The Quantity Theory of Money

In the previous post, we entered the fiat money system. Now we will examine the quantity theory of money.

The fiat currency’s supply and demand are different from the commodity money model(silver or gold) we examined earlier. There are two reasons for this:

  1. In the fiat money system, the government has unlimited control over the money stock and the cost of money production is almost zero.
  2. The demand for money is unit elastic when responding to changes in the value of money.

Inferences from these two factors also change the mechanics of monetary policy. When the gold standard was abandoned, monetary policy shifted to a policy of influencing MOA supply rather than affecting MOA demand. The Fed may shift the supply curve to the left at any time through open market operations or loans. Therefore, under the fiat money regime, the supply curve is actually a policy instrument representing the amount of base money.

Simple, right? Unfortunately not. Especially I think OMOs are confusing people and there is a misunderstanding. More specifically:

  1. You may have heard of the helicopter crash metaphor in economics. Some Keynesians believe that the introduction of the currency through a “helicopter crash” or OMOs is much more important and effective than other ways. The term “helicopter crash” was originally used to refer to combined monetary/fiscal expansion. Money to be dropped from helicopters works like “welfare” payments, and this also expands the money stock. But at this point Keynesians are wrong. The financial effects are almost zero significant compared to the monetary impact. While it is quite essential to increase the base by 0.2% of GDP in a normal period, it is not equally necessary to increase the public’s debt at the same rate.
  2. As I have read, quite a lot of Austrians are concerned about the “Cantillon effects” (Cantillon effects emphasize who gets the money first). The Austrians assume that the lucky group who will get the money earlier will increase their spending. However, there is a misinterpretation here. In such a case, money is not given but sold at market prices. Therefore, the first person to receive the money will not be in a better position than the others and therefore does not have a good incentive to spend much more than others.

These are both due to a common misinterpretation: the idea that injections of money are important and the theory that “people with more money spend more” derived from it. However, this interpretation cannot be more than a confusion of wealth and money.

I will say a phrase that you can often hear in your daily conversations: A billionaire bought a large yacht (or yachts) because he had a lot of money. Here we mean that person is very wealthy. But despite this, the billionaire may have very little cash. A close example can be said of Jeff Bezos and Elon Musk. It has appeared in many places where both are the richest people in the world. But this wealth means wealth: it includes loans, stocks, and many other things. Despite this, neither of them has a fortune as cash as reported in the news. Musk or Bezos, if their stock dropped incredibly overnight, they wouldn’t be that wealthy anymore. Cash is not like that.

So if we really want to grasp the sheer effects of monetary injections(without confusion like financial or Cantillon effects), we must consider a form of injection that doesn’t make anyone “better off”.

Consider this: Let’s say there are 100 million Americans who receive more than $500 check from the government each year. These include tax refunds, veteran benefits, unemployment insurance, state workers’ salaries, social security, etc. there are also payments. The Fed says that they will increase the base by $30 billion this year. The Treasury pays 100 million Federal check recipients the first $300 in cash and the rest by check. In this case, people do not receive any additional money compared to the previous ones, only some of the money they receive comes in cash instead of regular checks. If the Fed had decided not to increase the base, $300 would have been paid by check. This is the essence of monetary policy, free from confusion and misinterpretation.

If people don’t want to keep that much cash, they’ll want to get rid of it. But how can they do that? Here we come to the only concept that lies at the heart of money/macro – the illusion of composition. Individuals individually can get rid of unwanted cash, but society as a whole cannot. Why is that? How can we explain this seemingly paradoxical situation?

Let’s consider an example where the Fed raises its foreign exchange stock from $ 200 to $ 400 per person. How can a new equilibrium be reached? In the short term, prices are sticky and of course, short term interest rates can go down. But prices will change over time, and a new equilibrium will be formed, where society is happy to have $400 per person. Okay, but how high do prices have to rise for supply to equal demand at the original interest rate? How can we find that?

We can assume that people care about purchasing power rather than nominal amounts. According to this assumption, prices should double so that the purchasing power of the cash stock returns to its original level. Suppose people are holding enough money ($ 200 for this case) to shop for a week. According to this assumption, prices should increase up to $ 400 for one-week shopping.

The implication from these two assumptions is that prices rise in proportion to the increase in foreign exchange stock. This means that the demand curve for MOA is unit elastic. Unlike fiat money, when the commodity money (silver or gold) is MOA, these assets’ demand will not be unit elastic. The only value of fiat money is purchasing power – unlike gold or silver, it has no value in itself.

This takes us to the Quantity Theory of Money. When you double the money supply, the value of the money drops by half, and the price level doubles. Of course, this simple equation assumes that the demand for money does not change over time. However, the demand for money in the real world also changes. So the following statement is a bit more accurate: “A change in the money supply causes the price level to rise proportionally to where it would have been if the money supply had not changed.” But even this statement is not entirely correct because, in the real world, expected changes in the value of money can cause changes in demand for money.

So what we only can say is this:

Changes that occur once in the money supply cause a proportional increase in the price level in the long run compared to where the price level would be if the money supply changed.

The reason for this statement is that one-off changes in money supply do not change real money demand in the long run. This is a slightly “weaker” version of QTM, but paradoxically it’s the strongest and most defensible version. In my view, QTM is most useful when there are big changes in the money supply and/or in the long run.

In the next post, we will see how shifts in expectations can lead to some wildly inconsistent results with simple QTM(and yet the two are compatible with each other).

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