Fiscal Policy Using the Quantity Theory

by on March 3, 2009 at 7:10 am in Economics | Permalink

Much of the debate over fiscal policy has occurred in Keynesian terms but its worth pointing out that it's perfectly reasonable to discuss fiscal policy in a monetarist framework.  Start with the quantity theory of money MV=PY, money times velocity equals prices times real output.

In the long run we know that real GDP is pinned down by real factors (labor, capital, technology, institutions and so forth) so increases in M will increase P proportionally.  But in the short run there are plenty of reasons to think that increases in M can increase Y – this is accepted by monetarists, Austrians, rational expectation theorists (ala Lucas) for unexpected changes in money, Keynesians and new Keynesians (only originalist RBC type theorists would object.)  But M and V enter the equation in an identical fashion and thus logically must have the same effects for the same change.  Thus if you think money is potent then V must be potent as well and V is fiscal policy.

To be precise, V is how fast money turns over and we can think about shocks to V as spending shocks.  Spending shocks can be driven by consumers or by the government – this is what Brad DeLong means when he says "the government, in this respect, is just like any other group of starry-eyed optimists whose eagerness to spend pulls the economy into a high-employment, high-pressure boom."

One way of understanding the current recession is that V has fallen by a lot and it is dragging down Y (just as would a sharp fall in M).  We can counter with an increase in M (monetary policy) or by an increase in V (fiscal policy).

Now we might think that V driven by government is too slow or too wasteful (ala Kevin Murphy (pdf)) to work well or we might think that neither increases in V nor increases in M would be as effective as Keynesians imagine since there is also reverse causality (falls in Y and expectations of slower growth in Y are reducing M and V).  We could pursue the last point to its fullest and abandon the quantity theory altogether (making V an endogenous function of Y, for example, and removing it as an independent variable).  But if we hew to the basic ideas of the quantity theory–and remember, it's not a true model only a way of looking at the world!–then fiscal policy is not impossible.

1 E. Barandiaran March 3, 2009 at 7:55 am

The QT of money is much more than the equation MV = PY. You use the equation to say whatever it’s convenient to your argument. As Milton Friedman used to say the demand for money (that is, PY/V) must be stable (whatever it means, and this has been one of the many problems with Friedman’s QT) and the money supply (M) must be exogenous, that is, independent of the other three variables (the problem with M is that the theory doesn’t anything about how it should be defined, and therefore the theory is meaningless). To use today the equation “to organize” your ideas about what is going on is a clear indication of the failure of monetary economics and macroeconomics. To anyone interested in understanding the use of fiscal and monetary policies in the current situation, I recommend to read John Cochrane’s paper

2 OneEyedMan March 3, 2009 at 9:23 am

There are some interventions not involving spending which can alter the velocity of money. If you taxed reserves at the Fed instead of paying interest on them you would increase the velocity of money.

3 bbartlog March 3, 2009 at 9:36 am

I think now I see why your economics is rotten at its foundation: you are focused on maximizing these measured quantities (…must…increase…Y!) rather than specifically on constructing or maintaining a system that allows a lot of room for mutually beneficial transactions. Of course, a large and growing gross output is a symptom of a healthy economy just as a large appetite is a symptom of robust health and physical activity in a person; but it doesn’t follow that we should treat the sick by dreaming up ways to make them eat more. Nor does it follow that any measures taken that increase ‘Y’ are actually economically beneficial. Ultimately this looks just like a really complicated variation of the broken window fallacy, except that instead of a broken window to increase production you have a wide range of systemic distortions.

4 Bill Woolsey March 3, 2009 at 9:46 am


The reason why maintaining nominal income is considered desirable is that when nominal income falls, this required changes in either prices or real output.

The idea is that real output is the amount of mutually beneficial trades going on.

If a decrease in nominal income simply resulted in lower prices, and the same amount of real output–mutually benefitcial trade–then there would not be a problem.

The claim, however, is that prices do not adjust easily and smoothly, so a drop in nominal income results in a drop in real output–a loss of mutually benefitial trades.

So, maintaining nominal income is considered important. And so, if velocity falls, an increase in the money supply is considered disirable.

Using fiscal policy to raise velocity is controversial, because it involves shifts in the allocation of resouces. Different sorts of trades are being made, and not everyone may find them beneficial. But, remember, the argument is that the beneficial trades won’t be made anyway, if nominal income fallls (and the price level doesn’t fall.)

5 DanC March 3, 2009 at 10:16 am

If the shock to V is irrational on some level, some strange animal spirits or the only thing we have to fear is fear, perhaps government can change attitudes with increased fiscal spending.

But if the government is following policies that are anti-growth in the long run, will people just ignore that and respond with some big multiplier to the fiscal spending?

