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This chapter discusses the classical, Keynesian and monetarist theories regarding the
role of money in economic activity. In the classical theory, the role of money has
been relegated to the background. It is argued that monetary forces do not affect the
movements of the real variables that is, output and employment in the economy. In
the Keynesian theory it is suggested that a change in the money supply may change the
level of output via changes in interest rates. The monetarist school, headed by Milton
Friedman, contends that the classical rather than the Keynesian theory would be valid
so long as money can affect real variables in the short run, but only nominal magnitudes
in the long run. We shall first discuss the classical theory.
63
Real
wage
W
SL
E
(W/P)0
(W/P)1 D
C
DL
N
Employment
Eventually, full employment will be restored at a point like E in Figure 5.1. It can be
checked very easily from figure 5.1, where W/P is measured vertically, and employment
N is measured horizontally, that in case of an excess demand for labour (for example,
CD), the situation of over-full employment will be rectified again because the economy
will eventually move towards E, the point of full employment equilibrium, where the
demand for labour is exactly equal to the supply of labour, and resources are fully
utilized.
We can use the same analysis to explain how a disequilibrium situation will be
corrected in a goods market. If there is an excess demand for goods, prices will rise. This
will lead to a rise in supply (assuming a normal supply curve that slopes upwards) and a
fall in demand (assuming a downward-sloping demand curve). Eventually the economy
will reach equilibrium. Similarly, given an excess supply of goods, prices will fall, demand
will rise and supply will fall. The invisible hand has once again played the trick of
adjusting supply to demand. All the markets are now being cleared with flexible wages
and prices, and full employment prevails. Unemployment is, then, a phenomenon of
dynamic disequilibrium. Notice that money does not play any role in the determination
of employment and output.
of the output, this does not mean that total expenditure in the economy will be equal
to total production. In other words, supply may create its own income but it may not
be able to create enough expenditure. Such a shortfall in expenditure could occur when
people save a part of their income. A deficiency in demand could result, which might
lead to the accumulation of inventories and a fall in production. This could result in
unemployment. The crack in the classical wall can now be seen clearly. This idea
of under-consumption and its implications have been given considerable attention in
Keynesian economics, which will be discussed later.
S = Sr (5.1)
I = Ir (5.2)
S=I (5.3)
S
r
I
S1
G F
r1
Rate of interest
r0 E
r2
I
S1
S0 = I0 S, I
Savings and investment
MV = PQ (5.4)
Equation (5.4) is basically an identity, which simply states that when the money stock
is multiplied by V or the number of times money is used to buy final output, we obtain
total expenditure, which must be equal to the product of P and Q or the value of
output bought. In the original writing, T (that is, total transactions) and not Q was used.
Here Q has replaced T because there are some transactions that are not included in the
estimation of GNP.
Assume now that V is relatively fixed, because payments patterns and habits can be
regarded as relatively constant. Q also is fixed. We then obtain a direct relationship
between M and P, since
PQ
M= (5.5)
V
or
MV
P= (5.6)
Q
If the money supply is doubled, the price level will be doubled; equally, if M is halved,
P will also be halved. Nothing else in the world changes. Money is just a veil, its sole
purpose being to determine the general price level at which transactions of goods will
take place. Money burns holes in the pockets of individuals. The classical economists
assume that individuals are rational and wish to maximize utility. Money, per se, fails
to maximize utility. It is only as a medium of exchange that money enables people to
acquire goods and services. Therefore, a rational individual should not demand money
for its own sake. That is why the idea of a demand for money has been neglected in
classical quantity theory. However, the Cambridge economists viewed the matter rather
differently.
5.1.4 The Cambridge demand for money: the cash balance approach
According to the Cambridge school, it is necessary to pay attention to the fraction of
income that could be held in cash. But Equation (5.4) can now be written as a behavioural
equation, given a stable velocity and fixed Q (see later):
M = kPQ (5.7)
1
k= (5.8)
V
and formulated in this way, the difference between Equations (5.4) and (5.7) is insig-
nificant. Nevertheless, Equation (5.8) can now be regarded as the one that shows the
demand for money that enables people to carry out transactions.
