## Sunday, March 2, 2014

### 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 = kd PY,
where
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)
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 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.
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.

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

A central bank in non ZLB times can increase the qty of base money simply by lowering its target interest rates.

This increase in the money supply will lead to an increase in MV (people will spend more in nominal terms) unless you think an increase in M will lead to proportional decrease in V.

This increase in spending will result in an increase in PQ (either prices or qty sold or both will increase).

Unless you think that prices are totally inflexible and only Q will increase then doesn't the above demonstrate how the qty theory explains price increases ?

1. You mean the direction of causation is:

lower interest rates → more demand for credit → increase in broad money (bank money/credit money) → banks demand more high powered money when they need to clear more obligations → central bank supplies high powered money
---------------------

The direction of causation is the opposite of what the QT postulates.

Thanks for proving my point!

2. Lowering the target rate doesn't directly increase the demand for credit, it just makes banks more likely to lend at a lower interest rate, which will expand the money supply and lead to an increase in prices as explained by the qty theory.

An even simpler example of the qty theory in practice would be the govt running a deficit. This increases people's income (and M unless fully offset by bond-selling), People spend some of this increased Income (which increases MV) which must by definition increase PQ. Again unless you believe that prices are totally inflexible then this increase in PQ will result in both P and Q increasing.

BTW: I think what post-Keynesians tend to focus on is that changes in V or P can led to "endogenous" changes in M. This is true but only part of the full picture which also includes changes in M leading to changes in the other variables.

3. "Lowering the target rate doesn't directly increase the demand for credit, it just makes banks more likely to lend at a lower interest rate, which will expand the money supply and lead to an increase in prices as explained by the qty theory."

No, the part in bold does not follow.

And you've already made a massive concession here: money supply is mostly determined by demand for credit.

As for prices increasing in the way the QT predicts, no, that shows utter ignorance of markup pricing, capacity utilization and inventory use. Then even in flexprice markets we must add Cantillon effects.

The major causes of price increases in fixprice markets are changes in total average unit costs and changes in the mark-up, not changes in the money supply.

The QT is intellectually bankrupt: there is no way around it.

4. So just to be clear:

You are asserting that QT is bankrupt and that Increases in the money supply caused by either monetary policy or fiscal policy will (other things equal) NOT lead to an increase in P.

Is that correct ? If so then perhaps it is your analysis that is bankrupt.

The empirical fact that prices are "sticky" is one of the reasons that monetary policy works. (an increase in AD via monetary expansion will tend to affect Q more than P). Cost+markup pricing may be a good explanation for stick prices.

But to deny that there is NO correlation between M and P seems extreme and would need either

1) 100% fix price markets and unlimited availability of resources
or
2) unlimited demand to hold new money

to be true.

5. Your argument has rather a large hole in it Rob.

"Lowering the target rate doesn't directly increase the demand for credit, it just makes banks more likely to lend at a lower interest rate, which will expand the money supply"

But the money supply is not expanded here, we might see an increase in the demand for credit, leading to additional credit and an expansion of the money supply. Note the mechanism here is definitely credit based lending leading to an expansion in the money supply. This brings us to the second part,

"You are asserting that QT is bankrupt and that Increases in the money supply caused by either monetary policy or fiscal policy will (other things equal) NOT lead to an increase in P."

But there is not an increase in the money supply, just a drop in the cost of borrowing. Through the mechanism of lending, we can no longer have all other things equal, even if we exclude all other changes in the economy there have already been investment decision changes leading to the decision to borrow (and lend). The increase in the money supply is irrelevant, and any correlation between it and the price level is almost certainly a consequence of the expansion in credit due to price (or capacity utilisation changes).

2. Re direction of causation, there is a very common analysis that goes: changes in the demand and supply of credit cause changes in the money supply, which in turn cause changes in aggregate demand and NGDP. This is consistent with the QTM and, in fact, it is the way many monetarists would see things. However, a number of post-Keynesians appear to take the same view. They talk about endogenous money, as if it only refers to the relationship between credit and money (which I think is actually the less contentious part), and are quite happy to accept the QTM version of the relationship between money and demand. I take it you don't fall in to that camp.

1. "The increase in the money supply is irrelevant, and any correlation between it and the price level is almost certainly a consequence of the expansion in credit due to price (or capacity utilisation changes)."

