Chapter 6 complete

6.3.3 Keynes’ reformulation of the quantity theory of money 
Fisher’s quantity equation and Cambridge version of the QTM do not throw any light on the 
causal process by which change in supply of money result into change in the price level. 
Classicist stated that an increase in the supply of money directly increase in the price level. 
Even Keynes also accepted this, however he stated that an increase in the supply of money 
does not increases the price level directly but via low rate of interest, high investment, high 
income (through multiplier process), increases cost (because of increase in wages and raw 
materials), and finally increase in costs increases price level. Keynes also does not accept the 
existence of full employment is the economy as classical assumed. If once the assumption of 
full employment is discarded, the classical explanation of the quantity theory of money would 
be failed. When there is unemployment in the economy, increase in supply of money will not 
increase price level but leads to increase in output because increase in price level will leads to 
fall in the interest rate, which promote investment and increase in investment will increase 
output. Fisher’s quantity theory of money will be valid only when there is full employment in 
the economy. Increase in supply of money will leads to increase in the price level only after 
economy reached full employment. Because after full employment, output becomes static and 
it is the price level only which increases with the expansion of money supply. In this context, 
true inflation may be said to begin when the elasticity of supply of output in response to 
changes in the supply of money falls to zero. 
6.
Gupta, Suraj, B, 1982, Monetary Economics: Institutions, Theory and Policy, S. Chand and Company Ltd: 
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Keynes held the view that so long as the point of full employment is not reached, all 
increase in money supply would go to increase the output not the price level. This view of 
Keynes depends on two assumptions 
1.
There is perfectly elasticity of supply of productive factors when there is 
unemployment in the eonomy. This states that when there is unemployment in the 
economy, increase in the supply of money will make interest rate to fall and promote 
investment and increase investment will increase income through multiplier process. 
Expanding output will attract more productive factors to come forth for employment 
so that the output is not retarded and the price level is not allow to rise as a result of 
pressure from the increase in the supply of money;
2.
2. Production is not subject to diminishing return or increasing cost. 
At full employment, expansion of money supply would be immediately followed by an 
equivalent rise in the price level, assuming that velocity of circulation of money (V) remains 
constant. When the price level is rising, value of money would be falling as a result people 
would like to keep less money with them. They would like to part with the money as soon as 
it comes into their possession because no one like to hold an assets whose value is 
progressively decline. When everyone behaves in this manner, ‘V’ goes up. So, after the 
point of full employment, increase in supply of money increases the price level and increased 
price level in turn will increases the velocity of circulation of money, which leads to what is 
called hyperinflation.
The phenomenon of hyperinflation could also be explained in terms of the Keynesian 
concept of liquidity preference. When liquidity preference (demand for cash balance) 
increases, velocity of circulation of money decreases and when liquidity preference (LP) 
declines, velocity of circulation of money (V) goes up. A fall in LP leads to rise in V. 
Hyperinflation can be explained in terms of liquidity preference.
Having understood the Fisher’s transaction approach to QTM and Cambridge-Cash 
balance to QTM, let us now, distinguish between these two approaches to QTM.