It is necessary to point out here that Equation (5.4) is an identity that can be trans-
formed into a causal mechanism. A direct relationship can be established between M and
P if Q is fixed and V remains stable, since the demand for money is dictated by habits that
are unlikely to change much. It naturally follows that M and P will be directly related. If
M rises for some reason (let us say, by the actions taken by the central bank), people will
accumulate excess cash balances; this will lead to more spending and can only result in
a rise in prices, as output (or Q) cannot be raised beyond the level of full employment.
Analytically, the effect of changes of money supply on prices will be identical, no matter
whether one follows the basic equation of Fisher or the Cambridge demand-for-money
theory. According to the Cambridge theory, in the equilibrium situation the demand for
money must be equal to the supply of money. If M rises there would be more money
than people would wish to hold. In other words, ceteris paribus, the demand for money
will be less than the money supply. This will raise the level of expenditure and prices, as
output cannot change. Additional expenditure will come to an end when people wish
to hold rather than spend money that is, when the demand for money is equal to the
supply of money. Notice that, while money income changes, real income remains the
same. The Cambridge version of quantity theory thus underlines the real (M/P) rather
than nominal money holdings of the people.
If classical quantity theory is viewed as a long-run analysis, it is not difficult to under-
stand the assumptions regarding fixed Q and a stable V . But Keynes was not convinced
by the classical analysis. In any case, it might be quite interesting to look at the short-run
behaviour of the economy because in the long-run we are all dead.
for money is equal to the supply of money and the equilibrium between saving S and
investment I determines the level of income Y. Hence output will continue to fall
as long as planned saving exceeds planned investment. Eventually the equilibrium is
restored where S = I. In the Keynesian analysis, the theory of the consumption function
plays an important role. Keynes contended that, at the macro level, expenditure E
determines income Y. Total expenditure is the sum of consumption expenditure C
and investment expenditure I, that is
Y = C+1 (5.9)
C = a + bY (5.10)
Y = C+I (5.11)
Y = C + I (5.12)
Dividing by Y:
1
Y = I (5.16)
1b
Equation (5.15) defines the multiplier m, which is the inverse of the marginal
propensity to save. Clearly, the value of m will be positively related to the value of b or
MPC, and inversely to the MPS. It is now easy to see why savings constitute a leakage
in the stream of income generation. The whole process is summarized in Figures 5.3(a)
and (b).
In Figure 5.3(a) the equilibrium between S and I now determines the level of Y, rather
than the interest rate. Saving in the Keynesian theory is assumed to vary directly with
income. That is why we have SY. Investment (or I) is assumed to be autonomous. In
Figure 5.3(b) it has been shown that total expenditure or E= C + I determines Y0 .
Unlike in classical theory, there is no reason to assume within the Keynesian analysis
that equilibrium Y will also be a full employment level of income. The investment
function could be unstable as it depends on investors expectations regarding future
demand (or planned savings). If investment prospects are gloomy, then I may fall and
this will reduce equilibrium Y to a less than full employment level. This is shown in the
movement of II to I1 I1 and a fall in income from Y0 to Y1 in Figures 5.3(a) and (b). To
restore full employment, it might be necessary to stimulate expenditure by using fiscal
policies for example, an increase in government expenditure G or a cut in taxes, or
both, to stimulate demand. These are usually regarded as the Keynesian remedies to
cure recession or depression.
