This article will help you to learn about the difference between Keynesian Theory of Money and Quantity Theory.
Difference between Keynesian Theory of Money and Quantity Theory
The value of money differs from the value of any other object in one fundamental respect, namely, the fact that the value of money represents general purchasing power or command over goods and services. This means that a change in the value of money affects our general ability or command over goods and services.
Thus high prices of other things are reflected in the low exchange value of money/and low prices of other things are reflected in its high exchange value. The value of money is, therefore, the reciprocal of the general price level, and can be expressed as I/P. Changes in the value of money affect not only individual owners of given units of currency but the entire economy whose smooth functioning depends on stability in the value of money.
These changes affect different groups of individuals differently. Above all, changes in the value of money inject an element of instability into the economy as a whole. It is for these reasons that the investigation of the forces which alter the value of money is of such theoretical and practical importance.
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One of the oldest explanations of the value of money is the quantity theory of money. In its crude from the theory states that the purchasing power of money depends directly on the quantity of money. This may be expressed as M = kP, or P = I/kM, where M stands for the quantity of money, P for the general price level, and k for constant proportionality.
If, for example, k is 3, M is three times the price level. As long as A: is a constant, M and P will be proportional. The validity of this simple quantity formulation depends on the tacit assumptions that (a) the velocity of installation is stable, and (b) that the volume of goods and services to be bought with money remains constant.
The quantity theorists neglected the velocity of money because they were preoccupied with what Keynes call ‘transaction’ and ‘precautionary’ motives for holding money. But as soon as we take into account the ‘speculative’ motive (i.e., the desire for cash for uncertain future price or interest changes), we must admit the possibility of a change in the velocity of money.
The speculative motive is facilitated by the store of value function of money. Keynes pointed out that this last motive for holding money but also in general economic activity. If a part of a given quantity of money fails to appear in the income or spending stream, then the demand for money must have increased and therefore the velocity of money must have decreased.
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An increased liquidity preference implies a decreased income velocity. And as long as money is capable of serving as a store of value for speculative purposes, there is always the possibility that more money may be held than is required to satisfy the transaction and precautionary motives and this decreases the velocity of money.
Similarly, an increase in the velocity of money may be caused by a decrease in the demand for money to hold, if, for example, lending or investing is considered as a better alternative to holding money. The main point is that an increase (or a decrease) in the quantity of money may be offset by a decrease (or an increase) in the velocity of money, so that the general price level remains unaffected.
The assumption that the volume of goods and services remains constant is implicit in another assumption, namely, that full employment exists. Full employment implies that no idle resources are available to increase the production of goods and services to be bought with money.
Hence on this assumption the quantity of goods and services can be taken as fixed relatively to the quantity of money. But if an increase in the quantity of money is offset by an increase in the quantity of goods and services as is possible at less-than-full employment, then the general price level may not rise and therefore the value of money may not fall. This is Keynes’ most fundamental criticism of the quantity theory.
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The Keynesian View of Money:
Keynes believed that changes in the money supply affect aggregate demand because of the relationship between the rate of interest and planned investment. The link remains on the basis of how today’s Keynesians view the impact of monetary changes on GNP.
The Keynesian’ s view of the transmission of changes in the money supply can be stated as:
An increase in money supply lowers the interest rate. Thus planned investment increases. This causes the aggregate expenditure (C+I+G) schedule to shift up. This addition to aggregate expenditure increases equilibrium GNP by shifting the aggregate derived expenditure (C+I+G) schedule to the right.