Quantity theory of money

Quantity theory of money is, simply stated, the theory that changes in the quantity of monetary units tend to affect the purchasing power of money inversely, that is, with every increase in the quantity of money, each monetary unit tends to buy a smaller quantity of goods and services while a decrease in the quantity of monetary units has the opposite effect. Knowledge of the effects of changes in the quantity of money is vital to an understanding of the theory of money, one of the most misunderstood economic problems of our age.

History
In 1568, Jean Bodin pointed out that one reason for the then-recent rise in prices was the greater abundance of money due to the discovery of silver in America. He reasoned that since an abundance of anything made its value fall, this was what had happened in the case of money. In 1588, Bemardo Davanzati espoused the first crude quantity theory of money by equating the total quantity of monetary metal to the total of all things able to satisfy human wants and then reasoning that the prices of available commodity units were proportional to the available quantity of monetary units. Later versions of this crude theory equated the quantity of money available or the quantity of money that changed hands (quantity X velocity), to the quantity of goods and services exchanged for money and maintained that changes on the money side of the equation resulted in proportional changes in the prices of all goods and services sold, i.e., a 20% increase in the quantity of money, or the quantity of money spent for goods and services would raise all prices proportionally by 20%. (See "Equation of exchange.")

The fallacy of all such crude versions of the quantity theory is their holistic viewpoint of market transactions which ignores the fact that all changes in the quantity of money must start with changes in the cash holdings of some specific individuals and that it is through their subsequent market actions that the changes in the quantity of money set in motion their effect on price changes.

The refined and logically unassailable quantity theory of money traces the effect of every change in the quantity of money from its inception, as a change in the cash holdings of certain individuals, through the chain of changes in the prices these individuals pay and the effects such changes produce in the cash holdings and subsequent expenditures of other individuals until the full effect of the change in the quantity of money has spent its force and produced an entirely different set of price ratios or relations (price structures). Although a change in the quantity of money may eventually affect all prices, it does not and cannot affect all prices in the same manner, to the same degree or at the same time. The holistic idea that it does is false and has serious consequences.