WEBVTT NOTE A Rehabilitation of the Quantity Theory 1 00:00:00.000 --> 00:00:30.000 The motivation for this paper is that if you're anything like me, you look for a, you commonly look for a theory that describes the relationship between prices, quantities, inflation, the money supply, something like this, and we typically, at least if you're me and you probably are, you typically revert to the equation of exchange and the quantity theory of money to explain inflation, the relationship between inflation and money, and you know there's some problems with it and it doesn't fit into 2 00:00:30.000 --> 00:00:52.000 So starting from that foundation, what I wanted to do is say, what's wrong with the equation of exchange, what can we do to rehabilitate it and bring it more closely aligned with what we need it for, and then what would this rehabilitated theory actually look like? 3 00:00:52.000 --> 00:00:56.000 So just to briefly start, there's a couple of different ways you can look at it. 4 00:00:56.000 --> 00:01:00.000 The equation of exchange in general, and they're all tautologies, right? 5 00:01:00.000 --> 00:01:09.000 They're all true by definition. They're true by definition just by right of the way the definitions, the terms are actually defined and the way they interlock together. 6 00:01:09.000 --> 00:01:15.000 So the first one there, that's the Fisherian equation of exchange. 7 00:01:15.000 --> 00:01:20.000 PT on the right hand side is just an average price times the number of transactions in the economy. 8 00:01:20.000 --> 00:01:31.500 We've got Friedman's equation of exchange in the middle, where your right hand side is nominal income, prices times the real production of goods in the economy, or it's commonly proxied by real GDP. 9 00:01:31.500 --> 00:01:44.000 On the bottom we've got the Cambridge cash balance theory. This one's preferable in some circles because it actually looks like a money supply money demand equation, money supply on the right hand side, 10 00:01:44.000 --> 00:02:14.000 and then your money demand sorry money supply on the left hand side and then your demand on the right where some fraction K is what you demand to hold in your in your reserve balance or in your cash balance of your actual nominal income and they're all basically saying more or less the same thing or at least they can be made to be saying the same thing except in different terms and when I say they're all tautologies I mean that they're all true because of the way that we define the actual variables at hand and I don't think anybody would actually argue with that 11 00:02:14.000 --> 00:02:44.000 Now, what are some of the shortfalls of this? The first one that Austrians typically would look at is that we're dealing with one price level for the whole economy and it's a very ambiguous definition and it's one that we typically don't care about. Austrians like to talk about relative prices and not one price level in particular so this seems to be maybe not so useful. Money is ill-defined in these. What is the money supply? If you're dealing with the Cambridge cash 12 00:02:44.000 --> 00:02:48.320 Cash balance theory, the money supply you're using is typically M1 or something very narrow 13 00:02:48.320 --> 00:02:52.040 because we're looking at cash to be held for reserve balances. 14 00:02:52.040 --> 00:02:55.760 If you're looking at Friedman's equation of exchange, your money supply is typically 15 00:02:55.760 --> 00:03:00.140 a little bit more broad, M2 because you're looking at more credit-like instruments that 16 00:03:00.140 --> 00:03:02.640 would facilitate payments. 17 00:03:02.640 --> 00:03:05.260 Any way you talk, you slice it up. 18 00:03:05.260 --> 00:03:09.960 Money is a little bit different depending on which one you're actually using. 19 00:03:09.960 --> 00:03:14.840 The right hand side of these equations, we're looking at the gross level of transactions 20 00:03:14.840 --> 00:03:20.600 going on in the economy and that differs depending on what equation you're actually looking at. 21 00:03:20.600 --> 00:03:24.000 That's not a problem in and of itself, it just depends on how you want to actually define 22 00:03:24.000 --> 00:03:29.560 the equation, but I'd like to look at something that more is closely aligned with what Austrians 23 00:03:29.560 --> 00:03:34.280 would call a gross output or gross transactions taking place in the economy instead of something 24 00:03:34.280 --> 00:03:40.040 more narrowly defined like nominal GDP, which would be what the right hand side represents 25 00:03:40.040 --> 00:03:42.400 in Friedman's approach. 