the (quantity) theory of money and credit

The (quantity) theory of money and credit

Anthony J. Evans & Robert Thorpe

# Springer Science+Business Media New York 2013

Abstract The Theory of Money and Credit (1912) is rightly regarded as a seminalbook in the development of the Austrian school approach to monetary theory. Weargue that Mises’ understanding of the equation of exchange differs from both of theconventional textbook versions, and warrants recognition as being a distinct contri-bution. After supporting this claim we discuss it in light of expectations, monetaryregimes, and the microfoundations of the quantity theory.

Keywords Demand for money . Expectations . Quantity theory . Monetary theory

JEL Classification B53 . E41 . E42 . E58

1 Introduction

In his introduction to the 1934 edition of The Theory of Money and Credit, LionelRobbins said,

“In spite of a tendency observable in some quarters to revert to more mechanicalforms of the quantity theory… it seems fairly clear that further progress in theexplanation of the more elusive monetary phenomena is likely to take placealong this path” (Mises 1912, p.21)

Rev Austrian EconDOI 10.1007/s11138-013-0226-8

Versions of this paper have been presented as “The (Quantity) Theory of Money and Credit: Monetarismand von Mises” City University Economics Department Seminar, (November 2012) and “The (Quantity)Theory of Money and Credit”, Association of Private Enterprise Education (APEE), Maui (March 2013),and we thank participants for useful feedback. We also acknowledge helpful comments from NicolasCachanosky and Kevin Dowd. The usual disclaimer applies.

A. J. Evans (*)ESCP Europe Business School, 527 Finchley Road, Hampstead, London NW3 7BG, UKe-mail: [email protected]

R. ThorpeLimerick, Ireland

This article attempts to make further progress by reassessing the contributions thatMises himself made to the quantity theory in that very book.1 Section 1 outlines thebasic history of the quantity theory and puts the dates of publication of The Theory ofMoney and Credit into historical context. Section 2 offers an argument about whereMises falls on the key points of debate with regard to the Fisher and Cambridge versionsof the equation of exchange. Section 3 looks at the quantity theory (i.e. the introductionof causal assumptions to the variables of the equation of exchange), with particularemphasis on the subjectively perceived demand for money as a key driver. Section 4utilises this discussion to look at how expectations provide microfoundations for thequantity theory, and how this relates to monetary regimes. Section 5 concludes.

2 The inescapable relevance of the quantity theory

The quantity theory is as old as economics itself, originating from the school ofSalamanca and forming a part of the writings of the likes of Richard Cantillon, DavidHume and John Stuart Mill. In its crudest form it was used to explain how newdiscoveries of gold or silver would be expected to impact the economy, and followingthe work of Martin de Azpilcueta and Jean Bodin a causal link was made between thequantity of money and its purchasing power. As Blaug says, “the quantity theory ofmoney is, and always has been, a theory of the determination of the general pricelevel, which treats it as the variable to be explained and the quantity of money as thekey factor causing it to change” (Blaug et al. 1995, p.28, see also Laidler 1982).2

It is in this light that we can viewMises as a quantity theorist, since he built upon thewidely understood use of the concept.3 However he did not contribute to the debate inthe early c20th that sort to formalise the quantity theory via two alternative versions ofthe equation of exchange. Although originally released in 1912, The Theory of Moneyand Creditwas first published in English in 1934,4 reducing its impact amongst English-speaking economists. It is fascinating to consider how history might have changed had itbeen part of the “golden age” of the quantity theory, but in fact it had little directcontribution to that debate.5

1 This article will deliberately focus on this text, and although where necessary we will draw upon widerliterature, our intention is not to provide a broad and exhaustive history of the quantity theory (for this seeHumphrey 1974; Blaug et al. 1995). Rather, we intend to focus on Mises’ status as a quantity theorist asfound in The Theory of Money and Credit. We are reliant on translations from the original German, and willprovide citations for the 1981 Liberty Fund edition.2 Indeed it could be argued that the crudest form of the quantity theory renders the two concept assynonymous, and thus seeks to attribute any changes in the general price level to changes in the moneysupply.3 Although it’s interesting to note that Laidler cites Mises (and indeed FA Hayek) as being the intellectualforebears of New Classical economists such as Lucas, Barro, Sargant and Wallace in contrast to the“monetarists” that rest on more Keynesian foundations (Laidler 1982, p.ix).4 The publisher was Jonathan Cape Ltd (London), and another important edition was published by YaleUniversity Press in 1953.5 As Percy Greaves said, “only a few Americans were familiar with its contents before the passage of theFederal Reserve Act in December, 1913. If his great contribution had then been known, understood andaccepted, there would have been no post World War I inflations and no 1929 depression. The whole historyof our century would have been vastly different and living standards the world over would have been muchhigher than the world has ever known” (Mises 1978 p.xxiv)

A.J. Evans, R. Thorpe

Although we will look in more detail at the differences later on, for now we can simplyrefer to the “Fisher” version that was synonymous with economists working out ofChicago, and the “Cambridge” version that is also known as the “cash balance” approach.6

The foundation of the Fisher version was Purchasing Power of Money, written in1911, and whilst based on earlier works, (and not unique to Fisher), the originalequation of exchange is:

MV ¼ PT

Where M denotes the total money stock, V the velocity of circulation, P the generalprice level, and T the total number of transactions. What Fisher referred to as the quantitytheory is the causal influence of changes in the money supply to changes in the price level.

The Cambridge version arose in response to this, and the originations were in Pigou’s1917 article, “The Value of Money”. This was followed by several works in the 1920sby the likes of Dennis Robertson and John Maynard Keynes, making it an importanttopic when The Theory of Money and Credit first appeared in English. However Mises’work had already been written, and was done so in the context of an earlier age. Thus theonly reference that Mises makes to Pigou is on the use of the term “inflation” (Mises1912, p.271). In the time it took for Mises’ contribution to be translated and publishedthe Fisherian and Cambridge approaches had already spread and consequently had littleAustrian influence.

