In classical economic systems, changes in output occur, when all resources of the economy (labor) are fully employed. In fact, classical economists subtly suggest that changes in real output occur because of 1) change in capital or labor, as only these factors are capable of bringing real change in the economy, which is regarding goods and services. Therefore, the concept of natural level of output is recurring in the literature about classical economics (Green, 2016).
It also suggests that goods and services are not the real cause of inflation, in an economy, but rather money supply at a given or particular period. Classical economists maintain that inflation is determined by the supply of money in the economy. It implies that when in an economy, the supply of money increases, more than the output, inflation increases. In contrast, when a central bank (Federal Reserve in the case of the United States), does not increase the money supply by the growth of Real GDP, there would be deflation in the economy (Shostak, 2017).
This classical theory asserts that changes in money supply cannot bring changes in real output; neither in the short run nor the long run. This assertion, of classical economists, contradicts the Keynesian claim that in short-run, changes in money supply can bring changes in real output. However, Keynesian economists also acknowledge that changes in monetary policy alone cannot bring real changes to GDP. However, monetary policies and decisions can facilitate real changes in GDP, which is a prime goal (Classical dichotomy) (Serletis, 2007).
To understand classical and Keynesian viewpoint regarding money, its supply, and velocity (in an economy), it is imperative to discuss the concept of the money supply.
Monetary Policy
It is a policy about the supply of money and interest rates in an economy. The central bank, of a country is usually a semi-autonomous financial/economic institution, devices policy about money supply and interest rates. Such policies are short term, as they are devised to bring changes to immediate or existing economic or financial realities. For instance, a central bank can devise an expansionary monetary policy, if it finds that economic activity has slowed down (Cbn.Gov, 2017).
The systematic study, of monetary policy, in the liberal economic model, suggests that monetary policy aims to keep inflation rate healthy and interest rates facilitative. By healthy interest rate, it implies that an inflation rate that does not reduce the purchasing power of consumer and acts as an incentive for producers to invest in the economy. A facilitative interest rate is such interest rate, which increases the size of investment in an economy. To realize these with extremely significant objectives, central bank/Federal Reserve fluctuates supply of money in an economy.
Expansionary Monetary Policy
Such monetary policy is adopted when the economy is in turmoil. The Federal Reserve buys bonds and securities and injects money into the economy. Open Market Operations are performed; Federal Reserve buys treasury notes from member banks. Such measures usually consider extravagant spending by the Federal Reserve, which aims to increase consumer spending.
Interest rates are negatively related to investment; therefore, when interest rates fall, the size of investment increases in an economy. It is because loans are accessible or affordable than before, which directly influences the capital structure of a firm that operates in a corporate or economic system.
It is quite evident that expansionary monetary policy is an effective tool to change inflation and interest rate in an economy, which are means to greater ends that are high employment level and increase in real output.
Contractionary Monetary Policy
This policy is employed to reduce inflation and improve exchanged rates. For the implementation of such policy, open market operations remain the most effective tool. Also, the Federal Reserve buys securities and bonds, which reduces the quantity of money in circulation, in an economy. Also, in some cases, the Federal Reserve also increases Reserve Ratio, which also curbs both inflation and interest rates.
Federal Reserve/central bank does not adopt a contractionary policy, because it adversely affects economic activity in an economy. Such policy is usually employed when inflation gets out of control and strongly starts to affect the purchasing power of the consumer. For instance, a consumer buys less when prices of goods and services increase at an exceptional or abnormal rate. This economic development adversely affects aggregate consumption, which is considered an engine of economic growth.
Quantity Theory of Money
Quantity Theory of Money is, in fact, the classical theory of inflation rate; however, as it is associated with money supply; therefore, it is called the quantity theory of money. As per this theory, the change in the inflation rate is caused by a change in money supply. The formula for it is MV = PY, in which M is a supply of money, V is its velocity, P is general price level, and Y is output (Teles, Uhlig, & Valle e Azevedo, 2016). Classical economists to understand and determine the general price level in an economy use this equation. This equation has various variants, which are used for specific purposes. For instance;
We can rewrite the inflation equation as ΔY+ΔP t = ΔM t + ΔV……. 1
Or ΔP t = ΔM t + ΔV t – ΔY t ……………..2
Equation 2 suggests that there is a strong relationship between price and supply of money, which implies that whenever the supply of money will increase in an economy, more than the real output, inflation will increase and whenever the supply of money will be less than real output, the general price level will decrease. However, it is quite apparent that classical economics and classical economists are quite dismissive of perceptions, which play a great role in influencing prices. In fact, the episode of Great Depression suggests that perception is a very strong factor, which influences demand and supply, which includes demand and supply for money. Therefore, is not very prudent to be extremely dismissive about perception (Amedo, 2018).
