What is the Quantity Theory of Money?

The quantity theory of money is a theory that variations in price relate to variations in the money supply. The most common version, sometimes called the "neo-quantity theory" or Fisherian theory, suggests there is a mechanical and fixed proportional relationship between changes in the money supply and the general price level. This popular, albeit controversial, formulation of the quantity theory of money is based upon an equation by American economist Irving Fisher.

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What Is The Quantity Theory Of Money?

Understanding the Quantity Theory of Money

The Fisher equation is calculated as:

M×V=P×Twhere:M=money supplyV=velocity of moneyP=average price levelT=volume of transactions in the economy\begin{aligned} &\text{M} \times \text{V} = \text{P} \times \text{T} \\ &\textbf{where:} \\ &\text{M} = \text{money supply} \\ &\text{V} = \text{velocity of money} \\ &\text{P} = \text{average price level} \\ &\text{T} = \text{volume of transactions in the economy} \\ \end{aligned}M×V=P×Twhere:M=money supplyV=velocity of moneyP=average price levelT=volume of transactions in the economy

Generally speaking, the quantity theory of money assumes that increases in the quantity of money tend to create inflation, and vice versa. For example, if the Federal Reserve or European Central Bank (ECB) doubled the supply of money in the economy, the long-run prices in the economy would tend to increase dramatically. This is because more money circulating in an economy would equal more demand and spending by consumers, driving prices north.

Economists disagree about how quickly and how proportionately prices adjust after a change in the quantity of money. The classical treatment in most economic textbooks is based on the Fisher Equation, but competing theories exist.

Key Takeaways

  • The quantity theory of money is a framework to understand price changes in relation to the supply of money in an economy. It assumes an increase in money supply creates inflation and vice versa.
  • The Irving Fisher model is most commonly-used to apply the theory. Other competing models were formulated by British economist John Maynard Keynes and Swedish economist Knut Wicksell.
  • The other models are dynamic and posit an indirect relationship between money supply and price changes in an economy.

The Irving Fisher Model

The Fisher model has many strengths, including simplicity and applicability to mathematical models. However, it uses some spurious assumptions to generate its simplicity, including an insistence on proportional increases in the money supply, variable independence and emphasis on price stability.

Monetarist economics, usually associated with the Chicago school of economics, advocate the Fisher model. From their interpretation, monetarists often support a stable or consistent increase in money supply. While not all economists accept this view, more economists accept the monetarist claim that changes in the money supply cannot affect the real level of economic output in the long run.

Competing Quantity Theories

Keynesians more or less use the same framework as monetarists, with few exceptions. John Maynard Keynes rejected the direct relationship between M and P, as he felt it ignored the role of interest rates. Keynes also argued the process of money circulation is complicated and not direct, so individual prices for specific markets adapt differently to changes in the money supply. Keynes believed inflationary policies could help stimulate aggregate demand and boost short-term output to help an economy achieve full employment.

The most serious challenge to Fisher came from Swedish economist Knut Wicksell, whose theories developed in continental Europe, while Fisher's grew in the United States and Great Britain. Wicksell, along with later writers such as Ludwig von Mises and Joseph Schumpeter, agreed that increases in the quantity of money led to higher prices. However, an artificial stimulation of the money supply through the banking system would distort prices unevenly, particularly in the capital goods sectors. This, in turn, shifts real wealth unevenly and could even cause business cycles.

The dynamic Wicksellian and Keynesian models stand in contrast to the static Fisherian model. Unlike the monetarists, adherents to the later models don't advocate a stable price level in monetary policy.