MONETARY THEORY AND POLICY*
In order to isolate a field of study clearly enough demarcated to be usefully surveyed, it is necessary to define monetary theory as comprising theories concerning the influence of the quantity of money in the economic system, and monetary policy as policy employing the central bank’s control of the supply of money as an instrument for achieving the objectives of general economic policy. In surveying the field thus narrowly defined fourteen years ago, Henry Villard [123] began by remarking on the relative decline in the significance attached to it as compared with the offshoot fields of business cycle and fiscal (income and employment) theory, a decline related to the experience of the 1930’s, the intellectual impact of Keynes’ General Theory [66], and the inhibiting effects of the wartime expansion of public debt on monetary policy. While this division of labour has continued, and has indeed been accentuated by the emergence of the cross-cutting field of economic growth and development as an area of specialization, the field of money has been increasingly active and has received increasing attention in the past fourteen years.
This recent activity in the money field can be explained in part by the general logic of scientific progress, according to which disputed issues are investigated with the aid of more powerful theoretical tools, and the implications of new approaches are explored in rigorous detail. Thus, in monetary theory, the issues raised by Keynes’ attack on ‘classical’ monetary theory have been worked over with the apparatus of general equilibrium analysis developed by J. R. Hicks [60] (to the gradual eclipse of the Robertsonian and Swedish period analysis once considered most promising), and Keynes’ emphasis on treating money as an asset has been followed by subsequent theorists as a means of bringing money within the general framework of the theory of choice. In larger part, the revival of interest in money is a reflection of external developments—the postwar inflation, the consequent revival of monetary policy, and the persistence of inflation in the face of unemployment—together with recognition of the problems posed for both policy and theory by certain institutional characteristics of the modern economy (notably the widespread holding of liquid assets) and by potential conflicts between the diverse policy objectives now accepted as responsibilities of governmental policy.
The interest of professional economists in these matters has also been directly enlisted in the preparation of testimony and studies for a succession of large-scale enquiries into monetary policy and institutions, most recently the Radcliffe Report in Britain [127] and the Report [128] of the Commission on Money and Credit established by the Committee for Economic Development in the United States.1 Finally, recent work on both theory and policy has been strongly influenced by the increased postwar emphasis on (and capacity for) econometric model-building and testing, and stimulated by the availability of new data—especially Raymond Goldsmith’s data on saving [47] and financial intermediaries [48] in the United States, the Federal Reserve System’s flow-of-funds accounts ([126] and subsequent publications), and Milton Friedman and Anna Schwartz’ historical series of the United States money supply, forthcoming in [42].
While the impact of Keynes’ General Theory has been so great that most of recent theory and research on money can be classified either as application and extension of Keynesian ideas or as counter-revolutionary attack on them, it seems preferable in a survey of the field to organize the material according to the main areas of research rather than according to the issues Keynes raised. Readers interested in the present status of Keynes’ contributions to economics are referred to anniversary assessments by William Fellner and Dudley Dillard [32], James Schlesinger [102], H. G. Johnson [61], and R. E. Kuenne [71]. This survey deals with four broad topics: the neutrality of money; the theory of demand for money, which becomes the theory of velocity of circulation when the demand for money is related to income; the theory of money supply, monetary control, and monetary dynamics; and monetary policy. The theory of interest has been surveyed in a companion article by G. L. S. Shackle [105], and the theory of inflation is to be surveyed in a subsequent article in this Review by Martin Bronfenbrenner and Franklyn Holzman.
I. THE CLASSICAL DICHOTOMY AND THE NEUTRALITY OF MONEY
From the standpoint of pure theory, the most fundamental issue raised by Keynes in the General Theory lay in his attack on the traditional separation of monetary and value theory, the ‘classical dichotomy’ as (following Don Patinkin [94]) it has come to be called, according to which relative prices are determined by the ‘real’ forces of demand and supply and the absolute price level is determined by the quantity of money and its velocity of circulation. Keynes’ attack has been followed by a protracted, often confused, and usually intensely mathematical investigation of the ‘consistency’ or ‘validity’ of the classical dichotomy, the requirements of a consistent theory of value in a monetary economy, and the conditions under which money will or will not be ‘neutral’ (in the sense that a change in the quantity of money will not alter the real equilibrium of the system—relative prices and the interest rate). In the course of the controversy at least as much has been learned about the difficulty of extracting theoretical conclusions from systems of equations as has been contributed to usable monetary theory. The argument, it should be noted, has been concerned throughout with a monetary economy characterized by minimal uncertainty, whereas Keynes was concerned with a highly uncertain world in which money provides a major link between present and future (on this point see Shackle [105, p. 211]).
A. The Integration of Monetary and Value Theory
The early history of what is often described as ‘the Patinkin controversy’ is not worth recounting in detail; an annotated bibliography of it may be found in Valavanis [122], and Patinkin’s own summary in [90]. It began with Oskar Lange’s argument [72] that Say’s Law (which in this context is the principle that people sell goods only for the purpose of buying goods) logically precludes any monetary theory, since in combination with Walras’ Law (that the total supply of goods and money to the market must be equal to the total demand for goods and money from the market) it implies that the excess demand for money on the market is identically zero regardless of the absolute price level, which therefore is indeterminate. Patinkin took up this charge, shifting the object of criticism to the classical assumption that the demand and supply functions for commodities are homogeneous of degree zero in commodity prices (that is, a doubling of all commodity prices will leave quantities demanded and supplied unchanged—in other words, quantities demanded depend only on relative prices). This criticism was refined and its mathematical formulation clarified in response to subsequent critical contributions, of which the most important was Karl Brunner’s demonstration [17] that a consistent monetary theory could be constructed without assigning utility to money.
In its final form at this stage [90], Patinkin’s criticism of the classical dichotomy was that there was a logical contradiction between classical value theory, in which demands and supplies of commodities depended only on relative prices and not on the real value of people’s cash balances, and the quantity theory of money, in which the dependence of spending on the real value of money balances provides the mechanism by which the quantity of money determines a stable equilibrium absolute price level, a contradiction which could be removed neither by resort to Say’s Law nor by abandonment of the quantity theory in favour of some other monetary theory. But, Patinkin argued, the contradiction could be removed, and classical theory reconstituted, by making the demand and supply functions depend on real cash balances as well as relative prices; while this would eliminate the dichotomy, it would preserve the basic features of classical monetary theory, and particularly the invariance of the real equilibrium of the economy (relative prices and the rate of interest) with respect to changes in the quantity of money.
The integration of monetary and value theory through the explicit introduction of real balances as a determinant of behaviour, and the reconstitution of classical monetary theory, is the main theme and contribution of Patinkin’s monumentally scholarly work, Money, Interest, and Prices [93]. The first part of the book (‘Microeconomics’) develops the theory of the real balance effect (the effect of a change in the price level on the real value of money balances and hence on expenditure) in terms of a Hicksian exchange economy in which the individual starts each week with an endowment of commodities that must be consumed within the week and a stock of fiat money, and plans to exchange these for commodities to be consumed during the week and cash balances with which to start the next week. The demand for cash balances is a demand for real balances, derived rather artificially from the assumption that though equilibrium prices are fixed at the beginning of the week, cash payments and receipts are randomly distributed over the week and the individual attaches disutility to the prospect of being unable to pay cash on demand. A rise in prices lowers the real value of an individual’s initial cash holding and, provided that neither goods nor real balances are ‘inferior’, reduces his demand for both (implying a less than unit-elastic demand curve for money with respect to its purchasing power); but a proportional rise in prices accompanied by an equiproportional increase in the individual’s initial money stock does not alter his behaviour. Extended to the market as a whole, the first property ensures the stability of the money price level, the second yields the quantity theory result that a doubling of everyone’s money stock will double prices but leave the real equilibrium unchanged. When lending and borrowing by means of bonds are introduced, this latter result requires a doubling of everyone’s initial bond assets or liabilities as well as his money holdings. Patinkin’s chief criticism of the classical economists has now been reduced to their failure to analyse the role of the real balance effect in ensuring price level stability; the charge of definite inconsistency can only be fairly pinned to a few specific writers of later vintage.
