An Austrian Critique of Modern Quantity Theory of Money

A core presumption for the conduct of effective monetary policy is that the money-demand function indicates the capacity for an economy to adjust to changes in the money supply. An important element of this analysis involves how households and firms adjust their portfolios of assets. These portfolios include monetary instruments (e.g., cash), real goods (i.e., inventories of inputs or household goods) and interest-bearing financial instruments (e.g., bonds).

It turns out that most of the thinking about the demand for money arose during periods when the monetary regime was based on a commodity standard. In this context, changes in the demand for money would either inject or remove it from circulation and trigger responses in the real economy, price level or exchange rate.

As it was, the constraints on the supply of money (e.g., gold) were the primary reason that changing the demand for money was seen as being so consequential. For its part, classical monetary theory developed to examine a monetary regime unlike what exists today.

Since the Modern Quantity Theory of Money guides most monetary policy choices, one must ask if it can speak to the current conditions of a global fiat currency regime.

As it is, an essential aspect of the concept of money was of redemption, notes that circulated could be converted back into a commodity, so that debts were extinguished. As the debtor exits the debt loop, the debt itself no longer exists.

The global fiat currency regime of today involves an infinitely-elastic supply of irredeemable instruments. As such, debts are created by central banks in the form of fiat instruments and merely shuffled around. Individuals or firms or commercial may use fiat currency to pay off their debts, but they remain, backed only by other pieces of paper, usually public-sector debt.

A system that uses debt instruments to create and pay debts will not and cannot extinguish debts. For monetary theory to be complete, it must focus on how the system copes with (extinguishes) debt. The shifting of debt within an economy or from one economic actor to another is merely one aspect of what monetary theory should be about.

The inherent tendency of fiat currency to experience persistent losses in purchasing power reduces the incentive to hold cash outside the system. As such, the notion of “hoarding” has no meaning in the conventional (Keynesian) sense of the term.

Irredeemable fiat currency does not have the same properties as commodity money (e.g., gold) once did. In the first instance, there is a tendency for total debt in an irredeemable currency system to continue to grow. As such, debtors will become increasingly constrained and compelled to engage in rolling over their liabilities. This requires them to try to hold larger cash balances so they can service their debt obligations, even as market liquidity dries up.

The general proposition explored here is whether the absence of limits imposed by commodity standards requires a reformulation of monetary theory & central banking practice. Of particular interest is whether the demand for money or velocity of spending that supports monetary theory and much of macroeconomic theory are relevant within a global fiat currency regime.

Inasmuch as the Quantity Theory of Money is the basis of perpetual poor monetary policy choices, it can be seen as the primary source of macroeconomic instability. As such, central bankers will continue to destabilize financial or economic conditions until they abandon this flawed model.

Christopher LINGLE
Escuela de Negocios
Universidad Francisco Marroquín
CLingle@ufm.edu

Visiting-professor at Mackenzie Center for Economic Freedom

Funded by Mackpesquisa (Mackenzie Research Fund) resources