The Cambridge approach is typically given as:

M ¼ kPY

Here M is the nominal money supply, k is the proportion of real income consumerswish to hold as money, P is the price level and Y is real income. Textbook treatmentsare wont to merge the two, and this can be done by making two assumptions: that Y/Tis constant,7 and that V=1/k. We shall look at both of these in more detail later.

Mises is critical of the quantity theory, but mainly in the “mechanical” way it’sused.8 In fact we will claim that he is best understood through the lens of the variablesthat constitute the equation of exchange, and that he was a quantity theorist - he justrejected both the Fisher version and the Cambridge version. On this we followHorwitz’s claim that Mises, “saw his own contribution as putting the QuantityTheory framework on more solid theoretical grounds by explaining its foundationin the subjective theory of value” (Horwitz 2000, p.90).

3 The three equations of exchange

In this section we will draw attention to some of the key differences between the twotraditional versions of the quantity theory, and show that Mises was not consistently

6 Of course more than these versions of the quantity theory exist – Humphrey (1984) shows how Fisher andPigou’s algebraic equations “had already been largely or fully anticipated by at least 19 writers located infive countries over a time span of at least 140 years”. Horwitz (2006) makes the point that the cash balanceapproach adopted by Leland Yeager “dates back to at least Mises”.7 See Shaw et al. 1997, p.78.8 See Mises (1912, p.162–167, p.174–175, p.188–189; 1928, p.91; 1949 p.404–405) for a critique of themechanical version of the quantity theory.


in favour of either. Consequently in terms of the basic understanding of the variablescontained within the equation of exchange, Mises offers a third, distinct version.

There are two main differences we wish to draw between the Fisherian andCambridge versions. A simple comparison of the respective formulae reveals thatthere’s a disagreement about two variables – V vs. k, and T vs. Y. We shall look ateach in turn.

3.1 The velocity of circulation and the demand for money

A simplistic distinction to draw is that the Fisher approach focuses on the definitionof money as a medium of exchange, whereas the Cambridge approach places greateremphasis on it as a store of value. This fits into standard treatment is to split thedemand for money into several distinct “motives”, such as the transaction motive (tocover expected expenditure), precautionary motive (as a contingency againstunforeseen events) and speculative motive (to avoid capital losses from holdingbonds with a negative return). However there are problems with this framework.Money provides the individual holding it with a number of services. It isn’t possibleto designate a portion of an individual’s money holding that serves a “precautionary”purpose, nor is it possible to designate a portion that serves a transactional purpose orspeculative purpose.9 There are two reasons for this. Firstly, a holding of money mayprovide a number of services at the same time, and as with any other good we shouldexpect the owner to be willing to make trade offs at the margin. Imagine that anarchitect is designing a wall between two houses to be built as part of the samedevelopment. The architect has three specifications: a strength, an insulation, and asoundproofing specification. Let’s say that the strength spec requires that the wall beat least 6 in. thick, and the insulation spec that it be 7 in. thick. But the soundproofingspec requires that it be 10 in. thick – in which case a 10-in. thick wall must be used.The architect can’t say, “6 in. of the wall provides the strength and the other 4 in. thesoundproofing”. The entire wall provides all of the three properties required.Similarly any given holding of money will simultaneously fulfil all of the individual’smotives for holding it. Having said that, we can attribute changes in money holdingsto different motives. For example, our architect can say that because of thesoundproofing specification the wall is 3 in. thicker than it would have been withoutit. Money demand and holding is like this, but the “specs” for each person areconstantly changing and sometimes some are more important than others. If someonefeels more uncertain about the future we can say that their fresh demand for moneycomes from uncertainty. But once the person has acquired extra money demand wecan’t say that any portion fulfils any particular motive. The second problem witheconomist’s labelling parts of the money holdings is that it risks imposing subjectivejudgments on others.

Rather than labelling a holding of money some economists have attempted insteadto label money demand. But although this exercise doesn’t suffer from the firstproblem, it does suffer from the second. Here we don’t feel the need to enter this

9 Indeed the speculative demand for money almost glosses over money’s unique role as a “loose joint” andviews it as an asset class like any other.


morass since Mises’ theory can treat all types of money demand uniformly, so there isno reason to split them apart.10

Whilst money should be defined in terms of its function as a medium of exchange –and all other functions derive from this – these secondary functions are important.Because the future is uncertain to some degree it is impossible for an individual to knowprecisely when it will be in his or her interest to make a transaction. Since we use moneyto bridge different time periods (e.g. between when we receive our income and when wewish to purchase consumption goods) people will always need to “hold” money, andtherefore it must be used as a store of value. If a particular type of money is not anacceptably reliable store of value then agents will seek to reduce their reliance on it, andseek out alternative monies to use. Also, our money holdings constitute part of ourwealth, thus people are not indifferent to the opportunity costs involved in holding partof their wealth in one way compared to others. Money also serves as a unit of account.We use money to engage in economic calculation and as a numeraire to reduce thecomplexity of a system of exchange. As we shall see, changes in the demand for andsupply of money will have far reaching consequences precisely because it is such anintegral component of the economic communication system. Because the acceptedcurrency within a country is not necessarily the same as the legal currency, it is possiblethat debts may be written in a currency other than the medium of exchange (in order toobtain legal protection). This is typically referred to as the standard of deferred pay-ment.11 Finally, given the fact that cash is mostly used as a medium of exchange in theunderground economy it could also be argued that it serves the function of providinganonymity for indirect exchange.12

It’s hard to analytically separate the transaction, precautionary, and speculativedemand if one accepts that economic action takes place over time. All three formsnecessarily follow from money being defined as the medium of exchange, and arebased on the subjective value placed on them by consumers (Horwitz 1990). Forexample if I receive an electricity bill that is due in 1 week we might say that my“transaction” demand for money rises by this amount, but it is still subjectivelydetermined since I have a choice about how I go about satisfying this demand - forexample selling my most liquid assets immediately or waiting in the hope ofreceiving additional income to cover it.

