Joan Robinson on the Quantity Theory of Money

Joan Robinson (1970) is a short but perceptive paper on the quantity theory of money and its problems.

First, consider the equation of exchange:

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

Is T to include (1) all transactions in, say, a year or (2) only those that are connected with real GDP? (Robinson 1970: 504). The Cambridge Cash Balance equation remedies the confusion, and P is an index of prices suitably constructed as appropriate to the type of transactions in T (Robinson 1970: 504). But is not new money also spent, for example, on purchases of assets on secondary financial asset markets? How does this affect the equation? (one modern economist who defends the quantity theory tries to address the problem in this talk, with a Post Keynesian critique following).

Furthermore, the quantity theory has been interpreted to mean that changes in the quantity of money produce a proportionate change in the price level (Robinson 1970: 505), something which is mostly untrue.

And then there is the fundamental problem: the direction of causation in the relationship between money supply and real output:

“The correlations to be explained [sc. in the relationship between money supply and real output] could be set out in quantity theory terms if the equation were read right-handed. Thus we might suggest that a marked rise in the level of activity is likely to be preceded by an increase in the supply of money (if M is widely defined) or in the velocity of circulation (if M is narrowly defined) because a rise in the wage bill and in borrowing for working capital is likely to precede an increase in the value of output appearing in the statistics. Or that a fall in activity sharp enough to cause losses deprives the banks of credit-worthy borrowers and brings a contraction in their position. But the tradition of Chicago consists in reading the equation from left to right. Then the observed relations are interpreted without any hypothesis at all except post hoc ergo propter hoc.

There is an unearthly, mystical element in Friedman’s thought. The mere existence of a stock of money somehow promotes expenditure. …. The general implication of Friedman’s doctrines is that money is very important, not as a symptom but as a cause of instability. …

… the essence of the quantity theory is that there is a definable and recognizable quantity, M, the movements of which have a powerful influence upon the movements of PT. In short, the whole argument of both [sc. of the two main monetarist] schools [sc. of Friedman and Henry C. Simons] consists in reading the quantity equation from left to right instead of from right to left.” (Robinson 1970: 510–511).

This has always been the severe problem with the quantity theory.

That is, in contrast to monetarist and conventional neoclassical interpretations, the fundamental causal relationship is actually running from

(1) business demand for credit (to pay for goods and labour factor inputs, whose prices may have risen against previous production periods) + demand for demand deposits

→ (2) increases in broad money

→ (3) banks’ demand for more reserves (high-powered money) when they need to clear obligations.

→ (4) the central bank creates the needed reserves.

Changes in the general price level are a highly complex result of many factors, and not some simple function of money supply.

Further Reading
“Hans Albert on the Quantity Theory of Money,” March 2, 2014.

“The Quantity Theory of Money is Wrong,” August 7, 2013.

“Some Empirical Evidence on Endogenous Money,” May 27, 2013.

“Richard Werner on ‘The Quantity Theory of Credit,’” April 13, 2013.

“Empirical Evidence on Endogenous Money,” August 10, 2013.

“The Quantity Theory of Money: A Critique,” July 18, 2010.

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

Hans Albert on the Quantity Theory of Money

I continue with a topic from Albert et al. (2012): the quantity theory of money.

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,
where
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 = k_d PY,
where
M = quantity of money;
k_d = 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)

A number of assumptions have to be made for the quantity theory to explain changes in the price level:

(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.

(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 k_d 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.

So how realistic are these assumptions?

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.

(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).

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.

BIBLIOGRAPHY
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.