Classical Monetary Theory

See Classical Economics and Fiscal Policies

Before Adam Smith cleared the air with his Wealth of Nations in 1776, most nations’ policies were grounded in mercantilism, a doctrine that failed to differentiate money from wealth. Gold and silver were thought to be real wealth, so European countries often engaged in wars and colonial expansion to find these precious metals. Losers in wars of conquest were forced to pay winners out of their national treasuries. Aztec gold and Inca silver poured into Europe. Monarchs often debased their currencies to finance Old World wars and New World colonies. Whether debasement or foreign conquest enriched the royal coffers, the money in circulation grew.

The British philosopher David Hume (1711–1776) was among the early economic thinkers who noted that rapid monetary growth triggers inflation.

Quantity theories of money identify the money supply as the primary determinant of nominal spending and, ultimately, the price level.

Quantity theories of money were first formalized about a century ago by economists at Cambridge University and by Irving Fisher of Yale University. Fisher’s analysis began with the equation of exchange.

The Equation of Exchange

Gross Domestic Product can be written as PQ because GDP has price level (P) and real output (Q) components. But how is the money supply related to GDP? Economists approach this question by computing how many times, on average, money changes hands annually for purchases of final output. For example, GDP in 1994 was roughly \$7 trillion and the money supply (M1) averaged about \$1 trillion, so the average dollar was used roughly seven times for purchases of output produced in 1994.

The average number of times a unit of money is used annually is called the income velocity (V) of money.

Velocity is computed by dividing GDP by the money supply: V = PQ/M. Multiplying both sides of V = PQ/M by M yields MV = PQ, a result called the equation of exchange.

The equation of exchange is written

M ¥ V = P ¥ Q

This equation is definitionally true given our computation of velocity1 and is interpreted as the quantity of money times its velocity is equal to the price level times real output, which equals GDP. Note that this equation suggests that the velocity of money is just as important as the quantity of money in circulation.

A rough corollary is that the percentage change in the money supply plus the percentage change in velocity equals the percentage change in the price level plus the percentage change in real output:2

Focus on the right side of this equation. Does it make sense that if the price of, say, tea bags rose 1% and you cut your purchases 2%, your spending on tea would fall about 1%. Intuitively, the percentage change in price plus the percentage change in quantity roughly equals the percentage change in spending. Reexamine the equation. Suppose output grew 3%, velocity did not change, and the money supply rose 7%. Average prices would rise 4% (7% + 0% = 4% + 3%). Learning these relationships will help you comprehend arguments between classical monetary theorists and their detractors.

The Crude Quantity Theory of Money

From certain assumptions about the variables in the equation of exchange (M, V, P, and Q), classical economists (including Fisher) conclude that, in equilibrium, the price level (P) is exactly proportional to the money supply (M). Let us see how they arrived at this conclusion.

• Constancy of Velocity

Classical economic reasoning views the income velocity (V) of money as determined solely by institutional factors, such as the organizational structure and efficiency of banking and credit, and by people’s habitual patterns of spending money after receiving income. Velocity is thought to be constant,   at least in the short run, because changes tend to occur slowly (a) in financial technologies (e.g., the ways checks clear or loans are granted or repaid) and (b) in the inflows and outflows of individuals’ money (people’s spending habits and their frequencies of receipts of incomes).3 Thus, we see a central assumption of the classical quantity theory:   Focus 1 reveals, however, that assuming constant velocity would be unrealistic for international monetary data in recent years. Nor would this assumption fit U.S. data for different measures of the money supply; between 1970 and 1993, for example, velocity for M1 increased by roughly 40%, while velocity for M2 was relatively constant and velocity for M3 fell by roughly 15%.

But why does classical economics view velocity (V) as unaffected by the price level (P), the level of real output (Q), or the money supply (M)? An answer lies in why people demand money. Classical macroeconomics assumes that people want to hold money only to consummate transactions and that people’s spendings are fixed proportions of their incomes. The transactions motive is basically classical. Since National Income is roughly equal to GDP (or P ¥ Q), then the demand for money Md (a transactions demand) can be written

where   is a constant proportion of income held in monetary balances.4 For example, if each family held one-fifth of its average income of \$10,000 in the form of money, then the average quantity of money each family would demand would be Md = 0.20(\$10,000) = \$2,000. The quantity of money demanded in the economy would be \$2,000 times the number of families.

• Constancy of Real Output  Classical theory also assumes that real output (Q) does not depend on the other variables (M, V, and P) in the equation of exchange. Classical economists believe the natural state of the economy is full employment, so real output is influenced solely by the state of technology and by resource availability. Full employment is ensured by Say’s Law if prices, wages, and interest rates are perfectly flexible. Moreover, both technology and the amounts of resources available are thought to change slowly, if at all, in the short run. Thus, real output (Q) is assumed to be approximately constant, and DQ/Q = 0. This may seem like a very strong assertion, but the intuitive appeal of the idea that real output is independent of the quantity of money (M), its velocity (V), or the price level (P), is convincing both to classical monetary theorists and to new classical economists who have updated the classical tradition.