When Pigou launched the Cambridge approach, he distinguished it from the Fisherversion thus:

“it focuses attention on the proportion of their resources that people choose tokeep in the form of titles to legal tender instead of focusing it on “velocity ofcirculation” (Pigou 1917, p.54)

10 For an Austrian approach that does attempt to split up various facets of the demand for money, seeSalerno (2006).11 Interestingly, in 1923 and writing in German, Mises used the English phrase “standard of deferredpayment” without offering a comment (see Mises 1978, p.5). He argued that if a monetary unit deterioratesin value then it cannot be used as standard of deferred payment, which appears to conflate two of these“secondary” functions. However this ties in with his view that “it is simplest to regard this as part of itsfunction as medium of exchange” (Mises 1912, p.47).12 Indeed the rise of Bitcoin as a virtual currency that can be untraceable (when used in exchange) lendsevidence to the importance of anonymity in a near-money.


He goes on to suggest that the “real advantage” of this is that “it brings us at onceinto relation with volition – an ultimate cause of demand – instead of with somethingthat seems at first sight accidental and arbitrary” (Pigou 1917, p.54).13 We would saythat Mises’ approach is the same, in that he advocates k over V, “the dependence ofthe demand for money on objective conditions, such as the number and size of thepayments that have to be coped with, is only an indirect dependence through themedium of the subjective valuations of individuals” (Mises 1912, p.188).14

3.2 The difference between transactions and output

The second key difference between the Fisher and Cambridge version is the distinc-tion between the cash value of the number of transactions versus a measure ofnominal output. This leads to a consideration about what type of transactions get“counted” as output. Mises says, “Every economic agent is obliged to hold a stock ofthe common medium of exchange sufficient to cover his probable business andpersonal requirements” (Mises 1912, p.154) – but note that these “probable businessand personal requirements” might include transactions that aren’t found in the GDPmeasure of output. To individuals it is incidental if what they want to buy is aconstituent of GDP or not. When a person holds a stock of money he or she looksat its purchasing power in terms of everything that they are interested in buying, notjust GDP constituents.

In The Theory of Money and Credit, Mises takes issue with Wieser for advocatingthe exclusion of certain payments from the total of exchanges. He makes it clear thathis preferred concepts of the quantity theory and demand for money include alltransactions (1912, p.158–159). He includes not only buying and selling GDP goodsand capital, but also paying taxes, paying loan repayments and giving gifts of money(we might also add assets, second hand goods, capital goods, intermediate consump-tion goods, etc.). Indeed the notion that individuals wish to keep a reserve with aparticular purchasing power depends upon this view since a reserve is kept against allfuture expenses no matter where they come from (Mises 1912, p.159).

The assumption that final output (Q) is equivalent to income (Y) derives from thecircular flow. As Garrison says, “owing to the very fact of the economy’s circularflow, we can measure real output by the real income Y received by the factors ofproduction” (Garrison 2001, p.192).15 However the assumption that Q = Y seemsuncontroversial compared to its relation with T. Under certain conditions we mightexpect Y to tend towards T, but there’s no justification for believing that they movetogether.

Economists are forced to make an assumption that the time horizon is long in orderto believe that the quantity theory can be used in terms of final output (Q) rather thanall transactions (T). Indeed we might well expect Mises to reject such an assumption:

13 In that article Pigou doesn’t claim that Fisher’s equation is wrong, per se, indeed “Professor Irving Fisherhas accomplished great things. But less experienced craftsmen need, I think, a better – a more completelyfool-proof tool” (Pigou 1917, p.65).14 However, whereas the Cambridge approach treats k as a function of income, we would suggest that thedemand for money is the fraction of total assets one wishes to hold as cash.15 Although Q and Yare two of the equivalent techniques for the calculation of GDP, in reality the conceptsare quite different. Nalewaik (2010) shows that estimates of GDI differ from GDP in important ways.


“Monetarists are not bothered, as the Austrians would be, that the conversioneclipses all changed in the intertemporal capital structure” (Garrison 2001,p.192)

Suppose that an investor is optimistic about the future, so he reduces his moneyholdings and spends his money. In this case he pushes the demand for money (in theMisesian sense) down. But, that won’t have an effect on Y straight away since thedirect effect is that the investors increased spending will cause capital goods to rise invalue. This action will only have an effect on Y through two routes. Firstly, invest-ment goods could be bought by someone who has profited directly or indirectly fromthe higher capital prices. Or, consumer goods could be bought by an investor takingprofits. So, using Y there is a period of waiting for the results of some money holdingdecisions to show up. This is equivalent to saying that total transactions (T) dividedby Y is roughly constant in the long-run but may fluctuate in the short-run.16

This distinction can be glossed over; we could say that the Cambridge approach restson a more modest claim, that “the real value of transactions demand will be closelyrelated to the real income of society” (Shaw et al. 1997, p.79).17 Indeed Robertson said“we are interested, not in the “transaction-value” of money, but in its “income value” –its value in terms of the goods and services which enter into ordinary consumption”(Robertson 1922, p.84). But choosing between T and Y also means that the concept ofvelocity has changed. In the Cambridge equation it refers not to the average number oftimes money is spent, but to “the average number of times it is spent in purchase of thegoods and services which enter into ordinary consumption, during the week or otherperiod of time in question” (Robertson 1922, p.84). As Robertson points out, we mightexpect the income velocity to therefore be smaller than the transaction velocity.

