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…show more content… He brings to the fore 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.
According to Prof. Dillard, “This leads to the conclusion that all increases in the quantity of money tend to be inflationary, a conclusion quite valid under the assumption that resources are fully employed, a nonsense conclusion when this special assumption is dropped.” Keynes, on the other hand, does not assume full employment. To him unemployment is the rule and full employment only an exception. He says, “So long as there is unemployment, employment will change in the same proportion as the quantity of money; and when there is full employment, price will change in the same proportion as the quantity of…show more content… 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.
According to Classicals, every increase in money supply results in inflation (as full employment was always presumed). To Keynes, only that increase in money supply results in inflation which takes place beyond the level of full employment. Thus, Keynesian version shows a great advance on the traditional version of the quantity theory of money.
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