Theoretical Economics Letters, 2011, 1, 122-128
doi:10.4236/tel.2011.13026 Published Online November 2011 (http://www.SciRP.org/journal/tel)
Copyright © 2011 SciRes. TEL
A Pure Theory of Aggregate Price Determination
Masayuki Otaki
Institute of Social Science, University of Tokyo, Tokyo, Japan
E-mail: ohtaki@iss.u-tokyo.ac.jp
Received September 6, 2011; revised October 18, 2011; accepted October 26, 20 1 1
Abstract
This article considers aggregate price determination related to the neutrality of money. When the true cost of
living can be defined as a function of prices in an overlapping generations (OLG) model, the marginal cost of
a firm depends solely on the current and future prices. Thus, the sequence of equilibrium price becomes in-
dependent of the quantity of money. Hence, money becomes non-neutral. However, when people hold the
extraneous belief that prices increases proportionately with money, this belief becomes self-fulfilling as long
as the increment of money and true cost of living are low enough to guarantee full employment.
Keywords: Marginal Cost, True Cost of Living, Neutrality of Money, Credibility of Money, Rational
Extraneous Belief
1. Introduction
As Keynes [1] po ints out, a disparity exists between ma-
croeconomics and microeconomics on the mechanism of
price determination. In microeconomics, prices are gov-
erned by marginal costs. However, macroeconomics em-
phasizes the role of money in the process of aggregate
price determination. How are these perspectives related
to each other? The present paper explores this disparity
between microeconomics and macroeconomics.
The disparity is closely connected to the neutrality of
money. Otaki [2,3] has already shown, by using the
standard deterministic two-period overlapping genera-
tions (OLG) model of production economy, that the
equilibrium sequence of the aggregate price can b e inde-
pendent of the quantity of money. However, Lucas [4]
proves that the quantity theory of money holds.
These seemingly contradictory results suggest the fol-
lowing theoretical hypothesis: The assumption that
prices are determined by marginal costs means that equi-
librium production/employment level is an interior solu-
tion. That is, the economy is at the imperfect employ-
ment.
This interior solution emerges from to the lack of pur-
chasing power of money. By some plausible assumption,
the true cost of living becomes a function of the current
and future prices independent of quantities. Hence, the
nominal reservation wage also depends on these factors.
Thus, when the equilibrium current price is equal to the
marginal cost, the equilibrium price sequence becomes
independent of the quantity of money. If the quantity of
money is sufficiently smaller than the equilibrium price
level determined beforehand, some individuals are un-
employed, and the interior equilibrium emerges without
any price stickiness.
In other words, although most new Keynesian econo-
mists seem to believe that a price-stickiness assumption
or restriction concerning price realignment is unavoid-
able in obtaining the non-neutrality of money (e.g.,
Calvo [5], Mankiw an d Reis [6], Woodford [7 ], and Galì
[8], money is non-neutral without such frictions in the
OLG model.
The boundary solution, namely, the quantity theory of
money, can be achieved by the following two conditions.
First, people hold the extraneous belief that the price
level varies proportionately with the quantity of money.
For example, Lucas [4] specifies the equilibrium price
function as =(pmz)
to support the quantity th eory of
money under perfect information. This assumption cor-
responds to the extraneous belief in this article. Second,
the increased rate of money, that is, the inflation rate, is
sufficiently modest to reduce the true cost of living, and
every individual wishes to work.
Under these conditions, for an arbitrarily given money
supply, the current price level flexibly adjusts the pur-
chasing power of money to attain the full-employment
equilibrium. Thus, one-to-one correspondence is estab-
lished between the cu rrent price level and the quantity o f
money. Namely, the quantity th eory of money holds, and
money becomes neutral.
123
M. OTAKI
Consequently, money is intrinsically non-neutral and
affects the employment and output level without any
price friction, as Keynes [1] tacitly considers. The quan-
tity theory of money is upheld by the extraneous belief
that money is only a measure of value and possesses no
substantial value.
This paper is organized follows. Section 2 describes
the basic model and explains the non-neutrality of money
under perfect competition. Section 3 provides the neces-
sary-sufficient condition for supporting the quantity the-
ory of money. It also discusses the difference between
the Keynesian and monetarist views on money. Section 4
explains how the methods of injecting money affect the
conclusion. Section 5 provides the concluding remarks.
2. The Basic Model
2.1. Optimization Problems of Economic Agents
2.1.1. Individuals
We consider a standard two-period OLG model with
money and one perishable good under certainty. Indi-
viduals are born with continuum density between
in each period, and live for two periods: youth and old
age. They can supply unit labor at their discretion when
they are young. Their disutility is denoted as
[0,1]
. The
lifetime utility function of each individual is
U

