A Guide to Quantity Theory of Money and its Criticisms

Understanding Monetary Theory

 

Money holds an eminent position in the overall progress of a country. Even when it comes to economics, the power of money leads to the economic activity of a nation and its population. 

 

Perhaps money is the root cause of all types of economic behaviors and thus explains why a particular person/nation spends its money in a particular way. In order to understand this phenomenon, a lot of economists have formulated theories. One such theory is the Monetary Theory. 

 

According to the Monetary theory, when a nation’s supply of money rises, the economic activity or spending power of that nation wises as well. A nation’s money supply includes the total amount of money in circulation in the nation. 

 

When a nation’s employment level is near to its full capacity, then the general prices of goods in economics increases more than the production of goods or services, 

 

“Monetary economics is a branch of economics that studies different theories of money. One of the primary research areas for this branch of economics is the quantity theory of money (QTM). “

Monetary Theory 

 

This increase in the general prices of goods leads to an increased inflation rate in an economy. Defined as the decline in the purchasing power of a given currency, inflation can be reflected in the rise of general goods prices. 

 

When an economy experiences inflation, it refers to the declining purchasing power of the country’s currency that continues to buy goods or services, but in a less quantity. 

 

(Must read: Economic growth vs economic development)

 

 

What is the Quantity Theory of Money (QTM)?
 

As claimed by the Quantity Theory of Money, the general price level of goods or services is directly proportional to the money supply in an economic setup. 

 

Simply put, if the monetary amount in an economy increases (for instance, doubles up), then the prices of the goods in that economy will also increase (double up, in this case). 

 

In a way, the same economic factors that influence the flow of money in an economy, also influence the general prices of goods in that economic setup. One of the biggest takeaways from this theory is that the value of money in a market is determined by the availability of money in the market, with respect to all other factors being equal (e.g.- ceteris paribus economics). 

 

This is one of the biggest quantity theory of money assumptions - that other factors remain unchanged. In essence, the theory states that the stock of money (M) is the main determinant of the price level (P) of goods. The quantity theory of money formula is as follows -

 

(M)(V)=(P)(T)

 

Herein, M denotes the money supply in an economy, V denotes the circulation of money, P denotes the average price level, and T denotes the volume of transactions of goods and services. 

 

In a nation, the economy comprises all these factors that together influence the rate of inflation and thus, the economic expenditures of the people with the money supply. 

 

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Origin of the Theory 

 

One of the oldest theories existent in the field of economics, the QTM theory was invented by the famous mathematician Nicolaus Copernicus in 1517. 

 

Even though the real credit goes to Nicolaus Copernicus, the theory only gained worldwide attention when it was talked about by Milton Friedman and Anna Schwartz in their book - A Monetary History of the United States, 1867-1960, published in 1963. 

 

Later on, the theory was developed by John Maynard Keynes in the 1930s. A number of attempts had been made in order to find the correlation between the increasing goods prices and increasing supply of money. 

 

Originated as an effort to establish a direct relationship between the goods prices and monetary flow in an economy, the QTM theory 

 

Criticisms of the Quantity Theory of Money 

 

The QTM theory aims to find a relationship between the spending pattern in an economy with respect to the flow of money in the economy. 

 

However, not a lot of economists think that this is the best way to define the rate of inflation in an economy. Perhaps there have emerged a set of criticisms that help us understand the criticisms of the QTM theory. 

 

1. The first and foremost criticism of the theory comes from the section of taxpayers. Since the money supply in an economy increases, the price of the goods also increases. 

 

That said, the leftover money, in order to keep the savings process of the citizens unobstructed, must be taxed, as is suggested by taxation officials. However, a lot of economists and taxpayers worldwide suggest that procuring more money from people’s salaries will only lead to an upsurge in unemployment and rising economic concerns of the masses. 

 

Therefore, taxing the extra flow of money is a very unpopular alternative that has led to severe criticism of the QTM theory.

 

“Japan is often cited as an example. The country has run fiscal deficits for decades now, with mixed results. Critics regularly point out that continual deficit spending there has forced more people out of work and done little to boost GDP growth.”

Criticisms of the QTM Theory 

 

2. The second criticism of the theory threw light on the theory’s inability to consider other monetary factors apart from the money supply in an economy. Another argument came along that led to a major criticism of the theory. 

 

John Maynard Keynes had earlier been a supporter of the theory. However, with time he strongly argued that the price level of goods and services was not directly proportional to the money supply in an economy. 

 

He, along with Ludwig von Mises argued that the theory failed to consider other factors like the demand of money, and only focused on the factor of money flow in an economy. 

 

This, as stated by the latter, “failed to explain the mechanism of variations in the value of money”. Furthermore, as Keynes laid down in his criticism of the theory, the QTM theory failed to establish a direct relationship between M and P. 

 

Even though it did mention that these 2 factors were directly proportional, the theory could not adequately explain the basis of this relationship. 

 

3. In addition, the theory is a sheer example of truism. Highly obvious and nothing new, the QTM theory certainly states that there is a relation between the money supply and price level in an economy. 

 

However, it does not represent through evidence that a particular increase in the money supply in an economy leads to the same increase in the price level of goods or services. 

 

That said, the theory only recommends something that is known to laymen. However, it highly fails to prove the exact relative level between the 2 factors - money supply and price level. 

 

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4. The fourth criticism comes along with the assumption of the theory that all other things remain equal or unchanged, thus, implying a situation of ceteris paribus. Yet, in reality, other things do not always remain unchanged. 

 

This, in turn, fails to recognize the plausibility of the QTM theory that entirely focuses on the unchanged factors in an economy other than the money supply (M) and the price level of goods/services (P). 

 

This also means that the money supply is not the only factor responsible for the change in the price levels. Since auxiliary factors can influence the price levels and money supply as well, the whole theory becomes nothing more than a doubtful instance of economics. 

 

5. Another criticism of the quantity theory of money that is worth noting is in relation to the value of money. The value of money theory establishes a direct relationship between the number of goods that can be bought with a certain amount of money. 

 

However, as is the case of the QTM theory, the value of money theory is diminished to the extent that it only focuses on cash transactions in an economy. In reality, the theory does not aim to measure the purchasing power of money, thus, restricting it to a certain aspect of the economic activity in a nation. 

 

This clearly puts the theory in a weak position implying that the theory fails to adequately represent the value of money in its entirety.   

 

(Also read: Capital in Economics)

 

 

Summing Up

 

To sum up, the QTM theory originated back in the 16th century when the discipline of economics was still evolving. 

 

Even though it is a celebrated theory that clearly establishes one fact that the money supply in an economy is directly proportional to the price level of goods, it still fails to prove its points. On account of Keynesian economics, the theory only partly succeeds in convincing economists about its findings. 

 

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In the end, the quantity theory of money given by Copernicus helps us to assume that the price levels increase as the money supply in an economy rises, given that all other factors remain constant and unchanged over the time of transition.