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| {{unreliable sources|date=April 2013}}
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| {{primary sources|date=April 2013}}
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| In [[monetary economics]], the '''quantity theory of money''' states that [[money supply]] has a direct, proportional relationship with the price level. For example, if the currency in circulation increased, there would be a proportional increase in the price of goods.<ref>http://www.britannica.com/EBchecked/topic/486147/quantity-theory-of-money</ref>
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| The theory was challenged by [[Keynesian economics]],<ref name="minksy_keynes">Minsky, Hyman P. ''John Maynard Keynes'', McGraw-Hill. 2008. p.2.</ref> but updated and reinvigorated by [[Monetarism|the monetarist school of economics]]. While mainstream economists agree that the quantity theory holds true in the [[long run]], there is still disagreement about its applicability in the [[short run]]. Critics of the theory argue that [[money velocity]] is not stable and, in the short-run, prices are [[stick prices|sticky]], so the direct relationship between money supply and price level does not hold.
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| Alternative theories include the [[real bills doctrine]] and the more recent [[fiscal theory of the price level]].
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| == Origins and development of the quantity theory ==
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| The quantity theory descends from [[Copernicus]],<ref>{{cite journal
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| | last = Volckart | first = Oliver
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| | title = Early beginnings of the quantity theory of money and their context in Polish and Prussian monetary policies, c. 1520–1550
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| | journal = Economic History Review | volume = 50 | issue = 3 | pages = 430–449
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| | publisher = Blackwell | location = Oxford, UK | year = 1997
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| | url = http://www.jstor.org/stable/2599810
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| | jstor = 2599810 | issn = 00130117 | accessdate = 14 Jul 2013 }}</ref><ref>Nicolaus Copernicus (1517), memorandum on monetary policy.</ref> followers of the [[School of Salamanca]], [[Jean Bodin]],<ref>Jean Bodin, ''Responses aux paradoxes du sieur de Malestroict'' (1568).</ref> and various others who noted the increase in prices following the import of gold and silver, used in the coinage of money, from the [[New World]]. The “equation of exchange” relating the supply of money to the value of money transactions was stated by [[John Stuart Mill]]<ref>John Stuart Mill (1848), ''Principles of Political Economy''.</ref> who expanded on the ideas of [[David Hume]].<ref>David Hume (1748), “Of Interest,” "Of Interest" in ''Essays Moral and Political''.</ref> The quantity theory was developed by [[Simon Newcomb]],<ref>Simon Newcomb (1885), ''Principles of Political Economy''.</ref> Alfred de Foville,<ref>Alfred de Foville (1907), ''La Monnaie''.</ref> [[Irving Fisher]],<ref>Irving Fisher (1911), ''The Purchasing Power of Money'',</ref> and [[Ludwig von Mises]]<ref>von Mises, Ludwig Heinrich; ''[[Theorie des Geldes und der Umlaufsmittel]]'' <nowiki>[</nowiki>''The Theory of Money and Credit''<nowiki>]</nowiki></ref> in the latter 19th and early 20th century.
