The quantity theory of money
Why prices rise when a central bank prints too much money, using the quantity equation, monetary neutrality and the Fisher effect.
FinanceThe economy behind your investmentsAbout 5 min: 3 reading, 2 practiceUpdated
General education, not financial advice.
- Explain why inflation is mainly about the value of money
- Use the quantity equation M × V = P × Y
- Explain monetary neutrality, the inflation tax and the Fisher effect
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The economy behind your investments: lesson 4 of 16
- The economy behind your investments
- Financial markets and intermediaries 5 min
- The market for loanable funds 5 min
- Banks and the money supply 5 min
- The quantity theory of money 5 min
- The aggregate-demand curve 5 min
- Monetary policy and aggregate demand 5 min
- Aggregate supply and the business cycle 5 min
- Fiscal policy and the multiplier 5 min
- The Phillips curve 5 min
- Expectations and the cost of lower inflation 5 min
- Rules or discretion 6 min
- Deficits and the case for balance 7 min
- Exchange rates and purchasing-power parity 5 min
- Exports, imports and capital flows 5 min
- The market for foreign-currency exchange 5 min
- Policies and shocks in an open economy 5 min
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Pairs with any introductory economics textbook; for example N. Gregory Mankiw, Principles of Macroeconomics (6th ed.), chapter 17
What it is
Inflation is about the value of money. If P is the price level, then 1 ÷ P is the value of money: how many goods one unit of money buys. When prices double, money's value halves.
The quantity theory (associated with David Hume in the 18th century and Milton Friedman in the 20th) explains the price level by the supply of and demand for money:
- The central bank sets the money supply.
- The demand for money depends on how much people want to hold for buying things; at a higher price level, people need more money.
- In the long run, the price level adjusts until the quantity of money people want equals the quantity supplied. So when the central bank prints more money, the price level rises: Mankiw's Principle 9.
The quantity equation. The velocity of money (V) is how many times a typical unit of money is spent in a year: V = (P × Y) ÷ M, where P × Y is nominal GDP and M the money supply. Mankiw's example: an economy makes 100 pizzas a year at 10 dollars each and has 50 dollars of money, so V = (10 × 100) ÷ 50 = 20: each dollar is spent 20 times a year. Rearranged:
M × V = P × Y
If velocity is fairly stable, and real output (Y) is set by productivity, not by money, then faster money growth shows up as faster inflation.
Quick check
Tap an answer to check it.
Money supply 400, velocity 5, real output 1,000. What is the price level?
- That divides output by M × V; P = M × V ÷ Y
- That is nominal GDP, P × Y
Show answer
2. 400 × 5 ÷ 1,000 = 2.
Why it matters
The classical dichotomy and monetary neutrality. Economists divide variables into nominal ones (measured in money, such as prices and nominal wages) and real ones (measured in physical units, such as output and real wages). In the long run, changes in the money supply affect nominal variables but not real ones: monetary neutrality. Mankiw's analogy: halving the length of the "yard" doubles every measured distance but changes nothing real. Most economists think neutrality holds in the long run but not over a year or two, when monetary changes do affect real variables.
Hyperinflation and the inflation tax. Governments sometimes pay for spending by printing money. This is an inflation tax: as prices rise, the money people hold loses value. Mankiw shows four hyperinflations of the 1920s (Austria, Hungary, Germany, Poland) in which money growth and inflation moved almost in parallel, and mentions Zimbabwe's official 24,000% in 2008.
The Fisher effect. The nominal interest rate = real interest rate + inflation. In the long run, the real rate is set in the market for loanable funds, so a rise in money growth and inflation raises the nominal interest rate one for one. This is the Fisher effect, after Irving Fisher (1867–1947). It may not hold in the short run, when inflation catches lenders and borrowers by surprise.
Worked example
Using the quantity equation in growth rates: money growth + velocity growth ≈ inflation + real output growth.
An economy's money supply grows 7% a year, velocity is stable, and real output grows 3% a year.
- Inflation ≈ 7% + 0% − 3% = 4%.
- If the real interest rate is 2%, the Fisher effect gives a nominal interest rate of 2% + 4% = 6%.
- If the central bank raises money growth to 12%: inflation ≈ 9%, and the nominal interest rate rises to about 11%. Real output growth and the real interest rate don't change in the long run.
Common mistake
Blaming inflation mainly on particular prices, such as coffee or fuel. Mankiw's point is that sustained, general inflation is about the value of money, and over the long run it comes from growth in the money supply.
Key terms
- quantity theory of money
- the theory that the quantity of money determines the price level, and money growth the inflation rate
- nominal variables
- variables measured in money units
- real variables
- variables measured in physical units
- classical dichotomy
- the separation of variables into nominal and real
- monetary neutrality
- the idea that changes in the money supply don't affect real variables
- velocity of money
- the rate at which money changes hands
- quantity equation
- M × V = P × Y
- inflation tax
- the revenue a government raises by printing money
- Fisher effect
- the one-for-one adjustment of the nominal interest rate to inflation
Practise the key terms
Tap a card to turn it over. 9 cards.
| Front | Back |
|---|---|
| quantity theory of money | the theory that the quantity of money determines the price level, and money growth the inflation rate |
| nominal variables | variables measured in money units |
| real variables | variables measured in physical units |
| classical dichotomy | the separation of variables into nominal and real |
| monetary neutrality | the idea that changes in the money supply don't affect real variables |
| velocity of money | the rate at which money changes hands |
| quantity equation | M × V = P × Y |
| inflation tax | the revenue a government raises by printing money |
| Fisher effect | the one-for-one adjustment of the nominal interest rate to inflation |
Practice
Work it through
Nominal GDP is 15 trillion and the money supply is 3 trillion. Next year money grows 10%, velocity is unchanged and real output grows 4%.
- 15 ÷ 3
- 10 + 0 − 4
- 2 + 6
Quick quiz
Tap an answer to check it.
What does monetary neutrality say?
- It affects prices, a nominal variable
Show answer
In the long run, changes in the money supply affect nominal variables but not real ones. Like changing a unit of measurement.
Inflation rises from 2% to 5%. What does the Fisher effect predict for the nominal interest rate in the long run?
- The nominal rate adjusts one for one with inflation
- The real rate is unchanged, so the nominal rate rises
Show answer
It rises by about 3 points. Nominal rate = real rate + inflation.
Why is the inflation tax called a tax?
- No one receives a bill; money loses value
Show answer
It takes value from everyone who holds money, without a bill being sent. Printing money raises the price level, so money holdings buy less.
In short
- Inflation is a fall in the value of money; over the long run it comes from money growth.
- Quantity equation: M × V = P × Y.
- Monetary neutrality holds in the long run, not over a year or two.
- Inflation tax; Fisher effect: nominal rate = real rate + inflation.
Mastery check
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Check yourself
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In Mankiw's pizza example (100 pizzas at 10 dollars, 50 dollars of money), what is velocity?
Show answer
20.
What is the classical dichotomy?
Show answer
The division of variables into nominal (measured in money) and real (measured in physical units).
In the worked example, what inflation results from 12% money growth?
Show answer
About 9%.
Further reading
- N. Gregory Mankiw, Principles of Macroeconomics, 6th ed. (South-Western Cengage, 2012), chapter 17.
- On this site: Real and nominal interest rates and The costs of inflation.
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