Question

Explain the difference between the Keynesian and the monetarist views on how an increase in the money supply causes inflation.

Answer 1

Keynesian view on inflation: Keynesian economists do not believe in the direct link between the money supply in an economy and the inflation rate. They rejected the notion that velocity is constant and output is always near to the full employment level. They have proposed that money supply could affect the prices in an economy but only indirectly. Increase in money supply increases the amount of loanable funds which reduce down the interest rates further leading to the rise in the investment and thus production. The risen production will increase the real GDP and thus the prices.

Monetarists believe that the variable that affects the inflation are the prices in an economy. They proposed that the fiscal policy in an economy is unable to control inflation. As per a monetarist economist Milton Friedman, he said: “Inflation is always a monetary phenomenon”.

As per them, MV=PQ

Where V is the velocity of money which is assumed to be constant over time. Q is the output which depends on the productive capacity of an economy. The M(money supply) is directly proportional to the P(prices in an economy). The monetarists also argue that the demand for money is not very sensitive to the interest rates in the economy.