In its simplest form, the quantity theory states that MV = PT. In other words, the quantity of money multiplied by its velocity of circulation encompasses all relevant transactions. (Money, velocity, prices, and transactions are the respective terms of this equation.) More concretely, quantity theory suggests that it is useful to think of the “M” in this equation – the money supply – as active causal variable for macroeconomics. Politics.
Consider the recent 8-9% inflation spurt in the United States. The simple fact is that M2 – a broad measure of money supply – increased by around 40% between February 2020 and February 2022. In the quantity theory approach, this would be a reason to expect further inflation , and of course that is exactly what happened .
The quantity theory has never been exact, one of the reasons being that the velocity (or rate of turnover) of money can also vary. At the start of the pandemic, spending on many services was difficult, even dangerous, and so savings exploded. Yet those days did not last, and when the new increase in money supply was unleashed on the US economy, there were inflationary consequences.
This is consistent with one of the oldest truths in economic history, from the inflationary episodes of ancient Rome to the French Revolution to Weimar Germany. In retrospect, the current inflation problems in the United States should not have been a surprise.
One of the reasons the quantity theory fell out of favor was that the Fed dramatically increased bank reserves after the 2008 financial crisis. By mid-2010, the Fed had increased banking system reserves by 1. 2 trillion dollars, compared to about 15 billion dollars in the few years just before the crisis. Yet inflation remained below 2%, and during the early parts of the crisis fell.
On closer inspection, this episode does not refute the quantity theory. The theory leaves room for the possibility that decreases in velocity – which can also be referred to as increases in the demand for holding money – can counteract increases in the money supply. In this sense, the Fed started paying interest on bank reserves, which led banks to hold most of the new increase in reserves. The Fed’s policy was therefore more a capitalization of the banking system than a true expansionary monetary policy.
It is true that a former proponent of the quantity theory, the Nobel laureate Milton Friedman, overemphasized the stability of the demand for money. Friedman’s theory therefore did not apply too well to the period 2008-2010. But the more general version of quantity theory has held up well.
So what could a quantity theorist say about the current situation?
An obvious point is that, despite all the rhetoric from the Fed to the contrary, current monetary policy remains expansionary. If you look at interest rates, the recent fed funds rate has hovered around 2.5%. Many treasury bill rates are between 3% and 4%. You can debate the appropriate measure of price inflation (underlying inflation? Headline inflation? Median inflation?), but by any reasonable standard, these interest rates are still negative in real terms. The Fed is simply not doing much to stifle borrowing.
A more positive sign is M2 growth, which was 5.3% year-on-year in July 2022. With economic growth of 2%, this corresponds to inflation of just over 3%, assuming that Monetary gear changes do not occur. Even better, M2 growth rates have steadily declined from almost 14% in August 2021.
One way to think about all this data is that the US is likely to converge to lower rates of inflation – but this interest rate policy is overstated in its effectiveness. This perspective follows naturally from the tools of quantity theory.
Some analysts point out that reducing the inflation rate requires big changes in fiscal policy. This is generally true for bankrupt nations, which must print money to pay the bills. But for solvent countries like the United States, it is not necessary.
I predict that price inflation rates will fall significantly over the next three to five years without a very dramatic change in the overall fiscal position of the United States. If I’m right, it’s worth noting, it will represent a triumph for the quantity theory of money.
More from Bloomberg Opinion:
• No one knows how long inflation will last: Niall Ferguson
• Inflation surprises are bad even when they are good: Jonathan Levin
• Fed messaging needs an update: Editors
This column does not necessarily reflect the opinion of the Editorial Board or of Bloomberg LP and its owners.
Tyler Cowen is a Bloomberg Opinion columnist. He is a professor of economics at George Mason University and writes for the Marginal Revolution blog. He is co-author of “Talent: How to Identify the Energizers, Creatives and Winners in the World”.
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