Vous êtes sur la page 1sur 27






I, Rishabh would like to take this opportunity to thank Dr Ramachandrurdu (faculty of economics) for helping and guiding me in completing my project.

I would also like to thank our Vice-Chancellor, Prof .R.G.B. Bhagvath Kumar and our Registrar, Prof.P.Sudhakar, for giving me this opportunity to do a detailed study on the urban social problems. Lastly I would like to thank my friends for their efficient help and co-operation in helping me complete my project work

INTRODUCTION This project research deals with the quantitative theory of money which gives an idea about this particular area of economics. The concept of the Quantity Theory of Money (QTM) began in the 16th century. As gold and silver inflows from the Americas into Europe were being minted into coins, there was a resulting rise in inflation. This led economist Henry Thornton in 1802 to assume that more money equals more inflation and that an increase in money supply does not necessarily mean an increase in economic output. Here we look at the assumptions and calculations underlying the QTM, as well as its relationship to monetarism and ways the theory has been challenged. The quantity theory of money states that there is a direct relationship between the quantity of money in an economy and the level of prices of goods and services sold. According to QTM, if the amount of money in an economy doubles, price levels also double, causing inflation (the percentage rate at which the level of prices is rising in an economy). The consumer therefore pays twice as much for the same amount of the good or service. Like most things in economics, there is a market for money. The supply of money in the money market comes from the Fed. The Fed has the power to adjust the money supply by increasing or decreasing the number of bills in circulation. Nobody else can make this policy decision. The demand for money in the money market comes from consumers. The scope of this project extends to the money supply in the market, how money supply affects the economy and controls inflation and deflation, this project will help to understand the ways by which an economy is governed and driven. A brief analysis of each and every part of quantity theory of money is discussed in the project work. Effective measures with suggestions and recommendation are given in this project for the better understanding of the topic.


The concept of the Quantity Theory of Money (QTM) began in the 16th century. As gold and silver inflows from the Americas into Europe were being minted into coins, there was a resulting rise in inflation. This led economist Henry Thornton in 1802 to assume that more money equals more inflation and that an increase in money supply does not necessarily mean an increase in economic output. Here we look at the assumptions and calculations underlying the QTM, as well as its relationship to monetarism and ways the theory has been challenged. QTM IN A NUTSHELL

The quantity theory of money states that there is a direct relationship between the quantities of money in an economy and the level of prices of goods and services sold. According to the quantity theory of money, if the amount of money in an economy doubles, price levels also double, causing inflation. The consumer therefore pays twice as much for the same amount of the goods or service.

Another way to understand this theory is to recognize that money is like any other commodity: increases in its supply decrease marginal value (the buying capacity of one unit of currency). So an increase in money supply causes prices to rise (inflation) as they compensate for the decrease in moneys marginal value.


In simple form, the theory is


Each variables denotes the following :

M = money supply V = velocity of circulation P = average price level T = volume of transactions of goods and services

The original theory was considered orthodox among 17th century classical economists and was overhauled by 20th century economist irving fisher, who formulated the above equation, and Milton Friedman. It is built on the principle of equation of exchange.


Thus if an economy has US $ 3, and those $3 were spent 5 times in a month, total spending for the month would be $15.


QTM adds assumption to the logic of the equation of exchange.in its most basic form, the theory assumes that velocity and volume of transactions are constant in the short term. These assumption however, have been criticized, particularly the assumption that volume of transaction .the argument point out that the velocity of circulation depends on consumer and business spending impulses, which cannot be constant.

The theory also assumes that the quantity of money, which is determined by outside forces, is the main influence of economic activity in a society. A change in money supply results in changes in price levels and/or a change in supply of goods and services. It is primarily these changes in money stock that cause a change in spending. And the velocity of circulation depends not on the amount of money available or on the current price level but on changes in price levels. Finally, the number of transactions is determined by labor, capital, natural resources, knowledge and organization. The theory assumes an economy in equilibrium and at full employment. Essentially, the theorys assumptions imply that the value of money is determined by the amount of money available in an economy. An increase in money supply results in a decrease in the value of money because an increase in money supply causes a rise in inflation. As inflation rises, the purchasing power, or the value of money, decreases. It therefore will cost more to buy the same quantity of goods or services. MONEY SUPPLY, INFLATION AND MONETARISM As QTM says that quantity of money determines the value of money, it forms the cornerstone of monetarism. Monetarists say that a rapid increase in money supply leads to a rapid increase in inflation. Money growth that surpasses the growth of economic output results in inflation as there is too much

money behind too little production of goods and services. In order to curb inflation, money growth must fall below growth in economic output. This premise leads to how monetary policy is administered. Monetarists believe that money supply should be kept within an acceptable bandwidth so that levels of inflation can be controlled. Thus, for the near term, most monetarists agree that an increase in money supply can offer a quick-fix boost to a staggering economy in need of increased production. In the long term, however, the effects of monetary policy are still blurry.

