0:14

Two of the most important pillars of classical economics theory

Â are CA's Law and the quantity theory of money.

Â In our last module,

Â we learned how CA's law helps us think about

Â the determination of aggregate supply and aggregate demand,

Â and why, at least according to CA's law,

Â supply and demand should always tend towards equilibrium.

Â In this module, we take on the quantity theory of money.

Â In a classical economics framework,

Â this quantity theory of money is very useful in determining the rate of inflation.

Â That is the price level.

Â This theory will also be quite useful when we talk about

Â monetary policy in

Â a future lesson.

Â The quantity theory of money is based on the so-called equation of exchange.

Â This equation may be written as M Ã— V =

Â P Ã— Q. M of course equals the money supply.

Â V is the velocity of money or

Â the amount of income generated each year by a dollar of money.

Â P is the general price level as measured by an index such as

Â the consumer price index and Q is

Â the quantity of real inflation adjusted output that is sold.

Â That is; that's a nation's real inflation adjusted GDP.

Â Please also note that P Ã— Q is the nominal output or GDP of the economy.

Â While changes in the price level measure the rate

Â of inflation or deflation in an economy.

Â In its simplest terms,

Â the quantity theory of money says that the price level

Â varies in response to changes in the quantity of money.

Â The money supply rises, so will prices.

Â And that's called inflation.

Â In contrast, if the money supply falls, prices will fall.

Â And in this key definition,

Â when the price level falls, that's called deflation.

Â In fact, from this strict relationship between the money supply and the price level,

Â classical economists come to

Â a very important conclusion about how effective monetary policy.

Â Example, increasing the money supply M might be at stimulating growth in the real GDP.

Â So, what do you think that conclusion is?

Â Be committed now to jot down an answer before moving on.

Â In fact,

Â classical economists conclude from the quantity theory of

Â money relationship that discretionary monetary policy for example,

Â printing more money to stimulate growth in the real GDP won't be effective at all.

Â Indeed it shouldn't even be attempted because all it will do is create inflation.

Â In fact that's a very pessimistic view about expansionary monetary policy which

Â in today's modern times is regularly used to stimulate real GDP growth.

Â So, what exactly is going on here?

Â Well, the classical belief that printing more money only causes inflation

Â follows from two additional and quite restrictive assumptions

Â that the classical economists make.

Â Namely, that the velocity of money V is constant and that money is merely availed.

Â 4:23

In this key definition,

Â the velocity of money is the rate at which money is

Â exchanged in a given time period, say a year.

Â If the velocity of money is constant,

Â that rate does not change from time period to time period,

Â say from year to year.

Â To give this a bit of context,

Â suppose there are only two people in an economy,

Â the currency used is the euro and the total money supply is â‚¬50.

Â Suppose further that during a one year period,

Â Francois spends â‚¬50 buying wine from Heinrich and Heinrich

Â buys â‚¬25 of cheese and â‚¬25 of bread from Francois.

Â So, what is the velocity of money in this party time economy?

Â Work this out now, jot it down before we move on.

Â Well, in this example,

Â â‚¬100 changes hands during the time period specified,

Â while the money supply is â‚¬50.

Â Therefore, the velocity of money in this economy for the year is two.

Â And if the velocity is assumed to be constant,

Â will remain the same in future years.

Â Which one must again note here is a quite restrictive assumption in the real world.

Â 6:00

Now, what about the other important assumption

Â underpinning the classical view of the quantity theory of money.

Â This is the so-called veil of money assumption.

Â Under the veil of money assumption,

Â real output is not influenced by the money supply.

Â That is; it doesn't matter how much money the government prints.

Â This will not increase the amount of real goods and

Â services that the economy can actually produce.

Â And note here this key point;

Â if money is truly a veil,

Â that can have no impact on real growth in an economy,

Â then intervention by the government to stimulate growth in

Â the economy using monetary policy is fruitless.

Â 6:57

Based on our discussion of CA's law and the quantity theory of money,

Â you now see that the classical economists lived in

Â a world where supply would always create its own demand,

Â and there would never be any need for government intervention.

Â This is because the economy would always find a full employment equilibrium.

Â Moreover, in this classical world,

Â the only effect of an increase in the money supply beyond that needed to

Â sustain growth in real output would be inflation.

Â Nor by implication couldn't undersupply of money lead to a reduction in real output,

Â much less a recession or depression.

Â The question of course is why did classical theory fail to explain the great depression?

Â We'll look at that question in much more detail in our next lesson.

Â For now however, let's finish up this lesson

Â with an analysis of the classical aggregate demand,

Â and aggregate supply model which we'll see will be of

Â great use for both business executives and investors.

Â