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| [[Karl Marx]] modified it by arguing that the [[Labor Theory of Value]] requires that prices, under equilibrium conditions, are determined by socially necessary labor time needed to produce the commodity and that quantity of money was a function of the quantity of commodities, the prices of commodities, and the velocity.<ref>[http://www.marxists.org/archive/marx/works/download/pdf/Capital-Volume-I.pdf Capital Vol I, Chapter 3, B. The Currency of Money]</ref> Marx did not reject the basic concept of the Quantity Theory of Money but rejected the notion that each of the four elements were equal but rather argues that the quantity of commodities and the price of commodities are the determinative elements and that the volume of money follows from them. He argued... {{Quotation|"The law, that the quantity of the circulating medium is determined by the sum of the prices of the commodities circulating, and the average velocity of currency may also be stated as follows: given the sum of the values of commodities, and the average rapidity of their metamorphoses, the quantity of precious metal current as money depends on the value of that precious metal. The erroneous opinion that it is, on the contrary, prices that are determined by the quantity of the circulating medium, and that the latter depends on the quantity of the precious metals in a country;this opinion was based by those who first held it, on the absurd hypothesis that commodities are without a price, and money without a value, when they first enter into circulation, and that, once in the circulation, an aliquot part of the medley of commodities is exchanged for an aliquot part of the heap of precious metals."}}
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| [[John Maynard Keynes]], like Marx, accepted the theory in general and wrote... {{Quotation|"This Theory is fundamental. Its correspondence with fact is not open to question."}} Also like Marx he believed that the theory was misrepresented. Where Marx argues that the amount of money in circulation is determined by the quantity of goods times the prices of goods Keynes argued the amount of money was determined by the purchasing power or aggregate demand. He wrote {{Quotation|"Thus the number of notes which the public ordinarily have on hand is determined by the purchasing power which it suits them to hold or to carry about, and by nothing else."}} In the Tract on Monetary Reform (1924),<ref>[http://203.200.22.249:8080/jspui/bitstream/123456789/2209/1/A_tract_on_monetary_reform.pdf Tract on Monetary Reform, London, United Kingdom: Macmillan, 1924]</ref> Keynes developed his own quantity equation: n = p(k + rk'),where n is the number of "currency notes or other forms of cash in circulation with the public", p is "the index number of the cost of living", and r is "the proportion of the bank's potential liabilities (k') held in the form of cash." Keynes also assumes "...the public,(k') including the business world, finds it convenient to keep the equivalent of k consumption in cash and of a further available k' at their banks against cheques..." So long as k, k', and r do not change, changes in n cause proportional changes in p.<ref>"Keynes' Theory of Money and His Attack on the Classical Model", L. E. Johnson, R. Ley, & T. Cate (International Advances in Economic Research, November 2001) [http://216-230-72-154.client.cypresscom.net/journal2/iaer/nov_01/johnson_pdf.pdf]</ref>
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| Keynes however notes...{{Quotation|"The error often made by careless adherents of the Quantity Theory, which may be partly explain why it is not universally accepted is as follows. The Theory has often been expounded on the further assumption that a mere change in the quantity of the currency cannot affect k, r, and k',--that is to say, in mathematical parlance, that n is an independent variable in relation to these quantities. It would follow from this that an arbitrary doubling of n, since this in itself is assumed not to affect k, r, and k', must have the effect of raising p to double what it would have been otherwise. The Quantity Theory is often stated in this, or a similar, form.
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| Now "in the long run" this is probably true. If, after the American Civil War, that American dollar had been stabilized and defined by law at 10 per cent below its present value, it would be safe to assume that n and p would now be just 10 per cent greater than they actually are and that the present values of k, r, and k' would be entirely unaffected. But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean will be flat again.
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| In actual experience, a change in n is liable to have a reaction both on k and k' and on r. It will be enough to give a few typical instances. Before the war (and indeed since) there was a considerable element of what was conventional and arbitrary in the reserve policy of the banks, but especially in the policy of the State Banks towards their gold reserves. These reserves were kept for show rather than for use, and their amount was not the result of close reasoning. There was a decided tendency on the part of these banks between 1900 and 1914 to bottle up gold when it flowed towards them and to part with it reluctantly when the tide was flowing the other way. Consequently, when gold became relatively abundant they tended to hoard what came their way and to raise the proportion of the reserves, with the result that the increased output of South African gold was absorbed with less effect on the price level than would have been the case if an increase of n had been totally without reaction on the value of r.
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| ...Thus in these and other ways the terms of our equation tend in their movements to favor the stability of p, and there is a certain friction which prevents a moderate change in v from exercising its full proportionate effect on p. On the other hand, a large change in n, which rubs away the initial frictions, and especially a change in n due to causes which set up a general expectation of a further change in the same direction, may produce a more than proportionate effect on p".}}
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| Keynes thus accepts the Quantity Theory as accurate over the long-term but not over the short term. Keynes remarks that contrary to contemporaneous thinking, velocity and output were not stable but highly variable and as such, the quantity of money was of little importance in driving prices.
