The Analytical Foundations
The nature of the relationship between the general price level and the quantity of money (variously defined) has been a matter of dispute throughout the history of economics. Failure to resolve the debate suggests a failure to define in a precise manner, or ever to agree upon, the issues at stake. This failure is evident in the debates surrounding the modern revival of monetarism. Writers who claim that the issues are fundamentally theoretical are opposed by those who argue that it is empirical assumptions that divide the protagonists; and analyses of short-run dynamics—always a fruitful environment for the ad hoc—are counterposed to studies of long-run equilibrium. This chapter will attempt to elucidate some of the issues by examining the theoretical foundations of monetarism. Paradoxically, these foundations do not lie in the realm of monetary theory but, rather, in theories of the determination of real output.
Beginning from the equation of exchange, or monetary identity, MV ≡ PY, it is evident that even if the velocity of circulation may be assumed to be relatively stable, determined in the longer run by institutional phenomena, a direct behavioral link between M and P alone requires that Y be independently determined. Thus, the classical version of Say’s Law, in which the level of output is determined by the level of accumulation and the social productivity of labor, given that saving and investment are assumed equal, was the basis of classical monetarism (on the classical theory of output; see Green, 1982). Similarly, the neoclassical version of Say’s Law, in which the level of output is determined in the