The Quantity Theory of Money - Essay Example

Quantity Theory of Money (Word Count 833) Introduction The quantity theory of money is a theory of economics concerning the relationship between prices and the quantity of money in a given economic system (Pesek, 1963). While there had been ideas presented by different thinkers about such as relationship in the past, in modern times, it is Milton Friedman who lends his support to the theory. In historical terms, individuals such as Copernicus, Bodin, Hume, Mill and Fisher have all considered ideas which support the approach taken in the theory (Wikipedia, 2008). Quantity Theory of Money Before a discussion can be made about the theory and its applicability, it is important to understand several concepts which are used when discussing the theory itself. The first concept is the value of money since it is easy to understand that printed paper has little value on its own but it is the amount of goods and services which can be exchanged for that piece of paper which gives it value. However, the origins of that strength of money depend on the market of money itself and the price of money. Like all other commodities in the world, the price of money depends largely on its supply and demand. The supply in the case of money depends on the amount of money brought to the market by the government. The government can adjust this supple upwards or downwards through changing the level of money in circulation (Kaldor & Trevithick, 1992). However, the demand for money comes from the consumers and the businesses which use money in an economic system. Of course these are not the factors which determine the demand for money itself because the demand for money can be based on a multitude of factors such as the availability of credit cards, the need for spending and most importantly, the prices in an economy (Wikipedia, 2008). If prices are high, the demand for money will increase as goods and services will need to be bought at expensive rates. If prices in general are low, goods and services will cost less and little money will be demanded. The point at which the supply of money meets with the demand for money is the point which sets the value of money. The supply is controlled by the government and the demand is determined by the consumers of money (Pesek, 1963). The money market therefore, sets the value of money which remains a variable that can change with the determinants of supply and demand. Since it also determines the prices of goods and services in an economy, changes in the value of money cause changes in price levels. They may have the same magnitude but the direction of the change is always opposite. Thus the quantity theory of money is based on the changes brought to the supply (quantity) of money in the economic system. When governments or the banks which control the supply of money increase the supply of money, the value of money falls and prices go upwards. In essence, inflation is controlled by the supply of money and therefore governments can use central banks to control the level of inflation through the quantity theory of money. Keynesian Approach Of course this is a rather simplistic view of the quantity theory of money since real world scenarios may be quite a lot more complicated (Garrison, 1992). The economic complications come from the velocity of money which determines how quickly money changes hands in the economy. If this velocity is high then money is being rotated quickly in the economy which means that a relatively small amount of cash or money supply can handle a large economic system (Kaldor & Trevithick, 1992). If the velocity is slow then money is going from one person to another slowly therefore a large amount of money will be required to permit the same number of changes. The quantity of money theory is further complicated by the idea that the velocity of money changes dramatically over time. Consumer spending on goods and services can change their spending and saving preferences. Thus the quantity theory of money is based on four different elements and their relationship can be represented as: M x V = P x Q In this equation, M is the supply of money, V is the velocity at which money travels from one hand to the other and P is the price level. Q is the quantity output by the economic system. A rearrangement of the equation would allow us to say that the Velocity of money is equal to the nominal GDP of an economy divided by the supply of money. The importance of this theory becomes even more evident when we understand that there is positive relationship between the supply of money and the level of inflation in an economy (Garrison, 1992). Of course it is more difficult to create the ideal rate of inflation through the control of money supply because a negative or a positive rate of inflation will come with its own advantages and disadvantages. Politicians may prefer to see zero inflation since it is easy to project an idea of economic stability if they can point towards zero inflation as well as a zero unemployment rate (Palley, 1998). When it comes to applying the quantity theory of money in an economy, it seems that there is no consensus on how it can be applied and while some economists suggest that the optimal rate of inflation in an economy should be slightly negative (Friedman, M. 1969), recent examples and the analysis done by other economists suggest that a slightly positive rate of inflation could be better for the economy (Sinclair, 2003). While the quantity of theory money is certainly valuable and helps in understanding how an economic system operates. The