Carefully worked out as it is, Patinkin’s analysis of the real balance effect is conceptually inadequate and crucially incomplete; both defects are attributable to an unsatisfactory analysis of stock-flow relationships. The conceptual inadequacy is inherent in the lumping together of the stock of cash and the week’s income of goods into a total of disposable resources and the application of the conventional concept of inferiority to the possible effects of changes in this hybrid total on the quantities of real balances and goods demanded.1 The incompleteness is inherent in Patinkin’s restriction of his analysis of the effects of a disturbance to the single week in which it occurs. Archibald and Lipsey [2] have shown that over succeeding weeks an individual whose real balances differed from their desired level would accumulate or decumulate balances by spending less or more than his income until real balances attained the desired level, at which point expenditure would once again equal income. Thus, they argue, the real balance effect is a transient phenomenon, relevant only to short-run disequilibrium situations. If positions of long-run equilibrium are compared, the effect of a change in the quantity of money does not depend on its initial distribution (since individuals will redistribute it among themselves in adjusting their real balances to the desired level) and the demand for money with respect to its purchasing power has the classical unitary elasticity; finally, real balances can be dropped from the equations determining equilibrium, which can be written as functions of relative prices only.
On the basis of this last result, Archibald and Lipsey attacked the Lange–Patinkin charge of inconsistency in classical theory, and showed that a consistent system could be constructed using demand and supply functions homogeneous of degree zero in prices, supplemented by the quantity equation, though this system would not conform to Walras’ Law when out of equilibrium. Earlier, Valavanis [122] had disputed Patinkin’s apparent victory in the dichotomy debate, and shown that if the (in my opinion, misnamed) Cambridge equation is interpreted as an independent restraint on behaviour rather than as a behaviour relationship conflicting with Walras’ Law, there is no inconsistency. J. Encarnación has since shown [31] that Lange’s mathematical proof of inconsistency is invalid, and Patinkin’s rests on a misuse of the term ‘consistency’.
As a subsequent symposium [7] on the Archibald-Lipsey article has helped to show, these demonstrations, while justified perhaps by Patinkin’s continued emphasis on the ‘inconsistency’ theme, are really beside the main point. While a formally consistent theory can be constructed by interpreting velocity as an externally-imposed restraint on monetary behaviour (an interpretation for which there is ample precedent in the literature) this treatment not only leaves velocity itself unexplained on economic grounds, but precludes any analysis of monetary dynamics and the stability of monetary equilibrium by its inability to specify behaviour in disequilibrium conditions. As the better classical monetary theorists saw, these problems are most easily handled by assuming that money balances yield services of utility to their holders; and Patinkin’s major contribution has been to elaborate a rigorous formal theory of this approach.
B. The Neutrality and Nonneutrality of Money
The second part of Patinkin’s book reformulates the argument in terms of a short-run macroeconomic system, Keynesian in structure1 but based on ‘classical’ behaviour assumptions, and arrives at the classical result that relative prices and the rate of interest are independent of the quantity of money. The significance of this demonstration lies mainly in the assumptions required to establish the neutrality of money [93, Ch. 12]: wage and price flexibility, inelastic expectations, absence of ‘money illusion’, absence of ‘distribution effects’, homogeneity of ‘bonds’, and absence of government debt or open-market operations.1 This rarefied set of assumptions is the main object of attack in J. G. Gurley and E. S. Shaw’s Money in a Theory of Finance [52], a central purpose of which is to elucidate the conditions under which money will not be neutral.
Mention must first be made of an earlier, and influential, article by L. A. Metzler [83], whose analysis underlies the final assumption listed above. Metzler argued that the wealth-saving relationship assumed in the use of the Pigou effect by Keynes’ critics to demonstrate that price flexibility would maintain full employment in the Keynesian model2 implied a theory in which changes in the quantity of money could affect the rate of interest (and consequently the rate of growth). Assuming for simplicity that government obligations are fixed in real terms, and that interest on government holdings of its own debt is returned as income to the community, Metzler showed that the price increase consequent on monetary expansion effected by open-market purchase of government debt would leave the community with a smaller stock of real assets and a greater willingness to save, thus lowering the equilibrium interest rate, though monetary expansion effected through the printing press would not alter the equilibrium interest rate. As Haberler shortly pointed out [54], Metzler’s analysis of open-market operations implicitly rests on a distribution effect (the private sector but not the government being assumed to be influenced by a change in the latter’s real debt); but subsequent writers, including Patinkin, have accepted this as a legitimate assumption, and Gurley and Shaw’s analysis builds on it.
Gurley and Shaw’s book is related to their earlier work on financial intermediaries in relation to economic growth and monetary policy; these aspects of their analysis will be taken up in the appropriate context. Their contribution to the neutrality discussion, apart from their insistence that rigidities, money illusion, expectations, and distribution effects may be quite important in actuality, consists in bringing back into the analysis the monetary and financial structure and the differing liquidity characteristics of different assets excluded by assumption in Patinkin’s models. They begin by constructing a simple model alternative to Patinkin’s, in which money is not itself government debt but is issued by the monetary authority against private debt (‘inside’ money, as contrasted with ‘outside’ money), and showing that in this model the price level is determinate1 and money is neutral. They then show that money will not be neutral in a system containing inside and outside money, outside bonds, or a variety of securities against which money can be created. The key to these results is that in these cases an increase in the quantity of money of either variety, accompanied by a proportional increase in the prices of goods and private debts, alters the relative quantities of the various assets to be held by the public; and their significance to the neutrality debate can be reduced to any arbitrarily low level by arguing that they depend on a distribution effect, and that the appropriate test of neutrality is an equiproportional change in inside money, the assets backing it, and outside assets (see Patinkin [91, p. 108]). It may also be remarked that the results depend in no way on the presence of financial intermediaries.
Gurley and Shaw’s analysis follows the tradition of Metzler and Patinkin in relating nonneutrality to the existence of government debt; their inside-money analysis merely makes noninterest-bearing as well as interest-bearing government debt a disturber of neutrality. This tradition leaves modern formal monetary theory rather awkwardly dependent on adventitious institutional or historical details; and the question naturally arises whether this is the best that can be done. The source of the difficulty lies in the implicit distribution effect introduced by the recognition that, unlike other debtors, the government does not have to worry about the size of its debts. For this difference there are two reasons: (1) the government can always pay its debts by issuing fresh debts, since it controls the money supply, (2) the government can always command the resources required to pay the interest on its debts, since it possesses the taxing power. The latter is the reason relevant to the level of theoretical generality of the neutrality discussion; and at that level it provides grounds for denying that interest-bearing government debt should be treated as net assets of the public. The existence of government debt implies the levying of taxes to pay the interest on it, and in a world of reasonable certainty these taxes would be capitalized into liabilities equal in magnitude to the government debt; hence, if distribution effects between individuals are ignored, a change in the real amount of government debt will have no wealth-effect.1 Finally, if this logic applies to interest-bearing government debt, why should it not apply to the limiting case of noninterest-bearing government debt, which is equally a debt of the public to itself, and to commodity moneys, which are the same thing though based on custom rather than law?
This line of reasoning suggests that the more elegant approach to monetary theory lies along inside-money rather than outside-money lines, and that the foundation of the theory of monetary equilibrium and stability should be the substitution effect rather than the (in this case nonexistent) wealth effect of a change in real balances. It also has implications for the dichotomy debate: in the inside-money case the economy can be validly dichotomized into a real and a money sector, since the real-balance effect reduces to a change in the relative quantities of real balances and real debt (see Franco Modigliani [58, pp. 183–4] and Patinkin [91, p. 107]). Finally, it suggests an opportunity for a reassessment of Keynes’ theory of employment, which is guiltless of the charges brought against it by Pigou and elaborated by Patinkin and others if interpreted as applying to an inside-money world.
