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Please note: This article was posted in March 2020 and since then the paper "A Real Money Theory" was posted in July, 2020. This superceded the section in this aricle concerning the errors in the Quantity Theory of Money and therefore the section below in the side box entitled "The missing factors in the QTM-Quantity Theory of Money" has been updated to comply with the current understanding on this topic.

The latest (2022) full extension of the QTM replacement as the Real Money Theory (RMT) is described in the paper (pdf):

"Why the Bank of England cannot solve the Cost of Liiving Crisis"

on the British Strategic Review Notes section.

Optimized money supply

Hector McNeill1

In working on the PACM analyses of the main four economic crises, a decade of application of Quantitative Easing (QE), reduced base interest rates with expansion in debt, has exacerbated the contribution of economic policy to the wellbeing of the population.

The exclusive and perennial solution of assisting financial intermediaries is prejudicing the general economic prospects of this country.

I have almost completed a Production, Accessibility and Consumption Model (PACM) analysis of the last 4 financial crises but feel it is worth posting this note as a separate item in order to highlight it.

Interest rates

For over two centuries, interest rates have been variously set either by national governments or central banks. Almost no one questions the ability of governments or central banks to impose base interest rates on an economy and for banks and other financial intermediaries to impose an additional interest rate on top of that to apply as the operational interest rates in financial contracts and agreements. This is fairly unusual since it is unlikely that constituents would accept this sort of state intervention or the interests of any particular sector in interfering in the prices or costs of a product through central dictat. The general assumption of all is that free and responsibly operated market can benefit all.

The setting of interest rates by central dictat is has operated for so long, questions as to its efficacy are seldom raised. One reason for the lack of questioning is that this function lies in the hands of government and policy-makers who review broad macroeconomic trends in inflation, prices, consumption and unemployment. It is within the context of macroeconomics that the use of centralized interest rate setting is tolerated as a function of "monetary policy" along side other legal frameworks and regulations covering government revenue-seeking linked to taxation and accountancy norms.

When the source of money was from the supply side

Up until the mid-1970s an important source of funds was savings by companies, individuals and families. Here the supply side economy was able to pay those in employment nominal incomes that permitted saving of money over and above operational or budgetary commitments. Indeed, the post-war reconstruction between 1945 and 1965 showed an unprecedented rate of growth and general rise in standards of living. Because, in the past, the communications technologies available today did not exist, people would place savings in banks to earn an interest while the banks used fractional reserve operations to lend out money to others subject to due diligence procedures linked to the reasons for a loan, ability to pay and collateral. Therefore the generation of money for saving and investment was essentially a supply side phenomenon. This system was mutually beneficial since the saver did not have to find clients to use their savings and to pay back an interest, this was carried out by the bank. Also, the regular interest rate payments on savings in a bank earned an income. In the case of retired people or pension funds who would use the same accumulated savings from their members to earn money this operational structure was beneficial. For savers, an important factor was general price rises or inflation since inflation discounts interest rates meaning that the real income derived from savings is dependent upon the rate of inflation or purchasing power of the currency.

The impact of higher interest rates

One of the effects of raising interest rates is to attract money into banks to receive higher savings returns. At the national level the rise in procurement for the currency to place on deposit raises the exchange value of the currency vis a vis other currencies. This has two associated impacts. Exporters from this country become higher priced when expressed in terms of foreign currencies and investments fall because in many cases the return on investment will not cover interest payments with an adequate margin. Therefore the raising of interest rates depresses the purchasing power of foreign currencies to consume produce imported from Britain and at the same time investment in British production and services industries declines.

At the same time, while interest rates remain high domestic saves earn higher returns on their savings. Note that it is cheaper, if the funds saved are sufficient, to use savings as opposed to loans to invest.

