The Quantity Theory of Money: Keynes vs. Hayek

by Federica Cittadino, Alberto Di Felice and Noémie Paulus

June 2007

The quantity theory of money relates changes in the quantity of money to changes in the price levels. It holds that any change in the supply of money reflects variations in the general level of prices—that is, the purchasing power of money. In consequence, prices will tend to change proportionately with the quantity of money in circulation. Put succintly, the quantity theory of money states that inflation or deflation can be controlled by altering the quantity of money in circulation inversely with the level of prices.
Its modern formulation (MV=PT) was developed by Irving Fisher in 1911. It moved from the equivalence between nominal income and total expenditure. Total expenditure is the product of the total stock of money available in an economy (M) and the velocity of money circulation (V); nominal income is the product of the volume of transactions taking place (T) and the average price level (P). Classical economists indicated that V would remain relatively stable and that T would naturally tend to full employment; they thus came to the conclusion that increases in the money supply would lead to inflation. The key strategy was that of containing the money supply in order to keep inflation under control.

Keynes detects a major error in the theory, that of assuming that changes in the quantity of money have a direct influence on the level of prices without affecting other variables. He concedes that this might be true in the long run, but states that what is experienced in reality is that variations in the quantity of money do bear upon the way people use money and banks, and on the employment of reserves by banks. [1] This happens as a consequence of the fact that changes in the quantity of money may impact more than proportionately on prices, because of modified monetary habits of the public.
Since monetary habits cannot be directly manipulated, for the reason that they are contingent upon “the mood of the public and the business world,” Keynes suggests that action should be taken on those variables which are in the hands of central banks—i.e., money supply and reserves—so as to balance the former. [2]
In the light of this, it can be concluded that Keynes does not see money as neutral, as it does affect the real sphere of the economy. Hence, he declares the classic dichotomy untrue.

Hayek, on the other hand, expands on the classic version of the theory by highlighting some of its shortcomings. In particular, he finds fault with the belief that money touches on prices and production only if the general level of prices rises. The only factor he deems crucial is the influence that variations in the quantity of money have on relative prices. It is relative prices which alter individual equilibria and therefore cause the production structure to readjust through time.
Hayek places himself within a diachronic perspective, from which he derives that the monetary system interferes with the realignment of intertemporal prices. From his standpoint, monetary action can only worsen the negative effect of money on the business cycle.
Developments in the economy are a consequence of individuals’ expectations at various points in time. The price mechanism works as a coordinating force though which relative prices renovate equilibrium in the long run. For Hayek, the economy is a matter of coordination between individuals’ actions which works itself out by means of the information associated with prices.
The ideal to which Hayek aspires is that of “neutral” money. In his view, monetary expansion is to be avoided, in that it amounts to shocks in relative prices and interest rates. Changes in the money supply can be an important cause of discoordination, particularly as those changes affect the ability of prices to accurately reflect relative scarcities. [3] His negative view of monetary expansion is perfectly in line with that of the classics.

As will be apparent, while Keynes thinks about what happens in the short term and is not interested in changes in the capital stock, Hayek builds around the idea of the business cycle—i.e., changes in the structure of the capital stock, which implies long-term thinking. In the words of Olivier Blanchard and Daniel Cohen: “As long as people (and therefore economists) have different values, their opinions on the economic system will be equally different.” [4]

Keynes asserts that economic actors have the possibility of holding their savings in cash. Actors’ savings are a function of their own expectations about financial developments: for example, if they think that interest rates will rise, they consume less and wait for the raise to materialize before investing. This process causes money to be diverted from consumption. Supply does not create its demand, as part of the income is put on hold.
Keynes holds that the link between the money stock and the level of national income is weak and that the effect of the money supply on prices is virtually nil, at least in economies with heavy unemployment, such as those of the 1930s. To him, monetary expansion seems ineffective in combating phenomena such as deflation; he therefore argues that the levels of investment and government spending are more important than the money supply in determining economic activity. From Keynes’s perspective, therefore, crises happen on the demand side, and the way to balance them is by means of governmental action through budget, tax policy and direct control of investment.
According to Hayek, by contrast, crises happen on the supply side: an increase in the money supply has a perverse effect on prices and the production structure—that is, the capital/labor structure in the different branches of an industry. When banks lend credit, additional funds combine with voluntary savings to finance new investment. The interest rate falls below its natural value, the value of investment rises and resources are redirected toward the producer goods industries. The signals for producers to invest in new production do not correspond to consumers’ inclination to consume. Instead, consumers are “forced to save” by the rise in the prices of consumer goods. As a consequence, the structure of production becomes unsustainable.
As incomes come in line with the new prices, consumers will tend to restore their previous level of consumption, thus decreasing savings. When banks reduce credit to replenish reserves, the structure of production returns to its old dimension. This change necessarily gives birth to a crisis consisting of unemployment in the investment goods sector which is only gradually re-absorbed. Attempts to counteract a recession, or period of high unemployment, with an increase in the money supply would further distort the structure of the capital stock. “The transition towards less capitalistic methods of production necessarily takes the form of an economic crisis.” [5] Supplying more money may well help temporarily, but will make things worse in the end. His remedy is simply to allow the crisis to play itself out, thereby permitting the necessary adjustments.

NOTES

1. See John Maynard Keynes, A Tract on Monetary Reform (London: Macmillan, 1923), pp. 79–80. [↩]
2. See ibid., pp. 80–6. [↩]
3. See Jack Birner, Between Consensus and Dissent: The Intellectual Styles of Keynes and Hayek, ICER Working Papers 14/97, 1997. [↩]
4. Olivier Blanchard and Daniel Cohen, Macroéconomie (Paris: Village mondial, 2004), p. 23. Our translation. [↩]
5. Friedrich von Hayek, Prices and Production (London: Routledge, 1931), p. 52. [↩]