II. THE DEMAND FOR MONEY AND THE VELOCITY OF CIRCULATION
As Villard remarked in his earlier survey [123, pp. 316–24], the equation-of-exchange approach to monetary theory was eclipsed by the income-expenditure approach1 after 1930 largely because of the prevailing tendency to treat velocity as determined in principle by institutional factors governing the rapidity of circulation of the medium of exchange and as in practice a constant—a treatment clearly contradicted by experience in the 1930’s. The alternative theory expounded by Keynes emphasized the determinants of expenditure; but it also contained a monetary theory founded on the function of money as a store of value and on the special characteristics of money as a form of holding wealth. This theory has been refined and elaborated by subsequent writers in the Keynesian tradition. In the process, Keynes’ most extreme departure from previous analysis of the demand for money—his emphasis on the speculative demand for money at the expense of the precautionary—has been gradually abandoned (as has his awkward separation of the transactions and speculative demand for money), and the speculative motive has been relegated to the short run and reabsorbed into the general theory of asset holding. On the other side, the treatment of velocity as determined by payments institutions, while prominent in some expositions of the quantity theory, was by no means the core of classical monetary theory, which clearly recognized the opportunity cost of holding wealth in monetary form; and modern followers of the classical tradition, building on this foundation, treat velocity explicitly as reflecting a demand for money derived from preferences concerning the disposition of wealth.
In consequence, contemporary monetary theorists, whether avowedly ‘Keynesian’ or ‘quantity’, approach the demand for money in essentially the same way, as an application of the general theory of choice, though the former tend to formulate their analysis in terms of the demand for money as an asset alternative to other assets, and the latter, in terms of the demand for the services of money as a good. Aside from some conceptual perplexities concerning the relation between capital and income in this context, the chief substantive issues outstanding are three: first, what specific collection of assets corresponds most closely to the theoretical concept of money—an issue that arises as soon as the distinguishing characteristic of money ceases to be its function as a medium of exchange; second, what the variables are on which the demand for money so defined depends; and third, whether the demand for money is sufficiently stable to provide, in conjunction with the quantity of money, a better explanation of observed movements of money income and other aggregates than is provided by models built around income-expenditure relationships. These are essentially empirical issues, to which empirical research has as yet produced no conclusive answers; and they clearly have an important practical bearing on monetary policy.
A. Developments in Liquidity Preference Theory
To begin with the recent development of Keynesian analysis of the demand for money, subsequent contributions have been concerned with four aspects of Keynes’ treatment of this subject: the separation of the demand into a transactions demand dependent on income and a liquidity-preference demand dependent on the rate of interest; the emphasis on the speculative element in liquidity preference; the neglect of wealth as a determinant of liquidity preference; and the aggregation of all assets other than money into bonds implicit in the use of a single (long-term) rate of interest.
The separation of the demand for money into two parts, besides being mathematically inelegant, incorporated the mechanical treatment of transactions demand that Keynes had criticized in the quantity theory. Keynesian writers (for example, Alvin Hansen [56, pp. 66–67]) began to treat transactions demand as reflecting economic behaviour and particularly as being interest-elastic, from which it was a short step to making the demand for money as a whole depend on income and the rate of interest. The logic of treating transactions demand as reflecting rational choice was subsequently provided by W. J. Baumol [9] and James Tobin [117], the former’s analysis being more interesting in that it links the problem to inventory theory. Both authors show that an economic unit starting a period with a transactions balance to be spent evenly over the period, and having the opportunity of investing idle funds at interest and withdrawing them as needed at a cost partly fixed per withdrawal, will disinvest at more frequent intervals (carry a lower average cash balance) the higher the rate of interest. They also show that the average cash balance held by the unit will be higher the higher the amount of the initial transactions balance, but less than proportionately higher.1
Keynes’ emphasis on the extremely short-run speculative motive as the source of interest-elasticity in the liquidity demand for money was one of the main targets of Keynes’ critics. Subsequent Keynesian writing has stressed Keynes’ alternative explanation of liquidity preference, which rests this interest-elasticity on uncertainty about the future interest rate rather than on a definite expectation about its level; this explanation is really the precautionary motive in disguise (see Johnson [61, p. 8]). An elegant exposition of both explanations, using the theory of portfolio management, has been provided by Tobin [115].
The introduction of the value of wealth, which itself depends on the rate of interest, as an explicit determinant of the demand for money was part of a more general process of freeing Keynes’ theory from its short-period equilibrium assumptions. It implied for the theory of liquidity preference, as noticed by Lloyd Metzler [83], Ralph Turvey [120] and Frank Brechling [10], that the liquidity-preference curve would be different for a change in the quantity of money brought about by fiscal policy than for a change effected by open-market operations (these two curves, and a third corresponding to constant wealth, are discussed in Turvey [21, Ch. 2]). It also introduces the difficulty, noted earlier by Borje Kragh [69], that the speculative demand curve for money traced out by open-market operations will differ according to the size of the units in which these are conducted, since the effects on wealth will differ. The wealth effects of discontinuity in open-market operations are exploited in Sidney Weintraub’s recent contention [124, pp. 156–60] that the speculative demand curve is irreversible, as Richard Davis [30] has subsequently pointed out. At a far more fundamental level, the analysis of the demand for money that emerges from these developments, in which the demand for money depends on the interrelated variables income, the rate of interest, and wealth, raises important conceptual (and econometric) difficulties not always fully appreciated by monetary theorists; these difficulties will be referred to later in connection with Milton Friedman’s restatement of the quantity theory.
The fourth development stemming from Keynes’ theory of the demand for money has been the disaggregation of assets other than money and the elaboration of liquidity preference theory into a general theory of the relative prices of (rates of return on) assets of different types. The chief contributions in the direct line of Keynes’ own thought, by Joan Robinson [98] and Richard Kahn [63], are primarily concerned with reasserting Keynes’ view that the long-term rate of interest is determined by expectations about the future long-term rate, against Hicks’ dismissal of it as a bootstrap theory and his attempt to explain the long-term rate as an average of expected short-term rates [60, pp. 163–4]. Robinson and Kahn both employ a division of assets into cash, bills, bonds, and equities, and a classification of asset-holders into contrasting types according to whether their asset preferences are dominated by capital-uncertainty or income-uncertainty; but Robinson is concerned to set the argument against the background of a growing economy, while Kahn concentrates on a rather subtle analysis of the interaction of the precautionary and speculative motives.
In contrast, U.S. contributions have been prompted by concern with the problems posed for monetary, fiscal, and debt-management policy by the wartime legacy of a large public debt of short average maturity; two early articles influential in subsequent thinking were those of Roland McKean [80] and Richard Musgrave [87]. The common feature of subsequent work is the treatment of assets as possessing varying degrees of liquidity, and the application of general equilibrium theory to the determination of their relative prices (yields), which are treated as the outcome of the interaction of asset preferences and the relative quantities of the different assets available. This approach (which is also central in the analysis of Robinson and Kahn just mentioned) is exemplified in W. L. Smith’s study of debt management for the Joint Economic Committee [110] and Ralph Turvey’s book on interest rates and asset prices [121]. The latter is notable for its explicit general equilibrium approach and its careful attention to the requirements of consistent aggregation. The formulation of monetary theory as part of a more general theory of asset holding has been carried farthest by the group working at Yale University under the inspiration of James Tobin; their ‘portfolio balance’ approach has been strongly influenced by Harry Markowitz’s work on rational investor behaviour (notably [77a]). Unfortunately little of this group’s work is yet available in print (see, however, Tobin [113] [115] [116]).
