Quantity theory of money

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In economics, the velocity of money refers to a key term in the quantity theory of money, which centers on the equation of exchange:

where

<math>M</math> is the total amount of money in circulation in an economy at any one time (say, on average during a month).

<math>V</math> is the velocity of money, i.e., how often each unit of money is spent during the month. This reflects financial institutions and other economic conditions.

<math>P</math> is the average price level for the economy during the month.

<math>Q</math> is the total number of items purchased during the month with the particular kind of money represented by <math>M</math>.

For example, if <math>M</math> represents Central Bank notes (for example, green paper U.S. dollars) then <math>Q</math> is the quantity of goods or assets bought with Central Bank notes. If <math>M</math> represents Central Bank notes plus checking account balances, then <math>Q</math> represents the quantity of goods or assets bought with paper or checking account balances. Textbooks carelessly define <math>Q</math> (or "<math>Y</math>") as the total quantity of goods produced in the economy (i.e., real gross domestic product). But this can lead to serious errors. For example, if only 30% of goods are bought with paper or checking account balances, and if the quantity of this type of money doubled, then it might happen that the quantity of goods bought with paper or checking account balances would double from 30% to 60%, while real output of goods (and <math>P</math> and <math>V</math>) are unaffected. Besides money can be used to buy goods produced in another time period (especially assets).

The left-hand side of the equation above equals the total amount of money spent during the month. The right-hand side equals the amount of money received.

Given this identity, the velocity of money can be measured as

In an early work espousing the quantity theory, velocity is defined as 'the ratio of net national product in current prices to the money stock.'¹

Historically, the main rival of the quantity theory has been the real bills doctrine, which says that the value of money is determined by the assets and liabilities of the money-issuing entity, rather than by the ratio of money to real GDP.

1 Principles
2 Inflation
3 Critics
4 External Links
5 See also
6 References

[edit] Principles

The theory is based on the following principles:

The source of inflation is always, fundamentally, derived from the money supply.
The demand for money is a function of wealth, the rate of return and the value of liquidity.
Money demand is stable in the short run.
The long run is what matters most; injection effects are not that important.
The real interest rate is determined by non-monetary factors (productivity of capital, time preference).
The supply of money is usually exogenous.
Money demand determines the real money supply.
The purchasing power parity doesn't matter for money effects.

[edit] Inflation

The equation of exchange can be used as a rudimentary theory of inflation. If the velocity of money is given by financial institutions (such as the role of bank accounts and credit cards) and the amount of production is always at a fixed level (say, at full employment), then any increase in the amount of money leads to rising prices for the economy as a whole, i.e., inflation.

If <math>V</math> and <math>Q</math> are constant, then we can state the equation of exchange in terms of rates of growth:

the rate of growth of the money supply = the inflation rate

[edit] Critics

Critics point to several principles presented above. Money supply is endogeneous, as money is created by banks and other financial institutions in relation to a general optimism on the future return of investments. Private supply of money fluctuates in the short and long term and the central bank can only try to level off these fluctuations but has no control on the amount of supply of money. Indeed all central banks have failed in their attempts to target a given monetary growth. There can be huge variation in the stock of goods (especially production goods), goods produced in former period, and held and not consumed by economic agents. Whether economic agents try to add to their stock of goods or to unload it, it has an impact on the number of transactions for a given level of production (flow) and hence on inflation-deflation. Thus money demand also depends on expectations. If consumers expect both a rising consumption and rising prices they tend to add to their stocks, stocks rotate faster, there are more transactions, money demand is higher, and for a given money supply, deflation happens. Expectations are hence crucially important as optimism may lead to both higher money supply and higher money demand and pessimism to both lower money supply and money demand. Private money supply often overreacts to money demand through credit booms and credit bust, just as investment overreacts variation in the demand of final goods in the real sphere, hence the central bankers must try to keep things stable and regulation of he finance industry is to be advocated. Finally, for a given money supply, inflation can happen in consumption good prices or in production good prices (assets), and this depends from the relative strenght of labor and management of the labor market. For instance recent disinflation is less due to monetarist policies than to free trade and anti labor policies which boost profits while depriving labor of their pricing power.