Classical economists’ believed that government intervention should be avoided as market economy adjusts automatically and tends towards full employment (Keynes and the Classical Economists, n.d.). They believed that an increase in money supply results in an equal proportionate rise in price level (Ahuja, n.d.). These believes were well accepted until the Great Depression of 1930s when unemployment continued to rise and real GDP fell for a period of over 10 years (Keynes and the Classical Economists, n.d.).
John Maynard Keynes was the main critic of the Classic Model and he published ‘General Theory of Employment, Interest and Money’ in 1936. In this he argued that economies did not need to operate at full employment and that demand or spending were more important for economy’s success (Keynes and the Classical Economists, n.d.). He criticized the ‘Quantity Theory of Money’ and suggested that economic activity was not influenced by money. To Keynesians “Money did not matter” (Ahuja, n.d.) and the government had a role in influencing the economy (Boyd, n.d.).
During the fifties and sixties Milton Friedman developed counter arguments to the Keynesian theories, and reformulated the ‘Quantity Theory of Money’. He also presented the ‘Expectations Augmented Philips Curve Analysis’.
Friedman’s restatement of the ‘Irving Fisher Quantity Theory of Money’ can be presented by stating the original Fisher equation MV=PT, where M is the quantity of money, V is velocity, P is the price level and T is transactions. If the structure of the real economy is considered, T can be replaced with aggregate real income, Y. V therefore is no longer the transactions velocity of money, but rather represents the income velocity of money. MV = PY, where PY is the nominal income. If velocity is replaced with the fraction of income individuals wish to hold as money balances, k, the Fisher equation can be rewritten as M=kPY. This is Friedman’s restatement of the Fisher model and it assumes that if k is constant, changes in M will be reflected in nominal income, PY (Boyd, n.d.).
Friedman argues that “changes in money supply are the principal systematic determinants of the growth of nominal income” (Boyd, n.d.). He proposed that real national income (i.e. real output) and employment were also affected in certain ways, however, these occurred only in the short run (Ahuja, n.d.) (Boyd, n.d). Friedman through the ‘Expectations Augmented Philips Curve’ argued that even if government intervened to affect income and employment as per the Keynesian approach, the cost of the increase would be inflation (Boyd, n.d.).
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