Monetary economics is a branch of economics that studies different theories of money. One of the primary research areas for this branch of economics is the quantity theory of money (QTM). According to the quantity theory of money, the general price level of goods and services is proportional to the money supply in an economy. While this theory was originally formulated by Polish mathematician Nicolaus Copernicus in 1517, it was popularized later by economists Milton Friedman and Anna Schwartz after the publication of their book, "A Monetary History of the United States, 1867-1960," in 1963.

According to the quantity theory of money, if the amount of money in an economy doubles, all else equal, price levels will also double. This means that the consumer will pay twice as much for the same amount of goods and services. This increase in price levels will eventually result in a rising inflation level; inflation is a measure of the rate of rising prices of goods and services in an economy.

The same forces that influence the supply and demand of any commodity also influence the supply and demand of money: an increase in the supply of money decreases the marginal value of money–in other words, when the money supply increases, but with all else being equal or ceteris paribus, the buying capacity of one unit of currency decreases. As a way of adjusting for this decrease in money's marginal value, the prices of goods and services rises; this results in a higher inflation level.

Key Takeaways

  • One of the primary research areas for the branch of economics referred to as monetary economics is called the quantity theory of money.
  • According to the quantity theory of money, the general price level of goods and services is proportional to the money supply in an economy—assuming the level of real output is constant and the velocity of money is constant.
  • The same forces that influence the supply and demand of any commodity also influence the supply and demand of money: an increase in the supply of money, ceteris paribus
  • , decreases the marginal value of money so that the buying capacity of one unit of currency decreases.
  • Many Keynesian economists remain critical of the basic tenets of the quantity theory of money and monetarism, and challenge the assertion that economic policies that attempt to influence the money supply are the best way to address economic growth.
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What Is The Quantity Theory Of Money?

What Is the Quantity Theory of Money?

The quantity theory of money (QTM) also assumes that the quantity of money in an economy has a large influence on its level of economic activity. So, a change in the money supply results in either a change in the price levels or a change in the supply of goods and services, or both. In addition, the theory assumes that changes in the money supply are the primary reason for changes in spending.

One implication of these assumptions is that the value of money is determined by the amount of money available in an economy. An increase in the money supply results in a decrease in the value of money because an increase in the money supply also causes the rate of inflation to increase. As inflation rises, purchasing power decreases. Purchasing power is the value of a currency expressed in terms of the amount of goods or services that one unit of currency can buy. When the purchasing power of a unit of currency decreases, it requires more units of currency to buy the same quantity of goods or services.

Throughout the 1970s and 1980s, the quantity theory of money became more relevant as a result of the rise of monetarism. In monetary economics, the chief method of achieving economic stability is through controlling the supply of money. According to monetarism and monetary theory, changes in the money supply are the main forces underpinning all economic activity, so governments should implement policies that influence the money supply as a way of fostering economic growth. Because of its emphasis on the quantity of money determining the value of money, the quantity theory of money is central to the concept of monetarism.

Calculating QTM

The quantity theory of money proposes that the exchange value of money is determined like any other good, with supply and demand. The basic equation for the quantity theory is called The Fisher Equation because it was developed by American economist Irving Fisher. In it's simplest form, it looks like this:

( M ) ( V ) = ( P ) ( T ) where: 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 \begin{aligned} &(M)(V)=(P)(T)\\ &\textbf{where:}\\ &M=\text{Money Supply}\\ &V=\text{Velocity of circulation (the number of times }\\&\text{money changes hands)}\\ &P=\text{Average Price Level}\\ &T=\text{Volume of transactions of goods and services}\\ \end{aligned} (M)(V)=(P)(T)where:M=Money SupplyV=Velocity of circulation (the number of times money changes hands)P=Average Price LevelT=Volume of transactions of goods and services

Some variants of the quantity theory propose that inflation and deflation occur proportionately to increases or decreases in the supply of money. Empirical evidence has not demonstrated this, and most economists do not hold this view.

A more nuanced version of the quantity theory adds two caveats: 

  1. New money has to actually circulate in the economy to cause inflation.
  2. Inflation is relative—not absolute.

In other words, prices tend to be higher than they otherwise would have been if more dollar bills are involved in economic transactions.

Monetarism

According to monetarists, a rapid increase in the money supply can lead to a rapid increase in inflation. This is because when money growth surpasses the growth of economic output, there is too much money backing too little production of goods and services. In order to curb a rapid rise in the inflation level, it is imperative that growth in the money supply falls below the growth in economic output.

When monetarists are considering solutions for a staggering economy in need of an increased level of production, some monetarists may recommend an increase in the money supply as a short-term boost. However, the long-term effects of monetary policy are not as predictable, so many monetarists believe that the money supply should be kept within an acceptable bandwidth so that levels of inflation can be controlled.

Instead of governments continually adjusting economic policies through government spending and taxation levels, monetarists recommend letting non-inflationary policies–like a gradual reduction of the money supply–lead an economy to full employment.

Keynesianism

Many Keynesian economists remain critical of the basic tenets of the quantity theory of money and monetarism, and challenge the assertion that economic policies that attempt to influence the money supply are the best way to address economic growth.

Keynesian economics is a theory of economics that is primarily used to refer to the belief that the government should use activist stabilization and economic intervention policies in order to influence aggregate demand and achieve optimal economic performance. John Maynard Keynes was a British economist who developed this theory in the 1930s as part of his research trying to understand, first and foremost, the causes of the Great Depression. At the time, Keynes advocated for a government response to the global depression that would involve the government increasing their spending and lowering their taxes in order to stimulate demand and pull the global economy out of the depression.

In the 1930s, Keynes also challenged the quantity theory of money, saying that increases in the money supply actually lead to a decrease in the velocity of money in circulation and that real income–the flow of money to the factors of production–increased. Therefore, the velocity of money could change in response to changes in the money supply. In the years since Keynes' made this argument, other economists have proved that Keynes' contention with the quantity theory of money is, in fact, accurate.

Some of the tenets of monetarism became very popular in the 1980s in both the U.S. and the U.K. Leaders in both of these countries, such as Margaret Thatcher and Ronald Reagan, tried to apply the principles of the theory in order to achieve money growth targets for their countries' economies. However, it was revealed over time that strict adherence to a controlled money supply did not provide a solution for economic slowdowns.

According to Keynesian economists, inflation comes in two varieties: demand-pull and cost-push. Demand-pull inflation occurs when consumers demand goods, possibly because of the larger money supply, at a rate faster than production. Cost-push inflation occurs when the input prices for goods tend to rise, possibly because of larger money supply, at a rate faster than consumer preferences change.