Monday, March 3, 2014

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,
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.

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


  1. I don't think monetarists deny that causation can run from left to right - they just think that the appropriate policy response is to use M to optimize.

    Suppose the CB is targeting MV. P starts to rise.. At the existing target rate M will increase ("endogenously") in response. Market Monetarists believe that the appropriate response would be raise the interest rate target in order to bring MV back to target.

    You may disagree that this is the optimum policy - but it does show that "endogenous" changes to M are part of the monetarist model.

    1. "right to left" not "left to right"

    2. Doesn't raising the interest rate target tend to raise govt interest payments in the medium to long term. This would make the policy somewhat self defeating as more M is provided through this channel?