The quantity theory of money

The quantity theory of money examines how the amount of money available in an economy affects overall spending and prices. It suggests that the money supply has a direct link to aggregate demand and can also be influenced by it. This theory helps explain the causes of inflation through changes in the money supply.

The Fisher equation

The Fisher equation represents total spending in the economy and is a key part of the quantity theory of money.

$MV=PT$

Where:

• M = Money supply
• V = Velocity of circulation (average number of times each unit of money is spent in a period)
• P = Price level
• T = Total transactions (or output) in the economy

Both sides of the equation show the total value of economic activity: the left side (MV) is the money supply multiplied by how often it is used, while the right side (PT) is the price level multiplied by the quantity of goods and services.

Monetarist assumptions and implications

Monetarists believe that velocity of circulation (V) and total transactions (T) remain stable and are not influenced by changes in the money supply (M). Under these assumptions, any change in M leads to a proportional change in the price level (P).

Monetarist predictions:

• If the money supply rises, prices will increase by the same percentage, causing inflation.
• Monetarists argue that inflation is always caused by too much growth in the money supply.
• Keynesians challenge this by stating that V and T can vary when M changes, making it hard to predict the exact impact on P.

Equilibrium and disequilibrium in the Fisher equation

The Fisher equation always balances in the long run, as the two sides adjust to reach equilibrium. However, short-term imbalances can occur due to various factors, and understanding what disrupts this balance is important for analysing economic stability.

Factors affecting equilibrium

• Changes in expectations - If people anticipate higher inflation, they may spend money faster to avoid losing value, increasing the velocity of circulation (V).
• Spending behaviour - During periods of expected price rises, individuals and businesses accelerate purchases, pushing V higher and potentially causing disequilibrium until prices adjust.

The Keynesian theoretical approach

The Keynesian approach, developed by economist John Maynard Keynes (1883-1946), focuses on the idea that economies do not always self-correct to achieve full employment. Instead, active government involvement is needed to manage economic activity and prevent prolonged downturns.

Key beliefs in the Keynesian approach

• Market limitations - Free markets alone cannot ensure the economy reaches full employment; gross domestic product (GDP) can stay below potential for extended periods.
• Government intervention - Governments should step in to boost aggregate demand, especially during high unemployment.
• Budget deficits - Running a deficit (spending more than revenue) can stimulate the economy by increasing demand through public spending or tax cuts.
• Prioritising employment - Reducing unemployment is more important than other goals, as idle resources harm long-term growth.

The monetarist theoretical approach

The monetarist approach, championed by economist Milton Friedman (1912-2006), emphasises controlling inflation as the primary economic goal. Monetarists see the economy as naturally stable if left undisturbed, with problems mainly arising from poor management of the money supply.

Key beliefs in the monetarist approach

• Inflation control - Keeping inflation low is the top priority, as it stems from excessive increases in the money supply.
• Government role - The main task for governments is to manage the money supply steadily to avoid sudden changes.
• Limits of spending policies - Efforts to cut unemployment through government spending may work short-term but lead to higher inflation in the long run.
• Economic stability - The economy tends towards equilibrium unless disrupted by inconsistent money supply policies.

Worked example - Calculating the effect of money supply change on price level

An economy has a money supply of £150 billion, velocity of circulation of 5, price level of 120, and total transactions of 6.25 billion. If the money supply increases by 20% to £180 billion, calculate the new price level, assuming velocity and transactions remain constant.

Step 1: Identify the values

• Initial money supply (M) = £150 billion
• Velocity of circulation (V) = 5
• Initial price level (P) = 120
• Total transactions (T) = 6.25 billion
• New money supply = £180 billion

Step 2: Apply the Fisher equation for initial values

$MV=PT$ $\pounds 150\text{ billion}\times 5=120\times 6.25\text{ billion}$

Step 3: Calculate the new price level

Using the new money supply and assuming V and T unchanged:

$\pounds 180\text{ billion}\times 5=P\times 6.25\text{ billion}$

$P=\frac{\pounds 900\text{ billion}}{6.25\text{ billion}}=144$

Step 4: Interpretation

The price level rises by 20% from 120 to 144, matching the percentage increase in money supply, which demonstrates the monetarist view of inflation as a monetary issue.