What Is the Quantity Theory of Money (QTM)?

Monetary economics delves into various theories concerning money, and one of its key areas of focus is the Quantity Theory of Money (QTM).

This theory suggests that the overall price level of goods and services in an economy is directly linked to the amount of money circulating within it.

Although this theory was initially crafted by Polish mathematician Nicolaus Copernicus in 1517, it gained prominence thanks to economists Milton Friedman and Anna Schwartz, following the release of their influential book, “A Monetary History of the United States, 1867-1960,” in 1963.

So what is the quantity theory of money?

Well, the Quantity Theory of Money posits that if the money supply in an economy doubles, all else being equal, prices will also double. In simpler terms, consumers would need to pay twice as much for the same goods and services. This increase in prices eventually leads to inflation, a measure of how rapidly prices are rising across an economy.

Similar to the forces shaping the supply and demand of any commodity, money supply is influenced by these factors too. An increase in the money supply diminishes the value of each unit of currency.

In other words, when the money supply increases, but other factors remain constant (ceteris paribus), the purchasing power of one unit of currency decreases. As a way to account for this drop in the value of money, prices of goods and services rise, resulting in higher inflation rates.

What is the quantity theory of money: Highlights
Monetary economics explores the Quantity Theory of Money (QTM), a theory that links money supply to the general price level of goods and services in an economy.
QTM assumes constant real output and a stable velocity of money.
Forces affecting the supply and demand of any commodity also influence the supply and demand of money. When the money supply increases (ceteris paribus), the value of a single unit of currency decreases, leading to rising prices and inflation.
While some remain critical of the QTM and monetarism, arguing that influencing the money supply isn’t always the best approach for addressing economic growth, it remains a significant concept in the field of monetary economics.

What you'll learn:

➤ What Is the Quantity Theory of Money?

The Quantity Theory of Money (QTM) posits that the quantity of money circulating within an economy wields substantial influence over its economic activity. In simpler terms, a change in the money supply can result in alterations to price levels, shifts in the supply of goods and services, or both.

Moreover, this theory assumes that changes in the money supply serve as the primary driver of spending fluctuations.

One significant implication of these assumptions is that the value of money is intrinsically tied to the quantity of money present within an economy. When the money supply increases, the value of money decreases, concurrently driving up the inflation rate. As inflation surges, the purchasing power of money diminishes.

Purchasing power reflects the value of a currency in terms of how much goods or services a single unit of currency can purchase. As purchasing power decreases, it takes more units of currency to acquire the same quantity of goods or services.

During the 1970s and 1980s, the Quantity Theory of Money gained prominence, largely due to the rise of monetarism. Within monetary economics, the primary means of achieving economic stability is by controlling the money supply. According to monetarism and monetary theory, changes in the money supply serve as the fundamental driving forces behind all economic activities.

Consequently, governments should enact policies that influence the money supply to stimulate economic growth. The Quantity Theory of Money plays a pivotal role in monetarism due to its emphasis on the quantity of money as a determinant of its value.

➤ How to Calculate the Quantity Theory of Money (QTM)

The Quantity Theory of Money (QTM) suggests that the value of money operates much like any other commodity, governed by the principles of supply and demand. At its core, the fundamental equation of the quantity theory is known as the Fisher Equation, named after the American economist Irving Fisher. In its simplest form, it takes this shape:

(M)(V) = (P)(T)

Here’s a breakdown of the variables involved:

M: Represents the Money Supply.
V: Denotes the Velocity of circulation, signifying how frequently money changes hands.
P: Stands for the Average Price Level.
T: Represents the Volume of transactions for goods and services.

Some variations of the quantity theory propose that inflation and deflation occur proportionally to changes in the money supply. However, empirical evidence hasn’t consistently supported this idea, and most economists do not subscribe to it.

A more nuanced version of the quantity theory introduces two important considerations:

New money must actively circulate within the economy to contribute to inflation.
Inflation is relative, not absolute. This means that when more dollar bills are involved in economic transactions, prices generally tend to be higher than they would be otherwise.

In essence, the Quantity Theory of Money provides a framework for understanding the complex relationship between money supply, velocity of circulation, average price levels, and transaction volumes in an economy.

➤ Monetarism & The Quantity Theory of Money

Monetarists assert that a rapid surge in the money supply can trigger a swift rise in inflation. This phenomenon occurs when the growth in the supply of money outpaces the growth in economic output, resulting in an imbalance—too much money and too little production of goods and services.

To counteract a rapid escalation in inflation, it becomes crucial for the growth in the money supply to fall behind the growth in economic output.

When grappling with economic challenges, some monetarists may propose an increase in the money supply as a short-term measure to stimulate a sluggish economy in need of heightened production.

However, they caution that the long-term consequences of monetary policy are less predictable. Therefore, many monetarists advocate maintaining the money supply within an acceptable range to effectively manage inflation levels.

Instead of frequent government interventions, involving adjustments to policies like government spending and taxation, monetarists suggest relying on non-inflationary strategies, such as gradually reducing the money supply. This approach is believed to guide an economy toward achieving full employment while avoiding excessive inflation.

➤ Keynesianism & The Quantity Theory of Money

Keynesian economists often express skepticism toward the fundamental principles of the Quantity Theory of Money and monetarism. They challenge the notion that economic policies aimed at manipulating the money supply represent the most effective means of addressing economic growth.

Keynesian economics, a prominent economic theory, advocates for active government intervention and stabilization policies to influence aggregate demand and achieve optimal economic performance.

Developed by British economist John Maynard Keynes in the 1930s, this theory emerged as a response to the Great Depression. Keynes proposed that governments should increase spending and reduce taxes to stimulate demand and lift economies out of depressions, aiming for proactive economic intervention.

During the 1930s, Keynes also questioned the Quantity Theory of Money, contending that an increase in the money supply could lead to a decrease in the velocity of money in circulation while increasing real income.

In essence, Keynes argued that changes in the money supply could influence the velocity of money. Subsequent research has supported Keynes’ perspective on the Quantity Theory of Money.

In the 1980s, certain aspects of monetarism gained popularity in the United States and the United Kingdom. Leaders like Margaret Thatcher and Ronald Reagan attempted to apply these principles to their countries’ economies by setting money growth targets.

However, over time, it became apparent that strict control of the money supply did not offer a comprehensive solution to economic slowdowns.

According to Keynesian economists, inflation manifests in two forms: demand-pull and cost-push. Demand-pull inflation arises when consumers demand goods at a faster rate than production can meet, possibly due to an expanded money supply.

Cost-push inflation occurs when input prices for goods increase more rapidly than consumer preferences change, possibly driven by a larger money supply.

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