Double Money leads to Doubling of Prices

Second flaw in QTM is that it describes if we double the money and double the prices then nothing will be changed in real terms. Similarly if we half the money and prices are also cut by half then there will be no change in real at all. It means that amount of money in the economy makes no difference. But this is not necessarily true. Because if everybody gets exactly the same amount of money then nothing will happen in the economy. But it is not what actually happens in real world. In Keynesian theory money can have a real effect. To understand it let’s assume prices and wages are fixed and economy is in full employment equilibrium. There will be two effects depending on whether money supply goes up or down in the economy. If money supply goes down to half now according to QTM the prices and wages should also go down by half but as prices and wages are fixed, as we assumed, so downing money supply will create unemployment in the economy. It is because the real wages are too high from the equilibrium and due to it demand to labor will go down. But it is actually the consequence and what happens first is aggregate demand goes down as real prices are too high. Firms were producing the goods when money was there and there was full employment but now things can’t be sold any more as demand is not there. People who were buying the goods are no longer able to afford the goods as money is down to half in the economy.

There is second explanation by Keynes. Suppose prices and wages also go down as money supply is cut to half then the real price and real wage will remain the same. If real wage remains the same and aggregate demand goes down then unemployment will result. If we think intuitively about the economy there is some money, there is some prices, all the businesses are working, people are hiring laborers and everybody needs money to get all of the things done. This is one of the crucial element of market economy and a part of Great Transformation. If we would not have market economy then money would not have a central role and things would be entirely different. But in market economy everybody needs money to do everything. Now if suddenly the amount of money goes down then businesses will close. Money is like a blood of economy which circulates through business activities and without it nothing functions.

According to Classical economists this problem will correct by itself which means market is self-regulating. If economy is out of the equilibrium then it will move towards equilibrium by itself. But Keynes argued that economy can’t fix itself. It was realized in Great Depression that what economic theory says is not happening in real world. Keynes said may be our theory describes how we would like the economy to behave but it is not actually how it behaves. So, must study how actually economy behaves rather than what theory says.

According to QTM if we half the money then prices and wages will half and everything will be at its original level. But according to Keynesian theory this is not true because if we half the money then there will be unemployment. Now in Classical theory also this is acceptable as Classical theory also says that money can have a short term impact. That in short run if we suddenly half the money then prices will not adjust immediately and for little while there will be unemployment but economy is self-regulating and will be fixed by itself. People will see that there is too much supply so they will decrease the prices and wages because otherwise profits can’t be made and eventually, according to Classical theory, economy will get back to equilibrium. But this was not observed to happen in Great Depression. Keynes came up with a theory to explain why it does not happen.

Now consider an opposite case where we increase the money and it does have real effect in the economy. According to QTM, double the money all the prices will double and wages will double. But according to Keynes it may or may not be true. If economy is below full employment and there is excess capacity in the economy and there is certain supply of money and certain level of prices and wages. Now if money supply is doubles then the people who have the money start demanding goods, factories will start running and will demand for labor. Money will be used to add to the production and prices will not go up because there is unused capacity in the economy. But if economy is already at full employment level then doubling the money supply will not cause to increase production as there is no additional capacity to increase the production so, prices will go up in the economy as it’s the only way to get to equilibrium. If economy is not at full equilibrium then increase in money supply will not increase the prices instead it will increase the aggregate demand, production and hence the employment level and aggregate supply in the economy. But it also depends on the third point which is the distribution of money.