Question

Explain the Quantity Theory of Money and the Classical Dichotomy. Compare Keynes’ analysis of the determinants of money demand to the Quantity Theory approach.

Answer 1

Quantity theory of money says that increase in the quantity of money leads to proportionate rise in the price level. There will not be rise in the real output.

This is also called the classical dichotomy. Rise in demand would cause rise in inflation only but does not affect the real variables , only nominal variables are affected by the rise in the demand.

Quantity theory of money argues that money is demanded only for transaction purposes.

According to Keynes , money is demanded for following purposes:

• Transaction purposes.
• Precautionary purposes.
• Contingency purpose.