Forget interest rates policy. If the govt just gave money away on street corners this would probably lead to an increase in prices. This would also be an example of the qty theory in action.

2. oops, obviously hit wrong reply button. meant for Nie

3. "If the govt just gave money away on street corners this would probably lead to an increase in prices. This would also be an example of the qty theory in action."

But how often does that happen?! -- you're literally saying the QT would work if the government regularly printed up notes and gave the money away for free (with no need for debt) for people to spend! Hoist on your own petard...

Of course, if governments regularly monetised deficits and spent this money directly into the economy, you might have some case for the conventional direct of causation too to the extent the money affected fixprice markets. But how often does such a thing happen?

4. I think this is an interesting case, say the govt lowered income tax rates, this has the same effect as giving money away on street corners but its more common. I agree there is an increase in the money supply (actually peoples income, relative to not changing the tax rate a larger govt deficit) but I don't see any reason to conclude from this that businesses would put prices up as a result. In the current environment and even in a pre recession environment there is plenty of spare capacity in many fixed price businesses and many businesses would want to make more sales as a result.

As far as I see this can only be an empirical result, and there is no mechanism that I understand to imply it, though if there is full capacity utilisation I understand empirically this can be observed to cause inflation. It the mechanism is people believe its inflationary, therefore it is, then I don't see any evidence this is empirically true. Most people don't even realise what a deficit is, or know its size, so why anybody thinks your average economic denizen will regularly draw more sophisticated conclusions about it is beyond me.

LK govts 'monetise' their deficits it happens all the time. This implies its not inflationary
http://bilbo.economicoutlook.net/blog/?p=352. Note I put monetise in quotes there for a reason because its not really monetisation in the traditional sense.

5. I think the point is that conventional monetary/fiscal policy (of which giving money away is a very basic example) affects PQ largely (but not totally) by changing M.

Monetary/fiscal policy is normally used to counteract "endogenous" reasons for changes in M.

I understand that Post-Keynesian think that mainstream economists neglect the fact that M can change endogenously. However I don't think this is relevant to the equation of exchange. As Joan Robinson says it just means you sometimes have to read it from right to left in order to see what is going on in the economy.

6. "which will expand the money supply and lead to an increase in prices as explained by the qty theory"

We are still waiting for the explanation for why changes in M must lead to a related change in the price level. All we have seen is repeated assuming of the conclusions of the quantity theory, an argument which doesn't cut it.

My understanding of the supposed mechanism is that, it is firms must be price takers, this must be due to price taking behaviour being profit maximizing. Then firm prices are driven by demand and changes in spending which are driven by changes in income (just looking at the more reasonable tax cut examples).

This is strongly contradicted by the existence of wide spread fixed price markets, as in this case changes in demand do not push directly on the pricing mechanism. There is other evidence against at other points in the chain of reasoning.

3. Nie,

On "http://bilbo.economicoutlook.net/blog/?p=352. "

I don't disagree with too much in that post actually. Both fiscal and monetary policy can increase M and this will in turn increase PQ. It is quite likely that in a recession the P part will increase less than the Q part (that's why these policies are meant to work work!). But eventually that will reverse , and if you keep increasing M then inflation will increase and eventually lead to hyperinflation.

1. If your take away from this post is that increases (or decreases) in M will directly effect PQ, then you may need to read it again.

The main point and the point I was making to LK is that just as QE is not causally inflationary, soaking up excess reserves by govt bond issuance (which the treasury does, as well as the central bank) is not causally deflationary. This implies that there is no difference in inflation pressures between govt issuing debt and not issuing debt, especially if the target rate is at 0.

Also its quite clear that the link between monetary policy is quite complex, and adjusting the interest rate doesn't increase M directly but the money supply may increase (or decrease) through credit lending. This doesn't work anything like the quantity theory describes.

4. The main problem seems to be assuming that all that composes M is in motion.

It isn't. Much of what is traditionally viewed as M is static as a stock - as monetary savings, cash in wallets, etc.

For me the problem is describing the flow represented by MV as 'MV'. I think that's decomposition is too simplistic and flawed to be meaningful.

You'll notice that we're trapped by the framing. Only ever discussing the four letters and never 'Are four letters enough?'.