QUANTITY THEORY OF

MONEY
MONEY AND BANKING

ANUM KAZI
ID# 9260
QUANTITY THEORY OF MONEY

The concept of the Quantity Theory of Money (QTM) began in the 16 th century. As gold and silver inflows from the
Americas into Europe were being minted into coins, there was a resulting rise in inflation. This led economist Henry
Thornton in 1802 to assume that more money equals more inflation and that an increase in money supply does not
necessarily mean an increase in economic output. Here we look at the assumptions and calculations underlying the
QTM, as well as its relationship to monetarism and ways the theory has been challenged. 

QTM IN A NUTSHELL
The Quantity Theory of Money states that there is a direct relationship between the quantity of money
in an economy and the level of prices of goods and services sold. According to QTM, if the amount of
money in an economy doubles, price levels also double, causing inflation (the percentage rate at which
the level of prices is rising in an economy). The consumer therefore pays twice as much for the same
amount of the good or service. 

Another way to understand this theory is to recognize that money is like any other commodity:
increases in its supply decrease marginal value (the buying capacity of one unit of currency). So an
increase in money supply causes prices to rise (inflation) as they compensate for the decrease in
money’s marginal value. 
 The Theory’s Calculations
In its simplest form, the theory is expressed as:
 
MV = PT (the Fisher Equation)

Each variable denotes the following:

M = Money Supply
V = Velocity of Circulation (the number of times money changes hands)
P = Average Price Level
T = Volume of Transactions of Goods and Services  

The original theory was considered orthodox among 17 th century classical economists and was overhauled by 20 th-
century economists Irving Fisher, who formulated the above equation, and Milton Friedman.

It is built on the principle of "equation of exchange": 

Amount of Money x Velocity of Circulation = Total Spending

Thus if an economy has US$3, and those $3 were spent five times in a month, total spending for the month would
be $15.    

QTM Assumptions
QTM adds assumptions to the logic of the equation of exchange. In its most basic form, the theory assumes that V
(velocity of circulation) and T (volume of transactions) are constant in the short term. These assumptions,
however, have been criticized, particularly the assumption that V is constant. The arguments point out that the
velocity of circulation depends on consumer and business spending impulses, which cannot be constant.  

The theory also assumes that the quantity of money, which is determined by outside forces, is the main influence
of economic activity in a society. A change in money supply results in changes in price levels and/or a change in
supply of goods and services. It is primarily these changes in money stock that cause a change in spending. And the
velocity of circulation depends not on the amount of money available or on the current price level but on changes
in price levels.  

Finally, the number of transactions (T) is determined by labor, capital, natural resources (i.e. the factors of
production), knowledge and organization. The theory assumes an economy in equilibrium and at full
employment.  

Essentially, the theory’s assumptions imply that the value of money is determined by the amount of money
available in an economy. An increase in money supply results in a decrease in the value of money because an
increase in money supply causes a rise in inflation. As inflation rises, the purchasing power, or the value of money,
decreases. It therefore will cost more to buy the same quantity of goods or services.  

Money Supply, Inflation and Monetarism

As QTM says that quantity of money determines the value of money, it forms the cornerstone of monetarism.   

Monetarists say that a rapid increase in money supply leads to a rapid increase in inflation. Money growth that
surpasses the growth of economic output results in inflation as there is too much money behind too little
production of goods and services. In order to curb inflation, money growth must fall below growth in economic
output.  

This premise leads to how monetary policy is administered. Monetarists believe that money supply should be kept
within an acceptable bandwidth so that levels of inflation can be controlled. Thus, for the near term, most
monetarists agree that an increase in money supply can offer a quick-fix boost to a staggering economy in need of
increased production. In the long term, however, the effects of monetary policy are still blurry. 

Less orthodox monetarists, on the other hand, hold that an expanded money supply will not have any effect on
real economic activity (production, employment levels, spending and so forth). But for most monetarists any anti-
inflationary policy will stem from the basic concept that there should be a gradual reduction in the money supply.
Monetarists believe that instead of governments continually adjusting economic policies (i.e. government spending
and taxes), it is better to let non-inflationary policies (i.e. gradual reduction of money supply) lead an economy to
full employment.  

QTM Re-Experienced
John Maynard Keynes challenged the theory in the 1930s, saying that increases in money supply lead to a decrease
in the velocity of circulation and that real income, the flow of money to the factors of production, increased.
Therefore, velocity could change in response to changes in money supply. It was conceded by many economists
after him that Keynes’ idea was accurate.  

QTM, as it is rooted in monetarism, was very popular in the 1980s among some major economies such as the
United States and Great Britain under Ronald Reagan and Margaret Thatcher respectively. At the time, leaders
tried to apply the principles of the theory to economies where money growth targets were set. However, as time
went on, many accepted that strict adherence to a controlled money supply was not necessarily the cure-all for
economic malaise.
MARX’S THEORY OF MONEY

In the same way as his theory of rent, Marx’s theory of money is a straightforward application of the labour
theory of value. As value is but the embodiment of socially necessary labour, commodities exchange with each
other in proportion to the labour quanta they contain. This is true for the exchange of iron against wheat, as it is
true for the exchange of iron against gold or silver.

