A Keynesian perspective on money.

Monetarism is an analytical system whose roots go deep into the history of economic thought. It is the modern version of the quantity theory of money which, in turn, is an integral part of classical and neo-classical economic theory. The quantity theory of money viewed inflation as being solely the result of prior increase in the quantity of money in circulation: an x per cent increase in the quantity of money would ultimately produce an x per cent increase in the price level. Classical economist admitted that, in the short period, the increase in the money supply would stimulate output and employment, but that in the longer run it would be entirely dissipated in the form of higher prices, with output and employment returning to their former levels.

The quantity theory of money dominated thinking on economic policy from the mid-eighteenth century, throughout the nineteenth century and down to the early 1930s. The early formulation by David Hume was refined in the nineteenth century, the locus classicus of the modern presentation of the quantity theory being Irving Fisher's The Purchasing Power of Money (1911).(1) Later, a group of Austrian economists, the followers of Ludwig von Mises, elaborated the policy implications of the quantity theory. The main consequence of monetary expansion brought about through low interest rates was, they averred, a distortion in the structure of production which could last only for a long as the inflationary process continued. Sooner or later, natural forces would reassert themselves, the rate of interest would return to its initial level, and the processes of production which were profitable only at the lower rate of interest would be abandoned. The readjustment which inevitably followed the previous expansion of credit inevitably involved an abnormally high unemployment rate.

Another, less sophisticated, version of this approach to economic matters was particularly influential in Britain in the 1920s: the so-called Treasury View. According to this view, policies of public works expenditure or of encouraging additional investment by bank credit expansion and low interest rates are self-defeating since they simply divert saving from its 'normal' channels.

This approach to macroeconomic policy pervaded the thinking of academic economists and financial and economic advisers to governments right down to the Great Depression and into the early 1930s. It was challenged in the writings of John Maynard Keynes who, after several earlier attempts,(2) provided, in his General Theory of Employment, Interest and Money, a fully articulated alternative to the quantity theory of money. Keynes's theories have themselves recently been challenged by the followers of the new monetarism, who have successfully revived the old ideas of the quantity theory, dressing them in the apparel of modern formal analysis.

In this chapter we shall attempt to describe and criticize monetarist theory from a Keynesian perspective. In the course of this, we shall provide what, in our view, is a more convincing explanation of the determinants of aggregate demand. We shall also, at the end of the chapter, offer an alternative explanation of the chronic inflationary process which appears to have become endemic in capitalist economies since the Second World War, and has recently shown a definite tendency to accelerate.

The effects of increases in the supply of money on aggregate demand

Monetarists argue that if it can be shown that a stable relationship exists between the money stock (however measured) and money national income, it follows that the most effective way of controlling the course of money income over time is to regulate the growth of the money stock. On the basis of econometric research, the monetarists claim that a well-determined statistical relationship exists (though with a variable time-lag) for a wide variety of countries for differing periods.