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Classical Theory of Money
1. Introduction
📌 The Classical Theory of Money explains how the supply of money affects prices and economic activity. It is based on the Quantity Theory of Money (QTM), which states that money supply determines the price level in an economy.
🚀 Why is it important?
✔ Helps understand inflation, purchasing power, and monetary policy.
✔ Forms the foundation of modern monetarist theories (e.g., Milton Friedman’s approach).
✔ Explains the neutrality of money (money affects prices, not real economic variables).
2. Key Components of the Classical Theory of Money
🔹 1. The Quantity Theory of Money (QTM)
📌 The most fundamental principle in the classical theory is the Quantity Equation, given by: MV=PYMV = PY
Where:
- MM = Money supply
- VV = Velocity of money (how frequently money circulates)
- PP = Price level
- YY = Real output (GDP)
📌 Key Assumptions:
✔ Velocity (V) is constant – People spend money at a predictable rate.
✔ Output (Y) is fixed in the short run – Determined by labor, capital, and technology.
✔ Any increase in MM leads to an increase in PP, meaning inflation is a monetary phenomenon.
🔹 2. Neutrality of Money
📌 Classical economists (like David Hume and Adam Smith) believed that money only affects nominal variables (prices, wages) but not real variables (output, employment).
✔ If the money supply doubles, prices will double, but real wages, employment, and production remain unchanged.
✔ This means monetary policy cannot influence long-term economic growth.
🔹 3. Fisher Equation & Cambridge Approach
Fisher’s Equation of Exchange
📌 Irving Fisher formalized the QTM with: MV=PTM V = P T
Where T represents the total transactions in the economy.
Cambridge Cash Balance Approach
📌 The Cambridge economists (Marshall & Pigou) modified the QTM as: M=kPYM = k P Y
Where kk represents the fraction of income people hold as money.
✔ Unlike Fisher, the Cambridge approach emphasized money as a store of value.
3. Policy Implications of the Classical Theory of Money
🔹 1. Inflation is a Monetary Phenomenon
✔ If the central bank increases the money supply too much, inflation rises.
✔ Hyperinflation (e.g., Zimbabwe, Venezuela) occurs when governments print excessive money.
🔹 2. No Role for Monetary Policy in Long-Run Growth
✔ Money supply changes only impact prices, not real GDP or employment.
✔ Governments should focus on real factors like productivity, innovation, and investment.
🔹 3. Importance of Controlling Money Supply
✔ If money supply grows faster than output, inflation occurs.
✔ Classical economists favored a gold standard to control money supply and prevent inflation.
4. Criticism of the Classical Theory
🔸 1. Keynesian Critique
✔ John Maynard Keynes (1936) argued that money affects interest rates and demand, impacting output and employment.
✔ During recessions, increasing the money supply can boost spending and production.
🔸 2. Variable Velocity of Money
✔ In reality, velocity (V) is not constant – people change their spending habits based on economic conditions.
🔸 3. Short-Run Non-Neutrality
✔ Modern theories (like Monetarism) acknowledge that money affects real GDP in the short run, before returning to neutrality in the long run.
5. Conclusion
✔ The Classical Theory of Money states that money supply affects only prices, not real economic variables.
✔ It is based on the Quantity Theory of Money, which links money supply to inflation.
✔ Modern monetary policies use these principles but recognize short-run effects on employment and output.
✔ The theory remains relevant for inflation control but is less applicable during recessions (where Keynesian policies are favored).