• The view of The Money Enigma is that the quantity theory of money needs to be reinvented. More specifically, the traditional view of the monetary transmission mechanism is wrong and needs to be completely reexamined.

• The mainstream view of the monetary transmission mechanism is, in essence, that money creation leads to excess aggregate demand that, in turn, leads to higher prices. The view of The Money Enigma is that this transmission mechanism from more money to higher prices via an increase in aggregate demand is, at best, a secondary transmission mechanism.

• Rather, it will be argued that the primary monetary transmission mechanism is the impact of money creation on the market value of money. In essence, “too much money” leads directly to a fall in the value of money and a rise in the price of all goods as measured in money terms.

• The “value of money” is a notion that has been lost from economic theory. Indeed, mainstream economics simply doesn’t recognize the “value of money” as an independent variable, an issue that was discussed at length in “The Value of Money: Is Economics Missing a Variable?”

• In this week’s post, we will attempt to shed new light on the quantity theory of money by articulating an explicit role for the value of money in the monetary transmission mechanism.

• More specifically, we will discuss the role of the value of money in price level determination and we will consider, at least briefly, a theory of money that can explain why money creation leads to a fall in the value of money on some occasions, but not on others.

• While money supply and real output matter to price level determination, the view of The Money Enigma is that long-term expectations of these variables are far more important than their present level. We can only incorporate these long-term expectations into quantity theory by examining how these expectations impact the value of money and the role of the value of money in price level determination.

• Hopefully, this exercise will provide readers with a new and much clearer perspective on why the quantity theory of money tends to hold over long periods of time, but not necessarily over short periods of time.

The Strengths and Weaknesses of Quantity Theory

The quantity theory of money is one of the oldest surviving economic doctrines. It is a theory that dates back to at least the mid-16^th century and it was the dominant monetary theory until the Keynesian revolution of the 1930s. A good discussion of the history of the theory can be found in a 1974 paper published by the Richmond Fed, “The Quantity Theory of Money: Its Historical Evolution and Role in Policy Debates”.

It is hard to overestimate the importance and dominance of the quantity theory of money in the history of economic thought. Yet, despite a brief resurgence of interest in the late 1960s and early 1970s, quantity theory has become the forgotten child of economics: a theory that every economist learns, but one that very few seem to regard as relevant in our modern world.

While die-hard monetarists might blame the demise of quantity theory on the rise of Keynesianism, there is a more simple truth at play: quantity theory of money, as it is traditionally presented, is flawed.

The core principle at the heart of quantity theory, the notion that there is a strong relationship between the quantity of money and the price level, is fundamental, if for no other reason than the fact that it represents one of the strongest empirical relationships to be found between major economic variables.

When measured over long periods of time, there is a clear empirical relationship between the “monetary base/real output” ratio and the price level. For this reason alone, quantity theory should always occupy a revered position in the science of economics.

However, the problems for quantity theory begin when various practitioners and market commentators attempt to apply it over short periods of time. As has been well established by recent experience, there is no strict short-term relationship between the size of the monetary base and the price level. Over the past seven years, the Fed has quintupled the size of the monetary base, yet inflation has remained subdued.

This is the point at which many commentators throw quantity theory out with the garbage. Their view seems to be that if quantity theory doesn’t work in the short run, then it is as good as useless.

This is a mistake. Quantity theory should not be abandoned just because the relationship between money and prices does not hold in the short term.

Nevertheless, the burden of proof sits with advocates of quantity theory. Supporters of quantity theory need to be able to explain why quantity theory doesn’t work in the short term. The problem is that they can’t.

Why is this the case? Well, the key issue is that current theories of the monetary transmission mechanism don’t provide supporters of quantity theory with a sound basis for defending the lack of correlation between money and prices in the short run.

The view of most monetarists today is that supply and demand for money determines the interest rate. Therefore, an increase in the supply of money must operate by lowering the interest rate. In turn, a lower interest rate must stimulate economic activity leading to an increase in aggregate demand and higher prices.

