The Keynesian Theory of Money and Prices

(Assumptions, Superiority and Criticisms) |

Economics
He then presented a reformulated quantity theory of money which
brought about a transition from a monetary theory of prices to a
monetary theory of output. In doing this, Keynes made an attempt
to integrate monetary theory with value theory and also linked the
theory of interest into monetary theory. But “it is through the theory
of output that value theory and monetary theory is brought into just
a position with each other.”

Keynes does not agree with the older quantity theorists that there is
a direct and proportional relationship between quantity of money
and prices. According to him, the effect of a change in the quantity
of money on prices is indirect and non-proportional.

Keynes complains “that economics has been divided into two

compartments with no doors or windows between the theory of
value and the theory of money and prices.” This dichotomy between
the relative price level (as determined by demand and supply of
goods) and the absolute price level (as determined by demand and
supply of money) arises from the failure of the classical monetary
economists to integrate value theory with monetary theory.
Consequently, changes in the money supply affect only the absolute
price level but exercise no influence on the relative price level.

Further, Keynes criticises the classical theory of static equilibrium

in which money is regarded as neutral and does not influence the
economy‟s real equilibrium relating to relative prices. According to
him, the problems of the real world are related to the theory of
shifting equilibrium whereas money enters as a “link between the
present and future”.

Keynes’s Reformulated Quantity Theory of Money:

The Keynesian reformulated quantity theory of money is based on
the following:

1. All factors of production are in perfectly elastic supply so long as

there is any unemployment.

2. All unemployed factors are homogeneous, perfectly divisible and

interchangeable.

3. There are constant returns to scale so that prices do not rise or

fall as output increases.

4. Effective demand and quantity of money change in the same

proportion so long as there are any unemployed resources.

Given these assumptions, 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 capita], 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. Therefore,
the reformulated quantity theory of money stresses the point that
with increase in the quantity of money prices rise only when the
level of full employment is reached, and not before this.

This reformulated quantity theory of money is illustrated in Figure

67.1 (A) and (B) where OTC is the output curve relating to the
quantity of money and PRC is the price curve relating to the
quantity of money. Panel A of the figure shows that as the quantity
of money increases from О to M, the level of output also rises along
the ОТ portion of the OTC curve.
As the quantity of money reaches OM level, full employment output
OQF is being produced. But after point T the output curve becomes
vertical because any further increase in the quantity of money
cannot raise output beyond the full employment level OQF.

Panel В of the figure shows the relationship between quantity of

money and prices. So long as there is unemployment, prices remain
constant whatever the increase in the quantity of money. Prices
start rising only after the full employment level is reached.

In the figure, the price level OP remains constant at the OM

quantity of money corresponding to the full employment level of
output OQ1. But an increase in the quantity of money above OM
raises prices in the same proportion as the quantity of money. This
is shown by the RC portion of the price curve PRC.
Keynes himself pointed out that the real world is so complicated
that the simplifying assumptions, upon which the reformulated
quantity theory of money is based, will not hold. According to him,
the following possible complications would qualify the statement
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.”
(1) “Effective demand will not change in exact proportion to the
quantity of money.

(2) Since resources are homogenous, there will be diminishing, and

not constant returns as employment gradually increases.

(3) Since resources are not interchangeable, some commodities will

reach a condition of inelastic supply while there are still
unemployed resources available for the production of other
commodities.

(4) The wage-unit will tend to rise, before full employment has been
reached.

(5) The remunerations of factors entering into marginal cost will not
all change in the same proportion.”

Taking into account these complications, it is clear that the

reformulated quantity theory of money does not hold. An increase
in effective demand will not change in exact proportion to the
quantity of money, but it will partly spend itself in increasing output
and partly in increasing the price level. So long as there are
unemployed resources, the general price level will not rise much as
output increases. But a sudden large increase in aggregate demand
will encounter bottlenecks when resources are still unemployed.

It may be that the supply of some factors becomes inelastic or

others may be in short supply and are not interchangeable. This
may lead to increase in marginal cost and price. Price would
accordingly rise above average unit cost and profits would increase
rapidly which, in turn, tend to raise money wages owing to trade
union pressures. Diminishing returns may also set in. As full
employment is reached, the elasticity of supply of output falls to
zero and prices rise in proportion to the increase in the quantity of
money.

