A Critique of the Fundamental Principle of Neoclassical Monetary Economics
Money is traditionally defined as anything which is generally accepted as a means of payment and used to denote the value of the goods and services produced within an economy. It may occur in any form — commodities (such as gold or silver), livestock, or fiat money (by government decree). Money affects everyone everywhere — from deciding whether to buy aa notebook, to deciding how to invest one’s savings for future purposes. Money, in other words, is all pervasive and inevitable.
Monetary Economics is that branch of economics which studies the nature of money. This sub-discipline of economics originated with the inception of the Quantity Theory of Money, first postulated by Polish Mathematician Nicolaus Copernicus. The aforementioned theory is considered the fundamental principle of Monetary Economics. The theory gained prominence in 1963 post the publishing of the book “A Monetary History of the United States” authored by Milton Friedman and Anna J. Schwarz. In fact, this book has often been cited as the seminal text of the Neoclassical School of Monetary Economics, which is predominantly expounded at the University of Chicago.
Quantity Theory of Money
The Quantity Theory of Money (QTM) is essentially an equation that relates the real economy, which includes the goods and services produced in an economy, with the monetary economy, which includes the nominal money supply in the economy. To put it simply, The quantity theory of money states that the value of the real economy, expressed in units of currency, is proportional to the nominal money supply in an economy. Being a single equation, it will be easier to understand the theory mathematically, which is stated as follows:
Therefore, the quantity theory of money, mathematically, states that the product of nominal money supply and velocity of money is equal to the aggregate price level and aggregate real output at a point of time “i”. Velocity of money indicates the number of times a particular currency note or coin circulates in the economy; therefore, the same currency note may be used by two or more individuals, thus creating a multiplier effect for a given nominal money supply.
To be sure of the mathematical equation, an intuition provides the underlying rationale. To understand the intuition, I make use of another economic principle: The output in an economy for a given period is distributed as income to the factors of production. In that context, the right side of the equation is the output in a given period expressed in its currency units, that is, the aggregate income in an economy expressed in units of the currency in the given time period. The left side of the equation is the aggregate amount of nominal money which is used to purchase the goods and services so produced. Therefore, we find that the amount of money present in the economy to purchase the goods and services produced in the economy is equal to the nominal value of the goods and services produced in the economy. Thus, the amount of money that people have and can use to buy goods and services (demand) is exactly equal to the value of goods and services that have been produced and are available for consumption (supply). This satisfies the highly venerated supply-demand equilibrium, a concept sans which economics, as we know it, shall cease to exist.
There is however, another implication of this equation which is used not just for academic purposes, but has been integrated in the policy formulation framework of the monetary authorities of countries. By transforming the quantity theory of money equation in percentage rate of change form, we have:
Since velocity of money is usually affected by psychological and other structural forces, it is not required for the analysis I have provided in this article. Therefore, I take it to be constant, with the growth rate of velocity of money becoming 0. The modified QTM rate of change equation is thus:
Long-run effect and critique
Recalling the QTM rate of change equation, inflation is equal to the difference between growth rate of nominal money stock and growth rate of GDP. So far, so good.
The problem arises when one considers the elusive Long-Run Equilibrium, which is considered to be the equilibrium level of output that occurs when the only form of unemployment which takes place is due to structural inefficiencies in the economy; all factors of production are otherwise employed optimally. By defining long-run in this way, the role of monetary policy, an instrument that affects economic variables via the interest rate (which is further affected by other instruments of monetary policy such as open market operations, credit rationing) is nullified, since the only set of variables affecting the level of output is strictly the availability of resources. In the QTM, the effect of monetary policy is approximately captured by the growth rate of nominal money stock, since monetary policy involves the manipulation of the nominal money stock through various actions of the monetary authorities. Since, in the long-run, output is constant unless the quantum and/or efficiency of resources is not affected, the growth rate of aggregate real output is constant. Therefore, in the long-run, the QTM rate of change equation becomes:
This seems like a rather neat conclusion, except that it masks a certain inconsistency. The cost of holding nominal money stock is the nominal interest rate, also known as the opportunity cost of holding money. However, the interest rate feeds into the real economy by affecting the level of investment. Investment is traditionally defined as the change in capital stock, where capital in its broader sense includes not just machinery, but human capital as well. Capital stock, as a consequence of, say, lower interest rates rises, which then augments the overall resource base of the economy. Subsequently, the level of long-run output rises as the amount of capital in the economy goes up.
A neoclassical economist will go on to argue that when the output in a given time period exceeds the long-run output, price levels will shoot up, and the central bank will increase the interest rates, thus reducing investment demand, price levels, and output. True, except that the capital stock from higher investment during the period of low interest rates will not be eliminated completely. In other words, the increased quantum of resources cannot be offset by a lower supply of nominal money stock. Therefore, the long run level of output is, indeed, augmented.
To put it mathematically, I simply declare the stock of capital in an economy to be a function of interest rates. If that is the case, the long-run level of output becomes a function of the nominal interest rate in a given period. Since the nominal interest rate is essentially manipulated using the level of nominal money stock, the long run growth rate of real output cannot be 0 unless the nominal money stock is constant in the long run, the nominal interest rate is inelastic to changes in the level of nominal money stock, or the investment demand is inelastic to changes in the nominal interest rate.
Conclusion
A practical approach of the aforementioned finding is already present in financial economics; more specifically, when calculating the intrinsic (long-run) value of a company.
When calculating the intrinsic value of a company, changes in interest rates translate into lower overall cost of funds and, therefore, to greater borrowings. This can be seen in the form of an increase in total debt. Simultaneously, a simple empirical investigation will reveal that higher capital expenditure is undertaken to expand during a favourable demand phase. As a consequence, a company essentially scales up its production, and revenue. This can even lead to higher earnings for the company. Since earnings are essentially the returns enjoyed by the owners of the firm, this raises the total returns of the owners; therefore, raising the intrinsic value of the firm.
Economics is still nascent: There needs to be changes in every facet. While there does exist a need to analyse such theories more deeply, I hope that this article is a good starting point towards understanding the deficiencies in conventional economic theories which not only create the foundation of scholarly analysis, but also act as the basis for economic policymaking.
Link for Further Reading
https://www.sciencedirect.com/topics/economics-econometrics-and-finance/quantity-theory-of-money
This article has been written by Ayush Ghosh Roy who has recently graduated with a degree in Economics from the University of Delhi. He likes to challenge the conventional world-view by pointing out the deficiencies and inconsistencies in the theories which act as the foundation for our thought process. He wishes to make a real difference by forcing people to think and act outside the box when solving problems. During his free time, he can be found using comprehensive models to figure out if a company is a good investment or in the kitchen, experimenting with food.
