[MUSIC] To understand why Keynesian economic triumphs, it is important to understand how the two major pillars of classical economics crumble under the of Keyen's argument. There two pillars are Say's Law, and the Quantity Theory of Money. Let's start with Say's Law. It was formulated in the 1800s by French businessman Jean Baptiste Say, and popularized by British stockbroker David Ricardo. Say's Law says quite simply that supply creates its own demand. Well that sounds good, but what does it really mean? Think about it this way. When people work to produce goods and services, they earn income for doing so. Say's Law states that the total income generated by this work must equal the value of the goods and services. Thus, if the workers spend this income, it must be enough to pay for all the goods and services they produce. Therefore, supply creates its own demand. Or, in the parlance of macro economics, there must be enough aggregate demand for the available aggregate supply. Now right off the bat, there's a problem with Say's Law. Suppose that the income earners don't spend all their money, and instead save some of it. That's exactly the problem that Thomas Malthus raised in his critique of Say's Law. Malthus said that if people didn't spend all of their money, there would be a general glut of goods and people would be out of work. You've probably heard of Malthus before because he's famous for the Malthusian doctrine that population will grow faster than the production of food. And that this will lead to mass starvation. In fact, it was Mathus' dark vision that originally earned the economics profession it's label as the dismal science. Well, John Say and David Ricardo had an answer for Malthus, and it was simply this. It doesn't matter if people save some of their money, because all of these savings will, in turn, be invested in the economy. Therefore, aggregate demand, which equals consumption plus investment, will always equal aggregate supply. We can follow the logic of Say's Law by looking at the circular-flow diagram in this figure. In the figure, the employee compensation paid to workers, the rents paid to land owners, the interest paid to money lenders, and the profits earned by business owners, together represent the total income earned by all the people producing aggregate supply. This flow of income moves from right to left at the top of the figure, from business firms to households. And, it represents aggregate supply in Say's Law. On the demand side we see several arrows at the bottom of the figure. One arrow moves from left to right, and represents consumer purchases of goods and services from businesses. A second arrow shows consumer savings moving first into the banking and finance sector, and then emerging as investment by businesses. Together consumption plus investment equals aggregate demand in Say's Law. Say's law became a tenant of classical economics. It didn't say unemployment couldn't exist, but it did say if wages and prices and interest rates were allowed to adjust, unemployment would go away on its own. Classical economists but their Say's Law analysis with the quantity theory of money. The quantity theory of money determines the price level, while Say's Law analysis determines real output. The Quantity Theory of Money is based on the so called, Equation of Exchange. This may equation may be written as M*V = P*Q, M of course, equals the money supply, V is the velocity of money or amount of income generated each year, by a dollar of money. P is the general price level as measured by an index such as the consumer price index, and Q is the quantity of real outputs sold. While P * Q on the right side of the equation equals the nominal or inflation adjusted output of the economy, as measured by the Gross Domestic Product. In its simplest terms. The quantity theory of money says that the price level varies in response to changes in the quantity of money. Put another way, changes in the price level are caused by changes in the money supply. The money supply goes up 20% prices go up 20%. If the money supply goes down 5% prices go down 5%. To better understand this point, we have to understand two important classical assumptions about the quantity theory of money. The first is that velocity is constant. The second, known as the Veil of Money assumption, is that real output is not influenced by the money supply. That is, it doesn't matter how much money the government prints, it will not increase the amount of goods and services that the economy can actually produce. now Looking at the MV equals PQ equation why must it be that given these assumptions increasing the money supply m will only lead to inflation. Clearly, if the Velocity V is constant on the left side of the equation, and output Q on the right side of the equation is unaffected by the money supply, the only thing that can change if the money supply M changes, is the price level P.
