• Monetarism is a good idea that has been poorly executed. At its heart, the core principle of monetarism is that “money matters” to economic outcomes. More specifically, money creation, in excess of growth in real output, is the leading cause of inflation over long periods of time.

• This is a “good idea”, an idea that has been shown to be true in hundreds of empirical studies. Unfortunately, monetarism has largely faded from view due to its one key underlying weakness: its inability to correctly articulate the transmission mechanism from money creation to inflation.

• Monetarism’s failure in this regard stems from the fact that most advocates of monetarism were (and still are) in-the-closet Keynesians.

• Monetarism, as it is presented in the textbooks today, is built on a foundation of Keynesian theory. More specifically, monetarism accepts wholeheartedly the inherently Keynesian notion that supply and demand for money determines the interest rate.

• For all the great work done by Milton Friedman, Friedman never challenged this core principle of Keynesianism. And yet, it is this one flawed Keynesian principle that undermines the true potential of monetarism.

• The view of The Money Enigma is that monetarism needs to be reinvented. This reinvention needs to start at the most fundamental level by recognizing that (a) the price level is a function of both the market value of goods and the market value of money, and (b) supply and demand for money (or more specifically, supply and demand for the monetary base) determines the market value of money, not the interest rate.

• The market value of money is the denominator of the price level. Creating too much money, relative to output growth, over long periods of time reduces the market value of money, thereby raising prices as expressed in money terms. This is the primary transmission mechanism from too much money to inflation. The Keynesian view of the transmission mechanism, namely that too much money lowers interest rates and creates “too much demand”, is at best a secondary transmission mechanism.

A Quick Overview

The view of The Money Enigma is that the price level is a ratio of two market values: the market value of the basket of goods (“V_G”) and the market value of money (“V_M”). The market value of goods is the numerator of the price level: as the market value of goods falls, the price level falls. The market value of money is the denominator of the price level: as the market value of money falls, the price level rises. This theory is called “Ratio Theory of the Price Level” and was discussed in last week’s post.

At the most basic level, Ratio Theory implies that the inflationary outcome of any policy action needs to consider the impact of that policy on both (a) the market value of goods, and (b) the market value of money.

Historically, most monetarists have focused only on the impact of money creation on the numerator in our equation: the market value of goods. In essence, the traditional monetarist view is that base money creation leads to lower interest rates and, in turn, lower interest rates lead to an increase in aggregate demand. This lift in economic activity leads to “tightness” in the system as demand outpaces supply, the market value of goods rises and, therefore, prices rise.

This “monetarist” view is, in fact, an inherently Keynesian view of the world. In essence, it is a modified version of the view that inflation is created by “too much demand”.

The only real adaption by the monetarists is that it is too much money that creates too much demand which, in turn, leads to higher prices as the economy pushes up against its capacity limits. Moreover, this view implicitly assumes that money creation can not create inflation if the economy does not “overheat”.

The problem with this view of the monetary transmission mechanism is that it denies any role for the impact of money creation on the market value of money, the denominator in our equation.

Traditionally, monetarists have left themselves no other choice but to ignore the role of the “value of money”. The reason for this extraordinary oversight is that most monetarists, including Milton Friedman, ascribe to the view that supply and demand for money determines the interest rate. There is no role for the “market value of money” in current monetarist thinking because monetarists don’t recognize the market value of money as a variable in their equations nor do they recognize that supply and demand for money determines the market value of money. Therefore, monetarists are left with only one avenue to explain the impact of money on the price level: more money equals lower interest rates equals too much demand equals higher prices.

The view of The Money Enigma is that this (Keynesian) transmission mechanism is, at best, only a secondary transmission mechanism. This sequence of events can lead to higher prices, but it is of secondary importance.

The primary transmission mechanism from money creation to inflation is far more direct. Supply and demand for money determines the market value of money (see recent post “Supply and Demand for Money: Where Keynes Went Wrong”). Creating “too much money” leads to a fall in the market value of money and a rise in the price level.

Over long periods of time, creating too much money, relative to output growth, leads to a direct reduction in the market value of money. The market value of money is denominator of every money price in the economy. Therefore, as the market value of money falls, the price level rises. This is the primary transmission mechanism and is the primary reason for why base money growth in excess of real output growth leads to a rise in the price level over time.

