Classical and Keynesian Views on Money

In this article we will discuss about the classical and Keynesian views on money.

The Classical View on Money:

In the classical system, money is neutral in its effects on the economy. It plays no role in the determination of employment, income and output. Rather, they are determined by labour, capital stock, state of technology, availability of natural resources, saving habits of the people, and so on. In the classical system, the main function of money is to act as a medium of exchange.

It is to determine the general level of prices at which goods and services will be exchanged. The quantity theory of money states that the price level is a function of the supply of money. Algebraically, MV=PT, where, M, V, P and T are the supply of money, velocity of money, price level, and the volume of transactions (or total output) respectively.

The equation tells that the total money supply, MV, equals the total value of output, PT, in the economy. Assuming V and T to be constant, a change in M causes a proportionate change in P. Thus money is neutral. It is simply a ‘veil’ whose main function is to determine the general price level at which goods and services exchange.

The notion of neutrality of money in the classical system is explained in terms of Fig. 1. Where we start with an initial full employment equilibrium position with N_o, Q_o’ W/P_o’ M_o’ P_o, and W_o’ as illustrated in Panels (A), (B), (C) and (D) of Fig. 1. The initial equilibrium is disturbed when the quantity of money is increased from M₀ to M₁. This leads to a rise in effective demand from MV₀ to MV₁, and shown in Panel (C).

This raises commodity prices in proportion to the rise in M, since real output O is fixed. In other words, the rise in the price level is exactly proportional to the rise in the quantity of money, i.e. P₀ P₁=M₀ M₁. With increase in the price level, the money wage rate will rise as rapidly as prices to (Panel D) in order to keep the real wage rate W/P_o unchanged (Panel B). But with increase in the price level, the real wage rate tends to decrease from W/P_p to W/P₁, as shown in Panel B of the figure.

This increases the demand for labour by more than the supply of labour which is shown by the distance sd in Panel B. The competitive bidding for labour will ultimately lead to rise in the real wage rate to W/P₀ whereby the labour market equilibrium is restored at point E. Thus the result of an increase in money is to raise money wages and prices in equal proportion, leaving output, employment and the real wage rate unaffected. It is in this sense that money is a veil or neutral in the classical system.

The Keynesian View: Monetary Equilibrium:

The Keynesian theory assigns a key role to money. It contends that a change in the money supply can permanently change such real variables as the interest rate, the levels of employment, output and income. Keynes believed in the existence of unemployment equilibrium in the economy.

The existence of unemployment equilibrium implies that an increase in money supply can bring about permanent increases in the level of output. The ultimate influence of money supply on the price level depends upon its influence on aggregate demand and the elasticity of the supply of aggregate output.

The Keynesian chain of causation between changes in the quantity of money and in prices is an indirect one through the rate of interest. So when the quantity of money is increased, its first impact is on the rate of interest which tends to fall. Given the marginal efficiency of capital, a fall in the rate of interest will increase the volume of investment.

The increased investment will raise effective demand through the multiplier effect thereby increasing income, output and employment. Since the supply curve of factors of production is perfectly elastic in a situation of unemployment, wage and non-wage factors are available at constant rate of remuneration.

There being constant returns to scale, prices do not rise with the increase in output so long as there is any unemployment. Under the circumstances, output and employment will increase in the same proportion as effective demand, and the effective demand will increase in the same proportion as the quantity of money. But “once full employment is reached, output ceases to respond at all to changes in the supply of money and so in effective demand.

The elasticity of supply of output in response to changes in the supply, which was infinite as long as there was unemployment falls to zero. The entire effect of changes in the supply of money is exerted on prices, which rise in exact proportion with the increase in effective demand”. Thus, so long as there is unemployment, output will change in the same proportion as the quantity of money, and there will be no change in prices; and when there is full employment, prices will change in the same proportion as the quantity of money.

Therefore, Keynes stresses the point that with increase in the quantity of money, prices rise only when the level of full employment is reached, and not before this.

This is illustrated in Fig. 2, Panels (A) and (B) where OTC is the output curve relating to the quantity of money and PRC is the price curve relating to the quantity of money. Panel A of the figure shows that as the quantity of money increases from O to M, the level of output also rises along the OT portion of the OTC curve. As the quantity of money reaches OM level, full employment output OQ_F is being produced. But after point T the output curve becomes vertical because any further increase in the quantity of money cannot raise output and the full employment level OQ_F

Panel B of the figure shows the relationship between quantity of money and prices. So long as there is unemployment, prices remain constant whatever increase in the quantity of money. Prices start rising only after the full employment level is reached, In the figure, the price level op remains constant at the OM quantity of money corresponding to the full employment level of output OQ_F . But an increase in the quantity of money above OM raises prices in the same proportion as the quantity of money. This is shown by the RC portion of the price curve PRC.

