The relationship between money and prices

The quantity theory of money and its accompanying equation of exchange are generally accepted as defining the relationship between money and prices. The equation has been expressed a number of ways, always including “velocity of circulation”, which is a variable essential to balance the equation.

Few disagree with the simple premise that an increase in the quantity of money tends to increase prices; the mistake is to try to tie the relationship mathematically, because it rides roughshod over what actually happens. Not all prices rise at the same time, nor do they rise evenly. Furthermore, the equation of exchange cannot differentiate between price changes that emanate from demand for goods and those that emanate from changes in preference for money – two effects that can produce very different results. These unknowns are effectively wrapped up in that catch-all, velocity of circulation.

Aprioristic theory tells us where the error lies. People make a choice to allocate their income between current consumption and savings for the future. The most they can do without incurring debt is spend their earnings once. In practice most income is spent on consumption, but some is put aside for savings, and those savings are lent on through financial intermediaries to businesses for investment. Savings end up being spent on capital goods and working capital, instead of immediate consumption, but they are still spent.

If there is an increase in the quantity of money it is spent by those that first obtain it, but the same rule applies: they can only spend their money once. How that increase is spent determines which prices will tend to rise. Furthermore demand for goods can change as the quantity of currency and bank credit changes and consumers can also change their preference for money by hoarding or dishoarding only marginal amounts of cash. It is these factors that govern the relationship between money and prices. Therefore, the number of times a unit of account circulates over a given time is a red herring.

The fallacies behind the equation of exchange are more fully exposed in the case of a fiat currency, which unlike gold has no intrinsic value at all. What it will buy is set by its domestic acceptability as a money substitute amongst those that use it for transactions, and by its external value in the foreign exchanges set by those that don’t. Its purchasing power boils down to a matter of confidence and nothing else; therefore velocity is meaningless.

Consider the Icelandic krona’s dramatic fall in purchasing power in October 2008. According to the equation of exchange, the sharp increase in domestic prices that followed must be the result of an expansion in the quantity of money and/or an acceleration of velocity of circulation. What actually happened was simply a collapse in the purchasing power of the krona that originated in the markets, which had nothing to do with any monetary equation.

Velocity is an invention by economists to balance an equation conjured out of their own imagination, instead of understanding that the purchasing power of today’s fiat currencies is governed solely by the confidence placed in them. And because they have no intrinsic value, the quantity theory itself is a wholly inadequate explanation of the relationship between fiat money and prices.

This article was previously published at GoldMoney.com.

6 Comments

  • Alasdair Macleod will have to expand on his argument and make it much clearer if he wants to persuade anyone of his points.

    As far as I’m concerned, velocity is not, as Alisdair claims an “invention”: it ‘s a statistical fact. E.g. the velocity in New York state around 1932 was about a third it’s level in 1928. But if Alisdair has evidence that the hundreds of central bank officials and economists who have measured velocity over the decades have all got their facts or maths wrong, perhaps he can give us the evidence.

    Moreover, if the velocity of circulation of a given quantity of money doubles say, that means a doubling in demand for goods and services. That is a very real effect, strikes me. It is not, as Alisdair claims, a “red-herring”.

    • Craig Howard says:

      But if Alisdair has evidence that the hundreds of central bank officials and economists who have measured velocity over the decades have all got their facts or maths wrong, perhaps he can give us the evidence.

      Oh, one can certainly measure “velocity” [though how one does so in a particular state eludes me]. Macleod’s point is that how quickly one spends his money — bearing in mind that he can only spend it once — cannot predict some mythical “price level”. There is no such thing.

    • Responding to Ralph, I don’t think it could be more clear, bearing in mind my brief is to write 500 words or so.

      I am very comfortable with the thought that the entire establishment has got it wrong. They completely missed the developing banking crisis five years ago, when so far as I was concerned it was obvious that it would happen.

      Fiat money has no intrinsic value, as my krona example and countless others shows. Logically, it cannot be part of an equation that demands it must have an intrinsic value. Therefore the true purpose of velocity is to cover this deficiency. Changes in velocity covers all sins, including the effects of electronic cash.

      Keynesians and monetarists would understand this better if they stopped thinking that money is like water in a central heating system and took the trouble to understand basic price theory.

  • Gary says:

    “the equation of
    exchange cannot differentiate
    between price changes that
    emanate from demand for goods
    and those that emanate from
    changes in preference for money”

    This is one reason that inflation is such an insidious cancer on the economy. Price changes due to pure demand and supply of a commodity is masked by price changes due to the oversupply of money. Inflation. This causes investment to be misdirected from areas of genuine shortages. Inflation must be eliminated with all urgency, and that includes eliminating floating currencies and preventing the bankers or the govt printing money.

  • Gary says:

    I think the quantity theory of money is essentially correct. In that if you oversupply money you will EVENTUALLY AND IN UNKNOWN PATHS, cause prices to rise, by devaluing the money. It is the unknown paths that links to the Problem of Economic Calculation, and renders the uniformity of the money equation useless. Imo

  • Paul Marks says:

    I suspect that “expanding on his argument” will not do much good with the academic establishment (although Mr Musgrave may be different – who knows?).

    Almost a century ago Frank Fetter utterly refuted Irving Fisher – yet it was Irving Fisher (not the Frank Fetter) who academia followed.

    So the monetary policy to keep the “price level stable” became an article of faith – even among “free market economists”.

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