The Congress and President Obama are talking about increasing marginal tax rates on upper income groups and, even more important, they are talking about trillions in indirect tax increases from new regulations (in health care, energy, etc). These burdens are very real and create fear. Such fear can create a liquidity trap in that people withdraw from the game because they view the near term options as bad and worse. As I have mentioned elsewhere, what happens to private investment in South American countries when leftist governments take control? Why should we be shocked if it happens here.

Perhaps Friedman and Keynes were wrong about the power of monetary policy and fiscal policy, unless you assume that the government is following policies that encourage long term growth. In this view, the Great Depression was partially about monetary policy failure but also about policies from FDR that were anti-growth. Fiscal policy cannot overcome anti-growth policies.

The worst recession before this was under Reagan. Monetary policy helped defeat inflation but it was the pro-growth agenda of President Reagan (lower taxes, less regulation etc) that was the true source of growth.

The stock market is clearly voting that the policies of the current government will be negative for long term growth. All the planned tweaks to monetary policy and/or fiscal policy that ignore the anti-growth policies of the government are just small changes on the margin without dealing with fundamental problems.

Lastly, I do wonder why new players have not entered into the banking sector to take advantage of the crippled banks? Is it a fear of government reactions?

6 chin March 3, 2009 at 11:05 am

Krise China

Nun, von den amerikanischen Banken kommen seit einiger Zeit eher Nachrichten, von denen ich glaube, dass sie das Ende der Krise andeuten könnten. Und wenn der Finanzmarkt wieder beginnt zu funktionieren, kehrt auch das so wichtige Vertrauen zurück. Nicht zuletzt beginnt in China das riesige Konjunkturprogramm, das dort aufgelegt worden ist, zu greifen. So waren die Chinesen im Januar schon wieder Nettoimporteur von Aluminium. Und die zuletzt abgestürzten Frachtraten im Schiffsverkehr steigen wieder.

Bleiben wir zunächst bei den Banken: Was ist daran hoffnungsvoll, wenn die Citigroup nur durch eine signifikante Beteiligung des amerikanischen Staates aufgefangen werden kann und sich die 20 größten Institute des Landes einer Überprüfung unterziehen müssen, um ein Gefühl dafür zu bekommen, was passiert, wenn alles noch viel schlimmer wird?

7 spencer March 3, 2009 at 11:40 am

No DanC — Reagan’s policies were not the source of growth.

The private, profit making economy was the source of growth.

Government policy impacts growth on the margin, but it is not the source of growth.

8 Mike Sproul March 3, 2009 at 12:29 pm

MV=Py…..Money spent=money received. Sort of like saying that the amount of rain falling from the sky=the amount hitting the earth. It leads to the same kind of empty theorizing that Keynesians indulge in when they declare that Y=C+I+G (which also says that money spent=money received). Both monetarists and Keynesians, incidentally, accept the premise that modern paper currencies are not backed by the assets of the issuing central banks, even though the simplest arbitrage arguments show that all money must be backed by the assets of its issuer, or else competition from rival moneys would drive its value to zero.

9 DanC March 3, 2009 at 12:32 pm

To Spencer

Ok, Reagan stopped the government from creating undue burdens on the private sector. Once free of those burdens, the private sector grew.

Reagan understood that land, labor, capital and technology allowed to freely flow to their most productive uses creates the greatest growth and opportunity for the economy.

Happy now

10 Phil March 3, 2009 at 1:15 pm


Well said: Thank you.

11 Michael Martin March 3, 2009 at 1:23 pm

The way to increase V is to get private actors (here, the most important group being banks) to trust each other again. That’s not happening because nobody can see what anybody else is hiding from their balance sheets. More than fiscal or monetary policy, what this country needs now is ACCOUNTING REFORM. The government may help a little by stepping in, but it also introduces uncertainties that prevent private actors who have cash from spending it. Make banks open their books up to investors through the Internet, and let the private investors sort this out.

12 ung March 3, 2009 at 1:34 pm

raivo pommer

Ostgeld krisis

Länder vor der Pleite: Der ungarische Forint, der polnische Zloty, die tschechische Krone und der rumänische Lei stehen massiv unter Druck. EU-Währungskommissar Almunia warnt bereits vor dem Schlimmsten.

Die Europäische Union wappnet sich gegen mögliche Staatsbankrotte in einzelnen Mitgliedsländern. “Wir sind politisch und wirtschaftlich darauf eingerichtet, uns diesem Krisenszenario zu stellen”, sagte EU-Währungskommissar Joaquin Almunia am Dienstag in Brüssel. Die Kommission plant kein generelles Hilfspaket, sondern will von Fall zu Fall entscheiden.

