33
This painting by Dutch master Pieter
Bruegel (1559) shows vagrants rubbing
shoulders with the rich during Lent.
Steep price rises in the 15th century
led to much hardship among the poor,
a rise in vagrancy, and peasant revolts.Transactions) is the total value
of transactions occurring annually.
“M” is the supply of money. But
because PT is a total flow of goods,
while M represents a stock of money
that can be used over and over again,
the equation needs something to
represent the circulation of money.
This circular flow, which causes
money to rotate through the
economy—like the spinning drum
of a washing machine—is “V”, the
velocity of money.
This equation becomes a theory
when we make assumptions about
the relationships between the
letters, which economists do in
three ways. First, V, the velocity
of money, is assumed to be
constant, since the way in which
we use money is part of habit and
custom and does not change much
from year to year (our washing
machine drum spins at a steady
rate). This is the key assumption
behind the quantity theory of
money. Second, it is assumed
that T, the quantity of transactions
in an economy, is driven solely by
consumers’ demand and producers’
technology, which together
determine prices. Third, we allow
that there can be one-time changes
to M (the supply of money), such as
the flow of New World treasure into
Europe. With V (velocity) and T
(transactions) fixed, it follows that
a doubling of money will lead to a
doubling of prices.
Combined with the difference
between nominal and real, the
quantity theory of money has led to
the notion that money is neutral in
its effect on the economy.Challenge and restatement
But is money really neutral? Few
believe that it is neutral in the short
run. The immediate effect of more
money in the pocket is for it to be
spent on real goods and services.
John Maynard Keynes (p.161) said
it was probably neutral in the long
run, but in the short run it would
affect real variables such as output
and unemployment. Evidence also
suggests that money velocity (V)
is not constant. It seems to rise in
booms when inflation is high and
falls in recessions when inflation
is low.
Keynes had other ideas that
challenged the quantity theory
of money. He proposed that moneyLET TRADING BEGIN
is used, not just as a medium of
exchange, but also as a “store of
value”—something you can keep,
either for buying goods, for security
in case of hard times in the future,
or for future investments.
Keynesian economists argue
that these motives are affected less
by income or transactions (PT in
the formula) than by interest rates.
A rise in the interest rate will lead
to a rise in the velocity of money.
In 1956, US economist Milton
Friedman (p.199) defended the
quantity theory of money, arguing
that an individual’s demand for real
money balances (where money
buys more) depends on wealth. He
claimed that it is people’s incomes
that drive this demand.
Today, central banks print money
electronically and use it to buy
government debt in a process
known as quantitative easing.
Their aim has been to prevent a
feared fall in the money supply.
So far, the most visible effect has
been to reduce interest rates on
government debt. ■Inflation is always and
everywhere a monetary
phenomenon.
Milton Friedman