The above analysis, which has been labelled Keynes without money, suggests that
money does not play any role in determining output and employment. This is not
quite so in the full Keynesian model of a situation of unemployment. According to
(a)
S, I S (Y)
I I
I1 I1
0
Y1 Y0
(b)
C+I=E
C + I1
I I
45
0 Y1 Y0 Y
SCD
Price line
P2
P1
Q2
Q1
0 M1 M2 Mf M3 M4
Money supply
Keynes, an increase in money supply would increase the cash balances held by economic
agents. People would then be confronted with the following three choices: (i) to keep
money idle; (ii) to buy plant and machinery; or (iii) to buy bonds. The first alternative is
unacceptable, given the principle of utility maximization, and most people are not likely
to follow the second option. They are, according to Keynes, most likely to buy bonds
with excess cash balances. This will raise the bond prices and drive down the interest
rate. A fall in the interest rate will stimulate the level of investment and an increase
in investment will raise the level of income via the workings of the multiplier. Thus
an increase in money supply could increase the level of output, particularly at a less
than full-employment level, without affecting prices. There could be secondary effects
on prices but these are more likely to be important when the economy moves closer to
the zone of full employment. Any increase in money supply beyond the level of full
employment will raise the price level in the classical fashion. This is shown in Figure 5.4.
Output Q is measured on the vertical axis and money supply M is measured on the
horizontal axis. Full employment output is given by Mf Qf on an output growth curve
0Q and Mf Qf is consistent with a full employment money supply of 0Mf . Before Mf
any increase in money supply, for example, 0M1 to 0M2 raises production from M1 Q1 to
M2 Q2 . Beyond full employment, a rise in money supply from 0M3 to 0M4 simply bids up
the prices to P1 and P2 as has been indicated by the price line.
The interest rate is, however, determined in the money market, and this will be
discussed next.
run, and as such Ms is invariant to changes in r. This is shown by S1 S1 in Figure 5.5. The
demand for money (or Md ) consists of three parts: (a) transaction demand for money;
that is, M1 ; (b) precautionary demand for money, that is, Mp ; and (c) speculative demand
for money, that is, Msp . Thus we have
Md = Mt + Mp + Msp (5.17)
The demand for money for day-to-day transaction purposes usually depends on
the level of income, or Y. The precautionary demand for money also depends on Y,
and it stems from the necessity to hold cash balances for rainy days. The specu-
lative demand for money is the real Keynesian invention. If money could be regarded
as a financial asset in the portfolio, then such an asset could be held in the port-
folio along with other assets. Keynes lumped these other assets together and called
them bonds. People may wish to hold bonds rather than liquid money because
interest is paid to the bondholders. Bond prices could change, and thus bond-holding
involves some risks. Also, different rates of interest are paid on different bonds. The
average of such interest rates may be regarded as the interest on bonds. Keynes
argued that the demand for money or liquidity preference is an inverse function of r
(see Figure 5.5).
Let r be measured on the vertical axis and Md and Ms be measured on the horizontal
axis, as shown in Figure (5.6). It is shown by the line KN that Mt + Mp remain completely
inelastic with respect to changes in r. Msp is inversely related to changes in r. The reason
r S1
Rate of interest
r0
Msp
0 Mt + Mp S1 Md, Ms
Demand and supply of money
Figure 5.5 Money demand and supply in the Keynesian framework (1)
r N Ms Ms1 Ms2
r2
Rate of interest
r0 Msp1
r1
Msp
Figure 5.6 Money demand and supply in the Keynesian framework (2)
is simple. When r is low, people expect it to rise in the near future. Since the bond price
and r are inversely related, people would like to avoid the capital loss that accompanies
a rise in r. Hence, they would wish to hold more money. The reverse happens when r is
high. People part company with their liquid money and hold bonds, as they speculate
that r will fall and bond prices will rise. Hence, r can be regarded as a price paid for
parting with liquidity. In terms of the portfolio analysis of Tobin (1958), we can say
that, since people are not risk-lovers, therefore a higher r must be paid to seduce them
into holding a greater proportion of bonds in their wealth portfolios. The equilibrium
r is determined at r0 where Md = Ms . The interest rate could change with a change in Md
or Ms , or both. Thus, if the money supply increases from Md to Ms1 r falls from r0 to r1 .
