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QTM inflation analysis
A note

Hector McNeill1

Cautions served on this site have counseled against assumptions that the Quantity Theory of Money (QTM) and the substitute, Real Money Theory (RMT) provide any determinate functional analysis of the impacts of money volumes on inflation. This difficulty is caused by the association of asset markets and consumption item markets within one equation. If the Quantity Theory of Money (QTM) partitioning giving rise to the Real Money Theory (RMT) is extended and real incomes performance indicators applied to each market, the impact of money volumes on inflation becomes self-evident.

The note explains how this can be achieved.

Asset and consumption markets

RMT-Real Money Theory

A deterministic model of this relationship needs to replace the QTM, of the form:

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


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


M is the quantity of money;
P is the price level;
Y real income (substituting T in the Irving equation);
a is assets;
k is savings.

As can be observed, by moving "a" and "k" to the left, as a deduction from M, the very obvious depressive impact of rising asset holdings on the availability of money can be seen to reduce P.Y.

This has been the experience of countries who have applied QE, including the early introduction in Japan in the late 1980s. The universal impact has been depressed transactions and real incomes Y. This explains how the exogenous funds, that were not generated by the supply side (bank loans), were diverted in such a manner as to be inaccessible by the supply side for use as investment or transactions. With low interest rates, savings become less significant and assets become more significant. As a result, rather than see economic growth, in spite of close to zero interest rates, this has resulted in lower real incomes, lower substantive investment and deficient growth in productivity.

As is self-evident, the rise in exogenous money did not have any practical impact on "aggregate demand" and even less so on real economic growth.
The article A Real Money Theory (see box on right) identified two separate markets within an economy:

  • An asset market dealing with a range of assets held by a proportion of constituents

  • A consumption market dealing with regularly used goods and services by the majority of constituents.

In the explanation of the RMT in the box to the right, the asset market is supported by transferred savings, indicated as "k" as well as money flowing through banks into the hands of asset holders of total value "a".

Inflation analysis

Inflation is caused by price-setting and pricing transactional behaviour. The decision as to whether a unit price is inflationary i.e. is rising, stable i.e. not changing or deflationary i.e. falling can be expressed in terms of the Price performance Ratio (PPR). The pure measurement of the PPR is the percentage variation of a sales or output unit price divided by the percentage variation in aggregate unit costs of inputs:

PPR = dP/dC


dC is the percentage change in input costs in a defined period;
dP is the perentage change in unit output sales prices in the same period.

The relationship of the PPR to the direction of price movements is as follows:

PPR value
Change in price trends
Inflationary direction
< 1.00
Reduces input inflation rateDeflationary
= 1.00
Maintains input inflation rateNo change
> 1.00
Increases input inflation rateInflationary

Asset markets are not governed by the same pricing principles as those applied by the producers of goods and services for their output. Asset market are usually speculative with the money flowing into products whose aggregate unit costs are fixed at the unit price paid at the time of purchase and the "output" sales price is usually higher, stimulated by expectations of buyers of yet further price rises. As a result the PPR is normally well in excess of unity (1.00) resulting in an inflationary trend. Currently this can be observed in all assets markets including land, real estate, precious metals, some commodities, rare art objects and corporate share prices subjected to buy backs.

In consumption item and service production activities (the supply side of the economy), price setting is based on an assessment of unit costs of production, a view of the price elasticity of consumption for the product or service and an estimate of the resulting sales volume, revenues and profits according to the unit price of output set. As a result of activity options related choice of technology and techniques, operational configurations and human resources allocation, the PPRs can be in excess of unity (>1.00), be equal to unity (=1.00) or less that unity (<1.00). As a result the activities of individual enterprises can be inflationary, stabilizing unit prices or deflationary. As is self-evident, these decision have no connection to "money volumes" but are strictly tied to econmic unit pricing decisions.

Inflationary leakage

Over the medium to long term there builds up a pressure consisting of an ""inflationary leakage" from the inflationary asset markets into the goods and service consumer markets. For example the rising prices of real estate held as assets can result in owners of those assets increasing rents. Construction companies can delay the use of land purchased for low cost housing construction focusing on the value of that land as an asset with rising value rather than produce low cost housing. Construction company decisions, in terms of price setting, have tended to result in decisions to increase the building of higher priced housing and buildings to sell into the real estate asset market as opposed to serving the needs of those needing lower priced housing. As a result the availability of houses with accessible prices in the consumption market will fall as a direct function of the influence of the asset market conditions on construction company decision making. Ths leads to any savings "k" destined for house purchase having to increase at the ongoing cost of very low interest rates. Rises in rentals of houses, offices, SME industrial premises and of agricultural land, also result in these specific consumption items undergoiung rises in rentals and prices. These examples indicate how asset market prices, fed by money volumes flowing through banks into assets, end up impacting the real incomes by lowering the disposable income of those in the consumption item and services markets, i.e. the majority of the constituency.

Keeping things in focus

However, it is important to note that the relationship between money volume and inflation is transparent in the case of asset markets and asset market price leakage into the consumption item markets. In the case of consumption items produced by growers or manufacturers of goods and providers of services there is no direct connection between money volumes and unit prices. The presumed QTM impact of money volume on inflation only exists in the case of assets and not in the case of the majority of transaction in the supply side of the economy. It is important to keep this clear distinction in focus when discussing monetary policy.

This demonstrates that monetary policy uses a wholly inadequate set of policy instruments as a macroeconomic policy. Their impact is highly selective and biased towards the interests of a minority of constituents who happen to be assets holders.

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

Updated: 12 September 2020 - clarified content of PPR, inflationary impact table

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