The formulation of the general-equilibrium approach to the theory of asset prices and yields in the literature just described has some implicit biases which are apt to mislead the unwary, especially in its application to the analysis of the term structure of interest rates.1 In the first place, there is a tendency to follow too closely Hicks’ original sketch of the approach [59] in identifying the typical asset-holder with a bank, borrowing for a shorter term than it lends and therefore preferring the shorter-term assets. In the second place, emphasis on the slippery and ill-defined quality of liquidity as the characteristic differentiating alternative assets tends to divert attention from the linkage of asset markets by speculation, and so to exaggerate the sensitivity of the interest-rate pattern to changes in the relative quantities of assets.2 In this connection it is appropriate to refer briefly3 to some recent work on the term structure of interest rates by John Culbertson [29] and Joseph Conard [24, Part III], which on its empirical side contributes to filling the gap noted by Villard [123, pp. 336–7] between the theory and the historical facts of interest-rate behaviour. Both authors arrive at essentially the same major result, that short and long rates tend to move together in a rational way, though Culbertson regards his analysis as contradicting the classical ‘expectations’ theory whereas Conard regards his as confirming a modified version of it. The explanation of this difference is that Culbertson identifies accepted theory with the incorrect Hicks-Lutz formulation of it, according to which the investor is depicted as choosing between holding a bond to maturity and investing in successive short-term loans over the same period, whereas Conard identifies it with the correct formulation, in which the investor compares the expected yields (including interest and changes in capital value) of alternative assets over the period for which he expects or is obliged to remain invested. A more recent study by David Meiselman [81] advances both the theory and explanation of the rate structure (and incidentally refutes one of Culbertson’s main arguments against the expectations theory) by interpreting the yield curve as expressing expected future short-term rates and explaining changes in it as the market’s reaction to errors of expectation.
B. Restatement of the Quantity Theory
While Keynes’ formulation of the theory of demand for money has been evolving in the directions just described, a fundamentally very similar formulation has been developed by a group of scholars associated with the University of Chicago, inspired by Milton Friedman and claiming allegiance to the quantity theory as handed down in the oral tradition of that institution. The most complete statement of this group’s basic theory—which tends usually to be mentioned only briefly in the course of presenting the results of empirical research—is contained in the condensed and rather cryptic restatement of the quantity theory by Friedman that introduces four of their empirical studies [41], a restatement that takes the reader at a hard pace from the fundamental theory to the simplifications required for its empirical application. The central points in the restatement are that the quantity theory is a theory of the demand for money, not of output, money income, or prices; and that money is an asset or capital good, so that the demand for it is a problem in capital theory. In formulating the demand for money as a form of capital, however, Friedman differs from the Keynesian theorists in starting from the fundamentals of capital theory. He begins with the broad concept of wealth as comprising all sources of income, including human beings, and relates the demand for money to total wealth and the expected future streams of money income obtainable by holding wealth in alternative forms. Then, by a series of mathematical simplifications, approximations of nonobservable variables (of which the most important is the representation of the influence of human wealth by the ratio of nonhuman to human wealth), simplifying economic assumptions, and rearrangements of variables, he arrives at a demand function for money which depends on the price level, bond and equity yields, the rate of change of the price level, income, the ratio of nonhuman to human wealth, and a taste variable; finally, he makes neat use of the homogeneity assumption to show that the demand for real balances depends only on real variables and that it can be reformulated as a velocity function depending on the same variables.
In its final form, Friedman’s demand function for money is hard to distinguish from a modern Keynesian formulation, especially in view of his remark that the nonhuman to human wealth ratio ‘is closely allied to what is usually defined as the ratio of wealth to income’ [41, p. 8]. The apparent similarity is misleading, however, because what comes out as income originally entered as wealth, i.e. capitalized income, the process of capitalizing it being absorbed by Friedman’s simplications into the yield and wealth-ratio arguments of the function; and, as Friedman indicated by various remarks and has since demonstrated by the application of his permanent income concept to the explanation of the behaviour of velocity [38], the ‘income’ relevant to this equation is not income as measured in the national accounts but income conceived of as the net return on a stock of wealth, or wealth measured by the income it yields. The use of ‘income’ to represent what is really a wealth variable has incidentally contributed to some minor confusions of stock and flow concepts in the writings of Chicago monetary theorists, especially in the alternative formulation of the theory of demand for money as an application of demand theory developed by Richard Selden [104], where money rather than its services is described as the good demanded, the elasticity relating changes in the stock of money demanded to changes in the flow of income is described as an income-elasticity, and money is classed on the basis of the empirical magnitude of this elasticity as a luxury good.
Friedman’s application to monetary theory of the basic principle of capital theory—that income is the yield on capital, and capital the present value of income—is probably the most important development in monetary theory since Keynes’ General Theory. Its theoretical significance lies in the conceptual integration of wealth and income as influences on behaviour: Keynes ignored almost completely the influence of wealth, as was legitimate in short-period analysis; and while subsequent writers in the Keynesian tradition have reintroduced wealth they have generally followed the Cambridge practice of restricting wealth to nonhuman property, a practice which encourages uncritical treatment of wealth and income as entirely independent influences on behaviour. In consequence, as mentioned earlier, much of the recent monetary literature contains formulations of the demand for money relating it to income, wealth, and the rate of interest, variables which are in fact interdependent and the use of which in this way involves inelegant redundancy and promotes errors in both theoretical reasoning and empirical applications.
The most important implication of Friedman’s analysis, however, concerns not the formulation of monetary theory but the nature of the concept of ‘income’ relevant to monetary analysis, which, as explained above, should correspond to the notion of expected yield on wealth rather than the conventions of national income accounting. This concept Friedman has elaborated under the name of ‘permanent income’, and employed in his theory of the consumption function [35] and subsequent empirical work on the demand for money [38]. The statistical application of it has involved estimating expected income from past income, which means that empirically the theory is very similar to theories employing lagged income as a determinant of behaviour.1 This similarity exemplifies a serious problem in the empirical application and testing of economic theories—the theoretical interpretation of empirical results—which is especially acute in the interpretation of empirical findings on the demand for money because of the interrelationship, of income, wealth, and interest.
C. The Distinguishing Characteristics of Money
While the treatment of money as an asset distinguished from other assets by its superior liquidity is common ground among contemporary theorists, the transition from the conception of money as a medium of exchange to money as a store of value has raised new problems for debate among monetary theorists. These problems result from recognition of the substitutability between money (conventionally defined as medium of exchange) and the wide range of alternative financial assets provided by government debt and the obligations of financial institutions, and between money and the access to credit provided by an elaborate credit system, in a financially advanced economy. They concern the related empirical questions of the definition of an appropriate monetary magnitude, and the specification of the variables on which the demand for the selected magnitude depends, questions that pose little difficulty when money is defined as the medium of exchange and its velocity is assumed to be determined by institutional factors. These questions lead into the fundamental question of the importance of the quantity of money in monetary theory and monetary policy, since unless the demand for money—defined to correspond to some quantity the central bank can influence—can be shown to be a stable function of a few key variables, the quantity of money must be a subordinate and not a strategic element in both the explanation and the control of economic activity. Argument and opinion about these issues have frequently been clouded by confusion between constant velocity and a stable velocity function, and between elasticity and instability of the function. In discussing them, it is convenient to describe first the main schools of thought on these issues,1 and then the empirical research bearing on them.
At the cost of some arbitrary oversimplification, one can distinguish broadly four main schools of thought. At one extreme are those who continue to find the distinguishing characteristic of money in its function as medium of exchange, and define it as currency plus demand deposits adjusted [73]. Next to them are the Chicago quantity theorists, who define the function of money more broadly as a temporary abode of purchasing power,1 and in their empirical work define money as currency plus total commercial bank deposits adjusted, largely to obtain a consistent long statistical series [104] [38]. Both schools believe that there is a stable demand for money (velocity function), though they define money differently. A third school, at the opposite extreme, consists of those, usually specially interested in monetary policy rather than theory as such, who carry recognition of the similarity between money and other realizable assets or means of financing purchases to the point of rejecting money in favour of some much broader concept, measurable or unmeasurable. A measurable concept is exemplified by the long-established Federal Reserve Board theory that what matters is the total amount of credit outstanding, the quantity of money exercising an influence only because bank credit is a component of total credit (see for example [57, pp. 261–3 and 272–6]). An unmeasurable concept is exemplified by the Radcliffe Committee’s concept of the liquidity of the economy [127, Ch. 6], the theory of which was left unexplained in its Report but has since been expounded by Richard Sayers [101]; according to this more extreme theory velocity is a meaningless number, the economy being able to economize on money by substituting credit for it without limit [127, p. 133]. This school, in both its variants, does not so much advance a theory as assert a position that implies a highly elastic, complex, or unstable velocity function. The serious controversy of recent years has been aroused by a fourth school, in between those already mentioned, which has been concerned with the implications for velocity of the presence of a substantial volume of liquid assets closely substitutable for money. In the early years after the war, this school was mainly concerned with the influence of short-term public debt; since the mid-’fifties, the centre of attention has shifted to the liabilities of nonbank financial intermediaries.
