Top 12 Criticisms Against the Quantity Theory of Money

Here we detail about the twelve important criticisms against the quantity theory of money.

1. Simple Truism:

The quantity MV = PT is more truism, an obvious fact. It indicates that the total quantity of money given in exchange for goods and services (MV) is equal to the money value of goods and services given in exchange for money (PT).

In other words, the total amount of money expenditures of buyers is equal to the total amount of money receipts of sellers. The equation does not tell us anything new or precise about money and prices; it merely restates in a simple form that is evidently true. It does not show which the cause; which is the effect is, it simply shows what has happened.

2. Unreal Assumptions:

The quantity theory of money as stated by Prof. Fisher is based on unreal assumptions like the existence of full employment of resources and stability of expenditure. The theory assumes that other things like V, V’, M’ and T remain constant. But in actual practice a change in M is bound to affect V, M’, V’ and T. In a dynamic world, change in one factor induces changes in other factors. Experience has shown that the velocity of money instead of remaining constant varies in direct proportion to the volume of production (T).

3. It Fails to Explain Trade Cycle:

The transactions approach to the quantity theory of money does not help in explaining the trade cycle though it may be taken as a satisfactory- explanation of the long-term trends of prices. It is true that shortage of money (M) and credit (M’) has brought a boom to a sudden end but sometimes it collapses due to lack of the supply of money and credit. Moreover, quantity theory of money is not sufficient to explain the reversal of trend at the bottom of the slump.

If it is a decline in the quantity of money that causes a depression, an increase in it should be sufficient to cause an upturn but there are many examples, which go to prove its fallacy, as an increase in the supply of money at the bottom of a slump ‘did not raise the prices.

Prof. Crowther remarks:

“The quantity theory is, at best imperfect guide to the causes of the trade cycle.”

4. The Theory is Useful in the Long Period:

The quantity theory of money is also criticized on the ground that it explains only long-run phenomenon; it does not help to study the short-run phenomenon. Prof. Coulborn criticized the theory on the ground that “the theory is a concept of long- run phenomena”.

Fisher agrees that in the short-run of transition V and T do change but over a long- run, as the economy attains equilibrium they become constant. But in a continuously changing world, there is hardly anything like long period equilibrium; “equilibrium is like tomorrow it never comes”.

According to Prof. Crowther, “the most we can say for the quantity theory is that the quantity of money in existence seems to be the dominant influence on the price level on the average of long period. But in the short period…….. it may or may not control the movements of prices. And whether it does or does not depend on whether changes in the quantity of money are offset by changes in the velocity of its circulation.”

5. Interdependence of the Variable:

The various constituents of the transaction equation like M, V, M’, V’ P and T are not interdependent variables as assumed by the quantity theorists. They are independent. Therefore, it is difficult to know what affects what, and what the consequence of what is. If there is an increase in the physical volume of transactions (T), there is bound to be an increase in the velocity of circulation of money (V). Therefore, T and V are interdependent and rise or fall together.

Similarly, M may increase without any rise in P on account of the fact that T may have increased. The prosperity of the 1920s in the USA shows that a rise in T can lead to a rise in M without causing any change in P. The fact of the matter is that these variables are not independent of one another as Fisher has assumed. In, advanced economies, where the bulk of the quantity of money consists of bank credit, it is a consequence rather than a cause of the price level. The quantity theory of money unnecessarily overlooks the mutual interdependence of the factors involved and stresses the quantity of money as the cause and price level as the consequence.

6. It Does not Explain the Causal Relationship:

The theory fails to establish the causal relation­ship between P and M. The theory does explain why the price level is what it is at any particular time, it does not explain the causes which bring about changes in the price level. In other words, it provides no tools for the correct analysis of the hidden forces which produce variations in the value of money. Prof. Hayek and Prof. Chandler also expressed the view that theory tries to establish an unrealistic direct causal relationship between M and P without realizing the importance of other monetary factors and relative prices.

7. No Integration of Monetary Theory with Price Theory:

In the classical and neo-classical version of the theory, price formation is isolated from monetary phenomena. Money was considered a veil and played passive role, only as a translator of the values of commodities in terms of money. Thus, there could be no integration of monetary theory with the theory of relative prices (value).