Monetarism needs to throw out Keynes’ liquidity preference theory playbook and focus on what really matters: the impact of money creation on the market value of money. Once monetarists begin to do this, we can have a much more sensible debate about the role of monetary policy and the risks of aggressive monetary policies such as quantitative easing. Moreover, monetarists may be able to construct a better model to explain why significant levels of monetary creation lead to high inflation on some occasions but not on others, an issue we will discuss briefly at the end of this article.

But before we continue with this debate, let’s step back and see put these ideas in context.

Why Do Prices Rise?

Before we can begin a discussion about the role of money in price level determination, we need to be able to answer a simple microeconomic question: “why do prices rise?”

Let’s ignore complicated macroeconomic theory for a moment and think about the price of apples in money terms. What could explain a rise in the dollar price of apples?

In order to answer this question, we need to ask a more fundamental question: “what is a price?”

A price is a ratio of two quantities exchanged.

The price of apples, in dollar terms, is the ratio of two quantities exchanged: a quantity of dollars for a given quantity of apples. For example, the price of an apple might be two dollars for one apple.

At the most basic level, this ratio of quantities exchanged is determined by the relative market value of the two items that are being exchanged. More specifically, the ratio of the two quantities exchanged is the reciprocal of the ratio of the market value of the two goods. This relationship is illustrated in the slide below.

What does this means in non-technical language? Well, all the formula above is really saying is that if one apple is twice as valuable as one dollar, then the price of one apple, in dollar terms, is two dollars.

That’s not rocket science. If one thing is worth twice as much as another, then you will have to offer two of the second thing to purchase one of the first thing.

What makes the slide above slightly more technical is the way in which the property of “market value” is being measured.

Price is a relative measurement of market value: a price measures the market value of one good in terms of another. However, it is also possible to measure the market value of a good independently of the market value of another good by adopting a “standard unit” for the measurement of market value.

In the slide above, V(A) and V(B) represent the market value of goods A and B respectively as measured in terms of a “standard unit” for the measurement of market value. In this sense, both measurements can be considered to be absolute measurements of the market value of A & B.

The measurement of market value is an important and somewhat complex subject. I highly recommend that you read the following post “The Measurement of Market Value: Absolute, Relative and Real” when you have some time.

So, let’s return to the original question: “Why do prices rise?”

If price is a relative expression of the market value of two goods, then there are two primary reasons for why the price of a good may rise. The price of one good (the “primary good”), in terms of a second good (the “measurement good”), may rise for one of two basic reasons: either (a) the market value of the primary good rises, or (b) the market value of the measurement good falls.

The first explanation for a rise in the price of the primary good should be obvious. If the primary good becomes more valuable, then it will require more units of the measurement good to purchase it.

The second explanation is less obvious and, for some reason, seems to evade professional economists. If there is no change in the value of the primary good, but the measurement good becomes less valuable, then it will require more units of the measurement good to purchase the same number of units of the primary good.

In our money-based economy, the good most often used as the “measurement good” is money. The market value of all things is measured in money terms. Therefore, if the market value of money (the measurement good) falls, all else remaining equal, it will require more units of money to purchase the same basket of goods and services.

In the slide above, we have isolated the market value of the basket of goods and the market value of money by measuring each in terms of a “standard unit” of market value (a theoretical and invariable unit). By doing this, we can clearly see that the price level is a function of two variables: (a) the market value of the basket of goods, and (b) the market value of money.

How Does Creating Money Impact the Price Level?

Let’s think about this question using the Ratio Theory framework presented above. How might creating money impact: (a) the market value of the basket of goods (the numerator of the price level); and (b) the market value of money (the denominator of the price level).

(a) Impact on The Market Value of Goods

Arguably, we might expect that an expansion in the monetary base leads to an increase in the market value of goods. I use the term “arguably” because it is not clear, nor certain, that an expansion in the monetary base leads to an increase in the market value of goods.

When money is created, that money is used. In the current system, the central bank uses that money to buy government fixed-income securities, thereby raising the price of those securities and lowering the interest rate on those securities.

The Keynesian view is that this process of creating money and using it to suppress interest rates leads to higher aggregate demand (more consumption, more investment). This increase in demand leads to tightness in the economic system that, in turn, leads to higher prices and wages.

As is common with Keynesian theory, this analysis seems quite plausible. Unfortunately, it also misses half of the picture.

The view of The Money Enigma is that lowering interest rates increases both aggregate demand and aggregate supply.

