Keynes and the Quantity Theory of Money

"Best diss of the Quantity Theory of Money comes from Keynes", commented Toby Nangle on Twitter, referring to this paragraph from Keynes's Open Letter to Roosevelt (Toby's emphasis):
The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the Quantity Theory of Money. Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor.
But is Keynes really dissing the Quantity Theory of Money (QTM)? He is objecting to the way in which it is used, and the policies that are derived from it.

The QTM itself is an identity:


where M is the quantity of money in circulation, V is its velocity, P is the general price level and Y is output.

As this is an identity, it tells us nothing at all about the direction of causation. Indeed, in this form, MV is the dependent variable and should be regarded as responding to changes in PY, not vice versa.

But the identity can equally be written PY = MV.  And in this quotation, Keynes himself uses it in this way:
Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. 
We can use the QTM to explain this. If M is fixed, then when Y is rising either V must rise (money must circulate faster, which implies people spending more frequently) or P must fall. But when P is falling, people tend to delay purchases, which slows the velocity of money. So falling P tends to be associated with falling, not rising, V. Thus, if M is fixed, Y will eventually stagnate or even fall.  M should be allowed to rise as Y rises, keeping the price level stable.

So, far from dissing it, Keynes in effect used the QTM himself.

And yet he is definitely critical of it. So what is he really complaining about?

His objection is to ACTIVE expansion of the money supply in order to stimulate output. This is apparent from the final sentence:
It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor.
Putting this differently, we can say that although holding M fixed eventually prevents Y from rising (limiting factor), increasing M when Y is stagnant does not necessarily kick it into rising. Whether it does, depends on people's willingness to increase spending.

Apologists for the QTM tend to insist that increasing the money supply must stimulate spending: if people have more money they will spend it, duh. But this depends on other things. Really rather fundamental things, in fact.

The first concerns what we mean by "money". In its pure monetarist form - and I confess I have used it in this way myself - M is defined as the monetary base, M0. Arch-monetarists will tell you that increasing the monetary base increases economic activity, so all that is needed to get economies moving after a slump is lots and lots of QE. I'm afraid on this I am in agreement with Keynes. It is bunk. Increasing the monetary base alone is incapable of getting economies moving. A brief glance at Japan is more than enough to tell us this.

The problem is that in the modern monetary system, only a small proportion of money in circulation is monetary base. The rest is what we call "broad money", which is created by banks in the course of lending. And when banks are damaged, they don't lend. No, let me widen that. When private sector balance sheets are damaged - people are over-indebted, their credit ratings are shot to pieces and they are struggling to service their existing debts - banks don't lend and people don't borrow.

It's self-reinforcing: banks tighten credit standards to shore up their highly risky balance sheets just when the balance sheets of households and businesses are at their most fragile. We blame banks for not lending, while simultaneously demanding that they make themselves less risky: we blame businesses for not borrowing to invest in new capacity, while simultaneously encouraging households to cut back spending in order to pay down debt and save for the future. And into the middle of this steaming pile of double standards and conflicting messages, we pour enormous amounts of monetary base, in the mistaken belief that it will encourage banks to lend and people to spend. The truth is that it has very little effect on either.

Banks do not use monetary base for lending. Adding huge quantities of monetary base to the system does not make them lend. Again, a brief glance at anywhere that has been doing QE in any quantity is easily enough to tell us this. Broad money creation does not depend on the amount of M0 in the system. It depends on the willingness of banks to lend, and the willingness of households and businesses to borrow. And that depends on the health of private sector balance sheets. When private sector balance sheets are badly damaged, broad money stagnates, and no amount of monetary base will make any difference.

Keynes did not explain exactly why adding monetary base to the system makes no difference when private sector balance sheets are damaged. For that insight, we need to look to Richard Koo. But Keynes understood the effect. Adding monetary base to the system when banks do not want to lend and people do not want to spend is like "pushing on a piece of string". Or perhaps like leading a horse to water. If the horse does not want to drink, it will not, even if it is presented with the River Nile.

