the public ordinarily have on hand is determined by the purchasing power which it suits them to hold or to carry about, and by nothing else.
In the Tract on Monetary Reform (1923), Keynes developed his own quantity equation: n = p(k + rk’),where n is the number of “currency notes or other forms of cash in circulation with the public”, p is “the index number of the cost of living”, and r is “the proportion of the bank’s potential liabilities (k’) held in the form of cash.” Keynes also assumes “…the public,(k’) including the business world, finds it convenient to keep the equivalent of k consumption in cash and of a further available k’ at their banks against cheques…” So long as k, k’, and r do not change, changes in n cause proportional changes in p. Keynes however notes…
The error often made by careless adherents of the Quantity Theory, which may partly explain why it is not universally accepted is as follows. The Theory has often been expounded on the further assumption that a mere change in the quantity of the currency cannot affect k, r, and k’, – that is to say, in mathematical parlance, that n is an independent variable in relation to these quantities. It would follow from this that an arbitrary doubling of n, since this in itself is assumed not to affect k, r, and k’, must have the effect of raising p to double what it would have been otherwise. The Quantity Theory is often stated in this, or a similar, form.
Now “in the long run” this is probably true. If, after the American Civil War, that American dollar had been stabilized and defined by law at 10 per cent below its present value, it would be safe to assume that n and p would now be just 10 per cent greater than they actually are and that the present values of k, r, and k’ would be entirely unaffected. But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean will be flat again.
In actual experience, a change in n is liable to have a reaction both on k and k’ and on r. It will be enough to give a few typical instances. Before the war (and indeed since) there was a considerable element of what was conventional and arbitrary in the reserve policy of the banks, but especially in the policy of the State Banks towards their gold reserves. These reserves were kept for show rather than for use, and their amount was not the result of close reasoning. There was a decided tendency on the part of these banks between 1900 and 1914 to bottle up gold when it flowed towards them and to part with it reluctantly when the tide was flowing the other way. Consequently, when gold became relatively abundant they tended to hoard what came their way and to raise the proportion of the reserves, with the result that the increased output of South African gold was absorbed with less effect on the price level than would have been the case if an increase of n had been totally without reaction on the value of r.
…Thus in these and other ways the terms of our equation tend in their movements to favor the stability of p, and there is a certain friction which prevents a moderate change in v from exercising its full proportionate effect on p. On the other hand, a large change in n, which rubs away the initial frictions, and especially a change in n due to causes which set up a general expectation of a further change in the same direction, may produce a more than proportionate effect on p.
Keynes thus accepts the Quantity Theory as accurate over the long-term but not over the short term. Keynes remarks that contrary to contemporaneous thinking, velocity and output were not stable but highly variable and as such, the quantity of money was of little importance in driving prices.
The theory was influentially restated by Milton Friedman in response to the work of John Maynard Keynes and Keynesianism. Friedman understood that Keynes was like Friedman, a “quantity theorist” and that Keynes Revolution “was from, as it were, within the governing body”, i.e. consistent with previous Quantity Theory. Friedman notes the similarities between his views and those of Keynes when he wrote…
A counter-revolution, whether in politics or in science, never restores the initial situation. It always produces a situation that has some similarity to the initial one but is also strongly influenced by the intervening revolution. That is certainly true of monetarism which has benefited much from Keynes’s work. Indeed I may say, as have so many others since there is no way of contradicting it, that if Keynes were alive today he would no doubt be at the forefront of the counter-revolution.
Friedman notes that Keynes shifted the focus away from the quantity of money (Fisher’s M and Keynes’ n) and put the focus on price and output. Friedman writes…
What matters, said Keynes, is not the quantity of money. What matters is the part of total spending which is independent of current income, what has come to be called autonomous spending and to be identified in practice largely with investment by business and expenditures by government.