Data and Analysis
For this academic exercise, we have retrieved two types of data; however, the variables remain that same. In the first set of data, variables are 1) GDP growth in billions, 2) stock of M2 in billions, 3) velocity of money. The first set of data is quarterly, as we attempted to understand changes in these variables and their outcomes in the smaller period.
The second set of data is annual and in percentage form. For instance, we have retrieved data about GDP growth from the year 2000 (month January) to the year 2016 (month January). Similarly, we have retrieved data about M2, from the year 2000 to the year 2016.
For the first set of data, we have used the most rudimentary method to understand changes in prices (money supply/Real GDP in billion).
The table below pertains to GDP (real) in billions
| Observation date | GDPC1 | Change in GDP |
| 2000-01-01 | 12359.095 | |
| 2000-04-01 | 12592.530 | 1.89% |
| 2000-07-01 | 12607.676 | 0.12% |
| 2000-10-01 | 12679.338 | 0.57% |
| 2001-01-01 | 12643.283 | -0.28% |
| 2001-04-01 | 12710.303 | 0.53% |
| 2001-07-01 | 12670.106 | -0.32% |
| 2001-10-01 | 12705.269 | 0.28% |
| 2002-01-01 | 12822.258 | 0.92% |
| 2002-04-01 | 12893.002 | 0.55% |
| 2002-07-01 | 12955.769 | 0.49% |
| 2002-10-01 | 12964.016 | 0.06% |
| 2003-01-01 | 13031.169 | 0.52% |
| 2003-04-01 | 13152.089 | 0.93% |
| 2003-07-01 | 13372.357 | 1.67% |
| 2003-10-01 | 13528.710 | 1.17% |
| 2004-01-01 | 13606.509 | 0.58% |
| 2004-04-01 | 13706.247 | 0.73% |
| 2004-07-01 | 13830.828 | 0.91% |
| 2004-10-01 | 13950.376 | 0.86% |
| 2005-01-01 | 14099.081 | 1.07% |
| 2005-04-01 | 14172.695 | 0.52% |
| 2005-07-01 | 14291.757 | 0.84% |
| 2005-10-01 | 14373.438 | 0.57% |
| 2006-01-01 | 14546.119 | 1.20% |
| 2006-04-01 | 14589.585 | 0.30% |
| 2006-07-01 | 14602.633 | 0.09% |
| 2006-10-01 | 14716.930 | 0.78% |
| 2007-01-01 | 14726.022 | 0.06% |
| 2007-04-01 | 14838.664 | 0.76% |
| 2007-07-01 | 14938.467 | 0.67% |
| 2007-10-01 | 14991.784 | 0.36% |
| 2008-01-01 | 14889.450 | -0.68% |
| 2008-04-01 | 14963.357 | 0.50% |
| 2008-07-01 | 14891.643 | -0.48% |
| 2008-10-01 | 14576.985 | -2.11% |
| 2009-01-01 | 14375.018 | -1.39% |
| 2009-04-01 | 14355.558 | -0.14% |
| 2009-07-01 | 14402.477 | 0.33% |
| 2009-10-01 | 14541.901 | 0.97% |
| 2010-01-01 | 14604.845 | 0.43% |
| 2010-04-01 | 14745.933 | 0.97% |
| 2010-07-01 | 14845.458 | 0.67% |
| 2010-10-01 | 14939.001 | 0.63% |
| 2011-01-01 | 14881.301 | -0.39% |
| 2011-04-01 | 14989.555 | 0.73% |
| 2011-07-01 | 15021.149 | 0.21% |
| 2011-10-01 | 15190.255 | 1.13% |
| 2012-01-01 | 15291.035 | 0.66% |
| 2012-04-01 | 15362.415 | 0.47% |
| 2012-07-01 | 15380.802 | 0.12% |
| 2012-10-01 | 15384.254 | 0.02% |
| 2013-01-01 | 15491.878 | 0.70% |
| 2013-04-01 | 15521.559 | 0.19% |
| 2013-07-01 | 15641.336 | 0.77% |
| 2013-10-01 | 15793.928 | 0.98% |
| 2014-01-01 | 15757.570 | -0.23% |
| 2014-04-01 | 15935.825 | 1.13% |
| 2014-07-01 | 16139.513 | 1.28% |
| 2014-10-01 | 16220.222 | 0.50% |
| 2015-01-01 | 16349.970 | 0.80% |
| 2015-04-01 | 16460.889 | 0.68% |
| 2015-07-01 | 16527.587 | 0.41% |
| 2015-10-01 | 16547.619 | 0.12% |
| 2016-01-01 | 16571.573 | 0.14% |
| 2016-04-01 | 16663.516 | 0.55% |
| 2016-07-01 | 16778.148 | 0.69% |
| 2016-10-01 | 16851.420 | 0.44% |
| 2017-01-01 | 16903.240 | 0.31% |
| 2017-04-01 | 17031.085 | 0.76% |
| 2017-07-01 | 17163.894 | 0.78% |
The above table and graph show Real GDP and quarterly changes in it from the year 2000 to 2016. It provides understanding regarding the growth in the United States. It is evident that it has increased steadily; however, this table does not provide true understanding regarding the fluctuations in the economy.