But central banks can also add broad money to the system, if they buy securities directly from businesses and households rather than from banks. Does this work any better?

Not much, frankly. And this brings me to my second fundamental point. If what you want is to encourage people to spend, you must increase the money available to those most likely to spend it.

Simply buying the assets of the rich is not going to make much difference to economic activity. They will spend the money, yes - on other assets. But down at the grass roots level, businesses will still be struggling to find anyone to buy their goods and services, because the people who buy these things are not the rich - they are ordinary people who are underpaid, over-indebted and struggling to make ends meet. The people most likely to spend, given more money, are the poor, not the rich. So I might take a more nuanced view than Keynes. Loosening the belt can make the belly fatter, if the way in which the belt is loosened means the people with more money to spend are those most likely to spend it.

This may or may not mean an increase in broad money. It could simply mean redistribution of existing broad money. Soak the rich, in short. Or tax their unproductive investments (yes, I know, this is heresy).

Insufficient attention is paid in QTM-land to distributional niceties. And yet the distribution of money is as important as its quantity. If the majority of the money in the economy is held by a few, who circulate it among themselves to buy investment assets, then adding more money inflates the prices of those assets while output stagnates and the prices of goods and services used by ordinary people fall.

So helicopter money would be far better than QE as a monetary stimulus. But as John Kay points out, helicopter money is deficit spending, really. And this brings me to my third fundamental point.

Expanding the monetary base with QE while simultaneously reducing government spending and raising taxes to "fix the fiscal finances" is a wash. No, it's worse than that. It transfers money from households who would actually spend that money on goods and services, and businesses who would invest it for future growth, to banks and the rich, who only spend it on assets. The wealth effects from inflated asset prices may at the margin encourage more spending among those foolish enough to borrow (or dis-save) on the strength of unrealised capital gains, while the depressed interest rates that are the inevitable consequence of inflated asset prices may also encourage borrowing by those who would struggle to service debts if interest rates were higher. I am constantly amazed that any policymaker thinks that such unwise behaviour is to be encouraged.

 Deficit spending would be both safer and more effective than flooding banks with reserves and blowing up asset price bubbles. But we have tied ourselves into a ridiculous straitjacket because of wholly unjustified fear of government debt. So now we propose helicopter money and "people's QE" as a way of doing deficit spending while pretending we are not. Is anyone really fooled?

I leave the last word to Keynes, from the same letter to Roosevelt.
In the field of domestic policy, I put in the forefront, for the reasons given above, a large volume of Loan-expenditures under Government auspices. It is beyond my province to choose particular objects of expenditure. But preference should be given to those which can be made to mature quickly on a large scale, as for example the rehabilitation of the physical condition of the railroads. The object is to start the ball rolling. The United States is ready to roll towards prosperity, if a good hard shove can be given in the next six months. Could not the energy and enthusiasm, which launched the N.I.R.A. in its early days, be put behind a campaign for accelerating capital expenditures, as wisely chosen as the pressure of circumstances permits? You can at least feel sure that the country will be better enriched by such projects than by the involuntary idleness of millions.
Deficit spending - even dressed up as helicopter money - is a whole lot less scary than stagnation and lost output. Get on with it.

Related reading

Velocity Matters 


  1. One addition: You also have to improve economic rights and enforcement. Bankruptcy, assurances about titles to house, cars, real access to housing where jobs are, etc, etc. Money without rights will only be hoovered up by people with better access to power.

  2. Thanks for the article. Last sentence says it all. Let people be active, innovative and productive.

  3. As the Radcliffe Report 1957 put it at p. 391. The velocity of money 'is a statistical concept that tells us nothing directly about the motivation that influences the overall level of total demand'.
    The fact that this is still somehow a live issue, that we go round and round the same buoy, is exhibit 1 in the indictment of the economics profession. Exhibit 2 is the fact we can only approach the heresy of fiscal activism by talking about 'helicopters'. Just imagine some doctors arguing about whether to use pulmonary or cardiac policies when dealing with a patient bleeding out. If the consequences weren't so tragic, especially in Europe, it would be hilarious.

