How the Quantity Theory of Money Helps Us Understand Financial Markets

The quantity theory of money (QTM) is a cornerstone of macroeconomic theory, and it states that changes in the supply of money have a proportional impact on the overall price level in an economy. It is most often associated with the 20th-century economists Irving Fisher and Milton Friedman. The theory has roots that go further back, however, as far as the writings of the Scottish philosopher David Hume in the mid-18th century and perhaps even earlier. The QTM is essential for understanding volatility in financial markets, as well as for judging the merits of changes to monetary policy by central banks.

A more formal portrayal of the QTM is represented by the equation of exchange: MV = PQ. Here M represents the supply of money, V represents the velocity of money (i.e., the rate at which an average unit of currency is spent and respent as it is exchanged for goods and services), P represents the prices of goods and services, and Q represents the real quantity of goods and services produced in an economy.

To begin to see the implications of the equation of exchange, imagine a situation in which the supply of money increases while the velocity of money remains constant. It is obvious that some combination of prices and real output—which together constitute nominal spending on goods and services—must increase too. Based on similar logic, Milton Friedman once argued for a rule whereby the money supply grows at a constant rate.

Such a policy might make sense, since economic growth presumably benefits from increases in the money supply as this facilitates more transactions. In general, however, it is not safe to assume that the velocity of money is constant. Velocity is another way of describing the public’s demand to hold money. The slower the velocity, the greater the demand to hold cash and bank balances. Faster velocity means decreased demand for money: people spend their cash balances more quickly after receiving them.

One of the main jobs of a central bank is to respond to the pessimistic; they often seek to hold greater money balances and also bonds, such as U.S. Treasuries, thereby putting downward pressure on interest rates. In order to avoid a recession, the Federal Reserve and other central banks respond by lowering the interest rate at which banks borrow from one another, as well as by increasing the supply of bank reserves and currency so that banks and the public can hold the money balances they desire.

The QTM can also help us understand developments in modern cryptocurrency markets. As with the money growth rule Friedman advocated, the supply of crypto coins such as bitcoin or ether is often determined by an algorithm. The experience of cryptocurrencies suggests that an algorithmic approach would be problematic if it were adopted by national governments, however. The reason is that the simplest money growth algorithms do not respond to changes in the public’s demand for money, and this results in significant price volatility.

Consider that when demand for bitcoins increases significantly, the price of bitcoin surges. When investors pull back, the price plummets. Such volatility helps explain why cryptocurrencies aren’t used in more everyday transactions. If bitcoin were used for as many transactions as the U.S. dollar is, imagine how many prices in the economy would have to adjust in response to the frequent ups and downs in bitcoin’s value.

Stablecoins have emerged as one solution to price volatility in crypto markets. Like a currency board or a central bank with a fixed exchange rate, these cryptocurrencies are designed to maintain a stable price by linking their value to another asset—for instance, a fiat currency or a commodity such as gold. Tether and USD Coin are two examples of stablecoins pegged one to one with the U.S. dollar. Similarly, central bank digital currencies are digital versions of traditional fiat currencies that are issued by central banks. Like stablecoins, these currencies would aim to maintain a stable value to eliminate some of the volatility associated with cryptocurrencies.

The equation of exchange sheds light on how these proposed solutions to price volatility in crypto markets work. Price volatility can be offset by having the supply of money respond to changes in the demand for money, thereby stabilizing the money’s value. In this way, when a central bank or cryptocurrency issuer increases the supply of its currency, the act is not always inflationary. In other words, it does not always lead to a general increase in prices. Instead, such “money printing” often simply offsets increases in money demand that would otherwise cause a general deflation.

As these examples illustrate, a thorough understanding of the QTM is helpful for understanding the dynamics of modern financial markets. This is fascinating given the roots of the theory trace back hundreds of years. One insight of the QTM is that, in a growing economy, the quantity of money should generally increase in order to facilitate increased spending. Another is that, in order to keep the value of money relatively stable, the money supply should respond to changes in the public’s demand to hold cash or bank reserves. A critical challenge facing central banks, as well as cryptocurrency creators, is to address both of these related issues simultaneously. In a complex world, that is easier said than done.

James Broughel is a Senior Fellow at the Competitive Enterprise Institute with a focus on innovation and dynamism.