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| The theory was influentially restated by [[Milton Friedman]] in response to the work of [[John Maynard Keynes]] and [[Keynesianism]].<ref>Milton Friedman (1956), “The Quantity Theory of Money: A Restatement” in ''Studies in the Quantity Theory of Money'', edited by M. Friedman. Reprinted in M. Friedman ''The Optimum Quantity of Money'' (2005), pp. [http://books.google.com/books?id=XVCgcHQS_nQC&pg=PA51&dq=%22Studies+in+the+Quantity+Theory+of+Money%22+restatement&source=gbs_toc_r&cad=0_0 51]-[http://books.google.com/books?id=XVCgcHQS_nQC&pg=PA67&lpg=PR5&dq=%22Studies+in+the+Quantity+Theory+of+Money%22+restatement 67.]
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| </ref> Friedman understood that Keynes was like Friedman, a "quantity theorist" and that Keynes Revolution "was from, as it were, within the governing body", i.e. consistent with previous Quantity Theory.<ref>“The Counter-Revolution in Monetary Theory”, Milton Friedman (IEA Occasional Paper, no. 33 Institute of Economic Affairs. First published by the Institute of Economic Affairs, London, 1970.) [http://0055d26.netsolhost.com/friedman/pdfs/other_academia/IEA.1970.pdf]</ref> Friedman notes the similarities between his views and those of Keynes when he wrote...{{Quotation|"A counter-revolution, whether in politics or in science, never restores the initial situation. It always produces a situation that has some similarity to the initial one but is also strongly influenced by the intervening revolution. That is certainly true of monetarism which has benefited much from Keynes’s work. Indeed I may say, as have so many others since there is no way of contradicting it, that if Keynes were alive today he would no doubt be at the forefront of the counter-revolution."}}
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| Friedman notes that Keynes shifted the focus away from the quantity of money (Fisher's M and Keynes' n) and put the focus on price and output. Friedman writes...{{Quotation|"What matters, said Keynes, is not the quantity of money. What matters is the part of total spending which is independent of current income, what has come to be called autonomous spending and to be identified in practice largely with investment by business and expenditures by government."}}
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| The Monetarist counter-position was that contrary to Keynes, velocity was not a passive function of the quantity of money but it can be an independent variable. Friedman wrote:{{Quotation|"Perhaps the simplest way for me to suggest why this was relevant is to recall that an essential element of the Keynesian doctrine was the passivity of velocity. If money rose, velocity would decline. Empirically, however, it turns out that the movements of velocity tend to reinforce those of money instead of to offset them. When the quantity of money declined by a third from 1929 to 1933 in the United States, velocity declined also. When the quantity of money rises rapidly in almost any country, velocity also rises rapidly. Far from velocity offsetting the movements of the quantity of money, it reinforces them."}}
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| Thus while Marx, Keynes, and Friedman all accepted the Quantity Theory, they each placed different emphasis as to which variable was the driver in changing prices. Marx emphasized production, Keynes income and demand, and Friedman the quantity of money.
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| Academic discussion remains over the degree to which different figures developed the theory.<ref name="vol"/> For instance, Bieda argues that Copernicus's observation
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| {{Quotation|Money can lose its value through excessive abundance, if so much silver is coined as to heighten people's demand for silver bullion. For in this way, the coinage's estimation vanishes when it cannot buy as much silver as the money itself contains […]. The solution is to mint no more coinage until it recovers its par value.<ref name="vol">{{Citation| last = Volckart| first = Oliver | title = Early beginnings of the quantity theory of money and their context in Polish and Prussian monetary policies, c. 1520-1550 | journal = The Economic History Review| volume = 50| issue = 3| pages = 430–449| year = 1997| doi = 10.1111/1468-0289.00063 }}</ref>}}
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| amounts to a statement of the theory,<ref>{{Citation| last = Bieda| first = K.| title = Copernicus as an economist| journal = Economic Record| volume = 49| pages = 89–103| year = 1973| doi = 10.1111/j.1475-4932.1973.tb02270.x}}</ref> while other economic historians date the discovery later, to figures such as [[Jean Bodin]], [[David Hume]], and [[John Stuart Mill]].<ref name="vol"/><ref>{{Citation| last = Wennerlind| first = Carl| title = David Hume's monetary theory revisited| journal = Journal of Political Economy| volume = 113| issue = 1| pages = 233–237| year = 2005}}</ref>
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| Historically, the main rival of the quantity theory was the [[real bills doctrine]], which says that the issue of money does not raise prices, as long as the new money is issued in exchange for assets of sufficient value.<ref>Roy Green (1987), “real bills doctrine”, in ''The New Palgrave: A Dictionary of Economics'', v. 4, pp. 101-02.</ref>
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| == Equation of exchange ==
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| In its modern form, the quantity theory builds upon the following definitional relationship.