  4. Frances, You argue that the monetary base is unimportant because “..only a small proportion of money in circulation is monetary base”. A big weakness in that point is that the rest of the money supply (i.e. private bank created money) nets to nothing, as MMTers and Positive Money keep pointing out. That is, for every £ of that sort of money there is a £ of debt.

    In contrast, base money is a NET ASSET for the private sector. Thus increasing the base has a big effect on the private sector’s net liquid assets, which in turn ought to encourage spending.That’s why base money is sometimes referred to as “high powered money”.

    Of course the latter point does not apply where the base is increased via QE: that’s just an asset swap, which has little effect.

    But that’s not to deny what I think you imply in your last para, namely that the main effect of the state printing money and spending it comes via what might be called the FISCAL effect rather than the above mentioned MONETARY effect. That is, I fully accept that the main effect of “print and spend” may come from the SPENDING, rather than the above “liquid asset” point.

    Indeed, that’s the beauty of “print and spend”: there’s no need to worry about exactly how it works. I.e. we just fire ahead and implement the policy to a sufficient extent that it has the desired results.

    1. Many things net to nothing but have a huge effect. There has been societies practically without any government and it wasn't a problem. It was all about one sector lending to an other. And it hasn't changed, the government liability is just a common liability shared by all the private sectors (with some tax liability weighting).

      Think about a super charged MMT theory with a bigger considation: include the banking sector, the government and the central bank. Now the left over private sector, the true main street, has net financial assets, partly issued by banks and partly by public sector.

      If "nets to nothing" point would be relevant it would mean the (internal) private debt wouldn't matter (as it nets to nothing) but we know it pretty much dictates the business cycles.

      I fully agree with Frances and this is a great post.

    2. Jussi, I’ll take your points in turn.

      If government liabilities (govt debt and base money) are a liability of govt, they’re a very strange liability. Reason is that govt has the right to grab base money off the private sector whenever and in whatever amounts it sees fit: it’s called “tax”. In the case of a private bank, that’s the equivalent of me having the right to break into the bank that granted me my mortgage and grab wads of £10 notes and use them to pay off my mortgage. In short there may be some limited sense in which base money nets to nothing, but it’s wholly different to the sense in which privately created money nets to nothing.

      Second, in saying that privately created money nets to nothing, I am certainly not suggesting that therefor that type of money doesn’t have a significant effect. As you rightly say “it pretty much dictates the business cycle”. I was just criticising Frances’s claim that because the AMOUNT of base money is small compared to privately issued money, that therefor changes in the amount of base money have little effect: i.e. my answer to Frances’s claim is, base money has a stimulatory effect that private money does not.

      A further point is that the AMOUNT of private money has no long term stimulatory effect. As Steve Keen has explained, it is CHANGES in the amount of bank lending (aka the amount of private money) that are important. In contrast, the amount of base money has a PERMANENT effect via the so called “hot potato” effect. (That’s the simple fact that if a household has £X of spare cash, it will spend more than if it has no spare cash. And that spending ends up with other households, which in turn try to spend it away.)

    3. Ralph,

      The empirical evidence is that increasing bank reserves - which form the vast majority of base money - has little or no stimulatory effect. And the "hot potato" effect is no more effective with physical currency than it is with bank deposits, because these days bank deposits are as liquid as notes and coins, and for large transactions are more likely to be accepted. HPM doesn't burn holes in pockets.

      The whole post was about changes, not amounts. Including changes in bank lending. You must have missed this.

    4. Thanks Ralph,

      I think "breaking into the bank" metaphor is counter-productive and counter-intuitive. Often times it is more useful to think the government as a peculiar type of firm. It produces some services and we pay for them by paying taxes. It also redistributes income which might feel like a "breaking into the bank" but what is the alternative (less voting rights?)?