26 00:03:42.400 --> 00:03:45.000 Velocity comes under fire quite often. 27 00:03:45.000 --> 00:03:49.080 It's a little bit of an ambiguous contentless variable. 28 00:03:49.080 --> 00:03:56.600 In fact, if you actually look at the first two of these equations, velocity, it's really 29 00:03:56.600 --> 00:03:57.760 just the residual, right? 30 00:03:57.760 --> 00:04:02.260 It's the necessary equilibrating factor that you need to have and maybe the more correct 31 00:04:02.260 --> 00:04:18.260 Now, what's good about these equations? All of them are very easy explanations for price inflation. In fact, probably every single one of us, when we talk about inflation, price inflation in the economy, we resort to one of these explanations, right? 32 00:04:18.260 --> 00:04:28.260 Explanations for Price Inflation. In fact, probably every single one of us, when we talk about inflation, price inflation in the economy, we resort to one of these explanations, right? 33 00:04:28.260 --> 00:04:40.260 Austrian business cycles are fundamentally a theory of unsustainable inflationary-led booms, and here we have a very simple way that we can describe inflation in an economy. 34 00:04:40.260 --> 00:04:47.040 Hayek's policy norm for stabilizing nominal income through offsetting declines in the 35 00:04:47.040 --> 00:04:51.780 velocity of money with increases in the money supply. That's accepted in some circles, particularly 36 00:04:51.780 --> 00:04:56.060 free banking circles, and the equation of exchange seems fairly well suited for dealing 37 00:04:56.060 --> 00:04:58.660 with those kinds of prescriptions. 38 00:04:58.660 --> 00:05:01.340 So we've got some good things with it or some things that we want to keep, and we've got 39 00:05:01.340 --> 00:05:05.580 some bad things that we're trying to, or some shortfalls that we're trying to correct. So 40 00:05:05.580 --> 00:05:09.940 I want to take you through those four shortfalls I just showed you and rehabilitate it along 41 00:05:09.940 --> 00:05:28.940 So the first one was the price level that we use is really too broad to be useful for what we really want to use it for and what I, I should say it upfront, what I really want to use it for is integrating it into Austrian business cycle theory or having something that Austrians can actually deal with. 42 00:05:28.940 --> 00:05:33.640 Well, this is actually a fairly easy shortfall to correct. 43 00:05:33.640 --> 00:05:41.940 Austrians have a very good way that we can start categorizing goods depending on their nature or where they are in the process of production. 44 00:05:41.940 --> 00:05:47.440 So instead of just dealing with total transactions on the right hand side or total real output, 45 00:05:47.440 --> 00:05:55.940 why don't we break it up into output on capital goods or higher order goods and output which is devoted to consumer goods or lowest order goods. 46 00:05:55.940 --> 00:06:00.100 We end up with two different price levels, the price of consumer goods and the price of capital goods. 47 00:06:00.100 --> 00:06:06.100 They're still aggregate price levels, but notice that you now have a relative price in there, the relative price of capital 48 00:06:06.820 --> 00:06:08.820 with respect to consumer goods. 49 00:06:09.860 --> 00:06:14.540 Velocity, I call it V prime here because it's changed compared to how we would typically define it. Now 50 00:06:14.540 --> 00:06:19.280 it's not income velocity like it would be in Friedman's rendition of the equation of exchange. It's now 51 00:06:20.180 --> 00:06:24.260 total transactions or gross transactions velocity, if you want to call it that. 52 00:06:24.260 --> 00:06:31.460 Now, what about the second shortfall? The money supply is ill-defined and in 53 00:06:31.460 --> 00:06:35.060 particular what I have in mind when I say the money supply is ill-defined is 54 00:06:35.060 --> 00:06:40.580 the typical equation of exchange doesn't distinguish between base money or what 55 00:06:40.580 --> 00:06:45.380 we would call money proper and fiduciary media which is also used to 56 00:06:45.380 --> 00:06:50.620 enact transactions and payments. Quasi monies or close credit substitutes are 57 00:06:50.620 --> 00:06:56.620 are also something that we might want to keep in mind as something which facilitates transactions in the economy. 