Quantity Theory Of Money

Updated Jan 20, 2023

Definition of Quantity Theory of Money

The quantity theory of money (QTM) is an economic theory that states that the general price level of goods and services is directly proportional to the amount of money in circulation. That means if the money supply increases, the prices of goods and services will also increase proportionately. This theory was developed by the economists Irving Fisher, Simon Newcomb, Alfred de Foville, and Ludwig von Mises in the early 20th century.

Example

To illustrate the QTM, let’s look at a hypothetical economy with a fixed amount of goods and services. Now, assume the government decides to increase the money supply by printing more money. As a result, the amount of money in circulation doubles. Meanwhile, however, the amount of goods and services remains the same. That means the same amount of goods and services now has to be shared among more people. As a result, according to the QTM, the prices of goods and services also double.

Why Quantity Theory of Money Matters

The quantity theory of money is an important economic theory because it helps to explain the relationship between money supply and inflation. Although many Keynesian economists are very critical of the GTM, it is sometimes used by central banks to determine the optimal amount of money in circulation. If the central bank wants to increase the money supply, it can use the QTM to determine the optimal amount of money to print, considering the effects this has on price levels. This helps to ensure that the money supply is neither too low nor too high, which helps to keep inflation in check.