economic ideas propagated by Keynesian economists and post Keynesian theorists link inflation and the supply of money to the level of unemployment in an economic system. Beyond the quantity theory of money for determining and setting inflation rates, the Non-Accelerating Inflation Rate of Unemployment (NAIRU) is seen as a better method for determining the ideal rate of inflation in given set of circumstances (Palley, 1998). The theory goes beyond the quantity theory of money and links inflation to the unemployment rate. The theory suggests that if governments try to push unemployment below a certain natural rate, the results will create an increase in inflation and will have no permanent effect in unemployment levels. This is because the forces of supply and demand will push the economic system back to the natural level of unemployment and the only effect of sustained expansionist policies would be to increase the inflation rate. The theory maintains that governments cannot increase inflation in order to try and to reduce the unemployment (Capell and Cohn, 2004). However, no government seeks to have a negative rate of inflation since there is a significant difference here between theory and practice. Writing for the Bank of England Quarterly Bulletin, Sinclair (2003) reports that, “A large and growing number of central banks target inflation. Sometimes the central banks themselves set their own inflation targets. Others are given targets by government. No inflation targets, anywhere, are negative (Sinclair, 2003, Pg. 343)”. Therefore the question of the optimal supply of money is not an easy one to answer the perfectly optimal quantity and supply of money is more or less impossible to determine without taking into consideration a variety of factors that influence it (Garrison, 1992). While the optimal level of money supply and hence the optimal level of inflation is difficult to predict, analysts such as Palley (1998) show that zero is not the optimal rate of inflation. A study of the quantity theory of money along with the practical results from several years of inflation rates show that zero inflation is bad for an economy. In fact, Palley goes on to say that zero inflation is nothing more than a political agenda which may place a government on positive footings but it has very bad effects on the economy. He notes that, “The reality is that it is hard to make a persuasive economic case for zero inflation, and there is a strong case that it is downright harmful. Pursuit of zero inflation risks increasing unemployment, with only financial interests standing to benefit. This is the ultimate moral of the story (Palley, 1998, Pg. 5)”. The Present Situation Our present efforts to control an economy through the adjustments made to the supply of money with the raising or lowering of interest rates is a method which has come from various economic theories that have been created, developed, tested and evaluated by Keynesians as well as monetarists economists (Garrison, 1992). While the theorists may disagree with what means must be taken to handle the problems in a given economic system, they certainly agree with the idea that the supply or availability of money is an essential factor in determining interest rates. Controlling interest rates to manage unemployment, job creation, investment levels and other dependences are matters of argument which largely remain without perfect solutions. Conclusion Given the information available about the quantity theory of money as well as the objections to it, it becomes easy to say that the idea level for the supply of money or the ideal quantity of money in an economy would be the one which results naturally in an economic system without government intervention. In this manner, a liberal approach to the economy is perhaps the best because it helps in letting the market decide the price of money and it lets the market set interest rates for investments and unemployment. In the real world however, since governments are more than likely to interfere in an economic system, the suggestions given by Sinclair (2003) become very valid who suggests that, “For advanced countries at least, the case for a modestly positive rate of inflation looks decidedly a wise one (Sinclair, 2003, Pg. 349)”. In this manner, the quantity theory of money can be used by economists to create a supply level of money which encourages a modestly positive inflation for countries which need to maintain their rate of development. Works Cited Capell, K and Cohn, L. 2004, ‘Jobs: Whats Britains Secret?’, Business Week, vol. 3878, no. 1, pp. 50-51. Friedman, M. 1969, ‘The optimum quantity of money’, in The optimum quantity of money and other essays, Macmillan-Aldine. Garrison, R. 1992, ‘Is Milton Friedman a Keynesian?’, [Online] Available at: http://www.auburn.edu/~garriro/fm2friedman.htm Kaldor, N and Trevithick, J. 1992, ‘A Keynesian perspective on money’, [Online] Available at: http://www.accessmylibrary.com/coms2/summary_0286-9255002_ITM Palley, T. 1998, ‘Zero is not the optimal rate of inflation’, FindArticles.com [Online] Available at: http://www.findarticles.com/p/articles/mi_m1093/is_n1_v41/ai_20485329/pg_2 Pesek, B. 1963, ‘Determinants of the Demand for Money’, The Review of Economics and Statistics, vol. 45, no. 4, pp. 419-424. Sinclair, P. 2003, ‘The optimal rate of inflation: an academic perspective’, Bham.ac.uk, [Online] Available at: http://www.economics.bham.ac.uk/sinclair/inflation.pdf Wikipedia, 2008, ‘Quantity Theory of Money’, [Online] Available at: http://en.wikipedia.org/wiki/Quantity_theory_of_money Read More