QUANTITY THEORY OF MONEY

economic theory relating changes in the price level to changes in the quantity of money. In its developed form, it constitutes an analysis of the factors underlying inflation and deflation. As developed by the English philosopher John Locke in the 17th century, the Scottish philosopher David Hume in the 18th century, and others, it was a weapon against the mercantilists, who were accused of regarding wealth and money as identical. If the accumulation of money by a nation merely raised prices, the argument ran, the mercantilist emphasis on a favourable balance of trade would increase the supply of money but would not increase wealth. In the 19th century the quantity theory contributed to the ascendancy of free trade over protectionism. In the 19th and 20th centuries it played a part in the analysis of business cycles and in the theory of foreign exchange rates. The quantity theory came under attack during the 1930s, when monetary expansion seemed ineffective in combating deflation. Economists argued that the level of investment and government spending had more influence than the supply of money in determining the level of economic activity. In the 1960s the tide of opinion reversed. Experience with postwar inflations and new empirical studies of money and prices restored some of the theory's lost prestige. One implication of the quantity theory is that the size of the stock of money is of prime importance in governmental policies aimed at controlling price levels and maintaining full employment.