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The Quantity Theory and the
Keynesian Theory of Money
Classical analysis of prices and inflation


This model gives an introduction to
equilibrium in the money market
It further highlights important
theoretical controversies between
different schools of thought in
economics
 Keynesians
 Monetarists
Milton Friedman
The Quantity Theory
 The
quantity theory is by definition
correct
 MV = PY
M
= money supply
 V = velocity of circulation
 P = price level
 Y = national income
Money and the price level

Since MV = PY, it must be that
P

= MV/Y
Y is given like Yf (flexible prices), V is
constant. Therefore,
 Change
in M = change in P
 ”Inflation is anywhere and everywhere a
monetary phenomenon”
The effect of printing extra money: the classical analysis
Price level
AS
P2
P1
AD2
AD1
O
Q1
National output
Money and prices in Norway 1900-2000
50
Money
CPI
40
30
20
10
0
1900
-10
-20
1910
1920
1930
1940
1950
1960
1970
1980
1990
Money and Interest Rates
The Demand for Money
Keynesian money demand

Why do we need money:
 Transaction
purposes
 Precautionary purposes
 Safety purposes

Money demand is above all dependent
on:
 income
(+)
 interest rates (-)
THE DEMAND FOR MONEY

The motives for holding money:
liquidity preference
 transactions
and precautionary demand
for money: L1
Rate of interest
The transactions-plus-precautionary demand for money: L1
L1
O
Active balances
THE DEMAND FOR MONEY

The motives for holding money:
liquidity preference
 transactions
and precautionary demand
for money: L1
 speculative
demand for money: L2
Rate of interest
The speculative demand for money: L2
L2
O
Idle balances
THE DEMAND FOR MONEY

