Why the Quantity Theory of Money is Wrong

Updated: Nov 6

(Edited and derived from my other writing for DeficitOwls.org)

The Quantity Theory of Money is the idea that the primary determinant of movements in the price level is demand-pull inflation stemming from increases in the money supply. It is represented by the equation MV = PY, where M is the money supply, V is the velocity of money, P is the price level, and Y is the total amount of goods and services for sale. The theory states that as the money supply increases, V and Y tend to stay constant and P increases proportionately with M.

First, QTM overlooks that the amount of money in circulation is only one factor that affects its value.

The distribution of money is also very important, and the mere quantity of money tells you nothing about whether everyone has money or if only one person has most of the money. The distributional analysis is important because the marginal propensity to spend money on consumer goods decreases as wealth increases. If new money goes to businesses or to people whose material needs are already met, the amount of spending on consumer goods will not increase as much as if that same money went to someone who needed to make an immediate purchase to satisfy their material needs.

Second, the quantity of money tells you nothing about what that money is being used for, if it is used at all.

People cannot bid up prices unless they actually try to make purchases. Recipients of new money may want to save it, or they may want to spend it on something which functionally has an unlimited supply, such as online media, or they may want to invest it in financial assets or gamble it away. They may send it to relatives living in other countries. Of course, if they spend it on productive investment, this creates resistance to price increases.

Third, the Y in MV=PY is not fixed unless an economy is at full employment.

Most of the time, firms have flexibility in their output decisions, and the empirical research shows that they do adjust output and employment according to expected demand for their products. (McIntosh 1989)

However, even when an economy (or a specific industry) is at full employment, firms do not behave in the way this equation suggests. First, 55% of firms change prices no more than once per year, and 75% of firms change prices no more than twice per year, meaning that most firms are not responding to monthly or even quarterly updates regarding the aggregate money supply. (Blinder 1991) According to Blinder's price study, the most important factors in firms pricing decisions are (1) whether they can lengthen delivery times or provide fewer auxiliary services, (2) the desire to avoid being the first in their industry to raise prices, (3) increases in labor or material costs, and (4) implicit understandings with their customers to not raise prices when markets are tight. Increases in costs gave rise to price changes more quickly than increases in demand.

The way the quantity of money is supposed to work is that firms allegedly will check inflation expectations and statements by the Federal Reserve (which are derived from predictions about the quantity of money) and adjust their prices to keep up. However, there’s simply no empirical evidence that this takes place. Truman Bewley's presentation to the Boston Federal Reserve Bank in 2016 provides us with insight into the emptiness of this hypothesis. He found that long term contracts and integration of production processes make rapid price changes very difficult and adversarial. “Literally no one in the study "mentioned expectations about inflation or future Federal Reserve policy as a factor, and questions along these lines provoked ridicule.” Bewley hypothesized that inflation expectations might affect prices by impacting futures prices, which affect long-term fixed prices. However, Fed chairman Ben Bernake, speaking in 2008, conceded that the futures markets are highly unreliable predictors of commodity price increases, so it is unclear through what channel inflation expectations ultimately lead to price increases.

Monetarists respond by stating that “the reason firms don’t check or respond to inflation expectations is that expectations are well anchored, but if there were a major shock to the real economy, then expectations would become unanchored, and firms would respond to new information and raise prices to keep up with expectations.” However, this makes the theory unfalsifiable and unscientific. Virtually everyone concedes that a major shock to the real economy would have inflationary effects regardless of whether firms agreed on inflation expectations. If there were a drought, food prices would go up because food would be scarce. The fact that firms would expect food prices to go up is superfluous decoration distracting from events in the real economy.

Fourth, another channel through which increases to the money supply is supposed to lead to inflation is downward pressure on the exchange rate, but this effect is much weaker than most people realize.

The exaggerated concern for this risk is based on a misunderstanding of the volume and flow of international trade. Exchange rate depreciation only has the potential to directly affect the price of imported items; in an average country the aggregate value of imports is less than 30% of the country's GDP, and in the U.S., only about 10% of personal consumption expenditures are on imported goods or goods containing imports. Even then, the relationship between currency depreciation and inflation is not one-for-one because exporters sometimes relinquish profit margins to maintain market share or because they must compete with the price of equivalent domestic-produced goods. In 1989, the Federal Reserve of St. Louis’s research officer, R. W. Hafer, performed a thorough review of the literature and concluded that the view “that a falling foreign exchange value of the dollar means higher U.S. inflation” was “off the mark.” Most of the studies he reviewed found that a 10% dollar depreciation only led to around a 1% increase in inflation, but the studies he reviewed that attempted to separate dollar depreciation from oil price shocks found that a 10% dollar depreciation led to an increase in inflation of 0.02% or had “no appreciable effect.”

Fifth, a broader examination of the empirical data does not show that increasing the money supply directly and immediately causes inflation.

For detailed empirical analysis, read this paper written by The Private Debt Project and review the accompanying underlying data. The quantity of money and the consumer price level are correlated, but that causation is bidirectional but likely goes primarily in the opposite direction. Rather than firms unilaterally raising prices - and sacrificing market share - because the government announced lower rates or a new spending program, consumers increase their borrowing to meet their material needs when prices go up. To illustrate with a real-life example, when someone wants a new car, they research the model they want and then find a way to pay for it, which may include borrowing money up to the previously-agreed-upon price. If the price of the car goes up, then they borrow more. They do not do the opposite. They do not go to their bank, ask “What’s the most you’d be willing to lend me?,” then go to the car dealership and say “The bank loaned me this much money; sell me the most expensive car I can get with this money.” There is some increased willingness to pay for consumer goods that results from easier lending conditions, but generally people seek to avoid debt and make decisions about what consumer goods they can afford before considering interest rates.