The Quantity Theory of Money: An Inquiry Regarding Meaning and Method

Abstract

The quantity theory of money (QTM) is the oldest quantitative relationship that has been considered in economics. It also has the longest history of investigation by quantitative methods. In spite of all of the intellectual and empirical efforts that have been devoted to it, the validity of the QTM has remained controversial and the role that it has played in macroeconomic theory and policy has fluctuated largely over time. We believe that this unsatisfactory performance is due to deficiencies in how the empirical work on the QTM was done. A careful conceptual analysis of how the theory at issue is to be interpreted and of what the best empirical methods for dealing with it are is neglected. The interest in the QTM derives from the fact that it implies a relationship between the growth of the money supply and inflation. However, the simplest form of the QTM, the Cambridge equation, which relates the nominal stock of money to nominal expenditure, does not explicitly contain the inflation rate at all. In order to get an explicit expression for inflation, nominal expenditure has to be written as the product of real expenditure and a measure of the price level and the resulting equation differentiated logarithmically. We argue that the QTM is best dealt with in this simple ‘Cambridge form’, rather than in the usual more complex version that contains inflation explicitly. Most of the empirical work done on the QTM has used rather simple statistical measures of the correlation between money growth rates and inflation and has found the correlation to be strong, at least, for episodes of high inflation. More recently, the emphasis has been on more sophisticated tests of the validity of the QTM. However formulated in detail, these tests amount to a test of the constancy on the Cambridge k coefficient. We believe that such tests are essentially meaningless and derive from a failure to distinguish between a thought experiment and a historical evolution. The idea that k should be a constant derives from the thought experiment which considers two equilibria (e, e’) of an economy such that all physical magnitudes are the same, but the quantity of money in e’ is twice that in e. Then prices in e’ should be double those in e. While this thought experiment is suggestive, it cannot simply be applied to a comparison of two positions along the secular growth path of an existing economy. The demand for money is ultimately dependent on all of the technological and preference parameters pertaining to all of the agents of an economy. The past decades have seen vast changes in the financial system and the means of payment. That the demand for money, however measured, should under such conditions be an invariant constant is incredible. What is the sense of testing if a proposition is true, if we can be sure a priori that it must be false? We ask a different question: Not if k is a constant, but rather if it is stable enough to be useful for the formulation of monetary policy. In a large sample of 125 economies, not selected for episodes of high inflation, the answer turns out to be strongly positive.