The Quantity Theory of Money

The Quantity Theory of Money

In discussing the automatic control of the flow of money and commerce over international boundaries and the relative merits of gold vs. paper currency, we have touched on other important aspects of money. No idea has been more important in economic thought than what the economist calls the quantity theory of money. In the brief summaries given above of the ideas of such men as Law, Petty, Vanderlint, and Hume, the question of the influence of the quantity of money in circulation upon the price level was constantly referred to. Vague and undeveloped as it was with those early writers, it became the subject of extensive inquiry in the centuries following.

One of the earliest writers to be concerned specifically with the function of money and its effect upon prices was Jean Bodin (1530-1590). His explanation of the advance in prices during the Sixteenth Century, as found in his Reponse aux Paradoxes de Malestroit (1569) is far in advance of his time. He ascribes the current price changes to the abundance of gold and silver, scarcity caused by effort, and the debasement of currency. There is no doubt but that he had a fair understanding of the relation of the quantity and value of money to prices. He proceeds to cite historical facts to support his contentions. All in all, his analysis of French foreign trade during the period and the subsequent influx of gold is on a par with the thinking of a much later era.

To John Locke, however, goes the credit for the first formu­lation of the quantity theory of money. He claimed that the value of any commodity, money included, was determined by the re­lation of the supply to the demand. As long as the quantity of money remained the same, he maintained, any alterations in price were due to changes in the supply and demand for com­modities in terms of each other. If, however, the quantity of money was altered and the amount of trade remained the same, any change in price could be traced directly to the change in the quantity of money. Locke was aware also that in determining the quantity of money some consideration had to be shown for the speed of circulation, since a coin used several times would count for more than the same coin if used only once in the same period of time. The additions to the theory made by Gantillon, Vanderlint, and Hume were in the nature of refinements of de­tail. Gantillon showed that the increase in money due to the ex­ploitation of mines first affected prices of goods used in the proc­ess of mining, and then it affected the prices of goods used by those whose incomes were increased as a direct result of the in­creased mining activity. A general rise in prices would follow sooner or later throughout the country, the net effect of which was the dislocation of domestic industry through a development of foreign buying.

The earliest statements of the quantity theory of money were all made when the chief circulating medium was coin. During the years which followed, first paper money, then bank credit were introduced, and they quickly pushed metal money into ob­scurity. Then paper money for a time was the chief medium of exchange for business transactions, but since the middle of the Nineteenth Century bank credit alone has kept pace with the rapid expansion of business enterprise. These innovations have made the quantity theory of money more difficult to observe in practice, but they have not changed the basic principle. Until the 1930-1940 decade, it was generally understood that a nation's currency would be backed by precious metals which would be used to settle balances in international trade. The dislocations of international economic life and the practices of most nations in controlling both credit and note issue with little regard to the quantity of precious metals on hand have made this commonly accepted rule inoperative, at least temporarily. However, in or­dinary times, while the quantity theory did not assume that prices would bear a direct relation to the amount of gold or silver on hand, nevertheless—since the limits of note issue and credit were indirectly controlled by the quantity of metal a na­tion possessed—coin continued to hold an important place in the operation of the quantity theory. However, today in the determi­nation of the quantity of money on hand at a given time, bank credit, note issue, and other forms of credit are far more impor­tant than metal.

The modern economists interested in this field have constantly sought to describe these newer and more complex aspects of the quantity theory of money in terms which could be understood and applied. The attempts at simplification by mathematical means are not new, however. Montesquieu used common nu­merical ratios in his description, and Sir John Lubbock produced a formula which could be applied to determine the price level. Irving Fisher has been considered the best exponent of the quantity theory in modern times, and his equation is the present best known expression of the theory:


In the equation, P= the general price level, M== the quantity of metal money, V= the velocity of turnover of metal money, M'= the volume of bank deposits, V'= the velocity of turnover of these deposits, and T= the volume of trade, or number of transactions.

