The quantity theory of money, the view that the money supply is the key determinant of inflation, is dead, or todays mainstream economists tell us. The Federal Reserve is now engaged in a policy that will either put the nail in the quantity theorys coffin or restore it to the textbooks. Sadly, if the theory is alive and wins out, the economy is in for a very rough ride.
The theory has had a long history of evidence in its support. In earlier times new gold discoveries, the source for old-fashioned money, produced inflation. Years later, in the early 1970s, Milton Friedman warned President Richard Nixon about expanding the money supply. His advice fell on deaf ears, and Nixon proceeded to pressure Arthur Burns, then chair of the Federal Reserve, to goose the money supply.
A horrendous decade of inflation followed as the Fed feebly applied its policy tools to avoid recession. Despite this, two recessions occurred, and the inflation rate worsened throughout the decade. It took Paul Volcker in 1980 to really slam on the money-supply brakes to get the inflation under control. Interest rates soared; the economy dropped into a serious recession, but inflations back was finally broken.