File Name: quantity theory of money and inflation .zip
- Quantity Theory of Money
- Quantity Theory of Money
- How Does Money Supply Affect Inflation?
- International Financial Policy : Essays in honor of Jacques J. Polak
Quantity Theory of Money
Most economic historians who give some weight to monetary forces in European economic history usually employ some variant of the so-called Quantity Theory of Money. Even in the current economic history literature, the version most commonly used is the Fisher Identity, devised by the Yale economist Irving Fisher in his book The Purchasing Power of Money revised edn.
For that reason we cannot avoid it, even though most economists today are reluctant to use it without significant modification. The two values on each side of the sign are necessarily identical. For the medieval, early modern, modern, and present day eras this is a form of nitpicking that in no way invalidates the model.
Good proxies can be provided for most of these eras, certainly good enough to indicate general movements of both prices and monetary stocks. The other two objections are far more important. How can we resolve the problem of multiple counting?
How can we add up all the transactions involving so many different commodities and services: with what common denominator? Adding together apples and oranges as pieces of fruit is a very simple task by comparison.
This is a lesser-known rival to the Fisher Identity that emerged during the s at Cambridge, with a formula that resolved at least the problems concerning Velocity:. Pigou asked two principal questions :. The letter k thus indicates the proportion of the total value of all monetary transactions that the public chooses to hold in cash balances; and thus it tells us the necessary amount of M that is required for that level of P.
T total spending. Note that P times T again equals the total monetary value of all transactions; and thus suffers from the same problems of estimating the value of T, as indicated above for the Fisher Identity. Why do people wish to hold cash balances, instead of immediately spending or investing that money? He suggested three motivations. This is deemed to be the major need for holding ready cash. What is the cost of holding these cash balances? The true cost is the opportunity cost: i.
Consequently, we should find that cash balances are to some extent interest-sensitive, and vary with interest rates. That is, the proportion of national income held in cash balances k should fall as real interest rates rise, because rising interest rates will increase the opportunity cost of holding those balances; and conversely that proportion k held in cash balances should rise with falling real interest rates.
Why is k a more useful variable than V? Because k is much more 'predictable;' and conceptually k is an 'active' variable -- i. But V , on the contrary, is a passive i.
Thus one might say that k cash balances is a predictive measure of velocity, while V measures only resulting velocity. T ; and this proportion will not vary in the short run;. Modern economists, however, have more or less resolved that problem by ignoring the total volume of transactions, and by looking instead at the Net National Income or the aggregate of net national expenditures.
From that dollar amount we deduct a sum for 'depreciation' for depreciation of worn out, wasted capital stock in order to arrive at Net National Product.
That letter Y will be familiar to anyone who has studied at least the rudiments of Keynesian economics:. That value of a deflated NNI, or 'real NNI,' or 'net national income in constant dollars,' is expressed by lower-case y. Upper-case Y of course measures NNI in current dollars, which currently has meant a declining purchasing power, because of inflation. To calculate y: divide Y by P. The result divided by 1. This amount is 1. Thus V measures the income velocity of money: the rate at which a unit of money circulates in producing total net national income or net national expenditures or net national product.
Thus k measures the proportion of aggregate national income that the population collectively holds in cash balances. So you will presumably also prefer to use it: but at least please use it in this modernized form: M. In short, Velocity varies inversely with the money supply and directly with interest rates; alternatively, that k varies directly with the money supply and inversely with interest rates.
Remember that the interest rate represents the opportunity cost of holding cash balances. Furthermore, a more plentiful money supply reduces the need to economize on the use of money, thus also reducing Velocity or encouraging larger cash balances. Keynes, writing during the Great Depression years, argued that underemployment of resources was more often the normal state; and that an increase in monetized spending would induce the productive employment of further resources, resulting in an increased output and trade that would counteract any potential inflation from that increased spending.
But in the long run is there not some simpler relationship? This is a question for historical generalisation rather than for pure theory But again the historian may doubt that all the changes -- in M, V or k, and y -- are always so neatly counterbalancing, so that P the price level remains stable. But what about a pre-modern money supply that is far more based on precious metals? Are changes in the supply of precious metals and in mint outputs so fully endogenous in the Keynesian sense?
Furthermore, what about coinage debasements: what determines them? If, however, inflation also occurred a rise in P , historians must then explain why the evident monetary expansion was greater than the rise in real output and real incomes: why, with P, M.
Some combination of any or all of the three following might well happen:. Furthermore, if an increased M results in lower interest rates, V should also fall for that reason i. But note carefully: to the extent that y rises, and to the extent that V falls, then the rise in the price level P , the degree of inflation, will be proportionally much less than the increase in M. Conceivably, an increase in M could be totally offset by both a fall in V and an increase in y -- so that no inflation would result.
Thus inflation is far from being an automatic result of increasing the money supply -- it is from being predictable; and thus price changes depend upon purely real as well as monetary factors. But we have reason historically to doubt that all these factors will so automatically and neatly counterbalance each other. Historically, however, that proves to be quite false: there is almost never any linear relationship between changes in money supplies and prices.