Marx’s theory of money is therefore in the first place a commodity theory of money. A given commodity can
play the role of universal medium of exchange, as well as fulfil all the other functions of money, precisely
because it is a commodity, i.e. because it is itself the product of socially necessary labour. This applies to the
precious metals in the same way it applies to all the various commodities which, throughout history, have
played the role of money.
It follows that strong upheavals in the ’intrinsic’ value of the money-commodity will cause strong upheavals in
the general price level. In Marx’s theory of money, (market) prices are nothing but the expression of the value
of commodities in the value of the money commodity chosen as a monetary standard. If £1 sterling = 1/10
ounce of gold, the formula ’the price of 10 quarters of wheat is f 1’ means that 10 quarters of wheat have been
produced in the same socially necessary labour times as 1/10 ounce of gold. A strong decrease in the average
productivity of labour in gold mining (as a result for example of a depletion of the richer gold veins) will lead to
a general depression of the average price level, all other things remaining equal. Likewise, a sudden and radical
increase in the average productivity of labour in gold mining, through the discovery of new rich gold fields
(California after 1848; the Rand in South Africa in the 1890s) or through the application of new revolutionary
technology, will lead to a general increase in the price level of all other commodities.
Leaving aside short-term oscillations, the general price level will move in medium and long-term periods
according to the relation between the fluctuations of the productivity of labour in agriculture and industry on
the one hand, and the fluctuations of the productivity of labour in gold mining (if gold is the money-
commodity), on the other.
Basing himself on that commodity theory of money, Marx therefore criticized as inconsistent Ricardo’s quantity
theory. But for exactly the same reason of a consistent application of the labour theory of value, the quantity of
money in circulation enters Marx’s economic analysis when he deals with the phenomenon of paper money.
As gold has an intrinsic value, like all other commodities, there can be no ’gold inflation ’, as little as there can
be a ’steel inflation’. An abstraction made of short-term price fluctuations caused by fluctuations between
supply and demand, a persistent decline of the value of gold (exactly as for all other commodities) can only be
the result of a persistent increase in the average productivity of labour in gold mining and not of an ’excess’ of
circulation in gold. If the demand for gold falls consistently, this can only indirectly trigger a decline in the value
of gold through causing the closure of the least productive old mines. But in the case of the money-commodity,
such overproduction can hardly occur, given the special function of gold of serving as a universal reserve fund,
nationally and internationally. It will always therefore find a buyer, be it not, of course, always at the same
’prices’ (in Marx’s economic theory, the concept of the ’price of gold’ is meaningless. As the price of a
commodity is precisely its expression in the value of gold, the ’price of gold’ would be the expression of the
value of gold in the value of gold).
Paper money, banks notes, are a money sign representing a given quantity of the money-commodity. Starting
from the above-mentioned example, a banknote of £1 represents 1/10 ounce of gold. This is an objective ’fact
of life’, which no government or monetary authority can arbitrarily alter. It follows that any emission of paper
money in excess of that given proportion will automatically lead to an increase in the general price level, always
other things remaining equal. If £1 suddenly represents only 1/20 ounce of gold, because paper money
circulation has doubled without a significant increase in the total labour time spent in the economy, then the
price level will tend to double too. The value of 1/10 ounce of gold remains equal to the value of 10 quarters of
wheat. But as 1/10 ounce of gold is now represented by £2 in paper banknotes instead of being represented by
£1, the price of wheat will move from £1 to £2 for 10 quarters (from two shillings to four shillings a quarter
before the introduction of the decimal system).
This does not mean that in the case of paper money, Marx himself has become an advocate of a quantity theory
of money. While there are obvious analogies between his theory of paper money and the quantity theory, the
main difference is the rejection by Marx of any mechanical automatism between the quantity of paper money
emitted on the one hand, and the general dynamic of the economy (including on the price level) on the other.
In Marx’s explanation of the movement of the capitalist economy in its totality, the formula ceteris paribus is
meaningless. Excessive (or insufficient) emission of paper money never occurs in a vacuum. It always occurs at a
given stage of the business cycle, and in a given phase of the longer-term historical evolution of capitalism. It is
thereby always combined with given ups and downs of the rate of profit, of productivity of labour, of output, of
market conditions (overproduction or insufficient production). Only in connection with these other fluctuations
can the effect of paper money ’inflation’ or ’deflation’ be judged, including the effect on the general price level.
The key variables are in the field of production. The key synthetic resultant is in the field of profit. Price
moments are generally epiphenomena as much as they are signals. To untwine the tangle, more is necessary
than a simple analysis of the fluctuations of the quantity of money.
Only in the case of extreme runaway inflation of paper money would this be otherwise; and even in that border
case, relative price movements (different degrees of price increases for different commodities) would still
confirm that, in the last analysis, the law of values rules, and not the arbitrary decision of the Central Banks or
any other authority controlling or emitting paper money.
MONETARISM AND QUANTITY THEORY OF MONEY

The basics of monetarism

The key features of monetarist theory are as follows:

o The main cause of inflation is an excess supply of money leading to in the words of Monetarist Economist
Milton Friedman, “too much money chasing too few goods”. We will see graphically how this can lead to
a build up of inflationary pressure in an economy.
o Tight control of money and credit is required to maintain price stability
o Attempts by the government to use fiscal and monetary policy to “fine-tune” the rate of growth of
aggregate demand are often costly and ineffective. Fiscal policy has a role to play in stabilising the
economy providing that the government is successfully able to control its own borrowing.
o The key is for monetary policy to be credible – perhaps in the hands of an independent central bank – so
that people’s expectations of inflation are controlled.

A simple way of explaining how a surge in the amount of money in circulation can feed through to higher inflation
is shown in the next flow chart.

