The Quantity Versus The Austrian Theory Of Money

The Quantity Theory of Money (QTM) has been around since the time of Copernicus (the 1500s). In its original and most basic form it held that the general price level would change in direct proportion to the change in the supply of money, but to get around the problem that what was observed didn’t match this theory it was subsequently ‘enhanced’ by adding a fudge factor called “velocity”. From then on, rather than being solely a function of the money supply it was held that the general price level was determined by the money supply multiplied by the velocity of money in accordance with the famous Equation of Exchange (M*V = P*Q)**. However, adding a fudge factor that magically adjusts to be whatever it needs to be to make one side of a simplistic equation equal to the other side doesn’t help in understanding how the world actually works.

The great Austrian economists Carl Menger and Ludwig von Mises provided the first thorough theoretical refutation of the QTM, with Mises building on Menger’s foundation. The refutation is laid out in Mises’ Theory of Money and Credit, published in 1912.

According to the ‘Austrian school’, one of the most basic flaws in the QTM and in many other economic theories is the treatment of the economy as an amorphous blob that shifts one way or the other in response to stimuli provided by the government, the central bank, or a vague and unpredictable force called “animal spirits”. This is not a realistic starting point, because the real world comprises individuals who make decisions for a myriad of reasons and can only be understood by drilling down to what drives these individual actors.

For example, with regard to money there is supply and demand as there is with all other economic goods, but money demand cannot be properly understood as an economy-wide number. This is because the economy or the community or the country is not an entity that transacts. That is, a country doesn’t buy, sell, save or invest; only individuals — or organizations directed by individuals — do. Therefore, it is only possible to understand money demand by considering the subjective assessments of individuals.