The leading figures in this last development are J. G. Gurley and E. S. Shaw, who in a series of contributions [50] [51] [53] culminating in a major theoretical work [52] have developed an analysis of the role of finance and particularly of nonbank financial intermediaries in economic development which has important implications for monetary theory. Gurley and Shaw start from the fact that real economic development is accompanied by a process of financial development in which primary securities (those issued to finance expenditure) become differentiated and there emerge financial intermediaries—of which commercial banks are only one variety—whose function is to enable asset holders to hold primary securities indirectly in the more attractive forms of liabilities issued by the intermediaries. Contrary to the main stream of both classical and Keynesian monetary theory, which treats the financial structure as of secondary importance and relates the demand for money to the long-term rate of interest or to the rate of return on real capital, Gurley and Shaw maintain that monetary theory must take account of these details of financial organization and development, since they affect the demand for money. In particular, they argue that because nonbank financial intermediaries generally offer liabilities which are closer substitutes for money than for primary securities, and hold small reserves of money themselves, their growth tends to reduce the demand for money. One implication of this analysis, which comes out more strongly in their remarks on monetary policy than in their theory,1 but to which they do not in fact commit themselves, is that the ‘quantity of money’ relevant for monetary theory and policy should include the liabilities of nonbank financial intermediaries.
Gurley and Shaw’s work has provoked a number of critical journal articles, but those most specifically concerned with their theoretical analysis of the influence of nonbank intermediaries on the demand for money (by Culbertson [27] and Aschheim [3]) misunderstand both Gurley and Shaw’s argument and the theory of credit creation.2 The important question Gurley and Shaw raise is the empirical one of whether explanation of the demand for money requires introduction of the amounts of or yields on nonbank intermediary liabilities. This requires an elaborate statistical analysis of the demand for money and other assets which they have not yet produced. In [53] they show only that the facts of financial development in the United States can be rationalized by their theory; and Gurley’s independent demonstration [49] that interest rates in the postwar period can be explained on the assumption that an increase in liquid assets reduces the demand for money by half as much—that is, that a correspondingly weighted sum of money and liquid assets can be used to represent the ‘quantity of money’ in applying monetary theory—does not prove that money alone would do less well; indeed Gurley explains in an Appendix why money alone could have been used. The results of recent empirical research on the demand for money and velocity by other economists described below tend to contradict Gurley and Shaw’s contention, since the writers concerned find it possible to explain the demand for money without reference to the variety of alternative assets and do not discover the downward trend in demand for money implied by Gurley and Shaw’s thesis. This is, however, only an indirect test; and the empirical research in question is itself controversial.
D. Empirical Research on the Demand for Money
Prior to the General Theory, empirical research on velocity was primarily concerned with the measurement of the institutional determinants of transactions velocity; since then, attention has shifted to econometric explanation of income velocity and its alternative formulation, the demand for money,1 one of the prime objects being to determine the existence or otherwise of the Keynesian liquidity trap. An influential early contribution by James Tobin [114] followed Keynes’ theory in estimating idle balances by subtracting from total deposits an estimate of active balances derived from the maximum recorded velocity of circulation, and found a rough hyperbolic relationship between idle balances and interest rates, implying a liquidity trap. This relationship broke down for the postwar years, one reason being its failure to include the influence of total wealth; and subsequent researchers have generally preferred to avoid its assumption of a separable and proportional transactions demand in favour of analysing the total demand for money. Tobin’s method has, however, been employed in a more sophisticated form in a recent major study by Martin Bronfenbrenner and Thomas Mayer [13], which relates the demand for idle money (total money being defined as currency plus demand deposits adjusted) to the short-term interest rate, wealth, and idle balances of the previous year. They find that the last two variables explain most of the fluctuations in idle balances, and that the demand for idle balances is interest-inelastic with no tendency for the elasticity to increase as the rate falls. They interpret this last result as evidence against the liquidity trap; the validity of this inference depends on whether the liquidity trap is identified with infinite elasticity at some positive interest rate or an unlimited increase in the quantity of money demanded as the interest rate falls.
Estimates of the total demand function for money, besides avoiding arbitrary assumptions about transactions velocity, are easier to relate to income velocity than estimates of the Tobin type, since they usually use income as one of the explanatory variables.1 Among a number of such estimates the two most important, in terms of length of period covered, simplicity of the demand function fitted, and intrinsic theoretical interest, are those by Henry Latané [73] and to Milton Friedman [38]. Latané, adopting what he called a pragmatic approach to the constant-velocity and Keynesian formulations of demand for money, found that a simple linear relationship between the ratio of money (currency plus demand deposits) to income and the reciprocal of high-grade long-term interest rates fitted the historical data closely. Friedman’s contribution builds on Selden’s earlier finding (104) that the secular decline in velocity could be explained by the hypothesis that the demand for money (currency plus total commercial bank deposits) increases more rapidly than income (money is a ‘luxury good’), a finding apparently inconsistent with the fact that income and velocity vary together over the cycle. Friedman resolves the paradox by hypothesizing that the demand for real balances is an elastic function of permanent income, and showing that the apparent inconsistency of the cyclical behaviour of velocity with this hypothesis disappears when the expected income and expected prices indicated by the theory are used instead of their observed counterparts; moreover, since this empirical analysis explains velocity without introducing interest rates into the demand function for money, it seems to dispose of the liquidity trap.
These two empirical demand functions for money apparently conflict, in that Latané’s depends on both income (with a unitary income elasticity) and the long-term interest rate, whereas Friedman’s depends only on income, with an income-elasticity substantially above unity. But there is no necessary conflict, since Friedman’s definition of money includes time deposits, and may therefore absorb most of the substitution between demand deposits and currency and interest-bearing assets induced by interest-rate changes. The real issue is which definition of money gives the better empirical results. Latané has since shown [74] that his formulation fits the subsequent data well. He explains the difference between the income-elasticities of the two functions by the facts that over the period covered by Friedman’s calculations time deposits (whose inclusion he questions on theoretical grounds) grew more rapidly than demand deposits, and the long-term interest rate declined from 6.4 to 2.9 per cent. (Latané also adduces evidence for the existence of a liquidity trap, though he prefers to explain it by the cost of bond transactions rather than by Keynes’ speculative motive.) Friedman’s demand function, by contrast, does not fit the subsequent data, since the secular decline in velocity has reversed itself (Latané’s analysis would attribute this to the subsequent upward movement of interest rates). Friedman has since been experimenting with an extended permanent income hypothesis that allows for changes in the confidence with which expectations are held [37]. Latané’s demand function, incidentally, can be used to illustrate the difficulty of interpretation mentioned earlier: if wealth is assumed to be measured by income capitalized at the long-term interest rate, the quantity of money demanded in Latané’s function can be expressed alternatively as a function of interest and wealth or of wealth and income,1 thus being consistent with a variety of theoretical formulations.
The empirical studies of demand for money just discussed have a bearing on the fundamental issue, the subject of continued controversy in the history of monetary theory: whether monetary theory is more usefully formulated in terms of the demand for and supply of money or of the influence of money on expenditure and income—the equation-of-exchange approach or the income-expenditure approach. This issue, which Keynes’ promulgation of the propensity to consume as a behaviour relationship more stable than the discredited velocity of circulation seemed to have settled finally in favour of the income-expenditure approach, has become less settled with the postwar failure of the simple consumption function and the increasing complexity of Keynesian models on the one hand, and the increasing sophistication of modern adherents of the velocity approach on the other.
