Report

The quantity theory of money: a new restatement

This report from UK think tank the Institute of Economic Affairs emphasises the importance of a broadly defined money aggregate in the determination of nominal national income and wealth.

The overwhelming majority of economists were wrong in their forecasts about the consequences of the Covid-19 pandemic. They believed that it would result in years of falling inflation or even deflation. Instead, 2022 saw the highest inflation for 40 years in several leading economies. In early 2022, Professor Jason Furman, an influential American economist who advised President Obama, lamented the economics profession’s ‘dismal performance’ and ‘collective failure’.

However, from an early stage those few economists who tracked a broadly defined measure of money – including the author of this book – correctly forecast the inflation flare-up. They noticed that in spring and summer a money supply explosion was under way in the US, the euro zone and the UK, and indeed in many other jurisdictions.

This book argues that the high inflation numbers of 2022 and early 2023 were caused by excessive growth of the quantity of money. The Covid-related inflation episode was yet another illustration of Milton Friedman’s adage that ‘inflation is always and everywhere a monetary phenomenon’. Leading central banks – the Federal Reserve in the US, the European Central Bank in the euro zone, the Bank of England in the UK, and so on – organised the central bank asset purchases of long-dated securities from non-banks (or ‘quantitative easing’) which led to 2020’s money explosion. They were therefore responsible for annual inflation peaking, after a fairly standard lag of about two years, at close to or above 10% in many countries.

Different versions of the quantity theory of money – and of its modern incarnation as ‘monetarism’ – need to be distinguished. Meanwhile the equation of exchange (MV = PT) suffers from ambiguity and imprecision.

This study emphasises the importance of a broadly defined money aggregate in the determination of nominal national income and wealth. It differs from Chicago School monetarism by denying that the monetary base and narrow money play a major causative role in a modern economy. The proportionality postulate – which nowadays is the claim of similar changes in equilibrium of broad money and nominal national income – is a reasonable approximation to the facts, although it needs to be qualified by ‘financialisation’. This is the tendency for financial transactions (and hence the need for money) to grow faster than income as economies progress.

In practice and for much of the time, most economies suffer from a degree of ‘monetary disequilibrium’. (See chapters 4 and 5 for an explanation of this term.) Broad money may change substantially, and disruptively, in a particular period, shattering a previous monetary equilibrium. (The Covid-related events of 2020 were a good example.) If the quantity of money is then given for the next few periods, national income and wealth – along with the prices of goods and services, and of assets – have to change to restore equilibrium. Excess or deficient money causes these adjustments. The most important assets in the adjustment processes are corporate equity, housing and other forms of property, which have varying income over time.

Bonds are relatively unimportant, even though they are the focus of discussion in macroeconomics textbooks. Indeed, many textbooks – notably the Samuelson textbook, which first appeared in 1948 with a condensation of Keynes’s 1936 General Theory – adopt Keynes’s liquidity preference theory of ‘the rate of interest’ (that is, a bond yield). They give this theory (and the associated ‘IS function’) an inappropriately large status in national income determination. In macroeconomic analysis the proportionality postulate can be assumed to apply to variable-income assets in equilibrium. Interest-rate-only macroeconomics – particularly as exemplified in the three-equation version of New Keynesianism – has ostracised money from central bank research in the twenty-first century.

This kind of money-less macroeconomics is the key intellectual mistake behind the ‘dismal performance’ and ‘collective failure’ identified by Furman.