Keynes’s Version of Quantity Theory of Money – Explained !

Read this article to learn about the Keynes’s version of quantity theory of money.

Transmission Mechanism:

Keynes’ great merit lies in removing the old fallacy that prices are directly determined by the quantity of money. His theory of money and prices brings forth the truth that prices are determined primarily by the cost of production.

Keynes does not agree with the old analysis which establishes a direct causal relationship between the quantity of money and the level of prices. 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. The initial impact of the changes in the total quantity of money falls on the rate of interest rather than on prices.

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. A lowering of the rate of interest (marginal efficiency of capital remaining the same) will raise investment, which in turn, will result in an increase of income, output, employment and prices. The prices rise on account of various factors like the rise in labour costs, bottlenecks in production, etc.

Thus, in Keynes’ version the level of prices is affected indirectly as a result of the effects of the changes in the quantity of money on the rate of interest and hence investment. 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 transmission mechanism process that follows in Keynes is like this:

Increases in the quantity of money → result in a fall in the rate of interest → which encourages investment → which in turn, raises income, output and employment → it results in raising the cost of production → this results in raising prices. The traditional theory ignored the influence of the quantity of money on the rate of interest, and thereby on output and goes directly from increase in the quantity of money to increase in the level of prices. Therein lay the fault of its analysis.

Keynes, thus, removed the classical dichotomy in the traditional money-price relationship by rejecting the direct relationship between M and P. He asserted that the relationship between M and P is indirect and that the theories of money and prices can be integrated through the theory of aggregate demand or the theory of output. The missing link between the real and monetary theories, according to Keynes, is the rate of interest. The mechanism of the rate of interest will work as shown above, which will increase investment and through multiplier ultimate income.

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. The process of integration between M and P and the extent by which P will change, as a result of a given change in M, can be shown through a general theoretical model based on money supply (M), general price level (P), the aggregate demand (D), the level of income or output (Y or O), the level of employment (N) and the level of money wages (W).

These relationships can be expressed through elasticity coefficients. The ratio of a proportionate change in P to the proportionate change in M is shown by the elasticity of price level (e). The change in aggregate demand (D) to a given change in M is the elasticity of aggregate demand (e_d). The change in Y or O in response to a change in AD may be expressed as elasticity of income or output (e_y or e_o).

The change in price level, as a result of a given change in AD, is denoted by elasticity of price (e_p). The response of Y or O to an increase in employment (N) is shown by the elasticity of returns (e_r) and the response of money wages as a result of an increase in employment is the elasticity of money wages (e_w).

In the classical version of the quantity theory of money, which is based on the assumption of full employment and where money is only a medium of exchange, the elasticity of price level (e) and e_d remain equal to unity. The elasticity of output (e₀) is zero and as a consequence the elasticity of price (e_p) must be equal to unity. Since e₀ + e_p = 1 (unity), the price level, in this case rises in exact proportion to the quantity of money.

In Keynes’ version, e = 0, prior to full employment and e = 1, or unity, once the full employment level is attained. In the former case (less than full employment) e_d – unity and e_r will also be equal to unity on the presumption that production is governed by the law of constant returns, but e_r is determined by e_w. Before full employment money wages are assumed to be constant, therefore, e_w will be equal to zero. Assuming other factor prices also as constant, e_r will be equal to unity. If e_r is unity, then, e₀ will also be unity. If elasticity of output (e₀) is equal to unity, then e_p, must be equal to zero. 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.

Keynes, however, does not subscribe to the view that the price level will be constant before full employment, though the rise in price level may be less than proportionate. Because there is a possibility of money wages rising before full employment, e_w is greater than zero; e_w > 0 brings, in turn, the operation of the law of diminishing returns, so that e_r < 1 (unity) and, therefore, e_o will also be less than unity. The elasticity of aggregate demand (e_d) is equal to the sum of e_o and e_v (e_d = e_o + e_p). This shows that the determination of the magnitude of e_d is very complex matter depending upon a number of variables like LP, MEC etc. Since a part of the money is likely to be held by speculators as idle balances, e<i is likely to be less than unity; e_p will be greater than zero because e_w > 0 and e_r < unity. Thus, it is clear that the price level will start rising even before the full employment level is attained. Keynes’ analysis also shows that there is no direct or proportionate relation between M and P, in his analysis, the monetary and the real factors in the economy stand fully integrated.

