KEYNES QUANTITY THEORY OF MONEY

Keynes’ great merit lies in removing the old fallacy that prices are directly determined
by the quantity of money. His theory of money and prices brings forth the truth that prices are
determined primarily by the cost of production.
Keynes does not agree with the old analysis which establishes a direct causal
relationship between the quantity of money and the level of prices.
He believes that changes in the quantity of money do not affect the price level
(value of money) directly but indirectly through other elements like the rate of interest,
the level of investment, income, output and employment.
The initial impact of the changes in the total quantity of money falls on the rate of
interest rather than on prices.
As the quantity of money is increased (other things remaining the same), the rate of
interest is lowered because the quantity of money available to satisfy speculative motive
increases. A lowering of the rate of interest will raise investment, which in turn, will result in
an increase of income, output, employment and prices. The prices rise on account of various
factors like the rise in labour costs, bottlenecks in production, etc.
Thus, in Keynes’ version the level of prices is affected indirectly as a result of the
effects of the changes in the quantity of money on the rate of interest and hence investment.
It is on account of this reason that Keynes analysis is, at times, spoken of as the ‘contra-
quantity theory of causation’ because it takes rise in prices as a cause of the increase in the
quantity of money instead of taking the increase in the quantity of money as a cause of the
rise in prices.

The transmission mechanism process:

Increases in the quantity of money

Fall in the rate of interest

Encourages investment

Raises income, output and employment

Raising cost of production

Raising prices
 The traditional theory ignored the influence of the quantity of money on the rate of
interest, and thereby on output and goes directly from increase in the quantity of money to
increase in the level of prices. Keynes, thus, removed the classical dichotomy in the traditional
money-price relationship by rejecting the direct relationship between Money supply (M) and
Price level (P). He asserted that the relationship between M and P is indirect and that the
theories of money and prices can be integrated through the theory of aggregate demand or
the theory of output. The missing link between the real and monetary theories, according to
Keynes, is the rate of interest. The mechanism of the rate of interest will work as shown
above, which will increase investment and through multiplier ultimate income.

Merits of Keynes’ Version of the Quantity Theory of Money:

Keynes’ version of the quantity theory stands in sharp comparison to the old classical theory
and is considered superior to it on the following grounds:
1) It Analyses the Casual Process: Keynes’ great merit lies in removing the old notion
that prices are directly determined by the quantity of money. He brings the true and
real causal process which exists between the quantity of money and prices. The
relationship that exists is indirect and is brought through changes in the rate of interest.
2) It Does not Assume Full Employment: The quantity theory of money, like all
classical doctrines, is based on the assumption of full employment. As long as the
human and material resources were taken to be fully employed, it was easy for the
classical thinkers to say that an increase in the quantity of money was associated with
or followed by a rise in the price level. Since, money in the classical scheme could not
affect employment, it could raise prices only.
3) When to Dread Inflation: Keynesian approach to the quantity theory of money helps
us to look at inflation entirely from a different perspective. It tells us when dread
inflation and when not to dread it. As long as there is unemployment of resources,
inflation is not to be feared as it results in an increase in employment and output. But
once the level of full employment is attained, true inflation begins and it becomes a
real threat.
4) It Integrates Monetary Theory with the Theory of Value: Another great merit of
Keynes theory of money and prices is that it integrates monetary theory with the theory
of value. Keynes gave up the traditional division of the economy into the real sector
and the monetary sector and pointed out that there could be no monetary economy in
which money was neutral. The integration of the theory of money with the theory of
value on the one hand and with the theory of output on the other, was achieved through
the rate of interest the missing link (rate of interest) was at last discovered.
5) It Differentiates between the Determination of the General Price Level and
Individual Prices: Keynes theory ‘differentiates’ between the determination of the
general price level and individual prices. Individual prices of various commodities are
determined by the forces of demand and supply with reference to the nature of
competition and the type of market, whereas a large number of considerations enter
the determination of the general price level.