Posted on by Art Powell

It could be that the quantity theory of money is controversial and often dismissed because it deals with two aspects of economics where we most want to deceive ourselves – money and economic growth.

When I started to research and think about this post I quickly got so ticked off that I went downstairs to my lathe to transform a piece of firewood into a magic wand for one of my grandchildren. (Abracadabra. All economists will become fairy godmothers – in their next reincarnations.)

The theory states that MV=PQ where M is the money supply, V is the velocity at which the money changes hands, P is the price level and Q is the quantity of goods and services exchanged. What gets me ticked off is that this is frequently taken to mean there is a direct, proportional relationship between the money supply and the inflation rate or price level. Can’t people see there are four variables in this formula?

The value in this formula is in that it explains relationships and shows how the real or physical side of the economy connects to the financial. It is difficult because there are problems with fractional reserve money and because some people believe (or need to believe) that economic growth will always continue. I think these are two aspects of economics where some people have psychological problems accepting the truth. It becomes even more difficult if one tries to use this formula in a computer model as the four variables are difficult if not impossible to measure.

To maintain the equality, if one variable goes up then one or more of the other variables must also change, For example, if the money supply increases then velocity must go down and/or one or both of the price level or the quantity of goods and services produced must go up. It could be that during recent decades the money supply was increasing faster than Q was increasing. We saw the difference as inflation.

The way we create money is a major problem.

The fractional reserve creation of money works only so long as more and more money is being created. Bankers create money by making loans. The problem is the interest. If all loans plus interest had to be repaid at one time there would not be enough money in the system.. This is similar to a Ponze scheme and works only so long as more and more money can be created.

This means there is constant upwards pressure on the M in the formula – until the money creation breaks down and the M goes down suddenly and either prices fall or the quantity of goods and services produced goes down or both. When the United States was trying to stick to a gold standard there were frequent economic crises because there was not always enough gold to support the amount of economic activity for which there were human and material resources. The gold discoveries of the 19th century contributed to prosperity because they added to the money supply.

The big problem on the other side of the equation is Q. A lot of people believe or assume economic growth will continue forever. I figure Q behaves as a fractal, that is with ups and downs and ups and downs within each up and down – something like the seashore.

Some of the things which drive Q are not likely to be steady. Discoveries of energy and mineral resources are erratic; agricultural production can vary with the weather; and new technology comes in spurts. I think Q is currently being restrained because we have used up the most easily accessible energy and mineral resources. We have picked the low-hanging fruit and what is left is going to take a lot of energy to get.

As Q is a fractal its changes in direction are likely to throw the equation out of balance and force one or more of the other variables to adjust.

Prices appear to respond mostly to changes in M or Q. Sometimes governments decide to try to control inflation with price controls. and this usually causes problems with the balance of the equation. Inflation is to the advantage of borrowers and deflation is to the advantage of lenders. To be fair to everyone we need price stability. As governments are large borrowers it is natural for people concerned with government finances to favor inflation. Probably the best way to price stability would be to find another way of creating money so that the total is flexible. Then the money supply rather than prices could respond to changes in the quantity of goods and services produced.

To the best of my knowledge not much is known about velocity. I understand that in the days of the gold standard people would hoard gold if they were worried about other forms of money.

To call the formula MV+PQ the quantity theory of money is probably a little misleading. It would be better to think of it as the connectivity formula. As such I believe it is very valuable in understanding what is happening to the economy.

Perhaps if we had more fairy godmothers we would have a better understanding of what is happening to us.

If you liked this post your are invited to comment, press the like button and/or click one of the share buttons. If you disagree you are invited to say why in a comment. While I like the idea of sharing this platform, my personality is such that I don’t reply to many comments.

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Filed under: Economics | Tagged: economic growth, Economics, fractal, fractional reserve money, growth, inflation, interest, loans, magic wand, money, MV=PQ, quantity theory of money, relationships |