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| :<math>M\cdot V_T =\sum_{i} (p_i\cdot q_i)=\mathbf{p}^\mathrm{T}\mathbf{q}</math>
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| where
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| :<math>M\,</math> is the total amount of [[money supply|money]] in circulation on average in an economy during the period, say a year.
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| :<math>V_T\,</math> is the transactions [[velocity of money]], that is the average frequency across all transactions with which a unit of money is spent. This reflects availability of financial institutions, economic variables, and choices made as to how fast people turn over their money.
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| :<math>p_i\,</math> and <math>q_i\,</math> are the price and quantity of the i-th transaction.
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| :<math>\mathbf{p}</math> is a column vector of the <math>p_i\,</math>, and the superscript <sup>'''T'''</sup> is the [[transpose]] operator.
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| :<math>\mathbf{q}</math> is a column vector of the <math>q_i\,</math>.
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| Mainstream economics accepts a simplification, the [[equation of exchange]]:
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| :<math>M\cdot V_T = P_T\cdot T</math>
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| where
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| :<math>P_T</math> is the [[price level]] associated with transactions for the economy during the period
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| :<math>T</math> is an index of the [[Real versus nominal value (economics)|real value]] of aggregate transactions.
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| The previous equation presents the difficulty that the associated data are not available for all transactions. With the development of [[national income and product accounts]], emphasis shifted to national-income or final-product transactions, rather than gross transactions. Economists may therefore work with the form
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| :<math>M \cdot V = P \cdot Q</math>
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| where
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| :<math>V</math> is the [[velocity of money]] in final expenditures. | |
| :<math>Q</math> is an index of the real value of final expenditures.
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| As an example, <math>M</math> might represent currency plus deposits in checking and savings accounts held by the public, <math>Q</math> real output (which equals real expenditure in macroeconomic equilibrium) with <math>P</math> the corresponding price level, and <math>P\cdot Q</math> the [[Real versus nominal value (economics)|nominal]] (money) value of output. In one empirical formulation, velocity was taken to be “the ratio of net national product in current prices to the money stock”.<ref>{{Citation | author=Milton Friedman, and Anna J. Schwartz, | title=The Great Contraction 1929–1933 | location=Princeton | publisher=Princeton University Press | year=1965 | isbn=0-691-00350-5}}</ref>
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| Thus far, the theory is not particularly controversial, as the equation of exchange is an identity. A theory requires that assumptions be made about the causal relationships among the four variables in this one equation. There are debates about the extent to which each of these variables is dependent upon the others. Without further restrictions, the equation does not require that a change in the money supply would change the value of any or all of <math>P</math>, <math>Q</math>, or <math>P\cdot Q</math>. For example, a 10% increase in <math>M</math> could be accompanied by a 10% decrease in <math>V</math>, leaving <math>P\cdot Q</math> unchanged. The quantity theory postulates that the primary causal effect is an effect of ''M'' on ''P''.
