(MV=PQ) ≠ QTM


As I noted in an earlier post, I had a conversation with John Aziz regarding the quantity equation. Here is John’s question from Twitter:

Why did Milton Friedman say inflation was always a monetary phenomenon when his own equation says it is a combination of 3 variables?

Today, I see that he has a blog post expounding on the idea. Unfortunately he’s still missing the insight that Friedman’s statement regarding money and inflation did not come from the quantity equation, which is simply an identity. It actually comes from the quantity theory. In many places, the equation is confused to represent the theory, but that is wrong. But first, a little history.

At the time of writing "Inflation, Causes and Consequences", from which the eponymous quote comes, Milton Friedman's idea of inflation as monetary phenomenon was a revelation. It seems banal to think about nowadays, because the young people in the Western world have never experienced high and rising inflation…but at one time, there were indeed economists arguing that printing money was not the cause of inflation.

The heart of the quantity theory is that a permanent, exogenous increase in the supply of money causes a proportional increase in prices in the long run. The assumption is, of course, neutrality — monetary policy only affects prices in the long run (a proposition I disagree with, but said disagreement is unimportant here).

However, proportionality breaks down at low and stable inflation rates, particularly because central banks around the world have adopted policies of inflation targeting. Under credible inflation targeting regimes, money becomes endogenous as the central bank will supply any amount of base money needed to satisfy the demand to hold money and defend its target. This is why the LM curve in the IS/LM model is useless — it describes a monetary policy that doesn’t exist. LM today is now an “MP” curve, and it is horizontal under inflation targeting. There are certainly problems with inflation targeting, but that’s a separate issue.

However, proportionality does hold for countries in which inflation is high and rising.

So, this is the main conclusion of my conversation with John:

  1. He misconstrues Milton Friedman’s statement as arising from the quantity equation, where-as it arises from the quantity theory.
  2. That inflation is always and everywhere a monetary phenomenon, and where it is not a monetary phenomenon, it is not a phenomenon at all.

It really is the case that the world in which Milton Friedman made his famous comment was a much different world than the world we live in today…but that doesn’t make the quantity theory of money invalid, just not useful for short-run analysis.

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4 thoughts on “(MV=PQ) ≠ QTM

  1. I don’t think I ever said that the QTOM was a derivative of the EoE, and I certainly don’t think that. They are separate in origin.

    I was mostly pointing out that Friedman’s belief in both of these is quite inconsistent, because under EoE there are three possible variables that can lever P, whereas under the QTOM, ΔM is proportional to ΔP.

    Friedman seems to have leaned upon the idea that in the long run the level of V and the path of Q are stable, but empirical evidence shows that this is incorrect.

    This means that even in the simplified world of MV=PQ, inflation is a partially nonmonetary phenomenon. In the real world, where price changes in markets are hugely multivariate it is likely to be even more disconnected.

    That doesn’t mean that there cannot be some relationship between ΔM and ΔP. There is. But it is a messy, nonlinear one.

    1. I’m not saying that you said the EoE and the QTM are related in any way, I’m saying that you’re confusing the logic of Friedman’s inflation comment as deriving from the EoE, when in fact it arises from the QTM.

      The main point I’m making in rebuttal to the claim that inflation arises from the supply side so that makes Friedman’s comment confusing is that once central banks anchor inflation expectations, inflation is no longer interesting. Ceteris paribus, under a constant money supply, AS will shift back to intersecting AD at the LRAS. Friedman certainly understood that supply shocks exist.

      Also, I’m not sure what “believing” in the quantity equation means, exactly, but Friedman did seem to have used constant velocity in the past to explain the logic of targeting steady money supply growth. We now know that to not be optimal. That assumption sort of made the EoE a theory.

  2. I’ve had a similar discussion with Scott Sumner before. I have a 1987 copy of the New Palgrave Money, in which the first article is by Milton Friedman, entitled “Quantity theory of money”. Its first section is “The formal theory”, and the first equation is described as “transactions form of the quantity equation” MV=PT. It looks to me as if Friedman at least considered the basis of the quantity theory to be the quantity equation.

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