Friday, September 24, 2010

Keynes and the quantity theory of money

Feb. 2006 For a good part of his career as a policy economist and economic theorist John Maynard Keynes struggled to escape from the quantity theory of money. Although he was considered a quantity of money theorist until the late 1920s as early as 1911 Keynes rejected the classical doctrine of the natural rate of unemployment and therefore implicitly the quantity theory of money. In its classical formulation the quantity theory could be stated quite simply as MV = PO where M was the money stock, V the velocity or circulating turnover of the money stock in given time period , P the price level and O the level of output of goods and services.The classicals argued that because of Say's law output was always at the full employment level and velocity varied so slowly that it resembled a constant. If so then there was a direct relationship between money and prices. Keynes rejected the classical doctrine of Say's law that supply created its own demand.Unemployment was possible and it would not be cured by allowing the market and excess supply of labour to lower prices.In 1911 Keynes reviewed a book by the American economist Irving Fisher. In his review he rejected the classical doctrine that unemployment was impossible in the economic system unless people voluntarily rejected working at the prevailing wage. Instead Keynes accepted that involuntary unemployment could occur. He further developed that approach in his writings in the late 1920s and in the General theory of 1936. He argued "the celebrated optimism of traditional economic theory which has led economists to be looked upon as Candides who argued that all is for the best in the best of all possible worlds provided we let well enough alone is to be traced ...to their having neglected to take account the drag on prosperity which can be excercised by an insufficiency of aggregate demand.(GT p33-34) Keynes also dismissed the notion of the natural rate of unemployment arguing instead that output was not solely determined by current equipment and technique in the way that Ricardo and the classicals insisted. (See Michael Perleman, Keynes, Investment Theory and the Economic Slowdown: The role of investment and q ratios Macmillion 1989, p.100ff. Keynes believed that only under strict unrealistic assumptions could the Ricardian quantity theory of money hold sway and prices rise in direct proportion to MV. What is extraordinary is that these Ricardian and quantity theory simplifications have re-emerged in the late 1970s and held sway in economic policy for the past 30 years despite all the evidence that shows they are misguided.

2 comments:

  1. can an example be given on the debate between classical and keynesian theory of money

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  2. There are many examples but perhaps the most famous is the debate that took place within the pages of the the General Theory by Keynes in the chapters where he discussed the classical theory of interest and money as compared to his own theory of liquidity preference. See chapters 13, 14 and 17. after the war the British Radcliffe commission also explored these issues at length . Finally see Nicholas Kaldor's book, The Scourge of Monetarism versus Milton Friedman and Anna Schwartz's A Monetary History of the United states.

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