What are the policy implications of the quantity theory of money?

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pohnpei397 | College Teacher | (Level 3) Distinguished Educator

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The basic policy implication of the quantity theory of money is that central banks should not try to manipulate the money supply in response to changing economic conditions.  Instead, they should implement a predictable monetary policy (Milton Friedman prescribed a constant but small increase each year) and let the economy adjust itself in times of recession.

Conventional monetary policy calls for increasing the money supply in times of recession.  However, monetarists would argue that this policy is useless.  They say this because they argue that an increase in the supply of money will simply lead to an increase in the price level.  This is true, according to the quantity theory of money because the velocity of money and the quantity of output do not change easily.  If the velocity of money and the quantity of output do not change, the only effect of a change in money supply will be a change in price level. 

Because they do not think that changes in money supply are able to bring economies out of recession, monetarists say governments should avoid such changes.  Instead, they should simply raise the money supply by constant and small amount each year and let the economy adjust itself when recessions happen. 

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