Less orthodox monetarists, on the other hand, hold that an expanded money supply will not have any effect on real economic activity (production, employment levels, spending and so forth). But for most monetarists any anti-inflationary policy will stem from the basic concept that there should be a gradual reduction in the money supply. Monetarists believe that instead of governments continually adjusting economic policies (i.e. government spending and taxes), it is better to let non-inflationary policies (i.e. gradual reduction of money supply) lead an economy to full employment.

QTM RE EXPERIENCED John Maynard Keynes challenged the theory in the 1930s, saying that increases in money supply lead to a decrease in the velocity of circulation and that real income, the flow of money to the factors of production, increased. Therefore, velocity could change in response to changes in money supply. It was conceded by many economists after him that Keynes idea was accurate.

MONETARISM AND QUANTITY THEORY OF MONEY The basic of monetarism The key features of monetarist theory are as follows: The main cause of inflation is an excess supply of money leading to in the words of monetarist economist Milton Friedman, too much money chasing too few goods. We will see graphically how this can lead to a buildup of inflationary pressure in an economy. Tight control of money and credit is required to maintain price stability.

Attempts by the government to use fiscal and monetary policy to fine-tune the rate of growth of aggregate demand are often costly and ineffective. Fiscal policy has a role to play in stabilizing the economy providing that the government is successfully able to control its own borrowing.

The key is for monetary policy to be credible perhaps in the hands of an independent central bank so that peoples expectations of inflation are controlled.

A simple way of explaining how a surge in the amount of money in circulation can feed through to higher inflation is shown in the next flow chart.

Excess money balances held by households and businesses can affect demand and output in several directions. Consumers will often increase their own demand for goods and services adding directly to aggregate demand (although a high proportion of this extra spending may go on imports).

Secondly some of the excess balances will be saved in bonds and other financial assets, or invested in the housing market. An increase in the demand for bonds causes a downward movement in bond interest rates (there is an inverse relationship between the two) and this can then stimulate an increase in investment. Similarly money that flows into housing will push house prices higher, and we know understand quite well how a booming housing market stimulates consumer wealth, borrowing and an increase in spending.


The Quantity Theory was first developed by Irving Fisher in the inter-war years as is a basic theoretical explanation for the link between money and the general price level. The quantity theory rests on what is sometimes known as the Fisher identity or the equation of exchange. This is an identity which relates total aggregate demand to the total value of output (GDP).

MxV=PxY Where 1. 2. 3. 4. M is the money supply V is the velocity of circulation of money P is the general price level Y is the real value of national output (i.e. real GDP)

The velocity of circulation represents the number of times that a unit of currency (for example a 10 note) is used in a given period of time when used as a medium of exchange to buy goods and services. The velocity of circulation can be calculated by dividing the money value of national output by the money supply. In the basic theory of monetarism expressed using the equation of exchange, we assume that the velocity of circulation of money is predictable and therefore treated as a constant. We also make a working assumption that the real value of GDP is not influenced by monetary variables. For example the growth of a countrys productive capacity might be determined by the rate of productivity growth or an increase in the capital stock. We might therefore treat Y (real GDP) as a constant too. If V and Y are treated as constants, then changes in the rate of growth of the money supply will equate to changes in the general price level. Monetarists believe that the direction of causation is from money to prices (as we saw in the flow chart on the previous page). The experience of targeting the growth of the money supply as part of the monetarist experiment during the 1980s and early 1990s is that the velocity of circulation is not predictable indeed it can suddenly change, partly as a result of changes to peoples behaviour in their handling of money. During the 1980s it was found that direct and predictable links between the growth of the money supply and the rate of inflation broke down. This eventually caused central banks in different countries to place less importance on the money supply as a target of monetary policy. Instead they switched to having exchange rate targets, and latterly they have become devotees of inflation targets as an

anchor for the direction of monetary policy.