Excess money balances held by households and businesses can affect demand and output in several directions.
Consumers will often increase their own demand for goods and services adding directly to aggregate demand
(although a high proportion of this extra spending may go on imports).

Secondly some of the excess balances will be saved in bonds and other financial assets, or invested in the housing
market. An increase in the demand for bonds causes a downward movement in bond interest rates (there is an
inverse relationship between the two) and this can then stimulate an increase in investment.

Similarly money that flows into housing will push house prices higher, and we know understand quite well how a
booming housing market stimulates consumer wealth, borrowing and an increase in spending.
The Quantity Theory of Money

The Quantity Theory was first developed by Irving Fisher in the inter-war years as is a basic theoretical explanation
for the link between money and the general price level. The quantity theory rests on what is sometimes known as
the Fisher identity or the equation of exchange.  This is an identity which relates total aggregate demand to the
total value of output (GDP).

MxV=PxY
Where

1. M is the money supply

2. V is the velocity of circulation of money
3. P is the general price level
4. Y is the real value of national output (i.e. real GDP)

The velocity of circulation represents the number of times that a unit of currency (for example a £10 note) is used
in a given period of time when used as a medium of exchange to buy goods and services. The velocity of circulation
can be calculated by dividing the money value of national output by the money supply.
In the basic theory of monetarism expressed using the equation of exchange, we assume that the velocity of
circulation of money is predictable and therefore treated as a constant. We also make a working assumption that
the real value of GDP is not influenced by monetary variables. For example the growth of a country’s productive
capacity might be determined by the rate of productivity growth or an increase in the capital stock. We might
therefore treat Y (real GDP) as a constant too.

If V and Y are treated as constants, then changes in the rate of growth of the money supply will equate to changes
in the general price level. Monetarists believe that the direction of causation is from money to prices (as we saw in
the flow chart on the previous page).

The experience of targeting the growth of the money supply as part of the monetarist experiment during the 1980s
and early 1990s is that the velocity of circulation is not predictable – indeed it can suddenly change, partly as a
result of changes to people’s behaviour in their handling of money. During the 1980s it was found that direct and
predictable links between the growth of the money supply and the rate of inflation broke down. This eventually
caused central banks in different countries to place less importance on the money supply as a target of monetary
policy. Instead they switched to having exchange rate targets, and latterly they have become devotees of inflation
targets as an anchor for the direction of monetary policy.

Measuring the money supply

There is no unique measure of the money

supply because it is used in such a wide variety
of ways:
 
M0 (Narrow money) - comprises notes and
coins in circulation banks' operational balances
at the Bank of England. Over 99% of M0 is made
up of notes and coins as cash is used mainly as a
medium of exchange for buying goods and
services. Most economists believe that changes
in the amount of cash in circulation have little
significant effect on total national output and
inflation. At best M0 is seen as a co-incident indicator of consumer spending and retail sales. If people increase
their cash balances, it is mainly a sign that they are building up these balances to fund short term increases in
spending. M0 reflects changes in the economic cycle, but does not cause them.

M4 (Broad money) is a wider definition of what constitutes money. M4 includes deposits saved with banks and
building societies and also money created by lending in the form of loans and overdrafts.

M4 = M0 plus sight (current accounts) and time deposits (savings accounts).

When a bank or another lender grants a loan to a customer, bank liabilities and assets raise by the same amount
and so does the money supply. Again M4 is a useful background indicator to the strength of demand for credit. The
Bank takes M4 growth into account when assessing overall monetary conditions, but it is not used as an
intermediate target of monetary policy. Its main value is as a signpost of the strength of demand which can then
filter through the economy and eventually affect inflationary pressure.
NEO CLASSICAL THEORY

Economic Theory

As economies have developed over time, so economic theory has developed as well to try to explain changing
circumstances. In the 19th century and the beginning of the 20th century Classical theory held the balance of power
in economic circles, but it began to lose it at the
time of the Great Depression of the 1930s.
Classical theory had difficulty in explaining why the depression kept getting worse, and an economist called John
Maynard Keynes began to develop alternative ideas.

This marked the birth of Keynesian economics and most post-war governments managed the economy
using Keynesian policies up until the beginning of the 1970s. Then Keynesian theory ran into trouble as
unemployment and inflation began to rise together - a phenomenon known as
stagflation. At this point another economist stepped in - Milton Friedman. He was known as a Monetarist, and
along with a number of other Monetarist economists at Chicago University did a lot of
work trying to explain what caused inflation.

However, the Conservative government of the 1980s gradually became disillusioned with Monetarism and then
returned to a modern variation of classical economic management - Neo-Classical economics. Like Classical
economics, it stresses the role of free markets in delivering the best possible level of economic growth.

(Neo-)Classical Theory - Introduction

The term 'Classical' refers to work done by a group of economists in the 18th and 19 th centuries. Much of this work
was developing theories about the way markets and market
economies work. Much of this work has subsequently been updated by modern
economists and they are generally termed neo-classical economists, the word neo
meaning 'new'.

(Neo-)Classical Theory - Beliefs

Classical economists were not renowned for being a happy, optimistic bunch of economists
(in terms of their economic thinking!). Some believed that population growth would be too
rapid for the resources available (Malthus was a particular exponent of this view). If
this wasn't enough to depress the rate of long-term growth (and the rest of the
population along with it!) then diminishing returns
would cause further problems for growth.

