Page 175 - DECO201_MACRO_ECONOMICS_ENGLISH

Macro Economics

Notes The implication is that in the long run the price level varies directly with changes in money
supply and the quantity theory of money asserts that causation is one way: from money to
prices. The prediction of the theory is, thus, that an increase in the money supply will, in the long
run, lead to a proportional increase in the price level. In other words, if the money supply rises
by ten per cent the price level will rise by 10 per cent. Furthermore, monetarists argue that an
increase in money supply is the only cause of an increase in the price level. These two ideas can
be summarised as: an increase in the money supply is both a necessary and a sufficient condition
for an increase in the price level.

Self Assessment

State whether the following statements are true or false:
6. The quantity theory of money predicts that there is an unstable and proportional
relationship between changes in the money supply and the price level.
7. Income velocity of money is the average number of times the money supply is used to
purchase final output.
8. Monetarists argue that an increase in money supply is the only cause of an increase in the
price level.
10.3 The Keynesian Theory of Inflation

Traditionally, the Keynesian theory of inflation identifies two types of inflation: demand
pull and cost push inflation. However, the theory does not dispute the validity of the identity
MV = P . It is usually presented in a different form as M = kP , where k, is the inverse of V (i.e.,
y y y y
k = 1/V ). The Keynesian view is, however, that this identity does not imply causation. They
y
reject the notion that V is stable and the economy tends to some natural rate of unemployment.
y
They stress that changes in P are possible independently of changes in M.
y
Basically, the root cause of inflation lies in the imbalance between aggregate demand and
aggregate supply.
10.3.1 Demand Pull Inflation

Such an inflation occurs when aggregate demand rises more rapidly than the economy’s productive
potential, pulling prices up to equilibrate aggregate supply and demand. It is characterised by a
situation in which there is “too much money chasing too few goods”.
Keynes maintains that demand pull inflation could be caused by excessive fiscal deficit leading
to increase in government expenditure. An increase in government expenditure, especially
during a war, raises the demand for output well above the supply and ignites a rapid inflation.
This type of inflation was first explained by Keynes. He introduced the concept of ‘inflationary
gap’ to substantiate his approach to demand pull inflation. He defines inflationary gap as an
excess of planned (or anticipated) expenditure over the available output at pre-inflation or base
prices. Lipsey adds that this gap is the amount by which aggregate expenditure would exceed
aggregate output at the full employment level of income.
In the absence of government expenditure, the economy will be in equilibrium at income level
Y , at which aggregate income equals aggregate demand E (Figure 10.1).
o o
Aggregate expenditure is the sum of consumption expenditure of households and investment
expenditure of the firms. Thus, at point A, the equilibrium point Y = C + I.

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