Keynesian Theory Analysis

Before developing one of the most important economic school of thoughts, John Maynard Keynes (1883-1946) was also associated with the Cambridge approach. Keynes originally was a proponent of the quantity theory, until he criticized it in \citep{book:Keynes1936}. The Keynesian theory has a much broader scope compared to that of the classical quantity theory; despite its generality, it yields fruitful results concerning the relation of money supply and prices.

\subsection{Keynes critique on the quantity theory of money}

In the classical theory, changes in the quantity of money do not affect interest rates, and thus are channeled directly in the level of prices. The starting point of Keynes argumentation is that, in the short run, money supply

In particular, the merging of Keynesian and classical ideas is based on the distinction of long run and short run dynamics.

\subsection{Monetarism}

The Keynesian views were established as the mainstream economic thinking by the mid 20th century. However, Milton Friedman (1912-2006) in \citep{art:jeh:Friedman1957} argued in favor of the validity of the quantity theory of money. Friedman accepted that in the short run money supply and output are positively related, but he observed that in the long run increases in money supply have minor, if any at all, effects on output. Therefore, in the long run, increases in money supply lead to inflationary phenomena.

The doctrine of money supply rule promoted by Friedman as a counter measure to inflation and short run employment fluctuations. The \textbf{money supply rule} is a monetary policy rule proposal according to which central banks should increase money supply at the same rate as income grows, in order to eliminate inflation. The inspiration of the rule comes from the Friedman’s version of the quantity theory. This version of quantity theory is stated in percentage changes terms, i.e.

The economic stagnation during 1990s revived the interest in Keynesian ideas. By then, the formulation of macroeconomics had already became micro-founded, i.e. it was based on principles based in microeconomics. The new Keynesian economics is a modern school of though that combines Keynesean thinking with microeconomic foundations. New Keynesian models utilize price rigidities, market failures, asymmetric information and bounded rationality schemes to argue against the validity of classical dichotomy.

An argument often used in new Keynesian settings is that of \textbf{sticky prices}. According to this idea, prices do not change as easily of quickly as aggregate demand changes and thus quantities must adjust to clear the markets. In monetary terms, if the quantity of money in an economy increases then it cannot be absorbed directly by prices, as monetarism suggests, because it takes time for prices to adjust. For instance, the price adjustment mechanism may be slowed down because printing new menus and price catalogs is costly for firms. Assuming the velocity of circulation is constant, the inability of prices to adjust necessarily leads to an increase in