He assumed an economy with a large amount of unemployed resources, a highly elastic economy very responsive to changes in demand. He was also assuming that changes in M resulted endogenously from changes in investment or government expenditure, increasing output, income, and aggregate demand. Such increases in an economy of unemployed resources would be reflected by a rise in real net national product and income Y without any inflation, at least until the point of Full Employment was reached.
But, Keynes argued, once that point of full employment was reached, the traditional quantity theory would then finally apply: further increases in spending would be purely inflationary -- his concept of the 'inflationary gap'. Here full employment means not just full employment of the labour force, but full employment of all resources in the economy.
Thus, as aggregate demand rises, and as supply increases to meet that demand, resources in some sectors become more or less fully employed, producing some price increases in those sectors. That is, diminishing returns set in and supply becomes less and less elastic, less capable of expanding except at very high cost, thus producing price increases. But in other sectors, supply remains more flexible, more elastic, so that production can expand there without rising prices.
As aggregate demand further increases, however, more and more sectors encounter these rigidities with rising costs, and a rising price level becomes more and more general. But it is difficult to envisage any economy, over time, which has no capacity for further output -- absolute full employment.
There are always some technological and organizational changes possible to achieve some real gains. Conversely with heavy unemployment, in an economy with much of its resources lying idle, unutilized, an increasing M and rising aggregate demand will produce increased real output and incomes in y , without any significant price increases. Thus the extent of inflation, or price increases, depends as much on these real factors as on the purely monetary factors.
But time and space, and our mutual energies, do not permit an extended discussion of that debate here. But population growth may also or subsequently change the structure and distribution of that population; and increased urbanization, and consequent changes in markets and financial structures, may lead to a reduced k -- or, to say the same thing, an increased V , an increased velocity of money circulation.
Footnotes 1. See J. Let me begin on a positive note. This is indeed a most impressive work: a vigorous, sweeping, grandiose, and contentious, though highly entertaining, portrayal of European and North American economic history, from the High Middle Ages to the present, viewed through the lens of 'long-wave' secular price-trends.
Indeed its chief value may well lie in the controversies that it is bound to provoke, particularly from economists, to inspire new avenues of research in economic history, especially in price history. The author contends that, over the past eight centuries, the European economy has experienced four major 'price-revolutions,' whose inflationary forces ultimately became economically and socially destructive, with adverse consequences that provoked various complex reactions whose 'resolutions' in turn led to more harmonious, prosperous, and 'equitable' economic and social conditions during intervening eras of 'price equilibria'.
These four price-revolutions are rather too neatly set out as the following: 1 the later-medieval, from c. Though I am probably more sympathetic to the historical concept of 'long-waves' than the majority of economists, I do agree with many opponents of this concept that such long-waves are exceptionally difficult to define and explain in any mathematically convincing models, which are certainly not supplied here.
For reasons to be explored in the course of this review, I cannot accept his depictions, analysis, and explanations for any of them. This will not surprise Prof. Fischer, who is evidently not an admirer of the economics profession. He is particularly hostile to those of us deemed to be 'monetarists,' evidently used as a pejorative term. After rejecting not only the 'monetarist' but also the 'Malthusian, neo-Classical, agrarian, environmental, and historicist' models, for their perceived deficiencies in explaining inflations, and after condemning economists and historians alike for imposing rigid models in attempting to unravel the mysteries of European and North American economic history, Fischer himself imposes an exceptionally rigid and untenable model for all four of his so-called price-revolutions, containing in fact selected Malthusian and monetarist elements from these supposedly rejected models.
In essence, the Fischer model contends that all of his four long-wave inflations manifested the following six-part consecutive chain of causal and consequential factors, inducing new causes, etc.
First, each inflationary long-wave began with a prosperity created from the preceding era of price-equilibrium, one promoting a population growth that inevitably led to an expansion in aggregate demand that in turn outstripped aggregate supply, thus -- according to his model -- causing virtually ALL prices to rise. Evidently his model presupposes that all sectors of the economy, in all historical periods under examination, came to suffer from Malthusian-Ricardian diminishing returns and rising marginal costs, etc.
Second, in each and every such era, after some indefinite lapse of time, and after the general population had become convinced that rising prices constituted a persistent and genuine trend, the 'people' demanded and received from their governments an increase in the money supply to 'accommodate' the price rises. As Fischer specifically comments on p.
He never explains, however, for any of the four long-waves, why those increases in money stocks were always in excess of the amount required 'to accommodate inflation'.
Fourth, with such money-stock increases, the now accelerating inflation ultimately produced a steadily worsening impoverishment of the masses, aggravated malnutrition, generally deteriorating biological conditions, and a breakdown of family structures and the social order, with increasing incidences of crime and social violence: i.
Fifth, ultimately all these negative forces produced economic and social crises that finally brought the inflationary forces to a halt, producing a fall in population and thus by his model in prices, declines that subsequently led to a new era of 'price-equilibrium,' along with concomitant re-transfers of wealth and income from the richer to the poorer strata of society where such wealth presumably belonged.