In theory this sounds great, the problem is that it doesn’t work in practice. More specifically, it doesn’t explain why an increase in the monetary base leads to an increase in prices on some occasions but not others. Moreover, this simplistic view of the monetary transmission can’t account for periods of high inflation: for example, Zimbabwe didn’t experience hyperinflation because interest rates were too low and there was “too much demand”.

The problem with monetarism as it exists today is that it begins from the wrong starting point. Far from being a true monetarist view of the world, the monetary transmission mechanism described above represents a thoroughly Keynesian view of the world.

The view of The Money Enigma is that this inherently Keynesian perspective is flawed. Supply and demand for money does not determine the interest rate. Rather, supply and demand for the monetary base determines the market value of money. In turn, the market value of money is the denominator of every money price in the economy and, consequently, the denominator of the price level.

By recognizing that the primary transmission mechanism from money to prices must involve the “value of money”, we can come up with an expectations-adjusted version of quantity theory that can explain not only why quantity theory works in the long run, but also the circumstances that are required for quantity theory to work in the short run.

Our journey towards an expectations-adjusted quantity theory of money begins at a microeconomic level. More specifically, we need to explore three ideas: (1) money possesses the property of market value, (2) every price is a relative expression of market value, and (3) the price of a good, in money terms, depends upon both the market value of the good itself and the market value of money.

Price Determination and the Value of Money

If you ask most students of economics “what determines the price of a good?” then the answer you are most likely to hear is “supply and demand for that good”. This is the way that price determination is taught across schools and colleges today. However, this basic model of price determination presents a misleading and very one-sided view of the price determination process.

The problem is that economics seems to have forgotten a simple, but easily overlooked idea, an idea that was articulated centuries ago by both Adam Smith and David Ricardo: price is a relative measure of the value of two goods.

In order for a commercial exchange of goods to occur between two people, both of the goods being exchanged must possess the property of market value. In other words, I am only going to give you something of value if you give me something of value.

In a barter economy, I might have apples and you might have bananas. The ratio of exchange, apples for bananas, will depend upon the relative market value of apples and bananas at that time. For example, if an apple is twice as valuable as a banana, then the ratio of exchange is two bananas for one apples and the “price of apples in banana terms” is “two bananas”.

The price of apples in banana terms can rise for one of two basic reasons: either (a) the value of apples rises, or (b) the value of bananas falls.

Think about this for a moment. If bananas become less valuable in our community (there is a huge crop this year), then, all else remaining equal, you will have to offer me more bananas for each apple. Therefore, the price of apples in banana terms will rise.

In a money-based economy, the principle is no different.

In order for people to accept money in exchange for goods, money must possess the property of market value. For example, I wouldn’t accept money from you in exchange for my apples, unless I believe that money itself has value.

The ratio of exchange, apples for money, depends upon the relative market value of apples and money. If an apple is twice as valuable as one dollar, then the price of apples in dollar terms is two dollars. Moreover, the price of apples in dollar terms can rise because either (a) the market value of apples rises, or (b) the market value of money falls.

Mathematically, the price of a good in money terms is a ratio of two values (see following slide). The numerator is the market value of the good itself. The denominator is the market value of money.

The key to illustrating price determination in this way is recognizing that the property of market value can be measured in both relative and absolute terms. On the right hand side of the equation above, the market value of the good and the market value of money are both isolated as independent variables by measuring the market value of each in absolute terms. This is a rather complicated idea and I would strongly recommend that you read one of my earlier posts titled “The Measurement of Market Value: Absolute, Relative and Real” in order to more fully appreciate this concept.

This basic notion (price is a relative measurement of the market value of two goods) suggests that there are, in fact, two market processes at play in the determination of any price.

For example, in the case of the price of apples in money terms, one market process is determining the market value of apples, while another, completely different process, is determining the market value of money. The price of apples, in money terms, depends upon the equilibrium point that is found in both of these distinct processes.

Put another way, we can say that every price is a function of two sets of supply and demand. The price of one good (the primary good) in terms of another good (the measurement good) is a function of both supply and demand for the primary good and supply and demand for the measurement good.