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. The price
level is measured on the vertical axis and output on the horizontal
axis.

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. This increases output and employment in the
beginning but not the price level. In the figure, the increase in the
aggregate money demand from D1 to D2 raises output from OQ1 to
OQ2 but the price level remains constant at OP. As aggregate money
demand increases further from D2 to D3 output increases from
OQ2 to OQ3 and the price level also rises to OP3.
This is because costs rise as bottlenecks develop through the
immobility of resources. Diminishing returns set in and less
efficient labour and capital are employed. Output increases at a
slower rate than a given increase in aggregate money demand, and
this leads to higher prices. As full employment is approached,
bottlenecks increase. Further-more, rising prices lead to increased
demand, especially for stocks. Thus prices rise at an increasing rate.
This is shown over the range in the figure.

But when the economy reaches the full employment level of output,
any further increase in aggregate money demand brings about a
proportionate increase in the price level but output remains
unchanged at that level. 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.

Superiority of the Keynesian Theory over the Traditional

Quantity Theory of Money:
The Keynesian theory of money and prices is superior to the
traditional quantity theory of money for the following reasons.

Keynes‟s reformulated quantity theory of money is superior to the

traditional approach in that he discards the old view that the
relationship between the quantity of money and prices is direct and
proportional. Instead, he establishes an indirect and non-
proportional relationship between quantity of money and prices.

In establishing such a relationship, Keynes brought about a

transition from a pure monetary theory of prices to a monetary
theory of output and employment. In so doing, he integrates
monetary theory with value theory. He integrates monetary theory
with value theory and also with the theory of output and
employment through the rate of interest.

In fact, the integration between monetary theory and value theory is

done through the theory of output in which the rate of interest plays
the crucial role. When the quantity of money increases the rate of
interest falls which increases the volume of investment and
aggregate demand thereby raising output and employment. In this
way, monetary theory is integrated with the theory of output and
employment.

As output and employment increase they further raise the demand

for factors of production. Consequently, certain bottlenecks appear
which raise the marginal cost including money wage rates. Thus
prices start rising.

Monetary theory is integrated with value theory in this way. The

Keynesian theory is, therefore, superior to the traditional quantity
theory of money because it does not keep the real and monetary
sectors of the economy into two separate compartments with „no
doors or windows between the theory of value and the theory of
money and prices.‟
Again, the traditional quantity theory is based on the unrealistic
assumption of full employment of resources. Under this
assumption, a given increase in the quantity of money always leads
to a proportionate increase in the price level. Keynes, on the other
hand, believes that full employment is an exception.

Therefore, so long as there is unemployment, output and

employment will change in the same proportion as the quantity of
money, but 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. 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.

Further, the Keynesian theory is superior to the traditional quantity

theory of money in that it emphasises important policy
implications. The traditional theory believes that every increase in
the quantity of money leads to inflation.

Keynes, on the other hand, establishes that so long as there is

unemployment, the rise in prices is gradual and there is no danger
of inflation. 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. Thus “this approach has the
virtue of emphasising that the objectives of full employment and
price stability may be inherently irreconcilable.”
Criticisms of Keynes Theory of Money and Prices:
Keynes‟ views on money and prices have been criticised by the
monetarists on the following grounds.

1. Direct Relation:
Keynes mistakenly took prices as fixed so that the effect of money
appears in his analysis in terms of quantity of goods traded rather
than their average prices. That is why Keynes adopted an indirect
mechanism through bond prices, interest rates and investment of
the effects of monetary changes on economic activity. But the actual
effects of monetary changes are direct rather than indirect.

2. Stable Demand for Money:

Keynes assumed that monetary changes were largely absorbed by
changes in the demand for money. But Friedman has shown on the
basis of his empirical studies that the demand for money is highly
stable.

3. Nature of Money:
Keynes failed to understand the true nature of money. He believed
that money could be exchanged for bonds only. In fact, money can
be exchanged for many different types of assets like bonds,
securities, physical assets, human wealth, etc.

4. Effect of Money:
Since Keynes wrote for a depression period, this led him to conclude
that money had little effect on income. According to Friedman, it
was the contraction of money that precipitated the depression. It
was, therefore, wrong on the part of Keynes to argue that money
had little effect on income. Money does affect national income.