Sixth, after some period of economic prosperity and social harmony, this vicious cycle would recommence, i. While many economic historians, using more structured Malthusian-Ricardian type models, have also provided a similarly bleak portrayal of demographically-related upswings and downswings of the European economy, most have argued that this bleak cycle was broken with the economic forces of the modern Industrial Revolution era.
Fischer evidently does not. Are we therefore condemned, according to his view, to suffer these never-ending bleak cycles-- economic history according to the Myth of Sisyphus, as it were? Perhaps not, if government leaders were to listen to the various nostrums set forth in the final chapter, political recommendations on which I do not feel qualified to comment. Having engaged in considerable research, over the past 35 years, on European monetary, price, and wage histories from the 13 th to 19th centuries, I am, however, rather more qualified to comment on Fischer's four supposed long-waves.
Out of respect for the author's prodigious labours in producing this magnum opus , one that is bound to have a major impact on the historical profession, especially in covering such a vast temporal and spatial range, I feel duty-bound to provide detailed criticisms of his analyses of these secular price trends, with as much statistical evidence as I can readily muster.
Quantity Theory of Money
People hold money mainly for transactions purposes, i. If people want to exchange more goods and services they need more money. So the more money people need for transactions, the more money they demand and hold. The demand for money is related to the quantity of money because the money market reaches equilibrium when the two are equal. The link between the volume of transactions and the quantity of money is expressed in the following equation called the quantity equation of exchange:. In this equation T, on the right hand side, represents the total number of transactions per period, say, one year.
Most economic historians who give some weight to monetary forces in European economic history usually employ some variant of the so-called Quantity Theory of Money. Even in the current economic history literature, the version most commonly used is the Fisher Identity, devised by the Yale economist Irving Fisher in his book The Purchasing Power of Money revised edn. For that reason we cannot avoid it, even though most economists today are reluctant to use it without significant modification. The two values on each side of the sign are necessarily identical. For the medieval, early modern, modern, and present day eras this is a form of nitpicking that in no way invalidates the model. Good proxies can be provided for most of these eras, certainly good enough to indicate general movements of both prices and monetary stocks.
- Real GDP uses base-year prices and isolates change in quantities. GDP Deflator= x Nominal GDP. Real GDP. Page 5. I
How Does Money Supply Affect Inflation?
Monetary Economics pp Cite as. Lowness of interest is generally ascribed to plenty of money. But … augmentation [in the quantity of money] has no other effect than to heighten the price of labour and commodities … In the progress toward these changes, the augmentation may have some influence, by exciting industry, but after the prices are settled … it has no manner of influence.
In monetary economics , the quantity theory of money QTM states that the general price level of goods and services is directly proportional to the amount of money in circulation, or money supply. For example, if the amount of money in an economy doubles, QTM predicts that price levels will also double. The theory was challenged by Keynesian economics ,  but updated and reinvigorated by the monetarist school of economics. Critics of the theory argue that money velocity is not stable and, in the short-run, prices are sticky , so the direct relationship between money supply and price level does not hold.
What gives money value? We know that intrinsically, a dollar bill is just worthless paper and ink. However, the purchasing power of a dollar bill is much greater than that of another piece of paper of similar size.
International Financial Policy : Essays in honor of Jacques J. Polak
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Definition: Quantity theory of money states that money supply and price level in an economy are in direct proportion to one another. When there is a change in the supply of money, there is a proportional change in the price level and vice-versa. However, Keynesian economists and economists from the Monetarist School of Economics have criticized the theory. According to them, the theory fails in the short run when the prices are sticky. Moreover, it has been proved that velocity of money doesn't remain constant over time.
Tursoy, Turgut and Mar'i, Muhammad : Lead-lag and relationship between money growth and inflation in Turkey: New evidence from a wavelet analysis. The study investigates the relationship between money supply and inflation and Turkey by employing wavelet analysis, mainly continuous wavelet analysis, cross wavelet transforms and wavelet coherence and phase-difference, for the period from to Our main finding confirms the modern quantity theory of money about the existence of a relationship between inflation and money supply in the short-run and long-run, and also confirms the traditional quantity theory of money about the existence of a relationship in the long run. The phase difference confirms the existence of a bidirectional relationship between money supply and inflation. The result is consistent with both the traditional quantity theory of money in the long run and the modern quantity theory of money in the short-run and long-run in terms of the existence of a relationship between money supply and inflation.
The problem of adapting the quantity theory of money to the balance of payments adjustment mechanism presented a dilemma for the economists of the eighteenth and nineteenth centuries that was never completely resolved. Whereas, in a closed economy, an increase in the money supply would raise prices, in an open economy, subject to the law of one price, the domestic price level cannot rise by more than the world price level. Even Hume, co-discoverer 1 of the self-regulating mechanism of the balance of payments, stumbled on the dilemma, failing to make clear that demand could alter the balance of payments without changes in relative prices. In the Mill-Taussig-Viner theory, changes in relative prices did not violate the law of one price because they meant changes in the terms of trade. For over a century, the high authority of this school perpetuated an embarrassment in the modern literature.
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