The idea that the amount of paper currency or coins issued by the government has virtually no effect on the economy’s productive capacity seems reasonable. Similarly, the velocity of money should not influence capacity. But what about the price level? After all, the law of supply suggests that the quantities of individual goods and services supplied will be greater the higher the market prices are. Shouldn’t the nation’s output increase if the price level rises? Classical economists say no. Here is why.

• A Crude Monetary Theory of the Price Level

Suppose your income and the values of all your assets exactly double. (That’s the good news.) Now suppose that the prices of everything you buy and all your debts also precisely double. (That’s the bad news.) Should your behavior change in any way? Your intuition should suggest not. Using similar logic, classical economists conclude that, in the long run, neither real output nor any other aspect of “real” economic behavior is affected by changes in the price level. Economic behavior is shaped by relative prices, not the absolute price level.

Recall that the percentage changes in the money supply and velocity roughly equal the percentage changes in the price level and real output. If velocity is constant and output is stable at full employment in the short run, then

Classical economists are left with a fixed relationship between the money supply (M) and the price level (P). In equilibrium, the rate of inflation exactly equals the percentage growth rate of the money supply:

Thus, any acceleration of monetary growth would not affect real output, just inflation.

The Classical View of Investment

Firms buy machinery, construct buildings, or attempt to build up inventories whenever they expect the gross returns on these investments to exceed the total costs of acquiring them. Classical economists assume relatively stable and predictable economies, so they focus on the costs of acquiring investment goods; business investors’ expectations of profits are assumed realized, and the costs of new capital goods are presumed stable.

 Equilibrium investment occurs when the expected rate of return on investment equals the interest rate. Prices for capital equipment are fairly stable, so any changes in the costs of acquiring capital primarily result from changes in interest rates. [Investors are effectively trading dimes for dollars as long as the cost of borrowing (the interest rate) is less than the return from investments made possible by borrowing.] Naturally, people will not invest unless they expect a return at least as high as they would receive if they simply lent their own money out for the interest. Classical theorists view investment as very sensitive to the interest rate and believe that large swings in investment follow minute changes in interest rates. The expected rate of return (r) curve in Figure 6 is relatively sensitive, or flat. In this example, a decline in interest of 1/2 point (from 8% to 7.5%) boosts investment by 60% [(80 – 50)/50 = 30/50 = 0.60]. Flexible interest rates and a highly sensitive investment (rate of return) schedule easily equate planned saving and investment. All saving is invested, stabilizing the economy at full employment.

Classical Monetary Transmission

Classical monetary economists view linkages between the money supply and National Income as not only strong, but direct. This classical monetary transmission mechanism (how money enters the economy) is shown in Figure 7. Panel A reflects the effects of monetary changes on nominal income, and Panel B translates these changes into effects on real output.

Nominal income in Panel A is \$6 trillion (point a) if the money supply is initially \$1 trillion (Md). Note that   is the full employ- ment level of output and MV = PQ, so where . This figure initially assumes that   and, thus, that , or almost 1%. This \$6-trillion nominal income   is equal to 6 trillion units of real output (point a in Panel B) at an average price level P0 of 100

Money supply growth to \$1.5 trillion (M1) boosts nominal income to \$9 trillion (point b in Panel A). Output is fixed at full employment and velocity is constant at 6, so introducing this extra money into the economy increases Aggregate Demand from AD0 to AD1 which pushes the price level to 150

Thus, in a classical world, monetary policy shifts Aggregate Demand up or down along a vertical Aggregate Supply curve with only price effects, not quantity effects.

Summary: The Crude Quantity Theory

Sum-marizing the traditional classical foundations of the early crude quantity theory of money, we know that the equation of exchange is a truism because of the way velocity is computed: MV = PQ. It follows that

If velocity is assumed constant and real output is fixed at a full employment level   then DV/V = 0, and DQ/Q = 0. Moreover,

Thus, any changes in the money supply will be reflected in proportional changes in the price level. This is the major result of the crude classical quantity theory of money:

Another conclusion is that real output (or any other “real” economic behavior) is unaffected in the long run by either the money supply or the price level. These early versions of the quantity theory of money are clearly misnamed—they should be called monetary theories of the price level.

Classical theorists concluded by saying “Money is a evil.” By this they meant that money, inflation, or deflation may temporarily disguise the real world, but in the long run, money affects only the price level and has virtually no effect on such real variables as production, employment, labor force participation, unemployment, or relative prices. Even though classical theorists vehemently opposed large expansions of the money supply because of fear that inflation temporarily distorts behavior, it is probably fair to say that classical monetary theory leads to the conclusion that, in the long run, “money does not matter.” It does not affect production, consumption, investment, or any other “real” economic behavior. When we deal graphically with the demand and supply of money in later sections, we will resurrect these classical propositions to see how modern monetary theory treats them.

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