121 121
,, ,
tt tttt
Uc cuc c,


 (1)
where 1t and 21t are the current and future con-
sumptions of generation respectively. t
cc t
is a defini-
tion function that takes the value of unity when the indi-
vidual works and zero when he/she does not work.
( )u is well-behaved homothetic function that repre-
sents the lifetime utility derived from consumption. As
Shephard [9] proves, iff the utility fun ction is homothetic,
the true unit cost of living becomes a function of prices
independent of the consumption quantity.
Although the separability between the consumption
stream and leisure seems restrictive, the assumption can
be justified by Di ewert’s [10] dis cussion.
“Although this (homothetic) assumption is generally
not justified when we consider the consumer’s overall
cost of living index, it can be ju stified in the context of a
subaggregate if we assume that the consumer has a
separable subaggregator function, ()
f
q
q, which is line-
arly homogenous. In this case, is no longer inter-
preted as the entire consumption vector, but refers only
to a subaggregate such as ‘food’ or ‘clothing’ or some
more narrowly defined aggregate.”
From the economic perspective, Diewert [10] suggests
that aggregation should be performed among similar
goods. In this sense, in Equation (1), we assume that
consumption and leisure have quite different properties as
compared to the current and future consumption.1
The budget constraint that each individual faces is
112
,,
tttttttt
pcMWp cM
1

 (2)
where t is the price of the good; t
p
M
is the nominal
wage; and t
M
is the nominal money demand of gen-
eration to prepare for future consumption. The profits
of the firm can also become the income. However, we
assume that all the markets (goods, money, and labor)
are in perfect competition. Hence, we can neglect the
profits as a source of income.
t
An individual maximizes Equation (1) on
121
,,,
tt tt
cc M
subject to Equation (2). Since U is
homothetic, the true cost of living fun ction , which is
the expenditure function to attain a u tility le ve l , exists
such that
u

11
,,= ,
tt tt
pp ufupp

, (3)
where ( )
is a linear homogenous function. It also
increases with and . We can calculate the
nominal reservation wage
t
p1t
p
R
t
W by using the true cost of
living function Equation (3) as
1
=,
R
tt
Wf pp

.
t
(4)
In addition, the aggregate current consumption func-
tion of the young generation becomes
t
C

1
=
ttt
t
p
Cc wl
p


 , (5)
where is the employment level located within the
interval .
t
l(0,1)
2.1.2. Firms
Next, we proceed to the optimization problem of a rep-
resentative firm. The only production factor is labor. For
simplicity, the representative firm faces the constant re-
turn product i o n fu nct i o n
1The assumption that each individual can supply only one unit of labo
r
seems to be rather restrictive. However, the distinction between how
many individuals a firm employs and how many hours of work it offers
to each individual causes, at least theoretically, a difficultdynamic
p
roble
m
, when there is some fixed training costs for employing an
individual. Fukao and Otaki [11] have already solved this problem by
applying a real business cycle model. Nevertheless, since the purpose
of this paper is to show the existence of unemployment due to the
shortage of effective demand, we neglect the adjustment of hours
worked per individual and normalize the working time as unity.
=,
s
tt
y
l (6)
where
s
t
y
denotes the output level. Since the firm acts
as a price taker, the profits become zero in the equilib-
rium. Hence, using Equation (4), we obtain the following
important di f ference equatio n:
Copyright © 2011 SciRes. TEL
M. OTAKI
124



** 1
*1
*
==
1=1,.
R
tt ttt
t
t
pWp fpp
p
fp





**
,
(7)
Thus, we obtain
Lemma 1. If equilibrium emplo yment is located within
, that is, the equilibrium price is determined by the
marginal cost, the equilibrium price sequ ence,
(0,1)
*
0
tj
j
p,
can be determined independently of the sequence of the
quantity of money

