QTM Explained, Oxford Reference [www.oxfordreference.com]

For decades, the quantity theory of money (QTM) has shaped how economists and policymakers think about inflation. The theory’s famous equation, MV = PT, suggests that an increase in the money supply (M) leads to higher prices (P) if the velocity of money (V) remains constant. But in modern economies—where financialization, fiscal policy, wage dynamics, and central bank interventions play a larger role—this relationship is far more complex.

Nowhere is this more evident than in Israel, where monetary interventions like quantitative easing (QE) and quantitative tightening (QT) have produced inflationary patterns that challenge the traditional view of QTM. Despite aggressive money supply growth through QE, inflation remained subdued for years. Conversely, QT has not always curbed inflation as expected. What explains these anomalies? The answer lies in how money moves through the economy—not just how much of it exists.

The Quantity Theory of Money: A Simple Formula, A Complex Reality

QTM assumes a direct proportionality between money supply and inflation. If the central bank prints more money, prices should rise. If money supply contracts, inflation should fall. This theory helped explain Israel’s hyperinflation in the early 1980s, when reckless monetary expansion fueled annual price increases of over 400%. But in recent decades, the relationship between money growth and inflation has weakened, particularly due to:

1. Changes in money velocity (V): The speed at which money circulates in the economy is not fixed! V collapsed globally after the Global Financial Crisis in 2008.  [https://en.wikipedia.org/wiki/Velocity_of_money#/media/File:M2VelocityEMratioUS052009.png]. 
2. Financialization: A growing share of money is parked in financial assets rather than spent on goods and services. This may explain why V has been on a downward trend over several past decades. [https://www.researchgate.net/figure/The-Velocity-of-Money_fig3_254446983].
3. Central bank interventions: Tools like QE and QT complicate the direct link between money and inflation.
4. Fiscal policy interactions: Government deficits, subsidies, and stimulus spending influence inflation alongside money supply changes.
5. Wage growth dynamics: Rising labor costs can drive inflation even in the absence of money supply expansion.
6. Geopolitical risks: Wars, sanctions, and global supply chain disruptions distort monetary relationships.

Israel’s QE Experiment: Money Supply Up, Inflation Down?

When COVID-19 hit, Israel—like most advanced economies—turned to QE to prevent economic collapse. The Bank of Israel injected liquidity by purchasing government bonds, corporate debt, and mortgage-backed securities, significantly expanding the monetary base (M).

According to classic QTM logic, this should have led to immediate inflation. Instead, Israel experienced a period of low inflation despite rapid money growth. The reason? Velocity of Money collapsed. There are no figures for Israel Velocity of Money M1 at all so we can assume US as a proxy.

https://ycharts.com/indicators/velocity_of_us_m1_money_stock

• Households and businesses hoarded cash, reducing spending.
• Banks held excess reserves rather than lending aggressively.
• Uncertainty led to higher savings, keeping money from flowing into the real economy.

Thus, even though M increased, V declined, preventing a proportional rise in P (prices). This contradicts the rigid interpretation of QTM, which assumes that V remains stable.

See how V recovered dramatically since the end of COVID. [https://ycharts.com/indicators/velocity_of_us_m1_money_stock]

QE and Asset Price Inflation: The Distorted Face of QTM

While consumer price inflation remained low in the short term, Israel saw rapid inflation in asset prices—particularly housing and equities. With interest rates at historic lows due to QE, investors moved capital into stocks and real estate, driving up prices.

• Between 2020 and 2022, Israeli home prices surged by over 20%, fueled by cheap mortgages and excess liquidity.
• The Tel Aviv Stock Exchange saw significant gains, mirroring global asset bubbles inflated by QE.

This exposes another flaw in QTM’s traditional framework: not all inflation is the same. The theory primarily focuses on consumer price inflation (CPI), but modern economies experience dual inflationary effects—one in goods and services (CPI) and another in asset markets.

QT and the Inflation Puzzle: Why Tightening Doesn’t Always Work

By 2022-2023, inflation in Israel (and globally) began rising as post-pandemic demand surged and supply chains faltered. The Bank of Israel shifted to QT, rolling back its stimulus, raising interest rates, and reducing its bond holdings.

