Monetary-disequilibrium Theory - Monetary Equilibrium, Classics and Keynes

Monetary Equilibrium, Classics and Keynes

The monetary-equilibrium framework is in some ways not at all different from the Classical model. The three central theories of the Classical School are Say's Law, Quantity theory of money and the role of interest rates:

• Say's Law (supply creates its own demand) implies that aggregate supply would always be equal to aggregate demand. The argument was that the sales of goods in the market produces the necessary income to buy that supply. This view was a part of the belief in Laissez-faire that government intervention is not required to prevent general shortages.

• The Quantity theory of money explained the general price level whereas other microeconomic factors explained relative prices.

With relative prices being explained by resources and tastes, the possibilities of shortages excluded by Say's Law and Quantity theory of money being explained by the price level, the only missing factor was the intertemporal exchange.

• In the simplest model, income Y is made up of either Consumption (C) or Saving (S) while expenditure (Yi) were either on consumption or investment goods. Here, we ignore government and foreign trade. This can seen from equation 1. Now, if the preferences of the income earners shift towards the future resulting in a fall in C and increase in S as shown in equation 2. In the simple classical model increase in savings cause a fall in the interest rates thereby inducing additional investment expenditure. This increase in Investment (I) implies a fall in (C) on the expenditure side as shown in equation 3. As given Ci= Ce, the increase in investment is equal to the increase in savings and a shift in intertemporal preferences does not disrupt the equality between income and expenditure and also there is no change in income. (Equation4)

1. Yi = Ci + S = Ye= Ce+ I.

2. Yi = C↓+S↑

3. Ye = Ce↓+I↑

4. If S = I then Yi = Ye.

Thus, we can see that monetary-equilibrium shares a lot with the classical model.