Notice that if Ms increases further (with no change in Md , of course) r does not fall any
further. This is precisely what happens when the money supply rises from Ms1 to Ms2 as
the economy is caught in the liquidity trap. As r ceases to fall, there would not be any
effect on investment and income. The Keynesian liquidity trap, then, clearly shows the
limitation of monetary policy in curing recessions. The liquidity trap could operate at a
very low r when the demand for money is infinitely elastic, since everyone expects a rise
in r and a consequent fall in bond prices. Therefore, no one wants to hold bonds. It also
follows that the efficacy of monetary policy would decline when the demand for money
was more elastic. It is also implied that if the investment function is interest-elastic, there
would be a stronger impact on output or income. Obviously, the strength of monetary
policy will diminish considerably if the investment function is interest-inelastic. In
Figure 5.6, it has also been shown that if the Msp rises, the liquidity preference schedule
shifts to the right Msp Msp1 . Assuming that Ms is the supply of money, r rises to a new
equilibrium, r2 .
Md = fr Y (5.19)
Md = kY + fr (5.20)
Also, r can be determined by demand for and supply of loanable funds. The demand for
loanable funds is given by investment and the supply of loanable fund is given mainly
by savings plus dis-hoardings. Following Hicks, we can then write:
Md = fr Y (5.21)
S = Sr Y (5.22)
I = Ir Y (5.23)
Hicks argued that it is important to look at the basic relationships between r and Y via
changes in savings and the demand for money. If Y rises, S will rise and, following the
classical theory, r will fall. This is shown in Figure 5.7. When Y rises from Y0 to Y1 S
rises from S0 to S1 and the S curve shifts to the right. The interest rate r falls from r0 to r1 .
If Y rises further, say from Y1 to Y2 S also rises further, that is from S1 to S2 , as shown in
the further shift of the S curve to the right. The equilibrium r thus falls to r2 . If we then
join all the points of equilibrium between S and I, we obtain an IS curve which depicts
an inverse relationship between r and Y. It is clear that every point on the IS curve is a
point of equilibrium between I and S. This is shown in Figure 5.7.
In the money market, following Keynes, let us assume that the equilibrium interest
rate, r0 , is determined where Md = Ms , as shown in Figure 5.8. Let us think that this Md
is given by income Y0 (say, 100 billion rupees). If Y rises from Y0 to Y1 Md0 also rises,
and this is shown by the shift of the Md curve from Md0 to Md1 . The equilibrium r now
rises from r0 (say, 4 per cent) to r1 (say 5 per cent). If Y rises further, to Y2 (Y2 = 300
billion rupees), Md1 shifts upwards to Md2 and equilibrium r rises from r1 to r2 (that is,
say, from 5 per cent to 6 per cent). If we now join all the points of equilibrium between
Md and Ms with a rise in income, we trace out an upward-sloping curve, which has been
called LM. Once again, the LM curve depicts the relationship between r and Y when the
money market is in equilibrium (that is, Md = Ms ). If we now combine the two curves
r S0Y0
S1Y1
r0
r1
r2
S, I
Savings and investment
Figure 5.7 Savings, investment and the interest rate (Hicksian framework)
Ms
r
r2(6%)
Rate of interest
0
Ms Md, Ms
Money demand and supply
Figure 5.8 Money demand, supply and the interest rate (numerical example)
together, as in Figure 5.9, we obtain the equilibrium rate of interest, r (say, 5 per cent).
It can be checked easily that the equilibrium r is stable.
