James Hamilton explores the relationships within the the quantity theory equation (MV=PY--the quantity of money times its velocity of circulation equals the price level times the real level of GDP). This relationship may in fact hold in the long run (we all know what Keynes said about that) but this equation, using the usual definitions of M offers no insight into the current economic situation.
Paul Kasriel (chief economist at Northern Trust) has recently proposed the level of bank credit as a substitute for M in this equation. I suppose time will tell whether this substitution will work out as a useful definition in the equation, but it does seem to offer some explanatory power in the situation in which we find ourselves at present. Of course, the principal weakness in the quantity theory remains: it does not take into account the position of the economy vis-a-vis economic capacity. When does a change in the left side of the equation affect P and when does it affect Y?
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