13 Donald Last March 3, 2009 at 5:00 pm

In all this debate on liquidity traps and monetary expansion it is implicitly assumed that there is some effective solution immediately applicable, whether monetary or fiscal. But why should there be? The debt binge ran for a decade. Widespread resources of labour, capital and technology have in truth been misapplied, misallocated. Why should it be supposed that this can be cured in a matter of months. Of course banks don’t want to lend & bank reserves are rising. Of course, businesses and households in general want to get rid of debt. They are hell bent on surviving not launching into the wild blue yonder. They don’t want loans so banks are not pressed to give them. And that’s the way the cause runs: business and households demand loans and banks respond. Not the other way round. Banks are supine. Nowadays they are worse than supine: they want to hibernate. And actually they are being fed honey while asleep because the margin between funding costs and what they can earn is huge. Its a good time to start a new bank.

14 Bill Woolsey March 3, 2009 at 5:17 pm


I better understand were you are coming from now.

I have heard of Neil Wallace. Even read some things by him.

Can’t recollect a thing by him that would be relevant to the current crisis.

Nothing about the current crisis appears inconsistent with anything I learned from Yeager.

Are you sure you read Buchanan? What is it that economists should do?

Perhaps a review of the Essential Qualities of the Medium of Exchange or Money and Credit Still Confused would be helpful.

15 David Heigham March 4, 2009 at 11:58 am


I confess to using that framework some of the time. But is not the credit chunch a very sharp fall in V which the Fed are trying to counteract through massive increases in M? With sharp reductions in M to come when V recovers?

The counterpart is fiscal stimulus from more spending and lower taxes to be followed by higher taxes/(lower spending?)

These are the two mules in the Democratic policy yoke, and my impression is that the Administration is talking much more about the left hand fiscal animal, but actually counting more on the hauling capacity of the monetary mule.

16 böhrsens stor March 5, 2009 at 5:27 pm

Raivo Pommer

Gegen krise

Die norddeutschen Länder wollen gemeinsam beim Bund für ihre Verkehrsprojekte kämpfen. Hamburgs Bürgermeister Ole von Beust (CDU) sagte heute nach einem Treffen mit den Regierungschefs von Schleswig-Holstein, Niedersachsen, Bremen und Mecklenburg-Vorpommern, Berlin müsse sich der Hinterlandanbindung der Häfen und der Infrastruktur mehr widmen: “Wichtig ist uns, dass der Bund verstärkt einsteigt.” Aus dem Konjunkturprogramm I sei nicht genug angekommen. “Da geht es darum, das aufzustocken.” Bremens Bürgermeister Jens Böhrnsen (SPD) betonte: “Dazu gehört auch, dass wir (…) deutlich machen, dass der Anteil des Bundes an Hafeninvestitionen und vor allem auch an der Hafenunterhaltung viel zu gering ist.”

17 hubertus story March 7, 2009 at 6:22 pm

Raivo Pommer

Caos und Arbeitlos

Der Machtkampf zwischen Continental und Schaeffler eskaliert. Conti-Aufsichtsratschef Hubertus von Grünberg trat jetzt mit sofortiger Wirkung zurück.

«Es zeichnet sich ab, dass Continental weiter Schaden nimmt«, sagte der 66-Jährige gestern in Frankfurt nach einer Sitzung des Aufsichtsrats des Autozulieferers. «Wir laufen Gefahr, in das Schaeffler-Problem hineingezogen zu werden.« Von Grünberg kritisierte, die schwer angeschlagene Schaeffler-Gruppe sei der Forderung nach einem tragfähigen Zukunftskonzept nicht nachgekommen und stattdessen auf Konfrontationskurs gegangen.

Der Herzogenauracher Autozulieferer, der wegen der auf Pump finanzierten Conti-Übernahme hoch verschuldet ist, wies die Vorwürfe von Grünbergs zurück. Grünberg habe das Vertrauen im Aufsichtsrat verloren, hieß es. Die Besprechung eines Zukunftskonzeptes habe bei der Sitzung in Frankfurt überhaupt nicht auf der Agenda gestanden.

18 doug beta story March 9, 2009 at 1:47 pm

Raivo Pommer

Asia krise

Die Finanzkrise hat nach einer Studie der Asiatischen Entwicklungsbank (ADB) weltweit Vermögenswerte von 50 Billionen Dollar – umgerechnet 39,4 Billionen Euro – vernichtet. Asien war stärker betroffen als andere aufstrebende Regionen.

Dort seien 9,6 Billionen Dollar vernichtet worden, etwas mehr als das Bruttoinlandsprodukt (BIP) eines ganzen Jahres, berichtete die ADB am Montag an ihrem Sitz in Manila (Philippinen). ADB-Präsident Haruhiko Kuroda sprach von der schlimmsten Krise seit der großen Depression im vergangenen Jahrhundert. Doch werde sich Asien als eine der ersten Regionen von der Krise erholen.

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