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| == Cambridge approach ==
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| {{further|Cambridge equation}}
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| Economists [[Alfred Marshall]], [[A.C. Pigou]], and [[John Maynard Keynes]] (before he developed his own, eponymous school of thought) associated with [[Cambridge University]], took a slightly different approach to the quantity theory, focusing on money demand instead of money supply. They argued that a certain portion of the money supply will not be used for transactions; instead, it will be held for the convenience and security of having cash on hand. This portion of cash is commonly represented as ''k'', a portion of nominal income (<math>P \cdot Y</math>). The Cambridge economists also thought wealth would play a role, but wealth is often omitted for simplicity. The Cambridge equation is thus:
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| :<math>M^{\textit{d}}=\textit{k} \cdot P\cdot Y</math>
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| Assuming that the economy is at equilibrium (<math>M^{\textit{d}} = M</math>), <math>Y</math> is exogenous, and ''k'' is fixed in the short run, the Cambridge equation is equivalent to the equation of exchange with velocity equal to the inverse of ''k'':
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| :<math>M\cdot\frac{1}{k} = P\cdot Y</math>
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| The Cambridge version of the quantity theory led to both Keynes's attack on the quantity theory and the Monetarist revival of the theory.<ref>Froyen, Richard T. ''Macroeconomics: Theories and Policies''. 3rd Edition. Macmillan Publishing Company: New York, 1990. p. 70-71.</ref>
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| == Quantity theory and evidence==
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| As restated by Milton Friedman, the quantity theory emphasizes the following relationship of the nominal value of expenditures <math>PQ </math> and the price level <math>P</math> to the quantity of money <math>M </math>:
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| <!-- What is the '+' (plus sign) supposed to be over? The f & g or the M or what? Spacing was wrong for me - either use a ^ for a superscript or \overset if it's supposed to be stacked above -->
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| :<math>(1) PQ={f}(\overset{+}M)</math>
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| :<math>(2) P={g}(\overset{+}M)</math>
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| The plus signs indicate that a change in the money supply is hypothesized to change nominal expenditures and the price level in the same direction (for other variables [[ceteris paribus|held constant]]).
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| Friedman described the [[empirical]] regularity of substantial changes in the quantity of money and in the level of prices as perhaps the most-evidenced economic phenomenon on record.<ref>Milton Friedman (1987), “quantity theory of money”, ''[[The New Palgrave: A Dictionary of Economics]]'', v. 4, p. 15.</ref>
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| [[Empirical]] studies have found relations consistent with the [[model (economics)|models]] above and with causation running from money to prices.{{Citation needed|date=November 2013}} The short-run relation of a change in the money supply in the past has been relatively more associated with a change in real output <math>Q</math> than the price level <math>P</math> in (1) but with much variation in the precision, timing, and size of the relation. For the ''long''-run, there has been stronger support for (1) and (2) and no systematic association of <math>Q</math> and <math>M</math>.<ref>Summarized in Friedman (1987), “quantity theory of money”, pp. 15-17.</ref>
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| === Principles ===
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| The theory above is based on the following hypotheses:
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| # The source of [[inflation]] is fundamentally derived from the growth rate of the money supply.
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| # The supply of money is [[exogenous]].
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| # The demand for money, as reflected in its velocity, is a stable function of nominal [[income]], [[interest rate]]s, and so forth.
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| # The mechanism for injecting money into the economy is not that important in the long run.
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| # The [[real interest rate]] is determined by non-monetary factors: ([[productivity]] of [[Capital (economics)|capital]], [[time preference]]).
