Mechanical equations in economics trace origin to 1517, when Nicolaus Copernicus, proposed the quantity theory of money. Several centuries later, the quantity theory of money, perfected itself, in a mathematical sense, to become the modern monetary theory. While several economists made a bright career out it.

The quantity theory of money asserts that when money supply increases in an economy (for simplicity sake, let's assume a closed-economy, i.e. no exports or imports), and further assuming constant circulation and output, the general price level of goods and services would increase as a result. It's a 'clinching' mathematical proposition. Much like the formulae for celestial body motion, it is meant to be accurate to the human hair's breadth.

Or is it?

Perhaps not. The issue at hand is the assertion about the rise (or fall) in the general level of prices. In daily conversations, we know this as inflation or deflation. Though, economists refer to the change in the money supply itself as inflation or deflation, rather than its supposed effect.

Despite the more direct reference in economics, the effective meaning is the same: one of changes in the general level of prices.

The disagreement is, when there is an injection of new money, prices don't move in an all-at-once manner. That's a theoretical construct, something worth repeating several times. In reality, price changes are 'chaotic'. Price structure of all goods and services in an economy behave rather in an anarchistic fashion; much like a playground of children, rather than the march of an army regiment.

This doesn't mean the price of items today has zero correlation to yesterday's price. The emphasis is on the unison and direction of prices; the movement of all items in the marketplace, instantaneously.

But in reality, they don't all move lock-stock-barrel up and down. This is the where mechanistic arguments such as the quantity theory of money fail to convey reality in a correct manner.

Why is this so?

New money injected into an economy, don't reach the hands of all economic agents equally and all at once; even assuming they reach all at once, the cash holding by individual agents can defer the process of actual expenditure.

Suppose n is the new volume of cash and there are m participants, now, all participants don’t receive n/m amount of money; that is the distribution is unequal.

With a fiscal transfer payment there is at least, a possibility of a greater number assignable to the denominator m; that is, more participants receiving the new injection of money. With credit-creation, which we see later, this possibility is fully negated.

A caveat may be in order here. Such a fiscal transfer payment shall not be preceded or succeeded by compensatory tax increases, but only as a result of monetization of government debt.

The more likely method for money creation is through credit market channel, that is, fresh credit creation. With fresh credit creation interest rates naturally drop. This induces entrepreneurs who falsely believe in the lower of interest rates to be sustainable. Their ‘revised calculation’ show that complex projects have now become viable.

This money ends up in the hands of those entrepreneurs. Typically, these are businesses engaged in projects of long gestation. Their activities need licensing, which signify some form of close connection with the State. Such credit binges have been usually associated with crony capitalists who bid for projects of high value and high risks.

Yet, our focus here is on price dynamics, and not sustainability of those capital-projects.

After receiving the new money the narrow group of agents bids for resources that they need for their factories: equipment, raw material, power, labour, land etc.

The new demand pushes up the price of those goods and services in the economy.

Next, the recipients of this new money turnaround and bid for resources that they need: such as trade inventories, wages, self-consumption. This increases the price of those goods and services as well.

If there is a commonality of goods in the first set of transactions and second set, the push in prices is more accentuated.

This is akin to a wave effect. As the cash dissipates through the economy, the breadth of goods brought by new recipients also increases.

But, the later recipients are at a disadvantage compared to the initial receivers of money. The last receivers of money are, by extension, most disadvantaged. By the time they receive the money, prices would have already adjusted upwards.

Now, it appears to the economist that the general level of prices of all goods and services has increased. At least in a moment in time, this looks true.

However, there is an element of efflux of time, which is crucially missing in conventional analysis; without taking into account the passage of time, such an understanding is inadequate for any deriving meaningful conclusions. Firstly, it limits comprehension of the severity and effects on many agents during this time.

We will slow down and minutely examine this.  The phenomenon of price change (price increase for our discussion) is a revolution, rather than a peaceful, secular change. Prices fluctuate wildly in comparison to expectations. Some agents benefit from this price rise, others lose. Consumers certainly see higher expenditures.

Businesses whose input raw materials haven’t yet experienced the price rise, yet the finished goods have, benefit from uneven phenomenon; that is raw material price remain same, but product prices have risen. Those entrepreneurs will be wildly surprised and perhaps attribute the extraordinary success to their skills and imagination.

Whereas, others whose raw material prices have increased, yet product prices are yet to show any sign of increase, will be disappointed with the results.

Misled by their hubris, the entrepreneurs who benefited from inflation would increase investment to produce more, while the latter would exit their venture due to actual losses.