0
tj
j
M. Furthermore, the equi-
librium inflation rate,
*1
*
tj
K
tj
p
p

, is constant over
time.
In addition, to avoid the multiplicity of equilibrium in
the goods market, we define the credibility of money as
follows.
Definition 1. We say that money is credible when the
rational expectation concerning the future value of
money *
0
1
tj
j
p





is not perturbed by the change of
the sequence of nominal money supply . This
can be represented as follows: 0
{}
tjj
M
*=0, ,,0.
tj
tk
dp jkt
dM

Credibility of money implies that all individuals be-
lieve in the intrinsic value of money (the inverse of the
future price level), which is not affected by the quantity
of money. In other words, young individuals are ready to
accept all forms of additional money at the prevailing
price of the good. As long as money is credible, the ini-
tial price t is historically determined by the rational
expectation of the previous young generation. Thus, the
price t is endogenously fixed. In other words, the
price become sticky not because of frictions concerning
the revision of price (menu cost, Calvo rule, etc.) but
because of the belief in the stability of the value of
money.2
p
p
2.1.3. The government
Finally, we must specify the money supply rule. New
money 1tt
M
M
t
G is injected through the government
expenditure . Thereafter, money is supplied to keep
the real cash balance *
0
tj
tj
j
M
p

equal to the initial
level *
t
t
M
mp
. Therefore, using Lemma 1, the real gov-
ernment expenditure tj
g
is expressed by
1
*
*
, =
=1
1,
t
tt
tj
tj tj K
M
Mif
p
G
gpmifj

0,
1.
j


(8)
Note that either t
M
or t is the only exogenous
variable in our model. In addition, for simplicity, all the
goods that the government purchases are assumed to be
wasted.
G
2.2. Market Equilibrium
There are three kinds of markets in the model: goods
market, labor market, and money market. Following
Walras’ Law, we confine our attention to the first two
markets. When the labor market is in interior equilibrium,
, the equilibrium nominal wage is equal to the
nominal reservation wage
0< <1
t
l
R
t
W.
To clarify the discussion, let us define the neutrality of
money.
Definition 2. Money is called neutral iff the nominal
money supply tj
M
never affects the equilibrium real
GDP *
tj
y
. Note that
0
tj
j
M contains all the possi-
ble paths that are not confined to Equation (8).
From Lemma 1 and Definition 1, it is clear that iff the
goods market is located at an interior equilib rium, money
is not neutral. Thus, have
Theorem 1. Money is non-neutral iff the goods market
is in any interior equilibrium.
Proof. The aggregate demand for the good d
t
y
is de-
fined by

1
*
=.
t
dKs
t
tt
t
M
yc ygp
(9)
The third term of Equation (9) is the aggregate expendi-
ture of the old generation. Substituting Equation s (5), (6),
(8), and the zero-profit condition of the firm into Equa-
tion (9) and using Lemma 1, we obtain
=.
dKs
tt
yc ym
2Farmer [12, 13] also exhibits the price stickiness without frictions. He
assumes that money socially facilitates the exchange. Owing to the
expansion of opportunities for the exchange, increase in the nominal
money supply initially stimulates the output, leaving the price intact.
However, thereafter, the congestion in markets raises the price gradu-
ally and reduces the consumption. Ultimately, money is neutral in the
stationary state even in his models.
Since *==
ds
y
yy
, the equilibrium condition of the
goods market is
**
=
K
yc ym
. (10)
Consequently, if money is credible and is suffi- m
Copyright © 2011 SciRes. TEL
125
M. OTAKI
ciently small, an interior equilibrium exists in the sense
that some individuals are unemployed and
*
0< <1y
holds. It is evident from (10) that money is non-neutral in
any interior equilibrium.
Conversely, if the economy is located at the boundary
equilibrium , where prices cease to be equal to
marginal costs, by definition, money becomes neutral.
Hence, whenever money is non-neutral, the economy is
in some interior equilibrium.
*=1y
When the prices are determined by the marginal cost,
the Hicks-Samuelson 45° line analysis is justified under
perfect competition and rational expectations without
any exogenous price stickiness. If the expansionary
monetary-fiscal policy is implemented, the employment
and output increase. Thus, money is non-neutral. The
fiscal multiplier is

