Quantity Theory of Money

The Quantity Theory of Money states that money supply has a direct, proportional relationship with prices. While accepted for decades, it was challenged by Keynesian economics. Since then, the theory has been  modified, as it has been generally accepted that it holds true in the long run, but its validity in the short run is in question. Using data from the nation of Albania, and simplifying velocity to be constant, the theory was put to test.

The quantity theory of money states that the money supply has a direct and proportional relationship with price. Essentially, as money supply goes up, prices go up, and as the supply goes down, prices will follow as well. While the theory has found resurgence support through Milton Freidman, was built upon by prominent figures such as Simon Newcomb and Irving Fisher, and has its roots in Copernicus’s observations in gold and silver imports, its validity as a theory has been challenged by Marx and more recently monetarists of the Keynesian thinking. By examining the core the theory and running real economic data, a conclusion on its validity, in part or whole can be made.

The quantity theory of money is based on the following assumptions:

1. Inflation is derived from the growth of the money supply

2. The money supply is exogenous

3.  The demand for money is a function of income, interest rates,…

4.  Mechanisms for putting money into an economy is trivial in the long run

5. Real interest rate is also derived from non-monetary variables

In theory, as more money is printed and the total amount of money in circulation increases, the value of each bill is reduced, causing inflation. To still obtain the same economic welfare from selling a good, the producers changes the price to the level of inflation, therefore increasing the price of the good, making assumption one the core behind the overall theory.

Opponents of the theory has argued that the theory falls short, as it does not take into consideration the demand for money, simply the supply (assuming it is not put in practice under the neoclassical model with zero regulatory interference where supply would be set equal to demand), and that prices tend to be sticky in the short run.

To put this theory to a test, data was obtained from the International Monetary Fund from the nation of Albania. The model of the quantity theory of money has its variations, some for simplification and others for a more in depth look at an economic situation, but for this test a simplified model was used. Instead of using total money in the economy, the amount of Albanian Leks in circulation was used to account for money supply, while also taking into consideration many aspects of money velocity, such as money’s availability. Therefore money tied up in financial institutions, personal and private savings and international investments were not included in the total money supply; only the money directly in circulation was included.  The Albanian economy is also very much consumption dominated, as are most economies, so the consumer price data was used for the price variable.

A majority of opponents of the theory argue that in the short run prices are sticky, but the theory tends to hold true in the long run, making testing in a long run not necessary as there seems to be a consensus the theory holds true in the long run. Therefore assumption number four was not relevant for testing, and data was used for a short run time frame, 2001-2009.

DESCRIPTOR 2001 2002 2003 2004 2005 2006 2007 2008 2009
CONSUMER PRICES 88.1971 95.050 95.511 97.688 100.000 102.371 105.373 108.913 111.396
CURRENCY IN CIRCULATION 119.080 133.128 127.790 141.645 153.570 168.255 161.182 203.733 216.768

 Quantity Theory of Money

The theory maintains that there is a direct, proportional relationship between money supply and price, therefore it is a linear relationship.

To calculate the effect of money supply on price was essentially the same as calculating elasticity. The change over consumer prices from one period to the next and the change over change in circulating money supply from one period to the next was calculated. By dividing the two each year’s elasticity, or willingness for prices to move based on how much money in circulation change.  For simplification purposes the ln of the data from consumer prices and currency in circulation data, giving a smaller number for graphing purposes.  By taking the slope of the trend line, an overall elasticity of .3028 was found, meaning price was inelastic towards money supply. The R2 was .9432, showing that the trend line was a good fit towards the model.

Quantity Theory of Money

Taking the results into consideration, it can be concluded that in the short run, money supply does not tend to affect the price, as the relationship is inelastic. As opponents of the Quantity Theory of Money have stated, price tends to be sticky in the short run, leading to the rejection of the theory in its questionable parts.

 

Slideshow on The Quantity Theory of Money