The Quantity Theory of Money

Origins and development of the

quantity theory
The quantity theory descends from Copernicus.
The “equation of exchange” relating the supply
of money to the value of money transactions
was stated by John Stuart Mill who expanded on
the ideas of David Hume.
The quantity theory was developed by Simon
Newcomb,Alfred de Foville,Irving Fisher, and
Ludwig von Mises.
The Quantity Theory of Money
The quantity theory of money is the
proposition that, in the long run, an increase in
the quantity of money brings an equal
percentage increase in the price level.
The quantity theory of money is based on the
velocity of circulation and the equation of
exchange.
The velocity of circulation is the average
number of times in a year a dollar is used to
purchase goods and services.
The Quantity Theory of Money
In 1750, David Hume gave an early account of
the relationship between a country’s money
stock and price level, which is known as the
classical quantity theory.
V = PT/ M, where V, the transaction velocity of
circulation, measures the speed at which the
given sum of money circulates in the economy;
P is the general price level. T is the volume of
transactions & M is the nominal money supply.
The Quantity Theory of Money

The previous equation is also known as the

equation of exchange.
He then defined V= P*Y/M, where V, the
income velocity of circulation, measures the
speed at which a given sum of money circulates
in the economy, where Y is the real output.
The Quantity Theory of Money
◦Calling the velocity of circulation V, the price
level P, real GDP Y, and the quantity of money
M:
◦V = PY/ M
◦The equation of exchange states that
◦MV = PY
◦The equation of exchange becomes the quantity
theory of money by making two assumptions:
1. Velocity of circulation V is not influenced by M
2. Potential GDP, Y, is not influenced by M
The Quantity Theory of Money
◦ Given the assumption that V/Y does not
change, the change in P, P, is related to the
change in M, M, by the equation:
◦ P = (V/Y)M
◦ Divide this equation by
◦ P = (V/Y)M
◦ P/P = M/M
◦ P/P is the inflation rate and M/M is the
growth rate of the quantity of money.
Inflation- A Monetary phenomenon

P= (M * V)/ Y
Price level rises if
 Money supply rises.
 Velocity rises.
 Real GDP, Y falls.
This is a long run phenomenon.
The Quantity Theory of Money
 The Quantity Theory of Money
International
evidence shows a
marked tendency
for high money
growth rates to be
associated with
high inflation rates.
Figure (a) shows
the evidence for
134 countries from
1990 to 2004.
Market for money: as predicted by
quantity theory of money.
Supply of money (Ms) is exogenously
determined.
-as Ms controlled by the government.
-assume to be unaffected by interest rates
Demand for money (Md= PY, where P is
the general price level and Y is the real)
M*V=P*Y
M P
Cambridge approach to quantity
theory
Economists Alfred Marshall, A.C. Pigou, and
John Maynard Keynes associated with
Cambridge University focused on money
demand instead of money supply.

They argued that a certain portion of the money

supply will not be used for transactions; instead,
it will be held for the convenience and security
of having cash on hand.
Cambridge approach to quantity theory
 This portion of cash is commonly represented as
k.
 The Cambridge equation is thus:
Md = k . P . Y
 Assuming that the economy is at equilibrium
(Md = M), Y is exogenous, and k is fixed in the
short run, the Cambridge equation is equivalent
to the equation of exchange with velocity equal
to the inverse of k:
M . (1/k) = P . Y
Why should the Quantity Theory of
Money (QTM) be Introduced?
A simple version of the QTM ignores the effects
of interest rate and postulates that M/P = kY,
where K is a positive constant.
The advantage of the QTM is that it explicitly
brings in the relationship between the price level
and the money supply and output.
This is important because as remarked by
Milton Friedman, “Inflation is always and
everywhere a monetary phenomenon.” Without
the QTM, it is hard to discuss inflation.
Empirical Relevance of the QTM
How well does the QTM fit the empirical
data, given that we ignore the effects of
interest rate? Some variants of the QTM
have been applied to many economies,
including Hong Kong and China. It is
known that the QTM works very well.
To empirically test the model, usually we
need to modify the QTM a bit.
Empirical Relevance of the QTM
M/P = kY can be expressed in the form of
m – p = y,
where m is the % change in M,
p is the % change in P, and
y is the % change in Y.
(Note that the growth rate of k must be zero
because it is a constant.)

Alternatively, p = m – y, i.e., inflation is

positively related to growth rate in money
supply and negatively related to output growth.
Hypothesis that QTM is based upon
 The source of inflation is fundamentally
derived from the growth rate of the money
supply.
 The supply of money is exogenous.
 The demand for money, as reflected in its
velocity, is a stable function of nominal
income, interest rates, and so forth.
 The mechanism for injecting money into the
economy is not that important in the long run.
 The real interest rate is determined by non-
monetary factors: (productivity of capital, time
preference).
Criticism
The theory attracted criticism from John
Maynard Keynes, particularly in his work
The General Theory of Employment, Interest
and Money.
Ludwig von Mises agreed that there was a
core of truth in the Quantity Theory, but
criticized its focus on the supply of money
without adequately explaining the demand
for money. He said the theory "fails to
explain the mechanism of variations in the
value of money".