Sunday, July 18, 2010

The Quantity Theory of Money: A Critique

The quantity theory of money is widely used to predict that increases in the money supply lead to a direct, mechanistic increase in the price level. Keynes had strong criticisms of the quantity of money equation, and Post Keynesians have made even stronger attacks on the theory.

The quantity theory of money assumes that there is a direct, proportional relationship between the money supply and the inflation rate or price level.

Recent empirical work on whether this is actually true has not been kind to the quantity theory:
“The quantity theory of money is based on two propositions. First, in the long run, there is proportionality between money growth and inflation, i.e., when money growth increases by x% inflation also rises by x% .... We subjected these statements to empirical tests using a sample which covers most countries in the world during the last 30 years. Our findings can be summarised as follows. First, when analysing the full sample of countries, we find a strong positive relation between the long-run growth rate of money and inflation. However, this relation is not proportional. Our second finding is that this strong link between inflation and money growth is almost wholly due to the presence of high-inflation or hyperinflation countries in the sample. The relation between inflation and money growth for low-inflation countries (on average less than 10% per year over 30 years) is weak, if not absent” (De Grauwe and Polan 2005: 256).
First, for countries with inflation rates less than 10% (which is most of the developed world), the empirical evidence for the quantity theory of money is either very weak or just non-existent. This is a serious blow to the quantity theory.

Secondly, although countries with high-inflation or hyperinflation show a correlation between the growth rate of money supply and inflation, contrary to the quantity theory, that relation is not proportional. A further blow to the quantity theory is that, in very high inflation countries, inflation rates exceed the growth rates of the money supply, because the velocity of circulation of money increases with high inflation rates (De Grauwe and Polan 2005: 257). This instability in the velocity of circulation is contrary to the quantity theory, which posits a stable velocity of circulation, as we will see below. Finally, De Grauwe and Polan reach the conclusion:
“Our results have some implications for the question regarding the use of the money stock as an intermediate target in monetary policy …. The ECB bases this strategy on the view that ‘‘inflation is always and everywhere a monetary phenomenon.’’ This may be true for high-inflation countries. Our results, however, indicate that there is no evidence for this statement in relatively low-inflation environments … In these environments, money growth is not a useful signal of inflationary conditions, because it is dominated by ‘‘noise’’ originating from velocity shocks. It also follows that the use of the money stock as a guide for steering policies towards price stability is not likely to be useful for countries with a history of low inflation” (De Grauwe and Polan 2005: 258).
We can now move on to the theory itself. There are actually three versions of the quantity theory (the following account is based on Thirlwall 1999). First, Irving Fischer’s equation of exchange provides a widely-cited version of the theory, as follows:
Equation 1: MV = PT

M = quantity of money;
V = velocity of circulation of money;
T = volume of all transactions (both involving intermediate goods and financial assets);
P = average price of the transactions.
For an increase in M to lead to a proportional increase in P, both V and T must be assumed to be stable.

The second version is the income quantity theory of money, as follows:
Equation 2: MV = PY

V = income velocity of circulation of money, not the total velocity;
Y = the volume of all transactions that enter into the value of national income (goods and services).
It can be seen that Y replaces T in the second equation, and P is therefore the average price of goods and services. V and Y must be constant for the money supply to induce equal or proportional changes in the price level.

Yet a third version of the quantity theory of money is the Cambridge Cash Balance equation:
Equation 3: M = kd PY

Here kd is the demand to hold money per unit of money income. M and P are causally related, if kd and Y are constant (Thirlwall 1999). This version of the quantity theory was used by Milton Friedman.
It can be seen that V (whether it is regarded as the velocity of circulation of money as in equation 1, or the income velocity of circulation of money as in equation 2) or kd must be constant for the quantity theory of money to work, as must T (in equation 1) or Y (in equations 2 and 3).

Keynes correctly argued that neither kd nor Y is constant. Pre-Keynesians assumed that Y was constant because of their foolish belief that a free market economy was nearly always in, or moving towards, equilibrium (i.e., full employment and full use of resources). By contrast, Keynes, in his criticism of equation 3, argued that in the absence of full employment, Y will not be constant. Thus the theory breaks down, especially in a recession, depression or even in periods during expansions in the business cycle where full employment is not reached. The neoclassicals also assumed that V was constant because they only accepted the transactions demand for money. Keynes, however, showed that there are three motives for holding money: (1) the transactions motive, (2) the speculative motive, and the (3) precautionary motive.

Keynes thus rejected the idea that there is a direct and proportional relationship between the money supply and the price level. Instead, Keynes argued that the money supply influences the price level indirectly through its effects on the interest rate, income, output, employment and investment. Moreover, prices are also influenced by the costs of production. It is only when there is full employment and full use of resources that money supply increases could then increase the price level in the way the quantity theory predicts.

We can carry Keynes’s critique even further by adding Post Keynesian criticism of the quantity theory.

In reality, the quantity theory also makes an assumption that is fundamentally false. The quantity theory assumes this:
(1) an exogenous money supply;
(2) a stable V or kd in equation (3) above;
(3) a stable Y in equations (2) and (3) above, and
(4) equilibrium or near equilibrium (high capacity utilization/high employment).
First, we have already seen that (2) and (3) are false. The velocity of money is unstable, subject to shocks and moves pro-cyclically (Leo 2005). If the economy is not at full employment (and has less than full capacity utilization), then Y will actually rise as income rises, and the price level could remain stable in the face of this rising money supply/income.

