The Quantity Theory of Money is Wrong


The quantity theory of money is still at the heart of mainstream analysis of price movements and inflation.

In essence, there are two versions of theory:

(1) The Equation of Exchange: MV = PT,
M = quantity of money;
v = velocity of circulation;
P = general price level, and
T = total number of transactions.

(2) the Cambridge Cash Balance equation: M = kPY,
M = quantity of money;
k = demand for money;
P = general price level, and
Y = volume of all transactions in the value of national income.

Irving Fisher’s equation of exchange is actually not the basis of neoclassical monetary theory. Rather, the Cambridge cash balance equation is the more influential version of the theory (Flynn 1984). The Cambridge cash balance equation also replaces the velocity of circulation concept with the idea of the demand to hold money.

The worth of these equations and the quantity theory as a general theory of inflation are doubtful. (Of course, “inflation” must be understood in what follows as a general and sustained increase in prices as measured by a price index).

First, the contention that money stock increases induce direct and proportional changes in the price level is empirically questionable (De Grauwe and Polan 2005).

Secondly, there is the direction of causation. The quantity theory assumes the direction of causation runs from money supply increase to price rises.

At most, the quantity theory captures a basic truth that a sustained general increase in prices requires a growing money stock.

But, while a money supply increase is a precondition for this, it is also an intermediate factor, and not generally the cause of price inflation.

The fundamental causes of a general price inflation are still supply side factors (rises in wages or prices of factor input costs) or demand side ones (high demand causing price increases in flexprice markets).

The direction of causation in an endogenous money world is not, generally, from money supply increases to price increases, but from credit demand and price increases to money supply increases (King 2002: 166; Robinson 1970; Davidson and Weintraub 1973). The latter does provide an intermediate step whereby a larger money supply allows further price increases and sustained price inflation without causing macroeconomic problems induced by shortage of money and credit.

A rising broad money stock means that banks require more reserves for their clearing of debts and transactions conducted in bank credit money. Central banks provide those reserves.

Therefore the process runs:

credit money demand → broad money supply increase → base money increase. (Moore 2003: 118).

This should be quite clear because the money supply is endogenous: most of the money stock is “broad money” or bank money, and the major driver of the expansion of this type of money is credit expansion in the form of bank loans (the creation of ordinary demand deposits and saving accounts is also an important factor).

But what causes the demand for and changes in the level of bank loans?

For businesses, it is investment and often changes in factor input bills. Wage rises can be induced by wage bargaining and other institutional factors, and factor input prices generally rise because of administered pricing decisions or demand/supply dynamics in flexprice markets.

Conversely, when a severe price deflation occurs accompanied by a contraction in the money supply, the direction of causation between the two is highly complex. Falls in prices in both flexprice markets and even fixprice markets can be induced by severe demand collapses, administered price decisions, or falls in factor input prices. To the extent that credit growth is reduced by these factors, money supply growth from credit will also fall.

And an actual monetary contraction can also be the consequence of other factors such as a collapsing financial system, the contraction in broad money as credit money (or bank money) is destroyed as people scramble for the higher form of money (such as cash), and repayment of bank loans and debt further contracts broad money.

The issue is complicated by debates between Post Keynesian “horizontalists” and “structuralists” on the role of the interest rate and how credit supply is determined, but that need not concern me for the purposes of this post.

The idea that inflation is “always and everywhere a monetary phenomenon” is unacceptable because it assumes an exogenous money world and the wrong direction of causality.

This is why the solution to accelerating inflationary outbreaks in capitalist economies is:

(1) incomes policy, especially policies to stop excessive wage rises and wage–price spirals;
(2) price stabilisation of fundamental factor input prices through buffer stocks, and
(3) demand management.

Trying to control money supply growth rates, as in Friedmanite monetarism, is pointless, because (1) the direction of causation is backwards and (2) central banks do not have direct control over the rates of money supply growth anyway.

Davidson, Paul and Sidney Weintraub. 1973. “Money as Cause and Effect,” The Economic Journal 83.332: 1117–1132.

De Grauwe, P. and M. Polan. 2005. “Is Inflation Always and Everywhere a Monetary Phenomenon?,” Scandinavian Journal of Economics 107: 239–259.

Flynn, D. O. 1984. “Use and Misuse of the Quantity Theory of Money in Early Modern Historiography”, in E. van Cauwenberghe and F. Irsigler (eds.), Münzprägung, Geldumlauf und Wechselkurse: Akten des 8th International Economic History Congress, Section C7, Budapest 1982. Verlag Trierer Historische Forschungen, Trier. 383–417.

Ingham, Geoffrey K. 2004. The Nature of Money. Polity, Cambridge, UK and Malden, MA.

King, J. E. 2002. A History of Post Keynesian Economics since 1936. Edward Elgar Publishing, Cheltenham, UK and Northampton, MA.

Moore, B. 2003. “Endogenous Money,” in J. E. King, The Elgar Companion to Post Keynesian Economics. Edward Elgar, Cheltenham. 117–121.

Robinson, Joan. 1970. “Quantity Theories Old and New: Comment,” Journal of Money, Credit and Banking 2.4: 504–512.

Rogers, C. 1989. Money, Interest and Capital: A Study in the Foundations of Monetary Theory. Cambridge University Press, Cambridge.

Thirlwall, A. P. 1999. “Monetarism,” in P. A. O’Hara (ed.), Encyclopedia of Political Economy: L–Z (vol. 2). Routledge, London. 750–753

Smithin, J. 2012. “Inflation”, in J. E. King (ed.), The Elgar Companion to Post Keynesian Economics (2nd edn.). Edward Elgar, Cheltenham. 288–294.

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