Money and the economy:

We will start with the simple framework which explicitly shows theoretical relationshipbetween money, output and prices and is based on the Quantity Theory of Money.Next we examine the relationship in the context of Keynesian perspective whichcritically evaluates the Quantity Theory of Money and propounds a different approach.After that we look at the Friedman's restatement of Quantity Theory of Money.Then in subsequent sections, we take the discussion further and examine therelationship empirically between money with interest rate, and of money, outputgrowth, and inflation.

We're going to look at how money is related with other macroeconomicvariables, specifically the price level, its rate of change (the inflation rate), the interestrate, and the output level. The idea is that inflation is associated with high rates ofmoney growth. This theory, you'll see shortly, exhibits a strong separation between real and nominal variables, since we have already discussed how real variables aredetermined with no mention of the price level or inflation rate. This is the mostimportant feature of Classical theory. We'll also see shortly that the Keynesian theorydoes not subscribe to this view and considers the real and monetary sectors of theeconomy to be interdependent, and economists differ about whether it is strength, aweakness, or both.

We start with Quantity Theory of Money which has been hotly debated theory andin its original form quite intuitive. It relates money with nominal income throughvelocity. Interest rate does not enter the picture explicitly as it is believed to bedetermined in the real economy.Then we go to the Keynesian theory which links money with real economy as interestrate as well as output level is theorized to have strong link with money. We also bringin the Friedman's restatement of Quantity Theory of Money to bring in the morerecent development in the monetary theory.