The Quantity Theory of Money (QTM) says that Money supply (M) has a direct, proportional relationship with the price level (P) in the economy. Per QTM, changes in the value of money (i.e. Price level) are determined mainly by changes in the Money supply. When money supply is abundant, the value of money or its purchasing power drops i.e. prices rise, and when money is in scarce supply, the value of money or its purchasing power increases i. e. prices fall. Sounds intuitive, doesn’t it? It’s just like any other commodity.
What precisely does the Quantity Theory of Money state?
While that (above) is the intuitive message of QTM, let’s put down what the QTM precisely states.
The Quantity identity on which QTM is based is:
MV = PY
Where M = money supply, v = the income velocity of money, P = price level and Y = real GDP.
The income velocity of money measures the average number of times in a given period that each dollar is spent on currently produced goods and services.
Now, the Quantity identity is quite intuitive. It says that the amount of money in the economy x the number of times it changes hands = the nominal value of the output produced in the economy.
Based on this identity, Quantity theory asserts that a given change in Money supply (% ΔM) induces an equal change in inflation (% ΔP). This claim is based on 2 assumptions:
1. The income velocity of money (v) is constant.
2. Money growth has no impact on real GDP (Y), at least in the long run. So, Y is constant as well.
If these two assumptions are believed to be true (MV = PY, where V and Y are fixed), it’s pretty obviously that % ΔM = % ΔP.
So whether QTM holds or not, depends on how well these assumptions reflect economic reality.
Is Velocity of Money constant?
This has been a controversial subject in economic theory. Classical economists/ proponents of the Quantity theory believed that “v” was constant. Keynes and others subsequently refuted this assumption. Various (post WW2) studies have since shown that velocity (“v”) is infact not constant. It is now generally accepted the velocity function is a relatively stable one, determined by a number of factors, key among which are enumerated below.
Velocity varies directly with Real Income/Output (Y)
Studies have shown that when real output/income increases, the demand for money increases as well. Since the money supply is the same, in order to meet the increased demand for money, the public circulates each dollar more rapidly (i.e. “v” increases). So, an increase in “Y”, leads to an increase in “v”. Similarly, a fall in “Y” causes “v” to drop as well.
Velocity directly related to market Interest Rates
The alternative use of the money that the public holds is investment. The interest rate on these alternative investments (bank deposits, bonds etc.) is the “opportunity cost” of holding money i.e. the reward that one has to forgo in order to hold money. When market interest rates rise, the opportunity cost of holding money rises. As a result, the public becomes loathe to holding more money and instead, tends to circulate the money it holds more rapidly, leading to an increase in velocity.
Velocity increases with the availability of close Money Substitutes
The greater the availability of close money substitutes (we are using the M1 definition of money here; M1 = currency + demand deposits) i.e. liquid assets that can be quickly and easily converted into cash at low cost, the greater is the velocity of money. Why? Because when you know that you can easily access cash through money substitutes, you’ll tend to hold a smaller amount of money to fulfill your daily needs. You’ll circulate this money more rapidly (velocity rises), rather than holding a larger amount of money that doesn’t change hands much, but makes you feel more secure and prepared for financial emergencies.
Velocity rises with growing financial innovation and enhanced reach of financial institutions
ATMs and other types of financial innovation along with the growing reach of financial institutions, continues to allow customers to hold a lower amount of money for their day-to-day needs i.e. enable higher velocity of money. This factor and the availability of close money substitutes are intimately related.
Bottom-line: Though not constant, the velocity function is a relatively stable one determined by a number of independent variables (key among which are listed above), which makes it relatively predictable as well. That being said, the velocity of money continues to remain a controversial subject in economic theory. I’m sure I’ll do more posts to address some of the controversies/complexities surrounding this seemingly innocuous variable.
Is Output (Y) constant?
This is essentially the Classical vs. Keynesian assumption vis-a-vis “full employment” encapsulated into a single question. Classicals believe that the economy tends to operate at the full employment (full capacity) level barring some small periods of adjustment. If this is the case, then when money supply expands, all it does is raise the price level, since output is already at full capacity.
Keynesians however have asserted (and there is enough real-world evidence to back this up) that economies can and do operate below full-employment for long periods of time. As a result, monetary expansions/contractions can and do lead to changes in output, at least over the short term.
When does the Quantity Theory hold?
So, we know that MV = PY. Now we also know that “v” and “Y” are not constant. How then can % ΔM be = % ΔP? Does the Quantity theory hold at all?
The Quantity theory does hold over the long term, since in the long run, the economy does tend to operate at the full-employment level (Y), and the velocity of money (v) though not constant, is relatively stable and predictable. Over a shorter time horizon however, the proportional relationship between % ΔM and % ΔP is hard to observe.
For example, analysis shows that money growth and inflation are indeed highly correlated in the very long run. Over a 15-20 year period, a correlation of 0.6 - 0.8 has been observed between money growth and inflation. However, over a 2-8 year time period (horizon of a business cycle), the correlation never exceeded 0.4. (Source: St. Louis Federal Reserve).
Watch out for more QTM related posts.
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