Say’s law of market and Quantity

Theory of Money

Module 7
 Classical Economics
• A school of thought that provides insights into the
economy when it operates at or near full
employment.
• Adam Smith, Jean Baptiste Say, David Ricardo, John
Stuart Mill, Thomas Malthus, etc.

• With the classical model, wages and prices are

assumed to adjust freely and quickly according to the
laws of supply and demand
 Assumptions
•Pure competition

• Flexible wages and prices

• Motivation of self-interests

• People can not be fooled by money illusion

 Important Pillars
•Say’s law of Market
•Quantity theory of money
• Aggregate Production Function
• Labour market equilibrium
 Say’s Law
• The Say's law of markets is an economic rule that says that
production is the source of demand. Say's Law is named after
the 18th-century French classical liberal economist Jean-
Baptiste Say
• Say's Law is frequently misinterpreted as "supply creates its
own demand."
• According to Say's Law, when an individual produces a product
or service, he or she gets paid for that work, and is then able
to use that pay to demand other goods and services
• Demand would always be sufficient to purchase the goods and
services produced. Therefore, there cannot be general
overproduction and the problem of unemployment in the
economy.
 Voluntary Unemployment
•If there is general overproduction in the
economy, then some labourers may be asked to
leave their jobs. There may be the problem of
unemployment in the economy for some time.
In the long-run, the economy will automatically
tend toward full employment.
 Important facts about the law
•Production Creates Market (Demand) for Goods
•Barter System as its Basis
•General Overproduction Impossible
• Saving-Investment Equality
• Rate of Interest as a Determinant Factor of S-I
equality
• Labour Market
 Propositions and Implications of the Law

•Full Employment in the Economy

• Proper Utilization of Resources
• Perfect Competition
 Criticisms of Say’s Law

•Supply does not create its Demand

• Self-adjustment not Possible
• Money is not Neutral: Say’s law of markets is based on a barter
system and ignores the role of money in the system. Say believes that
money does not affect the economic activities of the markets.
• Over Production is Possible
•Underemployment Situation
• State Intervention
•Equality through Income: Keynes does not agree with the classical
view that the equality between saving and investment is brought about
through the mechanism of interest rate. But in reality, it is changes in
income rather than the rate of interest which bring the two to equality.
• Wage-cut no Solution
• Demand creates its own supply
 Quantity Theory of Money
• Basic Definition: The idea that the money
supply will directly impact both prices and
inflation rates, ceteris paribus
 Functions of Money

• Medium of exchange: replacement for barter (used

to purchase item instead of exchanging for another
i.e. barter)
• Standard of value: we use money to compare the
values of commodities.
• Store of value: for the purpose of saving (as long as
we are confident that it will keep/store it’s present
value and therefore retain it’s purchasing power in
the future when we come to use it)
• Means of deferred payment: being able to borrow
money and pay it back over a relatively long period
of time.
 Irving fisher

Lived from 1867 to 1947

American economist, health
campaigner, and eugenicist
Most famous for Fisher
“equation of exchange” put forth in his book
The Purchasing Power of Money(1911)
M V = P T as most simplified version
Where V and T are both assumed constant
Direction of causation from left to right, showing
money supply’s importance
The Quantity Theory of Money

• MV = PQ
– M = the money stock
– V = the velocity/speed of circulation (the number
of times a unit of currency e.g. $10 note is used
in a given period of time to buy G&S’s)
– P = the general price level
– Q = total output (GDP)
 The Crude Quantity Theory of Money
• Suggests that both V (speed of circulation) and Q (output of goods
and services) are constant.

• Therefore M (the money stock) is proportional to P (general price

level).
– Which implies that the general price level will rise with an increase in
the money stock, and fall with a decrease in the money stock.
• Later, bank money is added and hence the equation becomes:
• MV+M’V’ = PT where M’ is bank money and V’ its velocity of
circulation.
• Monetarist theory views velocity as generally stable, which
implies that nominal income is largely a function of the money
supply. Variations in nominal income reflect changes in real
economic activity (the number of goods and services sold) and
inflation (the average price paid for them).
 Example of Crude QTOM
• If the money supply is increased by 15% (remembering
level of GDP assumed to be fixed), this will mean that
there is MORE money in circulation chasing the same
quantity of goods. This in turn bids up prices as the
purchasing power of each dollar falls.

• The end result will be a proportional increase in the

price level, i.e. 15% increase in P.
 The Sophisticated Quantity Theory of Money

• Assumes only V (velocity of circulation) is constant, as

the output of goods and services produced can change.

• Therefore if the money stock was to increase, this could

lead to either a rise in the general price level (P) OR an
increase in output (Q).
– If the economy is operating near full capacity there will be
very little room for Q to increase, therefore the P (general
price level) will rise.
– If the economy is operating under full capacity it has the
potential to utilise idle resources to off-set inflation (rise in
P).
 V + T are constants
• Velocity of money is fixed because of
“institutional factors”, i.e. the money supply
being exogenous
• Classical dichotomy states that nominal and
real variables can be analyzed separately, so
output is determined in real variables, velocity
will remain unchanged because it is derived
from the money supply divided by price
 Fisher cont’d
• Fisher also assumed that there is no
propensity to hoard and always full
employment
• This equation is based on the idea that money
is simply used as a medium of exchange and
not for any speculative or precautionary
purposes
 Friedman
•Fisher’s quantity theory of money was later
restated by Friedman. The rise of monetarism
accelerated from Milton Friedman's 1956
restatement of the quantity theory of money.
•Freidman asserted that “money does matter”.