The motives for holding money:
liquidity preference
 transactions
and precautionary demand
for money: L1
 speculative
 the
demand for money: L2
total demand for money: L1 + L2
Rate of interest
The total demand-for-money curve: L (= L1 + L2)
L ( = L1 + L2 )
L2
L1
O
Total money balances
Money and Interest Rates
Equilibrium in the
Money Market
The supply of money curve: (a) exogenous money supply
Rate of interest
MS
O
Quantity of money
Equilibrium in the money market
Rate of interest
MS
re
L
O
Me
Money
Equilibrium in the money market
Rate of interest
MS
re
L
O
Me
Money
Relationship between the
Money and Goods Markets
Relationship between the Money and Goods
Markets
Effects of Monetary
Changes on National
Income
Effect of a rise in money supply:
the traditional Keynesian transmission mechanism
Rate of interest
Rate of interest
MS
r1
r1
L
O
I
O
Money
I1
Investment
Effect of a rise in money supply:
the traditional Keynesian transmission mechanism
MS'
Rate of interest
Rate of interest
MS
r1
r1
r2
r2
L
O
I
I1
Money
I2
Investment
(a) Stage 1: MS r 
(b) Stage 2: r I
O
Rate of interest
Rate of interest
Different views on the demand for investment
r1
r1
I
I
O
I1
Investment
(a) Keynesian
O
I1
Investment
(b) New classical / Monetarist
Rate of interest
Rate of interest
Different views on the demand for investment
r2
r1
r1
I
I
O
I2 I1
Investment
(a) Keynesian
O
I1
Investment
(b) New classical / Monetarist
Rate of interest
Rate of interest
Different views on the demand for investment
r2
r1
r2
r1
I
I
O
I2 I1
Investment
(a) Keynesian
O
I2
I1
Investment
(b) New classical / Monetarist
Relationship between the Money and Goods
Markets
ISLM Analysis
Sir John Hicks (1904 – 1989)
Injections, Withdrawals
Goods market equilibrium: deriving the IS curve
Assume that an interest
rate of r1 gives investment
of I1 and saving of S1
S1
I1
Rate of interest
O
r1
O
Injections, Withdrawals
Goods market equilibrium: deriving the IS curve
Assume that an interest
rate of r1 gives investment
of I1 and saving of S1
S1
I1
Rate of interest
O
r1
O
Y1
Injections, Withdrawals
Goods market equilibrium: deriving the IS curve
Assume that an interest
rate of r1 gives investment
of I1 and saving of S1
S1
I1
Rate of interest
O
Y1
r1
O
Y
Injections, Withdrawals
Goods market equilibrium: deriving the IS curve
Assume that an interest
rate of r1 gives investment
of I1 and saving of S1
S1
I1
Rate of interest
O
Y1
a
r1
O
Y
Injections, Withdrawals
Goods market equilibrium: deriving the IS curve
Now assume that the interest
rate falls to r2, giving
investment of I2 and saving of S2
S1
S2
I2
I1
Rate of interest
O
Y1
a
r1
r2
O
Y
Y2
Injections, Withdrawals
Goods market equilibrium: deriving the IS curve
Now assume that the interest
rate falls to r2, giving
investment of I2 and saving of S2
S1
S2
I2
I1
Rate of interest
O
Y1
a
r1
r2
O
Y
Y2
Injections, Withdrawals
Goods market equilibrium: deriving the IS curve
Now assume that the interest
rate falls to r2, giving
investment of I2 and saving of S2
S1
S2
I2
I1
Rate of interest
O
Y1
a
r1
b
r2
O
Y2
Y
Injections, Withdrawals
Goods market equilibrium: deriving the IS curve
Now assume that the interest
rate falls to r2, giving
investment of I2 and saving of S2
S1
S2
I2
I1
Rate of interest
O
Y1
Y2
a
r1
b
r2
IS
O
Y
Rate of interest
Injections, Withdrawals
The IS curve
S1
S2
I2
I1
O
O
Y1
r1
r2
Y
Y2
a
b
IS
Money market equilibrium: deriving the LM curve
L'
O
Rate of interest
Rate of interest
Assume that at a level of
national income, Y1,
the demand for money is L'
O
Money
Y1
National income
Money market equilibrium: deriving the LM curve
Assume that at a level of
national income, Y1,
the demand for money is L'
L'
O
Rate of interest
Rate of interest
MS
O
Money
Y1
National income
Money market equilibrium: deriving the LM curve
Assume that at a level of
national income, Y1,
the demand for money is L'
r1
L'
O
Rate of interest
Rate of interest
MS
r1
O
Money
Y1
National income
Money market equilibrium: deriving the LM curve
Assume that at a level of
national income, Y1,
the demand for money is L'
r1
L'
O
Rate of interest
Rate of interest
MS
r1
O
Money
c
Y1
National income
Money market equilibrium: deriving the LM curve
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
r1
L"
L'
O
Rate of interest
Rate of interest
MS
r1
O
Money
c
Y2
Y1
National income
Money market equilibrium: deriving the LM curve
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
r2
r1
L"
L'
O
Rate of interest
Rate of interest
MS
r2
r1
O
Money
c
Y2
Y1
National income
Money market equilibrium: deriving the LM curve
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
r2
r1
L"
L'
O
Rate of interest
Rate of interest
MS
r2
r1
O
Money
d
c
Y2
Y1
National income
Money market equilibrium: deriving the LM curve
Now assume that at the higher
level of national income, Y2,
the demand for money rises to L"
LM
r2
r1
L"
L'
O
Rate of interest
Rate of interest
MS
r2
r1
O
Money
d
c
Y2
Y1
National income
Equilibrium in both the goods and money markets
Rate of interest
LM
IS
O
National income
Equilibrium in both the goods and money markets
LM
Rate of interest
Assume that national income
is currently at a level of Y1
a
IS
O
Y1
National income
Equilibrium in both the goods and money markets
LM
Rate of interest
This gives a rate of
interest of r1 (point a)
r1
a
IS
O
Y1
National income
Equilibrium in both the goods and money markets
LM
Rate of interest
But at r1, national income
is below the goods market
equilibrium level (Y2)
a
b
r1
IS
O
Y1
Y2
National income
Equilibrium in both the goods and money markets
LM
Rate of interest
But as income rises, so there
will be a movement up the
LM curve. The interest rate
will rise, thereby reducing
national income below Y2.
a
b
r1
IS
O
Y1
Y2
National income
Equilibrium in both the goods and money markets
Rate of interest
LM
re
IS
O
Ye
National income
Rate of interest
ISLM analysis of changes in the goods and money
markets
LM
r1
IS
O
Y1
National income
ISLM analysis of changes in the goods and money
markets
LM
Rate of interest
A rise in
injections
r2
r1
IS2
IS1
O
Y1
Y2
National income
Rate of interest
ISLM analysis of changes in the goods and money
markets
LM1
LM2
A rise in the
money supply
r1
r3
IS
O
Y1
Y3
National income
Rate of interest
ISLM analysis of changes in the goods and money
markets
LM1
A rise in both
LM2
injections and
money supply
r1
IS2
IS1
O
Y1
National income
Y4
Liquidity trap
R
IS
IS`
LM
Y
The classical case
R
IS`
IS
LM
Y