Two of the most important pillars of classical economics theory are CA's Law and the quantity theory of money. In our last module, we learned how CA's law helps us think about the determination of aggregate supply and aggregate demand, and why, at least according to CA's law, supply and demand should always tend towards equilibrium. In this module, we take on the quantity theory of money. In a classical economics framework, this quantity theory of money is very useful in determining the rate of inflation. That is the price level. This theory will also be quite useful when we talk about monetary policy in a future lesson. The quantity theory of money is based on the so-called equation of exchange. This equation may be written as M × V = P × Q. M of course equals the money supply. V is the velocity of money or the amount of income generated each year by a dollar of money. P is the general price level as measured by an index such as the consumer price index and Q is the quantity of real inflation adjusted output that is sold. That is; that's a nation's real inflation adjusted GDP. Please also note that P × Q is the nominal output or GDP of the economy. While changes in the price level measure the rate of inflation or deflation in an economy. In its simplest terms, the quantity theory of money says that the price level varies in response to changes in the quantity of money. The money supply rises, so will prices. And that's called inflation. In contrast, if the money supply falls, prices will fall. And in this key definition, when the price level falls, that's called deflation. In fact, from this strict relationship between the money supply and the price level, classical economists come to a very important conclusion about how effective monetary policy. Example, increasing the money supply M might be at stimulating growth in the real GDP. So, what do you think that conclusion is? Be committed now to jot down an answer before moving on. In fact, classical economists conclude from the quantity theory of money relationship that discretionary monetary policy for example, printing more money to stimulate growth in the real GDP won't be effective at all. Indeed it shouldn't even be attempted because all it will do is create inflation. In fact that's a very pessimistic view about expansionary monetary policy which in today's modern times is regularly used to stimulate real GDP growth. So, what exactly is going on here? Well, the classical belief that printing more money only causes inflation follows from two additional and quite restrictive assumptions that the classical economists make. Namely, that the velocity of money V is constant and that money is merely availed. In this key definition, the velocity of money is the rate at which money is exchanged in a given time period, say a year. If the velocity of money is constant, that rate does not change from time period to time period, say from year to year. To give this a bit of context, suppose there are only two people in an economy, the currency used is the euro and the total money supply is €50. Suppose further that during a one year period, Francois spends €50 buying wine from Heinrich and Heinrich buys €25 of cheese and €25 of bread from Francois. So, what is the velocity of money in this party time economy? Work this out now, jot it down before we move on. Well, in this example, €100 changes hands during the time period specified, while the money supply is €50. Therefore, the velocity of money in this economy for the year is two. And if the velocity is assumed to be constant, will remain the same in future years. Which one must again note here is a quite restrictive assumption in the real world. Now, what about the other important assumption underpinning the classical view of the quantity theory of money. This is the so-called veil of money assumption. Under the veil of money assumption, real output is not influenced by the money supply. That is; it doesn't matter how much money the government prints. This will not increase the amount of real goods and services that the economy can actually produce. And note here this key point; if money is truly a veil, that can have no impact on real growth in an economy, then intervention by the government to stimulate growth in the economy using monetary policy is fruitless. Based on our discussion of CA's law and the quantity theory of money, you now see that the classical economists lived in a world where supply would always create its own demand, and there would never be any need for government intervention. This is because the economy would always find a full employment equilibrium. Moreover, in this classical world, the only effect of an increase in the money supply beyond that needed to sustain growth in real output would be inflation. Nor by implication couldn't undersupply of money lead to a reduction in real output, much less a recession or depression. The question of course is why did classical theory fail to explain the great depression? We'll look at that question in much more detail in our next lesson. For now however, let's finish up this lesson with an analysis of the classical aggregate demand, and aggregate supply model which we'll see will be of great use for both business executives and investors.