The slide above presents the general version of this theory of price determination. Supply and demand for good A, the primary good, determines the equilibrium market value of good A. Supply and demand for good B, the measurement good, determines the equilibrium market value of good B. The price of A in B terms is determined by the ratio of these two market values. Therefore, the price of A in B terms is determined by two sets of supply and demand.

In the case of a money-based economy, the measurement good most commonly used is money. Money must possess the property of market value in order for it to be used as a medium of exchange. The view of The Money Enigma is that the market value of money is determined by supply and demand for the monetary base.

If you are interested in learning more about this microeconomic theory of price determination then I would encourage you to visit the Price Determination section of this website.

For now, the key point that matters is that the price of a good in money terms depends upon both the market value of the good itself and the market value of money. The price of a good in money terms can rise because either (1) the good itself becomes more valuable, or (2) money becomes less valuable.

If this microeconomic theory of price determination is correct, then we can extend it to the determination of the price level. After all, the price level is merely a hypothetical measure of the overall price of the basket of goods.

If every price is a relative measure of market value, then the price level is also a relative measure of market value. More specifically, the price level is a relative measure of the market value of the basket of goods in terms of the market value of money.

Rethinking the Monetary Transmission Mechanism

In simple terms, the slide above implies that the price level can rise for one of two reasons: either (1) the market value of the basket of goods rises, or (2) the market value of money falls.

While this model of price level determination may seem simplistic, it does open up an important question regarding the way in which monetary policy operates. More specifically, does an expansion of the monetary base lead to a rise in prices because (a) lower interest rates drive higher aggregate demand which leads to a rise in the market value of goods, or (b) does an increase in the monetary base somehow lead to a fall in the market value of money?

In more technical terms, does an increase in the monetary base impact the numerator (“V_G”) or the denominator (“V_M”) in our price level equation? Does it impact both? And if it does impact both, then which represents the primary monetary transmission mechanism from “more money” to “higher prices”?

We will consider the reaction of the market value of money (the denominator) to an increase in the monetary base in a moment: it is a complicated subject and we need to spend quite a bit of time thinking about it. But before we do, let’s think about how the market value of the basket of goods (the numerator) might respond to an expansion of the monetary base.

In order to assist us in this process, we are going to introduce the “Goods-Money Framework” (see slide below). In essence, the Goods-Money Framework represents an adaptation of traditional aggregate supply and demand analysis. On the left-hand side of the slide below, aggregate supply and demand determine the equilibrium market value of the basket of goods. On the right-hand side, supply and demand for money determine the market value of money. As discussed, the price is determined by the ratio of these two values.

Let’s focus on the left hand side of the slide above and think about how the equilibrium market value of goods (“V_G”) is likely to respond to an expansion in the monetary base.

The traditional Keynesian view would suggest that an expansion of the monetary base leads to a fall in interest rates. In turn, a fall in interest rates leads to an increase in aggregate demand. In terms of our slide above, the aggregate demand curve shifts to the right and the market value of the basket of goods rises. Implicitly, the Keynesian view assumes that the market value of money is constant (I say “implicitly” because Keynesian theory doesn’t recognise a role for the “value of money” in price determination). Therefore, any rise in the market value of goods is reflected as a rise in the price level.

As far as the traditional Keynesian view is concerned, this is where the story ends. An increase in money supply leads to higher demand and higher prices. The problem is that this story completely ignores the impact of lower interest rates on the aggregate supply curve.

In the real world, lower long-term interest rates not only lead to an increase in aggregate demand, but also lead to an increase in aggregate supply. In terms of our slide above, a fall in interest rates moves both aggregate demand and aggregate supply curves to the right and the impact on the equilibrium market value of goods is uncertain.

Lowering the long-term interest rate on government securities does more than just reduce mortgage rates and stimulate consumer spending: it also reduces the required return on capital for all businesses. Lowering the required return on capital stimulates expansion by existing businesses and lowers the bar to the start up of new businesses. What is the end result of all this new business activity? More supply!

When the central bank lowers the long-term interest rate by creating money and buying government securities, it effectively lowers the long-term risk free rate, a core component of the long-term required rate of return on risk assets, thereby encouraging business formation and driving an increase in aggregate supply.

