It has later been discussed and developed by several prominent thinkers and economists including John Locke, David Hume, Irving Fisher and Alfred Marshall.
Assuming additionally that Y is exogenous, being independently determined by other factors, that V is constant, and that M is exogenous and under the control of the central bank, the equation is turned into a theory which says that inflation (the change in P over time) can be controlled by setting the growth rate of M. However, all three assumptions are arguable and have been challenged over time.
Output is generally believed to be affected by monetary policy at least temporarily, velocity has historically changed in unanticipated ways because of shifts in the money demand function, and some economists believe the money supply to be endogenously determined and hence not controlled by the monetary authorities.
[1] Nicolaus Copernicus noted in 1517 that money usually depreciates in value when it is too abundant,[2] which is by some historians taken as the first mention of the theory.
[3][4] Robert Dimand in the chapter on the history of monetary economics in The New Palgrave Dictionary of Economics identified Martín de Azpilcueta (1536)[5][6] and Jean Bodin (1568)[7] as the originators of a proper theory usable for explaining the observed quadrupling of prices during the phenomenon known as the Price revolution following the influx of silver from the New World to Europe.
[1] John Locke studied the velocity of circulation,[1] and David Hume in 1752 used the quantity theory to develop his price–specie flow mechanism explaining balance of payments adjustments.
[8][1] Also Henry Thornton,[9] John Stuart Mill[10][3] and Simon Newcomb[11][1] among others contributed to the development of the quantity theory.
[1] Another renowned monetary economist, Knut Wicksell, criticized the quantity theory of money, citing the notion of a "pure credit economy".
[15] Wicksell instead emphasized real shocks as a cause of observed price movements and developed his theory of the natural rate of interest to explain why the monetary authority should stabilize by setting the interest rate rather than the quantity of money – a position that has received renewed attention during the 21st century, exemplified in the influential Taylor rule of monetary policy.
[1] The extremely influential neoclassical economist Alfred Marshall, Professor at Cambridge, expounded the quantity theory in a version which stated that desired cash balances (i.e., money demand) was proportional to nominal income.
[1] Marshall's disciple John Maynard Keynes extended his monetary analysis in several ways and eventually integrated it into his General Theory of Employment, Interest and Money, published in 1936, which formed the cornerstone of the Keynesian Revolution.
[16] He emphasized that money demand (or, in his terminology, liquidity preference) depended on the interest rate as well as nominal income,[16][17] and contended that contrary to contemporaneous thinking, velocity and output were not stable, but highly variable and as such, the quantity of money was of little importance in driving prices.
[19] At the same time as Keynes personally and his followers which contributed to the resulting theoretical foundation of Keynesian economics in principle recognized a role for monetary policy in stabilizing economic fluctuations over the business cycle, in practice they believed that fiscal policy was more efficient for this purpose, maintaining that changes in interest rates had little effect on demand and output.
[20] In response to the Keynesian view of the world, he made a restatement of the quantity theory in 1956[21] and used it as a cornerstone for monetarist thinking.
Together with Anna Schwartz, he wrote in 1963 the influential book A Monetary History of the United States, concluding that movements in money explained most of the fluctuations in output, and reinterpreted the Great Depression as the result of a major mistake in American monetary policy, failing to avoid a large contraction in the money supply during the 1930s.
[23] Consequently, the monetarist application of the quantity-theory approach aimed at removing monetary policy as a source of macroeconomic instability by targeting a constant, low growth rate of the money supply.
In that situation several central banks turned to a money supply target in an attempt to reduce inflation.
For instance the U.S. Federal Reserve System led by chairman Paul Volcker announced a money growth target, starting from October 1979.
The reason for both problems was frequent shifts in the demand for money during the period, partly because of changes in financial intermediation.
[20] This made velocity unpredictable and weakened the link between money and prices implied by the quantity theory.
[28] The new classical model held that even in the short run, monetary policy could not be used to stabilize output as only unexpected changes in money could affect real variables.
[31] Among monetary researchers, the demise of the money supply as a policy variable was recognized and rationalized by Michael Woodford.
[34] Also in the policy making of the European Central Bank from 1999, monetary aggregates, which were initially officially assigned a prominent role as one of two pillars upon which the ECB monetary policy rested, were assigned a graduately more peripheral role among the indicators informing the bank's interest rate decisions.
In one empirical formulation, velocity was taken to be "the ratio of net national product in current prices to the money stock".
[36] The realism of each of the three assumptions has been debated over time, though, making the prominent monetarist economist David Laidler declare in 1991 that the quantity theory "is always and everywhere controversial".
[39][40] Indeed, the possibility of influencing and mitigating short-run output fluctuations is the basis for the stabilization policies of most central banks in developed countries today.
They argued that a certain portion of the money supply will not be used for transactions; instead, it will be held for the convenience and security of having cash on hand.
[45] In a more recent examination of data from 109 countries from 1991 onwards, it was found that inflation and money growth did not exhibit a proportional development; however, excess money growth did act as a predictor of inflation, but the effect during the time period examined was relatively low.
They found that for moderate-inflation countries (defined as countries with average inflation rates below 12%), the direct relationship between average inflation and the growth rate of money was very tenuous at best, though the fit could be improved by correcting for variation in output growth and the opportunity cost of money.
According to him, the theory "becomes wholly useless where several concurrent distinct kinds of money are simultaneously in use in the same territory."