The Quantity Theory of Money
The concept of the quantity theory of money began in the 16th century, as more and more money began to flood into the New World. Essentially, the quantity theory of money is the belief that as more money enters an economy, the rise in the money supply will be equal to more inflation. In 1802, the economist Henry Thornton coined the phrase in a book about his economic theories. The quantity theory of money is absolutely crucial to understanding many of the economic debates surround the Federal Reserve and the concept of monetary policy, which continue to be discussed today.
The quantity theory of money is based in the idea that an increase in the money supply does not equal an increase in economic output, due to the rising inflation. This is because the value of money will decrease as there becomes more of it readily available. As an example, if the amount of money available in an economy raises by 50%, so too will the prices of everything, making the extra money essentially worthless. Instead, those who believe in the quantity theory of money say that increases in production and valuables being produced will allow the money supply to increase without the side effect of drastic inflation.
For a long time, the quantity theory of money reigned supreme in the classical view of economics, and became heavily attached to the idea of monetarism. However, in the 1930’s, at the height of the Great Depression, a famous British economist by the name of John Maynard Keynes challenge the entire concept of the quantity theory of money. Keynes put forward a revolutionary concept by attaching the quantity theory of money to the velocity of money. This added factor into the economic formula pointed to the idea that increases in currency, if met with changes in the velocity of currency, could lead to changes in real income. In the time since, Keynes’ ideas have become widely accepted in the economic world.
Many different tangible understanding came from the quantity theory of money. Indeed, as a general rule, raising the amount of available money supply will indeed lead to inflation in an economy. However, there are many other factors that also tie in, particularly the velocity of money, which can change the effect of prices, regardless of the money supply, due to supply and demand economics. So in real life, there isn’t an exact relationship between money supply and price levels that can be calculated.