Therefore, if Keynesian economists were sincere about the impact of lower interest rates, they would recognize that lower interest rates lead to both an increase in aggregate demand and aggregate supply and that the impact of monetary expansion on the absolute market value of the basket of goods is uncertain.

If this is the case, the traditional monetary transmission mechanism that is postulated by mainstream macroeconomists (more money, lower interest rates, more demand) is at best a secondary mechanism, and at worst is completely irrelevant.

Clearly, this analysis has an important implication.

If the numerator in our price level equation (the market value of the basket of goods) doesn’t act as the primary transmission mechanism from more money to higher prices, then it must be the market value of money, the denominator in our price level equation, which acts as the primary monetary transmission mechanism.

But how does “more money” impact the value of money? And if monetary base expansion should lead to a fall in the market value of money, then why have we not experienced this over the past seven years?

What Determines the Value of Money?

Those of you who are familiar with The Money Enigma will know that this is a topic that has been discussed at length over the past six months. If you want to take the crash course on this topic, then I would suggest reading “The Evolution of Money: Why Does Fiat Money Have Value?” and a follow-on post titled “What Factors Influence the Value of Fiat Money?”

For the purposes of this exercise, we will briefly discuss the nature of fiat money and how the value of fiat money is determined and then we will discuss the implications of this theory for quantity theory and the monetary transmission mechanism

The view of The Money Enigma is that fiat money is a financial instrument and derives its value solely from the nature of the liability that it represents. Fiat money is an asset to one party because it is a liability to another: fiat money is, from an economic perspective, a liability of society and represents a claim on the future output of society. More specifically, fiat money is a long-duration, special-form equity instrument and a proportional claim on the future output of society.

Every asset is either a real asset or a financial instrument. Real assets derive their value from their physical properties; financial instruments derive their value from their contractual properties.

The view of The Money Enigma is that this paradigm governs the way in which every asset, including money, derives its value. In ancient times, money was a real asset: money was a commodity (such as rice or silver) that derived its value from its physical properties.

The problem with this “commodity money” is that it restricted the ability of governments to spend (you can’t spend gold you don’t have). However, at some point, governments found a way to get around this problem: issue paper notes that promise to deliver gold on request. By issuing this first form of paper money, known as “representative money”, governments could aggressively expand their spending.

This first paper money was a financial instrument. It derived its value from its contractual properties. More specifically, it represented an explicit promise to deliver a real asset on request.

Ultimately, the issuance of representative money also limited the amount of money that governments could create. Therefore, at some point the gold convertibility feature was removed. This point marks the shift from representative money to fiat money.

In effect, the explicit contract that governed representative money was rendered null and void. So why did paper money maintain any value? The view of The Money Enigma is that the explicit contract that governed representative money was replaced by an implied-in-fact contract that governs fiat money to this day.

Fiat money is not a real asset and does not derive its value from its physical properties. Therefore, prima facie, fiat money is a financial instrument and must derive its value from its contractual properties, even if that contract is implied rather than explicit.

The exact nature of the implied-in-fact contract that governs fiat money is difficult to unravel. It is an issue that is discussed at length in the “Theory of Money” section of this website. However, in simple terms, the view of The Money Enigma is that fiat money is a liability of society and represents a claim against the future output of society.

More importantly, fiat money represents a variable entitlement to future output. In this sense, fiat money can be considered to be similar to shares of common stock: fiat money is a proportional claim on the future output of society, just as a share of common stock is a proportional claim on the future cash flow of a company

While there are important differences between the two, this concept can help us think about the factors that influence the market value of money, the denominator in our price level equation.

For example, if this theory is correct, then the value of fiat money is determined primarily by expectations regarding the long-term future path of two economic variables: real output and the monetary base.

In simple terms, future real output is the cake and the size of the future monetary base represents the number of slices the cake must be cut up into. If people become more optimistic about the long-term rate of economic growth, then the market value of money rises. Conversely, if people believe that long-term monetary base growth will be higher than previously anticipated, then the market value of money will fall.

