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Limitations of The Quantity Theory

Today almost all economists agree that changes in the amount of money can be an important source of economic disturbance. The consensus among economists is that changes in the amount of money played important roles in German hyperinflation of the 1920s and in the Great Depression of the 1930s. In the Great Inflation there was a tremendous increase in the quantity of money in circulation. There was a sharp drop in the quantity of money at the beginning of the Great Depression. The quantity theory is a simple way to explaining why changes in money can disturb the rest of the economy. However, it is a theory with a number of weaknesses, and it has always had critics who have questioned the assumptions on which it is based.

The most obvious limitation of the quantity theory is that it does not explain recessions or unemployment because it assumes away adjustment problems. It assumes that production is determined by resources, and since money is not a resource, changes in money should not change production. This assumption seems more appropriate in the 19th century than in the 20th. For example, consider two great deflations in U.S. history, that of 1839-1843 and that of 1929-1933. Both had large declines in the amount of money, 34% in the first and 27% in the second. Both had substantial drops in price level, 42% in the first and 32% in the second. But they were totally different in what happened to real output. In the first case output increased by 15%, while it declined 30% in the second. 1

Though there are economists who argue that changes in the amount of money, if they are completely anticipated, should have no effect on output, most economists believe that monetary changes affect both prices and output. However, there ways to add an adjustment process to a quantity theory, and thus make monetary disturbances affect not just prices, but output and unemployment as well.

A second area of controversy about the quantity theory involves the assumption that changes in money are the cause, not the effect. There clearly is a correlation between changes in the amount of money and changes in spending, a correlation that can be found over vast stretches of history and in a great many countries. (See for example the graph below.) Critics of the quantity theory have suggested that this correlation exists because changes in the amount of money in circulation are caused by, rather than the cause of, changes in business activity. In other words, the critics argue that changes in money are the effect, not the cause.

Money and US GNP, 1929-50

It is hard to argue the critics' case when a society uses a commodity money. To see why, suppose that inflation has a nonmonetary cause. Inflation decreases the value of the commodity as money. When the value of a commodity money drops, people should shift from its monetary use to its commodity use, decreasing the amount of money in circulation. If spending determines money stock, the amount of a commodity money and price level should be inversely related, not directly related as the quantity theory maintains. However, inverse patterns of this sort do not seem to occur.

The critics' argument looks better in a system of bank-debt money. For example, both the amount of money in circulation and spending rise each November and December. It seems unlikely that the change in money causes the change in spending. It is more likely that Christmas causes the increased spending and the central bank provides extra money to help that spending take place. However, before we can examine the argument in terms of bank-debt money, we will need to examine more closely how the amount of money expands or contracts. Even quantity theorists accepted the idea that changes in business activity could, in the short run, have a direct effect on money stock.

Finally, the quantity theory assumes that changes in the amount of money in circulation do not alter velocity. The Keynesian Revolution in the 1930s attacked the assumption that velocity was independent of the level of money stock and dismissed it. Rather a new assumption became standard, that changes in money tended to be offset by changes in velocity. Thus if money increased by 10%, velocity would tend to decline, and as a result the change in income would be less than 10%, and could even be zero.

The reason for the position that money stock and velocity should be negatively correlated involves the interest rate. Assume that money earns no interest, or that it earns interest at a fixed rate. Then an increase in the interest rate paid on nonmonetary assets should make holding idle money balances more expensive. When people hold their assets in the form of money, they forgo the opportunity to earn the interest they could earn if they held assets in the form of bonds. Since people should take into account costs and benefits when determining money balances, they should hold smaller money balances in times of high interest rates.

Further, times of high interest rates should occur when money stock drops. A fall in money stock happens when the amount of bank lending decreases. This implies that fewer funds will be made available to borrowers, or that the supply of lendable funds decreases. This shift in the supply curve should cause the price of loanable funds, the interest rate, to increase. Thus a decrease in bank lending causes both a decrease in money stock and a rise in interest rates, and the rise in interest rates should cause people to reduce idle balances, or increase the velocity of money. The opposite should happen in the case of a rise in the stock of money.

On a theoretical level this criticism is difficult to evaluate. The quantity theory is a long-run theory, and people are in agreement about what it means only as a long-run theory. The quantity theory does not tells us about the short-run effects of a change in money stock, and this is a weakness of the model. The assertion that money stock and velocity were negatively correlated in the short run would not be a serious criticism if the critic did not also suggest that the effects held into the long run. Further, though the logic of the criticism is correct, the critics may be assuming that some variables can be held constant which could reverse the effects if they in fact are not constant. Two such variables are the rate of inflation and expectations of inflation. The amount of cash balances people want to hold should depend on the rate of inflation. When inflation is high, it is expensive to hold assets in the form of cash because money is losing value. Thus if a change in money stock changes either inflation or expectations of inflation, there will be factors changing velocity besides the effects of a shift in the supply curve for loanable funds to the left. Thus the issue is not really a theoretical issue, because one can argue it both ways. It is an issue that only an appeal to real-world evidence can resolve.

The data that the world threw up in the 1940s seemed consistent with the hypothesis that money and velocity are inversely related. During the Second World War the U.S. money stock increased rapidly, but velocity fell. One can also find a negative relationship if one looks at the very short run. If one looks at what is typical over the past century allowing for some short lags for money to affect spending, there is no clear relationship between cyclical movements in money and velocity.

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1 These statistics are from Mancur Olson, The Rise and Decline of Nations (Yale University Press, 1982), p. 223.

Copyright Robert Schenk