Quantity Theory of Money

The Quantity Theory of Money (QTM) is a macroeconomic theory that suggests there is a direct proportional relationship between the money supply in an economy and the general price level. In simpler terms, the more money there is in circulation, the higher the prices. In this blog, we will discuss the QTM, Different Perspectives of the QTM, limitations of QTM, and the impact of digital currencies on QTM.

Quantity Theory of Money Definition: According to the Quantity Theory of Money (QTM), the general price level of goods and services is proportional to the amount of money in the economy.

Here's a breakdown of the key points:

• Direct relationship: The QTM posits a direct relationship between money supply and prices. This means an increase in the money supply will increase prices and vice versa.
• Proportionality: The change in prices is proportional to the change in money supply. In other words, prices will also double if the money supply doubles.
• Historical development: The QTM has evolved, with different economists adding their nuances and insights, which we will discuss in the blog later.

QTM was originally postulated by Nicolas Copernicus, the mathematician and native of Poland, in 1517.  

Equation of Exchange in Quantity Theory of Money

The Equation of Exchange is the core concept in the Quantity Theory of Money. It highlights the relationship between the money supply, velocity of money, price level, and actual output in an economy. 

The Equation of Exchange is expressed as:

MxV = PxQ

Where:

• M: Money supply or the total amount of money circulating in an economy at a given time. 
• V: Velocity of money, which indicates the average number of times a unit of money is spent in a specific period. 
• P: Price level, representing the average price of goods and services in an economy.
• Q: Real output. It is the total quantity of goods and services produced in an economy over a given period, adjusted for inflation.

Significance of each variable:

• M: The money supply plays a crucial role in determining the overall level of economic activity. An increase in the money supply, while holding other factors constant, leads to inflation.
• V: The velocity of money is a crucial indicator of economic activity. A higher velocity suggests that money changes hands more frequently, increasing spending and economic growth. 
• P: The price level directly affects the purchasing power of money. An increase in the price level represents inflation.
• Q: Real output represents the actual production of goods and services, which ultimately determines the standard of living in an economy. An increase in actual output allows for greater consumption and higher economic well-being.

You can go through this video by Economics Understood to learn the concept in a more interesting way -

Source - Economics Understood (YouTube)

Different Perspectives of the Quantity Theory of Money

Over time, different versions of the Quantity Theory of Money have developed, each with its own ideas and implications. This summary provides some of the most popular economic theories related to QTM.

Classical Quantity Theory

The classical QTM, shaped in the 18th and 19th centuries, presumed a straightforward and proportional link between the money supply and prices. It posited that:

• Velocity of money remains constant: Money circulates at a fixed pace, regardless of changes in the money supply.
• Money supply changes directly affect prices: An increase in money supply with constant velocity results in inflation, while a decrease leads to deflation.

Fisher's Theory

In the 20th century, Irving Fisher refined the classical QTM by introducing the idea of a transaction demand for money. He argued that people hold money for transactions, and the demand for money depends on the price level and income, leading to the equation- 

MxV = PxT

Here, 'T' signifies transactions. This formulation acknowledged that velocity is not always constant and can be influenced by economic factors.

Keynesian Critique

In the 20th century, John Maynard Keynes challenged the classical QTM by highlighting the role of liquidity preference and interest rates. Keynes emphasised two key factors:

Liquidity preference: People prefer holding onto money for its own sake, not just for spending. They see it as a safer option than riskier investments like stocks.

Interest rates: The amount of interest earned on money influences how much people hold. When interest rates are low, people are less likely to invest and more likely to hold onto cash.

According to Keynes, these factors complicate the relationship between money supply and prices.

Monetarism

According to the monetarists, central banks are responsible for maintaining price stability. Monetarists, led by Milton Friedman, advocated for a significant role of money supply in influencing the economy. They asserted that "inflation is always and everywhere a monetary phenomenon," indicating that inflation primarily stems from excessive money supply growth. 

New Keynesian Quantity Theory

This theory attempts to blend aspects of the Keynesian and Monetarist viewpoints. It acknowledges the significance of money supply and interest rates in affecting inflation and recognises the impact of expectations, adjustment costs, and other factors.

The Impact of Digital Currencies on the Quantity Theory of Money

The rise of digital currencies has posed several challenges to the QTM:

• Decentralised Money Supply: Cryptocurrencies, such as Bitcoin, work differently from regular currencies controlled by central banks. Bitcoin and most other cryptocurrencies use "mining" to create new coins, so the supply is predictable and limited. This means that central banks can't use strategies like quantitative easing to change the amount of Bitcoin in circulation.
• Velocity Uncertainty: It's difficult to track how fast digital currencies like Bitcoin move around because they're anonymous and used worldwide. This makes it hard to know how much their movement affects the theory of how money works.
• Alternative Store of Value: The rise of digital currencies like Bitcoin has complicated the relationship between money supply and prices. People now have another option for storing their wealth beyond traditional currencies and gold. Additionally, Bitcoin's high volatility makes it a less stable store of value than gold, making it difficult to predict how changes in money supply affect prices.
• Uncertain Regulatory Landscape: Crypto regulations still need to be determined. These regulations will vary from country to country. This uncertainty makes it hard to predict how cryptocurrencies will affect the theory of how money works in the long run.

Implications

The integration of digital currencies into the global financial landscape carries various implications:

1. Central Bank Control Erosion: Decentralized money issuance weakens central banks' traditional control over the money supply. This erosion could affect the ability to manage inflation effectively and maintain economic stability.
2. Need for New Economic Models: The unique features of digital currencies may necessitate adaptations to traditional economic models to accommodate their influence on monetary policy.
3. Uncertainty and Volatility: Since cryptocurrencies are new in the market, their nature is considered more volatile, which generates uncertainty regarding their enduring impact on the global financial system and the Quantity Theory of Money.

Further Course of Action

To better understand how digital currencies affect economic theories like the QTM, we should consider the following areas:

• Velocity Measurement: Developing better ways to measure how fast digital currencies circulate is crucial for accurate economic analysis.
• Inflation and Growth: Analyzing the impact of cryptocurrencies on inflation and economic growth across different countries and scenarios is essential to understand how they impact the financial markets.
• Central Bank Digital Currencies (CBDCs): Examining the potential advantages and drawbacks of CBDCs in response to the growth of cryptocurrencies can offer valuable insights into the future of monetary policies.

Limitations of QTM

The Quantity Theory of Money offers a valuable framework for understanding the relationship between money supply and prices, but it has certain limitations:

• Neglects factors like technology, government policies, and international trade that influence prices.
• Fails to account for short-term economic dynamics.
• Assumes unrealistic constant money circulation speed.
• Focuses mainly on money supply, neglecting demand-side factors.
• Challenges in accurately measuring the money supply and velocity can lead to discrepancies in assessing their relationship with prices.
• Less suitable for open economies with international trade, exchange rates, and capital flows.
• Better for long-term trends than short-term fluctuations.
• Overlooks financial market and asset price impacts.

Conclusion 

The Quantity Theory of Money offers a valuable framework for comprehending inflation and economic growth. However, it's essential to recognise its limitations. This theory simplifies reality and doesn't encompass all real-world complexities.

Despite these limitations, the QTM remains a fundamental pillar of economic theory. It retains relevance in understanding the connection between money and the economy.