The impact of lower interest rates

One of the effects of lowering interest rates is to make holding of funds in banks less attractive because of lower returns. At the national level the fall in procurement for the currency to place on deposit lowers the exchange value of the currency vis a vis other currencies. This has two associated impacts. Exporters from this country become lower priced when expressed in terms of foreign currencies and investments increase because an increasing number of investments can cover interest payments with an adequate margin. Therefore the lowering of interest rates increases the purchasing power of foreign currencies to consume produce imported from Britain and at the same time investment in British production and services increases.

At the same time, while interest rates remain low domestic saves earn lower returns on their savings. Note that it is still cheaper, if the funds saved are sufficient, to use savings as opposed to loans to invest.

The fundamental and unfortunate switch in policy

Following the 2008 financial crisis an appeal by financial intermediaries and banks to political parties resulted in three important events under the guise of Quantitative Easing (QE), these were:
  • a massive bail out of failed banks
  • the switching to government debt to private banks to bail out the same banks
  • a destruction of savings as a supply side source of money
In a so-called free market system the close association of finance to government macroeconomic policy decision-making resulted in the government taking up the slack to bail out the banks rather than place a more restrictive set of corrections to guarantee supply side recovery. The result was that banks and other forms of financial intermediaries took advantage of the low interest regime to use these funds to support their own purchase of assets, high end real estate, land, shares and expensive and rare objects. There has been a prolonged financing of share buy backs to be reflected in a stock market "boom" where share prices bear no relationship to productivity, profits or prospects but have handsomely favoured the bonus payments of selected executives.
The missing factors in the QTM-Quantity Theory of Money

With the development of national accounts the QTM equation has been as follows:

M.V = P.Q ..... (i)


M is the total amount of money in circulation;
V is the velocity of circulation or the average frequency across all transactions in final expenditures.
P is the price level associated with transactions in the period under consideration;
Q is an index of the real value of final expenditures.

The economists Marshall, Pigou & Keynes, all associated with Cambridge University, reasoned that the application of money was more significant than the supply, in that a certain proportion of nominal income (designated as k in the short run) is not be used for transactions but it will be saved or held as cash. So the so-called Cambridge equation is as follows:

M = k . P. Y ..... (ii)


P is the price level
Y real income
k is savings
The problem with this equation or identity is that it is wrong in the sense that savings are not a multiplier2 but rather a component of the money supply that is not circulating and therefore this should be added to the remaining P.Y quantity as follows:

M = k + (P.Y) ..... (iii)

However, the economists involved considered wealth to have some influence, but unfortunately and for simplicity's sake, this element was omitted from the widely circulating QTM identity.

The last decade has shown that these economsts were correct, but at that time, based on experience, the wealth or asset class were generally not considered to be a significant determinant in the QTM.

Adding wealth in the form of assets

In the shadow of the evidence generated following a decade of quantitative easing (QE) has demonstrated that it is important to add to the equation assets as well as savings in order to reflect the effect of the diversion of the flow of monetary expansion into assets. This is not a theoretical notion, it is what has happened. Thus designating "a" as asset holdings, that is, money not circulating but invested in assets such as land, shares and stocks, both the Cambridge equation and the QTM need tobe substituted by a more realistic identity, herein referred to as the the Real Money Theory (RMT) which takes the following form:

M = (a + k) + (P.Y) ..... (iv)


P is the price level and Y real income, a is assets and k is savings. Under QE k is virtually zero as a result of close-to-zero interest rates.

M - (a+k)
=P .Y ..... (v)

Conclusion: As "k" (savings and cash) has been driven down by QE to close to zero, real incomes and prices (P and Y) fall to the degree that "a" (asset holdings) increase. This is exactly what QE has accomplished. As can be seen that the QTM equation (i) as applied has little relationship to reality, it is flawed as is the Cambridge equation in its application of the wrong operator to savings (multiplication instead of addition).

To see this in graphic form see "The outcome of quantitative easing on real incomes - summary note".

