Keynes and the Quantity Theory of Money
In the classical model a monetary impulse has no real effects on the economy.
Money is neutral. Since the quantity of real output is predetermined by the
combined impact of a competitive labour market and Say’s Law, any change
in the quantity of money can only affect the general price level. By rejecting
both Say’s Law and the classical model of the labour market, Keynes’s theory
no longer assumes that real output is predetermined at its full employment
level. In Chapter 21 of the General Theory, Keynes discusses the various
possibilities. If the aggregate supply curve is perfectly elastic, then a change
in effective demand brought about by an increase in the quantity of money
will cause output and employment to increase with no effect on the price
level until full employment is reached. However, in the normal course of
events, an increase in effective demand will ‘spend itself partly in increasing
the quantity of employment and partly in raising the level of prices’ (Keynes,
1936, p. 296). In other words, the supply response of the economy in Keynes’s
model can be represented by an aggregate supply function such as W0AS in
Figure 2.6, panel (b). Therefore for monetary expansions carried out when Y
< YF, both output and the price level will rise. Once the aggregate volume of
output corresponding to full employment is established, Keynes accepted that
‘the classical theory comes into its own again’ and monetary expansions will
produce ‘true inflation’ (Keynes, 1936, pp. 378, 303). A further complication
in Keynes’s model is that the linkage between a change in the quantity of
money and a change in effective demand is indirect, coming as it does via its
influence on interest rates, investment and the size of the multiplier. We
should also note that, once Keynes had introduced the theory of liquidity
preference, the possibility that the demand for money function might shift
about unpredictably, causing velocity to vary, implies that changes in M may
be offset by changes in V in the opposite direction. With Y and V no longer
assumed constant in the equation MV = PY, it is clear that changes in the
quantity of money may cause V, P or Y to vary. The neutrality of money is no
longer guaranteed.
In the classical model a monetary impulse has no real effects on the economy.
Money is neutral. Since the quantity of real output is predetermined by the
combined impact of a competitive labour market and Say’s Law, any change
in the quantity of money can only affect the general price level. By rejecting
both Say’s Law and the classical model of the labour market, Keynes’s theory
no longer assumes that real output is predetermined at its full employment
level. In Chapter 21 of the General Theory, Keynes discusses the various
possibilities. If the aggregate supply curve is perfectly elastic, then a change
in effective demand brought about by an increase in the quantity of money
will cause output and employment to increase with no effect on the price
level until full employment is reached. However, in the normal course of
events, an increase in effective demand will ‘spend itself partly in increasing
the quantity of employment and partly in raising the level of prices’ (Keynes,
1936, p. 296). In other words, the supply response of the economy in Keynes’s
model can be represented by an aggregate supply function such as W0AS in
Figure 2.6, panel (b). Therefore for monetary expansions carried out when Y
< YF, both output and the price level will rise. Once the aggregate volume of
output corresponding to full employment is established, Keynes accepted that
‘the classical theory comes into its own again’ and monetary expansions will
produce ‘true inflation’ (Keynes, 1936, pp. 378, 303). A further complication
in Keynes’s model is that the linkage between a change in the quantity of
money and a change in effective demand is indirect, coming as it does via its
influence on interest rates, investment and the size of the multiplier. We
should also note that, once Keynes had introduced the theory of liquidity
preference, the possibility that the demand for money function might shift
about unpredictably, causing velocity to vary, implies that changes in M may
be offset by changes in V in the opposite direction. With Y and V no longer
assumed constant in the equation MV = PY, it is clear that changes in the
quantity of money may cause V, P or Y to vary. The neutrality of money is no
longer guaranteed.
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