There was a false division of economics between theory of value and distribution on the one hand and the theory of money on the other. It is, however, to be realized that under dynamic conditions money has an active role to play, and therefore, the theory of prices must form an integral part of the theory of output, employment and money (monetary theory) and should not remain isolated as in the classical version.

8. It Ignores Money as a Store of Value:

The cash transactions equation upholds money because it is a good medium of exchange. Its great fault is that it completely ignores the significant role of money which it plays as a store of value. Keynes upheld the store of value function of money and laid great stress on the speculative motive for holding money as against the classical emphasis on the transaction and precautionary motives for holding money.

9. Mutually Inconsistent:

The theory is criticized on the ground that some of the elements used in the equation are mutually inconsistent for, example, P includes all sorts of prices, wholesale as well as retail, wages and profits. Some prices move fast, while others are rigid. It is very difficult to say whether P represents highly fluctuating wholesale prices of rigid retail prices.

Similarly, T includes goods as well as services. Further, whereas M refers to a point of time, V refers to the velocity of money over period, MV involves the error of multiplying mutually inconsistent and non-comparable factors. Thus, the quantity theory of money is said to consist of mutually inconsistent elements.

10. Undue Emphasis on Quantity of Money:

Quantity theorists wrongly stress the role of the quantity of money as the main determinant of price level. Keynes, however, points out that the change in economic activity or the price level is caused not a change in the quantity of money alone but also by other fundamental factors like income, expenditure, saving and investment. Thus, price level is not the function of money supply alone in turn, it is influenced by a large number of monetary and non­monetary factors.

11. Static:

Quantity theory of money has been criticized on the ground that it is highly static. It applies under conditions where things remain constant but ours is a dynamic world, where things are fast changing. The validity of the theory depends upon the existence of full employment, which is very difficult to attain in actual practice. For analyzing the problems of dynamic economy and fluctuations therein, the quantity theory proves to be utterly inadequate.

12. Inconsistent with Actual Facts:

The theory has been found to be inconsistent with actual facts. For example, a small increase in M may lead to a considerable increase in T. In Germany in 1923, hyper-inflation was caused not on account of an increase in M but in V, as everybody was spending the depreciating mark as quickly as possible. To overcome this, a decrease in V and not M was needed as this theory would like us to believe. Similarly, there are circumstances when M has increased without an increase in P or the increase in P is not in direct proportion to an increase in M. Thus, the quantity theory has been found, at times, to be inconsistent with actual facts.

Besides, quantity theory of money has been criticized by various monetary experts on different grounds. Prof. Crowther says, “The quantity theory can explain the ‘how it works’ fluctuations in the value of money…….. but it cannot explain the ‘why it works’, except in the long period……… it cannot even explain why it is that a certain amount of money will sometimes ‘take’ and start off a rise in prices, while at another time an equal creation may have no effect at all.” Prof. Hayek thinks that the quantity theory has unduly usurped the central place in monetary theory and that the point of view from which it springs is a positive hindrance to further progress.

According to Whittakers, “the quantity theory is admirable as an elucidation of the mechanism involved in the price level, but as an explanation of causation it has serious shortcomings.” To Lord Keynes, “the fundamental problem of monetary theory is not merely to establish identities (MV = PT)……. the real task of such a theory is to treat the problem dynamically, analysing the different elements…as to exhibit the causal process by which the price level is determined………. ” Prof. Halm expressed the view that the importance of the equation should by no means be overrated: otherwise, we are bound to get into difficulties.

Despite these criticisms, quantity theory of money has its own merits. A good number of examples are found in economic history which proves the validity of theory when large issues of money have pushed up the prices, like hyper-inflation in Germany in 1923 and in China in 1947-48. Prof. Kemmerer and Prof. Cassel have made attempts to prove the direct and proportional relationship between the supply of money and prices. Moreover, important instruments of credit control like bank rate and open market operations are based on the presumption that a large supply of money leads to higher prices.