There is no unique measure of the money supply because it is used in such a wide variety of ways : NARROW MONEY comprises notes and coins in circulation banks operational balances at the bank of England. Over 99% of M0 is made up of notes and coins as cash is used mainly as a medium of exchange for buying goods and services. Most economists believe that changes in the amount of cash in circulation have little significant effect on total national output and inflation. At best M0 is seen as a co-incident indicator of consumer spending and retail sales. If people increase their cash balances, it is mainly a sign that they are building up these balances to fund short term increases in spending. M0 reflects changes in the economic cycle, but does not cause them.

.M4 (BROAD MONEY) is a wider definition of what constitutes money.M4 includes deposits saved with banks and building societies and also money created by lending in the form of loans and overdrafts. M4 = M0 plus sight (current accounts) and time deposits (saving accounts).

When a bank or another lender grants a loan to a customer, bank liabilities and assets raise by the same amount and so does the money supply. Again M4 is a useful background indicator to the strength of demand for credit. The Bank takes M4 growth into account when assessing overall monetary conditions, but it is not used as an intermediate target of monetary policy. Its main value is as a signpost of the strength of demand which can then filter through the economy and eventually affect inflationary pressure.


Economic Theory

As economies have developed over time, so economic theory has developed as well to try to explain changing circumstances. In the 19th century and the beginning of the 20th century Classical theory held the balance of power in economic circles, but it began to lose it at the time of the Great Depression of the 1930s. Classical theory had difficulty in explaining why the depression kept getting worse, and an economist called John Maynard Keynes began to develop alternative ideas.

This marked the birth of Keynesian economics and most post-war governments managed the economy Using Keynesian policies up until the beginning of the 1970s. Then Keynesian theory ran into trouble as unemployment and inflation began to rise together - a phenomenon known as stagflation. At this point another economist stepped in - Milton Friedman. He was known as a Monetarist, and along with a number of other Monetarist economists at Chicago University did a lot of work trying to explain what caused inflation.

However, the Conservative government of the 1980s gradually became disillusioned with Monetarism and then returned to a modern variation of classical economic management - Neo-Classical economics. Like Classical economics, it stresses the role of free markets in delivering the best possible level of economic growth.

QUANTITY THEORY OF MONEY The classical economists view of inflation revolved around the Quantity Theory of Money, and this theory was in turn derived from the Fisher Equation of Exchange. This equation says that:


Where: M is the amount of money in circulation V is the velocity of circulation of that money P is the average price level and

T is the number of transactions taking place

Classical economists suggested that V would be relatively stable and T would (as we have seen above) always tend to full employment. Therefore they came to the conclusion that:


We have seen that Classical economists had complete faith in markets. They believed that the economy would always settle - automatically - at the full employment equilibrium in the long-run. However, they did acknowledge that there might be a slightly different reaction in the short run as the economy adjusted to its new long-run equilibrium. We can illustrate these changes with AS & AD analysis:


Any increase in aggregate demand in the short-run will lead to an increase in output (Q1 to Q2), but will also lead to prices increasing. This will happen as firms suffer from diminishing returns and are forced to increase the prices of their product to cover the higher level of costs. Increases in aggregate demand may come about for a variety of reasons including:

* Increases in the money supply * Lower levels of taxation * Increased government expenditure


In the long-run, however, the situation will be different. The economy will have tended towards full employment on its own, and so any further increases in demand will simply be inflationary. The shape of the long-run aggregate supply curve will therefore be vertical:


The long-run aggregate supply curve is vertical at the full employment level of output (Of), and any increase in aggregate demand leads to prices increasing, but no increase in output.


So, Classical economists are of the view that the economy is self-adjusting. We can therefore sum up their policy recommendations in a variation on a well-known phrase (you may well have heard it from your teacher or lecturer in its original form)

'Don't just do something, sit there!'

Of course, taking this too literally would be unfair on Classical economists, but it would be true to say that because the economy tends to full-employment, there is no need to actively intervene in the economy. In fact intervention may simply be destabilizing and inflationary. The key to long-term stable growth is therefore:

* Ensure free markets with no imperfections (through supply-side policies)

* Control the growth of the money supply to ensure low inflation


Supply-side policies can be used to reduce market imperfections. This should have the effect of increasing the capacity of the economy to produce (in other words the longrun aggregate supply). If the level of aggregate supply increases then Say's Law (the work of Jean Baptiste Say) predicts that demand will also increase. This will be the only non-inflationary way to get increases in output.

