The Quantity Theory of Money

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The theory we will explore in this article, known as the quantity theory of money, originates from the work of early monetary scholars, including the philosopher and economist David Hume (1711–1776). It continues to be the primary framework for understanding how money influences the economy in the long term.

Transactions and the Quantity Equation

When economists discuss the term “supply,” they often reference “demand” shortly thereafter. Having examined the money supply comprehensively, we now shift our focus to the demand for money.

At the core of the quantity theory of money lies the realization that individuals hold money to facilitate transactions for goods and services.

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The more transactions they engage in, the more money they require. Consequently, the quantity of money in circulation correlates with the volume of dollars exchanged in transactions.

This relationship between transactions and money is encapsulated in the quantity equation:

The Quantity Theory of Money

Let’s dissect each component of this equation.

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  • T represents the total number of transactions over a specific period, such as a year. Put simply, T reflects how often goods or services are exchanged for money within a year.
  • P denotes the price of a typical transaction, indicating the amount of money exchanged.
  • Therefore, the product of the price per transaction and the number of transactions (PT) represents the total value of transactions in a year.
  • M represents the money supply
  • V (referred to as the velocity of money) measures the pace at which money circulates within the economy. In essence, velocity indicates how frequently a dollar bill changes hands within a given timeframe.

For instance, suppose 50 loaves of bread are sold in a year at $2 per loaf. In this scenario, T equals 50 loaves per year, and P equals $2 per loaf. Consequently, the total value of transactions (PT) amounts to $100 per year.

PT = $2/loaf × 50 loaves/year = $100/year.

Now, let’s assume the money supply in the economy is $20. By rearranging the quantity equation, we can calculate velocity as:

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V = PT/M
= ($100/year)/($20)
= 5 times per year.

That is, for $20 of money to facilitate $100 of transactions per year, each dollar must change hands 5 times per year.

The quantity equation functions as an identity: the definitions of its variables render it true. This equation proves useful as it illustrates that any alteration in one variable necessitates corresponding adjustments in others to maintain equilibrium. For instance, if the money supply increases while velocity remains constant, either prices or the volume of transactions must rise.

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From Transactions to Income

When analyzing the role of money in the economy, economists often employ a modified version of the quantity equation. The initial equation poses challenges in measuring the number of transactions (T). To address this issue, economists substitute T with the total output of the economy, denoted as Y.

Transactions and output share a correlation; higher levels of production result in increased transactions. However, they are not identical concepts.

For instance, when an individual sells a used car, a transaction occurs even though the car isn’t part of current output. Nevertheless, the dollar value of transactions roughly aligns with the dollar value of output.

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If Y signifies the output level and P represents the price per unit of output, then the dollar value of output is expressed as PY.

These variables align with measures encountered in the discussion of national income accounts. Substituting these variables into the quantity equation yields:

The Quantity Theory of Money

In this version of the quantity equation, Y also denotes total income. Consequently, V is termed the income velocity of money, reflecting how often a dollar enters someone’s income within a specific period. This revised quantity equation is the most prevalent and will be the primary framework moving forward.

The Money Demand Function and the Quantity Equation When examining how money impacts the economy, it’s often beneficial to express the quantity of money in terms of the goods and services it can purchase. This measure, denoted as real money balances (M/P), reflects the purchasing power of the money supply.

A money demand function outlines the factors influencing the desired quantity of real money balances. A simplified form of this function is:

The Quantity Theory of Money

Here, k represents a constant indicating how much money individuals wish to hold for every dollar of income. Essentially, this equation posits that the demand for real money balances is proportional to real income.

The money demand function operates akin to the demand function for goods, with the “good” in this context being the convenience of holding real money balances. Just as higher income stimulates greater demand for goods, it also spurs a greater demand for real money balances.

This function offers an alternate perspective on the quantity equation. By incorporating the condition that the demand for real money balances must equal the supply, the equation becomes:

M/P = kY .

Rearranging terms yields: M(1/k)= PY ,

which can be written as : MV = PY ,

where V = 1/k. These few steps of simple mathematics show the link between the demand for money and the velocity of money.

This transformation underscores the connection between money demand and money velocity. When individuals prefer to hold more money relative to income (indicating a large k), money circulates less frequently (resulting in a smaller V).

Conversely, a preference for holding less money (small k) leads to more frequent money circulation (larger V). In essence, the parameters of money demand and velocity are interrelated.

The Assumption of Constant Velocity

While the quantity equation serves as a definition, assuming constant velocity transforms it into a practical theory known as the quantity theory of money. Like many assumptions in economics, the assumption of constant velocity is a simplification.

Velocity may fluctuate in response to changes in the money demand function, such as technological advancements like the introduction of ATMs. However, empirical evidence suggests that assuming constant velocity often proves useful.

With this assumption in place, the quantity equation becomes a theory explaining the impact of money on the economy. Specifically, it states:

The Quantity Theory of Money

Where V remains fixed. Consequently, any alteration in the money supply (M) necessitates a proportional adjustment in nominal GDP (PY). In essence, the quantity of money dictates the dollar value of the economy’s output.

Money, Prices, and Inflation The quantity theory of money provides insights into what governs the economy’s price level. It rests on three fundamental premises:

  1. The factors of production and the production function establish output Y.
  2. The money supply, determined by the central bank, determines nominal output PY, based on the quantity equation and the assumption of constant velocity.
  3. The price level P is the ratio of nominal output PY to output Y.

Put simply, the economy’s productive capacity determines real GDP, the money supply determines nominal GDP, and the GDP deflator reflects the ratio of nominal GDP to real GDP.

This theory elucidates the consequences of central bank interventions in the money supply. Since velocity is assumed constant, any change in the money supply leads to a proportional change in nominal output PY. Given that the factors of production and production function have already set output Y, adjustments in nominal output PY can only occur if the price level P changes.

Thus, according to the quantity theory, the price level is directly proportional to the money supply. This implies that controlling the money supply allows the central bank to influence inflation rates. If the central bank maintains a stable money supply, the price level will also remain stable. However, if the central bank increases the money supply rapidly, the price level will rise accordingly.

The theory also provides insights into inflation rates. By examining the percentage changes in the quantity of money, velocity, price level, and output, we can discern the factors contributing to inflation.

The quantity equation, written in percentage-change form, is

%ΔM + %ΔV = %ΔP + %ΔY .

The percentage change in the quantity of money (%ΔM) is under the control of the central bank. Meanwhile, the percentage change in velocity (%ΔV) reflects shifts in money demand, although we assume it remains constant for the sake of this analysis. The percentage change in the price level (%ΔP) represents the inflation rate, the phenomenon we aim to understand.

Lastly, the percentage change in output (%ΔY) depends on factors like production growth and technological advancements, which we consider exogenous for our current purposes.

This analysis underscores the central role of the money supply in determining inflation rates. Specifically, the quantity theory posits that changes in the money supply directly influence inflation. Therefore, by manipulating the money supply, the central bank can effectively control inflation rates within the economy.

Conclusion

In summary, the quantity theory of money asserts that the central bank, through its control over the money supply, wields significant influence over inflation rates.

By maintaining a stable money supply, the central bank can ensure price stability within the economy. Conversely, rapid increases in the money supply lead to higher inflation rates.

Thus, understanding and applying the principles of the quantity theory of money is essential for central banks in their efforts to maintain macroeconomic stability.

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