They believed that the government should not intervene to try to correct this as it would
only make things worse and so the only way to encourage growth was to allow free trade and
free markets. This approach is known as a 'laissez-faire' approach.
Essentially this approach places total reliance on markets, and anything that
prevent markets clearing properly should be done away with.

Much of Adam Smith's early work was on this theme, and he introduced the notion of an
invisible hand that guided economic activity and led to the optimum equilibrium. Many people see him as the
founding father of modern economics.
The Victorian period of rapid expansion worldwide seemed to cheer the Classical
economists up a little and they became a bit more optimistic, but still maintained their
total faith in the role of markets. For some more detail on their theories, policies and
Classical aggregate supply and demand analysis, follow the links below.

(Neo-)Classical Theory - Theories

Classical theories revolved mainly around the role of markets in the economy. If markets worked freely and
nothing prevented their rapid clearing then the economy would prosper. Any imperfections in the market that
prevented this process should be dealt with by government. The main roles of government are therefore to ensure
the free workings of markets using 'supply-side policies' and
to ensure a balanced budget. The main theories used to justify this view were:
* Free market theory
* Say's Law
* Quantity Theory of Money

Free market theory

The Classical economists assumed that if the economy was left to itself, then it would tend to full employment
equilibrium . This would happen if the labour market worked properly. If there was any unemployment, then the
following would happen:

unemployment increased equilibrium

surplus of [-->] fall in [-->] demand for [-->] restored at full
labour) wages labour employment

This can be shown on a diagram of the labour market. Wages are initially too high and there is unemployment of
ab. This causes wage rates to fall and employment increases as a result from Q1 to Q2. Any unemployment left in
the economy would be purely voluntary unemployment
- people who have chosen not to work at the going wage rate.

[Labour market diagram]

The same would also be true in the 'market for loanable funds' . If there was any discrepancy between savings and
investment the equilibrium would change in the market. This would again require a free market and flexible
prices. In this market the price is the rate of interest. Say, for example, investment
increased, then the following process would occur to restore equilibrium:
 increased
savings as
borrowers
increase in increased increased are equilibrium
investment [-->] demand [-->] rate of [-->] attracted [-->] is restored
for money interest
by higher
rates of
interest

Say's Law

Say's Law is imaginatively named after an economist called Say. Jean Baptiste Say was an economist of the early
nineteenth century. His law says (excuse the pun!) that:

'Supply creates its own demand.'

This once again provides a justification for the Classical view that the economy will tend to full employment. This is
because, according to this law, any increase in output of goods and services (supply) will lead to an increase in
expenditure to buy those goods and services (demand). There will not be any shortage of demand and there will
always be jobs for all workers - full employment. If there was any unemployment it would simply be temporary as
the pattern of demand shifted. However, equilibrium would soon be restored by the same process as shown
above.

Quantity Theory of Money

The classical economists view of inflation revolved around the Quantity Theory of Money, and this theory was in
turn derived from the Fisher Equation of Exchange.
This equation says that:

MV = PT

where:
M is the amount of money in circulation
V is the velocity of circulation of that money
P is the average price level and
T is the number of transactions taking place

Classical economists suggested that V would be relatively stable and T would (as we have seen above) always tend
to full employment. Therefore they came to the conclusion that:

(Neo-)Classical Theory - AS & AD

We have seen that Classical economists had complete faith in markets. They believed that the economy
would always settle - automatically - at the full employment equilibrium in the
long-run. However, they did acknowledge that there might be a slightly different reaction in the short
run as the economy adjusted to its new long-run equilibrium. We can illustrate these changes with AS
& AD analysis:
Short-run

[Short-run]

Any increase in aggregate demand in the short-run will lead to an increase in output (Q1 to
Q2), but will also lead to prices increasing. This will happen as firms suffer from diminishing returns and are forced
to increase the prices of their product to cover the higher level of costs. Increases in aggregate demand may come
about for a variety of reasons including:

* Increases in the money supply

* Lower levels of taxation
* Increased government expenditure

Long-run

In the long-run, however, the situation will be different. The economy will have tended towards full
employment on its own, and so any further increases in demand will simply be inflationary. The shape of the long-
run aggregate supply curve will therefore be vertical:

[Long-run]

The long-run aggregate supply curve is vertical at the full employment level of output (Qfe), and any
increase in aggregate demand leads to prices increasing, but no increase in output.

(Neo-)Classical Theory - Policies

So, Classical economists are of the view that the economy is self-adjusting. We can therefore sum
up their policy recommendations in a variation on a well-known phrase (you may well have heard it
from your teacher or lecturer in its original form!):
 'Don't just do something, sit there!'

Of course, taking this too literally would be unfair on Classical economists, but it would be true to say that because
the economy tends to full-employment, there is no need to actively intervene in the economy. In fact intervention
may simply be destabilising and inflationary. The key to long-term stable growth is therefore:

* Ensure free markets with no imperfections

(through supply-side policies)
* Control the growth of the money supply to
ensure low inflation

Supply-side policies

Supply-side policies can be used to reduce market imperfections. This should have the effect of increasing the
capacity of the economy to produce (in other words the long-run aggregate supply). If the level of aggregate supply
increases then Say's Law (the work of Jean Baptiste Say) predicts that demand
will also increase. This will be the only non-inflationary way to get increases in output.