Monetary Equilibrium:

So far as the rate of interest is concerned, it is a monetary phenomenon in the Keynesian theory. It is determined by the demand for and supply of money. The theory is thus characterised as the monetary theory of interest. The supply of money is considered to be fixed in the short run by monetary authorities. The demand for money, also called the liquidity preference, is the desire to hold cash.

There are three motives on the part of the people to hold cash:

(a) Transaction demand for money,

(b) Precautionary demand for money, and

(c) Speculative demand for money.

Money held for transactions and precautionary motives is a function of the level of income. L_T = f(Y). It varies directly with the level of income and inversely with the interest rate.

According to Keynes, it is expectations about changes in bond prices or in the market rate of interest that determine the speculative demand for money, Ls = f(r). The speculative demand for money is a decreasing function of the rate of interest.

The higher the rate of interest, the lower the speculative demand for money, and vice-versa. But at a very low interest rate, the speculative demand for money becomes perfectly elastic. This is the “liquidity trap” portion of the demand for money curve. In this range, people prefer to keep money in cash rather than invest in bonds because purchasing bonds will lead to loss.

Thus the total demand for money is a function of both income and the interest rate:

L_T+L_s = f (Y) +f (r)

Or L = f (Y) +f (r)

Or L = f(Y, r)

where L represents the total demand for money.

The necessary conditions for monetary equilibrium in the Keynesian theory are the equality of the money supply (M) and the demand for money (L) which determines the interest rate,

M= L (=L_T+L_s)

This is illustrated in Fig. 3 (A) and (B). The transactions (plus precautionary) demand for money is given by the curve L_T at OY, and OY₂ levels in Panel (A) of the figure. At OY₁ income level, it is given by OM₁ and at OY₂ level of income by OM₁. In Panel (B), the curve L represents the total demand for money consisting of transactions, precautionary and speculative demand, L_T + L_s.

On the horizontal axis, if OM is the total demand for money, and OM₂ is transactions (plus precautionary) demand for money, then M₂M is the speculative demand for money:

OM =OM₂+M₂M

In other words, if OM₂ is subtracted from OM, we get the speculative demand for money:

OM-OM₂=M₂M.

If the money supply is given as MS and it equals the demand for money represented by the curve L at point E₁ it determines the interest rate OR₁Thus the necessary conditions for monetary equilibrium at E₁ are the combination of money income OY₂ and money interest rate OR₁the demand for money, OM₂+M₂M, is equal to the supply of money, M_s.

If there is any deviation from the equilibrium position, an adjustment will take place via a change in the interest rate and level of income. Suppose the rate of interest rises to OR₂. This will reduce investment, output, employment and income. Assume that the income falls to OY₁, as shown in Panel (A) of the figure. In Panel (B) of the figure with rise in the interest rate to OR₂, the total demand for money falls to OM₂ which now consists of OM₁ of transactions (plus precautionary) demand and M₁M₂ of speculative demand.

If the monetary authority reduces the money supply to M₂S₂ equal to the fall in money demand, the new monetary equilibrium will be set at point E₂ where the L curve intersects it. The opposite will be the case if the rate of interest falls below OR₁ and continues to fall, the economy may be in the “liquidity trap”.

In the Keynesian monetary equilibrium, when the economy is in the ‘liquidity trap,’ there cannot be a further fall in the rate of interest even if the money supply is increased by the monetary authority. This implies that there will not be any effect on investment and income. In this situation, money is neutral and monetary policy has no effect on the economy. Given an interest-inelastic investment function, monetary policy will be ineffective.

Money is also neutral and plays no role in the Keynesian system in the full employment situation when an increase in the quantity of money brings about a proportionate increase in the price level, and employment, output and income remain unchanged. But money influences the macro variables of the economy in an important way between these two extreme cases of the liquidity trap and full employment in the Keynesian system.

To conclude, money plays a significant causal role in the Keynesian theory. “The degree of money’s importance depends upon its ability to alter money interest rates and upon the degree to which expenditure categories (consumption, investment, government outlays, and so forth) are sensitive to changes in the interest rate. To the extent that a given change in the money supply can induce large changes in the interest rate and that expenditures are highly sensitive to those changes, money matters very much in the Keynesian system.”