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| === Decline of money-supply targeting ===
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| An application of the quantity-theory approach aimed at removing [[monetary policy]] as a source of macroeconomic instability was to target a constant, low growth rate of the money supply.<ref>Friedman (1987), “quantity theory of money”, p. 19.</ref> Still, practical identification of the relevant [[money supply]], including measurement, was always somewhat controversial and difficult. As [[Financial intermediary|financial intermediation]] grew in complexity and sophistication in the 1980s and 1990s, it became more so. As a result, some [[central banks]], including the U.S. [[Federal Reserve]], which had targeted the money supply, reverted to targeting interest rates. But monetary aggregates remain a [[leading economic indicator]].<ref>NA (2005), How Does the Fed Determine Interest Rates to Control the Money Supply?”, Federal Reserve Bank of San Francisco. February,[http://www.frbsf.org/education/activities/drecon/answerxml.cfm?selectedurl=/2005/0502.html]</ref> with "some evidence that the linkages between money and economic activity are robust even at relatively short-run frequencies."<ref>R.W. Hafer and David C. Wheelock (2001), [http://research.stlouisfed.org/publications/review/01/0101rh.pdf “The Rise and Fall of a Policy Rule: Monetarism at the St. Louis Fed, 1968-1986”], Federal Reserve Bank of St. Louis, ''Review'', January/February, p. 19.</ref>
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| ==Criticisms==
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| [[John Maynard Keynes]] criticized the quantity theory of money in ''[[The General Theory of Employment, Interest and Money]]''. Keynes had originally been a proponent of the theory, but he presented an alternative in the ''General Theory''. Keynes argued that price level was not strictly determined by money supply. Changes in the money supply could have effects on real variables like output.<ref name="minksy_keynes" />
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| [[Ludwig von Mises]] agreed that there was a core of truth in the Quantity Theory, but criticized its focus on the supply of money without adequately explaining the demand for money. He said the theory "fails to explain the mechanism of variations in the value of money".<ref>Ludwig von Mises (1912), [http://mises.org/books/Theory_Money_Credit/Contents.aspx “The Theory of Money and Credit (Chapter 8, Sec 6)”].</ref>
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| == See also ==
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| {{colbegin|3}}
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| *[[Classical dichotomy]]
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| *[[Demand for money]]
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| *[[Equation of exchange]]
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| *[[Income velocity of money]]
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| *[[Liquidity preference]]
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| *[[Monetae cudendae ratio]]
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| *[[Monetarism]]
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| *[[Monetary inflation]]
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| *[[Monetary policy]]
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| *[[Neutrality of money]]
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| {{colend}}
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| ===Alternative theories===
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| * [[Benjamin Anderson]] (critic of mainstream variant)
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| * [[Fiscal theory of the price level]]
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| * [[Real bills doctrine]]
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| == References ==
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| {{Reflist}}
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| ==Further reading==
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| * Friedman, Milton (1987 [[The New Palgrave Dictionary of Economics|[2008]]]). “quantity theory of money”, ''[[The New Palgrave: A Dictionary of Economics]]'', v. 4, pp. 3–20. [http://www.dictionaryofeconomics.com/article?id=pde2008_Q000006&q=&result_number=1 Abstract.] Arrow-page searchable [http://books.google.com/books?id=jTx3VZd0T8oC&pg=PA1&lpg=PR5&dq=+norton preview] at John Eatwell et al.(1989), ''Money: The New Palgrave'', pp. 1–40.
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| * [[David Laidler|Laidler, David E.W.]] (1991). ''The Golden Age of the Quantity Theory: The Development of Neoclassical Monetary Economics, 1870-1914''. Princeton UP. [http://books.google.com/books?id=leueAAAAIAAJ&source=gbs_ViewAPI&pgis=1 Description] and [http://findarticles.com/p/articles/mi_qa5421/is_n4_v60/ai_n28638753/ review.]
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| * Mises, Ludwig Heinrich Edler von; ''Human Action: A Treatise on Economics'' (1949), Ch. XVII “Indirect Exchange”, §4. “The Determination of the Purchasing Power of Money”.
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| == External links ==
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| * The Quantity Theory of Money from [[John Stuart Mill]] through [[Irving Fisher]] from the New School
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| *[http://formularium.org/?go=53 “Quantity theory of money” at Formularium.org] — calculate M, V, P and Q with your own values to understand the equation
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| *[http://econblog.aplia.com/2006/08/how-to-cure-inflation.html How to Cure Inflation (from a Quantity Theory of Money perspective)] from Aplia Econ Blog
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| {{Spoken Wikipedia|Velocity_of_money.ogg|2006-01-02}}
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| {{DEFAULTSORT:Quantity Theory Of Money}}
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| [[Category:Macroeconomics]]
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| [[Category:Monetary economics]]
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| [[Category:Business cycle]]
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| [[Category:Economics terminology]]
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