[Supply-side policies]

Using supply-side policies has increased the level of output from Qfe1
to Qfe2, but the price
level has remained stable. Supply-side policies as we have said are
ones that reduce market
imperfections. They may include:
* Improving education & training to make the work-force more occupationally mobile
* Reducing the level of benefits to increase the incentive for people to work
* Reducing taxation to encourage enterprise and encourage hard work
* Policies to make people more geographically mobile (scrapping rent controls, simplifying
house buying to speed it up, ......)
* Reducing the power of trade unions to allow wages to be more flexible
* Getting rid of any capital controls
* Removing unnecessary regulations

Money supply policies

The other area that Classical economists felt was

important was to control monetary growth. In this
way (as predicted by the Quantity Theory of Money)
they would be able to maintain low inflation.
Policies might include:

* Open-market operations
[Look up Open-market Operations in glossary]
* Funding[Look up Funding in glossary]
* Monetary-base control
[Look up Monetary-base Control in glossary]
* Interest rate control
KEYNESIAN AND QUANTITY THEORY OF MONEY

Keynesian economics is an economic theory named after John Maynard Keynes (1883 - 1946), a British economist.
It was his simple explanation for the cause of the Great Depression for which he is most well-known. Keynes'
economic theory was based on an circular flow of money. His ideas spawned a slew of interventionist economic
policies during the Great Depression.

In Keynes' theory, one person's spending goes towards another’s earnings, and when that person spends her
earnings she is, in effect, supporting another’s earnings. This circle continues on and helps support a normal
functioning economy. When the Great Depression hit, people's natural reaction was to hoard their money. Under
Keynes' theory this stopped the circular flow of money, keeping the economy at a standstill.

Keynes' solution to this poor economic state was to prime the pump. By prime the pump, Keynes argued that the
government should step in to increase spending, either by increasing the money supply or by actually buying things
on the market itself. During the Great Depression, however, this was not a popular solution. It is said, however,
that the massive defense spending that United States President Franklin Delano Roosevelt initiated helped revive
the US economy.

Since Keynesian economics advocates for the public sector to step in to assist the economy generally, it is a
significant departure from popular economic thought which preceded it — laissez-fair capitalism. Laissez-fair
capitalism supported the exclusion of the public sector in the market. The belief was that an unfettered market
would achieve balance on its own. Proponents of free-market capitalism include the Austrian School of economic
thought; one of its earliest founders, Friedrich von Hayek, also lived in England alongside Keynes. The two had a
public rivalry for many years because of their opposing thoughts on the role of the state in the economic lives of
individuals.

Keynesian economics warns against the practice of too much saving, or under consumption, and not enough
consumption, or spending, in the economy. It also supports considerable redistribution of wealth, when needed.
Keynesian economics further concludes that there is a pragmatic reason for the massive redistribution of wealth: if
the poorer segments of society are given sums of money, they will likely spend it, rather than save it, thus
promoting economic growth. Another central idea of Keynesian economics is that trends in the macroeconomic
level can disproportionately influence consumer behavior at the micro-level. Keynesian economics, also called
macroeconomics for its wide look at the economy as a whole, remains one of the important schools in economic
thought today.

“Multiplier effect" and interest rates

Two aspects of Keynes' model had implications for policy:

First, there is the "Keynesian multiplier", first developed by Richard F. Kahn in 1931. Exogenous increases in
spending, such as an increase in government outlays, increases total spending by a multiple of that increase. A
government could stimulate a great deal of new production with a modest outlay if:

1. The people who receive this money then spend most on consumption goods and save the rest.
2. This extra spending allows businesses to hire more people and pay them, which in turn allows a further
increase consumer spending.
This process continues. At each step, the increase in spending is smaller than in the previous step, so that the
multiplier process tapers off and allows the attainment of an equilibrium. This story is modified and moderated if
we move beyond a "closed economy" and bring in the role of taxation: the rise in imports and tax payments at
each step reduces the amount of induced consumer spending and the size of the multiplier effect.

Second, Keynes re-analyzed the effect of the interest rate on investment. In the classical model, the supply of
funds (saving) determined the amount of fixed business investment. That is, since all savings was placed in banks,
and all business investors in need of borrowed funds went to banks, the amount of savings determined the
amount that was available to invest. To Keynes, the amount of investment was determined independently by long-
term profit expectations and, to a lesser extent, the interest rate. The latter opens the possibility of regulating the
economy through money supply changes, via monetary policy. Under conditions such as the Great Depression,
Keynes argued that this approach would be relatively ineffective compared to fiscal policy. But during more
"normal" times, monetary expansion can stimulate the economy.

Main theories
The two key theories of mainstream Keynesian economics are the IS-LM model of John Hicks, and the Phillips
curve; both of these are rejected by Post-Keynesians.

It was with John Hicks that Keynesian economics produced a clear model which policy-makers could use to attempt
to understand and control economic activity. This model, the IS-LM model is nearly as influential as Keynes' original
analysis in determining actual policy and economics education. It relates aggregate demand and employment to
three exogenous quantities, i.e., the amount of money in circulation, the government budget, and the state of
business expectations. This model was very popular with economists after World War II because it could be
understood in terms of general equilibrium theory. This encouraged a much more static vision of macroeconomics
than that described above.

