Why is the Quantity Theory of Money Wrong and can Anything be Salvaged from it?

The quantity theory of money states that when the money supply expands or contracts, this is the cause – when other variables are constant – of proportional or equal changes in the price level.

In the quantity theory, the direction of causation therefore runs from the money supply to the price level, the money supply is assumed to be exogenous, and the money supply function independent in the sense described by Colin Rogers (1989: 244–245).

The standard form of the Cambridge Cash Balance Equation as used today is usually given as follows:

M = kPY or
M = k_d PY
where M = the quantity of money;
k or k_d = the amount of money held as cash or money balances;
P = the general price level;
Y = real value of the volume of all transactions entering into the value of national income (that is, goods and services).

In the Cambridge approach, the variable k was held to be superior to Irving Fisher’s “velocity of circulation” concept V, because, unlike V, k is supposed to be empirically measurable.

Therefore M and P are causally related, if k_d and Y are constant (Thirlwall 1999).

I will use the Cambridge Cash Balance Equation in what follows.

Post Keynesians say that the quantity theory is not true for modern advanced capitalist economies, where money is largely endogenous.

Perhaps it might be true for an economy with pure commodity money and an exogenous supply, as Colin Rogers (1989: 175, 244) argues, but even here the idea that the relationship between money supply and price level, even if k_d and Y are constant, must necessarily and always be proportional in a real world economy, as compared with an analytic mathematical equation true merely by definition, seems questionable.

Of course, advocates of the quantity theory will appeal to the econometric evidence. Doesn’t this prove their case? Not really. A review of the econometric evidence, as, for example, in a good study like Grauwe and Polan (2005) shows that it is a mixed bag, at best. Some studies show a proportional relationship (e.g., Vogel 1974), but others do not, but merely demonstrate a strong positive correlation (Grauwe and Polan 2005; McCandless and Weber 1995; Dwyer and Hafer 1988). Supporters of the quantity theory respond by saying that, if the data does not show a proportional relationship, then by definition k_d and Y must have changed. The trouble is that this starts to render the quantity theory a tautology – the sort of mathematical or analytic a priori statement immune from empirical verification or falsification, because it is not in fact an empirical statement at all.

In reality, there are deeper empirical criticisms of the quantity theory than the mixed evidence on proportionality, because the quantity theory requires certain prior assumptions for the theory to work.

But, before we get to these criticisms, what can be salvaged from the quantity theory?

It is true that the quantity theory captures some basic truths. These are as follows:

(1) a long-run, sustained price inflation does need a growing money supply to sustain it;

(2) so in view of (1), it is not at all surprising that the econometric literature often finds a strong or very strong positive correlation between the money supply changes and price level changes (Grauwe and Polan 2005; McCandless and Weber 1995; Dwyer and Hafer 1988).

(3) it is also true that deflations are often correlated with a falling money supply or decelerations in money supply growth.

To be clear, the issue is not whether an expanding money supply is necessary for a sustained, long-run price inflation. An expanding money supply is indeed a necessary, but not sufficient, condition for price inflation.

But when quantity theorists say that “inflation is always and everywhere a monetary phenomenon” (Friedman 1968: 98) they mean something more than just the basic ideas expressed above.

The crucial issues as raised by the quantity theory as part of its assumptions are:

(1) is the money supply exogenously determined, and is there an independent money supply function?

(2) is the assumption of long-run money neutrality as required for the quantity theory to work a realistic one? (It is true that some naïve versions of the quantity theory would assume even a short-run neutrality, but most modern neoclassical economists are realistic enough to recognise the strong degree of nominal price and wage rigidity that exists in modern economies, which, they admit, causes short-run money non-neutrality.)

(3) is the direction of causation as assumed in the quantity theory equation from left to right (that is, from the money supply to the price level)? That is to say, it is really an exogenously-determined money supply that is the fundamental cause, or driver, of price level changes?

A crucial issue is (1) above: is there an exogenous, independent money supply? Is it the primary, causal origin of changes in the price level?

Quantity theorists are asserting that a truly independent and exogenous money supply is the causal driver of inflation and deflation.

So why do Post Keynesians reject the quantity theory?

The first and most important point is that the modern money supply is endogenous.

What this means is that normally broad money creation is credit-driven. That is, most money is created by private banks and its quantity is determined by the private demand for it. This is the essence of endogenous money. In an endogenous money system, even the “monetary base” is normally endogenous too, given that the central bank must accommodate the banks’ demand for high-powered money to avoid financial crises and banking panics.

So what of question (1) above?

