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Assumptions of the Quantity Theory

The quantity theory of money implies that a number of interactions are not possible. First, the quantity theory assumes that changes in spending do not simply cause proportional changes in the money stock. It is changes in money stock that are the cause, not the effect. In the jargon of economists, money is an exogenous variable, one determined by forces outside the model.

Second, the quantity theory assumes that the value of velocity is not dependent on either the amount of money or on the price level.1 Changes in velocity are possible, however, due to factors such as changes in transportation, new financial institutions, or other exogenous factors.

Finally, the quantity theory assumes that T, or the number of transactions, is determined by the availability of labor, capital, natural resources, knowledge, and organization. The quantity theory assumes not only that markets clear in equilibrium, but also that any adjustment problems are small enough to ignore. If there are unemployed resources, then the prices of those resources should be dropping, which means that the economy is not in equilibrium. Only when the price in each market has reached a point at which the quantity supplied equals quantity demanded will the economy be in equilibrium, and in this situation there will be no resources that cannot find employment. In other words, the quantity theory assumes that in the long run the economy tends to full employment.

Unlike labor or machines, money is not a resource that results in the production of output. Hence, additional money does not act as an input that increases output. However, the quotation from Thornton does not say that prices move in exact proportion to money. It is possible that the adjustment process can influence the amount of machinery available, and thus a change in money can have long-run influences on the amount of transactions. All quantity theorists, however, believed that any effects of this sort were small enough so that they could be ignored in making predictions about the long-run effects of changes in money stock.

Although the quantity theory makes the most sense when presented as a theory of explaining total transactions, today it is more commonly discussed as a theory of total spending for production, or of GDP. In part this is because data on GDP are available while those for total transactions are very sketchy, and in part because GDP is a more interesting item to explain than total transactions. There would be no difficulty in making this change if GDP transactions were a constant percentage of total transactions, but they do not seem to be. Not only does the percentage change gradually over long periods, but there are erratic changes over shorter periods. Most proponents of the quantity theory have believed this problem is small enough so that the quantity theory can be used to explain variations in GDP.

The quantity theory can be illustrated with an aggregate supply and demand graph.

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1 Care must be taken here, because this does not mean that velocity is unaffected by changes in price level. However, if price level is changing, the system cannot be in equilibrium. Recall that the assumptions we are discussing are assumptions of what happens in equilibrium.

Copyright Robert Schenk