Merits of Keynes’ Version of the Quantity Theory of Money:

Keynes’ version of the quantity theory stands in sharp comparison to the old classical theory and is considered superior to it on the following grounds:

(i) It Analyses the Casual Process:

Keynes’ great merit lies in removing the old notion that prices are directly determined by the quantity of money. He brings to the fore the true and real causal process which exists between the quantity of money and prices. The relationship that exists is indirect and is brought through changes in the rate of interest.

(ii) It Does not Assume Full Employment:

The quantity theory of money, like all classical doctrines, is based on the assumption of full employment. As long as the human and material resources were taken to be fully employed, it was easy for the classical thinkers to say that an increase in the quantity of money was associated with or followed by a rise in the price level. Since, money in the classical scheme could not affect employment, it could raise prices only.

According to Prof. Dillard, “This leads to the conclusion that all increases in the quantity of money tend to be inflationary, a conclusion quite valid under the assumption that resources are fully employed, a nonsense conclusion when this special assumption is dropped.” Keynes, on the other hand, does not assume full employment. To him unemployment is the rule and full employment only an exception. He says, “So long as there is unemployment, employment will change in the same proportion as the quantity of money; and when there is full employment, price will change in the same proportion as the quantity of money.”

(iii) When to Dread Inflation:

Keynesian approach to the quantity theory of money helps us to look at inflation entirely from a different perspective. It tells us when dread inflation and when not to dread it. As long as there is unemployment of resources, inflation is not to be feared as it results in an increase in employment and output. But once the level of full employment is attained, true inflation begins and it becomes a real threat.

According to classicals, every increase in money supply results in inflation (as full employment was always presumed). To Keynes, only that increase in money supply results in inflation which takes place beyond the level of full employment. Thus, Keynesian version shows a great advance on the traditional version of the quantity theory of money.

(iv) It Integrates Monetary Theory with the Theory of Value:

Another great merit of Keynes theory of money and prices is that it integrates monetary theory with the theory of value. Keynes gave up the traditional division of the economy into the real sector and the monetary sector and pointed out that there could be no monetary economy in which money was neutral. 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.

According to value theory, the price (which is the value expressed in terms of money) is determined by the forces of demand and supply and the production is carried to the extent of the equality of the marginal cost with marginal revenue. Thus, the concepts of marginal cost, marginal revenue, demand and supply, their elasticities (specially in the short period) become important in the theory of value.

When Keynes discusses the theory of prices in general (price level), he emphasises cost of production, elasticity of demand, elasticity of supply and other concepts which are important in the theory of value of individual price determination. 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.

As such, he was concerned with the elasticities of prices in response to changes in aggregate demand and the elasticity of aggregate demand in response to changes is the quantity of money. Keynes shows that prices rise on account of the rise in costs of production; costs of production rise because of the inelasticity of short-period supply of output and employment. Front a monetary theory of prices, Keynes, thus, shifted to a monetary theory of output. This, in itself, turned out to be an important contribution as it resulted in a successful integration of the quantity theory of money with the theory of value.

Further, Keynes also integrated the theory of output with the theory of money. In fact, the integration of monetary theory with the theory of value is accomplished through the theory of output, in which the rate of interest, by influencing the volume of investment, plays a vital role. Changes in the quantity of money, by bringing about changes in the rate of interest affect investment and hence output and employment. As the volume of output and employment changes, the costs of production vary and prices are also affected.

The traditional theory did not pay any heed, to the influence that the quantity of money exerts on the rate of interest and through it on income, output, employment and prices. Thus, in addition to integrating the theory of output with the theory of money, Keynes also integrated the theory of output with the monetary theory (theory of money).

(v) It Differentiates between the Determination of the General Price Level and Individual Prices:

Keynes theory ‘differentiates’ between the determination of the general price level and individual prices. Individual prices of various commodities are determined by the forces of demand and supply with reference to the nature of competition and the type of market, whereas a large number of considerations enter the determination of the general price level.