Secondly, what about (1)? Neoclassical Keynesians accepted the idea of an exogenous money supply determined by the central bank (as did Keynes himself), and notably Keynes never broke with the quantity theory of money fully, despite his criticisms. But today Post Keynesian economists have shown that we have an essentially endogenous money supply, so that assumption (1) is wrong. In a modern economy, money is endogenous in the sense that most money is credit money created by banks in response to demand for it from the private sector. As Steve Keen has argued,
“the point made by endogenous money theorists is that we don’t live in a fiat-money system, but in a credit-money system which has had a relatively small and subservient fiat money system tacked onto it …. Calling our current financial system a “fiat money” or “fractional reserve banking system” is akin to the blind man who classified an elephant as a snake, because he felt its trunk. We live in a credit money system with a fiat money subsystem that has some independence, but certainly doesn’t rule the monetary roost—far from it.”
Steve Keen, “The Roving Cavaliers of Credit,” Debt Watch, January 31st, 2009
Thirdly, in a recession capacity utilization is low and unemployment is high. The quantity theory also ignores imports in open economies, which can keep inflation low.

It follows that the quantity theory is thus fundamentally false. It can be noted that even Austrian economists reject it as a simplistic theory (see my post The Austrian Theory of Inflation: Myths and Reality).

The Austrians argue that changes in the level of prices depend very much on both real and monetary factors. This is essentially correct. In reality, whether inflation happens or not in an economy could be determined by real factors. Real factors that can overwhelm inflationary pressures from increasing demand when the money supply rises include:
1. the falling prices of specific goods through increasing productivity or output;
2. low capacity utilization rates;
3. a rise in cheaper imports into a country;
4. falls in the prices of imported basic commodities that are factor inputs;
5. changes in the velocity of circulation of money, and
6. level of employment (= level of demand for goods and services).
An appreciating exchange rate can also reduce inflationary pressures. Whether you get inflation or not in the face of rising money supply depends on the particular state of the economy at that time.

The quantity theory of money was the foundation of monetarism, the macroeconomic theory of Milton Friedman. Monetarism was tried in the US and the UK in the late 1970s and early 1980s, and failed miserably. In the case of the US, Paul Volcker adopted a monetarist policy at the Federal Reserve in October, 1979. He gave up direct targeting of the federal funds rate and wanted to control the growth rate of M1 by directly targeting the growth rate of nonborrowed-reserves. According to the quantity theory, the central bank had the power to exogenously set the money supply and thus control inflation. But the result was a catastrophe. The Federal Reserve was utterly unable to achieve its reserve target or M1 target. This provides strong empirical evidence that broad money supply is endogenous. In October 1982, Volcker abandoned monetarism and returned to a discretionary interest rate policy. Inflation was brought under control because the monetarist disaster caused the federal funds rate to surge to 20%, which caused a crippling recession and demand contraction (as well as a heavy blow to US manufacturing and the Third World debt crisis). The fiction that the Federal Reserve controls the growth rates of monetary aggregates officially ended in 1993, but in practice had ended in 1982. In a 2003 interview with the Financial Times, even Friedman himself admitted that monetary targeting as a central bank policy was a failure:
prepare to be amazed: Milton Friedman has changed his mind. “The use of quantity of money as a target has not been a success,” concedes the grand old man of conservative economics. “I’m not sure I would as of today push it as hard as I once did.
Simon London, “Lunch with the FT – Milton Friedman,” Financial Times (7 June 2003)
Are there cases when the quantity theory of money can actually be a reasonable predictor of inflation? To do so, the economy in question must have these characteristics:
(1) an exogenous money supply;
(2) full or near full employment;
(3) high capacity utilization;
(4) relatively closed to trade;
(5) stable velocity of circulation.
In an astonishing paradox of history, it turns out that, along with price controls, some Marxist and Communist states used a version of the quantity theory of money to predict and control inflation (although how successfully is another question). One can also note that the centrally-planned Communist states were closer to fulfilling the conditions listed above than Western mixed, open economies. Most Communist states fulfilled (2), (3), (4) and arguably (1). Thus Communist states used a crude, short-run version of the quantity theory in planning (Portes 1978: 78; Burton 1980: 4).

Factors (1) to (5) above, however, do not generally apply to a modern developed open economy, so the quantity theory remains a poor method of predicting or explaining inflation.


Burton, J. 1980. “On Monetarism and Libertarianism,” Journal of the Libertarian Alliance 1.4 (Winter): 1–5.

Davidson, P. 2009. The Keynes Solution: The Path to Global Economic Prosperity, Palgrave Macmillan, New York.

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

Galbraith, J. K. 2008. “The Collapse of Monetarism and the Irrelevance of the New Monetary Consensus,” The Levy Economics Institute of Bard College Policy Note, 2008

Leo, P. 2005. “Why does the Velocity of Money move Pro-cyclically?,”International Review of Applied Economics 19.1: 119–135.

London, S. 2003. “Lunch with the FT – Milton Friedman,” Financial Times (7 June).

Portes, R. 1978. “Inflation under Central Planning,” in F. Hirsch and J. H. Goldthorpe (eds), The Political Economy of Inflation, Martin Robertson, London.

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

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