Quantity Theory of Money

Why should the Quantity Theory of Money

(QTM) be Introduced?
The QTM can be viewed as a special case of the
economic theory behind the LM curve.
The equation behind the LM curve is that the
real supply for money (M/P)
s
is equal to the real
demand for money, and the demand of money
depends on the transaction demand (i.e., it
depends positively on output Y) and the
speculative demand (i.e., it depends negatively
on interest rate r)

Why should the Quantity Theory of Money
(QTM) be Introduced?
A simple version of the QTM ignores the effects
of interest rate and postulates that M/P = kY,
where K is a positive constant.
The advantage of the QTM is that it explicitly
brings in the relationship between the price level
and the money supply and output.
This is important because as remarked by Milton
Friedman, Inflation is always and everywhere a
monetary phenomenon. Without the QTM, it is
hard to discuss inflation.
Empirical Relevance of the QTM
How well does the QTM fit the empirical
data, given that we ignore the effects of
interest rate? Some variants of the QTM
have been applied to many economies,
including Hong Kong and China. It is
known that the QTM works very well.
To empirically test the model, usually we
need to modify the QTM a bit.
Empirical Relevance of the QTM
M/P = kY can be expressed in the form of
m p = y,
where m is the % change in M,
p is the % change in P, and
y is the % change in Y.
(Note that the growth rate of k must be zero because it is
a constant.)

Alternatively, p = m y, i.e., inflation is positively related
to growth rate in money supply and negatively related to
output growth.

Empirical Relevance of the QTM
More advanced theories tell us that the real
demand for money is better described by M/P
e
,
where P
e
is expected inflation rate. This is
because we dont know what inflation is going to
be, and so we can only form expectation of it. In
practice, expected inflation rate depends on past
values of actual inflation. Due to this
complication, more sophisticated versions of the
QTM assume that inflation depends on current
and past values of the growth rates of M and Y.
This version of the QTM can explain more than
99% of the changes in prices in Hong Kong.
Earlier Versions of the QTM
Historically, the QTM has another form:
MV = PY, where V is the velocity of money. It
is supposed to measure how often the money
stock turns over in each period. Alternatively,
we can write V = nominal GDP/nominal money
supply, i.e., V = PY/M.
MV = PY should be treated as an identity,
rather than an equation, because by the
definition of V, it must always true. When there
are changes in M, P, or Y, then V may have to
adjust.

Earlier Versions of the QTM
Empirically, the V in the identity above
need not be a constant.
If we impose the assumption that V is a
constant, then we have the QTM, which
can be tested empirically. The new version
of the QTM is M/P = kY, where k = 1/V.