When the central bank lowers “the interest rate”, the central bank effectively lower the required return on capital across the entire risk spectrum. This is a subject that was discussed in a recent post titled “Interest Rate Manipulation and the Illusion of Prosperity”, so I won’t discuss it in too much detail here. But the bottom line is that when the Fed buys government bonds, it creates a domino effect across all risk assets, raising the price of those assets and lowering the expected/required return on those assets.

Lowering the required return on capital leads to an increase in aggregate supply. At the margin, a lower required return on capital allows more new businesses to be formed and allows more existing business to expand capacity.

If both aggregate demand and aggregate supply curves shift to the right, then the impact on the market value of goods is likely to be negligible. While there may be an increase in economic activity, that increase in economic activity is met with an increase in capacity. Therefore, the net effect on the market value of goods is likely to be small.

In summary, contrary to Keynesian wisdom, expanding the monetary base and using this money to buy government securities may have little to no impact on the market value of the basket of goods, the numerator in our price level equation. Moreover, while there may be some short-term positive impact on the market value of goods, that impact is unlikely to be sustained on a longer term basis: ultimately, aggregate supply will react to the increase in demand.

(b) Impact on the Market Value of Money

If an increase in the monetary base is unlikely to have any significant impact on the market value of goods, then how does an expansion in the monetary base lead to inflation? The view of The Money Enigma is that the answer to this question involves an analysis of the impact of money creation on the market value of money, the denominator of every money price in the economy.

The view of The Money Enigma is that, over long periods of time, growth in the monetary base that is in excess of growth in real output will lead to a decline in the market value of money and that it is this decline in the value of money that is primarily responsible for the rise in money prices over long periods of time.

This notion represents what one might consider to be a “pure” or “true” monetarist perspective on the world: a version of monetarism that is unadulterated by the Keynesian worldview.

The challenge for this pure version of monetarism is explaining why the market value of money depends on the level of the monetary base relative to real output. After all, why should it matter to the value of money if money growth dramatically exceeds real output growth?

The answer to this question involves a reexamination of economic theories regarding the nature of money.

The view of The Money Enigma is that fiat money is a financial instrument: fiat money derives its value from it contractual properties. More specifically, fiat money represents a proportional claim on the future output of society. In more slightly technical terms, the fiat monetary base is a special-form, long-duration equity instrument issued by society under an implied-in-fact contract.

The key phrase in that last paragraph is “proportional claim on the future output of society”. To its holder, fiat money represents a variable entitlement to the future economic output of society.

One way to think about this is to imagine that future economic output is “the pie” and each unit of the monetary base represents “a share of the pie”. Clearly, each unit of money is more valuable if either (a) there is a bigger pie, or (b) there are fewer shares to that pie.

In slightly more formal terms we can say that the market value of fiat money depends upon long-term (20-30 year) expectations of the path of real output relative to the monetary base. The market value of one unit of fiat money will become more valuable if either (a) people decide that future real economic growth will be stronger than previously expected (“there will be more pie”), or (b) people decide that the growth of the monetary base will be lower than previously expected (“there will be fewer shares of the pie”).

This is a complicated subject which is addressed in several recent posts including “Money as the Equity of Society”, “The Evolution of Money: Why Does Fiat Money Have Value?” and “What Factors Influence the Value of Fiat Money?”

In the short term, the market value of money is highly sensitive to changes in these long-term expectations. This shouldn’t be surprising: the value of any long-duration asset (equities, property, 30-year bonds) is highly sensitive to small changes in long-term expectations.

Similarly, one of the unexpected but important implications of this theory is that in the short term, the market value of money can be highly insensitive to the current level of the monetary base. A massive increase in the monetary base can have little or no impact on the market value of money, particularly if that increase in the monetary base is perceived to be “temporary” in nature.

However, the other implication of this theory is that over very long periods of time, the market value of money will fall if the growth in the monetary base far exceeds the growth in real output.

These observations can explain why quantity theory of money works in the long term but not in the short term. “Too much money” (relative to real output) will reduce the market value of money over long periods of time, but not necessarily over short periods of time. It is this decline in the market value of money that is the key driver of higher prices and inflation.

In summary, the challenge for monetarism is to retake the high ground in the economic debate. There is a clear path to do this, but it involves the recognition that the price level is a relative measurement of market value: the market value of the basket of goods in terms of the market value of money. Once the “value of money” is isolated as an independent variable, the challenge for monetarists is to provide a credible theoretical framework for the determination of the market value of fiat money.