The Monetarist counter-position was that contrary to Keynes, velocity was not a passive function of the quantity of money but it can be an independent variable. Friedman wrote:
Perhaps the simplest way for me to suggest why this was relevant is to recall that an essential element of the Keynesian doctrine was the passivity of velocity. If money rose, velocity would decline. Empirically, however, it turns out that the movements of velocity tend to reinforce those of money instead of to offset them. When the quantity of money declined by a third from 1929 to 1933 in the United States, velocity declined also. When the quantity of money rises rapidly in almost any country, velocity also rises rapidly. Far from velocity offsetting the movements of the quantity of money, it reinforces them.
Thus while Marx, Keynes, and Friedman all accepted the Quantity Theory, they each placed different emphasis as to which variable was the driver in changing prices. Marx emphasized production, Keynes income and demand, and Friedman the quantity of money.
Academic discussion remains over the degree to which different figures developed the theory. For instance, Bieda argues that Copernicus’s observation
Money can lose its value through excessive abundance, if so much silver is coined as to heighten people’s demand for silver bullion. For in this way, the coinage’s estimation vanishes when it cannot buy as much silver as the money itself contains […]. The solution is to mint no more coinage until it recovers its par value.
amounts to a statement of the theory, while other economic historians date the discovery later, to figures such as Jean Bodin, David Hume, and John Stuart Mill.
The quantity theory of money preserved its importance even in the decades after Friedmanian monetarism had occurred. In new classical macroeconomics the quantity theory of money was still a doctrine of fundamental importance, but Robert E. Lucas and other leading new classical economists made serious efforts to specify and refine its theoretical meaning. For new classical economists, following David Hume’s famous essay “Of Money”, money was not neutral in the short-run, so the quantity theory was assumed to hold only in the long-run. These theoretical considerations involved serious changes as to the scope of countercyclical economic policy.
Historically, the main rival of the quantity theory was the real bills doctrine, which says that the issue of money does not raise prices, as long as the new money is issued in exchange for assets of sufficient value.
Knut Wicksell criticized the quantity theory of money, citing the notion of a “pure credit economy”.
John Maynard Keynes criticized the quantity theory of money in The General Theory of Employment, Interest and Money. Keynes had originally been a proponent of the theory, but he presented an alternative in the General Theory. Keynes argued that the price level was not strictly determined by the money supply. Changes in the money supply could have effects on real variables like output.
Ludwig von Mises agreed that there was a core of truth in the quantity theory, but criticized its focus on the supply of money without adequately explaining the demand for money. He said the theory “fails to explain the mechanism of variations in the value of money”.
- ^ Jump up to:ab Volckart, Oliver (1997). “Early beginnings of the quantity theory of money and their context in Polish and Prussian monetary policies, c. 1520–1550”. The Economic History Review. Wiley-Blackwell. 50 (3): 430–49. doi:10.1111/1468-0289.00063. ISSN 0013-0117. JSTOR 2599810.
- ^“Quantity theory of money”. Encyclopædia Britannica. Encyclopædia Britannica, Inc.
- ^ Jump up to:ab Hamilton, Earl J. (1965). American Treasure and the Price Revolution in Spain, 1501-1650. New York: Octagon.
- ^ Jump up to:ab Minsky, Hyman P. John Maynard Keynes, McGraw-Hill. 2008. p.2.
- ^Nicolaus Copernicus (1517), memorandum on monetary policy.
- ^Hutchinson, Marjorie (1952). The School of Salamanca; Readings in Spanish Monetary Theory, 1544-1605. Oxford: Clarendon.
- ^John Stuart Mill (1848), Principles of Political Economy.
- ^David Hume (1748), “Of Interest,” “Of Interest” in Essays Moral and Political.
- ^Simon Newcomb (1885), Principles of Political Economy.
- ^Alfred de Foville (1907), La Monnaie.
