Albert et al. (2012: 304) notes that the classical quantity theory of money holds that changes in the stock of money cause changes in the price level, and in extreme forms that the changes are proportional.
When this empirically testable version of the theory proved questionable, less stringent forms of the quantity theory were developed:
“Unfortunately, this [sc. Classical] theory has not proven to be successful, consequently it has been necessary to resort to a less demanding form of it. In the course of the development of economic thought, this form, too, has been abandoned in favor of what is known as the quantity or exchange equation, which maintains that the product of the amount of money and speed of money flow is identical to the product of the trade volume and the price level. However, as it is normally interpreted, this equation is analytic; thus the transition from the old quantity theory to the equation of exchange results in a tautology, and consequently a decrease in the informational content to zero, something which has by no means been noticed by all theoreticians.” (Albert et al. 2012: 304–305).Thus the stipulation of the quantity theory that the velocity of circulation and trade volume need to be held constant is akin to the ceteris paribus assumption of the law of demand.
In fact, matters are far worse than even Albert believes.
As Albert notes, two main versions of quantity theory are used:
(1) The Equation of Exchange: MV = PT,A number of assumptions have to be made for the quantity theory to explain changes in the price level:
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 = kd PY,
M = quantity of money;
kd = the amount of money held as cash or money balances;
P = general price level, and
Y = real value of the volume of all transactions entering into the value of national income (that is, goods and services)
(1) prices are flexible and respond to demand changes in either (1) both the short and long run, or (2) at least in the long run. Related to this is a tacit assumption that the economy is near equilibrium in the sense of full use of resources and high employment, where stocks and capacity utilization are not fundamental methods to deal with demand.So how realistic are these assumptions?
(2) money supply is exogenous;
(3) under the equation of exchange, for an increase in M to lead to a proportional increase in P, both V and T must be assumed to be stable.
Under the Cambridge Cash Balance equation, M and P are causally related, if kd and Y are constant (Thirlwall 1999).
(4) the direction of causation. The quantity theory assumes the direction of causation runs from money supply increase to price rises.
(5) in some extreme forms there is the assumption, following from (1), that money stock increases induce direct and proportional changes in the price level.
The answer is not very realistic at all:
(1) most prices are mark-up prices and relatively inflexible with respect to demand changes in both the short and long run. Most capitalist economies are far from full use of resources, and even in booms businesses make use of stocks and capacity utilisation to manage demand changes, rather than changes in prices.It follows that the quantity theory in most of its theoretical forms can only be made true by simply transforming it into an analytic a priori statement about a hypothetical world of marginal or near zero relevance to the real world.
(2) money supply is largely endogenous;
(3) The velocity of money and demand for money are unstable, subject to shocks and move pro-cyclically (Leo 2005; Levy-Orlik 2012: 170);
(4) the direction of causation. Under an endogenous system the direction of causation is generally from credit demand and price increases to money supply increases (Robinson 1970; Davidson and Weintraub 1973).
Therefore the direction of causation generally runs:credit/demand deposit money demand → broad money supply increase → base money increase. (Moore 2003: 118).This is true, as noted above, since 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 (1) credit expansion in the form of bank loans plus (2) the creation of ordinary demand deposits and saving accounts.
(5) that money stock increases necessarily or generally induce direct and proportional changes in the price level is empirically false (De Grauwe and Polan 2005).
Albert, Hans, Arnold, Darrell and Frank Maier-Rigaud. 2012. “Model Platonism: Neoclassical economic thought in critical light,” Journal of Institutional Economics 8.3: 295–323.
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.
Leo, P. 2005. “Why does the Velocity of Money move Pro-cyclically?,” International Review of Applied Economics 19.1: 119–135.
Levy-Orlik, N. 2012. “Keynes’s Views in Financing Economic Growth: The Role of Capital Markets in the Process of Funding,” in Jesper Jespersen and Mogens Ove Madsen (eds.), Keynes’s General Theory for Today: Contemporary Perspectives. Edward Elgar, Cheltenham. 167–185.
Moore, B. 2003. “Endogenous Money,” in J. E. King (ed.), 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.
Thirlwall, A. P. 1999. “Monetarism,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy: L–Z. Routledge, London and New York. 750–753.