Primer: When Does The Quantity Theory Of Coin Brand Sense?

In this post, I hand a quick overview of the Quantity Theory of Money, as well as I await at the empirical show inwards post-World War II North America. H5N1 weak shape of the theory tin flaming live on arrived at inwards a number of ways, as well as i could fighting that it holds "in the long run". But equally my empirical show shows, the "long run" may live on far besides long to live on of whatever operate for analysis. I tend to ignore the theory for this reason, which appears to live on a consensus sentiment alongside fixed income analysts.

The Strong Version Of The Quantity Theory Of Money

The equation of exchange is a formula which acts equally the Definition of the velocity of money. There are a number of forms of writing the equation, as well as I volition use:

M(t)V(t) = P(t)Q(t) = Y(t),

or, inwards English,

Money * Velocity = (Price Level)*(Quantity Of Goods) = Nominal GDP,

for variables at fourth dimension t.

Note that since this defines "velocity", it ever holds.

What I refer to equally the "Strong Version Of The Quantity Theory Of Money" is that velocity inwards the higher upwards equation is a constant value, V.

The implications of this theory are straightforward as well as powerful. For example, a rapid doubling the "money supply" (I hash out the number of which monetary aggregate to operate below) implies that nominal gross domestic product volition double over that period. Since it is unlikely that existent production tin flaming react speedily to a alter inwards the money supply, the mass of the adjustment would live on inwards the shape of cost changes, thus the cost grade would roughly double.

I volition forthwith greenback that no respectable living economist believes inwards the Quantity Theory of Money inwards this potent form. Earlier economists may get got written downward theories that were equivalent to this version, but they were operating inwards an era where macroeconomic information were either unavailable or fifty-fifty non fifty-fifty conceptualised yet. The existent debate is over a weaker version of the theory, equally I hash out below. However, this uncomplicated version allows us to come across what the indicate of the quantity theory is - it provides a machinery to explicate inflation.

Weaker Versions Of The Quantity Theory

Quantity theory exists inwards a weaker form, inwards which the velocity of money is non constant, rather it is a percentage of other economical variables. The thought is that the velocity volition hateful revert to a long run value, as well as and so the potent human relationship betwixt money as well as nominal gross domestic product volition concord "in the long run". This thought has a long history, as well as I practice non want to hash out it here; I volition refer the reader to the Wikipedia entry for to a greater extent than details.

I volition instead run through reasons why velocity may live on stable inwards the long run.

• Stock-Flow Norms. Stock-Flow norms are a concept embedded inwards Stock-Flow Consistent modelling, Roughly speaking, people volition desire to concord assets - including money - close target ratios relative to nominal income. Although mainstream economic science to a greater extent than oft than non does non subscribe to the concept of stock-flow norms, real similar logic is used inwards the instance of money. As a result, the ratio of money holdings relative to nominal incomes (hence GDP) cannot teach besides large or besides small. Correspondingly, the functioning of stock-flow norms implicitly defines upper as well as lower boundaries for velocity.
• Debt-Based Growth. It is real hard for an economic scheme to grow without at to the lowest degree or as well as so entities spending to a greater extent than money than they have inwards the electrical flow accounting period. This tin flaming entirely live on done sustainably equally the lawsuit of debt issuance. Amongst others, this was a indicate raised past times the economist Hyman Minsky, as well as to a greater extent than late Steve Keen has written extensively on this topic. Since banking concern lending creates deposits, this agency that nominal increment has to drag along the monetary aggregates for the ride.
• Payment Constraints. Until the widespread adoption of credit cards, entities needed money holdings inwards advance to pay for most goods as well as services. "Cash-in-advance" constraints volition practice a bound to how fast money tin flaming circulate inside an economic scheme (hence the terminology of velocity), putting limits on the ratio of nominal activity to the monetary aggregates.

Although these arguments are hard to refute theoretically, the empirical usefulness of these observations is limited, equally seen inwards the side past times side sections.

US Experience

Although the U.S. Federal Reserve's Quantitative Easing did zip useful for the economy, it was helpful inwards putting a stake through the pump of the Quantity Theory Of Money.

The nautical chart higher upwards shows the human relationship betwixt the (adjusted) monetary base of operations - which includes deposits at the fundamental bank, equally good equally notes as well as coins - as well as nominal GDP. During the flow 1950-2007, velocity ranged from less than 10 to to a greater extent than than 20. This agency that the potent version of the quantity theory of money would yield predictions of nominal gross domestic product that are off past times 100%, which is a fairly lousy performance.

More recently, a foolish hyper-activity past times the Fed subsequently the fiscal crisis led to the monetary base of operations exploding inwards size, as well as velocity collapsing. There has been no deport upon on nominal gross domestic product growth, which is mired at a steady state annual increment charge per unit of measurement of close 4%.

One of the problems with the Quantity Theory of Money is that it is unclear what monetary aggregate to use. Within simplistic DSGE models, inwards which banks practice non appear, money is a well-defined concept, as well as corresponds to the monetary base. But inwards the existent world, nosotros involve to accept into employment organization human relationship banking concern lending, specially if y'all are a believer inwards the "debt-based growth" explanation of the quantity theory. As a result, nosotros tin flaming define the velocity inwards price of a broader monetary aggregate.

Once nosotros movement to a broader monetary aggregate - M2 inwards this instance - velocity is to a greater extent than stable. However, when nosotros await at the bottom panel of the chart, in that location is all the same real niggling human relationship betwixt M2 increment rates as well as the increment charge per unit of measurement of nominal GDP.

The Canadian Experience

The Canadian sense is similar to that of the United States, but in that location are 2 divergences. Firstly, the Bank of Canada did non teach caught upwards inwards the Quantitative Easing insanity that infected other fundamental banks. This keeps the serial spiralling out of command at the destination of the information set. Secondly, Canada abolished regulatory reserve requirements inside the banking system. As a result, the monetary base of operations has shrunken relative to nominal GDP. (Since velocity is but the inverse of the percent of gross domestic product of money, I dropped the velocity panel from the charts equally existence redundant.)

The 2 charts higher upwards demonstrate wider Canadian monetary aggregates: M1+ as well as M3 (gross). Both get got been rising faster than nominal gross domestic product since the mid-1980s. The recent spurt of increment non-coincidently arose when the Canadian housing marketplace has entered a rather spectacular debt-fuelled bubble. 

This latter component in all probability explains why nosotros cannot operate the Quantity Theory of Money on reasonable forecast horizons - three to five years, say. Money is non but used to back upwards transactions inwards the existent economy, it is also used to back upwards transactions inwards assets, notably existent estate assets. Since buying as well as selling houses practice non direct add together to gross domestic product (other than diverse fees), a spectacular wedge tin flaming arise betwixt debt/money increment as well as gross domestic product growth.

Concluding Remarks

Although the Quantity Theory of Money may concord inwards uncomplicated economical models, velocity is besides unstable for it to live on useful for estimating inflation or nominal gross domestic product on whatever reasonable forecast horizon. Even if velocity hateful reverts on a real long horizon (20-30 years, for example), nosotros get got no way of forecasting money increment on such a horizon.

(c) Brian Romanchuk 2014