One of the age-old questions in the field of economics is whether or not money is neutral. In other words, the introduction of new money into the economy only has a nominal impact . It only raises prices and does not impact variables on employment or output (Cecchetti, P.1) . The lack of influence of an increase in the amount of money on the aggregate economy is a core assumption of the Quantity Theory of Money. An economic theory that was exposited by no other than John Locke. Locke is renowned for his moral philosophy and political theory often is overlooked in terms of his early contributions to economics.
In a broad application, the theory simply entails that the quantity of money is the key factor in the “changes in purchasing power” (Humphery, 1974, P.1) . The theory stipulates that introducing new money will decrease the value of the currency resulting in higher prices (Humphery, 1974, P.1) . This observation pertaining to alterations in purchasing power is generally widely accepted.
M= Stock of Money
P= Price Level (Humphery, 1974, P. 1) .
Locke explicitly detailed back in 1691 that the Price Level (P) is “always proportional” to the stock of money (M) (Humphery. 1974, P.4) . Locke’s assumption the effects of introducing new money may have considered its impact on prices. However, it also assumes even that the changes in prices throughout the economy would be uniform. It is reasonable to question whether this assumption falls into the same folly that many other economic models suffer from. That is the gulf between theory and actual application. Wouldn’t it be possible for some actors in the economy to have access to the new money prior to the rise in prices? Shouldn’t be also be considered that how the money is distributed could only magnify such potential effects? Whether due to the mechanism of distribution or institutional advantages.
….The mistake of this plausible way of Reasoning will be easily discovered, when we consider that the measure of the value of money, in proportion to anything purchasable by it, is the quantity of the ready Money we have, in comparison with the quantity of that thing and its Vent; or which amounts to the same thing, The price of any commodity rises or falls, by the proportion of the number of Buyers and Sellers; This rule holds Universally in all Things that are to be bought and Sold, bateing now and then an extravagant Phancy of some particular Person, which never amounts to so considerable a part of Trade as to make anything in the account worthy to be thought an exceprion to this Rule. (Locke, 1691, P. 16) .
Locke may have been a brilliant thinker and the grandfather of liberalism, that does not make him above reproach. The likes of David Hume and Richard Cantillon expressed disagreements with the assumptions of Locke. Hume’s postulations are so similar to those of Cantillon that some have levied accusations of plagiarism (Bilo, 2015, P.4) . I will provide no further commentary on that claim. Both Hume and Cantillon did not see the role of money in the economy as being neutral. It can be argued that this is not a realistic view of the function of money. Cantillon suggests that the point of injection of new money and the velocity of circulation plays a role in its impact (Thorton, 2006, P.4) . A point that is clearly neglected in Locke’s account of the role of newly introduced currency. If money was neutral how additional quantities are introduced would not matter.
Both Hume and Cantillon noticed other factors that clearly demonstrated the nonneutral nature of money. Which include the following:
(1) the lag of money wages behind prices which temporarily reduces real wages, thereby encouraging increased demand for labor ; (2) the stimulus to output occasioned by inflation-induced reductions in real debt burdens which shift real income from unproductive creditor-rentiers to the productive debtor- entrepreneurs ; (3) so-called “forced-saving” effects, i.e., changes in the fraction of the economy’s resources diverted from consumption into capital formation owing to price-induced redistributions of income among socio-economic classes having different propensities to save and invest; and (4) the stimulus to investment spending imparted by a temporary reduction in the loan rate of interest below the profit rate on real capital. (Humphery. 1974, P.4) .
All of the listed observations are clearly distortions caused by the unequal distribution of new money throughout the economy. Those who have access to the new money first reap the advantage of the lower prices. As the reverberations of the new money have not echoed throughout the economy. In other words, prices have not increased to reflect the depreciation in the value of the currency. If the new money is introduced through highly centralized institutions this discrepancy will be quite salient. Versus being more evenly distributed. Those with early access to the new money will spend it prior to the rise in prices. Such consequences being indicative of Cantillon’s eponymous theory the Cantillon Effect.
It is possible that Locke may have potentially oversimplified the more intricate impact that introducing more money has on the economy. However, empirical research has not always yield findings congenial to Cantillon’s finding (Wagner & Daley, 2004, P. 8) . Veteran economists Richard Wagner and Steven Daley suggest that “…comparative statics of monetary or macro aggregates.. “are inappropriate for studying Cantillon Effects. Rather we should focus on the “… structural composition of economic activity..” (Wagner & Daley, 2004. P.17) . Despite my paucity of economic credentials, I would wholeheartedly agree. Locke’s Quantity Theory of Money lacks an acknowledgment of how money is circulated. If new money is distributed unevenly the adverse ramifications of inflation will be felt differently.