A Dent in the Quantity Theory of Money

Quantities do not determine prices. Individuals pursuing quantities do.

Photo by Ibrahim Rifath on Unsplash

Uncharacteristically of me, I am asking you to keep an open mind when reading this essay. The Quantity Theory of Money is so entrenched in today’s economic thought, that to question it is like questioning the law of gravitation. But questioning it I shall.

For the sake of readers who are unacquainted with the theory, QTM holds that if the amount of money in circulation increases, the prices of goods appreciate proportionately; if the amount of money in circulation decreases, the prices of goods depreciate proportionately. How much proportionally or evenhandedly? This is a debate for the disciples of QTM. While economists may disagree on the theory’s application, most take the theory for granted, namely, that the aggregate amount of the money supply (i.e., money in circulation) affects the general prices of goods and services. Thus QTM treats the quantity of money as the causal factor of the general prices in the economy.

To illustrate why I reject this causal relationship, we must begin with Say’s Law; or to be more precise, with the premises on which Say’s Law rest.

The classical economist, J. B. Say, stated: “in reality we do not buy articles of consumption with money, the circulating medium with which we pay for them. We must, in the first instance, have bought this money itself by the sale of our produce.” In other words, “products can only be purchased with products,” namely, production makes trade possible. When we produce goods we trade them with other producers who produce their own goods. The act of buying and selling may obfuscate this simple fact, but we can only buy goods with the money we earned through our productive effort.

Under the same token, the more goods we produce, the more goods we can purchase—and the fewer goods we produce, the fewer goods we can attain. Prices are merely a reflection of this fact. The more productive a society, the more prices will fall (i.e., its members will purchase more goods); the less productive a society, the more prices will rise (i.e., its members will purchase fewer goods).

Remember that money is a representation of how productive an individual is. The more productive an individual, namely, the more products he creates and sells, the more money he will likely make. Hence, the more money a producer earns suggests that he is creating more products and can purchase more goods. However, the Quantity Theory of Money implies that with more money in his hands he will raise the prices of goods. The QTM disciple can contend that while the money supply expands, the supply of goods expands even more, hence prices fall. Thus while money’s value falls “relatively to itself,” its amount in relation to the larger pool of goods has actually decreased. This explanation, however, is dubious. It implies that had people earned less money for a greater output of goods, prices would have fallen even further. In other words: being more productive but earning less depreciates prices the most (“Hey Johnny, we decided to award you with a lower salary this month so you can purchase more goods!”). This is of course ludicrous and points to a contradiction in QTM.

In real life, quantities do not explain quantities. Economics is not a subset of physics. Only economic agents and their choices can explain quantities. It is the productive capacity and action of the individual that influences the economy, not his static quantitative condition.

Money and goods do not “chase” each other—values and goals do. Relationships between quantities do not determine prices—individuals pursuing quantities do. Goods are constantly created, traded, and consumed (destroyed); they increase or decrease according to the choices of individuals—not according to their alleged relationships.

To think of quantities in aggregate is to ignore the creation (or consumption) process of particular quantities. To think of money in aggregate is to ignore its particular owners and their particular goals. You cannot “zoom out” of a specific possessor of money and treat the total quantity of money as if it has a God-like owner with a purpose of its own. Never is all the money pursuing all the goods (or vice versa). In reality, only an owner of a specific amount of money is in pursuit of a specific range of goods. My $10,000 in the bank may “chase” a potential of 500 goods, but no more. These 500 goods may “chase” $1,000,000 in the banks of its owners, but no more. The relationships between these intricate webs of ranges affect each other, and lead to changes in these relationships, but they never work as one unit, severed from the economic agents that drive these relationships. A change in one range will lead to subsequent changes in other ranges, and so forth, in a fast-paced economic environment of production and trade (at least in a free market).

Consider a grocery store that offers a wide range of goods to various degrees of quality. If shoppers’ incomes increase, they will start buying the higher-end goods, i.e., demand for quality goods will rise (and demand for basic goods will fall). The owner of the grocery store will want to take full advantage of the increase of his consumers’ prosperity and will lower the prices of quality goods. The reason is that when the range of demand expands, it propels the creation of more quantities in total.

Instead of buying one loaf of quality bread for $12, one steak for $25, and 10 fruit for $60 under the old pricing for a sum of $97, customers will now buy 2 loafs for $20, 2 steaks for $40, and 20 fruit for $100—under the new pricing—for $160 (or more in greater quantities).

This type of “wide demand” is quantity-led, i.e., the quantity that buyers pursue determines the price. In this scenario, sellers are competing for buyers: the more prices fall, the more buyers will flock to a specific seller to procure goods in greater quantities (and sellers maximize profits from the increase of buyers’ total savings).

