Tiêu đề Chapter 2 Development of monetary theory.docx ✅

1 Unit 2 Development of Monetary theory 1) Classical School/ Theory (MV = PT) 2) Neo-Classical school (Cash balance approach) 3) Keynesian school – (for 20 marks) 4) Patinkin's theory of real balance effect 5) Monetarism (Milton Friedman’s theory) – for(20 marks) 6) neo-liberal school of McKinnon and Shaw 7) New-classical school (Rational Expectation equation approach) 1) Classical School/Theory Questions Give a brief account of classical monetary theory. Does the theory assumes neutrality of money? Discuss. Explain the classical monetary theory/School. What do you mean by neutrality of money? The classical monetary theory was developed after the publication of Adam Smith's 'An enquiry into the nature and causes of wealth of Nation' in 1776 AD. After that economic theory was systematically developed. Therefore Adam smith is known as father of economics. There are various economists such as T R. Malthus, JB. Say, J.S. Mill, David Ricardo are supported the Adam smith's theory. Therefore, they are called classical economist/Classicists. As such, classical theories developed over a period of time and made micro economic in nature as central question that they addressed relates to the better allocation of resources (i.e. what to produce? How to produce? For whom to produce?) In an economy. As they consider full employment to be normal situation of an economy. The classical monetary theory has made following 3 major conclusion i.e. 1) There is always full employment in the economy (involuntary unemployment) is a temporary phenomenon caused due to increase in labor supply, seasonal migration of labor etc. This will be taken care by natural forces i.e. demand and supply of the market. 2) There exist a dichotomy between real and nominal (monetary) sector of an economy. This exist due to the neutral role played by money. As money, simply is a medium of exchange. 3) Due to this dichotomy money does not matter in the determination of output and employment of money.
2 Classical monetary theory based on the following assumptions: 1) The markets are perfectly competitive. 2) There is wage price flexibility. 3) There is absence of money illusion (i.e. people do not hold money for any purpose) 4) Labor is the single variable factor of production (i.e. N, i.e. Q = f (N), N = employed labor) 5) Money only functions as a 'medium of exchange' 6) The production function based on short run law of variable proportion. 7) On the basis of these assumption, classical monetary theory define the role of money in an economy in the following manner. 8) Real sector equation It gives the equation point when demand for labor (DL) is equal to supply of labor (SL) and defining the production function. a) Demand for labor (D L ) As the classical theory assumes the perfectly competitive market, the equilibrium condition is MC = MR. But in case of labor market, it can be expressed as W = P × MPP L Where, W = money wage, P = Price, MPP L = Marginal physical productivity of labor W/p = real wage Now, the marginal physical productivity of labor (MPP L ) follows the law of diminishing returns. Therefore the demand for labor is an inverse function of real wage rate i.e. DL = f (w/p), f' < 0.... . (i) DL W/P DL O Above, figure shows the inverse relationship between number of employed labor (N) and real wage (w/p). b) Supply of labor (S L ) Supply of labor is a +v e function of real wage rate i.e. SL = f (w/p); f' > 0 ............... to justify this, as the real wage increases the labors have a choice between work and leisure. To maximize their personal benefit, the labor chose over leisure. Therefore supply of labor increases when real wage increases mathematically it can be written as SL = f (w/p), f' > 0........ (ii)
3 Graphically, it can presented as SL W/P SL O Above, figure shows the +ve relationship between number of employed labor (N) and real wage rate (w/p). d) Equilibrium of real sector When the demand for labor and supply of labor equal to each other it gives real sector equilibrium. Both are the function of real wage rate (w/p). If we plot DL and SL on same graph, then we get equilibrium level of employed labor (N) and equilibrium real wage rate (w/p). Mathematically it can be written as D L = S L .............. (iii) Graphically, N W/P DL O SL N Q Q = F(N) O N0 W/P0 Q0 N0 E
4 There is no condition of excess supply (i.e. unemployment) or excess demand (i.e. scarcity of labor). As the real wage will adjust itself (i.e. at point E) due to assumption of wage price flexibility. c) Production function The production function is based on law of variable proportion. The level of output is a function employed labor (employment). As we have assumed to be labor is a single variable factor of production. Mathematically it can be written as, Q = f (N), f' > 0  it implies MP L is increasing. f"< 0  implies MPL L is increasing decreasing rate. N Q Q = F(N) O Above figure, shows that production function based on law of variable proportion (Short run) e) Determination of output and employment The determination of output and employment of an economy on the basis of classical theory is based on 2 function i.e. production function (i.e. Q = f (N) and Labor market equilibrium (i.e. DL = SL). Therefore in this determination process of process of output and employment money has no role to play in an economy. Graphically it can be present as: