Statement

The level of prices depend on the quantity of money.

Early discussions on this matter can be found in the essays of John Locke, David Hume and Irving Fisher (see Reference).

Discussion

Provided that the item used as money can be divided and combined as necessary, any amount of money is sufficient for running an economy. Ideas about bringing lasting changes to an economy by expanding the money supply are invalid. Should the money supply increase, all else equal, the prices of goods and services would increase proportionately. Thus, the outcome would ultimately be neutral.

In the short-term, however, there would be distortions. Adjustments do not occur instantaneously or simultaneously throughout the economy. Before the general price levels increase, people who get their hands on the new monetary units would be able to enjoy greater purchasing power. With more money available to lend, financial institutions would be incentivized to lower interest rates. Businesses availing loans at these low rates would be able to benefit for a while.

The boost to the economy seen directly after the injection of new money is illusory. Over time, prices would adapt. First for one good, then another; in one location, then another; in one industry, and so on. Higher prices would prompt greater borrowing, which would put an upward pressure on the interest rates offered by financial institutions.

It is important to note that the price increases after the introduction of added money will not necessarily be equiproportionate. Also, the short-term distortions will exact long-term costs.

The discussion above does not account for trade amongst different countries. The extension of the quantity theory of money is discussed in this note about the price-specie-flow mechanism

  1. “If we consider any one kingdom by itself, it is evident, that the greater or less plenty of money is of no consequence; since the prices of commodities are always proportioned to the plenty of money.” — David Hume in Of Money (1752)
  2. “At first, no alteration is perceived; by degrees, the price rises, first of one commodity, then of another; till the whole at last reaches a just proportion with the new quantity of specie which is in the kingdom.” — David Hume in Of Money (1752)
  3. “For suppose that, by miracle, every man in Great Britain should have five pounds slipped into his pocket in one night; this would much more than double the whole money that is at present in the kingdom; yet there would not next day, nor for some time, be any more lenders, nor any variation in the interest.” — David Hume in Of Interest (1752)

Note how in the above quotes, Hume hops from one equilibrium position to another, ignoring the short-term transition dynamics.

References

  1. Robert Dimand, David Hume and Irving Fisher on the Quantity Theory of Money in the Long Run and the Short Run (2013).
  2. John Locke, Some Considerations of the Consequences of the Lowering of Interest and the Raising the Value of Money (1691).
  3. David Hume, Of Money (1752) and Of Interest (1752).
  4. Irving Fisher, The Purchasing Power of Money (1911).
  5. Murray Rothbard, David Hume and the Theory of Money (1995).