[Supply-side policies]

Using supply-side policies has increased the level of output from Qfe1 to Qfe2, but the price level has remained stable. Supply-side policies as we have said are ones that reduce market imperfections. They may include: *Improving education & training to make the work-force more occupationally mobile *Reducing the level of benefits to increase the incentive for people to work *Reducing taxation to encourage enterprise and encourage hard work *Policies to make people more geographically mobile * Reducing the power of trade unions to allow wages to be more flexible * Getting rid of any capital controls * Removing unnecessary regulations


The other area that a Classical economist felt was important was to control monetary growth. In this way (as predicted by the Quantity Theory of Money) they would be able to maintain low inflation. Policies might include:

* Open-market operations [Look up Open-market Operations in glossary] * Funding [Look up Funding in glossary] * Monetary-base contro [Look up Monetary-base Control in glossary] * Interest rate control


Keynesian economics is an economic theory named after John Maynard Keynes (1883 - 1946), a British economist. It was his simple explanation for the cause of the Great Depression for which he is most wellknown. Keynes' economic theory was based on an circular flow of money. His ideas spawned a slew of interventionist economic policies during the Great Depression. In Keynes' theory, one person's spending goes towards anothers earnings, and when that person spends her earnings she is, in effect, supporting anothers earnings. This circle continues on and helps support a normal functioning economy. When the Great Depression hit, people's natural reaction was to hoard their money. Under Keynes' theory this stopped the circular flow of money, keeping the economy at a standstill. Keynes' solution to this poor economic state was to prime the pump. By prime the pump, Keynes argued that the government should step in to increase spending, either by increasing the money supply or by actually buying things on the market itself. During the Great Depression, however, this was not a popular solution. It is said, however, that the massive defense spending that United States President Franklin Delano Roosevelt initiated helped revive the US economy. Since Keynesian economics advocates for the public sector to step in to assist the economy generally, it is a significant departure from popular economic thought which preceded it laissez-fair capitalism. Laissez-fair capitalism supported the exclusion of the public sector in the market. The belief was that an unfettered market would achieve balance on its own. Proponents of free-market capitalism include the Austrian School of economic thought; one of its earliest founders, Friedrich von Hayek, also lived in England alongside Keynes. The two had a public rivalry for many years because of their opposing thoughts on the role of the state in the economic lives of individuals. Keynesian economics warns against the practice of too much saving, or under consumption, and not enough consumption, or spending, in the economy. It also supports considerable redistribution of wealth, when needed. Keynesian economics further concludes that there is a pragmatic reason for the massive redistribution of wealth: if the poorer segments of society are given sums of money, they will likely spend it, rather than save it, thus promoting economic growth. Another central idea of Keynesian economics is

that trends in the macroeconomic level can disproportionately influence consumer behavior at the microlevel. Keynesian economics, also called macroeconomics for its wide look at the economy as a whole, remains one of the important schools in economic thought today. Multiplier effect" and interest rates are two aspects of Keynes' model had implications for policy:

First, there is the "Keynesian multiplier", first developed by Richard F. Kahn in 1931. Exogenous increases in spending, such as an increase in government outlays, increases total spending by a multiple of that increase. A government could stimulate a great deal of new production with a modest outlay if:

1. The people who receive this money then spend most on consumption goods and save the rest. 2. This extra spending allows businesses to hire more people and pay them, which in turn allows a further increase consumer spending.

This process continues. At each step, the increase in spending is smaller than in the previous step, so that the multiplier process tapers off and allows the attainment of an equilibrium. This story is modified and moderated if we move beyond a "closed economy" and bring in the role of taxation: the rise in imports and tax payments at each step reduces the amount of induced consumer spending and the size of the multiplier effect . Second, Keynes re-analyzed the effect of the interest rate on investment. In the classical model, the supply of funds (saving) determined the amount of fixed business investment. That is, since all savings was placed in banks, and all business investors in need of borrowed funds went to banks, the amount of savings determined the amount that was available to invest. To Keynes, the amount of investment was determined independently by long-term profit expectations and, to a lesser extent, the interest rate. The latter opens the possibility of regulating the economy through money supply changes, via monetary policy. Under conditions such as the Great Depression, Keynes argued that this approach would be relatively ineffective compared to fiscal policy. But during more "normal" times, monetary expansion can stimulate the economy.