1
1K
c
, as shown by Kahn [14]
and Keynes [1].
Note that the induced effective demand theory, which
is summarized by Equation (10), corresponds to the
long-run stationary equilibrium without any price friction.
This correspondence implies that the friction or sticki-
ness concerning prices is not a necessary condition for
the non-neutrality of money. Furthermore, the properties
of the basic model clearly differ from the new Keynesian
economics, in that money is non-neutral even in the long
run and the theory extended in Keynes [1] can be inter-
preted as the economics of the stationary state.
3. Sustaining the Quanti ty Theory of Money
The previous section proves that money is intrinsically
non-neutral, and an expansionary fiscal-monetary policy
stimulates employment and output. This section deals
with the necessary/sufficient condition for sustaining the
quantity theory of money in the basic model.
3.1. Two Different Briefs on the Value of Money
The basic model supports the Keynesian view that im-
perfect unemployment equilibrium emerges from the
lack of effective demand without any price friction.
Equation (7) and the concept of credibility play crucial
roles in this assertion.
Nevertheless, even if money is credible, the value of
money is determined by its own future (rational) expec-
tation. Equation (7) also implies that if individuals expect
money to become more valuable in the future independ-
ent of nominal money supply, it is soon transmitted to its
current value appreciation (deflation) and vice versa.
Such fragility of the base of the credibility of money is
rooted in the fact that money does not provide any utility
by itself. These properties of money resemble those of
the fiat money we actually use. To sum up, when prices
are determined by marginal costs, the value of money is
determined not by its quantity but by its credibility. This
is considered to be the Keynesian view on money.
In other words, the fact that the price of a good is in-
sensitive or sticky to a monetary shock does not indicate
the significant existence of various frictions on the revi-
sion of price but the high credibility of money.
However, the monetarist view regards money only as a
measure of value; hence, individuals believe that an in-
crease in the quantity of money brings about a propor-
tional price increase and has no effect on the employ-
ment and output level under rational expectations.
In comparison with the Keynesian view, which con-
siders that people believe in the intrinsic value of money,
the monetarist view entirely lacks the of credibility of
money aspect. Friedman and Schwartz [15] consider that
money can be circulated solely on the basis of the confi-
dence of others will.
Although the two concepts of credibility of money and
confidence of others will, appear to resemble each other,
the situation where the confidence of others will be-
comes indispensable to sustain the monetary economy,
by itself, reveals that the credibility of money is entirely
lost and that the role of money has become quite restrict-
tive. This is because estimating the will of numerous and
anonymous others is far more difficult than assuming
that each individual simply believes in the intrinsic value
of money. Furthermore, even if the confidence exists,
another problem persists.
That is, how much money do young individuals re-
quire in exchange for a unit of goods when the credibility
collapses? Thus, once the credibility of money is lost,
money ceases to have absolute substance and is re-
duced to the relative measure of value. In such cases, it is
plausible for each individual to expect that prices are
determined by the quantity of money.
Such a phenomeno n occurs in the following two polar
cases. In the first case, the economy is located at the full-
employment equilibrium. Here, any additional money
does not produce any output. Accordingly, prices in-
crease proportionately with money. Keynes [1] calls this
inflation as true inflation.
The second is the polar case of hyperinflation, in
which money completely loses credibility and is used
only as a measure of value.
Note that the seminal empirical work of Cagan [16],
concerning the quantity theory of money, confines the
data to the period of hyperinflation in six European
countries immediately after World Wars I and II. (Greece
is an exception. The data used for Greece belong to the
Copyright © 2011 SciRes. TEL
M. OTAKI
126
World War II period). Accordin g to Ca gan [16],
“Even a substantial fall in real income, which gener-
ally has not occurred in hyperinflations, would be small
compared with the typical rise in prices. Relations be-
tween monetary factors can be studied, therefore, in what
almost amounts to isolation from the real sector of the
economy.”
However, credibility of money was highly damaged
soon after the World Wars. There are two persuasive
reasons for this. First, the potential production capacity
of the economy was at its lowest. In addition, govern-
ments were forced to monetize huge amounts of debt
issued for military expenditure. Such aspects of hyperin-
flation are similar to those of true inflation.
The second reason, which is more important than the
first, concerns the incentive of labor supply. When indi-
viduals hold the extraneous belief that prices increase
proportionately with the quantity of money, the rate of
increase of nominal money supply is equal to the equi-
librium inflation rate. Once the inflation rate is higher
than some threshold, the equilibrium nominal reservation
wages begin to exceed the price of the current good.
This is because the true cost of living index
be-
comes extremely high owing to the acceleration of infla-
tion. Consequently, individuals begin to lose their incen-
tive to work. The credibility of money is entirely lost in
this polar case. Contrary to Cagan [16], hyperinflation
can be regarded as the pathology of the monetary econ-
omy.
On the basis of the above discussion, in the next sub-
section, we shall show how the basic model is trans-
formed into a model that justifies the quantity theory of
money.
3.2. Rational Extraneous Belief and the
Monetary Policy
To transform the basic model into a monetarist model,
we need to assume the following.
Assumption 1. Every individual believes that money
is not credible and holds an extraneous belief that the
price of a good is proportional to the quantity of money.
That is, each individual considers that the equilibrium
price function takes the following form:
1
=,
tjtj tj
pMM