The second main part of a Keynesian policy-makers theoretical apparatus was the Phillips curve. This curve, which
was more of an empirical observation than a theory, indicated that increased employment, and decreased
unemployment, implied increased inflation. Keynes had only predicted that falling unemployment would cause a
higher price, not a higher inflation rate. Thus, the economist could use the IS-LM model to predict, for example,
that an increase in the money supply would raise output and employment—and then use the Phillips curve to
predict an increase in inflation.
POST KENEYSIAN
Post Keynesian Economics (1970s-80s)

Post-Keynesian economics is a school of thought which is based on the ideas of John Maynard Keynes. It differs
from the interpretation of Keynes' ideas offered by mainstream Keynesian economics, such as the new Keynesian
economics, emphasizing in particular:
 The importance of uncertainty, historical time, or non-ergodicity (as opposed to risk, logical time, and
ergodic processes).
 The idea that money matters for the "real" economy (output, employment, etc.) in both the short and
long runs.
 A rejection of neoclassical general equilibrium models.
Post-Keynesian economists believe that a capitalist economy has no natural or automatic tendency towards full
employment. Fixed investment is a major determinant of the level of aggregate demand in closed or large
economy. Decisions on the level and direction of investment are made in anticipation of future events, which
agents cannot know even probabilistically. Post-Keynesians emphasize the need for government fiscal policy to
support institutions to support employment and incomes.
"Logical time" is the type of "time" seen in most economic models, i.e., comparative statics exercises in which
equilibrium is disturbed and the model automatically moves to a new, predetermined, equilibrium with no
attention given by the economist to the process of getting there. On the other hand, "historical time," the present
is nothing but a moment in the passage from the immutable past to the unknowable future (to paraphrase Joan
Robinson). The economy is always a dynamic process and (almost) never in an equilibrium state. The actual
process of going from situation A to situation B is path dependent, helping to determine the character of situation
B rather than it being predetermined. Thus, the post-Keynesian conception of the "long run" differs from that of
neoclassicals and various neoclassical schools of Keynesian economics.
Post-Keynesians believe, along with others, that what many call Keynesianism is, in fact, a counterrevolution
against the economics of Keynes. Keynesianism, as developed by many American economists, teaches that
involuntary unemployment. In economics, a person who is able and willing to work yet is unable to find a paying
job is considered unemployed. The unemployment rate measures the number of unemployed workers as a
proportion of the total civilian labor force, where the latter include is a temporary or medium-run phenomenon.
Government priming like other institutions, governments operate on a budget or try to do so. When the
expenditures of a government (its purchases of goods and services, plus its transfers (grants) to individuals and
corporations) are greater than its tax revenues, it creates may be desirable, but if wages and prices were perfectly
flexible, mainstream Keynesian economists believe, the labor market would eventually clear, as in the
unemployment In economics, a person who is able and willing to work yet is unable to find a paying job is
considered unemployed. The unemployment rate measures the number of unemployed workers as a proportion of
the total civilian labor force, where the latter include.

There are divisions within post-Keynesian economics, for example between American post-Keynesians such as Paul
Davidson and the Cambridge (England) - Italian branch. The latter often focuses on issues of microeconomics.
Microeconomics is the study of the economic behavior of individual consumers, firms, and industries and the
distribution of production and income among them. It considers individuals both as suppliers of labor and capital
and as the ultimate consumers o, especially the controversy The capital controversy refers to a debate in
economics concerning the nature and role of capital goods (or means of production) that occurred during the
1960s, largely between economists such as Joan Robinson and Piero Sraffa at the University of Cambri and is
closely related to the school The neo-Ricardian school is an economic school that derives from the close reading
and interpretation of David Ricardo by Piero Sraffa, and from Sraffa's critique of Neoclassical economics as
presented in his "The Production of Commodities by Means of Com.
Post-Keynesian economics emphasizes macroeconomics. Macroeconomics is the study of the entire economy in
terms of the total amount of goods and services produced, total income earned, the level of employment of
productive resources, and the general behavior of prices. Macroeconomics can be used to analyze. Many post-
Keynesians look to American Institutionalists. In economics, the institutional economics school goes beyond the
usual economic focus on markets, to look more closely at human-made institutions. Institutional economics was
once the dominant school of economics in the United States, including such famous for microeconomics.
Institutionalists include such economists as Thorstein Veblen, John R. Commons, Wesley Clair Mitchell, John
Maurice Clark, Clarence Ayres, Gunnar Myrdal (not an American), and John Kenneth Galbraith.

Thanks to Samuelson's reconciliation, today neoclassical economics is known as microeconomics and Keynesian
economics has become largely known as macroeconomics the twin pillars of mainstream or orthodox economic
thought. However, because this reconciliation clearly disavowed many of Keynes's original ideas that were not held
to be compatible with neoclassical economics, many critics have sought to revive some of them and to combine
them with theories of scholars such as Michael Kalecki, Joan Robinson, and Piero Sraffa to form a new school of
economic thought known as "post-Keynesian Economics" (see Eicher, 1979).