      I often imagine a very small economy (eg. three person). Then it is easy to see that if they create a common liability it doesn't actually change much if the burden is equally shared. This doesn't mean it couldn't help the economy in certain situations. Think about the case where one out of three is super rich and other two votes for more equally split of real flows. This might then mean higher consumption and more sensible investments benefiting a larger share of population (exactly Frances point I think). There is a balance, as we know from econ 101, because a too equal split discourages working.

      So, yes, I think government paper (and its implicit tax liability) is a type of contract with asset and liability side. It just tend to distribute real flows / wealth somewhat differently than other types of (private) contracts.

      On the other issue: think about HPE of the goverment bonds, more bonds than private sector would like to hold should correlate with lower price, right? But that is not right! Looking history of market economy disproves it: more bonds has meant higher prices?!

  5. Useful piece.
    The assumption has always been that money cannot "rest" - if you "save" then money goes through banking to be made available to the economy again. I think until we get some prestigious work done on how money can pool up and become isolated from the main economy, we're going to keep erroneously believing that everything is fine and will sort itself out.

    1. The issue is that the act of individual "saving" doesn't really cause there is more money available to the economy to be lent. Money spent is also money saved just for someone else. So when I choose to save 20% of my income this does not make that amount available to be lent. Lending is constrained by borrowing/ lending desires, capital requirements of banks, and the marginal cost of additional reserves.

  6. Frances, there is another perspective, and I really would like to help you see it - I hope you will keep an open mind. The first step is understanding the true meaning of velocity. V has nothing to do with speed of circulation, transactions or money churn. Instead, V is truly a measure of ex-ante money demand, and as such it is the most misunderstood macro variable. Here is a simple thought experiment:

    Imagine a world where people hold no money, instead they use credit cards to accommodate all spending. Upon receipt of income, they repay their credit balances in full. If they want to save, they have the option to invest by either purchasing bonds or equity. What is the velocity in such model economy?

    This story illustrates a simple fact: since money is a liability that can be created and redeemed in the same period, its "speed of circulation" could be infinite. In other words, the reason we observe velocity is twofold: people choose to hold domestic currency and the central bank exogenously supplies the monetary base.

    Understanding V as a measure of ex-ante money demand is equivalent to "heliocentric" shift in perspective. I know it is counter-intuitive, and it's much easier to see V as a dumb plug in QTM. However, this is really the first step in seeing the economy for what it truly is.

    1. I don't see V as a "dumb plug" in QTM, and I did not treat it as such n the post. Velocity is a measure of liquidity preference - or, if you prefer, money demand. In hyperinflation, the value of money crashes because of hypervelocity, ie rapidly falling demand for money. A liquidity trap is the opposite: demand for money is so high that velocity slows to a crawl. So price is positively correlated with velocity, and the cure for stagnant or falling velocity and prices is to persuade people to spend money.

  7. Contrarian the Barbarian19 May 2016 at 13:51

    Wow! Great post!

    This is my own unarticulated views explained so that even I can understand them

  8. Yes, that is correct - glad to see that you recognize the fact that V is a measure of money demand. The next step is to realize that Money supply and demand are determined ex-ante - in other words, the causality in QTM flows from MV with incomes, prices and employment being mere residuals.

    This follows along Keynes insight that ex-ante disequilibrium between desired savings / borrowers (money supply / demand) will cause fluctuations in incomes such that we have the ex-post identity between savings/borrowings (money supply and demand).

    You can also extend this to Say's law - aggregate demand (as determined by ex-ante money supply and demand)comes first. In other words, demand creates its own nominal supply.

    I also go a step further - once you accept that prices are residuals, it also becomes clear that the notion of market equilibrium is a tautology. Prices do no clear markets - rather, markets always clear with the unknown residuals being incomes, prices, employment.

  9. Very good post, and very clear, indeed

  10. Its the old capitalist conundrum. If the oiks are skint they wont buy stuff, but if you don't keep 'em hungry they wont work. Question is how to keep them a bit hungry with a big juicy steak dangling in front of them that they will almost never be able to reach. The last thing you want to do when the scheme of things goes belly up is take away the dangling steaks; quite the opposite - let them believe its their turn to win and they will be working and buying like its out of fashion. Not sure about using helicopters though - they will all go off work with sore necks from too much craning.