Analysis
In this section, we have used the rudimentary method of calculating inflation rate (not the equation about the Quantity Theory of Money). We divided money supply with Real Output to find average price. Then we calculated the percentage change Average Price to obtain data about the inflation rate. We found that from the year 2007 to 2009, GDP growth was very small or in negative; however, inflation rate changed, which suggests that during this period, money supply was expanded (Federal Reserve employed expansionary monetary policy).
Second Set of Data
The second set of data pertains to same variables; however, it is growth data, and to fin changes in the inflation rate, we have used the 2nd equation of the Quantity Theory of Money.
| Observation Date | GDP |
| 2000-01-01 | 4.1 |
| 2001-01-01 | 1.0 |
| 2002-01-01 | 1.8 |
| 2003-01-01 | 2.8 |
| 2004-01-01 | 3.8 |
| 2005-01-01 | 3.3 |
| 2006-01-01 | 2.7 |
| 2007-01-01 | 1.8 |
| 2008-01-01 | -0.3 |
| 2009-01-01 | -2.8 |
| 2010-01-01 | 2.5 |
| 2011-01-01 | 1.6 |
| 2012-01-01 | 2.2 |
| 2013-01-01 | 1.7 |
| 2014-01-01 | 2.6 |
| 2015-01-01 | 2.9 |
| 2016-01-01 | 1.5 |
In this above table, we have data growth data related to GDP, M2 Stock, MV, change in GDP, Change in M2, and Change in MV. All this data is used to determine QTM. In fact, QTM is changing at an inflation rate (annual). The change in the inflation rate is negative for the year 2006 to 2009, which is by the theory that during the deflationary periods, inflation dwindles. However, to counter that supply of money is expanded.
Conclusion
It is quite apparent that the major contributor to inflation is money supply, which is used as an instrument by the Federal Reserve to realize various kinds of objectives. For instance, the Federal Reserve will use expansionary monetary policy to increase inflation and reduce interest rates to intensify economic activity. From the study of data and its analysis, we also learn that Federal Reserve observed classical notions and tried to keep money supply equal to the output, as evident from the data and analysis of GDP and M2 in billions. However, from the systematic scrutiny, it is also apparent that perceptions play a crucial part in determining price, in short run.
References
Amedo, K. (2018, March 15). The Great Depression: What Happened, What Caused It, How It Ended. Retrieved from https://www.thebalance.com/the-great-depression-of-1929-3306033
Cbn.Gov. (2017, December 1). How Does Monetary Policy Affect Economic Growth? Retrieved from https://www.cbn.gov.ng/Out/EduSeries/Series11.pdf
Green, R. (2016). Classical Theories of Money, Output and Inflation: A Study in Historical Economics (1 ed.). Springer.
Serletis, A. (2007). The Demand for Money: Theoretical and Empirical Approaches (1 ed.). Springer Science & Business Media.
Shostak, F. (2017, May 5). The Connection Between Money-Supply Growth and Inflation. Retrieved from https://mises.org/wire/connection-between-money-supply-growth-and-inflation
Teles, P., Uhlig, H., & Valle e Azevedo, J. (2016). Is quantity theory still alive? The Economic Journal, 126(3), 442-464.
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