In the same way that V is different, so too is P. In the Fisher equation P is thegeneral price level for all goods, however in the Cambridge equation it is only a priceindex for current output (see Shaw et al. 1997, p.78). Continuing the example above,if all goods were “freely reproducible” in the short-term and included in Y then therewould be no significant difference between the two Ps. But, since inventory isn’tincluded in Y there is, and since assets of many sorts are not freely reproducible (ornot reproducible in a short time frame) there is. The investor reduces his demand formoney and bids up a form of capital that isn’t reproducible in a short time frame (such asshares in a company), that has no effect on P in M = kPY but it does affect MV = PT.Only after a “long and variable lag” will it affect M = kPY

This brings us to the issue of timescale - recollect that GDP is defined over a year.Unless this time period can be shown to have some special bearing on economics it isarbitrary. Let’s suppose that we were to account GDP and other things per half year. Inthat case a large amount of goods that are “inventory” in our present system wouldbecome investment goods in the 6 month system. That quantity could vary from time totime and need not follow the other aggregate precisely. This shows that the time periodcan have an effect on our conclusions. For example, imagine we use 12 month

16 George Selgin makes the point that during a boom total nominal spending (PT) can be expected to rise bymore than measured nominal income (PY), and therefore especially during a boom Y is not a goodapproximation of T. See “Intermediate spending booms” FreeBanking.org, October 1st 2012. [http://www.freebanking.org/2012/10/01/intermediate-spending-booms/.] Accessed May 7, 13.17 Note that this is in the context of the transaction demand for money


http://www.freebanking.org/2012/10/01/intermediate-spending-booms/

http://www.freebanking.org/2012/10/01/intermediate-spending-booms/

accounting and aggregate investment is the same in one period as it was in the previous.If we were targeting NGDP (PY) this would seem fine.18 But, suppose the sameeconomic situation occurs under 6 month accounting and it’s found that investmenthas fallen. That could happen because the proportion of investment that got movedacross from inventory could change. In that case it may appear that NGDP has fallen andthat the central bank should act to raise it. Broader measures of output, such as Skousen(2010) don’t suffer from this criticism since it uses no arbitrary break between invest-ment and inventory – it acknowledges that the trade of intermediate goods still earnsincome for some, and are relevant for any ideas about short-run income.19

To see whether Mises came closer to basing his understanding on T or Y, considerthe following quote:

“It was impossible to overlook the well-known connection between variationsin the available quantity of goods and variations in prices, and the propositionwas soon formulated that a good would rise in price if the available quantity ofit diminished. Similarly, the importance of the total volume of transactions inthe determination of prices was also realised” (Mises 1912, p.150)

When he talks about “the available quantity of goods” he is not talking about Y, orsome other aggregate concept, but goods in the general sense. Indeed the example hegoes on to provide, regarding “a good”, demonstrates that he is using a microeco-nomic explanation. He uses the “total volume of transactions” as the macroeconomicequivalent of the same underlying phenomena: that of a relationship between quantityand price. Mises is clearly thinking in terms of T. As White (1999) says,

“The turnover of its liabilities a bank must worry about is not only fromspending on final goods and services, but from all transactions. Thus, the theoryreally applies better to transactions velocity, and indicate a stabilisation not ofnominal income (Py or nominal GDP) but of total nominal transactions volume(PT). (White 1999, p.67)

In summary there are two key debates underpinning the quantity theory. The firstis whether the concept of velocity captures the demand for money, and on this issueMises sides with the Cambridge approach: k is subject to change and derives from thesubjective demand for money, not mysterious “institutional” constants. The secondissue is whether we should be restricted to measures of final output, or whether alleconomic transactions are part of the object of study. On this issue Mises sides withthe Fisherian version: T ≠ Y. Thus we might attribute a hybrid equation of exchange,M = kPT as a Misesian alternative.

4 From an identity to a theory

Thus far we have focused exclusively on the variables contained with three alterna-tive “equations of exchange”. The controversy arises when causal theories are placed

18 For a proposal to target NGDP see Gustavson and Randazzo (2010) and Sumner (2011)19 This is perhaps a relic from the mistaken classical attempts to distinguish between fixed and circulatingcapital, and the debate over whether capital approximates income.


on top of this, and we can now look at them. Note that the validity of these assertionsin no way detract from the usefulness of the equation of exchange as a simple identity –according to Horwitz,

“one can hold V and Q[Y] as given and conclude that movements in P mustcorrelate with movements in M. The mathematics of the equal sign compel sucha relationship, although the theory as such offers no explanation of causality”(Horwitz 2000, p.83).

Blaug et al. (1995) uses the Fisher equation to present three propositions thatdemonstrate the practical relevance of the quantity theory.20 The first is that causationruns from the left side of the equation (MV) to the right (PT). The second is that V isstable and independent of M.21 The third is long run neutrality - that the volume oftransactions (or income, in the Cambridge version) is derived from real factors, thusalso independent of M (and indeed P). As Fisher himself warned, “the equation ofexchange… exerts no causal relations between quantity of money and price level, anymore than it asserts causal relation between any other two factors” (Fisher 1911,p. 156–7). But if the above propositions hold we end up with the famous finding thatchanges in M should lead to proportional changes in P.

One can rearrange the Fisher equation in terms of the real money supply, findingthat M/P = T/V. The right hand side of this equation is the demand for money to fulfilall transactions, given the institutional constraint of V. This puts the transactionapproach into the framework of monetary equilibrium, one shared by both Fisherand Mises.22 Mises refers to the “one fundamental idea” that is contained within thequantity theory:

“the idea that a connection exists between variations in the value of money onthe one hand and variations in the relations between the demand for money andthe supply of it on the other hand” (Mises 1912, p.152).