Post Keynesians contend that a truly independent money supply function does not actually exist in an endogenous money world, because credit money comes into existence because it has been demanded (Rogers 1989: 244–245). So the broad money supply is not independent of money demand, but can be demand-led (Ingham 2004: 53).

Next, what of question (2)?

There is considerable evidence that money can never be neutral, not even in the long run. The concept of neutral money holds that changes in the money supply will only affect nominal values (e.g., money prices, nominal money wages, etc.), not real variables (such as production, employment, and investment). Nevertheless, neoclassical economists accept the evidence that price and wage rigidity is a strong characteristic of the real world. They must then assume that prices and wages are sufficiently flexible in the long run, and that they really do adjust in the long period. The trouble is that there is little evidence for this. 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.

The mysterious long-run flexibility does not seem to be visible in the data, and the long run is just a sequence of short-run periods anyway.

A further complication is that nominal variables can also be found in contracts, such as debts, production orders, or forward contracts, but these are precisely the things that will not necessarily change when the money supply changes.

And, even if you assume an exogenous money supply, a direction of causation from left to right, and reasonably flexible prices, there will still be Cantillon effects, the phenomenon that price level changes caused by increases in the quantity of money depend on the way new money is injected into the economy, and actually where it affects prices first. That is to say, although prices rise as the exogenous quantity of money increases, contrary to the quantity theory of money, we should not expect prices to rise proportionally, but in a complex manner that depends on who received the money and how they spent it (this idea, as it happens, is used by Austrians as the basis of their own criticism of the quantity theory.)

Finally, what of question (3), concerning the direction of causation?

Under an endogenous money system, the direction of causation is generally from credit demand (via business loans to finance labour and other factor inputs) to money supply increases (Robinson 1970; Davidson and Weintraub 1973).

Therefore the direction of causation generally runs:

(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.

This crucial point about the direction of causation in the relationship between money supply and output/prices is discussed by Joan Robinson:

“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.” (Robinson 1970: 510–511).

So what we can say is that – in contrast to the quantity theory – money supply changes are often the effect of changes in credit demand, production and economic activity, and not the cause of the latter phenomena.

In short, money is generally the effect, not the cause.

Finally, what drives an inflation can be complex, and there is no simple, monocausal explanation. Often inflations are a cost-push phenomenon, in which

(1) workers or unions demand higher wages and businesses agree to these increases and/or

(2) prices of other factor inputs rise, and then businesses will need to obtain higher levels of credit from banks.

So inflation might be driven by demand for higher wages or supply-side factors. Hence broad money supply growth rates rise in an endogenous money world which generally accommodates the demand for credit, but this rise precedes further price increases because businesses will generally raise mark-up prices to maintain profit margins at a later time, given that most firms engage in time-dependent reviews and changes of their prices at regular intervals. In extreme situations, a wage–price spiral might break out: this involves the same process as above but in a vicious circle.

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

“Endogenous Money 101,” April 20, 2013.

“Rochon and Rossi on the History of Endogenous Money,” May 4, 2013.

“Endogenous Money under the Gold Standard,” May 19, 2013.

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

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

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

“How is New Bank Money Created?,” March 22, 2014.

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

“Joan Robinson on the Quantity Theory of Money,” March 3, 2014.

“Bob Murphy on 1970s Inflation,” April 24, 2014.

“The Various Versions of the Quantity Theory,” September 12, 2014.

BIBLIOGRAPHY
Davidson, Paul and Sidney Weintraub. 1973. “Money as Cause and Effect,” The Economic Journal 83.332: 1117–1132.

Dwyer, G. P. and R.W. Hafer. 1988. “Is Money Irrelevant?,” Federal Reserve Bank of St. Louis Review 70: 3–17.

Friedman. M. 1963. Inflation: Causes and Consequences. Asia Publishing House, New York.

Friedman, M. 1968. “Inflation: Causes and Consequences,” in M. Friedman, Dollars and Deficits. Prentice-Hall, Englewood Cliffs, NJ.

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

Ingham, G. 2004. The Nature of Money. Polity, Cambridge, UK and Malden, MA.

Kaldor, N. 1970. “The New Monetarism,” Lloyds Bank Review (July): 1–17.

McCandless, G. T. and W. E. Weber. 1995. “Some Monetary Facts,” Federal Reserve Bank of Minneapolis Quarterly Review 19.3: 2–11.

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.

Rogers, Colin. 1989. Money, Interest and Capital: A Study in the Foundations of Monetary Theory. Cambridge University Press, Cambridge.

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