The Quantity Theory of Credit is an economic theory that emphasizes the role of credit creation by banks in influencing the overall money supply and the economy.
This theory offers an alternative view to the traditional Quantity Theory of Money, which focuses on the money supply’s effect on price levels and inflation.
Developed by economist Richard Werner, the Quantity Theory of Credit posits that the allocation of credit has a more direct impact on economic growth and the health of an economy.
Understanding the Quantity Theory of Credit
The Quantity Theory of Credit revolves around the idea that the primary driver of economic growth is not simply the money supply, but rather the creation and allocation of credit by banks.
According to this theory, when banks create new credit, they directly affect the total amount of money circulating in the economy.
The supply of bank credit depends on the available liquidity in the banking system, while the demand for credit depends on borrowing needs in the real economy.
According to the Quantity Theory of Credit:
Credit Growth = Growth in Liquidity - Growth in Real GDP
In other words, excess liquidity in the banking system will result in higher growth of bank credit. This is because banks have more money to lend, while the needs of the real economy remain unchanged.
On the other hand, if the real economy is growing strongly but liquidity remains unchanged, it will also lead to higher credit growth as businesses and households demand more loans to finance their spending and investments.
However, if liquidity and real economic growth move together, the growth of credit should remain stable and balanced. There is no excess supply or demand.
Types of Credit
Werner distinguishes between two types of credit:
1. Productive Credit:
Productive credit refers to credit that is extended to businesses and individuals for productive purposes, such as investments in new technologies, infrastructure, or the expansion of businesses.
This type of credit allocation leads to increased production, job creation, and sustainable economic growth.
2. Unproductive Credit
Unproductive credit is used for purposes that do not contribute to economic growth, such as financial speculation or consumer loans for non-essential items.
Unproductive credit can lead to asset bubbles, increased indebtedness, and ultimately, financial instability.
Implications of the Quantity Theory of Credit
According to the Quantity Theory of Credit, an increase in the supply of productive credit will lead to an increase in economic activity, as borrowers have more funds to invest and spend.
This increase in activity will, in turn, lead to an increase in prices and inflation.
Conversely, a decrease in the supply of productive credit will lead to a decrease in economic activity and a decrease in prices and inflation.
The Quantity Theory of Credit has several important implications for understanding economic growth and financial stability:
- The role of banks: According to this theory, banks play a crucial role in determining the direction of an economy. By deciding how much credit to create and allocate, and to whom, banks can influence economic growth and financial stability.
- The importance of credit allocation: The theory highlights the significance of credit allocation between productive and unproductive uses. Sustainable economic growth relies on a higher proportion of credit being directed toward productive purposes.
- Policy implications: The Quantity Theory of Credit suggests that policymakers should focus on regulating and monitoring credit creation and allocation rather than simply targeting money supply or interest rates. This includes implementing policies that encourage banks to lend more to productive sectors and discourage excessive lending for unproductive purposes.
The key implication is that rapid expansion of bank credit (much faster than real GDP growth) is often a sign of too much liquidity and risk-taking in the system.
It can lead to the accumulation of debt and asset price bubbles, ultimately threatening financial stability.
By tracking the Quantity Theory of Credit, central banks and regulators can monitor signs of excess liquidity and credit growth.
They can then tighten policy to curb instability risks. So the Quantity Theory provides an important tool for financial stability analysis and macroprudential policy.
Quantity Theory of Credit vs. Quantity Theory of Money
The theory is often associated with monetarism, a school of economic thought that emphasizes the role of money supply in determining economic outcomes.
Monetarists believe that the money supply is the primary driver of economic activity. They argue that changes in the money supply have a direct and predictable impact on economic growth.
However, the Quantity Theory of Credit differs from the Quantity Theory of Money in that it focuses specifically on the impact of credit creation.
This theory posits that the allocation of credit has a more direct impact on economic growth and the health of an economy.
Werner distinguishes between productive credit (used for productive purposes, such as investments) and unproductive credit (used for financial speculation or non-essential consumer loans).
The Quantity Theory of Credit argues that sustainable economic growth relies on a higher proportion of credit being directed toward productive purposes.
Here’s a cheat sheet:
Quantity Theory of Money (QTM):
- Focus: Emphasizes the money supply, specifically the amount of circulating cash and coin, as the main driver of inflation and economic activity.
- Mechanism: Proposes that an increase in the money supply leads to higher spending and investment, which raises prices and boosts economic growth. Conversely, a decrease in the money supply has the opposite effect.
- Example: Think of injecting money into the economy like inflating a balloon. As the air volume increases, so does pressure (prices) and overall size (economic activity).
Quantity Theory of Credit (QTC):
- Focus: Expands the scope beyond cash and coin to include broader credit aggregates, such as bank loans and other financial instruments. This theory argues that productive credit creation, not just the money supply, is a major driver of economic activity.
- Mechanism: Suggests that increased credit availability leads to more borrowing and spending, propelling growth and inflation. Similarly, when credit tightens, economic activity slows down.
- Example: Think of productive credit as fuel for an engine. More fuel (credit) allows the engine (economy) to run faster and produce more (economic activity).
Key Differences:
- Scope: QTM focuses on the narrower money supply, while QTC incorporates a wider range of credit instruments.
- Emphasis: QTM prioritizes cash and coin in influencing inflation and economic activity, while QTC highlights the role of credit creation in driving these factors.
- Complexity: QTC acknowledges the complexities of the financial system and the multiple ways credit creation can impact the economy.
Summary
The Quantity Theory of Credit is an economic theory that suggests that changes in the supply of credit from banks in an economy have a direct impact on the level of economic activity and inflation.
The Quantity Theory of Credit offers an alternative perspective on the drivers of economic growth and the role of banks in shaping the economy.