Sudhir Mulji: The quantity theory revisited

The connection between price inflation and real economic growth has been a central question.

The quantity theory of money has been described as "fundamental. Its correspondence with fact is not open to question".

Although the theory is expressed as an equation, it is, as Professor Pigou pointed out, "a set of formulae that are merely devices for enabling us to bring together the principal causes by which the value of money is determined".

It is this confusion in regard to the nature of the equation linking the factors of the quantity theory that often leads to a misunderstanding of the determinants of the quantity of money, which in turn leads to a misunderstanding of the implications of the theory.

The basic equation is expressed as MV=PQ, where M is the stock of money V the average number of times the money is used, P the price index and Q the goods exchanged for money.

Put in this way the formula seems complicated but it simplifies considerably if you can treat V and Q as constants. It then develops into the simple rule that the price index is influenced by the stock of money.

The larger the stock of money the higher will be the price index; and the affirmation or denial of this latter proposition is at the heart of the argument between monetarists and Keynesians.

The logic for treating the velocity of circulation of money and the quantity of goods produced and offered for exchange as constants needs explanation.

Q, the quantity of goods exchanged, depends on Say's proposition that all goods produced are either for sale or personal consumption. If a good cannot be sold in markets, it is either priced too high or it is a commodity for which there is no demand in the markets even at zero prices.

Since the absence of demand for any commodity is unlikely when its price is suitably reduced, the conclusion must be that the potential seller is voluntarily withholding his goods from the market because he is not willing to accept the market price and therefore should no longer count as a seller.

Further, it is argued that if the good cannot be sold to finance the purchase of other goods the producer should use these resources to produce goods of a different kind.

The absolute quantity of goods cannot be increased because they are constrained by technology. Therefore, without sacrificing the production of some goods it is not possible to create additional resources.

Given the known technology, every person in a free society already strives to the very best of his ability to produce what he can with the resources available to him.

If he finds the cost of the resources greater than he can afford the implication is that he has no profitable use of additional resources because he does not find the employment of additional resources worthwhile at market prices.

The implication of that is quite simply that either other producers of the resource in question have a better use for it, or that in a given state of affairs the resources are so surplus that they are useless.

The general conclusion is not that the goods cannot be exchanged but that the seller of that commodity has not adjusted his price to the point where it can be exchanged for other goods.

It is of course possible that institutional arrangements may prevent individuals from pricing their goods or services, particularly their labour services, freely; but then the solution lies in changing the institutional arrangements.

In any event, changes in the stock of money will affect only prices and not the quantity of goods produced or exchanged in the market

It is a fundamental conclusion of the quantity theory that resources with some scarcity value cannot be involuntarily unemployed. So long as prices can adjust to reflect the scarcity or surplus of goods, the markets will adjust towards a point of equilibrium through a fluctuation of prices. The entire impact of money changes must fall on prices, if technology determines output. This also accords with common sense because money, a unit of account, cannot influence real activity any more than an increase in money in the game of monopoly influences real activity.

In strict logic, therefore, changes in the stock of money must fall on prices in proportion unless all the increase or decrease in money is not used for exchanging goods in markets.

It is recognised that money can be used actively for an exchange of goods, or passively hoarded, in which case it can have no affect on the market.

Clearly, if an increase in the stock of money is not circulated in the markets for an exchange of goods, it will have no impact, whatever the stock of money.

To avoid this somewhat sterile conclusion, it is necessary to have some theory for the circulation of money. The quantification of circulation is considered in the quantity theory by measuring K, which represents the number of times money is used.

To understand the concept of circulation it is more useful to reflect on the inverse of K, which represents the quantity of money not circulated but hoarded for future use.

In any society, a proportion of income received is spent immediately and another proportion is withheld for future spending.

If the total stock of money changes there may be an immediate short-term change in the proportion spent or the proportion hoarded, but in the longer run the assumption is that these changes will even out and that the proportion spent or hoarded from any given income reflects a customary habit and will tend towards constancy.

To put it plainly, if we tend to keep unspent 10 per cent of our income, that proportion will not change as our income fluctuates in shorter periods.

If we now revert to the formula of the quantity theory, that is MV=PQ, and if we conclude that both V and Q maintain constancy, V because of custom and habit of retaining a proportion of income and Q because it is restricted by technological resources available to us, it follows that changes in M, the money stock, can only have an impact on P, the price index.

M, the stock of money, and P, the price index for goods, are positively correlated, thus an increase in the supply of money simply fritters away in an increase in prices.

This tautological conclusion follows the underlying theory of the quantity of money.

However, modern controversy in economics has not been dominated by the impact of an increase in money supply on the price index. The more difficult question is whether the inflation of prices will increase the supply of goods produced and exchanged.

The connection between price inflation and the growth of real economic activity has been the central debate in macroeconomics for the last century.

In the United States, it has recently been deliberated at MIT between Solow and Taylor, with the latter arguing in the past four decades changes in inflation rates from a low of 1.6 per cent to a high of 9 per cent did not lead to any reduction in unemployment, which continued to hover around 6 per cent.

Whether that tentative conclusion and all the implicit assumptions of the quantity theory are relevant to poorer developing countries is probably the most interesting problem for makers of economic policy.

(The views here are the author's and not any organisation's.)

sjmulji@aol.com