Currently the most underrated theory in economics is the so-called Quantity Theory of Money. It has been out of fashion for a long time, and even Federal Reserve Chair Jerome Powell has said that a strong money-price connection has not held for at least 40 years. Nonetheless, on closer examination the quantity theory does a reasonable job of explaining much of recent economic history.
In its simplest form, the quantity theory states that MV = PT. That is, the quantity of money multiplied by its velocity of circulation encapsulates all relevant transactions. (Money, velocity, prices and transactions are the respective terms in that equation.) More substantively, the quantity theory suggests that it is useful to think about the “M” in this equation—the money supply—as an active causal variable for macro policy.
Consider the recent spurt of 8% to 9% inflation in the U.S. The simple fact is that M2—one broad measure of the money supply—went up about 40% between February 2020 and February 2022. In the quantity theory approach, that would be reason to expect additional inflation, and of course that is exactly what happened.
The quantity theory has never held exactly, one reason being that the velocity (or rate of turnover) of money can vary as well. Early on in the pandemic, spending on many services was difficult or even dangerous, and so savings skyrocketed. Yet those days did not last, and when the new money supply increase was unleashed on the U.S. economy, there were inflationary consequences.
This is consistent with one of the longest-standing truths of economic history, from the inflationary episodes of ancient Rome to the French Revolution to Weimar Germany. In retrospect, America’s current inflation troubles should not have been a surprise.
One reason the quantity theory fell out of favor is that the Fed increased bank reserves significantly following the financial crisis of 2008. By mid-2010, the Fed had increased reserves to the banking system by $1.2 trillion, in comparison with about $15 billion in the years just before the crisis. Yet inflation stayed below 2%, and during early parts of the crisis it fell.
On closer examination, that episode does not refute the quantity theory. The theory leaves room for the possibility that declines in velocity—which also can be called increases in the demand to hold money—can counteract increases in money supply. Along those lines, the Fed started paying interest on bank reserves, which led banks to hold most of the new surge in reserves. The Fed’s policy was thus more of a capitalization of the banking system than a truly expansionary monetary policy.
It is true that one earlier quantity theory advocate, Nobel laureate Milton Friedman, placed too much stress on the stability of money demand. So Friedman’s theory did not apply too well to the 2008-2010 period. But the more general version of the quantity theory held up fine.
So what might a quantity theorist say about the current situation?
One obvious point is that, for all the Fed’s talk to the contrary, current monetary policy remains expansionary. If you look at interest rates, the recent Fed funds rate has been hovering in the range of about 2.5%. Many T-Bill rates are in the range of 3% to 4%. You can debate which is the appropriate measure of price inflation (core inflation? overall inflation? median inflation?), but under any sensible standards these interest rates are still negative in real terms. The Fed just isn’t doing that much to choke off borrowing.