- ^Irving Fisher (1911), The Purchasing Power of Money,
- ^von Mises, Ludwig Heinrich; Theorie des Geldes und der Umlaufsmittel [The Theory of Money and Credit]
- ^Hetzel, Robert L. “Henry Thornton: Seminal Monetary Theorist and Father of the Modern Central Bank.” Henry Thornton: Seminal Monetary Theorist and Father of the Modern Central Bank (n.d.): 1. July–Aug. 1987.
- ^Capital Vol I, Chapter 3, B. The Currency of Money, as well A Contribution to the Critique of Political Economy Chapter II, 3 “Money”
- ^Tract on Monetary Reform, London, United Kingdom: Macmillan, 1924 Archived August 8, 2013, at the Wayback Machine
- ^“Keynes’ Theory of Money and His Attack on the Classical Model”, L. E. Johnson, R. Ley, & T. Cate (International Advances in Economic Research, November 2001) “Archived copy”(PDF). Archived from the original (PDF) on July 17, 2013. Retrieved June 17, 2013.
- ^ Jump up to:ab “The Counter-Revolution in Monetary Theory”, Milton Friedman (IEA Occasional Paper, no. 33 Institute of Economic Affairs. First published by the Institute of Economic Affairs, London, 1970.) “Archived copy” (PDF). Archived from the original (PDF) on 2014-03-22. Retrieved 2013-06-17.
- ^Milton Friedman (1956), “The Quantity Theory of Money: A Restatement” in Studies in the Quantity Theory of Money, edited by M. Friedman. Reprinted in M. Friedman The Optimum Quantity of Money (2005), 51-p. 67.
- ^ Jump up to:ab c Volckart, Oliver (1997), “Early beginnings of the quantity theory of money and their context in Polish and Prussian monetary policies, c. 1520–1550”, The Economic History Review, 50 (3): 430–49, doi:10.1111/1468-0289.00063
- ^Bieda, K. (1973), “Copernicus as an economist”, Economic Record, 49: 89–103, doi:10.1111/j.1475-4932.1973.tb02270.x
- ^Wennerlind, Carl (2005), “David Hume’s monetary theory revisited”, Journal of Political Economy, 113 (1): 233–37, doi:10.1086/426037
- ^Galbács, Peter (2015). The Theory of New Classical Macroeconomics. A Positive Critique. Contributions to Economics. Heidelberg/New York/Dordrecht/London: Springer. doi:10.1007/978-3-319-17578-2. ISBN 978-3-319-17578-2.
- ^Roy Green (1987), “real bills doctrine”, in The New Palgrave: A Dictionary of Economics, v. 4, pp. 101–02.
- ^Milton Friedman & Anna J. Schwartz (1965), The Great Contraction 1929–1933, Princeton: Princeton University Press, ISBN 978-0-691-00350-4
- ^Froyen, Richard T. Macroeconomics: Theories and Policies. 3rd Edition. Macmillan Publishing Company: New York, 1990. pp. 70–71.
- ^Milton Friedman (1987), “quantity theory of money”, The New Palgrave: A Dictionary of Economics, v. 4, p. 15.
- ^Summarized in Friedman (1987), “quantity theory of money”, pp. 15–17.
- ^Friedman (1987), “quantity theory of money”, p. 19.
- ^Jahan, Sarwat. “Inflation Targeting: Holding the Line”. International Monetary Funds, Finance & Development. Retrieved 28 December 2014.
- ^NA (2005), How Does the Fed Determine Interest Rates to Control the Money Supply?”, Federal Reserve Bank of San Francisco. February,“Archived copy”. Archived from the original on December 8, 2008. Retrieved November 1, 2007.
- ^W. Hafer and David C. Wheelock (2001), “The Rise and Fall of a Policy Rule: Monetarism at the St. Louis Fed, 1968-1986”, Federal Reserve Bank of St. Louis, Review, January/February, p. 19.
- ^Wicksell, Knut (1898). Interest and Prices (PDF).
- ^Ludwig von Mises (1912), “The Theory of Money and Credit (Chapter 8, Sec 6)”.