ABSTRACT
In its analysis of price formation in market economies, neoclassical economics has evolved around a dichotomy (bipartition of theory), that is at the centre of a perennial debate about money. In the microeconomic reasoning that is based on the individual decisions of consumers and producers, the structure of prices is determined by the marginal principle (see Chapter 4). In the macroeconomic determination of aggregate production, some version of the time-honoured quantity theory of money is usually invoked to explain any change in the general level of prices as the result of changes in the volume of money in the same direction (see Chapter 2). This analytical separation between money prices and relative prices implies that money is neutral with regard to real economic activity: An increase (decrease) in the volume of money could make the total demand for goods and services exceed (fall short of) supply, thereby causing the price level to rise (fall). But such monetary impulses cannot change the allocation of resources to the extent that the structure and level of real output and income will be affected, at least not in the long run. Monetary changes may temporarily disturb the price mechanism that equilibrates aggregate supply and demand, but they cannot permanently keep it out of order. Sooner or later, the price mechanism will return the market system to its initial equilibrium position in real terms. Or so it was believed in the first decades after the ‘marginalist revolution’. There was no theory that would make a rigorous connection of the marginal principle with the quantity theory.