To Mises this “constitutes the core truth in the theory” (Mises 1912, p.152), andfollowing him we intend to utilise this as a “cornerstone”. The aspect of the quantitytheory that Mises really rails against is the “mechanical” version, and he believed thatit leads people to think that changes in the quantity of money have a uniform impacton prices (Mises 1912 p.162). There are two degrees to which we can categoriseeconomists on this. The first is uniformity, and this would imply that if the moneysupply rose by 5 % the price of all goods would rise by 5 %. It’s important to pointout that this is mostly a straw man, and few economists would believe this to be the

20 It’s important to point out that these propositions aren’t universally endorsed, and we’re not endorsingthem now.21 This usually rests on an assumption that V is determine by habit and assumed constant in the short run.22 We are using “monetary equilibrium” here to refer to the notion that the balance between the demand forand supply of money determine its value. Mises refers to this as the “money relation”, for example “the coreof the doctrine consists in the proposition that the supply of money and the demand for it both effect itsvalue” (Mises 1912, p.152), or “The insight that the exchange ratio between money on the one hand and thevendible commodities and services on the other is determined, in the same way as the mutual exchangeration between the various vendible goods, by demand and supply was the essence of the quantity theory ofmoney. This theory is essentially an application of the general theory of supply and demand to the specialinstance of money” (Mises 1949, p.405).


case.23 Short run factors such as sticky prices, labour market rigidities and the signalextraction problem were acknowledged by most classical economists (see Blaug et al.1995, p. 32), and Fisher himself analysed the “temporary effects during the period oftransition separately from the permanent or ultimate effects… [which] follow after anew equilibrium is established” (Fisher 1911, p.55–56).24

What Fisher is relying on here is not so much an assumption of uniformity, but ofproportionality. This posits that a 5 % increase in the money supply would not raiseall prices by 5 %, but that eventually the general price level would rise by thatamount. There are two things to add to this. The first is that it brings us to the seminalinsight of monetary theory - that the absolute quantity of money in circulation doesnot matter. But this doesn’t mean that changes in the quantity of money have noeffect. Indeed these bring in the welfare implications of relative price changes, whichMises is clear to stress:

“The increase in the quantity of money does not mean an increase of income forall individuals. On the contrary, those sections of the community that are the lastto be reached by the additional quantity of money have their incomes reduced”(1912, p.162)25

This is why the thought experiment of a “helicopter drop” is often invoked, butMises was clear that even this wouldn’t lead to a uniform or proportional rise inprices, “every increase in the quantity of money would necessarily cause an alterationin the condition of demand, which would lead to a disparate increase in the prices ofthe individual economic goods” (p.163). He is responding to Hume’s example ofeveryone waking one morning to find that they’d been left 5 gold pieces during thenight. Mill argued that even this wouldn’t lead to a uniform change in the price level,due to different propensities to consume. Mises says that even if the increase in thequantity of money could be made proportional to the consumers stock of wealth,relative price effects would still occur (p.163).

If the question is “how neutral is money”, it’s easy to create stereotypes. Classicaleconomists did not utilise the same assumptions of neutrality that might be associatedwith more modern New Classical or Real Business Cycle models. However they onlyescaped this by shifting from uniformity to proportionality – by assuming that thetransition process was over and that the long run had arrived.26 Since Mises was moreconcerned with the real mechanisms of change, the process by which a monetary

23 Note that Mises deals effectively with one type of counter suggestion. For example, in July 2005 theRomanian government attempted to simplify their currency, which still showed the effects of past hyperinfla-tion. The government replaced the leu (ROL) with the leu (RON), where 1 RON=10,000 ROL. According toMises this wouldn’t constitute a uniform change in the money supply and price level, but merely a change in theactual currency (Mises 1912, p.167).24 Note that he goes on to suggest that there’s a tendency towards equilibrium rather than viewing it as anattainable state, saying “—if, indeed, such a condition as equilibrium may be said ever to be established”(Fisher 1911).25 It is interesting that economists tend to focus on inflation when providing these examples. As Mises says,“to simplify and to shorten our analysis let us look at the case of inflation only” (1938), however there’s noreason to believe that different laws apply to deflation. Also, we are not aware of Mises going beyond theclaim that this leads to a redistribution of wealth and specifically argue that this process makes society as awhole poorer, see Horwitz (2003), who does.26 Again, this risks caricaturing the classical school see Cairnes (1854).


expansion manifested itself in higher prices was of chief concern. Thus he gives fargreater attention to the implications of non-neutral money and the absurdity of helicopterdrops. Just because prices are not sticky in the long-run doesn’t mean that money isneutral in the long run, since short run price differences have permanent consequences.So, ultimately, short run non-neutrality implies long-run non-neutrality.

To a great extent the debate between the Fisher and Cambridge equations wasswept to one side by the work of Milton Friedman (1956), who provided the revisedversion that is typically used today:

MV ¼ PY

Economists tend to define V as being equivalent to 1/k, and shift emphasis from thedetermination of prices to the determination of money national income (PY, or NGDP).An important thing to point out is that this version, in comparison to T, lends itselfsignificantly more easily to empirical testing, and it was the empirical attempts to studythe quantity theory that led to an assumption of equiproportionality. As Humphrey(1973) says, “the Snyder-Working doctrine of neutralising fluctuations of V and T wasreplaced by the doctrine of constancy of both Vand T” (p.301). Criticisms of the “naïve”form of the quantity theory focus on the offshoots of the earliest attempts to measure theimpact, which were reliant upon early twentieth century statistical techniques. But theyare at odds with how classical economists understood the quantity theory, and thus(ironically) such criticisms are themselves highly naïve.

But rather than view Yand T as two distinct concepts, we might view a continuumbetween what is theoretically rich yet impossible to measure at one end and theoret-ically flawed but easy to observe at the other. If monetarists are guilty of focusing toomuch on one extreme, possibly Austrians are guilty of focusing too much at the other.To this end consider the concept of “gross output” or “gross domestic expenditure” asa middle ground. Skousen (2010) argues that GDP measures erroneously leave outcertain capital goods, and creates a new measure, GDE, which includes intermediateconsumption. This is clearly a step in the direction away from Y and towards T.

We make this point to defend Austrian’s use of the consensus notation. In the sameway that “M” doesn’t endorse any particular measure of the money supply, what weunderstand as “T”, could be viewed as an improved measure of GDP. No economistwould defend GDP as being a perfect measure of final output; even a basic course ineconomics exposes it’s flaws. Instead of viewing T and Y as two different categories,they can be seen as a spectrum attempting to capture similar phenomena. There’s avery real debate about what should and shouldn’t go into GDP figures, therefore we’retaking a very broad view here: that we can use Y as an approximation for T, and thenhave a separate debate about how to measure it.27 Similarly a debate about whether touse M0 or M4 to approximate M is similar to whether GDP or GDI or GDE is the bestpractical middle ground between Yand T. Finally, a further advantage of following theconsensus notation is that having two variables on either side can be seen as a moreelegant way to present the theory, as it captures the core essence of the identity: that“total monetary expenditure is equal to the monetary value of all goods traded” (Shawet al. 1997, p.77), or even more simply that spending equals receipts.

