Introduction to the famous Quantity Theory of Money

February 18th, 2008

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Remember, back in Cause of inflation: Shanghai bubble case study, we mentioned about the definition of inflation by the Austrian School of economic thought:

The mainstream economists? definition of inflation is rise in the general level of prices. However, according to the Austrian School of economic thought, the definition of inflation is the increase in the supply of money [and credit], in which the effect is the rise in the general level of prices.

That definition of inflation was based on a very old economic idea, the Quantity Theory of Money, which was revived by Milton Friedman in the form of ‘monetarism.’ This theory has a very famous mathematical equation:


M is the supply of money, V is the velocity of money (i.e. the number of times that the money is used), P is the price level and Y is the level of output by the economy. Assuming that V and Y is constant, then this equation tells us that the price levels in the economy is proportional to the supply of money.

This equation is inherently true because it is just a mathematical relationship. The problem is, it floundered when it comes to the application of economic policy. First, as we said before in our guide, What is inflation and deflation?,

Today, in this modern age of finance, money is far more complicated than what it was used to be (i.e. simple gold and silver). It has come to the point that it is very hard to even define what money is, let alone measure its quantity. Alan Greenspan, the former head of the US Federal Reserve was believed to have said ?We don?t know what money is, any more.?

The price level is also another troublesome measurement. As we said before in How much can we trust the price indices (e.g. CPI)?, the whole idea of price indices is logically invalid.

Monetarism became popular due to the infamous stagflation of the late 1970s. At one time, central bankers target the quantity of money as a way to deal with the intractable problem of stagflation. As history has shown, monetarism did not work and was discredited. There are subtle differences between monetarism and Austrian School monetary theory. We will not delve deep into it today, as we know it is very boring and abstract unless we can bring it to life with a relevant contemporary application. But we would like to bring to your attention one thing: there is a crucial insight from the Austrian School that is missed by monetarism. Monetary inflation (or ‘printing’ money or increasing the money supply) results in the distortion of the relative price levels. That is, when money is ‘printed,’ prices will be affected in varying degrees for different things with different time lags (see How to secretly rob the people with monetary inflation?).  This is the key Austrian School insight.