An inefficient producer, held together by inflation, can continue in business longer than in normal times. On the other hand, an efficient producer, due to circumstances beyond his control, faces bankruptcy.

These are the ravaging impacts of inflation.

Not just business profitability, the social impact as well, of inflation is ignored by the quantity theorists. They look at money supply increase and the price increase as an on-off switch. As Ben Bernanke once famously remarked, that, he can yank out inflation in ‘five minutes’ by turning off the money supply tap. An approach conditioned by thinking only in equilibrium terms, where adjustments happening 'mechanically'.

This (mis)understanding of inflation is just one issue.

In this post, I want to touch upon another, more fundamental, free-market related understanding of money and prices. That is, if there be no credit infusion, would there be no price revolution of the type discussed? Would prices be benign in the absence of monetary disturbances; by disturbances one means liquidity changes in markets - not by voluntary saving or consuming - but by actions of the central bank?

This is where the commentators opposing the quantity theory take extreme, untenable positions. They argue for a Utopian scenario of flat prices. Is such a scenario likely, and from a social stand-point, preferable?

More simply, the question is, in the absence of money supply changes, will prices change?

Prices of goods (and services) will always change.

This is because economic agents are continually bidding up some resources and bidding down other resources.  Entrepreneurs are constantly engaged in a game, where, with pooled capital, they buy low priced resources and sell at higher prices. These price forecasts are made in advance. Those with better predictive ability succeed. Those who predict poorly fail. Correctly or incorrectly anticipating consumer’s future behaviour can lead to profits or losses.

Similarly, consumers contribute to the price war by buying at the lowest available prices. In any market, there would be consumers who don't make adequate efforts in price discovery and end up paying higher prices. They don’t push enough against the high prices charged by entrepreneurs.

The above describes the real, dynamic nature of any economy. A static price environment can be expected only in a 'dead' economy; or theoretically speaking, in an economy that remains in full equilibrium.

In the real world, however, prices are messy. It's what drives entrepreneurs. It's what forces consumers to budget; that is, to consume, save and invest. The purpose of money itself is to facilitate exchange when exchange ratios fluctuate.

It's obvious to state here that a prediction of the direction of the general level of prices cannot be made in this model. One cannot make such sweeping generalizations. All that we can safely assume is, even in the absence of monetary stimulus, prices do and will fluctuate.

Entrepreneurs will look to maximize profits, and consumers will look to maximize utility.

It important to reiterate that entrepreneurs offering high prices and consumers bidding down those prices is what makes the market. Which forces prevail, in summary, is not even a question. The question is which set of entrepreneurs eventually meet the needs of consumers.

Also, technically, no economic agent has infinite wealth to alter all prices in unison; with that axiom we completely negate the theory of general level price changes.

We also arrive at a clearer thinking position; that absent exogenous cash injections, the normal dancing around of prices in an economy is both good and expected. In such an environment, the margins earned by entrepreneurs should not be value-judged the policy maker. Because, these changes take place in the free market, where there is no coercion. If the State interferes in the free market, it either creates a glut or a drought of those goods. Whereas, in the free markets, a higher price does have an automatic stabilizer; it’s in the form of lower consumer demand. You only need to allow it to function.

This understanding of price mechanism has other serious implications for the policy maker. For instance, they should not be captured by interest groups who complain of elevated input prices or depressed output prices. Complaining about the lack of ‘liquidity’ in markets is another euphemistic manner of asking for subsidies or protection.

For every interest group that complains of unfavourable price equation, there are others who have benefited from those prices; just that those voices remain silent as they have nothing to complain about.

The government should play the role of an umpire. It should not assist in changing the rules midway so that one favoured team wins. By exhibiting alarm at the increase in certain prices, the government exhibits a bias towards action. A tighter liquidity or price regulation is the usual after reaction. This frustrates the plans of agents and contributes to reduced entrepreneurial activity. In an earlier post, How Budget Deficits Add to Entrepreneur Risks we identified risk-externalities as those actions by the government, or autonomous events, that hinder entrepreneurial plans.

In this post, we want to highlight that the quantity theory of money has wrong lessons to impart. The other extreme position, of a static price environment is flawed too. Value judging the price margins earned by producers, and with interventionist consequences, adversely affect free market processes.

Those who cleverly combine capital and minimize the space and time of consumable resources - an activity aimed at enhancing consumer utility - should not be vilified.

Similarly, one must keep faith that consumers will vote freely on the price margins charged by entrepreneurs. The former will maximize utility by bidding down high prices and bidding up lower prices. These prices form an important signal for coordinating activities. Disturbances to price processes results in mis-allocation of resources.