,,j (11)
where is some positive constant.
Under Assumption 1, we can prove the following
theorem:
Theorem 2. A rational extraneous belief equilibrium
exists under full employment. That is, there exist *
f
p,
*
f
, and 1
*tj
f
tj
M
M

that satisfy Equation (11) and
for an arbitrarily given
*=1yt
M
.
Proof. To attain the full-employment equilibrium, the
price of the good must exceed the equilibrium reserve-
tion wage. From Equation (7), the equilibrium price
*
f
t
p should satisfy



** 1
*
1
*
>>
1> 1,
**
,
fR fff
tt ttt
f
tf
t
pW ppp
p
fp




.
f

(12)
Since each individual agrees with Equation (11), by sub-
stituting it into Equation (12), we obtain
*.
f
1> 1,f

(13)
Because
is a continuous and increasing function on
, taking Equation (7) into consideration, *
f
must
satisfy
*
>.
K
f
(14)
By the continuity of
, it is certain that there exists
*
f
that satisfies (14).
Condition (14) assures full employment. Next, we de-
termine
**
,
ff
p
in order to be consistent with Equa-
tion (11). Note that . Then, using Equations (10)
and (11), we obtain
*=1y

** **
1= ff f
cc
 
 
=1
f
. (15)
By Equations (11) and (15), we finally determine the
equilibrium price function as
**
tj
=
f
tj f
M
p
.
(16)
This equation completes the proof.
We now deal with the case of hyperinflation. To avoid
the unboundedness of the current equilibrium price, we
make the following assumption:
Assumption 2. There are some individuals whose dis-
utility of labor is zero. Their Lebesgue measure is
,
0< 1
.
Under this assumption, we obtain the following theo-
rem concerning hyperinflation.
Theorem 3. A rational extraneous belief equilibrium
exists where the employment and output level is at its
lowest
. That is, there exist , , and
*h
p*h
*h
that
satisfy Equation (11) and
**
==yl .
(17)
Furthermore, the equilibrium inflation rate *h
is the
highest in comparison with the economies described by
Theorems 1 and 2.
Proof. From (7), the following inequality is the nec-
essary and sufficient condition that the employment and
Copyright © 2011 SciRes. TEL
127
M. OTAKI
output level is at its lowest
:



*1
**
< 1<1,
=1, <.
hR t
tt t
hKh
p
pW fp
f

 


(18)
By the continuity of
, there exists *h
that satisfies
Equation (18) .
Next, we prove the existence of . Using (10),
*h
 

*** *
= =1
hhh h
c.c

 
 
Finally, by Equation (11), we obtain the equilibrium
price function as
**
=
tj
h
tj h
M
p
.
*
.
(19)
By Equations (14) and (18), the equ ilibrium inflation rate
is shown as
*
<<
f
Kh

(20)
This completes the proof.
4. The Injection Methods of Money
In the previous section, we assume that money is sup-
plied through the government expenditure and is equally
distributed to each individual. However, this differs from
the rule in Lucas [4]. Lucas [4] assumes that new money
is injected into the economy as interest on the existing
money. In this section, we consider how such a differ-
ence in money supply rule affects the conclusions in
Theorems 1, 2, and 3.3
Let us denote the gross rate of interest of money dur-
ing period as
tt
x
. Hence, the money supply rule
obeys
11
=
tt
.
t
M
xM

(21)
In addition, we assume that Assumption 1 holds, and all
individuals expect the equilibrium price as in Equation
(11).
Then, the budget constraint of each employed indi-
vidual becomes
112
1
12
1
,
.
ttttt ttt
t
ttt
tt
pcMWp cx M
p
ccw
px


