Quantity theory of money
The Quantity Theory of Money is an economic model that posits a direct relationship between the money supply in an economy and price levels. According to this theory, an increase in the money supply leads to inflation, while a decrease results in deflation. Originating in the sixteenth century, it was notably informed by early observations of price changes following the influx of precious metals from the New World to Europe. The theory was further developed by various economists, including Jean Bodin and Henry Thornton, who highlighted that money growth must align with economic output to avoid inflation.
A key mathematical formulation of this theory is the Fisher Equation, represented as MV = PT, where M is the money supply, V is the velocity of currency exchange, P is the average price level, and T is the volume of goods and services. While the theory has faced criticism, particularly from economists like John Maynard Keynes, it remains influential, especially regarding long-term economic trends. Contemporary examples illustrate its relevance, as seen during the 2008-2013 period in the U.S., where a significant increase in money supply did not correlate with expected inflation due to altered spending behaviors among consumers.
Quantity theory of money
The quantity theory of money is an economic model that suggests changes in the money supply in an economy produce proportional changes in prices. A higher supply of money results in higher prices (inflation), whereas a lower supply leads to lower prices (deflation).
The quantity theory of money was first proposed in the sixteenth century and has been revised numerous times. The theory relies on several assumptions regarding economic activity and has been shown to be more accurate over longer periods than in the short term.
Origins
The first form of monetary exchange in history was the barter system—a system where goods and services were exchanged for other goods or services. The first metal coins were used in China about 1000 BCE, and the first use of precious metals—gold, silver, and bronze—in coinage developed about 500 years later. By the late medieval period, gold and silver coins were common forms of currency and were used for trade between Europe and China. Chinese goods were valuable items in Europe, but the reverse was not true. As a result, much of Europe's supply of gold and silver migrated to China in the form of payment, and little returned. This resulted in the demand for money in Europe outpacing the supply.
The discovery of the New World in the late fifteenth century opened up a bounty of natural resources for European nations. New supplies of gold and silver were discovered in the Americas and shipped across the Atlantic to be minted into coins. Suddenly, gold and silver was flowing into Europe rather than out of it. By the beginning of the seventeenth century, Europe's money supply had significantly increased. Prices of good also skyrocketed, jumping by an estimated 300 to 400 percent.
In the late sixteenth century, French philosopher and economist Jean Bodin (1530-1596) was among the first to notice the relationship between the amount of gold and silver in circulation and the rise in prices. Other scholars built upon the theory and considered how trade practices and the speed of monetary circulation affected prices.
In 1802, English economist Henry Thornton (1760-1815) theorized that an increase in the money supply leads to higher prices but does not necessarily increase economic output. In this model, money growth that outpaces economic output fuels inflation; to curb this effect, money growth must equal or fall below economic output.
Fisher Equation
Economists in the twentieth century viewed money as a commodity, similar to oil, wheat, or sugar. They suggested that an increase in supply lowers prices, while a decrease raises them. In other words, if the quantity of money doubled, prices would also double and the value of money would be halved.
American economist Irving Fisher (1867-1947) developed a mathematical formula, the Fisher equation, to illustrate the quantity theory of money. This equation states that MV = PT, in which
- M stands for the money supply;
- V stands for the velocity of the currency exchange, or the rate at which money changes hands;
- P represents the average price level; and
- T is the volume of the transactions of goods and services.
The amount of money in the economy (M) multiplied by the velocity at which it is spent (V) is called total spending. The average price (P) multiplied by the volume of goods and services (T) is the total dollar value of an economy's output, or nominal gross domestic product (GDP).
For example, if an economy had a $100 money supply and that money changed hands four times, total spending would be $400. If the economy's volume of goods and services consisted of 100 units, the average price would have to be $4 to balance the equation. If the money supply grew to $200 and the V and T factors remained constant, the average price would rise to $8.
Assumptions and Criticism
The Fisher equation assumes that the velocity of exchange and the amount of goods produced remain stable—variables that often fluctuate in real life. Additionally, the number of goods produced depends on many factors, including labor costs, capital, and available resources. Consumers also sometimes decide to save money rather than spend it, which decreases the rate at which money changes hands. Finally, the theory assumes an economy is operating at full employment and is not undergoing a recession.
In the 1930s, English economist John Maynard Keynes (1883-1946) cast doubt on the theory by claiming an increase in money supply would lead to a slowdown in the velocity of circulation and consumers' real income would increase. Real income is income that takes into consideration the effects of inflation.
Most economists say the theory remains credible, however, because in the long run, fluctuating economic variables tend to even out.
Modern Applications
From 2008 to 2013, the money supply in the United States grew at an average of 33 percent. Factoring in the goods output and assuming money velocity was constant, the country should have experienced an inflation rate of 31 percent. However, the inflation rate in that period was less than 2 percent.
Economists account for this by pointing out the deep recession of 2008-2009. They say that Americans began saving money at this time instead of spending it. This produced a 4.4 velocity rate—the slowest on record. With less money in circulation, there was more of a demand for it, and its value remained higher, accounting for low inflation.
Bibliography
Ajuzie, Emmanuel I.S., et al. "Import Response and Inflationary Pressures in the New Economy: The Quantity Theory of Money Revisited." Journal of Business & Economics Research. Clute Institute, May 2008. Web. 10 March 2016. http://cluteinstitute.com/ojs/index.php/JBER/article/viewFile/2424/2471
Graff, Michael. "The Quantity Theory of Money in Historical Perspective." Canadian Economics Association. Canadian Economics Association, April 2008. Web. 10 March 2016. http://economics.ca/2008/papers/0256.pdf
Heakal, Reem. "What Is the Quantity Theory of Money?" Investopedia. Investopedia, LLC. Web. 10 March 2016. http://www.investopedia.com/articles/05/010705.asp
"The History of Money." PBS.org. Public Broadcasting System, 26 Oct 1996. http://www.pbs.org/wgbh/nova/ancient/history-money.html
Wen, Yi, and Maria Arias. "What Does Money Velocity Tell Us about Low Inflation in the U.S.?" Federal Reserve Bank of St. Louis. Federal Reserve System, 1 Sept 2014. Web. 10 March 2016. https://www.stlouisfed.org/On-The-Economy/2014/September/What-Does-Money-Velocity-Tell-Us-about-Low-Inflation-in-the-US