58 00:06:56.620 --> 00:07:00.620 And as Austrians, we have some pretty good tools or some pretty good theories to deal with this. 59 00:07:00.620 --> 00:07:05.620 The easiest one that I would start with is just to say, what kind of money do you actually want to define? 60 00:07:05.620 --> 00:07:07.620 Do that first and go from there. 61 00:07:07.620 --> 00:07:13.620 So the money supply that I want to define is base money and fiduciary media, which is fairly straightforward. 62 00:07:13.620 --> 00:07:27.620 This is Econ 101, M-naught or the total supply of base money in fiduciary media is just equal to your supply of base money divided by your reserve ratio, reserve ratio goes down, a greater amount of fiduciary media is outstanding. 63 00:07:27.620 --> 00:07:35.620 For $100 worth of base money at a 10% reserve ratio you've got $1000 worth of total money supply under this definition. 64 00:07:35.620 --> 00:07:45.620 Now, if we've got a definition for what we're actually talking about with money, let's start looking at what the specific reasons why you would hold money are. 65 00:07:45.620 --> 00:07:51.620 And in looking at this, there's two economists that I want to focus on, Murray Rothbard and John Keynes. 66 00:07:51.620 --> 00:07:59.620 Now, Rothbard, I should start by saying I think both of these approaches have a pitfall and both of them have an advantage. 67 00:07:59.620 --> 00:08:29.620 Rothbard's is the one that I actually prefer here. Rothbard does a very novel application where he divides the demand to hold money into two separate demands, your reservation demand, which is M superscript R, that's the amount of money out of your cash balance that you desire to hold to mitigate perceived uncertainty in the future, you don't intend to spend this, you will if an emergency arises, but you really hold it for an unknown reason. 68 00:08:29.620 --> 00:08:32.620 for a reason that's not yet materialized anyway. 69 00:08:32.620 --> 00:08:39.620 And then Rothbard has the exchange demand for money, this is your cash balance that you hold to enact payments or to facilitate you with payments. 70 00:08:39.620 --> 00:08:50.620 Now Keynes uses some similar terminology, he has the precautionary demand to hold money which is roughly analogous in many ways to the reservation demand to hold money. 71 00:08:50.620 --> 00:08:57.620 Keynes has the transactions demand for money, that demand you hold of money to facilitate your transactions. 72 00:08:57.620 --> 00:09:27.620 Transactions. And then Keynes has the savings demand, sorry, the speculative demand for money. This is the money you desire to hold to help you or to facilitate you in speculating in the economy. Or later on, a year later after the General Theory in 1937, he refined this and he called it the finance demand to hold money. It's just your demand to hold money for financial purposes instead of consumptive purposes. Now, I don't want to get into the debate of liquidity preference or where that enters into Keynes' 73 00:09:27.620 --> 00:09:36.620 I don't want to talk about time preference and how it enters into Rothbard's money demand, but I want to integrate the two of these together. 74 00:09:36.620 --> 00:09:41.620 The three terms that I integrate together are the reservation demand to hold money. 75 00:09:41.620 --> 00:09:46.620 This is your cash balance that you just want to put in your bank account for an unforeseen emergency. 76 00:09:46.620 --> 00:09:54.620 The exchange demand for money, which is that sum of money that you want to hold on to facilitate transactions for goods and services in the economy. 77 00:09:54.620 --> 00:10:04.620 And then I want to throw in there, for good measure, Keynes' speculative demand for money, although speculative is not the word that I want to use. I'd rather use the savings demand for money. 78 00:10:04.620 --> 00:10:13.620 This is your money that you hold in your cash balance to facilitate savings in the form of financial investment activities, loans typically. 