2 if k is a savings rate the and then expressed as (1-k) where k is a percentage decimal then the Cambridge equation would make more sense but then this loses the absolute value of savings from the identity. This is important in policy terms and even more important when the signifiant impact of monetary flows into assets, as experienced under QE, need to be taken into account.
This flow of funds drained a large proportion of the "monetary growth" (read debt expansion) from the transactional economy of the supply side investment and production of goods and services and the payment of wages ( See: "The outcome of quantitative easing on real incomes - summary note" ). This behaviour did not start with QE, it is now apparent that this has been as trend since the mid 1970s and occurred leading up to the 1929 Crash on the New York Stock Exchange. However, post-2008 this pernicious impact of QE was particularly apparent.

The combination of low interest rates and a declining real income of wage earners, again something in train for over 30-40 years resulted in a slow decline and then liquidation of savings under QE. This has impacted millions of pensioners and pension funds causing hardship just as changes in retirement age legislation has also prejudiced specific groups. This has also been associated with a policy of cutting back on public services, local authority budgets under a general policy of "austerity".

The debt bubble and loss of resilience

The result of this drawn out process which has accelerated since 2008 has been a major distortion in the means of raising money by making the economy and macroeconomic policy decision making and practical outcomes wholly reliant on a few hundred decision makers in a very small number of private banks and financial intermediaries. It is therefore not surprising to find a rapidly increasing holding of income and wealth, in terms of assets, being held by those associated with this industry and their favoured corporate clients. This bias in favour of the interests of this industry has prejudiced the majority as can be appreciated in the evolution of the impact of Covid-19. It has been very quickly realized that too many people live under precarious circumstances, most have no or very limited savings and a large number have no support with respect to social provisions because their contractual conditions "do not include such cover".

The monetary policy that has been pursued is based on the Aggregate Demand Model and the Quantity Theory of Money (QTM). The QTM is a theory that doesn't operate in practice, just like the ADM. For example, one of the "objectives", besides the primary one of making those in the finance industry very rich, was to generate demand and growth in the economy. This is an extremely cynical objective given some 30 years of destruction of supply side investment the resulting declining productivity and an insipid cash flow.


In terms of the constituency of this country the availability of money is in no way optimized, indeed, it has turned out to be damaging to the general interests of the majority of the population. It is biased towards the interests of financial services and not towards savers. The effective periods of growth in this country were also those periods when the supply side provided the basis for monetary growth in the form of savings when interest rates were moderate. Today financial contracts are not based on the foundation of supply side generation of output, wages, business and individual savings. They rest on the simple act of a banker entering a positive balance in an account (See: Bank of England Note: Money creation in the modern economy ) while receiving in return, quite often collateral, whose value exceeds the value of the "loan".

Whereas politicians enthusiastically inform us that we are the 5th or 6th "most successful economy in the world" and that we employ more people now than ever before the stark reality to most is that we have not been successful in ensuring that the policies have provided a monetary growth framework that has benefited savers. More are employed because the population is bigger. There has been a complete failure to reduced the primitive indicator of income and wealth disparity which has, in fact, increased and real incomes have fallen. All of this can be related to the lack of optimization of policies concerning money management in this country.

The puzzling factor is to ask why this is not more questioned by the electorate when the damage wreaked by QE has continued day by day over the last decade. The reality is that inverting this process is virtually impossible because of the likely financial collapse resulting from increasing interest rates. Covid-19 is likely to impose on economists a need to rethink how to start up the economy again and they are advised to avoid the current ADM and QTM models.

Towards an optimized system

It would seem to be that the role of the supply side in generating output in exchange or revenues paid for by those employed by the supply side from their wages needs to be acknowledged. This should also encourage consideration of returning money generation to the supply side rather than increasing national and private debt when this has clearly benefited the interests of a tiny group, a minority faction, whose self-serving enrichment has drained resources from the supply side and prejudiced any recovery. The first step would appear to be to terminate centralized interest rate fixing to move towards natural interest rates which are wholly responsive to the specific needs of savers and lenders ( See: "Is there such a thing as a natural interest rate? - note" ). Given the current turmoil, this transition would have to be carefully managed.

1 Hector McNeill is the Director of SEEL-Systems Engineering Economics Lab.