The integration of the theory of money with the theory of value on the one hand and with the theory of output on the other, was achieved through the rate of interest the missing link (rate of interest) was at last discovered. Thus “this approach has the virtue of emphasising that the objectives of full employment and price stability may be inherently irreconcilable.”. to the Plagiarism Prevention 4. According to him, the effect of a change in the quantity of money on prices is indirect and non-proportional. As the quantity of money is increased (other things remaining the same), the rate of interest is lowered because the quantity of money available to satisfy speculative motive increases. According to Friedman, it was the contraction of money that precipitated the depression. Let us now understand Keynes’ theory of money and prices in terms of effective demand. The elasticity of output (e0) is zero and as a consequence the elasticity of price (ep) must be equal to unity. Thus the Keynesian analysis is superior to the traditional analysis because it studies the relationship between the quantity of money and prices both under unemployment and full employment situations. Output increases at a slower rate than a given increase in aggregate money demand, and this leads to higher prices. Disclaimer Copyright, Share Your Knowledge Keynesian theory of employment has the following policy implications: I. Changes in the quantity of money, by bringing about changes in the rate of interest affect investment and hence output and employment. The Keynesian Challenge to the Quantity Theory The income-expenditure analysis developed by John Maynard Keynes in his General Theory (Keynes 1936) offered an alternative approach The prices rise on account of various factors like the rise in labour costs, bottlenecks in production, etc. This is shown in the figure when the demand curve D5 shifts upward to D6 and the price level increases from OP5 to OP6 while the level of output remains constant at OQF. TOS 7. It has developed further by other economists of Keynesian … 4. In his approach of money and prices, Keynes attempted to integrate the real and monetary sectors of the economy and as such he brought in the concept of elasticity no less into the theory of money than in the theory of value. Before full employment money wages are assumed to be constant, therefore, ew will be equal to zero. Keynes failed to understand the true nature of money. Keynesian analysis of interest rates, investment behaviour: inflation and demand determination is presented in a framework of non-neutral money and Keynes' principle of effective demand. The most famous proponent of monetarist theory was the late Nobel laureate economist Milton Friedman, who famously laid the blame for the Great Depression with the Federal Reserve, which controls the U.S. money supply. The I Theory of Money Markus K. Brunnermeiery and Yuliy Sannikovz rst version: Oct. 10, 2010 this version: June 5, 2011 Abstract This paper provides a theory of money, whose value depends on the functioning of the intermediary sector, and a uni ed framework for analyzing the interaction between price and nancial stability. 12. The Keynesian theory of money and prices is superior to the traditional quantity theory of money for the following reasons. According to classicals, every increase in money supply results in inflation (as full employment was always presumed). It is on account of this reason that Keynes analysis is, at times, spoken of as the ‘contra-quantity theory of causation’ because it takes rise in prices as a cause of the increase in the quantity of money instead of taking the increase in the quantity of money as a cause of the rise in prices. The increase in aggregate demand for commodities and a higher push given to wages and costs will raise firstly the relative prices and then the general price level. Content Filtrations 6. This may lead to increase in marginal cost and price. Thus prices rise at an increasing rate. Keynes assumed that monetary changes were largely absorbed by changes in the demand for money. The ratio of a proportionate change in P to the proportionate change in M is shown by the elasticity of price level (e). 3. Despite these shortcomings, Keynes’ analysis is more acceptable as it takes into consideration the phenomenon of unemployment in the economy and is superior to the traditional theory in many ways. The complicated model of the Keynesian theory of money and prices is shown diagrammatically in Figure 67.2 in terms of aggregate supply (S) and aggregate demand (D) curves. Yet, the new version has its own shortcomings. Thus, the reformulated quantity theory of money suggests that the price level will remain constant so long as there are unemployed resources in the economy. 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.”. According to Keynes, an increase in the quantity of money increases aggregate money demand on investment as a result of the fall in the rate of interest. No doubt the reformulated version of the quantity theory of money takes into consideration a large number of factors, which were ignored in the classical quantity theory of money. He believes that changes in the quantity of money do not affect the price level (value of money) directly but indirectly through other elements like the rate of interest, the level of investment, income, output and employment. ... Keynes advocated cheap money policy. It is only when the economy reaches the level of full employment that the rise in prices is inflationary with every increase in the quantity of money. Friedman allowed the return on money to vary and to increase above zero, making it more realistic than Keynes… A rise in prices during this period may occur on account of the following reasons: (a) Increased bargaining powers of the workers: As output expands on account of an increase in money supply, it creates more employment. 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