27 Or, to put it another way, when pushed we suspect that many economists would favour T over Y inprinciple, but the availability of GDP figures biases analysis in that direction.


In economics we can draw a “science side” and “policy side” distinction. A scienceside distinction is one made to make the scientific ideas clear. A “policy side” distinctionis one that’s needed for acting on economic ideas, something needed for policy. So,Mises provides here a science side reason why we should think in terms of PT ratherthan PY, but that doesn’t mean there isn’t a policy side reason for thinking in terms ofPY. In a free-banking system the problem of waiting for income to change does notreally apply, because if the demand for money changes then clearings would changeaccordingly (Selgin 1988). Because clearings don’t differentiate between capital andincome changes, in a free-banking framework we don’t have a reason to split up thescience side and policy side ideas. For Quasi-Monetarists though it may be wise to useMV = PY for the policy side. It would be very difficult for central banks to accuratelymeasure PT in MV = PT. It would leave open the door to quite a lot of discretion, so itmay be safer to hold fire until money incomes change. MV = PY is safer in that respectand maybe better for Quasi-Monetarist policies for that reason.28

5 Expectations as the cornerstone of the quantity theory

Whereas focusing on “velocity” provides a mechanical approach, attention to thedemand for money draws upon a behavioural foundation. With regard to the me-chanical theory, Mises says that “we cannot dismiss it offhand as erroneous” (p.151),but goes on to provide the “ultimate determinant of prices” (p.151) – which are “allthe factors that motivate people in buying and selling” (p.151). The criticism of the“mechanistic” version of the quantity theory is really the same criticism of macro-economics more generally – that aggregate variables are seen to be affecting eachother directly. The Austrian rejoinder is that human action needs to be grounded inchoice, and macroeconomic phenomena are actually the emergent outcomes ofindividual interaction. Mainstream models sometimes use microfoundations, butthese can fall short. For example, as we have pointed out consumers are indifferentto whether a good is part of GDP output or not. That means that microfoundationsthat only concern output prices are not taking into account all relevant factors.

Hence Mises,

“for individual economic agents it is impossible to make use of the formula:total volume of transactions ÷ velocity of circulation” (1912, p.154)

We can make two comments on this quote. Firstly – supporting the point madeearlier in this article - he is viewing the quantity theory in terms of T rather than Y,and is not denying that at a theoretical, abstract level the formula is valid. Secondly,his concern is how an economic agent can make use of it when attempting to act. Thereason he uses this example is to say that the aggregate demand for money cannotexist independent of the individual demands for money held by individuals, and it isthe subjectively perceived valuation that should be the object of enquiry. When Misesargues that economic agents’ demand for money is based on their “probable business

28 Also, to Quasi-Monetarists the PY equation is most important because it’s reductions in nominal incomethat affects debts, an important aspect of the debt-deflation story (Fisher 1933).


and personal requirements” he adds that “The amount that will be required dependson individual circumstances” (Mises 1912, p.154).

He goes on to explore these “circumstances”, arguing that this cannot be objectivelypredicted based on data; “it is the subjective valuations of the separate economic agentsthat alone are decisive” (p.154). Interpretation comes into play since the same peoplefacing the same objective situation may well possess a different demand for money. Soalthough Mises’ criticism of the “mechanistic” use of the quantity theory is that itcontradicts methodological individualism, by giving due attention to the demand formoney Mises himself shows us the way to reconcile this.

As Friedman says, “the quantity theory is in the first instance a theory of thedemand for money” (1956, p.4), and its telling that Mises titles a section, “theconsequences of an increase in the quantity of money while the demand for moneyremains unchanged or does not increase to the same extent”. In it, he spells out that anincrease in the amount of money will – ceteris paribus – results in a fall in themarginal utility of the monetary unit for those who hold it. This is a direct conse-quence of a change in the ratio between the demand for and supply of money. Forthose who receive the new money, it will increase the prices of the goods they buy,and reduce the objective exchange value of money.

“Those who have brought these goods to market will have their incomes andtheir proportionate stocks of money increased and, in their turn, will be in aposition to demand more intensively the goods they want, so that these goodswill also rise in price. Thus the increase of prices continues, having adiminishing effect, until all commodities, some to a greater and some to a lesserextent, are reached by it” (Mises 1912, p.162)

Recollect that by rearranging the Fisher equation we get M/P = T/V. If M increasesand T/Vare fixed, the money supply will be greater than the demand for money. Peoplewill attempt to offload their excess supply of money and in doing so bid up prices.29 Thisis an equilibrium story, and at its heart is individual action. Mises shows how to talkabout monetary equilibrium without abandoning the equation of exchange.

But there’s nothing to say that the demand for money should be considered to befixed, or even stable.30 There’s nothing to say that k can only be a variable if it’sconstant. Indeed evidence has shown that demand for money rises when people areuncertain about the future. This isn’t surprising as the main economic purpose thatholding a stock of money supplies is a fund that can be used immediately on anypurchase. Prices are sticky to some degree. When money is withdrawn from theeconomy in various places by people increasing their money holdings and no extramoney is created, the equation M = kPT tells us that PT must fall. The prices thatmake up P are sticky, so it cannot fall quickly or uniformly. And account falsifica-tion occurs as prices fall just as it does as they rise.31 As a result, there is a fall in T

