The quantity theory of money was one of the most influential theoretical developments to the practice of monetary policy by central banks which states that printing money only leads to inflation and rising prices in the long run.²⁴
The quantity theory of money has its roots in the 18th century (David Hume, Richard Cantillon, John Locke). It states that the price levels of products are determined by the changes in the quantity of money in circulation. Thus, if money becomes abundant, its value falls, and conversely, if money becomes scarce, the value of money increases.²⁵ The Fisher — Equation, based on the economist Irving Fisher who developed this equation with Milton Friedman in the 20th century, explains the link between money and transactions as follows:²⁶
M × V states the money used to make transactions and in which velocity the money changes from one person to another person. P × T is about transactions, the price of each transaction, and the number of them. The product of the transaction price equals the money exchanged in a certain period.²⁷
In economics, a slightly different equation is used as the number of transactions (T) is difficult to measure. Thus, it is replaced with Y, the amount of output of an economy:
The right-side of the equation (P × Y) can be considered as the economic output of a nation: the nominal GDP, with Pas GDP Deflator and Yas real GDP.
The quantitative money theory has been criticized heavily by John Maynard Keynes and other economists who claimed that assumptions like unemployment and interest rates have been ignored. Furthermore, it is a static model, ignoring the dynamics of the economy. Nonetheless, despite the critics, the quantitative monetary theory is a widely accepted model to determine exchange rates. As the exchange rate is a relative price of two currencies, the money supply and demand is an important factor to consider.²⁸
Economic models like the quantitative theory of money do appear more and more in cryptocurrency literature. There are intentions to value Bitcoin with the theory and also Vitalik Buterin, the developer of Ether used a modified version of the equation, translating it to market capitalization (MC) equal to the economic value transacted per day (T) times the holding time (H). Buterin also mentioned that this is a static model assuming that the number of users being there. However, all terms are dynamic as the number of users can change; the price can change as well as the holding time.²⁹
The consultant company Ernst & Young considers the valuation of utility tokens with the quantitative theory of money as the right approach due to the meaningful parallels with fiat currencies and its function as a medium of exchange.³⁰
They apply the quantity theory of money in the following way:³¹
- The Money Supply is the number of tokens fixed (M) by the developers, and the floating factor (f) equal to one minus the percentage of the tokens retained as a reserve.
- The Money Velocity can be the inverse of the average time a token is held by a web wallet.
- The Volume of Goods and Services Transacted are market size (D) and market share (s) changing the GDP term Y from equation (2.1) in two components.
- The Price Level can be put as fiat denominated quantity, and an increase of it corresponds to inflation.
The result of the equation is as follows:³²
One critical factor which is not considered in this model is the time value of money to discount the output of the formula with an adequate discount rate to finish the valuation.³³
In the next section, we will determine the price mechanism of the DECA Token, which is, like other cryptocurrencies, a modified version of the quantitative theory of money.
²⁴ Thammarak Moenjak, 2014, Central Banking
²⁶ Mankiw, Ball (2010): Macroeconomics and the Financial System
²⁸ https://rb.gy/lnnktr 2019–05–21
²⁹ https://vitalik.ca/general/2017/10/17/moe.html 2019–05–21
³⁰ https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/emeia-nancialservices/ey-the-valuation-of-crypto-assets.pdf 2019–05–21
³¹ https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/emeia-nancialservices/ey-the-valuation-of-crypto-assets.pdf 2019–05–21
³² https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/emeia-nancialservices/ey-the-valuation-of-crypto-assets.pdf 2019–05–21
³³ https://assets.ey.com/content/dam/ey-sites/ey-com/en_gl/topics/emeia-nancialservices/ey-the-valuation-of-crypto-assets.pdf 2019–05–21