In its simplest form, quantity theory states that MV = PT. That is, the money supply multiplied by its velocity includes all relevant transactions. (Money, speed, prices, and transactions are the respective terms in this equation.) In substance, 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 politics.
Consider the recent 8% to 9% surge in inflation in the US. The simple fact is that between February 2020 and February 2022, M2 – a broad measure of money supply – increased by about 40%. According to the set-theoretic approach, this would be reason to expect additional inflation, and of course that’s what happened.
The quantity theory has never held true exactly, one reason is that the velocity (or turnover rate) of money can also vary. At the start of the pandemic, spending on many services was difficult or even dangerous, so savings skyrocketed. But those days didn’t last, and when the new monetary expansion was unleashed on the US economy, it had inflationary consequences.
This is consistent with one of the longest-standing truths in economic history, from the inflationary episodes of ancient Rome to the French Revolution to the Weimar Republic. In retrospect, America’s current inflation woes should not have come as a surprise.
One reason the set theory has fallen out of favor is that the Fed significantly increased bank reserves following the 2008 financial crisis. By mid-2010, the Fed had increased reserves for the banking system by $1.2 trillion, compared to about $15 billion a year just before the crisis. However, inflation remained below 2% and declined in the early stages of the crisis.
On closer inspection, this episode does not refute the quantity theory. The theory leaves room for the possibility that decelerations – which can also be described as increases in demand for holding money – may counteract increases in the money supply. With that in mind, the Fed began paying interest on bank reserves, resulting in banks holding most of the new surge in reserves. So the Fed’s policy was one of capitalizing the banking system rather than truly accommodative monetary policy.
It is true that a former proponent of quantity theory, Nobel laureate Milton Friedman, placed too much emphasis on the stability of money demand. So Friedman’s theory didn’t apply too well to the 2008-2010 period. But the more general version of the quantity theory held up well.
So what might a quantity theorist say about the current situation?
One obvious point is that current monetary policy remains accommodative despite all the Fed’s rumors to the contrary. If you look at interest rates, the Fed’s current policy rate is in the range of around 2.5%. Many T-Bill interest rates are in the 3% to 4% range. One can debate what the appropriate measure of price inflation is (core inflation? headline inflation? median inflation?), but by reasonable standards these interest rates are still negative in real terms. The Fed just isn’t doing much to choke off borrowing.
A better sign is M2 growth, which was 5.3% yoy in July 2022. Assuming economic growth of 2%, this equates to inflation of just over 3%, assuming changes in the velocity of money do not intervene. Better still, M2 growth rates have steadily declined, from almost 14% in August 2021.
One way to think about all of this data is that the US is likely to converge towards lower inflation rates – but this interest rate policy is being overestimated in its effectiveness. This perspective comes naturally from the tools of quantity theory.
Some analysts emphasize that lowering the inflation rate will require major changes in fiscal policy. That’s usually true of bankrupt nations that need to print money to pay the bills. But this is not necessary for solvent nations like the USA.
I expect inflation rates to fall significantly over the next three to five years without a dramatic change in the overall US fiscal position. If I am correct, it is worth noting that this will mark a triumph for the quantity theory of money.
More from the Bloomberg Opinion:
• Nobody knows how long inflation will last: Niall Ferguson
• Inflation surprises are bad even when they are good: Jonathan Levin
• The Fed’s messaging needs an update: The editors
This column does not necessarily represent the opinion of the editors or of Bloomberg LP and its owners.
Tyler Cowen is a columnist for the Bloomberg Opinion. He is Professor of Economics at George Mason University and writes for the blog Marginal Revolution. He is co-author of Talent: How to Identify Energizers, Creatives, and Winners Around the World.
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