In simple language the formula means that the price level may be determined if the quantity of money in circulation—in­cluding both currency and bank credit—is multiplied by the number of times it changes hands, or turns over, in a given period, and then divided by the total number of business trans­actions which have taken place during the same period. The price level indicated will be in the nature of a number which— when compared to similar numbers applicable to different times —will show the exact amount of change in the price level.

The quantity theory of money has never been completely acceptable among economists generally. It was held first that the formula itself was meaningless, since each of the items in the formula was not an independent variable but was interdependent with each other item. Further, Othmar Spann claimed that the assumption that the doubling of the quantity of money equaled a doubling in the demand for all commodities was untrue since a doubling of the quantity of money had a very uneven result, affecting both production and the demand for money in very different ways under different circumstances.

The defenders of the quantity theory were hard pressed to ex­plain the downward trend in prices during the last three decades of the Nineteenth Century and the upward swing of the first two of the Twentieth. They pointed out that such fluctuations were directly traceable to the decline in gold production during the first period and the discoveries of new mines at the beginning of the second period. Gustav Cassel, a contemporary writer of Swedish origin, has done much to explain the price changes of recent times in terms of the quantity theory. By his research he was able to show that an annual increase of 3 percent (allowing a small percentage for wastage) in the gold supply was sufficient to stabilize prices. Larger or smaller increases in gold he believed resulted in price fluctuation, and the changes in prices were in direct ratio to the variations of the additional gold supply from the norm.

J. H. Laughlin also took exception to the quantity theory. He ascribed the decline in prices of the 1865-1896 period to the tremendous increases in production of that time. The rise in prices in the decades following he claimed was due to the exten­sion of credit based upon the increase in commodities which had already taken place. As business activity increased, the medium of exchange expanded with it. Hence, the quantity of money or means of exchange had no influence on prices. Obviously so complex a matter as the nature and behavior of money will not be represented by one theory alone. There are many different ways of thinking about money. Spann pointed out in his The History of Economics that one group of economists claimed that the value of money as a medium of exchange lay essentially in its own commodity value. That is, money was readily acceptable by all people because it had a value in itself as a commodity. Thus, gold is acceptable because gold has value in use. The other group, he said, were those who considered the value of money to lie in the legal fact of its being designated as a medium of exchange by the state, or by mass agreement. As he described the groups, the former were the economists of the classical English tradition, while the latter included members from the German historical and the Austrian schools.

John Maynard Keynes has in recent years become known for his analysis of the place and importance of money in the operation of modern economic life. Both in his A Treatise on Money (1930) and his The General Theory of Employment Interest and Money (1936), he emphasized the fact that money had unique characteristics which set it apart from other com­modities. While the volume of most commodities can be almost indefinitely increased by the application of labor and capital, that is not so with money. Money can be increased, but the amount of increase is a matter of arbitrary decision by govern­ment authority and is not self-regulated by production costs and selling price as are other commodities. Also, there is no substitute for money. When the exchange value of other commodities rises, substitute products usually are available; but not so with money. Further, money holds a liquidity preference higher than any other commodity. It is the one commodity for which there is always a market. And, finally, Keynes claimed that the im­portance of money lay in its being the link between present and future values. As a general statement of relationship, Keynes ac­cepted Fisher's formula of the quantity theory of money, but he added so many possible variables—such as the demand for money, labor factors, and physical factors determining the rate of diminishing returns in production—that the simple formula for him had very little meaning and could only be used in rela­tively artificial situations where one of the variables arbitrarily was held constant. In the long run the effect of the changing quantity of money on prices has never been allowed to operate. The normal trend of prices and wage rates has been upward. If by chance a deficiency of the supply of money caused a decline in prices and wage-rates, the increasing burden of the debt struc­ture which followed such changes was too painful to tolerate. Measures of debt relief and changes in the monetary unit were introduced by the state to curb the deflationary trend. Keynes' investigations into the role of money and its effect upon interest and employment resulted in a recommendation that has under­mined the whole classical tradition. He suggested that depressions could be ended through a form of controlled inflation which would eliminate the necessity of raising wage rates, and would keep interest rates stabilized at a point high enough to insure con­tinued investment.