Monetary economics is a branch of economics that studies different theories of money. One of the main areas of research in this branch of economics is quantitative theory of money (QTM). According to the quantitative theory of money, the general price level of goods and services is proportional to the money supply in an economy. While this theory was originally formulated by the Polish mathematician Nicolaus Copernicus in 1517, it was later popularized by economists Milton Friedman and Anna Schwartz after the publication of their book “A Monetary History of the United States, 1867 -1960 âin 1963.
According to the quantitative theory of money, if the quantity of money in an economy doubles, all other things being equal, price levels will also double. This means that the consumer will pay twice as much for the same amount of goods and services. This increase in price levels will ultimately result in an increase in the level of inflation; inflation is a measure of the rate of rise in the prices of goods and services in an economy.
The same forces that influence the supply and demand of any commodity also influence the supply and demand for money: an increase in the supply of money decreases the marginal value of money, in other words, when the mass monetary increases, but with everything else being equal or ceteris paribus, the purchasing capacity of a monetary unit decreases. To compensate for this decrease in the marginal value of money, the prices of goods and services increase; this results in a higher level of inflation.
Key points to remember
- One of the main areas of research for the branch of economics called monetary economics is called the quantitative theory of money.
- According to the quantitative theory of money, the general price level of goods and services is proportional to the money supply in an economy, assuming that the level of real production is constant and the speed of money is constant.
- The same forces that influence the supply and demand of any commodity also influence the supply of and demand for money: an increase in the supply of money, ceteris paribus
- , decreases the marginal value of money so that the purchasing capacity of a monetary unit decreases.
- Many Keynesian economists remain critical of the basic tenets of quantitative theory of money and monetarism, and dispute the claim that economic policies that attempt to influence the money supply are the best way to approach Economic Growth.
What is the quantity of money theory?
What is the quantitative theory of money?
Quantitative Theory of Money (QTM) also assumes that the amount of money in an economy has a great influence on its level of economic activity. Thus, a change in the money supply results in either a change in price levels or a change in the supply of goods and services, or both. In addition, the theory assumes that changes in the money supply are the main reason for changes in spending.
One implication of these assumptions is that the value of money is determined by the amount of money available in an economy. An increase in the money supply leads to a decrease in the value of money, because an increase in the money supply also leads to an increase in the rate of inflation. When inflation increases, purchasing power decreases. Purchasing power is the value of a currency expressed in terms of the amount of goods or services that a unit of currency can purchase. When the purchasing power of a currency unit decreases, more currency units are needed to purchase the same amount of goods or services.
Throughout the 1970s and 1980s, the quantitative theory of money became more relevant due to the rise of monetarism. In monetary economics, the main method of achieving economic stability is to control the money supply. According to monetarism and monetary theory, changes in the money supply are the main forces underlying all economic activity, so governments should implement policies that influence the money supply in order to promote economic growth. Because of its emphasis on the quantity of money determining the value of money, the quantitative theory of money is central to the concept of monetarism.
Calculation of QTM
The quantitative theory of money proposes that the exchange value of money is determined like any other good, along with supply and demand. The basic equation of quantitative theory is called the Fisher equation because it was developed by the American economist Irving Fisher. In its simplest form, it looks like this:
(M)(V)=(P)(T)or:M=Money incomeV=Traffic speed (the number of times money changes hands)P=Average price levelT=Volume of transactions in goods and services
Some variations of quantitative theory propose that inflation and deflation occur in proportion to increases or decreases in the money supply. The empirical evidence has not shown this, and most economists do not share this view.
A more nuanced version of quantitative theory adds two caveats:
- New money has to actually flow through the economy to cause inflation.
- Inflation is relative and not absolute.
In other words, prices tend to be higher than they would have been if more dollar bills were involved in economic transactions.
According to monetarists, a rapid increase in the money supply can lead to a rapid increase in inflation. Indeed, when monetary growth exceeds the growth of economic production, there is too much money which supports too little the production of goods and services. In order to curb a rapid rise in the level of inflation, it is imperative that the growth of the money supply be lower than the growth of economic output.
When monetarists contemplate solutions for a booming economy requiring an increased level of production, some monetarists may recommend an increase in the money supply as a short-term boost. However, the long-term effects of monetary policy are not as predictable, so many monetarists believe that the money supply should be kept within an acceptable range so that inflation levels can be brought under control.
Instead of governments continually adjusting economic policies through public spending and tax levels, monetarists recommend letting non-inflationary policies, such as a gradual reduction in the money supply, lead an economy to full employment.
Many Keynesian economists remain critical of the basic tenets of quantitative theory of money and monetarism, and dispute the claim that economic policies that attempt to influence the money supply are the best way to approach Economic Growth.
Keynesian economics is a theory of economics that is primarily used to refer to the belief that the government should use militant policies of stabilization and economic intervention in order to influence aggregate demand and achieve economic performance. optimal. John Maynard Keynes was a British economist who developed this theory in the 1930s as part of his research trying to understand, above all, the causes of the Great Depression. At the time, Keynes argued for a government response to the global depression that would involve the government increasing spending and lowering taxes in order to stimulate demand and pull the global economy out of depression.
In the 1930s, Keynes also challenged the quantitative theory of money, arguing that an increase in the money supply actually leads to a decrease in the speed of money circulation and that real income – the flow of money to factors of production – increases. Therefore, the speed of money could change in response to changes in the money supply. In the years following Keynes ‘argument, other economists proved that Keynes’ claim with the quantitative theory of money is, in fact, correct.
Some of the principles of monetarism became very popular in the 1980s in the United States and the United Kingdom. The leaders of these two countries, such as Margaret Thatcher and Ronald Reagan, tried to apply the principles of theory in order to achieve monetary growth targets for their countries’ economies. However, over time, strict adherence to a controlled money supply has proven to be no solution to economic downturns.
According to Keynesian economists, inflation comes in two forms: pulling demand and pushing costs. Demand-driven inflation occurs when consumers demand goods, perhaps due to the larger money supply, at a rate faster than output. Cost-push inflation occurs when the prices of inputs for goods tend to rise, perhaps due to a larger money supply, at a faster rate as consumer preferences change.