Post-Keynesians are highly concerned with short-term economic growth as induced by aggregate demand and,
unlike neo-classical economists, are concerned with real world variables that exist in a very concrete historical
situation. For them, the adjustment process of the economy to equilibrium conditions is not so "automatic" as
neoclassical economist's claimed because it largely depends on the economic agent's interpretation of both the
past and expectations for the future all in the midst of a decision making setting involving complex
interdependencies and unforeseen factors. As a result of these beliefs, post-Keynesians essentially deny relevance
of conventional equilibrium analysis. Moreover, reliance on the role of uncertainty has created some problems for
post-Keynesians because it has made it nearly impossible for them to devise any viable theory for long-term
growth. It has further prevented them from developing a formal economic model that they all agree upon.
According to Professor J. A. Kregel (1976), one of the most distinguished post-Keynesian economists, "post-
Keynesian theory can be viewed as an attempt to analyze various different economic problems, e.g., capital
accumulation, income distribution, etc., through the methodology of Keynes." Keynes's methodology, then, was to
confront "the analysis of an uncertain world was in terms of alternative specifications about effects of uncertainty
and disappointment."
Using this approach while adopting theories of both Keynes and Kalecki, post-Keynesians have analyzed the
relationship between income distribution and economic growth. One of the most significant conclusions of post-
Keynesian economics is that for a given level of investment and an economy at equilibrium where savings equals
investment, the lower the capitalist's propensity to save, the higher will be their share of national income and the
lower will be the worker's share. This assertion is significant because it contradicts the claim by neoclassical
economists that capitalists enjoyed a high income due to the pain that is necessary for them to save.
This result of the post-Keynesians is founded in their belief that saving is passively linked to changes in level of
income, and investment is highly correlated with capitalists' expectations for the future. If optimistic, investment
increases, growth occurs, and capitalists' share of income increases as well. As their income rises, capitalists save
more bringing savings back in line to a new level of Keynesian equilibrium where savings and investment equate.
What this means is that if capitalists are frugal (i.e. save more), or if they are abstemious (i.e. abstain from
consuming), they lower their share of the national income. This, of course, directly violates Nassau Senior's
assertion that the high income of capitalists was morally justified by their painful abstinence of personal
consumption and willful propensity to reinvest their profits into the growth of capital.
Another area where post-Keynesians have divergent economic thought from orthodoxy has to do with their belief
in the endogenity of money. For them, post-Keynesians stress the fact that real commodity and labor flows are
expressed in the economy as monetary flows. They also assume that money possesses a negligible elasticity of
substitution with any other medium of exchange and therefore has the unique capacity to be able to be used by
financial institutions as a tool to mitigate the effects of exogenous economic system shocks.

NEW KEYNESIAN

New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic
foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics
by adherents of New Classical macroeconomics.

Two main assumptions define the New Keynesian approach to macroeconomics. Like the New Classical approach,
New Keynesian macroeconomic analysis usually assumes that households and firms have rational expectations.
But the two schools differ in that New Keynesian analysis usually assumes a variety of market failures. In particular,
New Keynesians assume prices and wages are "sticky", which means they do not adjust instantaneously to changes
in economic conditions.

Wage and price stickiness, and the other market failures present in New Keynesian models, imply that the
economy may fail to attain full employment. Therefore, New Keynesians argue that macroeconomic stabilization
by the government (using fiscal policy) or by the central bank (using monetary policy) can lead to a more efficient
macroeconomic outcome than a laissez faire policy would.

Origins

Significant early contributions to New Keynesian theory were compiled in 1991 by editors N. Gregory Mankiw and
David Romer in New Keynesian Economics, volumes 1 and 2. The papers in these volumes focused mostly on micro
foundations, that is, microeconomic ingredients that could produce Keynesian macroeconomic effects, and did not
yet attempt to construct complete macroeconomic models.

More recently, macroeconomists have begun to build dynamic stochastic general equilibrium (DSGE) models with
Keynesian features. The New Keynesian DSGE modeling methodology is explained in Michael Woodford's textbook
Interest and Prices: Foundations of a Theory of Monetary Policy. Economists are now actively estimating
quantitative models of this type, and using them to analyze optimal monetary and fiscal policy.

Micro foundations of price stickiness

'Nominal rigidities', that is, sticky prices and wages, are a central aspect of all New Keynesian models. Why should
prices adjust slowly? One common explanation given by New Keynesians is the presence of 'menu costs', meaning
small costs that must be paid in order to adjust nominal prices. For example, the costs of making a new catalog,
price list, or menu would be considered menu costs. Even though these costs seem small, New Keynesians explain
how they could amplify short-run fluctuations. Not only do the firms have to pay to change the price, but also,
according to N. Gregory Mankiw, there are also externalities that go along with changing prices. As Mankiw
describes, a firm that lowers its prices because of a decrease in the money supply will be raising the real income of
the customers of that product. This will allow the buyers to purchase more, which will not necessarily be from the
firm that lowered their prices. As firms do not receive the full benefit from reducing their prices their incentive to
adjust prices in response to macroeconomic events is reduced.
Recent studies (e.g. Golosov and Lucas) find that the size of the menu cost needed to match the micro-data of
price adjustment inside an otherwise standard business cycle model is implausibily large to justify the menu-cost
argument. The reason is that such models lack "real rigidity" (see Ball and Romer). This is a property that markups
do not get squeezed by large adjustment in factor prices (such as wages) that could occur in response to the
monetary shock. Modern New Keynesian models address this issue by assuming that the labor market is
segmented, so that the expansion in employment by a given firm does not lead to lower profits for the other firms
(see Woodford 2003).

Other microeconomic ingredients

Besides sticky prices, another market imperfection built into most New Keynesian models is the assumption that
firms are monopolistic competitors. In fact, without some monopoly power it would make no sense to assume
sticky prices, because under perfect competition, any firm with a price slightly higher than the others would be
unable to sell anything, and any firm with a price slightly lower than the others would be obliged to sell much more
than they can profitably produce. Therefore, New Keynesian models assume instead that firms use their market
power to maintain their prices above marginal cost, so that even if they fail to set prices optimally they will remain
profitable. Many macroeconomic studies have estimated typical firms' degree of market power, so this
information can be used in parameterizing New Keynesian models.