  11. I know that some textbooks and some economists say MV = PQ is QTM, but I'm almost certain at this point that it just isn't. MV = PQ is officially known as the Equation of Exchange, and quite rightly is an identity, tautology and not a theory. QTM on the other hand is the *theory* that, at least over the long term, M and P are correlated (with causation going from M to P, usually).

    1. You have probably seen this?

      And this reply to a M.M.

      “ . . . Again, however, I’m afraid I don’t see a direct answer to my question. I asked what mechanism in the real world the Fed has available to raise money supply above money demand (something that you said above is necessary if inflation is to occur). Money supply can rise if the Fed buys assets or if loans are made from available reserves. To my way of thinking, neither of these can occur without the full and conscious participation of the other side of the transaction. Hence, the supply of money cannot be increased in the absence of demand.
      Yet you say (above) that inflation only occurs when money supply is in excess of money demand. You have defended this with analogies, but not with real-world examples of the underlying process. I am a huge fan of using analogies to get the essential idea across; however, unless these mirror something that is going on in the real world (and in a very real and tangible sense), then recommending policies based on such stories is dangerous to say the least.
      I hope you don’t think I’m being rude, but I think this is a key question and one that I have never found a monetarist able to answer: how is it in the real world that the central bank raises money supply above money demand? Can you please tell me this and in the context of actual Federal reserve policy tools?
      This is not a trivial question. The entire monetarist superstructure rests on it. If the answer is that in reality this cannot happen, then I’m not sure how the rest of the monetarist analysis survives.”

  12. "If what you want is to encourage people to spend, you must increase the money available to those most likely to spend it."

    How about $36,000 per citizen per year from birth to death? National income for citizens would more than double. This is but one of the ideas set in my new book, "Faction-Free Democracy." the Intro to the book can be read at

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  14. If it's an identity it should be written with a triple bar identity sign to avoid the confusion that you write about.

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  17. Thank you, Frances, for this post. But I think that Japan in a more comfortable position now than if they didn't use any QE and their experience was very helpful.

    1. They implemented the 'wrong' type of QE?

      “With no consensus among British economists, who better to consult than Richard Werner, who coined the term “quantitative easing” in 1994. Werner, now of Southampton University, is an expert on Japan. “Quantitative easing” is a translation of a specific Japanese term that he devised to shine a light on the inadequate, sluggish policies of the Bank of Japan (BoJ).
      Werner believes that quantitative easing in Britain has been a “sham”—as it was in Japan—and not really QE at all. “The Bank has dug a PR hole for itself with QE—I don’t know why they are using my expression,” he tells me. He says his idea involved efforts to increase credit, because the money transmission system, the banking system, was broken. He derides the monetarists and their obsession with obscure measures of money, and instead suggests a focus on creating credit. When the BoJ acted in 2001, he argues their policy was not QE, but a bog-standard monetary policy that the BoJ dressed up as new for political reasons. It was a type of economic placebo. Now, he claims, something similar is happening in Britain.”

  18. "Expanding the monetary base with QE while simultaneously reducing government spending and raising taxes to "fix the fiscal finances" is a wash. No, it's worse than that. It transfers money from households who would actually spend that money on goods and services, and businesses who would invest it for future growth, to banks and the rich, who only spend it on assets. The wealth effects from inflated asset prices may at the margin encourage more spending among those foolish enough to borrow (or dis-save) on the strength of unrealised capital gains, while the depressed interest rates that are the inevitable consequence of inflated asset prices may also encourage borrowing by those who would struggle to service debts if interest rates were higher. I am constantly amazed that any policymaker thinks that such unwise behaviour is to be encouraged."

    I agree.

    However, I think 'they' would 'argue' that the new voodoo economics, the Barro/Ricardo equivalence proposition, would lead, along with the 'monetary expansion' and 'supply side' measures, to an offsetting increase in aggregate demand.

  19. Here is someone that 'concludes':

    "The American experience shows that cutting public spending can expand the economy."


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