29 Notice how this ties into the “real balance effect” attributed to Patinkin (1955).30 Note that if it is supposed that the demand for money increases, then that assumption also supposes -ceteris paribus - that the demand for goods, services and assets falls.31 Since accounting is done in nominal terms, if the price level is changing (especially if it’s changing in anunexpected way) then the real value of profits will change too. Businesses that use nominal profits to guidefuture plans will be fooled. This is what we mean by “account falsification” - the profit signal must beextracted from the noise of inflation and deflation.


as well as in P. In any economy where most of the constituent of T are wealthcreating transactions that means we have a recession. This can create a “secondaryrecession” “Wicksellian cumulative rot” or “Keynesian type recession”. In this casecreation of money brings us the possibility of leaving T roughly unaffected. Itprevents the problems of price adjustments from causing real losses. To put itanother way, what creation of new money can produce is the prevention of realadjustment costs. This theory is just the inverse of the Mises-Hayek theory of theboom.32

This expectations channel comes strongly into play when linked to policy changes.For example, the financial crisis harmed the reputations of the central banks greatly,causing markets to lose some trust in their ability to achieve their policy goals. Thissituation causes great uncertainty in the future return on assets that in turn causesinvestors and speculators to increase their demand for money holdings (the part thatKeynes concentrated on). But in order to invest well investors must be able toestimate the future path of the purchasing power of money. If they cannot thenthey’re forced to avoid long-term investments with nominal returns, (and in practicelots of other sorts of investment too).

Considering the aftermath of the financial crisis of 2008, if the only issue had beenthe demand to hold money to buy “output” then the central banks could have met thatdemand with a small expansion. The problem has been that the central banks exposedthemselves as being incompetent and by doing so cast doubt upon the future path ofprices. So, we moved from a regime of inflation targeting to a regime of radicaluncertainty. Once that happened there was a rise in demand for money holdings frominvestors defending their portfolios against future central bank incompetence. Thatdemand wasn’t satisfied, and maybe it never could have been. The demand for moneyand short-term financial assets from financial businesses and investors caused thecentral bank’s expansion to have less effect on others than it would have had. This isthe core truth of the “credit channel” argument. Banks cannot loan money intoexistence unless they can draw up a schedule of repayments for the borrower tofollow, and they can only do that if they know what the real value of those re-payments will be. If they know that there will be a rise in prices and how much it islikely to be then they can mark it in by adding a premium. But if they know that anyexpectations they may have are based on little sound knowledge, then things aremuch worse: when money loses it’s function as a numeraire, people become hesitantto form long term nominal contracts.

Going further, it’s not just the future path of the price level that’s important, but thefuture constellation of relative prices. Mises gives the argument that if a steady rate ofinflation is expected then agents will adjust their behaviour to that rate (1912, p.257),but this only holds in the aggregate. Consider Wagner (1999)’s argument that “theaggregate data are widely and readily available” - the problem is not so much theidentification of inflation, but an understanding about whereabouts in the chain ofCantillon effects an individual finds herself.

32 See Selgin (1988), Horwitz (1994, p.229), White (1999 p. 67), Horwitz (2000, p.91) and White (2008)for a more detailed account of how monetary equilibrium theory ties into the quantity theory in terms of thestabilization of MV.


This brings us to how expectations are formed, which we would claim aresome combination of experience and data - both of which get muddied during aninflation.

Each person’s expectations are focused on the goods that they trade in and theirclose substitutes therefore it’s not possible to say much about expectations in specificcircumstances such as particular industries or sectors; local knowledge dominatesthere. But it’s reasonable to say that if there are general trends occurring across theeconomy then there can be general expectations about those trends too. If consumergoods prices are generally rising then any particular consumer can expect to beaffected by that rise even if their own costs don’t change in proportion to any priceindex. Even if consumer goods prices don’t rise in proportion with each other aconsumer can notice a rise that’s underway and use that as information to help formexpectations. Because consumer goods tend to be substitutable few can rise or fall inprice without affecting others, and that is especially true when the trend in prices islarge.

Mises recognized this, claiming that the people of his time were generally unawareof fluctuations in the value of money and certainly unaware that gold changes invalue (1912, p.230). But he points out that if people were aware then they wouldfactor it into debts. In later writings he makes more allowance for the general public’sunderstanding of price inflation (Mises 1949 p.777, and 1952 p.154). This is under-standable because in the first half of the 20th century period of inflation became morefrequent. It may be true that the public of western countries weren’t very aware of theproblem in 1900, but were much more aware in 1950. In The Theory of Money andCredit, Chapter 13 Mises says that if the price fluctuation is large then it willgenerally be noticed.

In Mises’ explanations of injection effects there isn’t much consideration ofexpectations. There isn’t in most other descriptions too. His view is that if theprice level rise or fall is large enough to be noticable then money demand willchange accordingly. If prices rise demand will fall because of the opportunity costof holding money, and if prices fall demand will rise. But, due to the fact thatinjections never provide a clear change in the price level at the start there is noinitial sign of a price level change. In Mises and others who lived during goldstandard times the expected price inflation rate is close to 0 % or slightly below it.Indeed his ideas on monetary changes are primarily concerned with unexpectedchanges. In a 1975 pamphlet Milton Friedman praises Fisher (1926) for drawing adistinction between anticipated and unanticipated changes in inflation, and he usesthis to explain that Fisher was ahead of the Keynesian challenges that were tofollow (especially in terms of the Phillips curve). But Mises was ahead of themtoo – and earlier.33 Mises’ theory of interest also relies on unexpected changes. Hedescribes how injection effects cause higher profits and apparent profits and make

33 In another example of Mises being somewhat neglected, Friedman (1975) uses Abraham Lincoln’sdictum that “you can fool all of the people some of the time, you can fool some of the people all of the time,but you can’t fool all of the people all of the time”, as being a key insight behind the rational expectationsrevolution. However as Garrison (1998) points out Mises had previously utilised the same quote to explainhow expectations adjust. (Note that although this appears in The Theory of Money and Credit, it is in theepilogue to the 1953 edition.)


higher interest rates more affordable to entrepreneurs (1912, p.387).34 He thengoes on to discuss how injections of money beyond demand by central bankscause the interest rate to fall.35

However, Mises does have some things to say about expected changes too. Theseare mostly in his discussions of hyperinflation. Mises writes,

“If the future prospects for a money are considered poor, its value in specula-tions, which anticipate its future purchasing power, will be lower than the actualdemand and supply situation at the moment would indicate. Prices will be askedand paid which more nearly correspond to anticipated future conditions than tothe present demand for, and quantity of, money in circulation” (1923, p.8).