The counterattack on Keynesian income theory first launched by Friedman [36] [41] has been carried further in an article by Friedman and Gary Becker [43], which argues that the proper test of Keynesian theory is not the stability of the consumption function but its ability to predict consumption from investment, and produces some evidence that the investment multiplier is a poorer predictor of consumption than is the trend of consumption. In reply, Lawrence Klein [67] and John Johnston [62] have argued that a proper test should be concerned with the sophisticated and not the naïve version of a theory, and should test the predictive power of the complete model and not just one part of it. This preliminary skirmish probably indicates the main lines of the battle that is likely to follow publication of a major study by Friedman and David Meiselman [44], which shows by exhaustive statistical tests on U.S. data since 1897, that except for the 1930’s, the quantity of money has been a better predictor of consumption than has autonomous spending.
These results pose an important theoretical problem, since they imply that a change in the quantity of money that has no wealth-effect nevertheless will have an effect on consumption even though it has no effect on interest rates. The difficulty of understanding how this can be prompted the dissatisfaction of Keynes, Wicksell, and other income-expenditure theorists with the quantity theory, and provides the hard core of contemporary resistance to it. Friedman and Meiselman’s explanation of their results may therefore initiate a new and possibly fruitful debate on how money influences activity.
III. THE SUPPLY OF MONEY, MONETARY CONTROL, AND MONETARY DYNAMICS
A. The Supply of Money
The theory of money supply is virtually a newly-discovered area of monetary research. The general practice in monetary theory has been to treat the quantity of money as determined directly by the monetary authority, without reference to the links intervening between reserves provided by the central bank on the one hand, and the total of currency and bank deposits on the other. This treatment has rested on a mechanical analysis of the determination of money supply, very similar to the outmoded treatment of velocity, in which the money supply is related to the reserve base by a multiplier determined by the reserve ratio observed by the banking system, and the ratio between currency and deposits held by the public. In conformity with developments on the side of demand, the trend of recent research on money supply has been towards treating these ratios as behaviour relationships reflecting asset choices rather than as exogenous variables, and elaborating the analysis to include the part played by other financial intermediaries than commercial banks, in the process evolving a less mechanical theory of central bank control. In part, recent developments in this area reflect a more general tendency to formulate the dynamics of monetary change in terms of the adjustment of actual to desired stocks rather than in terms of changes in flows.
Though Keynes followed convention in treating the quantity of money as a direct policy variable, other monetary theorists (an early example is Kragh [70]) applied the notion of liquidity preference to the reserve behaviour of banks, and the same idea has been incorporated in various Keynesian models (not always consistently) by making the money supply vary with the rate of interest. Theorists concerned with the money supply have, however, tended until recently to stick to the mechanical ‘money multiplier’ approach, extending it to allow for the different reserve requirements against time and demand deposits and the demand for money by financial intermediaries; and empirical research has followed the same line, partitioning changes in the quantity of money among changes in the currency-deposit and reserve-deposit ratios and the reserve base, and changes in the reserve base among changes in reserve bank liabilities and assets. These techniques can be extremely fruitful—notable examples are Donald Shelby’s investigation of the monetary implications of the growth of financial intermediaries [107], and Brunner’s empirical study of U.S. monetary policy in the middle 1930’s [15]—but asset ratios are a crude technique for representing behaviour relationships.
Philip Cagan’s study of the demand for currency relative to the total money supply [19] has broken new ground in attempting an economic explanation of the ratio of currency to currency plus total deposits. Cagan examines a number of possible determining factors, and finds that expected real income per capita explains most of the decline in the ratio from 1875 to 1919, while changes in the net cost of holding currency instead of deposits explain most of the variation in the ratio from 1919 to 1955, though the rate of personal income tax (taken to represent the possible gain from tax evasion permitted by using currency for transactions) is required to explain the rise in the currency ratio in the Second World War.
Other researchers have concerned themselves with the response of the banking system to changes in reserves, though so far the published results have been theoretical rather than empirical. Recent work on this problem has departed from the ‘money-multiplier’ approach in three respects: first, in basing the analysis on the behaviour of the individual bank instead of the banking system; second, in applying economic theory to the explanation of the level of reserves desired by the bank and relating its behaviour in expanding or contracting its assets to the difference between its actual and its desired reserves; and third, in treating the loss of reserves consequent on expansion as a stochastic process. These innovations are exemplified in two recent articles, both intended as a basis for empirical research: Brunner’s schema for the supply theory of money [16], the central feature of which is a relationship between a bank’s surplus reserves and its desired rate of change in its asset portfolio, formulated in terms of a ‘loss coefficient’ measuring the (probable) loss of surplus reserves per dollar of asset expansion; and Daniel Orr and W. J. Mellon’s analysis of bank credit expansion [89], which applies inventory theory to the bank’s holding of reserves against cash losses (which are assumed to be random and normally distributed). Orr and Mellon show, in contrast to the results of money-multiplier analysis, that the marginal expansion ratio will be lower than the average for a monopoly bank, and lower for a banking system than for a monopoly bank; and that for a banking system the marginal expansion ratio depends on the distribution of the additional reserves among banks.
B. Monetary Control: A Theoretical Issue
The research just mentioned is concerned with introducing into the theory of money supply recognition of the fact that commercial banks are profit-maximizing institutions with economic behaviour patterns on which the central bank must operate to control the money supply. The fact that monetary control operates in this way is the source of one group of issues in recent discussions of monetary policy, to be described in the next section; it also poses the interesting theoretical question of what powers the central bank needs to control the price level. This question has been raised and discussed by Gurley and Shaw [52, Ch. 6], who conclude their book by contrasting monetary control in a private commercial banking system with their standard case, in which the government determines the nominal quantity of money and the deposit rate on it. Unfortunately their argument is nonrigorous and inconsistent: having shown [52, pp. 261–2] that control of the nominal quantity of bank reserves and the rate of interest paid on these reserves is sufficient for control of the price level (though they argue that this control is weaker than in their standard case because bank liquidity preferences or deposit rates may change independently of central bank action), they conclude their discussion of the technical apparatus of monetary control with the statement that ‘of three indirect techniques—fixing nominal reserves, setting the reserve-balance rate, and setting members’ own deposit rate—the Central Bank can get along with any two in regulating all nominal variables in the economic system’ [52, pp. 274–5].1 Patinkin [91, pp. 112–16] has shown that this statement is incorrect, and that the central bank needs to control nominal reserves and one of the interest rates.2
C. Monetary Dynamics
As mentioned above, one of the recent innovations in the theory of money supply is the analysis of bank response to changes in reserves in terms of the adjustment of actual to desired reserves. This way of stating the problem reflects a more general tendency toward the formulation of monetary dynamics in terms of adjustment of actual to desired stocks, associated in turn with the formulation of monetary theory in terms of asset choices as described in the previous section. This tendency has developed somewhat apart from, and has been concerned with more fundamental issues than, the controversy over the interrelated issues of stock versus flow analysis and liquidity-preference versus loanable-funds theories that has broken out anew since the war. Much of the relevant literature on the latter subject has been surveyed by Shackle [105]; unfortunately, Shackle’s discussion of the issues is vitiated by the erroneous belief that the presence of both a stock of old securities and a flow of new securities implies a conflict of forces—stock demand and supply, and flow demand and supply—operating on the interest rate, and that this conflict poses a dilemma for monetary theory that can only be resolved by the postulation of two rates of interest. It is therefore necessary to describe the controversy briefly, before turning to the more important development in monetary dynamics.
