The quantity theory of money (QTM) is a hypothesis within monetary economics which states that the general price level of goods and services is directly proportional to the amount of money in circulation (i.e., the money supply), and that the causality runs from money to prices. This implies that the theory potentially explains inflation. It originated in the 16th century and has been proclaimed the oldest surviving theory in economics. According to some, the theory was originally formulated by Renaissance mathematician Nicolaus Copernicus in 1517, whereas others mention Martín de Azpilcueta and Jean Bodin as independent originators of the theory. It has later been discussed and developed by several prominent thinkers and economists including John Locke, David Hume, Irving Fisher and Alfred Marshall. Milton Friedman made a restatement of the theory in 1956 and made it into a cornerstone of monetarist thinking. The theory is often stated in terms of the equation MV = PY, where M is the money supply, V is the velocity of money, and PY is the nominal value of output or nominal GDP (P itself being a price index and Y the amount of real output). This equation is known as the quantity equation or the equation of exchange and is itself uncontroversial, as it can be seen as an accounting identity, residually defining velocity as the ratio of nominal output to the supply of money. Assuming additionally that Y is exogenous, being independently determined by other factors, that V is constant, and that M is exogenous and under the control of the central bank, the equation is turned into a theory which says that inflation (the change in P over time) can be controlled by setting the growth rate of M. However, all three assumptions are arguable and have been challenged over time. Output is generally believed to be affected by monetary policy at least temporarily, velocity has historically changed in unanticipated ways because of shifts in the money demand function, and some economists believe the money supply to be endogenously determined and hence not controlled by the monetary authorities. While it is called the Quantity Theory of Money, as James Tobin pointed out in his debate with Milton Friedman it should be called the Quantity Theory of Prices or Inflation, since it is a theory of the inflation rate, and not of the money growth rate. The QTM played an important role in the monetary policy of the 1970s and 1980s when several leading central banks (including the Federal Reserve, the Bank of England and Bundesbank) based their policies on a money supply target in accordance with the theory. However, the results were not satisfactory, and strategies focusing specifically on monetary aggregates were generally abandoned during the 1980s and 1990s. Today, most major central banks in practice follow inflation targeting by suitably changing interest rates, and monetary aggregates play little role in monetary policy considerations in most countries.
Origins and development
Before 1900: Early contributions The "state savings" (國蓄 pinyin:guó xù) chapter of the Guanzi (a Chinese philosophical and political text compiled in the early Han dynasty which discusses concepts of political economy that evolved in the Spring and Autumn period) has been described as the first-ever exposition of the quantity theory of money. Economic historian Mark Blaug has called the quantity theory of money "the oldest surviving theory in economics", its origins originating in the 16th century. Nicolaus Copernicus noted in 1517 that money usually depreciates in value when it is too abundant, which is by some historians taken as the first mention of the theory. Robert Dimand in the chapter on the history of monetary economics in The New Palgrave Dictionary of Economics identified Martín de Azpilcueta (1536) and Jean Bodin (1568) as the originators of a proper theory usable for explaining the observed quadrupling of prices during the phenomenon known as the Price Revolution following the influx of silver from the New World to Europe. John Locke studied the velocity of circulation, and David Hume in 1752 used the quantity theory to develop his price–specie flow mechanism explaining balance of payments adjustments. Also Henry Thornton, John Stuart Mill and Simon Newcomb among others contributed to the development of the quantity theory. During the 19th century, a main rival of the quantity theory was the real bills doctrine, which says that the issue of money does not raise prices, as long as the new money is issued in exchange for assets of sufficient value. According to proponents of the real bills doctrine, money supply responded passively in response to money demand. Consequently, there could be no causal influence from money to prices; conversely, the connection ran in the opposite direction: Money demand was determined by income and prices, which were affected by inflation, caused by various real (i.e., non-monetary) reasons.
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