Mises mentions in several places that speculators are usually the first to correctlyanticipate changes in the price level. Mises explains how those who correctlyanticipate changes in the value of money can profit from it (1912, p.245–246). But,Mises doesn’t say speculators will forecast perfectly or that all groups are able toforecast well.

Mises also mentions the “Fisher Effect”, which is the interest-rate premium causedby expectation of a change of the price level. Mises is often quite sceptical about it,though he accepts the logic. He writes:

“The individual businessman is not generally aware of the fact that monetaryvalue is affected by changes from the side of money. Even if he were, thedifficulties which hamper the formation of a halfway reliable judgment, as tothe direction and extent of anticipated changes, are tremendous, if not outrightinsurmountable. Consequently, monetary units used in credit transactions aregenerally regarded rather naïvely as being ‘stable’ in value. So, with agreementas to conditions under which credit will be applied for and granted, a pricepremium is not generally considered in the calculation. This is practicallyalways true, even for long-term credit. If opinion is shaken as to the ‘stabilityof value’ of a certain kind of money, this money is not used at all in long-termcredit transactions. Thus, in all nations using credit money, whose purchasingpower fluctuated violently, long-term credit obligations were drawn up in gold,whose value was held to be ‘stable.’” (Mises 1928, p.94)36

These comments about expected changes are strange and perhaps wrong tomodern eyes (a point made by Wagner 1999). But in the times of the internationalgold standard there would be little reason for those making a loan to put up with riskycurrency; they could bank in a gold standard country and eliminate a large part of thatrisk. Today things are much less clear and dealing in long-term debt in countries withfluctuating price-levels is a necessity.

34 Notice the explanation here isn’t the same as a traditional one that would have interest rates rise becauseof expectations of future inflation.35 It’s important to stress that Mises isn’t contradicting himself. When a central bank performs an injectionseveral things happen. The purchase of bonds transfers reserves to commercial banks who can use thosereserves to issue more loans. Those loans are deposited which increases the money stock. The increase inthe supply of loans reduces the market interest rate.36 He says something similar in Mises (1912, p.230–231)


Mises’ connection of expected changes with hyperinflation is also quite reason-able for the time. Today we’re accustomed to expected change, but in theinternational gold standard things were different. Once a large inflationary changewas in motion the government and central bank had few good options. They couldeither deflate, temporarily suspend convertability or officially devalue. Becauseconversion to gold was possible different price levels in terms of gold couldn’teasily open up between different countries since they would provide a hugeopportunity for speculators. Deflating would cause low profits and unemploymentand would be unpopular. Suspension or devaluation would cause major loss ofreputation especially abroad. In any case, whenever some significant price levelchange threatened the central bank would be best to respond sooner rather thanlater. So, significant price inflation only occurred when the central bank orgovernment were incompetent or malign. Expected changes were not safe in the19th century, and that may have been more significant than Mises’ explanationthat inflation accelerated because of the reduction in demand for money caused bythe real cost of holding it. The issue was more that when further inflation becamelikely, that increased the likelihood of destructive deflation, suspension or deval-uation. As a result demand for the money of the nation in question fell anddemand for foreign money grew quickly.

6 Conclusion

A further reason why the historical period is important is because the implications ofthe quantity theory are not universally valid – they depends on the institutionalcontext. In a free banking environment the supply of money will enter/leave circulationbased on the prevailing demand to hold it (Selgin 1988).37 According to Horwitz (1994p.226),

“If paper money (and deposits) are convertible into gold (or other base money),then the quantity theory, in the sense that the quantity of paper money (anddeposits) determines the price level, might not hold.”

He goes on to explain how under fiat money we might expect changes in M to leadto changes in P, but under free banking - where the quantity of money is endogenous,and responds to changes in V to ensure that MV is stable - it is changes in Y that leadto changes in P (Horwitz 1994, p.229). The key point to note though is that we arestill utilising the equation of exchange as a productive way to understand monetarytheory. Whilst it might be a push to call Mises a quantity theorist, we can view theequation of exchange as a foundation of Austrian monetary theory. According to A.C.Pigou,

“The formulae employed in the exposition of that theory are merely devices forenabling us to bring together in an orderly way the principal causes by whichthe value of money is determined. As to what these principle causes are,

37 We are grateful to Nicolas Cachanosky for pointing out to us that the concept of velocity is important interms of free banking, since it’s related to turnover and the level of deposits at issuer banks.


competent writers of all schools are, I venture to think, really in substantialagreement” (Pigou 1917, p.38)

We concur, but also posit that a richer understanding of the history of economicthought would make the following distinction:

Chicago = Fisher transaction version : MV ¼ PTCambridge=cashbalance=incomeversion : M ¼ kPYAustrian = subjectivist version : M ¼ kPT

All three of these can be viewed as the underpinnings of the general form MV = PY,so our aim is not so much to change terminology, but to add firmer (and more nuanced)theoretical foundations. Objections to the quantity theory are rife, especially within theAustrian community. But Mises’ own objections are important since they showed a wayforward. Despite being tautological, it is the fact that the equation of exchange is anidentity (i.e. an example of praxeology) that serves as a starting point for analysis. Andby focusing on the “core truth” we find that the quantity theory is “capable of thedisaggregated, individualistic, and subjective analysis of temporal process that hasalways identified the Austrian school” (Egger 1995, p.20). It is important to separatethe policy goals of monetarism from the theoretical validity of the quantity theory,because in discussing Mises’ use of the quantity theory we feel that it is possible todefend it against simplistic charges: it is a useful tool when properly employed.

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