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only price increases. This belief is often referred to as the
money neutrality
proposition. This view is formalized in the quantity theory of money equation, discussed later in chapter 8. In this theory the relationship between money and income is captured by the formula
Mv = PQ
where
M
is the money supply,
v
is a constant called
velocity, P
is the overall price level, and
Q
is output. The classical economists viewed output in the long run as being maintained at its full-employment level by the flexing of wages, so
Q
is considered fixed. Velocity also was thought to be fixed, reflecting the nature of the economy's payments system. Because v and
Q
are fixed, a doubling of the money supply by the quantity theory equation in the long run merely doubles the price level: money is neutral, playing no role in affecting the real dimension of the economy, such as output and employment levels.
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Keynes did not agree that it was legitimate to view output
Q
as constant. Although
Q
may be constant in the long run, movement to that long-run position may be so slow that prolonged recessions could develop, permitting an increase in the money supply to affect output. (This process is described in chapter 9.) Furthermore, because the interest rate can affect people's desired cash holdings, velocity should not be considered constant.
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Modern schools of economic thought do not ignore the short run and its associated dynamics. They do not believe in Say's law, and they have reinterpreted the quantity theory to make it more palatable. But one difference between the classical and Keynesian views described earlier continues to divide modern macroeconmic theorists: the classical school believed that wages and prices are quite flexible and that, as a result, government should not intervene in the operation of the economy, whereas Keynes believed the opposite. The same difference characterizes New Classicals and New Keynesians, the modern counterparts to the classical and Keynesian schools, discussed later in curiosity 12.1 in chapter 12.
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Appendix 4.2—
The Circular Flow of Income
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A popular way of illustrating the Keynesian analysis of aggregate demand is through the circular-flow diagram. This diagram shows how from year to year the income earned producing things enables people to buy these things and thereby permits the process to continue in a never-ending circular flow of income earning and spending.
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The flow of income and spending is shown circulating clockwise in figure 4.3. In the bottom box are producers who pay income in the form of wages, profits, interest, and rent, which flow up to the left to households in the top box. These households use this income to finance spending, which flows down to the right to the producers, providing them with the means to continue producing and paying incomes. Along the route of this circle, however, are several leakages from and injections into this circular flow.
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The first leakage is taxes taken from income as it flows to households. A second leakage is saving, which goes to financial markets where it is made available to investors. (Saving is also made available to governments selling bonds to finance budget deficits. To keep figure
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