Other microeconomic elements that appear in some New Keynesian models (though not so commonly as sticky
prices and imperfect competition) include the following.

 Credit market imperfections

 Coordination failures, leading to aggregate demand multipliers and possible multiplicity of equilibrium
 Unemployment caused by moral hazard problems, or unemployment caused by matching frictions

Policy implications

New Keynesian economists fully agree with New Classical economists that in the long run, changes in the money
supply are neutral. However, because prices are sticky in the New Keynesian model, an increase in the money
supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short
run.

Nonetheless, New Keynesian economists do not advocate using expansive monetary policy just for short run gains
in output and employment, because doing so would raise inflationary expectations and thus store up problems for
the future. Instead, they advocate using monetary policy for stabilization. That is, suddenly increasing the money
supply just to produce a temporary economic boom is a bad idea (because eliminating the increased inflationary
expectations will be impossible without producing a recession). But when the economy is hit by some unexpected
external shock, it may be a good idea to offset the macroeconomic effects of the shock with monetary policy. This
is especially true if the unexpected shock is one (like a fall in consumer confidence) which tends to lower both
output and inflation; in that case, expanding the money supply (lowering interest rates) helps by increasing output
while stabilizing inflation and inflationary expectations.

Studies of optimal monetary policy in New Keynesian DSGE models have focused on interest rate rules (especially
'Taylor rules'), specifying how the central bank should adjust the nominal interest rate in response to changes in
inflation and output. (More precisely, optimal rules usually react to changes in the output gap, rather than changes
in output per se.) In some simple New Keynesian DSGE models, it turns out that stabilizing inflation suffices,
because maintaining perfectly stable inflation also stabilizes output and employment to the maximum degree
desirable. Blanchard and Galí have called this property the 'divine coincidence'.[13] However, they also show
that in models with more than one market imperfection (for example, frictions in adjusting the
employment level, as well as sticky prices), there is no longer a 'divine coincidence', and instead there is
a tradeoff between stabilizing inflation and stabilizing employment.

The heart of the 'new Keynesian' view rests on microeconomic models that indicate that nominal wages and prices
are "sticky," i.e., do not change easily or quickly with changes in supply and demand, so that quantity adjustment
prevails. According to economist Paul Krugman, "while I regard the evidence for such stickiness as overwhelming,
the assumption of at least temporarily rigid nominal prices is one of those things that works beautifully in practice
but very badly in theory." This integration is further spurred by the work of other economists which questions
rational decision-making in a perfect information environment as a necessity for micro-economic theory. Imperfect
decision making such as that investigated by Joseph Stiglitz underlines the importance of management of risk in
the economy.

Over time, many macroeconomists have returned to the IS-LM model and the Phillips curve as a first
approximation of how an economy works. New versions of the Phillips curve, such as the "Triangle Model", allow
for stagflation, since the curve can shift due to supply shocks or changes in built-in inflation. In the 1990s, the
original ideas of "full employment" had been modified by the NAIRU doctrine, sometimes called the "natural rate
of unemployment." NAIRU advocates suggest restraint in combating unemployment, in case accelerating inflation
should result. However, it is unclear exactly what the value of the NAIRU should be—or whether it even exists.
 Keynesians vs. Monetarists
Keynesians and Monetarists fought head-to-head in the 1970s. Most economists conclude that Keynesians won
the war, but Monetarists won many battles. Because of the healthy debate, Keynesians are more convinced of the
importance of the money supply and monetary policy, especially over the long run. They are more acutely aware
of the long-term threat to price stability that
rapid money growth can bring. Keynesians are TABLE 1
also now more likely to prefer monetary policy to Monetarists Keynesians
fiscal policy. Tie monetary policy to rules Give policymakers discretion.
Fiscal policy is not useful. Fiscal policy may be useful.
Despite the convergence, substantial differences AS curve has a steep slope. Economy can be unstable.
remain between the two bodies of thought. We Economy is inherently stable. AS curve can be flat.
summarize the more important differences here
and in Table 1.

 Keynesians argue that the Fed should use discretion in conducting monetary policy, while Monetarists
advocate a long-run money growth rule.
 Keynesians still view fiscal policy as potentially important. Monetarists are less convinced of the
usefulness of fiscal policy.
 As a general rule, Keynesians believe that the Aggregate Supply curve is more horizontal than vertical in
the short run so stabilization policy can have big impacts on output and employment. Because
Monetarists believe that the economy is inherently stable, they tend to view the Aggregate Supply curve
as more vertical so discretionary stabilization policy is not as important.

Although differences remain, the debate between Keynesians and Monetarists cooled considerably in the 1990s.
Monetarists could no longer defend a simple relationship between M1 and nominal GDP. Many Monetarists now
emphasize the longer-run relationship between M2 growth and nominal GDP growth. Although Keynesians do not
stress the importance of money growth as much as Monetarists, the focus on the long run is much less
controversial.

Keynesian Vs New classical

Another influential school of thought was based on the Lucas critique of Keynesian economics. This called for
greater consistency with microeconomic theory and rationality, and particularly emphasized the idea of rational
expectations. Lucas and others argued that Keynesian economics required remarkably foolish and short-sighted
behavior from people, which totally contradicted the economic understanding of their behavior at a micro level.
New classical economics introduced a set of macroeconomic theories which were based on optimising
microeconomic behavior. These models have been developed into the Real Business Cycle Theory, which argues
that business cycle fluctuations can to a large extent be accounted for by real (in contrast to nominal) shocks.