79 00:10:13.620 --> 00:10:20.620 Now, the total money supply then has to be divided between all three of these money demands. They sum to unity. 80 00:10:20.620 --> 00:10:27.620 And the money demand which comes from your reserve is not going to be used for facilitating transactions in the economy. 81 00:10:27.620 --> 00:10:33.120 So we can factor that out if you're completely, which is what I've done over here on the extreme left-hand side, 82 00:10:33.120 --> 00:10:40.620 one minus your reserve demand for money, basically that is just factoring out for your reserve demand for money. 83 00:10:40.620 --> 00:10:46.120 And what you're left with is all of your cash balances that you hold to either facilitate transactions for good and services, 84 00:10:46.120 --> 00:10:52.640 Mises which is your money demand for exchange or financial transactions or savings transactions 85 00:10:52.640 --> 00:11:00.680 which is what I call M superscript S. Now each one of those dollars or currency unit 86 00:11:00.680 --> 00:11:07.200 that you hold in your cash balance does circulate throughout the economy at a certain velocity. 87 00:11:07.200 --> 00:11:11.800 Now in this case we're going to end up with two velocities. You get the velocity that 88 00:11:11.800 --> 00:11:15.440 your exchange money is going to circulate at and you get the velocity that your savings 89 00:11:15.440 --> 00:11:26.440 Now, in reality, we can't really disentangle these two effects, and everybody's well aware of that. In fact, your total money supply, you can't really disentangle this easily. It's just one big cash balance, correct? 90 00:11:26.440 --> 00:11:34.440 But theoretically, we can definitely distinguish between the two, and it's useful to do so as I'll show you here in a couple minutes. 91 00:11:34.440 --> 00:11:43.440 Now, focus on this term right here. This is basically the gross amount of lending that's taking place in an economy in any given time period. 92 00:11:43.440 --> 00:11:55.440 Period. It's your cash balance which you have held for saving or for finance purposes, times the velocity that it's circulating at, and it becomes the gross amount of loans which are being issued in the economy. 93 00:11:55.440 --> 00:12:08.440 If you're issuing loans in the economy at any given moment in time, it means that they have to be paid at some moment in time as well. So we need to add a term to the right hand side, and the term I add to the right hand side is just D for gross debt repayment. 94 00:12:08.440 --> 00:12:17.440 On the left-hand side, this term basically represents gross loans issued and the right-hand side offsets it with gross debt repayment. 95 00:12:17.440 --> 00:12:30.440 Just to simplify things, I've cleaned up this term here and called it M'. M' just represents that amount of your cash balance that you're holding to actually enact payments for exchanges or savings. 96 00:12:30.440 --> 00:12:36.440 Now, what are some things that we can talk about with this equation of exchange? 97 00:12:36.440 --> 00:12:45.440 One of the things that we might want to talk about is how the repayment of debt factors into the determination of price levels in the economy. 98 00:12:45.440 --> 00:12:53.440 Conceptually it's maybe a little bit more straightforward if we just regroup all of our debt terms or our loan terms over here on the right hand side. 99 00:12:53.440 --> 00:12:57.440 D is the total amount of debt which we're paying back in any time period. 100 00:12:57.440 --> 00:13:01.440 This term here is the total amount of loans which are being issued in any given time period. 101 00:13:01.440 --> 00:13:05.440 So the difference between them is just your net debt repayment. 102 00:13:05.440 --> 00:13:14.440 And from there, it's fairly straightforward to see that when it's positive, that is, more debts are being repaid in any time period than new loans are being issued. 103 00:13:14.440 --> 00:13:22.440 Chater as Paribus, the effect on your individual price levels of capital and consumer goods has to be negative or disinflationary. 104 00:13:22.440 --> 00:13:33.440 And the corollary holds true, if you're issuing more loans or more credit in any given time period than you are repaying debt, price pressures on capital and consumption have to be on net positive. 