 
1
.
t
t
(22)
From Equation (11),
11
11
=, =
ttt t
pMp xM



(23)
Substituting Equation (23) into (22), we obtain
12 =.
tt
t
cc wy (24)
While we assume here that the production function s is
Equation (6), in this section t is assumed to be hours
worked per individual. Thus, the values of 1t
lm
and
1
,
tt
x
x
are irrelevant to an individual’s consumption-
leisure decision, independent of the form of utility func-
tion. This implies the neutrality of money. Con sequently,
we obtain the following theorem.
Theorem 4. When every individual holds the extrane-
ous belief of (11) and money supply obeys rule (21)
money is neutral in the sense that and
0
{}
tjj
x1t
M
do not affect *
y
.
Proof. It is enough to show the unique existence of
*
. Equation (24) can be reinterpreted as the goods
market equilibrium condition. Let us denote the optimal
consumption decision as
**
12
,cc. Note that the equilib-
rium output *
y
is independent of equilibrium prices
**
12
,pp, so are these variables. Then, by Equations (11)
and (24),
 

** *****
12 2
*
***
2
= =,
=.
tj
tj
M
cy cyycy
p
cy

(25)
This completes the proof.
A monetarist may find Theorem 4 to be very effective
at the first glance. Theorem 3 implies that the quantity
theory of money is upheld even in the normal economy,
at least mathematically. The superneutrality of money is
also supported. Nevertheless, some unusual phenomenon
will be observed in this economy. That is, even if the
economy possesses idling resources and the marginal
cost is constant additional money only raises the price
level. In other words, the credibility of money is entirely
lost in the economy.
Equation (11) in Assumption 1 and Equation (21) are
crucial factors. The newly issued money subject to (21)
refers to a kind of denomination—the change of the unit
of money—and hence, it is possible for individuals to
lose the credibility of money. As a result, individuals
hold an extraneous belief that prices increase proportion-
ately with the quantity of money. Such a method of in-
jecting money—continuous denomination that reduces
money from the absolute substance to the relative meas-
ure of value—is scarcely adopted. Therefore, the rele-
vance of Theorem 4 is much lower than that of Theorem
1.
5. Concluding Remarks
3Otani [17] has already proved that if the money-supply rule differs
from Lucas [4], money becomes non-neutral in the more general
framework than ours. However, it is not his concern how the change o
f
nominal money supply affects the macro economy.
We have analyzed the mechanism of aggregate price
determination, which closely relates to the problem of
the neutrality of money. The results obtained are as fol-
Copyright © 2011 SciRes. TEL
M. OTAKI
Copyright © 2011 SciRes. TEL
128
lows.
First, when the economy stays within imperfect em-
ployment equilibrium, the price of the good is deter-
mined by its marginal cost, independent of the quantity
of money. This conversely implies that imperfect em-
ployment equilibrium emerges from the lack of effective
demand (or money).
The stickiness of the aggregate price, which the new
Keynesian economists emphasize, may not indicate the
substantial cost of changing the price, but the high credi-
bility of money. We have succeeded in proving the ag-
gregate price stability by introducing the concept of
credibility of money by using a model in which prices
can change flexibly in accordance with exogenous shocks.
Second, we have also succeeded in transforming the
basic Keynesian model into a monetarist model in which
the quantity theory of money is upheld and money is
insignificant.
The transformation requires two additional conditions
to the basic model. One is the extraneous belief on the
equilibrium aggregate price lev el. That is, all individuals
believe that the aggregate price level changes propor-
tionately with the quantity of money. The other is the
qualification on the rate of increase of money supply.
Under such an extraneous belief, the inflation rate be-
comes equal to the rate of increase of money supply.
Accordingly, if the rate of increase of money supply is
sufficiently low, nominal reservation wages will be lower
than the current pr ice of the good. Hence, full-employment
equilibrium is attained. Since newly issued money can-
not bear any output, the extraneous belief becomes self-
fulfilling. Keynes [1] calls this case true inflation.
The other polar case is hyperinflation. When the rate
of increase of money supply (the inflation rate) is high
enough, nominal reservation wages exceed the current
price of the good. In such a case, massive unemployment
occurs and the production level falls to its lowest. Thus,
the quantity theo ry of money holds.
To sum up, the quantity theory of money is valid in
the two polar cases where money loses its intrinsic valu e
and only operates as a relative measure of value. Al-
though the money supply rule, that new money is added
as interest on the outstanding money, strengthens the
monetarist’s view, such a rule is rarely adopted in reality.
6. References
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