Tariffs and the Quantity Theory of Money

What does the quantity theory of money have to say about tariffs: will they raise the general level of prices, lower them, or not affect them at all?

AI-generated photo of gold coins and shipping containers.

The imposition of tariffs is an interesting case study of the quantity theory of money.

If you take the quantity theory of money literally, there are three scenarios with which to estimate what will occur to the general level of prices in the market through its prism.

Scenario #1: The aggregate supply of goods decreases and the general level of prices increases.

Since consumers will not want to pay higher prices for imported goods with tariffs, the demand for these goods will diminish, and in turn demand for domestic goods will rise, leading to rising prices of imported and domestic goods. With the same amount of money and fewer goods, the general level of prices appreciates.

Note that even if foreign producers can withstand the tariff-tax and keep selling their products for the same price, the marginal foreign producer will not be able to remain profitable and will go bankrupt. In either case, the overall supply of goods decreases, necessarily leading to rising prices.

Scenario #2: The aggregate supply of goods remains the same and prices decrease.

With foreign and domestic supply still existing as it did before tariffs were imposed, the only thing that changes is the added tax on imported goods. And since consumers are now paying an extra sum of money for imported goods, taxed by the government, they have less money for the same amount of goods. With less money and the total supply of goods remaining unchanged—aggregate prices depreciate (!).

Scenario #3: The aggregate supply of goods remains the same and prices remain the same.

The idea is this: the introduction of tariffs did not change the quantity of money or of goods in the economy. We still have the same amount of money and the same amount of goods in the world. The only thing that changes is that some goods (those that are tariffed) are sold for more, which means that other goods must be sold for less. An importer of lumber for example may decide to close his business and start producing T-shirts. The price of lumber increases but the added productivity in the clothing industry leads to decreasing prices of T-shirts.

What will actually happen in the economy, of course, is scenario #1, because more (government) force always means more impoverishment. In the long term, the economy may adjust to the new reality; and then it is anybody’s guess what happens to the supply chain and overall quantities and prices.

The main takeaway here is that the quantity theory of money ignores the economic principle that quantities and prices are determined by human choice.

Quantities, as such, cannot explain the decision-making of individuals.

Prices, as such, are not a mechanistic relationship between quantities.

Prices are formed in the mind of the trader. They are not physics—they are evaluations of individuals.

In the same token, quantities do not “merely exist.” Their existence/creation depends on human action. Individuals react to market conditions and change their decisions, change their course of behavior, change their production and consumption patterns. These in effect will determine the future quantities in the economy: both in the money supply side and the goods supply side.

The relationship between money, goods and prices is a dynamic relationship, not a static relationship in a void.

The economist must never take quantities and prices for granted. By ignoring the choices of individuals in a given context, the quantity theorists point to the latest general level of prices and conclude that the quantities that currently exist caused the latest general level of prices. It is a circular argument that substitutes effect for cause.

When one tries to point to the contradictions and empirical examples that contradict their theory, they simply explain away the causal factors of people’s choices by pointing to the end result as what caused the decisions, and not the decisions as what caused the end result.

Although the quantity theory will never admit this, implicitly it denies human choice as the basis for price-formation. If all the money in circulation buys all the goods, then there is no room for human choice. Human choice implies that all the money in circulation does not, in fact, or necessarily, buy all the goods for trade.

There is no plausible reason for this to be true, as nothing suggests that people cannot exhaust all their money before exhausting all the goods; or that they cannot exhaust all the goods while keeping some of their money. But more importantly, not all goods and all money exchange for each other in any given moment. People react to market changes by producing different goods, or new goods, or raising prices, or lowering prices, or taking loans, or declaring bankruptcy, or lobbying to the government—you get the idea. Never is all the money offered for all the goods. What actually transpires in reality is that in a given moment individuals in their respective contexts offer some of their money to a specific range of goods.

The idea that all money in circulation is the exact amount sufficient to buy all goods or to formulate all prices in the economy is ludicrous.

Even the proposition that there is such a thing as “money in circulation” is erroneous. Money enters or exits a savings account by a matter of a decision. And money in a checking account does not always circulate either. Whether money is in circulation or not is a dynamic question of its own. All of the factors invoked by the quantity theory of money impact one another over the course of time, and neither of them can be isolated as fundamentals for prices without taking into account the human mind.

If one seeks fundamentals in economics he must look elsewhere for a proper theory of prices.

For the start of an alternative hypothesis, I refer you to the following article.

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