Keynes’s Monetary Theory : Money, Income and Prices

INTRODUCTION: INTEGRATING MONEY MARKET WITH GOOD MARKET

• Keynes criticized the classical quantity theory for assuming constant velocity of circulation and full employment as the normal condition of a free-market economy.

• He argued that velocity is volatile and that economies frequently experience underemployment due to recessionary conditions.

• Classical economists believed money was demanded only for transactions and was proportional to nominal income, but Keynes rejected this narrow view.

• Keynes introduced three motives for holding money: transactions, precautionary, and speculative motive, the last treating money as an asset.

• Since bonds and other assets yield interest, the rate of interest becomes the opportunity cost of holding money; higher interest rates reduce money demand, while lower rates increase it.

• Individuals adjust their money holdings to match desired levels: excess money leads to higher spending or asset purchases, while deficiency leads to reduced spending or sale of assets such as bonds and shares.

• Keynes emphasized financial investment in bonds as a key mechanism through which people adjust money balances.

• His monetary theory explains the impact of changes in money supply on real income, output, employment, and the price level indirectly through changes in the rate of interest.

• An expansion of money supply lowers interest rates, stimulates investment, increases aggregate demand, and thereby influences economic activity and, eventually, the price level.

KEYNES’S MONETARY THEORY: THE EFFECT OF MONEY SUPPLY ON THE LEVEL OF ECONOMIC ACTIVITY

• Changes in money supply influence economic activity through their impact on the rate of interest and, in turn, on aggregate demand.

• Monetary policy affects interest rates, and an increase in money supply generally reduces the rate of interest.

• A lower rate of interest stimulates investment, as borrowing becomes cheaper and more profitable.

• The rise in investment increases income through the multiplier process.

• Higher income leads to an increase in aggregate expenditure or aggregate demand.

• As aggregate demand expands, real national income and aggregate output rise.

Transmission Mechanism

• Keynes explained the transmission mechanism of monetary expansion as: increase in money supply (Mˢ) → fall in rate of interest (r↓) → rise in aggregate demand (C + I + G + Xₙ) → increase in national income (Y or GNP).

• The first link is the effect of increased money supply on the rate of interest, which depends on the interest elasticity of demand for money; greater elasticity weakens the fall in interest.

• The second link is the response of investment to changes in interest rate, determined by the interest elasticity of investment; lower interest rates encourage higher investment.

• The third link is the multiplier effect, through which increased investment raises aggregate demand, income, output, and employment.

• The overall impact of monetary expansion on economic activity depends on the responsiveness of money demand, sensitivity of investment to interest changes, and the size of the multiplier.

• An increase in money supply that raises aggregate demand affects both real national income and the price level, though these effects are analysed separately for clarity.