105 00:13:33.440 --> 00:13:41.040 Now you might think at this moment, why is it that you would include credit in this equation? 106 00:13:41.040 --> 00:13:46.160 Because one person, if they loan money to somebody, they've given up the purchasing power of that money 107 00:13:46.160 --> 00:13:49.760 and somebody else is using it to facilitate a transaction. 108 00:13:49.760 --> 00:13:51.680 So really there's no net change, right? 109 00:13:51.680 --> 00:13:55.560 One person's loss is another person's gain and then they're going to reverse it at some time in the future. 110 00:13:55.560 --> 00:13:57.200 So there really shouldn't be any effect. 111 00:13:57.200 --> 00:14:01.880 Joe, you take this approach in your paper, a simple theory of money prices, 112 00:14:01.880 --> 00:14:05.560 called something like that. Friedman is actually very clear on this when he 113 00:14:05.560 --> 00:14:09.320 formulates his own equation of exchange. I'll tell you why it's important to 114 00:14:09.320 --> 00:14:14.040 factor this out. If you are dealing with a monetary system that did not have 115 00:14:14.040 --> 00:14:17.440 fractional reserves, it's true that all credit that's issued in the economy 116 00:14:17.440 --> 00:14:22.080 would have to represent a renunciation of money by somebody else, but in the 117 00:14:22.080 --> 00:14:25.160 fractional reserve banking system things don't work this way, right? You have 118 00:14:25.160 --> 00:14:29.760 fractional reserves or fiduciary media which banks use to facilitate loans 119 00:14:29.760 --> 00:14:34.760 which do not represent a renunciation of consumption or investment 120 00:14:34.760 --> 00:14:36.760 by the person who's deposited that money in the bank. 121 00:14:36.760 --> 00:14:45.760 There's a disconnect here, which is why I've added it or felt the need to add this credit portion to the actual equation. 122 00:14:45.760 --> 00:14:51.760 Now I'll show you, we can make this look like the more conventional equation of exchange very easily. 123 00:14:51.760 --> 00:14:55.760 What would happen if there was no maturity transformation in the economy? 124 00:14:55.760 --> 00:15:02.760 If there's no maturity transformation, every single loan which gets issued is paid back in the exact same time period that it's issued. 125 00:15:02.760 --> 00:15:09.760 In our equation, that would just mean that debt repayments have to be the exact same as loans in any given time period. 126 00:15:09.760 --> 00:15:12.760 And if they're the same, that final term falls off. 127 00:15:12.760 --> 00:15:18.760 In fact, because this looks more like our conventional equation of exchange or is roughly analogous to it, 128 00:15:18.760 --> 00:15:22.760 we find that it's actually a specific case where there's no maturity transformation in the economy. 129 00:15:22.760 --> 00:15:29.760 If all loans are being repaid in the exact same period of time at which they are issued, then you don't have to worry about this. 130 00:15:29.760 --> 00:15:38.760 Well, so much for defining the money supply. What about the other two shortfalls? They're now taken care of as well, fairly well, or I feel fairly well. 131 00:15:38.760 --> 00:15:44.760 What is the, on the right-hand side of the equation of exchange, how do we actually define transactions? 132 00:15:44.760 --> 00:15:50.400 Transactions. The way that I've defined it is total money spent on capital goods plus 133 00:15:50.400 --> 00:15:56.480 total money spent on consumption goods plus all debt repayments. This is really the gross 134 00:15:56.480 --> 00:16:01.100 amount of money that you could spend in a given time period, right? You buy your goods, 135 00:16:01.100 --> 00:16:05.000 your consumption goods, you invest some of your money in capital goods and you pay off 136 00:16:05.000 --> 00:16:09.660 some of your debts that facilitated purchase of goods in the past. So we've got now a gross 137 00:16:09.660 --> 00:16:16.440 and the gross amount of transactions that are taking place instead of a much narrower 138 00:16:16.440 --> 00:16:21.340 definiment of it like would be used, defining of it like would be used in Friedman's case 139 00:16:21.340 --> 00:16:24.340 with nominal income. 140 00:16:24.340 --> 00:16:28.460 How about velocity being a contentless residual? 