To him, the analysis of the fluctuations in the general price level is not so simple and straight as has been assumed by the exponents of the traditional quantity theory of money; that is, an increase in the volume of money will straightway raise the price level. The whole process is highly complicated and roundabout, certainly not so direct and simple as was claimed by the classical economists.

Reformulated Theory of Money:

From a close analysis, it is clear that Keynes almost reformulated the quantity theory of money. The pith and substance of the theory of money as reformulated by him is: as long as there are human and material unemployed resources in the economy, a rise in the price level will help expansion of income, output and employment.

However, when the level of full employment has been attained and the supply of the factors of production becomes in inelastic, true inflation sets in. Steps have to be taken to curb it and to keep within bounds. The reformulated version exposes the fallacy of old thinking and brings forth the fact that an increase in money becomes a matter of concern only after full employment.

Thus, it points out the desirability of resorting to deficit financing in order to fight deflation. Let us now understand Keynes’ theory of money and prices in terms of effective demand. Changes in aggregate demand will affect prices according to the effect of such changes on cost and output.

It may be noted that effective demand will not change in exact proportion to the variations in the quantity of money nor will prices change in exact proportion to changes in effective demand increased effective demand will manifest itself partly in increased employment and partly in increased prices. In the beginning, starting from a period of depression, employment is likely to rise faster than prices; later as full employment is approached, prices are likely to rise faster than employment.

However, the proposition that “so long as there is unemployment employment will change in the same proportion as the quantity of money; and when there is full employment, prices will change in the same proportion as the quantity of money” is mere approximation to the truth. It is a general sort of statement subject to so many qualifications as price do rise during the transition period (till the level of full employment is reached).

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. As the scarcity of labour is felt, their bargaining power is strengthened. They demand higher wages. Employers shift the burden of the increased cost of production on account of higher wages to consumers, as a result of which prices rise.

(b) Operation of the law of diminishing return (increasing costs):

Another reason is the operation of the Law of Diminishing Returns or increasing costs in the short period. It applies because one constant factor of production (labour or capital) gets combined with other variable factors. In other words, it may be possible to increase some factors of production while others, like plant and machinery may not be increased. Hence, returns may diminish or costs may go up resulting in higher prices.

(c) Bottlenecks in production:

As production increases during the transitional period on account of increased money supply, various types of bottlenecks, like shortages of raw material, capital, power, transport etc., start manifesting themselves. As long as these shortages last, prices soar high. It is not impossible to overcome these shortages. Bottlenecks are accentuated by a rapid rise in output. When a bottleneck is experienced in one line of production, the price of the item in question rises sharply and ‘bottleneck inflation’ comes to exist; given sufficient time, it can be easily overcome.

Assumptions and Limitations:

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. Yet, the new version has its own shortcomings. They mostly stem from its assumptions. For example, it presumes that productive resources are perfectly elastic in supply before the level of full employment, i.e., there are no shortages of land, labour, capital. It further presumes perfectly inelastic supply of the factors beyond the level of full employment. Again, it presumes that effective demand increases in proportion to an increase in the quantity of money, failing which output will not expand.

Moreover, the whole relationship between the quantity of money and the price level is set in motion through the so-called missing link—the rate of interest. But whether or not change in the rate of interest will cause a corresponding change in the whole chain of investment, employment, income, output, cost of production and prices, will depend upon two other determinants, namely, the marginal efficiency of capital and the propensity to consume.

Suppose, for instance, that marginal efficiency of capital is falling or the propensity to consume is decreasing, a fall in the rate of interest may not be able to generate any increase in income, output, employment and hence prices. Thus, unless these elements are presumed to be given or constant, the whole chain of causation may not work at all.

The theory also wrongly presumes that money wages remain constant as the employment expands. With an increase in the number of workers employed and a rise in the demand for labour, better bargaining power of trade unions, workers are bound to put forward claims for higher wages.

Money wage rates tend to increase in response to a rise in employment even before the economy attains the level of full employment. The assumption of perfect homogeneity of resources is also highly unrealistic. No two units of any factor of production, not to speak of labour, are homogeneous. 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.