Saturday, August 22, 2009

Keynes Contribution to the Quantity Theory of Money

The modern theorists, especially the Keynesians lay emphasis that the value of money or the price level is infact a consequence of the total income rather than quantity of money. The real cause of fluctuation in prices is to be found in fluctuations in the level of aggregate income or expenditure. Therefore changes in the quantity of money can bring about changes in the level of prices only if they change aggregate spending in relation to the supply of output. Unless spending increases there can be no increase in demand for goods. And if demand for goods does not increase, the question of price rise does not arise. However eve if aggregate spending does not increase prices may still not rise. If the supply curve of output is fairly elastic. Therefore the effects of a change in quantity of money on the price level depends on the following factors.
(i) Effect of change in money supply on the level of aggregate demand or spending.
(ii) Relation between aggregate spending and the volume of production.
As regards the volume of spending, it depends on the following.
(i) The Consumption function
(ii) The investment demand schedule
(iii) Liquidity preference schedule
(iv) Supply of money
An increase in the quantity of money in the Keynesian system will lower the rate of investment. But if the rate of interest is already very low, further increase in the quantity, of money will not be able to reduce it still further. And we know that a fall in the rate of interest encourages now investment. Thus if the rate of interest is reduces as a result of an increase in money supply, the rate of investment will rise and the increase in investment will lead to increase in income via the multiplier. If this happens there will be an increase in the quantity of money i.e. we are operating along the perfectly elastic part of the liquidly preference curve, the rate of investment will not increase, and if investment does not increase, income and spending cannot increase.
Thus there are circumstances when an increase in the quantity of money may fail to increase the level of aggregate spending. If this is the case, prices will not rise at all, even though the quantity of money has increased.
Even if aggregate sending does increase because of an increase in the rate of investment, it is not necessary that prices must rise at all, much less proportionately to the increase in money supply. If we have less than fall employment and there are idle capital and labour resources, the supply curve of output will be fairly elastic, and increases in aggregate spending will lead to an increase in production without much increase in prices. On the hand if there is full employment an increase in aggregate spending will largely result in an increase in the level of prices rather than output.

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