Quantity Theory of Money

Anticipations

The monetary system in the part, that was mostly stable upto a thousand years did not feature much inflation. If inflation did happen, it was a planned one. This usually mean that the government in power would direct the mint to use lesser amounts of metal to produce the same amount of coin. The result of this was that the coin would be smaller or slightly adulterated with copper or some other fairly indistinguishable metal. This was called debasement of currency and was usually done in war time in an attempt to finance war expenditure. Once the public got word of this fall in value within each coin, naturally there was inflation up till the point where the price rise matched the value debased. However there was inflation caused from other sources. And it was in this discovery that the quantity theory of money was founded.

After the conquest of Persia under Alexander the Great caused a great influx of persian gold that resulted in a widespread inflation. There was a lot of gold coin depreciation (natural fall in value). Money lost its value by almost fifty times, with an inflation of 4 percent for over a century.   

In the 16th century as gold and silver coins poured in from the America into Europe, there was a massive rise in almost all prices. This brought in the idea that as the total amount of money in circulation rose, the prices rose with it. Henry Thornton in 1802, wrote about how the total volume of money circulating in the economy rose, it brought inflation with it.

The quantity theory of money had a resurgence in the 1970’s when Milton Friedman provided a strong theory and advocated monetary targeting. The hype died down by the 1980’s, but its prominence remained. As of today, most central banks do not adopt monetary targeting or attempt to focus so much on the money supply, but there is still a tendency to bring in this theory in modern economic debate.

The Quantity Theory of Money

An economic theory which states that there is a direct positive relation between the change in money supply and the level of prices and goods and services sold. According to the theory if money supply in the economy doubles, prices will also double leading to inflation. The consumer therefore pays twice as much for the same good or service.

Increase in the supply of money causes a decrease in its marginal value(buying capacity of one unit of currency). This causes inflation to compensate for the decrease in marginal value.

CALCULATIONS

where M=Money Supply,

  V=Velocity of Money,

  P=Price Level,

          T=Real value of Total Transactions,

The basic equation for the theory is,

MV=PT                                                                           (Fischer Equation)

It is based on the equation of exchange,

Amount of Money Velocity of Circulation = Total Spending

       ASSUMPTIONS

The Quantity Theory of Money is based on several assumptions. In its most basic form it states that V and T are constant.

if V and T are constant;

MV=PT,

or %dMV=%dPT

or %dM +%dV=%dP+%dT

or

change in money supply =change in price level

These assumptions have been criticised a lot.

firstly, V is the velocity of circulation of money ie the number of times money changes hands.It depends on consumer and business spending impulses and therefore cannot be constant. In reality V depends on the ease of borrowing and access to credit. When credit cards were first introduced the value of V rose, causing general price rise.

The real value of transactions T depends on labour, capital, knowledge and enterprise. The theory assumes an economy at equilibrium and at full employment. Sometimes T is written as Y or national income since national income equals national expenditure. T is assumed equal to national expenditure since the total real value of all transactions is almost equal to the expenditure on final goods and services.

Monetarist Economics

Monetarists say that a rapid increase in money supply will lead to a rapid increase in prices of goods leading to inflation. This is because money surpasses the production output of goods and there is too much money for too little output. In order to curb inflation money growth must fall below economic output growth.

Monetarists believe that the money supply should be kept within an accepted range so that inflation can be controlled. In the short run an increase in money supply can provide a quick boost to an economy in need of an increase in production levels. However its effect on the long term is still not clear. Instead of various government economic policies it is better to let non inflationary policies like gradual reduction in money supply lead an economy to full employment.

Keynes challenged the theory in 1930. He said that an increase in money supply led to a decrease in velocity of circulation.Thus velocity could change in response to changes in money supply. It was confirmed by many economists afterwards that Keynes was right.

The theory was very popular in the 1980s especially in USA and Great Britain. Leaders tried to apply the principles to their economic framework. However later it was agreed that a controlled money supply was not always the solution to economic problems regarding production output and inflation.

-Pranjal, Noyonika Presidency University