The Older Theory.—The older view, which received its most complete expression at the hands of Irving Fisher in his Purchasing Power of Money before the World War 0910, ultimately rests upon the following assumptions. The dynamic consequences of the theory flow from the fact that additional supplies of money constitute an incentive to additional spending. Additional supplies of money drive prices up, because (the supply of goods being as sumed constant) there will be more to spend and competition among spenders is a cause of rising prices. The additional sup plies of money, secondly, will be spent because money possesses no intrinsic power of yielding satisfactions; the satisfactions arising from the possession of money can be realized only by ac quiring goods and services which possess a direct power of satis fying wants. Now, given these two assumptions, it follows almost as a matter of course not only that prices will rise as the quantity of money rises, but that the price-rise will be in proportion to the increase in the quantity of money. For, given a certain increase in the volume of money and a disproportionate alteration of prices, disequilibrium will prevail until the price level is in direct relation to the new total quantity of money. If prices have risen less than in proportion to money, goods will seem unusually cheap to con sumers and this will stimulate further consumption of them. If prices have risen more than in proportion to the increased quantity of money, consumers will, in spite of additional quantities of money, find prices unusually high and will check their consump tion, with the result that prices will fall. If, but only if, prices alter in exact correspondence to changes in the quantity of money, everyone will find himself in the same position as formerly, with the same real income of satisfaction, but with higher prices on the one hand, and larger money supplies available on the other.
The quantity theory, in the course of its evolution, gradually acquired complexity of exposition. Three separate points have to be noted in this connection. The first is the modification intro duced when changes in the volume of goods are taken into account. Changes in production may be increasing the supply of goods con temporaneously with the increased monetary supply and the latter may even exert some stimulating effect upon production. Other things in this case will not be equal, so that the price level will be forced upwards or downwards according as the influence of in creased supplies of money or of goods exerts the preponderating influence; so that the quantity theory is usually expressed in the form that prices move directly with the supply of money and in versely with the supply of goods. Further, it is not the volume of physical goods but the volume of goods and services which must be contrasted with the supply of money : an increase in the number of separate transactions associated with production works, in this connection, as a price reducing factor, because, in fact, transac tions represent services rendered in connection with physical sup ply. Next, the theory has to take account of the fact that, during a given period of time, each unit of money, passing from hand to hand, necessarily plays a part in the number of transactions, the number depending upon the rapidity of its circulation. Given a
certain number of monetary units, an increase in their velocity of circulation is equivalent in effect to increasing the supply of units acting as money during the period of time considered, so that an increase in the velocity of circulation, other things being equal, raises prices, whilst a decrease in the velocity reduces prices. Lastly, the quantity theory has to take account of credit instru ments of various kinds. Here two solutions are possible. One is to treat these instruments as additional to the supply of metallic money and bank and government notes, so that an increase in the supply of credit instruments raises prices in exactly the same way as an increase of money would have done. The second alter native is to regard credit instruments as a substitute for ordinary forms of money, which are replaced in a certain number of trans actions by credit instruments, so that, in relation to transactions, the supply of money rises and prices rise in correspondence.
The New Formulation of the Quantity Theory.—The theory fashionable in pre-war days had two great defects. By contrasting money as a whole with transactions as a whole, it was unable adequately to take account of the individual process of re valuation which is implied in a change in the price level. Secondly, the facts of inflation during the war threw grave doubt on the view that prices were altered proportionately to changes in the quantity of money, the fact being that prices rose much more rapidly in the later stages of inflation, and appreciably less rapidly in the early stages of inflation, than the theory warranted. The new formulations have no difficulty in dealing with these points.
The modern quantity theory starts from the fact that each in dependent individual or other economic unit requires to keep on hand at all times a certain stock of money. At any moment, of course, money may be passing out of one stock into another, but this does not invalidate the fact that considerations of convenience and habit dictate the keeping of a certain stock on hand. This stock of money on hand or, as Hawtrey calls it, "The unspent margin," is as much required as a stock of clothes or a stock of food, if the economic system is to function adequately. The ag gregate demand for money, then, is derived from the sum of indi vidual demands for stocks, just as the demand for houses is rived from the individual demands of those who desire to occupy them. An increase in demand for money is equivalent to an un willingness to reduce the stock actually held and a desire to add to it. If the supply of money is fixed, this must mean that money acquires a higher value, that is, prices will fall, because people can add to their stocks only by parting with goods or services in order to increase the stock they hold and, since the total stock of money is assumed to be fixed, this can only be at the expense of other stocks held by other individuals. If there is a general desire to decrease stocks on hand, prices must rise, in spite of the total supply of money being fixed, because if there is a general altera tion in the desire to hold money, holders can only get rid of what they have by offering it more cheaply, that is, at a lower price in goods to the taker. But this is equivalent to a rise of prices.