Main theories The two key theories of mainstream Keynesian economics are the IS-LM model of John Hicks, and the Phillips curve; both of these are rejected by Post-Keynesians.

It was with John Hicks that Keynesian economics produced a clear model which policy-makers could use to attempt to understand and control economic activity. This model, the IS-LM model is nearly as influential as Keynes' original analysis in determining actual policy and economics education. It relates aggregate demand and employment to three exogenous quantities, i.e., the amount of money in circulation, the government budget, and the state of business expectations. This model was very popular with economists after World War II because it could be understood in terms of general equilibrium theory. This encouraged a much more static vision of macroeconomics than that described above. The second main part of a Keynesian policy-makers theoretical apparatus was the Phillips curve. This curve, which was more of an empirical observation than a theory, indicated that increased employment, and decreased unemployment, implied increased inflation. Keynes had only predicted that falling unemployment would cause a higher price, not a higher inflation rate. Thus, the economist could use the IS-LM model to predict, for example, that an increase in the money supply would raise output and employmentand then use the Phillips curve to predict an increase in inflation.


Post Keynesian Economics (1970s-80s) Post-Keynesian economics is a school of thought which is based on the ideas of John Maynard Keynes. It differs from the interpretation of Keynes' ideas offered by mainstream Keynesian economics, such as the new Keynesian economics, emphasizing in particular: The importance of uncertainty, historical time, or non- ergodicity (as opposed to risk, logical time, and ergodic processes). The idea that money matters for the "real" economy (output, employment, etc.) in both the short and long runs. A rejection of neoclassical general equilibrium models.

Post-Keynesian economists believe that a capitalist economy has no natural or automatic tendency towards full employment. Fixed investment is a major determinant of the level of aggregate demand in closed or large economy. Decisions on the level and direction of investment are made in anticipation of

future events, which agents cannot know even probabilistically. Post-Keynesians emphasize the need for government fiscal policy to support institutions to support employment and incomes. "Logical time" is the type of "time" seen in most economic models, i.e., comparative statics exercises in which equilibrium is disturbed and the model automatically moves to a new, predetermined, equilibrium with no attention given by the economist to the process of getting there. On the other hand, "historical time," the present is nothing but a moment in the passage from the immutable past to the unknowable future (to paraphrase Joan Robinson). The economy is always a dynamic process and (almost) never in an equilibrium state. The actual process of going from situation A to situation B is path dependent, helping to determine the character of situation B rather than it being predetermined. Thus, the post-Keynesian conception of the "long run" differs from that of neoclassical and various neoclassical schools of Keynesian economics. Post-Keynesians believe, along with others, that what many call Keynesianism is, in fact, a counterrevolution against the economics of Keynes. Keynesianism, as developed by many American economists, teaches that involuntary unemployment. In economics, a person who is able and willing to work yet is unable to find a paying job is considered unemployed. The unemployment rate measures the number of unemployed workers as a proportion of the total civilian labor force, where the latter include is a temporary or medium-run phenomenon. Government priming like other institutions, governments operate on a budget or try to do so. When the expenditures of a government (its purchases of goods and services, plus its transfers (grants) to individuals and corporations) are greater than its tax revenues, it creates may be desirable, but if wages and prices were perfectly flexible, mainstream Keynesian economists believe, the labor market would eventually clear, as in the unemployment In economics, a person who is able and willing to work yet is unable to find a paying job is considered unemployed. The unemployment rate measures the number of unemployed workers as a proportion of the total civilian labor force, where the latter include. There are divisions within post-Keynesian economics, for example between American post-Keynesians such as Paul Davidson and the Cambridge (England) - Italian branch. The latter often focuses on issues of microeconomics. Microeconomics is the study of the economic behavior of individual consumers, firms, and industries and the distribution of production and income among them. It considers individuals both as suppliers of labor and capital and as the ultimate consumers o, especially the controversy The capital controversy refers to a debate in economics concerning the nature and role of capital goods (or means of production) that occurred during the 1960s, largely between economists such as Joan Robinson and Piero Sraffa at the University of Cambri and is closely related to the school The neo-Ricardian school is an economic school that derives from the close reading and interpretation of David Ricardo by Piero Sraffa,

