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4.2 The Quantity Theory of Money Approach

The first stage in the development of orthodox monetarism can be traced

from the mid-1950s to the mid-1960s, and involved an attempt to re-establish

the quantity theory of money approach to macroeconomic analysis, which

had been usurped by the Keynesian revolution. Within the quantity theory of

money approach (see also Chapter 2, section 2.5) changes in the money stock

are regarded as the predominant, though not the only, factor explaining changes

in money or nominal income (see Laidler, 1991).

Orthodox Keynesian analysis (see Chapter 3, section 3.3) emphasized real

disturbances (notably fluctuations in investment and autonomous consump166

tion) as the main cause of fluctuations in money income, predominantly in

the form of changes in real income. In terms of the stylized quantity theory

outlined in Chapter 2, section 2.5, Keynes’s General Theory was interpreted

as implying that in conditions of underemployment (which could prevail for

protracted periods) income velocity (V) would be highly unstable and would

passively adapt to whatever changes occurred independently in the money

supply (M) or money income (PY). In these circumstances money was regarded

as being relatively unimportant. For example, in the two extreme

cases of the liquidity and investment traps, money does not matter inasmuch

as monetary policy would be completely ineffective in influencing economic

activity. In the liquidity trap case, an increase in the money supply would be

exactly and completely offset by an opposite change in velocity. The increase

in the money supply would be absorbed entirely into idle/speculative balances

at an unchanged rate of interest and level of income. In the investment

trap case, where investment is completely interest-inelastic, an increase in the

money supply would again have no effect on the level of real income. The

money supply would be powerless to influence real income because investment

is insensitive to interest rate changes. Velocity would fall as the demand

for money increased relative to an unchanged level of income. Readers should

verify for themselves that, in either of these two extreme Keynesian cases

where money does not matter, any change in autonomous consumption, investment

or government expenditure would result in the full multiplier effect

of the simple Keynesian cross or 45° model. Under such conditions, although

the quantity theory relationship (equation 2.16) would be valid, orthodox

Keynesians argued it would be useless in terms of monetary policy prescription.