Modern controversy over liquidity-preference versus loanable funds theories starts from Hicks’ demonstration of the formal equivalence of the two [60, pp. 160–2]; Hicks used the fact that Walras’ Law permits the elimination of one of the equations in a general equilibrium system to argue that one can omit either the excess-demand-for-money equation, leaving a loanable-funds theory of interest, or the excess-demand-for-securities equation, leaving a liquidity-preference theory of interest. The omitted equations are flow equations; William Fellner and Harold Somers [33] subsequently showed that they could be identified with the desired change in the stock of money or securities over the market period, so that flow analysis and stock analysis of monetary equilibrium were equivalent. Fellner and Somers also argued in favour of the loanable-funds theory and against the liquidity-preference theory that, as the rate of interest is the price of securities, it is more sensible to regard it as determined by the demand for and supply of securities than by the demand for and supply of money. This led to a controversy with L. R. Klein [68], who objected to Fellner and Somers’ assumption that the period of analysis starts with equilibrium between actual and desired stocks as begging the question of stock versus flow theory, and declared that the real difference between the liquidity-preference and loanable-funds theories was a dynamic one, liquidity-preference theory maintaining that the rate of interest would change in response to an excess demand for or supply of money, not an excess supply of or demand for securities [68, pp. 236–41].1
In commenting on the controversy, Brunner [68, pp. 247–51] pointed out that Fellner and Somers’ analysis, while correct, evaded the real issue that Klein was raising—that there is a difference between the dynamic adjustment processes of markets in which the object of demand is primarily a stock to be held, and of those in which the object of demand is primarily a flow to be consumed; but he sided with Fellner and Somers against Klein on the dynamic determinants of interest-rate changes. Earlier, Lerner had produced a much-quoted but untraceable objection to Hicks’ original argument: that if the excess demand equation for some commodity (Lerner chose peanuts) is eliminated by Walras’ Law, the resulting system includes both a loanable-funds and a money equation, one of which must be used to determine the price of the excluded commodity.
Subsequent contributors to the debate can be classed as those who maintain the identity of the two theories, and those who maintain that the liquidity-preference theory is different from (and superior to) the loanable-funds theory. To clarify the issues, it is convenient to discuss these groups in order. Among the former group, S. C. Tsiang [119], W. L. Smith [111], and Don Patinkin [92] deserve mention—Smith for his compact exposition and explicit recognition of the difference between stock and flow theories of behaviour.
Tsiang objects to the Hicks-Fellner and Somers use of Walras’ Law to establish the equivalence of the two theories on the Lerner grounds that this law only permits the elimination of one of the general equilibrium equations, and maintains that to establish the equivalence it is necessary to show that the individual can only demand or supply securities by supplying or demanding money. He also objects that the flow demand and supply of money in the Fellner–Somers analysis bears no relation to the stock demand and supply of Keynesian theory. To get around these difficulties (which, as Patinkin [92] shows, are of Tsiang’s own creating) Tsiang chooses a period so short that the economic unit cannot plan on using its proceeds from planned sales of commodities to finance planned purchases of them; by this arbitrary device the flow and stock demands for money are equated and the only choice left to the unit is between holding cash (as an idle balance or for spending) and holding securities, so that identity of the two theories (in Tsiang’s sense) necessarily follows.
Patinkin’s article is an elegant restatement of the Hicksian position. Patinkin argues that the Lerner objection merely means that it is wrong to classify interest theories by the equation omitted, and that the two theories are simply alternative formulations of one general equilibrium theory of interest. He disposes of Tsiang’s objection to the Fellner–Somers analysis by showing that the excess flow-demand for money is identical with the excess stock-demand for money for the period (Patinkin slips in not making explicit that to translate a desired change in a stock over a period into a flow during the period it is necessary to divide the change by the length of the period). Finally, he disposes of Klein’s statement of the difference between the two theories by showing that this difference refers to the dynamic behaviour of the same market—the securities market—so that the choice of which market to eliminate is not relevant.
Patinkin goes on to argue, with the help of the apparatus of dynamic theory developed in his book, that the Klein hypothesis concerning the dynamics of the interest rate is inherently implausible, since it implies that the interest rate will fall (rise) in the face of excess supply (demand) in the securities market. This argument, appealing as it is, is restricted by its dependence on Patinkin’s dynamic apparatus, which permits simultaneous disequilibrium in all markets and relates the direction of movement of individual prices to the excess demand or supply in the corresponding markets. It can be objected both that there is no reason why the movement of price in a market should be dominated by the excess demand or supply in that market (Brunner’s argument against Klein recognized this point [68, p. 251]) and that a dynamic analysis of price movements in one market requires specification of how disequilibria in the remaining markets are resolved.1 Further, in setting up a dynamic analysis—particularly a period analysis—explicitly allowing for the (temporary) resolution of disequilibrium, it is possible and sometimes convenient to define the relationships in such a way that Walras’ Law does not hold. This is the procedure that has been adopted (implicitly or explicitly) by recent defenders of the liquidity-preference theory: Joan Robinson’s exposition of it [98] employs a period analysis in which retailers confronted with unintended increases in inventories finance themselves by releasing cash or securities, and Hugh Rose’s dynamic version of Keynes’ theory [100] (which behaves according to Klein’s hypothesis) uses the same model with inventories being financed by security issues. In both cases the demand and supply of goods are equated ex post by the accommodating behaviour of retailers, but this behaviour is not included in the ex ante description of disturbances to equilibrium. F. H. Hahn’s reformulation of the liquidity-preference theory as a theory of the ratios in which cash and securities are held [55] employs a similar but more subtle device—a distinction between the investment-planning period, and a shorter ‘investment-financing’ period during which the loanable-funds but not the liquidity-preference theory applies—to reconcile the two theories dynamically.
Elegant as it is, Patinkin’s analysis is confined to the determination of equilibrium in a single period, and ignores the effects of the changes in stocks determined in that period on the equilibrium determined in the next period. Other participants in the controversy have followed him (or rather Keynes) in abstracting from the process of accumulation of real and financial wealth. The discussion has therefore stopped short of the issue raised by Klein, and elaborated on by Brunner, of the dynamics of price in a market characterized by a large stock and small demand-and-supply flows per period. Brunner [68, pp. 247–9] sketched a theory of such a market; in this theory price is determined at every moment by the demand for the existing stock, but at this price there may be a net flow demand or supply which gradually changes the existing stock and therefore the price; and full equilibrium requires a price which both equates the stock demand and supply and induces a zero net flow.1 A very similar theory has since been elaborated by Robert Clower [22], who uses it to argue that productivity and thrift have only an indirect effect on interest (through the net flow of new securities) unless they affect the stock demand for security directly by changing expectations. Clower and D. W. Bushaw [23] have produced a general theory of price for an economy that includes commodities appearing only as stocks, commodities appearing only as flows, and commodities appearing as both stocks and flows; in this theory the equilibrium price in the market for a stock-flow commodity must equate both the desired and actual stock and the flow demand and supply, and in the dynamic analysis the rate of change of price depends on both the excess-stock and excess-flow demands.2
Neither the Brunner–Clower nor the Clower–Bushaw theory really solves the stock-flow problem: the former subordinates the flow analysis entirely to the stock, the latter simply adds stock and flow analysis together. The defect common to both is the absence of a connection between the price at which a stock will be held and the current rate of change of the stock held, and correspondingly between the price at which a stock will be supplied and the current rate of change of the stock supplied; such connections would yield a simultaneous equilibrium of stock and flow evolving towards full stock equilibrium (zero net flow.)3 The addition of such connections would require treating savings and investment as processes of adding to stock, rather than as flows as they have customarily been treated in the post-Keynesian literature.4
This is the approach to monetary dynamics that has been emerging in the past few years, from both ‘Keynesian’ and ‘quantity’ theorists, as an outgrowth of the formulation of monetary theory as part of a general theory of asset holding. The essence of the new approach, elements of which are to be found in recent works of such diverse writers as Cagan [20], Tobin [116], Friedman [40, pp. 461–3] and Brunner [18], is to view a monetary disturbance as altering the terms on which assets will be held (by altering either preferences among assets or the relative quantities of them available), and so inducing behaviour designed to adjust the available stocks of assets to the changed amounts desired.1 The new approach has been aptly summarized, from the point of view of monetary policy, by Brunner [18, p. 612]:
‘Variations in policy variables induce a reallocation of assets (or liabilities) in the balance sheets of economic units which spills over to current output and thus affect the price level. Injections of base-money (or “high-powered” money) modify the composition of financial assets and total wealth available to banks and other economic units. Absorption of the new base money requires suitable alterations in asset yields or asset prices. The banks and the public are thus induced to reshuffle their balance sheets to adjust desired and actual balance-sheet position.
