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Noor Javid Econ 215Prof. Debora M/W 5PMAssignment #2:Question #1: Classical Theory and Keynesian Theory have different approaches to the demand formoney. Classical Theory says that one part of the economy will adjust and the equilibrium willgo back to full employment, but Keynesian Theory says that markets could fail (that equilibriumcould be achieved with underemployment). In the Classical Theory, we find that there are threevariations of how money is measured. One variation is the “Equation of Exchange”, wheremoney is related to transactions velocity, the price on the transactions, and the number oftransactions. The classical approach views money as a medium for exchange. The value of allgoods and services must be equal to the value all the transaction that have taken place. Thesecond way is an income based variations where relates money to income, along with thevelocity of money and price. The last variation is the Cambridge Approach, where we see thatthe fraction of spending that is made in money balances. We learn that the role of money isneutral. Money has only one effect and it is on pricing. More demand than supply will lead to aneed for production and more supply than demand will lead to a need to reduce production andlower prices. Classical Theory says that there is a point where they meet, but that money onlyaffects prices. In addition, Classical theory views government intervention as having a negativeeffect on the economy. Also that workers are willing to take lower wages and companies willlower their prices until equilibrium is once again achieved. This, however, is debunked byeconomistKeynes.John Meynard Keynes came up with a theory we refer to as Keynesian Theory. One wayKeynesian theory differs from Classical theory is that it looks at the markets in the short-run,because in the “long-run we are all dead.” In addition, Keynes believed that wages and prices
are more rigid than believed in Classical theory. That people would not be willing to take lowerwages to stay employed, and that companies would not sell goods at a lower price just to get ridof surplus inventory. Instead, Keynes argued that equilibrium would not be at full employment.In Keynes’ money demand theory, there is a demand for cash and “bonds”. By this theory, wheninterest rates are high, demand for bonds is high and demand for cash is low. When interest ratesare low, demand for bonds is low and demand for cash is high. The theory lays down somefactors as the reasons for holding money. First, the transactions motive which is comprised of thetransactions by households firms, and individual. Secondly, the precautionary demand whichindicates that the public will hold money to serve uncertainties in future. Thirdly the speculativedemand whereby the public will hold cash in the face of bonds that earn interest. There are two