The other important implication of this theory is that expectations regarding the long-term path of money and real output are far more important than current levels of money and real output in the determination of the value of money. Money is a long-duration asset and, like all long-duration assets, its value primarily depends on long-term expectations, not current conditions.

Why does this matter to quantity theory? Well, it may just be the missing piece that explains why quantity theory works well over long periods of time, but not short periods of time.

An Expectations-Adjusted Quantity Theory of Money

Let’s start by thinking about why the quantity theory of money works over long periods of time.

If the theory of money articulated above is correct, then for any long period of time (30 years+), an increase in the monetary base that is far in excess of the increase in real output should lead to a significant fall in the market value of money and, correspondingly, a significant rise in the price level.

If money is a proportional claim on economic output and, over a long period of time, the growth in the number of claims (the monetary base) far exceeds the growth in the economic benefit (real output), then one would reasonably expect the value of each claim to fall considerably as measured from point to point over that extended period of time.

Moreover, since the price level is a relative measure of the market value of goods in terms of the market value of money, one would also reasonably expect the price level to rise considerably over that same time period, assuming there was no reason for a massive collapse in the market value of goods.

In summary, quantity theory works in the long term because the market value of money roughly tracks the ratio of “real output/base money” over the long term.

However, the quantity theory of money breaks down over short periods of time. The reason for this is that short-term variations in the value of money are primarily driven by shifts in long-term expectations.

If you take a long hard look at the equation of exchange (the core equation of quantity theory), the one thing that should strike you about it is that it allows no explicit role for expectations in the determination of the price level.

If interpreted literally, then the equation of exchange implies that the price level is a function of only three variables: the current level of real output, the current level of money supply, and the current level of the velocity of money.

However, nearly all economists would agree that expectations play a key role in price level determination. Intuitively, it simply does not make sense to believe that prices across our economy have nothing to do with the expectations of economic agents.

So, how do we incorporate a role for expectations in the quantity theory of money?

The answer is to go back to our simple model of price level determination and think about how an increase in the quantity of money (an expansion of the monetary base) might impact both the numerator and the denominator in our price level equation.

As discussed earlier, if the numerator in our equation is relatively unresponsive to monetary policy, then it must the denominator in our equation, the market value of money that acts as the transfer agent from “more money” to “higher prices”. But we also know that “more money” (an expansion in the monetary base) does not automatically lead to a sudden fall in the value of money.

So, what are the circumstances in which an expansion of the monetary base will lead to a decline in the market value of money?

In simple terms, the rule of thumb is that an increase in the monetary base will only lead to a decline in the market value of money if that increase is believed to be “permanent” in nature. Conversely, an expansion of the monetary base will have little to no impact on the market value of money is that increase is believed to be “temporary” in nature.

Money is a long-duration asset. The value of money depends primarily not upon what is happening today, or is expected to happen in the next couple of years, but what is expected to happen over the next 20-30 years. More specifically, money is a long-duration, variable entitlement to future output. The value of money depends primarily upon expectations of the long-term path of both real output and the monetary base,.

In and of itself, a change in the current level of the monetary base is largely irrelevant to current market value of money. What really matters is how that change in the monetary base impacts expectations regarding the long-term path of the monetary base.

Putting this in the context of quantity theory, the conclusion we can draw is that it is not an increase in money supply per se that leads to an increase in the price level (although this will tend to be true when measured over long periods of time). Rather, the price level will rise if a monetary policy shift is deemed by the markets to indicate that the future growth of the monetary base will be higher than previously anticipated. Such a shift in expectations will lead to an immediate decline in the market value of money and, correspondingly, a sudden rise in the price level.

In summary, quantity theory is an important idea, but it needs to be modified to reflect the fact that expectations matter. More specifically, long-term expectations regarding the future economic prospects of society are the key determinant of the market value of money, the denominator of the price level. Moreover, it is the market value of money that acts as the primary transmission point from “too much money” to “higher prices”, whereas the interaction between monetary expansion and aggregate demand is, at best, a secondary transmission mechanism.

Author: Gervaise Heddle