Quantity Theory of Money

The quantity theory of money is dedicated to the relationship between the money supply and prices, or more specifically, how the first influences the latter. Basically, the most widespread version of the theory introduced by American economist Irving Fisher states that the growth of money in a particular economy might lead it to inflation, or growth of prices. Consequently, the decrease of the quantity of money might be a potential threat of deflation. Therefore, the relationship between these economic phenomena is direct.

The quantity theory of money is one of the main component of monetarism. It’s closely related to the equation of exchange, which can be considered as a mathematical representation of the theory. It illustrates and partially explains the change in prices.

Fisher’s Quantity Theory of Money

The roots of the quantity theory of money can be traced back to the 16th century, where the first ideas about the correlation between the quantity of money and other economic phenomena were formed. However, one of the most famous and widespread version of the theory was suggested by Fisher in the 20th century. We’ll take a close look at it because this theory as well as the associated formula are viewed as a modern classic in economics.

There are several versions of the quantity theory of money based on the classic one, but represented its postulates quite differently. Some of them suggest a direct relationship between the quantity of money and prices as the Fisher’s theory, and some, on the contrary, represent them as indirect.

But first, let’s describe the Fisher’s quantity theory of money in particular. Otherwise, it’s known as a “neo-quantity” theory. It advocates that the interconnection of the aforementioned economic phenomena are fixed and can be calculated by a certain mathematical formula, also introduced by Fisher and presented below.

According to the Fisher’s theory, the velocity of money (V) is a constant variable, and the money supply (M) is strongly connected to the volume of transactions (T). Therefore, the change of the money supply (M) directly influences on the average price level (P).

However, despite its popularity, this theory is often seen as controversial.

Pros and cons of the Fisher’s Quantity Theory of Money

The main advantage of the quantity theory of money is its simplicity and statistical applicability. The equation introduced by Fisher still has been used in the economic literature as a principal mathematical representation of the theory. However, as we mentioned before, the Fisher’s version is frequently criticized by other economists, thereby highlighting some of its disadvantages.

The theory’s simplicity might be explained by the fact that some of the equation’s variables (V as the velocity of money and T as the volume of transactions) are unchangeable, and a lot of economists consider it questionable. The correlation between the money supply and prices is measured quite proportionally, which also provides the simplicity of the equation, but at the same time, it might represent this relationship incorrectly.

Other versions of Quantity Theory of Money

Due to the contradictory aspects of the Fisher’s quantity theory of money, other theories were developed, trying to complement the original version or view the problem from a different perspective. There are some of the main theories:

• The theory of monetarists is based on the Fisherian model. Therefore, they consider that the money supply has a primary influence on the economy. A country’s economic performance, consequently, might be generally corrected by the changes in the quantity of money. More specifically, they might be used as a means of controlling the inflation rate. However, although the monetarists protect the traditional theory, they disagree with some of its points, thereby creating a little modification to the Fisherian model. For example, they dispute the assumption of constant velocity of money (V, in the equation). Monetarists suggest that this variable isn’t constant, but quite predictable. Also, they consider that the money supply can’t have an impact on the economy in a long-term period.
• The theory of Keynesians is named after John Maynard Keynes, a British economist. Proponents of this theory disagree with the original assumption that the money supply and prices are directly interconnected. They believe that the correlation between these economic phenomena are more complex and unpredictable. As the previous theory, it doesn’t postulate that the velocity of money is a constant variable. According to Keynesian economics, the velocity of money can differ significantly depending on the situation and future forecasts. Promising or, in contrast, negative forecasts for the future might lead to liquidity preference, which, in turn, is strongly connected with the money supply.
• The theory of Knut Wicksell, as opposed to the original model, denies that the quantity of money is the key to the economy’s recovery. The theory was developed by Swedish economist Knut Wicksell. Also, a similar theory was introduced by the group of economists from Austria. All of them represent another view on the relationship between the money supply and the economy. This point of view has gained popularity mostly in Europe, while the Fisher’s theory has been widespread in the US. These theories agree with the Fisherian hypothesis that an increase in the quantity of money leads to an increase in prices, but contradict the assumption that the prices can be corrected by the artificial change of the money supply. The theory even postulates that such strategy of the economy’s recovery might do more harm than good and distort the prices.

All listed competing theories are seen as a dynamic representation of the economic phenomena, while the Fisherian theory is more static, and therefore, simplified.