MV = PY is an identity that means the amount of money (M) multiplied by the turnover of money (V for velocity) is identical to the amount of economic activity (Y) multiplied by the price level (P). MV = PY also appears as MV = PT. Here the T in place of Y stands for transactions.
What this says, in effect, is that purchases during a period are equal to sales over the period. Or, since what is spent is someone else's income, income equals expenditure over the period. MV represents money spent, and PY, or PT represents money earned. Give and take are always equal as a matter of accounting.
Generally, what is of interest in macroeconomics is Y, since Y is aggregate income (demand) and also aggregate product (supply), that is, Y (national income) equals GDP (gross domestic product). This is written as the identity, Y = C (for household consumption expenditure) + I (for firm capital expenditure) + G (for government fiscal expenditure) + (X - M), signifying net exports, that is, the trade balance. Summing this, national income (aggregate demand) equals national expenditure (aggregate supply).
Monetarism v. Fiscalism
On one hand, monetarists target money supply as the independent variable of economic policy since they view it as the chief means to control firm investment, hence, income leading to demand. For in their view, supply, which comes from investment, creates its own demand, which comes from income, iaw Say's law, in that firm expenditure funds household income.
On the other hand, fiscalists target income since income is the basis of effective demand, and in their analysis demand draws forth supply, since firms invest in response to effective demand for their goods. Effective demand sends a signal to firms to invest.
Strict monetarists reject fiscalism as ineffective. Fiscalists reject monetarism in a non-convertible floating rate system as inefficient if not also ineffective. New Keynesians accept fiscalism in a so-called liquidity trap but not otherwise. This is the basic kerfuffle going on in many current debates.
The basis of the debate between monetarists and fiscalists that is now raging is over whether monetary or fiscal policy is most appropriate, although some economists argue that neither is appropriate and the government should but out and let "the free market" take its course. This is crucial to understanding the debate between MMT and mainstream economists, most of whom are monetarists or have monetarist tendencies.
Monetarism
Monetarists are most concerned with M rather than Y, since their focus is inflation. While all economists agree that MV = PY, Milton Friedman used this identity to ground the quantity theory of money (QTM), which explains inflation in terms of change in M, or money supply. QTM holds that increases in M (money supply) imply a corresponding increase in P (price level), i.e., inflation, presuming that V (money turnover or velocity) and Y (product) are constant.
For monetarists, M (money supply) is the independent variable in MV = PY, changes in which influence the price level. So, according to monetarists, M needs to be controlled through changes in interest rates, since it is the interest rate channel that affects the relationship of saving and investment as primary determinants of economic activity.
The relationship of saving and investment is adjusted through interest rates to encourage investment without provoking inflation. In this view, saving funds investment. The central bank sets interest rates iaw inflationary expectations to adjust the balance of savings and investment, increasing rates to encourage saving when inflationary expectations rise, and lowering them to encourage investment when inflationary expectations are low enough.
This view presumes a credit-based monetary system, in which money is borrowed into existence from a central bank that is independent of the Treasury, or from the private sector, instead of being issued directly by the Treasury. This assumes that loanable funds are based on fractional reserve banking and the so-called money multiplier, such that deposits (saving) create reserves that fund loans. By adjusting reserves through monetary operations involving interest rate setting and reserve requirements, the central bank can therefore control the endogenous money supply in this view, and since the Treasury issues debt instruments sold to the private sector in order to obtain reserves needed for fiscal expenditure, it competes for loanable funds to the degree that expenditure exceeds revenue from taxation, thereby "crowding out" private investment.
In this view, interest rates are used to target inflation expectation, using unemployment as a tool wrt a rule that is based on a presumption of a natural rate of unemployment defined as "full employment." This creates a buffer stock of unemployed, which implies permanent idle resources. Idle resources are inefficient and wasteful, which economists agree should be avoided if possible.
This is admittedly somewhat of an oversimplification since the monetarist position has evolved since Friedman developed it, but it gives the basic idea as a heuristic device.
Fiscalism and MMT
For fiscalists, employment is of primary concern. Y (income) is the independent variable in PY = MV, changes in which affect effective demand. So fiscalists hold that Y needs to be controlled through fiscal policy, which affects effective demand. Effective demand draws forth investment to meet profit opportunity, and effective demand is income-dependent, since consumption cannot be funded by drawing down savings, selling assets, or financed by borrowing sustainably. If supply and demand are stabilized at optimal resource use, they unemployment is reduced.
The holy grail of macroeconomics is full employment along with price stability, which implies highly efficient use of resources while controlling price level.
In the first place, MMT rejects the monetarist explanation virtually in toto, claiming that it is based on an incorrect view of actual operations of the Treasury, central bank, and commercial banking, and how they interact. Secondly, MMT explains how to succeed in the quest for the holy grail through employment of the sectoral balance approach developed by Wynne Godley and functional finance developed by Abba Lerner. The thrust of this approach is to maintain effective demand sufficient for purchase of production (supply) at full employment by offsetting non-government saving desire with the currency issuer's fiscal balance. This stabilizes aggregate demand and aggregate supply at full employment (adjusting aggregate demand wrt changes in population and productivity) without risking inflation arising owing to excessive demand.
Note that this does not apply to price level rising due to supply shock, such as an oil crisis provoked by a cartel exerting a monopoly, or shortage of real resources., e.g. due to natural disaster, war, or climate. This is a separate issue and must be addressed differently according to MMT.
In a non-convertible floating rate monetary system, the currency issuer is not constrained operationally. The only constraint is real resources. If effective demand outruns the capacity of the economy to expand to meet it, then inflation will result. If effective demand falls short of the capacity of the economy to produce at full employment, then the economy will contract, an output gap open, and unemployment will rise.
This view is based on a Treasury-based monetary regime, in which money is created through currency issuance mediated by government fiscal expenditure. Issuance of Treasury securities to offset deficits functions as a reserve drain, which functions as a monetary operation that enables the central bank to hit its target rate rather than being a fiscal operation involving financing. Similarly, taxes are seen not as a funding operation for government expenditure, but as a means to withdraw non-government net financial assets created government expenditure, in order to control effective demand and thereby reduce inflationary pressure as needed iaw the sectoral balance approach and functional finance.
This view is quite the opposite of the credit-based monetary presumptions of monetarists, which MMT regards as appropriate to a convertible fixed rate regime like the gold standard but not to the current non-convertible floating rate system that began when President Nixon shut the gold window on August 15, 1971, and was later adopted by most nations, excepting those that pegged their currencies, ran currency boards, or gave up currency sovereignty as did members of the European Monetary Union in adopting the euro as a common currency.
It is important to note that MMT economists are NOT recommending the adoption of a Treasury-based monetary system. Rather, they are asserting that the present monetary system is already Treasury-based operationally, even when governments choose to impose political restraints that mimic obsolete practices and create the impression that these are operationally necessary.
MMT also recommends an employer assurance program (ELR, JG) to create a buffer stock of employed that the private sector can draw on as needed. This reduces idle resources and presents the possibility of achieving actual full employment (allowing 2% for transitional) along with price stability, which monetarism presumes inflationary. The ELR program also establishes a wage floor as price anchor for price stability.
(This post grew out of a short comment I made at
Warren Mosler's blog in response to a question asked by Mario. Hat tip to Mario for bringing it up.)
