Quantity Theory of Money (QTM), Excess Demand and Inflation

Quantity Theory of Money (QTM), Excess Demand and Inflation!

An alternative theory of excess demand inflation is that provided by the QTM which was born as a theory P. The monetarist explanation of inflation is a simple extension of it.

As in the Keynesian inflation analysis, the QTM also takes potential output as given with, however, one important difference.

Whereas in the neoclassical theory (of which the QTM is a part) actual output is always equal to potential output which is determined endogenously by the employment-production conditions of the economy, in the Keynesian theory, potential output serves only as the notional short-run maximum of feasible output.

The crucial difference between the two theories is in respect of the sources of excess demand. Whereas the Keynesian theory identifies them with the autonomous components of expenditure, mainly G (government expenditure) and I (private investment expenditure) in a closed economy (and also exports if foreign trade is taken into account), the QTM holds excess increases in the quantity of money responsible for increases in prices. This is easily explained with the help of the QTM.

First consider the case of a static economy with a given level of y (potential as well as actual). With constant V (assumption), P in it can rise only if M is increased. Alternatively speaking, increases in M alone are responsible for increases in P. On the assumptions of the QTM, P increases in the same proportion as M is increased, so that

P=M, (14.1)

where P and M are proportionate rates of change (per unit time) of P and M respectively. Since M is a policy-determined variable, the rate of inflation (under strict QTM) also becomes policy-determined.

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Now consider the case of a growing economy—an economy which y is growing over time due to the working of various growth factors. In the theories of excess-demand inflation, any general deficiency of aggregate demand is ruled out by definition.

So, demand deficiency cannot inhibit growth, and all potential growth feasible from the operation of supply-side factors is realized. In a growing economy the real demand for money will also be growing over time. In the QTM model the rate of growth of the real demand for money will be equal to the rate of growth of y, since in the simple QTM demand for money equation (11.2) the income elasticity of demand for money is necessarily unity. This growth rate in the demand for money gives the rate at which new money is (or can be) absorbed in the economy at constant prices. Only excess increases in the stock of money will lead to increase in prices, so that, for a growing economy, the rate of inflation is given by

P = M-y (14.2)

where (M-y) gives the excess rate of increase in the supply of money. How can excess increase in the quantity of money (M—y) be interpreted as giving excess demand for output relevant for demand- pull inflation? The answer is provided by the QTM of y, which translates excess supply of money into excess demand for output at given prices.

The limitations of the strict QTM model of P are equally also the limitations of the QTM explanation of inflation. It is now generally admitted (even by monetarists, including Friedman) that the simple QTM model does not give a good enough explanation of the behaviour of prices or of inflation from one short period (of even one year) to the next.

It is also generally admitted by all shades of economists that increases in the supply of money are necessary for inflation to continue for any length of time—that endogenous increases in V (with M^s constant) can help finance ever-increasing money value of transactions due to inflation only up to a point.