The Quantity Theory of Money

While writing an op-ed, I came up with a good way to explain the quantity theory of money, which is the primary explanation for how inflation happens. But I had to edit it out for space reasons. Fortunately, a blog is the perfect repository for such things, so I share it here:

I am about six feet tall. But suppose I would rather be ten feet tall! There are two ways to do this. One is to actually grow taller. The other is to change the value of a foot so that it takes ten of them to describe my height instead of six. The first option is akin to economic growth; the second is essentially height inflation. Devaluing the foot so that it takes more of them to describe the same amount of height is the same as using more dollars to describe the same amount of wealth. This is what economists call the quantity theory of money. It doesn’t operate in the real world quite so smoothly as it does on the blackboard, but it is still broadly correct.

Keynesians, monetarists, and Austrians might not agree on much, but they do all agree with the quantity theory. There are other factors involved in how inflation happens, but few doubt that the money supply is the most important factor.

The other key insight to remember is that money is not wealth. Money has value because you can exchange it for wealth — goods and services. Think of an equation with the amount of money on one side and the amount of wealth on the other. When you fiddle with one side but not the other, the price level changes. Printing more money while leaving wealth unchanged causes inflation. So does leaving the money supply alone but reducing the amount of wealth — about which more later.

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