Inflation Is Best Explained by This Underrated Economic Theory

Currently, the most underrated theory in economics is the so-called Quantity Theory of Money. It has been out of fashion for a long time, and even Federal Reserve Chair Jerome Powell has said that a strong money-price connection has not held for at least 40 years. Nonetheless, on closer examination, the quantity theory does a reasonable job of explaining much of recent economic history.

In its simplest form, the quantity theory states that MV = PT. That is, the quantity of money multiplied by its velocity of circulation encapsulates all relevant transactions. (Money, velocity, prices and transactions are the respective terms in that equation.) More substantively, the quantity theory suggests that it is useful to think about the “M” in this equation — the money supply — as an active causal variable for macro policy.

Consider the recent spurt of 8% to 9% inflation in the US. The simple fact is that M2 — one broad measure of the money supply — went up about 40% between February 2020 and February 2022. In the quantity theory approach, that would be reason to expect additional inflation, and of course, that is exactly what happened.