The quantity of money and its velocity of circulation

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The so-called quantity equation is an essential foundation of the prevailing economic doctrine. A highly questionable one!

The ideas of a circulating money supply and a connection between this money supply and the level of the price level result from an idea in which all money consists of a clearly defined amount of cash, e.g., in the form of a certain and limited number of gold and silver coins. But this has nothing to do with reality, let alone today’s realities. Nevertheless, many economists obviously still believe this fairy tale to be a reality. The purpose of this nonsense is to make people believe that monetary policy does not influence the economy, growth, and employment but that the “money supply” is merely controlled to ensure price stability.

The basis of this hoax is the so-called quantity theory of money or the quantity equation of Irving Fisher (M x V = P x Y) with M = money supply, V = velocity of circulation of money per year, Y = real gross national product of an economy, P = price level. The expression (Y * P) denotes the value of the social product produced and sold (quantity of goods produced and sold, valued at prices), M x V the quantity of money “in circulation.”

The quantity equation's essential statement is then — under the assumption that V and Y (output at full employment!) is constant or given. The prices double if one doubles the money supply. Otherwise, however, nothing changes (neutrality of money). Real economic variables, such as economic activity, growth, and employment, would remain unaffected.

In reality, however, there is a problem: In reality, the quantity of money in circulation (flow) cannot be determined at all. All that is known is the stock of money at a given point in time. And these constantly change during a period as a result of borrowing and loan repayments (flows). How can we determine the amount of money in circulation? Let alone its velocity of circulation. The latter is, therefore, not measured but calculated by transforming the quantity equation.

In truth, one uses or misuses the quantity equation as a mathematical equation. However, it is merely an identity that actually says no more than that the sum of money spent to buy the social product, valued at prices, is identical to the sum of money spent to produce it. Because every purchase presupposes a sale or every sale a purchase, not a particularly witty insight. So what’s all this nonsense about?

Money is created by credit. Money is credit. And credit is existential for an economy based on the division of labor. Products and services are created over long value chains to pre-finance production and employment. And in principle, these credits could be generated and provided in virtually any order of magnitude. There is ultimately no scarcity here. Unless one creates it intentionally. In a paper money system, money and credit are not scarce. On the contrary, money and credit can be generated like dirt.

This is not a big deal because what matters is not how much credit is created and given, but only what the credit is used for. If it is used to pre-finance more production and employment, i.e., higher incomes, nothing will be said against it in principle. On the contrary. Only through increased borrowing, only through credit-financed expenditure surpluses (positive net borrowing) is higher output (Y), i.e., higher incomes, ultimately possible.

Therefore, the core task of monetary policy should be to ensure the supply of credit to the economy so that it can easily pre-finance its investment needs.

So be it. It was only by assuming a constant velocity of circulation (= 1) that the prevailing economic theory was able to misuse the quantity theory as a mathematical equation to arrive at the obviously desired result, according to which there is a causal relationship between “money supply” and “price level.” Thus, inflation could only occur if the central bank were to overextend the money supply (inflation), which, of course, could be prevented with the right “money supply control.” But this is nothing but nonsense.

In any case, the absurd argumentation looks like this: An increase in the money supply would lead to a surplus in the transaction fund (that’s what economics professors call their purse) and thus to an increase in demand, which in turn — according to the law of supply and demand — would cause rising prices.

In other words, people do not deposit surplus money in their bank accounts, from where it ultimately goes back to the central bank. No, people spend the surplus money in the economy until prices have risen. The surplus in the purse has disappeared. Already at this point, one can actually only rub one’s eyes in wonder.

Above all, however, the mystery of why, why, and why humans have now “more money” in their purse, which they spend then so long until the prices rose, remains a mystery. Apparently, it was somehow miraculously conjured into their pockets or, as Milton Friedman once explained in a short story, it was dropped from a helicopter, collected by the people, and then spent until this additional amount of money disappeared again due to price increases.

One to the result, to which one wanted to come probably also: The money supply only influences the price level. If the money supply is doubled, only prices double, but nothing else changes. Real economic variables such as the economy, growth, and employment would, therefore, remain unaffected. What colossal nonsense!

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The quantity of money and its velocity of circulation was originally published in The Capital on Medium, where people are continuing the conversation by highlighting and responding to this story.

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