The Quantity Theory of Money

We have not said much in detail about the impact of changes in the monetary system on the market system. Modern ideas on that will have to wait for a later chapter on "Monetary Policy." But these modern ideas grow out of an idea from the Classical Economists, known as the Quantity Theory of Money.

The quantity theory is based on the identity

M*V = p*RGDP

where M is the quantity of money in circulation, p*RGDP is nominal GDP, and V is the "velocity of money." The idea here is that each transaction will require a certain amount of money to carry it out. The amount of money for a given transaction will depend on the habits and customs of the time and place, but will be fairly stable in the short run. In turn, the number of transactions (of each specific type) will be roughly proportionate to production, that is, to RGDP. So we have a predictable relationship between the production, RGDP, and the quantity of money needed to finance and sell it. An increase in the price level would proportionately increase the amount of money needed to do that.

The equation

M*V = p*RGDP

is an identity because V is defined as p*RGDP/M. But early quantity theorists held that V is a constant, which means that the demand for money is proportional to nominal income -- an hypothesis which we can test against the facts.

Over the twentieth century as a whole, this hypothesis has done pretty well as a first approximation, though some monetary economists feel that the relationship has been less predictable, for the U. S. A, in the last decades of the twentieth century.

Money and the Price Level