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The Theory of Money

If money is to be managed, the questions immediately arise: how, by whom, and for what purpose? In the United States the Federal Reserve System has been assigned the task by Congress. It does so by controlling the dollar amount of commercial bank reserves and, through these reserves, the total money supply.

Goals of Monetary Policy

In the Employment Act of 1946, Congress spelled out government policy as being "to promote maximum employment, production, and purchasing power." Presumably, then, the goals or purposes of managing the money supply are to achieve price stability, full employment, and as rapid a rate of economic growth as possible. While some of these goals may be inconsistent, and while there are other forces that may be operating, monetary policy and the quantity of money have a strong effect on them.

The Quantity Theory of Money

This theory holds that there is a direct and powerful link between the quantity of money and the level of prices. This theory was developed by Alfred de Foville, Irving Fisher and Simon Newcomb in the latter 19th, early 20th century. In the post-Keynesian era, it was restated by Milton Friedman. The Quantity theory can be illustrated by the equation of exchange:

MV = PT,  or  MV=∑(p_i* q_i) = PT

M - is the money supply
V - is the velocity of circulation
P - is the overall price level (transactions for the economy during the period) and
T - is total transaction, or the amount of goods and services produced,
p_i - price of the i-th transaction,
q_i - the quantity of the i-th transaction.

This equation also used in the rudementary theory of inflation. P = (M*V)/Q,

The equation of exchange has some compelling implications for monetary policy. First, however, some assumptions must be made regarding velocity (V) and output (T). Many economists believe that velocity is relatively stable, at least in the short run, and that if the economy is at or near full employment, output also cannot change in the short run. In such a case, changes in the money supply (M) will cause a proportionate change in the overall price level, and in the same direction. The task for the Federal Reserve now becomes obvious. If the goal is stable prices, merely increase M to finance increases in T if and when they occur, as they will in the long run. Even if V changes, the direction that monetary policy should take is still obvious. The money supply must now be changed to offset the change in V in addition to financing any possible increase in T.

The quantity theory holds that an increase in M also will temporarily lower the interest rate. This is because just as more money drives up the price of goods and services, more money also results in more dollars seeking loan outlets, which drives the price of money (interest) down. But after a lag has taken place, then at the new higher overall price level, more money is needed to finance a larger dollar-volume of goods and services, and hence the money supply is no more plentiful than before. Consequently, the interest rate rises to its previous level again.

Although this may sound beautifully simple, the quantity theory came under attack during the 1930s and 1940's. Critics argued that there are lags and imperfections in the system. Money is not the only independent variable in the equation, according to the Keynesians, who led the attack on the quantity theory. P and T, as well as V, could all vary on their own. With the coming of the Great Depression in 1929, the quantity theory was discredited by many economists, who considered monetary policy ineffective.

Principles the Quantity theory is based on the following hypotheses:

- The supply of money is exogenous.
- The source of inflation is fundamentally derived from the growth rate of the money supply.
- The demand for money, as reflected in its velocity is a stable function of nominal income, interest rates, and so forth.
- The real interest rate is determined by non-monetary factors: productivity of capital, time preference.
- The mechanism for injecting money into the economy is not that important in the long run.

The New Quantity Theory

A new quantity theory emerged in the late 1950's, and out of it developed a new economic school of thought called the "Monetarists". While the older quantity theory made an allowance for possible changes in velocity, the importance and effectiveness of monetary policy would be lessened if there were independent variables in the equation of exchange other than M. The new quantity theory seeks to show that velocity (V) is functionally stable, although it may not be arithmetically stable. Moreover, they argue that velocity is sufficiently stable arithmetically, except during extreme crises such as hyperinflation, for monetary policy to be effective. Velocity is stable because the demand for money is relatively stable.

The monetarists argue that money is the most important single factor in determining money output, even though there are lags between changes in the money supply and the impact of the changes. They argue further that while, in the short run, changes in factors other than money may have an impact on the level of both prices and output (P and T in the equation of exchange), changes in the money supply are by far the most important. In the long run, they contend, the impact of changes in the money supply will be entirely on prices and not at all on output. Only changes in the money supply and nothing else will determine prices.

Rules Versus Discretion in Formulating Monetary Policy

Some powerful implications stem from the monetarists' position. If, for example, money is all that is important (or even the most important factor), monetary policy becomes paramount. Moreover, because of the lags involved, a managed discretionary policy by the Federal Reserve is likely to be wrong as often as it is correct. This is especially true if there are errors in judgment in making monetary policy as well as lags in its implementation. The monetarists also believe that the economy is basically stable and that past monetary policy errors have contributed to instability. Therefore, they suggest, the Federal Reserve System should not be permitted to formulate a managed discretionary monetary policy, but rather the nation should have a monetary policy based on rules.

The money supply, according to the monetarists, should be expanded by just enough to finance increases in real output. Real output (T in the equation of exchange) increases due to technological change as well as the changes in the population or, more correctly, the labor force. The rate of increases in productivity is known from historical experience, and the rate of growth in the labor force can be measured. Hence the increase in the money supply needed to finance the annual increase in output can be calculated.

As a second alternative, the monetarists suggest a band of monetary expansion of from, say, 4% to 6%. The Federal Reserve could then put into effect a managed discretionary monetary policy within this narrow band. Such a policy, according to the monetarists, would maximize the likelihood of achieving full employment, price stability, and rapid economic growth.

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