Now, if shoppers’ incomes decrease, they will return to buying the lower-grade goods, i.e., demand for basic goods will rise (and demand for quality goods will fall). Now buyers’ range of demand narrows, even though their demand for some particular goods rises. In this case, the owner needs to readjust the supplied quantities to decrease them in total. When he raises prices, he mitigates the slowing rate of his profits.

So if regular bread cost $4 in the past, now the owner will raise the bread to $6, the price of rice from $3 to $6, and the price of 10 vegetables from $8 to $15. The shoppers willingly pay higher prices for these basic goods because they would still save money in comparison with their former living standards.

This type of “narrow demand” is price-led, i.e., the price that sellers set determines the quantities. In this scenario, it is the buyers who compete for quantities: the more prices rise, the more those with larger savings can outbid those with smaller savings and get their hands on the quality goods first (and sellers squeeze as much profit from the shrinking of buyers’ total savings).

The following charts display the differences.

Note that I did not account for production costs or proposed how much the price would rise or fall in either case. My purpose here is not to offer a theory of prices but only the basic factors for the trend of prices—moving up or down.

The conventional laws of supply and demand do not fit the scenario I described above. Allegedly, if demand rises prices should rise as well, and if prices rise demand should fall. But as we have seen, this depends on the broader context of the demand, namely, on the dynamic of the market: if production levels are growing or shrinking.

Buyers with increased wealth propel sellers to compete for customers, granting buyers the control over how many quantities they buy, i.e., they are in more control over how much they pay. Buyers with decreased wealth lose their control over quantities (to the sellers), as they compete to outbid each other’s savings—those willing to lose more savings (in absolute terms!) procuring the goods.

Greater production leads to more profits, which lead to more savings.

Slower production leads to fewer profits, which lead to fewer savings.

Now I can propose the primary principle of price-trend: prices fall due to the willingness of the seller to lower prices and prices rise due to the willingness of the buyer to pay higher prices—regardless of the specific dynamic of the market.

Although it may seem counterintuitive, the principle is simple: for the price to trend upward the buyer must accept a higher offer and for the price to trend downward the seller must accept a lower bid. The buyer can bid whatever low price he wishes, but if the seller is unwilling to lower the price, the buyer will remain with his hands empty. Similarly, the seller can ask for whatever price he wants, but if the buyer is reluctant to pay a higher price, the seller will remain full-handed but with no money.

In an expanding economy, the seller is incentivized to lower prices where demand is widening and competition for profits is high. In a contracting economy, the buyer is incentivized to accept higher prices where demand is narrowing and competition against savings is high.

The latter is easily demonstrated in a tightly regulated renting market where rising prices do not dissuade renters from paying more. Renters are willing to cut more of their savings when an apartment becomes available, even for a higher price, in order to outbid others in a condition of scarcity. The same phenomenon can occur in a thriving economy when buyers outbid each other’s savings in an auction for a rare painting.

It should be noted that force can distort these mechanisms in many intricate ways. Our current economic system is complex and must be analyzed with extreme scientific precision; but these fundamental truths should be the underlying factors upon which to understand how prices trend in today’s circumstances.

My principal point is that when productivity rises, the supply and demand of economic agents widens, their profits and savings rise together, and the total quantity of money increases. The results is depreciating prices. When productivity falls, the supply and demand of economic agents narrows, their profits grow slower (for those still in business) and savings decline, i.e., less money enters circulation (the total amount of money, at least in gold terms, cannot decrease because gold cannot go out of existence [though it can be kept away from the market]). The result is appreciating prices, with the only caveat that a huge drop in productivity can lead to such large-scale economic destruction that demand will fall for all goods—including the most basic commodities. In this case, prices will inevitably fall.

Notice that I start with productivity, continue with quantity, and end with money. This is the fundamental causal order of production and the creation of an economy. Money, as a tool that solves the problem of trade, is the end result of individuals’ productive actions, not the prime mover.

The Quantity Theory of Money must be reexamined seriously. Quantity cannot explain prices; only productivity can. The proposition that more money causes “upward pressure” on prices and less money causes “downward pressure” on prices is asserted arbitrarily and never proven. The premises of Say’s Law teach us that the more one is productive, i.e., selling more products, the more money he earns; which opens new ranges of goods for him to purchase; which drives larger quantities in the market; which leads to larger profits and increased savings; which incentivizes sellers to lower prices for a bigger share of the augmentation of wealth—and vice versa.

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A brief update. I’ve had a very content-full week.

It started with my guest appearance on The Reality Show, which I think was my best appearance to date.

It continued with a feature on Dr. Uri Milstein’s semi-popular YouTube podcast, talking about Israel’s war (in Hebrew) from an Objectivist perspective.

My interview with Iris Haim, whose son tragically died from IDF fire while trying to escape Hamas captivity in Gaza, was published in the Times of Israel.

And I even got a mention by Tal Tsfani, ARI’s CEO, in his keynote speech at OCON (minute ~44:30).

Here’s to more quality content!