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