Undergraduates majoring in economics all have to take some sort of introductory macroeconomics course.  And they all come across the Quantity Theory of Money.  When I was taught it, I associated with Milton Friedman as it is the theoretical foundation of monetarism, the theory Friedman proposed.  What is the quantity theory?  It boils down to the manipulation of one equation:

MV  = PT

where M= money supply, V= velocity of money P= price level and T = transactions.  Basically, the total value of transactions has to equal the product of the money supply and the number of times money changes hands.  It is an accounting identity, a tautology and so far it’s not a theory of anything.

Monetarism or Chicago style economics is one theory.  Money exists simply to facilitate transactions and reduce transactions costs.  T is driven by fundamentals such as preferences, endowments of real goods and technology.  V is stable in the short-run.  So, if you increase M you increase P with no real effects.  This idea is very old and goes back maybe to the 19th century.

The other idea is Keynesian.  In this world, T can fall below full employment levels because of a failure of “aggregate demand”.  When this happens the government can stimulate demand by printing money and buying stuff with it.  Or it could give tax cuts etc.  Bernanke is doing something along these lines by buying securities with money.  This  increases demand for the securities, driving up their prices and driving down the interest or return they have to pay.  As it’s cheaper to borrow money, businesses can start to borrow more etc…at least in theory.

For an academic economist, the question is: what happened to Chicago style macro?  To get an answer, check this out.

It’s a video of eminent economists, including Kevin Murphy and Robert Lucas (Nobel Prize winner).  It’s hard to follow Murphy as he keeps referring to an equation which is never shown.  Lucas is very interesting.  He uses the quantity theory of money to argue for an increases in the money supply, at least this is how I interpret it.  In doing this, he honestly seems to disown some of his own famous research where he showed that in a world with rational expectations, increasing the money supply should have no effect.  The basic idea is that decision-makers realize that increases in the money supply have no real effects and are not fooled by monetary expansion.  He seems to say that this does not hold in a depression/recession.  He gives no real explanation for why.

I take two things from this.  First, Robert Lucas is a confident intellectual.  Confident enough to acknowledge when he does not fully understand what is going on.  Second, there is huge amount of work to be done in macro.  I wish I’d carried on studying it.