and from Sraffa's critique of Neoclassical economics as presented in his "The Production of Commodities by Means of Com. Post-Keynesian economics emphasizes macroeconomics. Macroeconomics is the study of the entire economy in terms of the total amount of goods and services produced, total income earned, the level of employment of productive resources, and the general behavior of prices. Macroeconomics can be used to analyze. Many post-Keynesians look to American Institutionalists. In economics, the institutional economics school goes beyond the usual economic focus on markets, to look more closely at humanmade institutions. Institutional economics was once the dominant school of economics in the United States, including such famous for microeconomics. Institutionalists include such economists as Thorstein Veblen, John R. Commons, Wesley Clair Mitchell, John Maurice Clark, Clarence Ayres, Gunnar Myrdal (not an American), and John Kenneth Galbraith. Thanks to Samuelson's reconciliation, today neoclassical economics is known as microeconomics and Keynesian economics has become largely known as macroeconomics the twin pillars of mainstream or orthodox economic thought. However, because this reconciliation clearly disavowed many of Keynes's original ideas that were not held to be compatible with neoclassical economics, many critics have sought to revive some of them and to combine them with theories of scholars such as Michael Kalecki, Joan Robinson, and Piero Sraffa to form a new school of economic thought known as "post-Keynesian Economics" (see Eicher, 1979).

Post-Keynesians are highly concerned with short-term economic growth as induced by aggregate demand and, unlike neo-classical economists, are concerned with real world variables that exist in a very concrete historical situation. For them, the adjustment process of the economy to equilibrium conditions is not so "automatic" as neoclassical economist's claimed because it largely depends on the economic agent's interpretation of both the past and expectations for the future all in the midst of a decision making setting involving complex interdependencies and unforeseen factors. As a result of these beliefs, post-Keynesians essentially deny relevance of conventional equilibrium analysis. Moreover, reliance on the role of uncertainty has created some problems for post-Keynesians because it has made it nearly impossible for them to devise any viable theory for long-term growth. It has further prevented them from developing a formal economic model that they all agree upon. According to Professor J. A. Kregel (1976), one of the most distinguished post-Keynesian economists, "post-Keynesian theory can be viewed as an attempt to analyze various different economic problems, e.g., capital accumulation, income distribution, etc., through the methodology of Keynes." Keynes's methodology, then, was to confront "the analysis of an uncertain world was in terms of alternative specifications about effects of uncertainty and disappointment."

Using this approach while adopting theories of both Keynes and Kalecki, post-Keynesians have analyzed the relationship between income distribution and economic growth. One of the most significant conclusions of post-Keynesian economics is that for a given level of investment and an economy at equilibrium where savings equals investment, the lower the capitalist's propensity to save, the higher will be their share of national income and the lower will be the worker's share. This assertion is significant because it contradicts the claim by neoclassical economists that capitalists enjoyed a high income due to the pain that is necessary for them to save. This result of the post-Keynesians is founded in their belief that saving is passively linked to changes in level of income, and investment is highly correlated with capitalists' expectations for the future. If optimistic, investment increases, growth occurs, and capitalists' share of income increases as well. As their income rises, capitalists save more bringing savings back in line to a new level of Keynesian equilibrium where savings and investment equate. What this means is that if capitalists are frugal (i.e. save more), or if they are abstemious (i.e. abstain from consuming), they lower their share of the national income. This, of course, directly violates Nassau Senior's assertion that the high income of capitalists was morally justified by their painful abstinence of personal consumption and willful propensity to reinvest their profits into the growth of capital. Another area where post-Keynesians have divergent economic thought from orthodoxy has to do with their belief in the endogenity of money. For them, post-Keynesians stress the fact that real commodity and labor flows are expressed in the economy as monetary flows. They also assume that money possesses a negligible elasticity of substitution with any other medium of exchange and therefore has the unique capacity to be able to be used by financial institutions as a tool to mitigate the effects of exogenous economic system shocks.


New Keynesian economics is a school of contemporary macroeconomics that strives to provide microeconomic foundations for Keynesian economics. It developed partly as a response to criticisms of Keynesian macroeconomics by adherents of New Classical macroeconomics. Two main assumptions define the New Keynesian approach to macroeconomics. Like the New Classical approach, New Keynesian macroeconomic analysis usually assumes that households and firms have rational expectations. But the two schools differ in that New Keynesian analysis usually assumes a variety of market failures. In particular, New Keynesians assume prices and wages are "sticky", which means they do not adjust instantaneously to changes in economic conditions.

