Quantity Theory of Money
What Is The Quantity Theory of Money?
The quantity theory of money is a simple economic theory that states that the price of goods and services is directly proportional to the amount of money in circulation.
In other words, if the money supply increases, then prices will also increase.
This theory is based on the idea that people will demand more goods and services when there is more money available to them.
How Does The Quantity Theory Of Money Work?
The quantity theory of money works by looking at the relationship between the supply of money and the price of goods and services.
When there is more money in circulation, people are able to buy more goods and services.
As a result, businesses must raise their prices in order to keep up with this increased demand.
Calculating QTM
The quantity theory of money can be represented by the equation:
M x V = P x Y
Where:
- M is the money supply
- V is the velocity of money (the number of times that money changes hands in a given period)
- P is the price level
- Y is real GDP or output
This equation simply states that the price level (P) is equal to the money supply (M) multiplied by the velocity of money (V), divided by real GDP (Y).
It’s important to note that this equation only holds true in the long run. In the short run, prices can change for a variety of reasons unrelated to the money supply or velocity of money.
However, in the long run, prices will eventually adjust to be in line with the money supply and velocity of money.
Monetarism
Monetarism is an economic theory that suggests that the money supply is the most important determinant of economic activity.
Monetarists believe that central banks should focus on controlling the money supply in order to manage inflation and stabilize the economy.
The quantity theory of money is a key part of monetarist thinking.
Friedman’s Equation Of Exchange
Milton Friedman was a well-known monetarist economist who popularized what’s known as the “equation of exchange”.
It’s also commonly called the Fisher equation, after early-20th century economist Irving Fisher, who inaugurated the school of thought now known as monetarism.
This equation states that: M x V = P x Y which is essentially the same as the quantity theory of money.
However, Friedman’s equation goes one step further by breaking down velocity into its two components:
- transactions velocity and
- turnover velocity
Transactions velocity is the number of times that money is exchanged in a given period for goods and services.
Turnover velocity is the number of times that money changes hands within a given period.
Friedman’s equation states that: M x Transactions Velocity = P x Y which simply means that the price level is determined by the money supply and transactions velocity.
What this equation implies is that if the central bank wants to stabilize prices, they need to control the money supply and transactions velocity.
Quantity Theory of Money – Irving Fisher
Keynesianism
Keynesianism is an economic theory that suggests that government spending is the most important determinant of economic activity.
Keynesians believe that the government should actively manage the economy in order to smooth out business cycles and reduce unemployment.
The quantity theory of money is not compatible with Keynesian thinking.
This is because Keynesians believe that prices are sticky in the short run, meaning that they do not adjust immediately to changes in the money supply.
As a result, Keynesians believe that changes in the money supply will only have an impact on economic activity in the long run.
This is why Keynesians are not concerned with controlling the money supply in order to manage inflation.
Instead, they believe that the government should use more fiscal policy (government spending) to actively manage the economy, such as deficit spending when necessary.
Implications Of The Quantity Theory Of Money
There are a few key implications of the quantity theory of money that you should be aware of.
Money supply increases can cause inflation
First, the quantity theory of money suggests that inflation is caused by an increase in the money supply.
This is because an increase in the money supply will lead to more money chasing the same amount of goods and services, which will bid up prices.
Money supply and inflation have a direct cause and effect.
Suggests central banks can control inflation by controlling the money supply
The quantity theory of money suggests that central banks can control inflation by controlling the money supply.
If the central bank wants to target a specific level of inflation, they can adjust the money supply accordingly.
Deflation can be caused by a decrease in the money supply
The quantity theory of money suggests that deflation (a decrease in prices) is caused by a decrease in the money supply.
This is because a decrease in the money supply will lead to less money chasing the same amount of goods and services, which will bid down prices.
Open market operations influence the money supply
Fourth, the quantity theory of money suggests that central banks can use open market operations to influence the money supply.
Open market operations are when the central bank buys or sells government securities in order to increase or decrease the money supply.
If the central bank wants to increase the money supply, they will buy government securities. This will inject more money into the economy and increase the money supply.
If the central bank wants to decrease the money supply, they will sell government securities. This will remove money from the economy and decrease the money supply.
If you understand how the money supply is shifting, you can understand future price movements
The price of anything is the money and credit spent on it divided by the quantity.
So if you know how much liquidity is being put into or taken out of the market, you can predict market movements.
Criticisms of the Quantity Theory of Money
Velocity
What economists call “velocity” is a misleading term created to explain how the amount of spending in a year (GDP) could be paid for by a smaller amount of money.
To explain the “velocity” relationship, they divided the amount of GDP by the amount of money (and most of what they call money is really credit) to convey the picture that money is going around at a speed of so many times per year.
The economy doesn’t work like that. Instead, much of spending is from credit creation, not money, and credit creation doesn’t need money to move around in order to occur.
Confusions between money and credit
Most of what central bankers call money through traditional measures – e.g., M1, M2 – is actually credit, which is something that has to be paid back.
This confuses the analysis of what is happening in an economy.
Knut Wicksell criticized the QTM, believing reality was closer to a “pure credit economy”.
Focus on the supply side and not the demand side
Ludwig von Mises criticized the QTM’s focus on the supply of money without doing enough to explain the demand for money.
He asserted that the QTM “fails to explain the mechanism of variations in the value of money”.
How the Quantity Theory of Money Can Inform Trading and Investment Decisions
The quantity theory of money is a simple but important economic theory that has a number of implications for the economy. Understanding how it works can help you make better decisions trading the markets.
Liquidity is primarily what drives markets.
When central banks lower interest rates and/or buy securities to expand money and credit, this goes into the purchase of financial assets, which impact their prices.
During a monetary expansion, this tends to be good for the prices of riskier assets, like stocks, commodities, and real estate.
Cash and bonds tend to do less well, which have low fixed yields.
Therefore, the QTM can provide insight into how central bank policy decisions may impact markets and asset prices.
For example, if the Fed were to expand the money supply through quantitative easing (QE), this would likely lead to higher stock prices.
Conversely, if the Fed were to contract the money supply by selling securities or raising interest rates, this could lead to lower stock prices.
So, the QTM can be used to inform trading and investment decisions by helping to anticipate how central bank policy changes may impact markets.
FAQs – Quantity Theory of Money
What is the quantity theory of money?
The quantity theory of money is an economic theory that states that there is a direct relationship between the money supply and inflation.
What is monetarism?
Monetarism is an economic theory that states that the money supply is the main driver of economic growth.
What is the difference between monetarism and Keynesian economics?
Keynesian economics is an economic theory that states that government spending is the main driver of economic growth.
Monetarism is an economic theory that states that the money supply is the main driver of economic growth.
Conclusion – Quantity Theory of Money
The quantity theory of money is a simple but intuitive economic theory that has a number of implications for central banks and the economy as a whole.
The theory states that there is a direct relationship between the money supply and inflation.
This means that if the central bank wants to control inflation, they need to control the money supply.
The theory also has implications for investment decisions, as it can help investors anticipate how central bank policy changes may impact markets and asset prices.