Different views regarding the importance of money are presented below

Economists do not agree on the question of the role of money and monetary policy. Different views regarding the importance of money are presented below:

1. The Classical View:

The classical economists believed that money was only a medium of exchange. People keep money as a medium of exchange. People keep as little money as possible, for as short a time as possible, in order to make transactions.

The classical economists further believed that money was neutral. It means that changes in the money supply are neutral; increases in money supply cause all prices to rise at the same rate; decreases in the money supply cause all prices to fall at the same rate.

Since all prices change at the same rate, changes in money supply leave relative prices unchanged. But, consumer-spending and business-spending decisions depend upon relative prices.

Therefore, changes in money supply do not affect real variables such as employment, output and real income. In short, changes in money supply affect money variables and not real variables. It is in this sense that money has been regarded as neutral.

The classical economists assigned a modest stabilising role to monetary policy to deal with the disequi­librium situations during the adjustment period between two equilibrium positions.

They recognised the existence of unemployment as a temporary phenomenon which appears in the form of frictional unemploy­ment and represents a disequilibrium situation. Such a situation arises when wages and prices are sticky downward.

To meet such a situation of unemployment, the classical economists advocated a stabilising monetary policy of increasing money supply. The increase in money supply increases total spending and all prices.

Wages will rise less rapidly (or relative wages will fall) in the labour surplus areas, thereby reducing unemployment.

Thus, according to the classical economists, through a judicious use of monetary policy, the time lag between disequilibrium and adjustment can be shortened, or, in other words, in the case of fricitional unemployment, the duration of unemployment can be reduced.

2. Keynes’ View:

Great depression of 1930s destroyed the classical notion of a self-regulating economy. Wages and prices fell, but, at the same time, output and unemployment also declined. It was a widespread depression marked by general unemployment and not a mere situation of frictional unemployment.

These events inspired Keynes to bring out his revolutionary work, i.e., General Theory of Employment, Interest and Money (1936).

Keynes storngly criticised the classical concept of a self- regulating economy and advocated an active role for government policies for achieving full employment.

According to Keynes, a judiciously designed fiscal policy combined with monetary expansion, and not the monetary policy alone, is the most effective way to combat a depression.

He maintained that expansionary monetary policy is ineffective in the period of depression. For monetary policy to be effective, a small increase in money supply should lead to significant fall in the rate of interest, which, in turn, should lead to significant increase in investment.

But, in depression, interest rates are already very low. Moreover, demand for business loans is quite low because of bleak profit expectations. However, Keynes favoured a tight-money policy to tackle the problem of inflation.

3. Early Keynesian View:

Early Keynesians, who accepted and applied Keynes’ ideas following World War II tended to (a) ignore the importance of money all-together, and (b) emphasise the effectiveness of fiscal policy for the economies both close to full employment as well as in deep recession.

During the 1950s and early 1960s, the Keynesians also maintained that moderate inflation was necessary for achieving the objective of full employment.

4. Monetarist View:

In the 1970s, the United States and other countries experienced the problem of stagflation which refers to the simultaneous existence of both high levels of inflation and high levels of unemployment.

The Friedman-Phelps model attempted to explain the situation of stagflation through the concept of natural rate of unemployment to which an economy returns in the long run.

Unemployment consists of frictional unemployment plus the unemployment caused by a host of laws and instituitonal arrangements that interfere with price-wage reduction.

According to Friedman-Phelps model, monetary policy can reduce unemployment only by fooling buyers and sellers of labour. After adjusting to these policies, however, people are no longer fooled and both the duration and the rate of unemployment rise.

Eventually, therefore, the unemployment rate returns to the natural rate of unemployment and the natural output rate returns to the level consistent with the natural rate of unemployment.

Basically, the Friedman-model is identical with the classical view in two respects (a) It assumes a self-regulatory economy which eventually returns ‘o some natural employment level, (b) It maintains that the monetary supply does not affect real variables, such as employment and output after an adjustment period (i.e., in the longrun).

Thus, according to monetarists, money is neutral in the longrun. But, unlike the classical predictions, the monetarists believe that changes in the money supply can alter relative prices (and therefore real variables) in the short run; unemployment can depart from its natural rate in the short run.

5. New Classical View:

Friedman-Phelps model predicts that monetary policy can affect the real variables only in the short period because people cannot be fooled in the long run.

A more recent theory, the rational-expe’ctations hypothesis, first formulated by J.F. Muth in 1961 and applied to the theory of stabilisa­tion policy a decade later, suggests that you cannot fool people systematically even in the short run.

In other words, monetary and fiscal policies cannot affect real variables systematically even in the short run; hence they are useless or, according to some, even destabilising.

6. Neo-Keynesian View:

Most economists would still consider themselves Keynesians and continue to assign considerable importance to fiscal policy.

However, the Keynesian view has been somewhat modified. In the Keynesian explanations of inflation and unemployment, now, at least as much emphasis is placed on monetary policy as on fiscal policy.