QUANTITY THEORY OF MONEY

According to the quantity theory of money there is a direct relationship between prices, income, and the amount of money circulating in the economy. The quantity theory was first propounded in its most basic form by French philosopher Jean Bodin (1530–1596), who observed that the large amounts of gold and silver being brought back from the New World were driving up prices across Europe. Later two British philosophers, John Locke (1632–1704) and David Hume (1711–1776), noted that when the quantity of money grew, so did purchasing power and economic activity. Thus, if a government wanted to lower prices to combat inflation, according to the quantity theory, all it had to do was decrease the amount of money in circulation. Consumers would have less money to spend, demand would fall, and prices would drop. Over the next two centuries other economists elaborated on this basic interconnection between the quantity of money, income, and prices, and until the 1930s it remained the dominant theory for explaining inflation, deflation, and the nature of business cycles.

During the 1930s the quantity theory came under attack because its opponents argued that government attempts to increase the amount of money in circulation during the early years of the Great Depression (1929–1939) had almost no affect on consumer demand. The primary opponent of the quantity theory was British economist John Maynard Keynes (1883–1946). He claimed that increasing the money supply alone would never be enough to stimulate a contracting economy. Only high levels of employment could resuscitate demand and that meant the government had to create jobs for unemployed workers if the private economy could not.

Keynes's "fiscal policy" approach to economic growth ruled the world of economics until the 1960s when a new quantity theory of money arose to take its place. Led by U.S. economist Milton Friedman (1911–), the new quantity-of-money theorists agreed with Keynes that government fiscal policy had an important role to play in stimulating the economy. However, they showed that during the Great Depression government officials had not really expanded the money supply fast enough or in large enough quantities to get the economy growing, so the Depression did not really disprove the quantity theory of money after all. Moreover, using new tools of economic research, the Friedman school of economists showed that increasing and decreasing the money supply did in fact have a direct effect on inflation and deflation.