The quantity theory of
money proposes that the exchange value of money is determined like any other
good, with supply and demand. The basic equation for the quantity theory is
called The Fisher Equation because it was developed by American economist
Irving Fisher. In it's simplest form, it looks like this:
(M)(V)=(P)(T)
where:
M=Money Supply
V=Velocity of circulation
(the number of times money changes hands)
P=Average Price Level
T=Volume of transactions
of goods and services
Some variants of the
quantity theory propose that inflation and deflation occur proportionately to
increases or decreases in the supply of money. Empirical evidence has not
demonstrated this, and most economists do not hold this view.
A more nuanced version
of the quantity theory adds two caveats:
New money has to
actually circulate in the economy to cause inflation.
Inflation is
relative—not absolute.
In other words, prices
tend to be higher than they otherwise would have been if more dollar bills are
involved in economic transactions.
Monetarism
According to
monetarists, a rapid increase in the money supply can lead to a rapid increase
in inflation. This is because when money growth surpasses the growth of
economic output, there is too much money backing too little production of goods
and services. In order to curb a rapid rise in the inflation level, it is
imperative that growth in the money supply falls below the growth in economic
output.
When monetarists are
considering solutions for a staggering economy in need of an increased level of
production, some monetarists may recommend an increase in the money supply as a
short-term boost. However, the long-term effects of monetary policy are not as
predictable, so many monetarists believe that the money supply should be kept
within an acceptable bandwidth so that levels of inflation can be controlled.
Instead of governments
continually adjusting economic policies through government spending and
taxation levels, monetarists recommend letting non-inflationary policies–like a
gradual reduction of the money supply–lead an economy to full employment.
Keynesianism
Many Keynesian
economists remain critical of the basic tenets of the quantity theory of money
and monetarism, and challenge the assertion that economic policies that attempt
to influence the money supply are the best way to address economic growth.
Keynesian economics is
a theory of economics that is primarily used to refer to the belief that the
government should use activist stabilization and economic intervention policies
in order to influence aggregate demand and achieve optimal economic performance.
John Maynard Keynes was a British economist who developed this theory in the
1930s as part of his research trying to understand, first and foremost, the
causes of the Great Depression. At the time, Keynes advocated for a government
response to the global depression that would involve the government increasing
their spending and lowering their taxes in order to stimulate demand and pull
the global economy out of the depression.
In the 1930s, Keynes
also challenged the quantity theory of money, saying that increases in the
money supply actually lead to a decrease in the velocity of money in
circulation and that real income–the flow of money to the factors of
production–increased. Therefore, the velocity of money could change in response
to changes in the money supply. In the years since Keynes' made this argument,
other economists have proved that Keynes' contention with the quantity theory
of money is, in fact, accurate.
Some of the tenets of monetarism became very popular in the 1980s in both the U.S. and the U.K. Leaders in both of these countries, such as Margaret Thatcher and Ronald Reagan, tried to apply the principles of the theory in order to achieve money growth targets for their countries' economies. However, it was revealed over time that strict adherence to a controlled money supply did not provide a solution for economic slowdowns