In simple terms, a general equilibrium theory of interest rate determination should
include the following factors:
r l
M
6%
Rate of interest
r (5%) E
4%
L
S
0
Y0(100 bn) Y1(100 bn) Y2(100 bn)
Y(Rs)
Output
savings;
investment demand;
the liquidity preference; and
the quantity of money.
l1
r
M
l
Rate of interest l2 M1
r 1 S2
S
L1 S1
Y0 Y2 Y1 Y3 Y
Income
l1
r
l M1
M
Rate of interest
r1
r0
S1
L
L1 S
Y0 Y2 Y1 Y
Income
money supply. Such a large rise in r would reduce significantly the level of private invest-
ment, which would lead to a small increase in Y. This impact is now called the crowding
out effect. When the LM schedule is completely inelastic, fiscal policy has no effect on Y.
The shift of the IS curve to the right on a vertical LM curve simply raises the r.
has its roots in the ancient quantity theory but is broader than its predecessor. Stated
in a very simple way, the modern quantity theory states that a change in money supply
will change the price level as long as the demand for money is stable; such a change
also effects the real value of national income and economic activity, but in the short run
only. For Friedman, the stability in the demand for money is just a behavioural fact,
proven by empirical evidence. As long as the demand for money is stable it is possible
to predict the effects of changes of money supply on total expenditure and income. The
monetarists argue that, if the economy operates at a less than full-employment level,
then an increase in money supply will lead to a rise in output and employment because
of a rise in expenditure, but only in the short run. After a time, the economy will return
to a less than full-employment situation which must be caused by other, real factors.
The monetarists believe that changes in money supply cannot affect the real variables
in the long run. At near full-employment point or beyond it, an increase in money
supply will raise prices. Before full employment, Y rises with a rise in money supply and
expenditure. The rise in Y will, then, crucially depend on the ratio of income to money
supply; that is, Y/M, or velocity. With an increase in spending during a recession, Y
will continue to rise until it has reached a limit where it stands in its previous ratio to
M, because at that point output can no longer be increased. People will now raise their
demand for money rather than spend it, and the supply of and demand for money would
once again be equal to one another. These arguments are illustrated in Figure 5.12. Let
us assume that Y is measured vertically, and demand for Md and supply of money Ms
Ms Ms1 Md = kY
Y
Y2
Y0
Y1
Md = Ms Ms1 Md , Ms
Demand for / supply of money
are measured horizontally. Assume that money supply is fixed (and therefore that the
Ms line is completely inelastic with respect to changes in Y). The Md varies with income,
but this relationship is proportional since Md = kY (people always hold a given fraction,
k, of their income). The monetarists thus emphasize the transactions demand for money.
The equilibrium Y is given by Y0 where Md = Ms . If Md < Ms as at Y1 , total expenditure
rises and Y rises from Y1 to Y0 .
If M rises, the Ms curve shifts to the right to Ms1 and Y rises to Y2 because Ms > Md
and spending rises until Ms = Md at a higher level of income (that is, Y2 ). In contra-
distinction to the Keynesian analysis, note that nothing is known about changes in r
when Ms changes. It is also assumed that the demand for money remains stable; in other
words, 1/k is fixed. Given the stability in the velocity, the central bank can control the
volume of spending by controlling the money supply. The stabilization policy should
then concentrate only on monetary policy; that is, controlling the volume of the money
supply.
The central issue that one faces in the above analysis is whether the demand for money
is stable or not. It is, however, possible to be a Keynesian and still accept that there is
stability in the demand for money. The recent debate between the monetarists and the
Keynesians centres round the question of changing aggregate demand by monetary or
fiscal policies. The so-called Keynesians point out that only fiscal policies can change
the level of income by changing aggregate demand, whereas the monetarists argue that
aggregate demand can be changed only by monetary policies. It is not certain whether
Keynes himself in fact held such views. Nevertheless, it seems that the monetarists case
rests on the working of a vertical or near-vertical LM curve. This implies that the demand
for money is very inelastic to changes in the interest rate. Similarly, the Keynesian case
rests on the working of a vertical or near-vertical IS schedule with a normal LM curve.
This implies a very low elasticity of the investment function with respect to changes in
the interest rate. We now turn to the empirical evidence, which will largely determine
the validity of one theory or the other.