141 00:16:28.460 --> 00:16:30.260 We haven't really corrected that at all. 142 00:16:30.260 --> 00:16:33.540 In fact, if anything, we've made it worse because we introduced a whole new velocity 143 00:16:33.540 --> 00:16:35.880 term into the mix. 144 00:16:35.880 --> 00:16:38.360 But actually, there's some hope. 145 00:16:38.360 --> 00:16:42.880 On the exchange side of things, and this isn't specific to my rehabilitation, it applies 146 00:16:42.880 --> 00:16:46.840 to the more typical equations of exchange. 147 00:16:46.840 --> 00:16:50.840 The velocity of exchange is roughly analogous to the inverse of your demand to hold real 148 00:16:50.840 --> 00:16:52.440 cash balances, right? 149 00:16:52.440 --> 00:16:55.160 Celgen and free bankers are very clear on this. 150 00:16:55.160 --> 00:17:01.200 Reductions in velocity represent increases in your demand to hold cash in the form of 151 00:17:01.200 --> 00:17:03.360 your reservation demand. 152 00:17:03.360 --> 00:17:09.360 Now, the velocity of savings in here, it's really just the inverse of the average maturity 153 00:17:09.360 --> 00:17:12.420 of loans that you're issuing in any given time period. 154 00:17:12.420 --> 00:17:16.840 If your equation of exchange is dealing with a base period of one year and you've lent 155 00:17:16.840 --> 00:17:21.600 money for six months and then rolled it over to loan it again for six months, the average 156 00:17:21.600 --> 00:17:25.900 maturity of that six month loan was one half of the time period, which means the velocity 157 00:17:25.900 --> 00:17:31.160 of your loans or the velocity of your credit issued was two, right? 158 00:17:31.160 --> 00:17:37.000 You have issued your credit two times over or it circulated twice in that time period. 159 00:17:37.000 --> 00:17:43.040 Now I want to finish here because Joe is going to cut me off with one really big advantage 160 00:17:43.040 --> 00:17:45.240 of this. 161 00:17:45.240 --> 00:17:49.000 Actually it will coincide mostly with what Justin was just saying, why can't the Fed 162 00:17:49.000 --> 00:17:50.920 generate inflation? 163 00:17:50.920 --> 00:17:59.680 Now if you are to rely on the old equation of exchange, money supply increased by a lot, 164 00:17:59.680 --> 00:18:02.080 Prices didn't really do all that much. 165 00:18:02.080 --> 00:18:04.360 Real income didn't really do all that much. 166 00:18:04.360 --> 00:18:08.520 So velocity by definition had to just decline to offset it. 167 00:18:08.520 --> 00:18:10.400 You don't really say much in that statement. 168 00:18:10.400 --> 00:18:12.480 In fact, you could even go one step further. 169 00:18:12.480 --> 00:18:14.560 If you look back to one of the motivations for Keynes 170 00:18:14.560 --> 00:18:17.280 to write the general theory, it was a discontent 171 00:18:17.280 --> 00:18:18.880 with determining short-term income 172 00:18:18.880 --> 00:18:21.440 through the classical equation of exchange 173 00:18:21.440 --> 00:18:23.280 and the fact that if prices are sticky 174 00:18:23.280 --> 00:18:24.640 and if income doesn't really adjust 175 00:18:24.640 --> 00:18:26.440 to the money supply in the short term 176 00:18:26.440 --> 00:18:28.560 that increases in money have to just be offset 177 00:18:28.560 --> 00:18:30.680 by Declines in the Velocity of Money. 178 00:18:30.680 --> 00:18:33.640 There's not much you can really say about that. 179 00:18:33.640 --> 00:18:35.780 Now, this is just the long form 180 00:18:35.780 --> 00:18:38.840 of my rehabilitated equation of exchange. 181 00:18:38.840 --> 00:18:40.120 What has the Fed done? 182 00:18:41.440 --> 00:18:43.880 It's increased base money supply by a lot. 183 00:18:43.880 --> 00:18:46.240 That's always only been a small portion 184 00:18:46.240 --> 00:18:48.640 of the total increase in money supply 185 00:18:48.640 --> 00:18:51.040 because banks have increased the amount 186 00:18:51.040 --> 00:18:52.040 that they're holding onto. 187 00:18:52.040 --> 00:18:54.100 Their reserve ratio has increased. 188 00:18:54.100 --> 00:18:57.120 Individuals have increased the reservation demand for money 189 00:18:57.120 --> 00:19:01.560 and there is more debt repayment going on in the economy right now than there is 190 00:19:01.560 --> 00:19:04.000 gross loans being issued. 191 00:19:04.000 --> 00:19:06.040 I'll leave it at that. 192 00:19:06.040 --> 00:19:06.560 Thanks for the time.