The Economics Book

32

supply of money led to inflation. His
thorough study is considered the
first important statement of the
quantity theory of money.
The reasoning behind this theory
is partly based on common sense.
Why is the price of a cup of coffee in
a rich part of town so much higher
than in a poor area? The answer is
that customers in the rich part have
more money to spend. If we consider
the population of a whole country
and double the money in people’s
pockets, it is natural that they will
want to use their increased
spending power to buy more goods
and services. But goods and services
are always in limited supply, so there
will be too much money chasing too
few goods, and prices will rise.
This chain of events shows the
important relationship between
the quantity of money in an economy
and the general price level. The
quantity theory of money states that
a doubling of the supply of money
will result in a doubling in the value
of transactions (or income or
expenditure). In the theory’s more
extreme form, a doubling of money

will lead to a doubling of prices, but

not real value. Money will be neutral

in its effect on the real, relative value

of goods and services—for example,

on how many jackets can be bought

for the price of a computer.

Real price, nominal price

After Bodin, many economists

developed his idea further. They

came to recognize that there is a

distinct separation between the

real side of the economy and the

nominal, or money, side. Nominal

prices are simply money prices,

which can change with inflation.

This is why economists focus on

real prices—on what quantity of a

thing (jackets, computers, or time

spent working) has to be given up

in return for another kind of thing,

no matter what the nominal price

is. In the extreme quantity theory,

changes in the money supply may

influence prices, but it has no effect

on the real economic variables, such

as output and unemployment. What

is more, economists realized that

money is itself a “good” that people

want to own for its spending power.

THE QUANTITY THEORY OF MONEY

Irving Fisher used the analogy of a scale to
illustrate the quantity theory of money. If there is an
increase in the amount of money in circulation, the
bag gets heavier, and the price of goods rises and
moves to the right, balancing the scale.

However, the money they want

is not nominal money, but “real

money”—money that can buy more.

Fisher’s equation

The fullest statement of the

quantity theory of money was made

by the US economist Irving Fisher

(1867–1947), who used the

mathematical formula MV = PT.

Here “P” is the general level of prices,

and “T” is the transactions that take

place in a year, so PT (Prices ×

The abundance of gold and

silver... is greater in this

kingdom today than it has

been in the last 400 years.

Jean Bodin

Money circulation Price level

25 20 15 10 5 5 10 15 20 25