The quantity theory of money

The only theory of prices available to Keynes at the time was the quantity theory of money. Detailed formulations of the theory varied. Unsurprisingly, Keynes preferred the oral Cambridge tradition inherited from Marshall (see Keynes 1911 [1983]).

Part of Keynes’s explanation involved a shift of focus from state-supplied money (notes and coin), still thought to be the only proper money, to their close substitute, bank deposits. Although the note issue was broadly speaking unchanged, private bank lending could break the link between central bank money and deposits, so the velocity of circulation of central bank money had become unstable and unpredictable. Once again, Keynes’s empirical observation and institutional insight gave rise to a new approach.

Keynes argued that the enhanced importance of the banking system called for a more active monetary policy, directed towards stability of the domestic price level rather than the exchange rate. This was feasible as long as Britain was de facto off gold. (This recom­mendation echoes the thinking in ICF.)

The quantity theory failed to explain the course of prices not only because it ignored bank lending: more importantly, it was a long-run, equilibrium theory. The quantity theory was at one with the rest of economics at the time, which saw the short run as transitory and therefore not worth the theorist’s attention. Keynes ventured into short­run territory to attempt to explain post-war price fluctuations. He expressed his dis­satisfaction with the quantity theory’s equilibrium method forcefully: “But the long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again” (TMR, Keynes 1923 [1971]: 65). However, he left its long-run theoretical proposition unchallenged: he had not yet given up the quantity theory altogether.