Quanitity Theory of Money, Wicksell

Quanitity Theory of Money, Wicksell and Inflation and Interest Rates

There are several most important economics schools which have shaped the overall economic theory and the way that present scholars look at the economic development and its' drivers. Often, representatives of different economic schools had different views on basic economic phenomenon and they found sensible reasoning for their believes. One of the differences in economics schools is the quantity theory of money which was based on the equation of exchange which is formulated as follows: M * V = P * Q, where M. is the amount of money available within economy, V refers to velocity of money or how often the money unit is spent within economy and thus how often the money re-circulates within the economy, P is the average price rate of the economy during the period, and Q. stands for the quantity of goods purchased within economy with the money M. during the specific period. In original works, velocity was described as "the ratio of net national product in current prices to the money stock."

Though quantity theory of money is based on the equation of exchange, both are not identical notions. Thus, quantity theory of money is not a definition which holds without any assumptions as with the case of equation of exchange, quantity theory of money rests on the assumptions of main causal and effect relationship within economy. The quantity theory of money assumes that the main cause of inflation within the economy is the supply of money which is exogenous, and the demand of money drives real money supply and demand is influenced by wealth, rate of return and value of liquidity within the economy, and the demand for money is sustainable in the short-term and the longer term demand for money is more important to the explanation of economic fluctuations. The interest rate deducted for inflation, or the real interest rate is a function of such determinants as productivity of the capital available, and time preference. Thus, classicists believed that an increase in money supply will lead to proportional increase in price level as they believed velocity and quantity of transactions, or goods sold to be constant in the short run, as they treated money as a normal commodity, price for which grows if the supply of it increases, and vice versa, price for which declines if the supply of it decreases. In the long run, the volatility of money supply will also only cause changes in inflation rate and thus the nominal GDP of the country, as believed by monetarists, as the markets are believed to be always approaching their full employment rate.

But with evolution of capital markets and appearance of numerous wealth capitalization methods besides holding M1, the velocity of money became very variable rather than stable and equal to one, which made scholars hesitate on the validity of Quantity Theory of Money, while equation of exchange is supported by majority of economics schools.

Besides many contributions made by Knut Wicksell into the economic theory, the major appreciated work is the interest theory implications from his work Interest and Prices, where he separated the notion of monetary interest rate, or interest rate derived from the capital markets; and the natural interest rate, or the interest rate neutral to the prices in the real markets and which equates the supply and demand in the real market, resting on the assumption that the capital markets are not necessary. Developing this theoretic background, Austrian economists have suggested that economic growth begins when the natural interest rate exceeds the one observed in the capital markets, this theory referred to as the theory of business cycles. The findings of Wicksell had also big effect on further Keynes "The General Theory of Employment, Interest, and Money."