The quantity theory of money states that there's a direct relationship between the money supply and the average price level of goods and services.
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The quantity theory of money holds that the price of goods and services is directly linked to an economy's money supply. The Renaissance astronomer and mathematician Nicolaus Copernicus formulated the idea in the 1500s. American economists Milton Friedman and Anna Schwartz revitalized it in the mid-20th century.
Before diving into the quantity theory of money, it's helpful to brush up on a few terms:
"The quantity theory of money simply states that an increase in the money supply will result in the same increase in inflation, all else being equal," says Dan North, chief economist at Allianz Trade. "A doubling in the money supply will result in a doubling in inflation."
Of course, certain events can cause specific commodity prices to increase. For example, a hurricane in the Gulf of Mexico can bump up prices at the gas pump, or a Midwest drought can make wheat more expensive. But the quantity theory of money posits that average prices shouldn't rise as long as appropriate monetary policy controls the money supply.
Monetarism is a macroeconomic theory that argues governments can achieve economic stability by controlling the money supply. The Federal Reserve and other central banks have done this through a policy known as quantitative easing, which involves purchasing a large number of long-term securities in the open market to increase the money supply and encourage lending and investment.
Hermann Simon, founder and honorary chairman at Simon-Kucher & Partners, says that the quantity theory of money equation is "at the heart of quantitative easing and monetarism."
Here's the equation:
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"M is the quantity of money. V is the speed money flows around the economy. P is the level of prices. And T is the number of transactions," Simon says.
It's dubbed the Fisher equation after American economist Irving Fisher, who touched on the quantity theory of money in his 1911 book, "The Purchasing Power of Money."
The velocity of money is the number of times one unit of currency is spent on goods and services over a given period. If the velocity of money increases, it means that more transactions are taking place in the economy and vice versa. The figures can help determine if consumers and businesses are saving or spending their money.
To understand how the quantity theory of money works, Luke Tilley, chief economist at Wilmington Trust, offers an example:
"Imagine a simple economy with 100 people that produce and consume only one type of good," Tilley says. "[The economy] can make 100 per year with its labor force and capital. And that economy has $100. The economy produces 100 units per year, which are each sold once (V=1) for $1 each (P=$1). Seems very simple."
However, things start to change if the money supply grows. "If you dump another $100 into the economy by giving each person $1, they all want to buy another unit of the good, so they'll bid up the price," says Tilley. "But because the economy's labor force and level of capital haven't changed, it can't make any more. The new dollars push the price up to $2. Nothing has really changed, except prices are higher and the economy experienced inflation."
The above example "is a real-world description of Friedman's famous statement that inflation is always and everywhere a monetary phenomenon," says Tilley. "The Fed (and other major central banks) have very much adopted this theory. For the Fed, it is included in their long-run goals and strategy statement. It's not as clear for the non-economist, but they say something along the lines of, 'Over the long run, monetary policy is the only thing that can affect inflation.'"
To be sure, monetary policy is a balancing act.
"If the Fed provides too much money, you get inflation," says Allianz Trade's North. "If the Fed does not provide enough money, you get deflation and a slowing economy with rising unemployment. The Fed's mandate is to balance inflation and unemployment."
Copernicus, perhaps best known as the father of modern astronomy, is credited with formulating the quantity theory of money in the early 16th century. Copernicus believed the supply of money is the primary determinant of prices.
"We in our sluggishness do not realize that the dearness of everything is the result of the cheapness of money," Copernicus wrote. "For prices increase and decrease according to the condition of the money."
Over the years, the quantity theory of money was reaffirmed by philosophers John Locke, David Hume, and Jean Bodin. Eventually, Friedman and Schwartz formalized and popularized the theory in their 1963 book, "A Monetary History of the United States, 1867–1960."
Of course, like all economic theories, not everyone agrees with the quantity theory of money. Keynesian economists – who believe peak economic performance can be reached through government intervention and activist stabilization, not by changing the money supply – are among its biggest critics.
Critics argue that changing the money supply isn't effective in influencing economic growth.
North points to the Fed's measures to increase the money supply and lower interest rates when the pandemic brought parts of the economy to a virtual standstill. While the economy bounced back, officials maintained those policies for too long, leading to a surge in inflation two years later, he says.
"Too much easy money for too long is the classic formula for inflation, and for tears," North says.
Critics also contend that the velocity of money isn't stable, so the relationship between money supply and price levels isn't constant. For example, Tilley explains that output is a moving target that's hard to pin down given the ever-changing nature of how companies and the workforce interact.
"The way that labor and capital work together (productivity) is always changing and hard to track," Tilley says. "The so-called velocity of money can be described conceptually. Perhaps it increases or decreases because debit cards or some other technology make it faster and easier for dollars to exchange hands. But for me, the V is just a byproduct of the equation. It's not very helpful."
