Explain the Keyne's critique of the quantity theory of Money.

- Useless truism. With the qualification that velocity of money (V) and the total output (T) remain the same, the equation of exchange (MV = PT) is useless truism. The real trouble is that those things seldom remain the same. They change not only in the long run but also in the short run. Fishers equation simply tell us that the expenditure made on goods (MV) is equal to the value of the output of goods and services sold (PT).

- Velocity of Money is not stable. According to Keynesian economist velocity of money changes inversely with the change in money supply. They argue that increase in money supply, demand for money remaining constant, leads to fall in the rate of interest. At a lower rate of interest people will be induced to hold more money as idle cash balances (under speculative motive). This means velocity of circulation of money will be reduced. Thus, if a decline in interest rate reduces velocity, then increase in the money supply will be offset by reduction in the velocity which means that price level does not have to rise with the increase in the money supply.

- Increase in quantity of money does not always increase in aggregate spending or demand. According to Keynesians, the quantity theory of money is based on two more wrong assumptions i.e. an increase in money must lead tom an increase in spending(no part of additional money should created should be kept in idle hoards and the resulting increase in spending or aggregate demand must face a totally inelastic output. Accordingly, the failure of either makes the quantity theory of money null and void. If the first assumption fails, prices or output will not change. Further there is no direct link between increase in quantity of money and the increase in the volume of the total spending or aggregate demand. No one is going to increase his spending simply because the government has printed more monies or the banks are more liberal in their lending policies. Thus if the demand for money is highly interest inelastic, the increase in money supply will not lead to any appreciable fall in the rate of interest. With no significant fall in the rate of interest, investment expenditure and expenditure on durable consumer goods will not increase much. As a result, increase in money supply may not lead to increase expenditure or aggregate demand and therefore p[rice level remain unaffected. However we cannot conclude that changes in the quantity of money have no influence whatsoever on the volume of aggregate spending. What Keynesians’ deny is the assertion that there exist a direct, simple, and more or less a proportional relation between variation in money supply and the variation in the level of total spending.

- Assumption of constant volume of transactions or constant level of aggregate output is not valid. Keynes asserted that the assumption of constant aggregate output valid only under the assumption of full employment. It is only then that we can assume a totally inelastic supply of output, for all the available resources are being already fully utilized. In conditions of less than full employment, the supply curve of output will be elastic. If we now assume that the aggregate spending or demand increases with an increase in the quantity of money, it does not follow that prices must necessarily rise. If the supply curve of output if fairly elastic, it is more likely that effect of an increase in spending will mostly raise the production rather than prices. Of course, at full employment level every further increase in spending or aggregate demand must lead to rise in price level as output is inelastic in supply at full employment level. Since Full employment assumption cannot be a normal affair, we cannot accept the quantity theory of money as a valid explanation of changes in the price level in the short run.

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Kavungya answered the question on March 26, 2019 at 06:24