Inspired by the “Books for Dummies” series I decided to write an easy digest of the Quantity Theory of Money (QTM). Most of my very intelligent first year undergraduates have not done any economics before and will have just 13 weeks to introduce themselves to the subject. The course is intense but the rewards are the lightbulb and eureka moments. A lightbulb moment was illustrated by a former student who came up to me and said I always remember when you explained the difference between profit maximisation and revenue maximisation. I now own a multi-million pound business. Another said I had that eureka moment when you gave your explanation of QTM, everything seemed to fall into place and now I am a Professor of Economics.
In explaining QTM I like to start with M x V = P x T (Fisher Equation) where:-
M = the stock of money in the economy which is crudely a sum of cash and current accounts.
V = the flow of money, the number of times, on average, each unit of money is used over a given period of time
P = the average price level of goods and services
T = the number of transaction over that given time period.
If we play around with it we can see what would happen if M increased and V and T remained constant. We would get inflation and we can then introduce feedback loops and behavioural economics because as people see prices rising and worry that this may continue so they bring forward purchases: I was going to buy a car next year, but I had better buy it now as its price is likely to continue going up. This reinforces more inflation as V increases.
Let us suppose that T increases and initially M and V remain constant then deflation occurs, people will put back purchases V will slow and make that deflation worse.
From here we can start explaining other economic concepts for example M can be disaggregated into its component parts of cash (M0) and money created by bank loans. When these are added together we get a broad monetary aggregate like M4. If we make a simple division we get:-
M4/M0 = money multiplier.
This is a concept that economists do not like to talk about these days, but it quite clearly shows a ratio that is important to banks as they do not want cash reserves to be too low and risk suffering a “Northern Rock moment”.
In a simple sense we can think of M x V as aggregate monetary demand (AMD) and P x T as nominal gross domestic product (NGDP) therefore:
AMD = NGDP
We can now disaggregate AMD into its various components, C+I+G+X-M where:-
C = private consumption
I = private investment
G = Government spending
X = demand for exports
M = demand for imports.
Now our QTM is looking much more Keynesian as:-
C+I+G+X-M = NGDP
If any of the components on the left change, such as “I” increasing, then, with feedback loops overtime, the NGDP will increase by more than the change in “I” such that we have identified another multiplier:
change in NGDP/change in I = income multiplier
Let us assume that “I” can then be further disaggregated into productive investment, which will bring about economic growth with a change in real GDP (RGDP), and unproductive investment which is just the flipping of assets. A change in either or both will change NGDP but only productive investment will change RGDP. This is an interesting situation as the, almost ZIRP policy, since the financial crisis has boosted unproductive investment at the expense of productive investment. At this point it is possible to introduce the concept of a deflator:
NGDP/RGDP x 100 = GDP deflator
Any relevant number divided by the deflator x 100 can then be used to remove inflation and therefore identify its real value.
In very simple terms we can see that M x V = P x T in a monetarist world is very similar to AMD = NGDP in a Keynesian world.
Hopefully as you read this you had an eureka moment and began to see things falling in to place. If you disagreed with everything I said then, if it made you think, it was still worthwhile.
J B Hearn 10/1/18