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In this article we will discuss about the Monetarists and Keynesians view on changes in national income.
The Monetarist View on Changes in National Income:
According to the monetarists, the money supply is the “dominant, though not exclusive” determinant of both the level of output and prices in the short run and of the level of prices in the long run. The long-run level of output is not influenced by the money supply.
It is dependent on such real factors as technology and the quantity and quality of productive resources. Although factors other than the money supply affect the level of output, employment and prices in the short run, yet their effects are subordinate to that of the money supply.
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A change in the money supply will inevitably affect the price level and output in the short run. But in the long run, the effect of change in the money supply will be entirely on the price level. Because the economy is near full employment in the long run and the increase in national income will consist mainly of higher prices.
Thus changes in the money supply affect national income directly. This is due to the assumption that the velocity of circulation of money is stable.
The Keynesians, on the other hand, maintain that changes in the money supply work indirectly on the level of aggregate expenditure and income through changes in the interest rates. The main difference between the monetarists and Keynesians rests on the influence of interest rates on the demand for and supply of money and aggregate expenditure.
The monetarists hold that the rate of interest plays no part in determining the demand for money. The demand for money is the transactions demand for money which is determined by the level of income. The monetarists believe that the money supply is also not influenced by interest rates. This insensitiveness of both demand for and supply of money is based on the quantity theory of money.
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The simplest quantity equation is MV=PQ, where M is the quantity of money, Vis its velocity, Q is the number of physical transactions, and P is the price level. Taking PQ=Y, where Y is the national income, the quantity equation becomes MV=Y. As V remains constant, changes in M cause changes in Y.
Fig. 1 explains the monetarist view graphically. The demand for and supply of money are taken on the horizontal axis and income on the vertical axis. The demand curve MD is drawn from the origin which shows the amount of money people want to hold for transaction purposes at various levels of income. Ms is the money supply curve which is drawn vertical to show a given supply of money. OY is the equilibrium level of income where the money demanded and supplied equal at E.
If people have more money than they want equal to AB at OY, income level1 they will start spending it till income increases to the equilibrium level OY. If they have less money than they want equal to CD at OY2 income level, they will start reducing their spending till it reaches the equilibrium level OY.
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The changes in the money supply affect aggregate demand and income through effects on a wide range of assets than “the bonds only” model of the Keynesians. This view of the monetarists is based on the belief that money is a good substitute for all types of assets such as securities, houses, durable consumer goods, etc.
Friedman’s historical findings show a “stable money demand function” which implies that the demand for money is a stable function of peoples’ income. In other words, the amount of money people want to hold is related in a fixed way to their income.
If the central bank increases the money supply, it affects interest rates in three different ways. First, there is the liquidity effect which causes a very short-run reduction in interest rates. As a result, people will sell securities and their holdings of money will increase. They will, therefore, spend their excess money balances on financial assets and on durable consumer goods, houses, etc. This increase in aggregate expenditure on assets and goods will tend to raise output, employment and income. This is the output effect.
This will lead to a rise in interest rates because of the rise in output and demand for money resulting from the liquidity effect. Finally, there is the price expectations effect which occurs due to the expectations of lenders that inflation will continue. They will demand higher interest rates in order to cover the expected inflation rate.
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Thus with the short-run liquidity effect bringing a downward pressure on interest rates and both the output and price expectations effects bringing an upward pressure on them, the combined effect will be an increase in interest rates. These will, in turn, discourage investment, and reduce output and employment. This is illustrated in Fig. 2.
The demand for and supply of money are taken on the horizontal axis and the interest rate on the vertical axis. MD is the demand curve for money and Ms the money supply curve. Both intersect at E and determine OR interest rate. With increase in the money supply the Ms curve shifts to Ms1. If the money demand remains constant, the interest rate would fall from OR to OR1.
The increased demand for financial assets and durable consumer goods leads to an increase in output and prices so that the demand for money increases at every interest rate. As a result, the MD curve shifts upwards to Mm and the interest rate increases to OR2 .The MD curve is drawn steeply which reflects the monetarist view that the demand for money is interest elastic.
The Keynesian View on Changes in National Income:
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The Keynesians hold just the opposite views to monetarists about the demand for and supply of money and the aggregate expenditure. Both the demand for and supply of money are highly interest elastic while the aggregate expenditure is not.
The Keynesians consider the supply of money 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 transactions, precautionary and speculative demand for money. Money held for transactions and precautionary motives is a function of the level of income, and for the speculative motive, it is a function of the interest rate.
To the Keynesians, it is expectations about changes in bond prices or in the market rate of interest that determine the speculative demand for money. 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.
On the whole, given the level of national income, the demand for money is a decreasing function of the interest rate. The Keynesians believe money and financial assets to be good substitutes for each other. They are highly liquid and yield interest. So even small changes in interest rates lead to substitution between money and financial assets.
A small fall in the interest rate will mean a rise in the price of securities, which will induce people to sell securities and hold more money. The reverse will be the case in the event of a small rise in the’ rate of interest. Thus the demand for money is highly interest-elastic under Keynesianism.
The Keynesians believe in the existence of unemployment equilibrium. This 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.
In the Keynesian transmission mechanism, changes in the money supply affect aggregate expenditure and national income indirectly by changes in interest rates. Suppose the money supply is increased, it lowers the interest rate which, in turn, increases investment and expenditure thereby raising the national income.
The mechanism by which changes in the money supply are transmitted into the level of income is the asset effect. For example, an increase in the money supply causes people to spend their excess holdings of money on financial assets.
This means an increase in the demand for such assets and a rise in their prices. Rise in the prices of assets (securities), brings down the interest rates which, in turn, increase aggregate expenditure, investment and hence income. Thus, according to the Keynesian view, a change in the money supply can only affect aggregate spending and national income first through changes in interest rates, and then only if the aggregate spending is sensitive to interest rate changes.
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