Wage and price stickiness, and the other market failures present in New Keynesian models, imply that the economy may fail to attain full employment. Therefore, New Keynesians argue that macroeconomic stabilization by the government (using fiscal policy) or by the central bank (using monetary policy) can lead to a more efficient macroeconomic outcome than a laissez faire policy would.


Significant early contributions to New Keynesian theory were compiled in 1991 by editors N. Gregory Mankiw and David Romer in New Keynesian Economics, volumes 1 and 2. The papers in these volumes focused mostly on micro foundations, that is, microeconomic ingredients that could produce Keynesian macroeconomic effects, and did not yet attempt to construct complete macroeconomic models. More recently, macroeconomists have begun to build dynamic stochastic general equilibrium (DSGE) models with Keynesian features. The New Keynesian DSGE modeling methodology is explained in Michael Woodford's textbook Interest and Prices: Foundations of a Theory of Monetary Policy. Economists are now actively estimating quantitative models of this type, and using them to analyze optimal monetary and fiscal policy.

Micro foundations of price stickiness

'Nominal rigidities', that is, sticky prices and wages, are a central aspect of all New Keynesian models. Why should prices adjust slowly? One common explanation given by New Keynesians is the presence of 'menu costs', meaning small costs that must be paid in order to adjust nominal prices. For example, the costs of making a new catalog, price list, or menu would be considered menu costs. Even though these costs seem small, New Keynesians explain how they could amplify short-run fluctuations. Not only do the firms have to pay to change the price, but also, according to N. Gregory Mankiw, there are also externalities that go along with changing prices. As Mankiw describes, a firm that lowers its prices because of a decrease in the money supply will be raising the real income of the customers of that product. This will allow the buyers to purchase more, which will not necessarily be from the firm that lowered their prices. As firms do not receive the full benefit from reducing their prices their incentive to adjust prices in response to macroeconomic events is reduced. Recent studies (e.g. Golosov and Lucas) find that the size of the menu cost needed to match the microdata of price adjustment inside an otherwise standard business cycle model is implausibily large to justify the menu-cost argument. The reason is that such models lack "real rigidity" (see Ball and Romer). This is a property that markups do not get squeezed by large adjustment in factor prices (such as wages) that

could occur in response to the monetary shock. Modern New Keynesian models address this issue by assuming that the labor market is segmented, so that the expansion in employment by a given firm does not lead to lower profits for the other firms (see Woodford 2003). Other microeconomic ingredients Besides sticky prices, another market imperfection built into most New Keynesian models is the assumption that firms are monopolistic competitors. In fact, without some monopoly power it would make no sense to assume sticky prices, because under perfect competition, any firm with a price slightly higher than the others would be unable to sell anything, and any firm with a price slightly lower than the others would be obliged to sell much more than they can profitably produce. Therefore, New Keynesian models assume instead that firms use their market power to maintain their prices above marginal cost, so that even if they fail to set prices optimally they will remain profitable. Many macroeconomic studies have estimated typical firms' degree of market power, so this information can be used in parameterizing New Keynesian models. Other microeconomic elements that appear in some New Keynesian models (though not so commonly as sticky prices and imperfect competition) include the following. Credit market imperfections Coordination failures, leading to aggregate demand multipliers and possible multiplicity of equilibrium Unemployment caused by moral hazard problems, or unemployment caused by matching frictions Policy implications

New Keynesian economists fully agree with New Classical economists that in the long run, changes in the money supply are neutral. However, because prices are sticky in the New Keynesian model, an increase in the money supply (or equivalently, a decrease in the interest rate) does increase output and lower unemployment in the short run. Nonetheless, New Keynesian economists do not advocate using expansive monetary policy just for short run gains in output and employment, because doing so would raise inflationary expectations and thus store up problems for the future. Instead, they advocate using monetary policy for stabilization. That is, suddenly increasing the money supply just to produce a temporary economic boom is a bad idea (because eliminating the increased inflationary expectations will be impossible without producing a recession). But when the economy is hit by some unexpected external shock, it may be a good idea to offset the macroeconomic effects of the shock with monetary policy. This is especially true if the unexpected shock is one (like a fall in consumer confidence) which tends to lower both output and inflation; in that case, expanding the money supply (lowering interest rates) helps by increasing output while stabilizing inflation and inflationary expectations.