In theory, this should have reduced M, leading to lower P. However, just as QE’s impact on inflation was muted, QT’s ability to curb price growth was weaker than expected. The explanation lies again in velocity and expectations:

1. Rising interest rates increased velocity
   • As interest rates climbed, people and businesses were less willing to hold cash and more likely to spend.
   • This increase in V offset the contraction in M, softening the expected deflationary impact.
2. Inflation expectations anchored price behavior
   • If businesses and workers expect inflation to persist, they continue raising prices and demanding higher wages, even as the money supply tightens.
   • In Israel, inflation expectations remained elevated, delaying QT’s full impact.
3. Fiscal policy remained expansionary
   • Despite QT, the Israeli government maintained stimulus measures, social spending, and subsidies.
   • This kept aggregate demand high, partially offsetting the deflationary impact of QT.
4. Wage growth sustained price pressures
   • Israel’s tight labor market led to rising wages, pushing up production costs.
   • Businesses passed these higher labor costs onto consumers, weakening QT’s effect on inflation.
5. Global supply-side factors
   • QT operates primarily through demand-side channels, but Israel’s inflation was also driven by supply constraints (energy costs, global shipping disruptions, and commodity price fluctuations).
   • Even if QT reduced M, external shocks kept P from falling as much as expected.

The Role of Geopolitics and Exogenous Shocks

One major challenge to QTM is that inflation is not solely a function of domestic monetary policy. In Israel, geopolitical risks exert a strong influence on inflation and economic conditions.

• The Gaza conflict has created supply chain disruptions, increased government spending on defense, and led to uncertainty, affecting consumer and business confidence.
• The war in Ukraine has driven up global energy and food prices, impacting Israel’s cost of living despite domestic monetary policy actions.
• Tensions with Syria and Iran can lead to sudden capital outflows, affecting the shekel’s exchange rate and increasing import costs.

Current Monetary Policy, Systemic Weaknesses, and Global Financial Risks

The Bank of Israel faces a difficult policy environment. Inflation has shown signs of cooling, but interest rates remain high, and the risk of over-tightening looms. The central bank must balance inflation control with the need to support economic growth. However, current systemic weaknesses could complicate its efforts:

• High private debt levels: Israeli households and businesses have accumulated significant debt due to years of low interest rates. As rates rise, debt servicing costs increase, potentially slowing consumption and investment.
• Fragile housing market: After years of rapid price appreciation, QT and higher mortgage rates could trigger a market correction. A sharp decline in housing prices could dampen economic growth.
• Fiscal risks: Government spending remains elevated, particularly on defense and subsidies. If fiscal expansion continues while QT remains in effect, the two forces may work against each other, reducing policy effectiveness.

Additionally, global financial shocks remain a key risk factor. If the US Federal Reserve or European Central Bank over-tighten monetary policy, the resulting slowdown could spill over into Israel. A global credit crunch or financial crisis—particularly in China or emerging markets—could trigger capital flight, weakening the shekel and making imported inflation a renewed concern. Trump’s trade wars could be inflationary calling for interest rates to remain higher for longer. Within the current realm of global recessionary expectations this could lead to stagflation later in 2025 and 2026.

Conclusion: QTM in the 21st Century—Still Relevant, But Not Enough

The quantity theory of money remains a useful framework, but it is insufficient on its own to explain modern inflation dynamics—especially in an era of QE, QT, financialization, and rapid geopolitical shifts.

Israel’s experience shows that M is not the sole driver of inflation—V, financial asset behavior, exchange rates, fiscal policy, expectations, and global supply chains all play critical roles. If policymakers fail to recognize these complexities, they risk making the wrong moves at the wrong time.

Ultimately, inflation control in the modern world requires more than just watching the money supply—it requires understanding where money goes, how fast it moves, and what people expect to happen next. Only by considering these factors can central banks navigate the post-QE, post-QT world effectively. Plenty of monetary and fiscal pot holes on the horizon! I feel the Bank of Israel may do well to compute a value for V and associated attributes particularly within the context of CBDCs, Central Bank Digital Currencies.