Understanding the Quantity Theory of money
Their aim is to control the quantity of money, and by doing so, keep a specific rate of inflation such that the economy does not enter a deflationary stage.
Monetarists and Keynesian economists are afraid of deflation, which they believe will always spiral out of control and lead to economic depressions. (They are apparently ignoring the curative effects of limited currency in regulating the business cycle and preventing larger fluctuations in booms and busts. )
Monetarist economists stress a theory called the quantity theory which basically stipulates that a rise in prices of goods and services will be observed proportional to the rise in the supply of money. The theory states that price rises will occur when money is supplied and in proportion to it. Therefore, if one could keep a steady low rate of increase, then a steady inflation would keep prices rising and prevent deflation.
One of the main issues with the quantity theory, as pointed out by Austrian Economists, is the observance that all prices do not rise in an economy uniformly and that prices do not rise in the same proportion as the money supply. Therefore, it is very difficult to control inflation through this monetary policy.
As Henry Hazlitt described on page 75 of his work, The Inflation Crisis and How to Resolve It, the German hyperinflation observed in the 1920s was not uniform. At first, the increase in the supply of money by the bank did not immediately increase all prices uniformly. What happened then is the public observed some prices rising, and simply refrained from purchasing those items with the expectation they would come down. The rise in prices was less than that of the inflation of the money supply by the German bank.
Eventually, the price increases caught up to the increae in the money supply, and during the 3rd stage of the inflation, greatly surpassed the increase in supply of money. The German printintg presses could not keep up with the increased level of prices even at full operating capacity.
What happened then? The expectation of higher prices by the people caused them to spend their money much more quickly. They feared that money would be less tomorrow, so it was better to spend it today to buy bread and goods. As everyone did this, the exceleration in use of money caused the sellers to increase their prices very quickly as they could not keep up with demand.
As Henry Hazlitt explains,
In the late stages of the German inflation of 1923, for example, the entire stock of paper money, though with a stamped value billions of times higher, had a gold-exchange value of 1/9th of what it had before the inflation started. Of course the paper mark had become utterly valueless, as had the French assignats in 1796 and the American Continental currency in 1781.
Prices rose faster than the supply of money because of the subjective view of the people of the relative worth of the current bills. The hyperinflation that occured after the currency supply had been greatly increased. And in fact, the hyperinflation stage happened so quickly as to show very little relation to any subsequent increases in money supply; it is as if the people decided that the money had less worth and therefore it would not have mattered what the central bankers had done to the supply of money at that point.
Thus, the quantity theory of money is not accurate because the expected future value of money matters more than the existing quantity of it.