Studies of optimal monetary policy in New Keynesian DSGE models have focused on interest rate rules (especially 'Taylor rules'), specifying how the central bank should adjust the nominal interest rate in response to changes in inflation and output. (More precisely, optimal rules usually react to changes in the output gap, rather than changes in output per se.) In some simple New Keynesian DSGE models, it turns out that stabilizing inflation suffices, because maintaining perfectly stable inflation also stabilizes output and employment to the maximum degree desirable. Blanchard and Gal have called this property the 'divine coincidence'. However, they also show that in models with more than one market imperfection (for example, frictions in adjusting the employment level, as well as sticky prices), there is no longer a 'divine coincidence', and instead there is a tradeoff between stabilizing inflation and stabilizing employment. The heart of the 'new Keynesian' view rests on microeconomic models that indicate that nominal wages and prices are "sticky," i.e., do not change easily or quickly with changes in supply and demand, so that quantity adjustment prevails. According to economist Paul Krugman, "while I regard the evidence for such stickiness as overwhelming, the assumption of at least temporarily rigid nominal prices is one of those things that work beautifully in practice but very badly in theory." This integration is further spurred by the work of other economists which questions rational decision-making in a perfect information environment as a necessity for micro-economic theory. Imperfect decision making such as that investigated by Joseph Stiglitz underlines the importance of management of risk in the economy. Over time, many macroeconomists have returned to the IS-LM model and the Phillips curve as a first approximation of how an economy works. New versions of the Phillips curve, such as the "Triangle Model", allow for stagflation, since the curve can shift due to supply shocks or changes in built-in inflation. In the 1990s, the original ideas of "full employment" had been modified by the NAIRU doctrine, sometimes called the "natural rate of unemployment." NAIRU advocates suggest restraint in combating unemployment, in case accelerating inflation should result. However, it is unclear exactly what the value of the NAIRU should beor whether it even exists.

Keynesians vs. Monetarists

Keynesians and Monetarists fought head-to-head in the 1970s. Most economists conclude that Keynesians won the war, but Monetarists won many battles. Because of the healthy debate, Keynesians are more convinced of the importance of the money supply and monetary policy, especially over the long run. They are more acutely aware of the long-term threat to price stability that rapid money growth can bring. Keynesians are also now more likely to prefer monetary policy to fiscal policy.

TABLE 1 Monetarist Tie monetary policy to rules Fiscal policy is not useful. AS curve has a steep slope. Economy is inherently stable. AS curve can be flat. Economy can be unstable. Keynesians Give policymakers discretion. Fiscal policy may be useful.

Despite the convergence, substantial differences remain between the two bodies of thought. We summarize the more important differences here and in Table 1. Keynesians argue that the Fed should use discretion in conducting monetary policy, while Monetarists advocate a long-run money growth rule. Keynesians still view fiscal policy as potentially important. Monetarists are less convinced of the usefulness of fiscal policy. As a general rule, Keynesians believe that the Aggregate Supply curve is more horizontal than vertical in the short run so stabilization policy can have big impacts on output and employment. Because Monetarists believe that the economy is inherently stable, they tend to view the Aggregate Supply curve as more vertical so discretionary stabilization policy is not as important.

Although differences remain, the debate between Keynesians and Monetarists cooled considerably in the 1990s. Monetarists could no longer defend a simple relationship between M1 and nominal GDP. Many Monetarists now emphasize the longer-run relationship between M2 growth and nominal GDP growth. Although Keynesians do not stress the importance of money growth as much as Monetarists, the focus on the long run is much less controversial.

Keynesian Vs. New classical

Another influential school of thought was based on the Lucas critique of Keynesian economics. This called for greater consistency with microeconomic theory and rationality, and particularly emphasized the idea of rational expectations. Lucas and others argued that Keynesian economics required remarkably

foolish and short-sighted behavior from people, which totally contradicted the economic understanding of their behavior at a micro level. New classical economics introduced a set of macroeconomic theories which were based on optimizing microeconomic behavior. These models have been developed into the Real Business Cycle Theory, which argues that business cycle fluctuations can to a large extent be accounted for by real (in contrast to nominal) shocks.

Surabhi arora, central law publication, 7th edition,2011 Studies in the Quantity Theory of Money, Milton friedman University of Chicago Press; 1st edition (November 22, 1956) The Optimum Quantity of Money, Milton friedman,2nd edition,1995,Albania press

WWW.kent.edu www.freepatents.edu/article www.moneyillusion.com/article www.aeaweb.org www.economics.about.com www.investopedia.com/articles