Classical Economics

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Classical Economics
The Quantity Theory of Money
The Quantity Theory of Money seeks to establish that, in the long run, the price level/
rate of inflation is determined by the level/ rate of increase of the money supply.
Although the Quantity Theory of Money is an extremely old proposition, it was first
formalised in the early part of the 20th century by Yale economist, Irving Fisher and later
by a group of Cambridge economists, Alfred Marshall and most notably A. C. Pigou.
(a) Fisher’s Transactions Approach
This approach first emerged in Fisher’s book The Purchasing Power of Money (1911).
For most economists of that period, money was viewed solely as a means of exchange.
The only reason for holding money was to facilitate transactions. Fisher’s analysis
commences with a simple identity (a statement that is by definition true), sometimes
referred to as the equation of exchange.
MVt ≡ PT where
 M = Money Supply
 Vt = Transactions Velocity of Circulation of money (the number of times the
money stock changes hands per period).
 P = Price level.
 T = The number of Transactions undertaken per period
Note that
MVt = money stock * number of times the money stock is spent per period
= total spending per period.
PT = Price of goods & services * volume of goods & services bought per period
= total expenditure per period.
Thus, at first sight, the Quantity Theory is an innocuous tautology. To turn this identity
into a theory of price determination, Fisher made further assumptions about the nature of
each variable.
 M, the money stock was taken to be exogenously determined by the monetary
authorities
 and independent of the other 3 variables
 Vt, the velocity of circulation was assumed to be more or less constant and was
determined by conditions in the financial system that tend to change very slowly.
Again, V was thought to be independent of M, P & T.
 T, the number of transactions per period was also taken as fixed. Recall that
Classical scholars believed that in the long term, output tended to be at or near the
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full employment level. The number of transactions was viewed as fixed at any
given level of income.
 P, the price level was determined by the interaction of the 3 other factors.
Thus,
MVt = PT
This suggests that the price level is determined by the money supply.
Note, T is likely to be extremely difficult to calculate or even conceptualize and V is not
an independent variable. Vt is a residual which is generally derived given knowledge of
the other 3. i.e. Vt = (PT)/M.
(b) The Cambridge Cash Balance Approach.
Fisher’s approach can be viewed as deterministic. Essentially, Fisher argued that, given
the full employment volume of transactions and the speed with which the financial
system could process payments, the quantity of money that agents required to hold was
effectively determined.
Marshall, Pigou and colleagues took a radically different tack. Like Fisher, the
Cambridge School assumed that money was only held to expedite transactions and had
no further purpose. Thus, if the money supply increased, agents holding the increased
money stock would seek to get rid of it. However, the emphasis in this approach
concentrated on establishing the quantity of money that agents would voluntarily desire
to hold. The Cambridge school were in effect attempting to set out a theory of the
demand for money.
David Laidler (1985) puts it thus
“In the Cambridge approach the principle determinant of people’s “taste” for money
holding is the fact that it is a convenient asset to have, being universally acceptable in
exchange for goods and services. The more transactions an individual has to undertake,
the more cash he will want to hold and to this extent the approach is similar to Fisher.
The emphasis, however, is on want to hold, rather than have to hold; and this is the basic
difference between Cambridge monetary theory and the Fisher framework.”
The Cambridge approach emphasises that there are alternatives to holding money in the
shape of shares and bonds. These assets yield a return which can be viewed as the
opportunity cost of holding money. As interest rates rise, agents will economise on
money holdings and vice versa. Another factor that will influence money holdings is the
expected rate of inflation. If inflation is expected to be high, then the purchasing power of
money will fall. This will prompt agents to buy securities or commodities as a hedge
against inflation.
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We can set out the Cambridge cash balance approach as follows
MD = kPy
MD = MS
Where
k = k(E(inf), r, u)
This sets out that MD is some fraction k of nominal GDP where k depends on expected
inflation, interest rates/returns and u, a set of unspecified factors which may influence
money demand. Note that r is a vector of returns reflecting an appreciation that agents
had a choice of assets such as shares and bonds.
The Cambridge cash balance equation can be recast to facilitate comparison with Fisher’s
equation of exchange.
MS = kPy = (1/V)Py.
In this formulation, V can be construed as the income velocity of circulation. As with the
Fisher approach, k was not regarded as fixed but rather was viewed as a stable and
predictable function of its determinants. In the long run, changes in the money stock
would eventually lead to proportional changes in the price level.
The Cambridge approach is universally regarded as the superior account and it forms the
basis of later developments in the demand for money by Keynes, Milton Friedman and
others.
(c) The Transmission Mechanism
The transmission mechanism sets out the process by which a change in the money stock
affects economic activity. In the classical context this requires a clear explanation of how
ΔM → ΔP. Classical economists argued that there would be both a direct and indirect
mechanism. The direct mechanism is the direct influence of a change in M on
expenditure and the price level whilst the indirect mechanism operates through the
interest rate.
To understand this fully, we must be more specific about the definition of money. Money
can be narrowly conceived of as notes & coins in circulation. However, bank deposits can
also be properly regarded as a component of the money stock. Classical economists
focussed on the ability of banks to create money through the expansion of loans. Fisher
restated his equation of exchange to incorporate the banking sector. Thus,
PT ≡ MV + M’V’
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Where M is quantity of currency (termed primary money by Fisher)
V is the velocity of circulation of currency
M’ is the quantity of bank deposits
and V’ is the velocity of circulation of deposit money
Assume that M (the quantity of primary money) rises. This could be achieved by the
central bank buying bonds and securities from the non bank private sector and paying for
these purchases with cash. This would raise prices directly via the direct mechanism.
Fisher demonstrated that the emergence of inflation would result in a divergence between
the real and nominal rates of interest.
Rt = rt + ΔPe
t
where R is the nominal rate of interest,
r is the real rate of interest
and ΔPe
t is the expected rate of inflation
The Classical theorists viewed the interest rate as ‘the reward for waiting’. If agents were
to be persuaded to forego current consumption, they would require to be compensated
with greater a greater volume of consumption in a later period. Thus, the real rate of
interest reflects the reward in terms of actual goods and services required to persuade
agents to save. If r = 5%, this suggests that agents require a 5% more goods and services
in future if they are to be tempted to forego 1 unit of current consumption.
Note that in the preceding account, prices remained constant. If prices are rising by 5%,
the nominal rate of interest would have to be 10% in order to ensure a 5% rise in actual
goods and services as a reward for waiting.
Hence, Fisher argued that an increase in the primary money stock would initially serve to
drive up prices. The increase in inflation would cause the nominal rate of interest to rise
above the real rate. However, Fisher contended that the rise in the nominal rate would be
insufficient to maintain the real rate at its equilibrium level. Thus, following a price
increase, the real rate of interest would fall. This would result in an increase in the
demand for loans by borrowers.
Fisher argued that banks would increase the volume of loans at the lower real rate thus
increasing the volume of deposits, M’. The expenditure made possible by these loans
drives up the price level. Although in the short run, this increased spending may increase
the number of transactions, the long run impact of the direct and indirect mechanisms
would result in a rise in the price level proportional to the rise in the money supply.
Other classical writers such as Knut Wicksell envisaged a role for bank behaviour leading
to changes in M resulting in changes in r.


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