‘The interaction between banks and public, which forms the essential core of money-supply theory, generates the peculiar leverage or multiplier effect of injections of base money on bank assets and deposits and, correspondingly, on specific asset and liability items of the public’s balance sheet. The readjustment process induces a change in the relative yield (or price) structure of assets crucial for the transmission of monetary policy-action to the rate of economic activity. The relative price of base money and its close substitutes falls, and the relative price of other assets rises.
‘The stock of real capital dominates these other assets. The increase in the price of capital relative to the price of financial assets simultaneously raises real capital’s market value relative to the capital stock’s replacement costs and increases the desired stock relative to the actual stock. The relative increase in the desired stock of capital induces an adjustment in the actual stock through new production. In this manner current output and prices of durable goods are affected by the readjustments in the balance sheets and the related price movements set in motion by the injection of base money. The wealth, income, and relative price effects involved in the whole transmission process also tend to raise demand for non-durable goods.’
IV. MONETARY POLICY
There is probably no field of economics in which the writings of economists are so strongly influenced by both current fashions in opinion and current problems of economic policy as the field of monetary policy. In the period immediately after the war, economists writing on monetary policy were generally agreed that monetary expansion was of little use in combating depression. Scepticism about the effectiveness of monetary restraint in combating inflation was less marked, though some took the extreme view that monetary restraint would either prove ineffective or precipitate a collapse. But it was generally thought that the wartime legacy of a large and widely-held public debt was a major obstacle to the application of monetary restraint, both because it was feared that abandonment of the bond-support programme adopted to assist war financing would destroy public confidence in government debt, and because the transfer from the government to the private banking system that would result from an increase in the interest payable on the latter’s large holdings of public debt was regarded as undesirable. Economists therefore divided into those who advocated schemes for insulating bank-held government debt from general interest-rate movements, as a means of clearing the way for monetary restraint, and those who argued for an extension of selective credit controls.
The inflation that accompanied the Korean War forced the termination of the bond-support programme, and thereafter monetary policy became the chief instrument for controlling short-run fluctuations. The nonmaterialization of the disastrous consequences that some had predicted would follow the termination of the bond-support programme, together with the development of the availability doctrine (which enlisted liquidity preference on the side of monetary policy and made a widely-held public debt a help rather than a hindrance) strengthened confidence in the power of monetary restraint to control inflation, though the availability doctrine also provided ammunition to advocates of selective controls by depicting monetary policy as achieving its results through irrational and discriminatory mechanisms. Subsequent experience, together with empirical and theoretical research, has fairly conclusively disposed of the availability doctrine’s most appealing feature—the proposition that the central bank can produce large reductions in private spending by means of small increases in interest rates—and research has tended to refute the contention that monetary policy operates discriminatorily. Nevertheless, the availability doctrine has left its mark on the field, inasmuch as the majority of monetary economists would probably explain how monetary policy influences the economy by reference to its effects on the availability and cost of credit, with the stress on availability. Trust in the power of monetary restraint to control inflation has been further reduced by the coexistence of rising prices and higher average unemployment in the late 1950’s, and the associated revival and elaboration of cost-push theories of inflation. On the other hand, experience of monetary policy in three mild business cycles has revived confidence in the efficacy of monetary expansion in combating recessions and dispelled the belief that monetary restraint in a boom will do either nothing or far too much. In fact, the wheel has come full circle, and prevailing opinion has returned to the characteristic 1920’s view that monetary policy is probably more effective in checking deflation than in checking inflation.1
Changing fashions in prevailing opinion apart, the revival of monetary policy as a major branch of economic policy has stimulated much controversy, thought, and research on all aspects of monetary policy. In addition, the legacy of war debt and the increased size and frequency of government debt debt operations that it has entailed, together with the difficulties created for the Treasury by ‘bills only’ and other Federal Reserve and governmental policies, has brought the whole subject of debt management within the purview of monetary economists as a special form of open-market operations. It is neither possible nor worth while to attempt to survey all the issues discussed in this voluminous literature: the Report of the Commission on Money and Credit [128] contains a consensus of informed professional opinion on most of them, the usefulness of which is much reduced by the absence of documentation of empirical statements and precise references to conflicting points of view; Friedman’s A Program for Monetary Stability [34] discusses many of the issues within a consistent theoretical framework; and a 1960 Review of Economics and Statistics symposium [57] assembles the views of a variety of monetary specialists. The remainder of this part will instead concentrate on what seem to be the significant developments in three areas: the objectives of economic policy and the instrumental role of monetary policy; the means by which monetary policy influences the economy and their effectiveness; and the adequacy of the tools of monetary policy.
A. The Objectives and Instrumental Role of Monetary Policy
In pre-Keynesian days, monetary policy was the single established instrument of aggregative economic policy, and price stability was its established objective. The Keynesian revolution introduced an alternative instrument, fiscal policy, and a second objective, maintenance of full employment (now more commonly described as economic stability), which might conflict with the objective of price stability. Since the war, debt management has been added almost universally to the list of instruments; and since the middle 1950’s many economists have added a third item—adequately rapid economic growth—to the list of objectives. In recent years the balance of-payments problem has been forcing the admission of a fourth objective—international balance—and may eventually establish a fourth instrument—foreign economic policy.
Recognition of several objectives of economic policy introduces the possibility of a conflict of objectives requiring resolution by a compromise. This possibility and its implications have been more clearly recognized elsewhere (for example by the Radcliffe Committee [127, pp. 17–18]) than in the United States, where there has been a tendency to evade the issue by denying the possibility of conflict1 or by insisting that conflicts be eliminated by some other means than sacrifice of the achievement of any of the objectives.2 Where a conflict of objectives has been clearly recognized—notably in the criticisms directed at the anti-inflationary emphasis of Federal Reserve policy in 1957–60—the arguments about alternative compromises have been qualitative and nonrigorous; rigorous theoretical exploration and quantitative assessment of the costs and benefits of alternative compromises between conflicting policy objectives remain to be undertaken.
The availability of alternative policy instruments introduces the question of their absolute and comparative effectiveness; research on this range of problems has been undertaken by a number of economists, but has not progressed far towards an accepted body of knowledge. As already mentioned, monetary policy since 1951 has resumed a large part of the responsibility for short-run economic stabilization—a consequence of both the inadaptability of the budgetary process to the requirements of a flexible fiscal policy and the domination of the budget by other objectives of national policy than stabilization. Reliance on monetary policy for this purpose has raised the question of how effectively the task is likely to be performed. The argument for using monetary policy is usually expressed in terms of the ‘flexibility’ of monetary policy, by which is often meant no more than that monetary policy can be changed quickly. But the real issues are whether the monetary authorities are likely to take appropriate action at the right time, and whether the effects of monetary action on the economy occur soon enough and reliably enough to have a significant stabilizing effect.
As to the first question, there is general agreement that the Federal Reserve has committed errors in the timing, extent and duration of policy changes. Most economists seem inclined to trust the System to improve its performance with experience and the benefit of their criticism. Some, however, are so distrust-of discretionary authority in principle, or so sceptical of the feasibility of effective stabilization by monetary means, as to advocate that the Federal Reserve should not attempt short-run stabilization, but should confine itself (or be confined) to expanding the money supply at a steady rate appropriate to the growth of the economy (for variants of this proposal, see Friedman [34, pp. 84–99], Angell [57, pp. 247–52], and Shaw [106]). The proposal to substitute a monetary rule for the discretion of the monetary authority is not of course new—Henry Simons’ classic statement of the case for it [108] appeared in the 1930’s—but the definition of the rule in terms of the rate of monetary expansion rather than stability of a price index reflects both the modern concern with growth and a more sophisticated understanding of the stabilization problem.
Whether such a rule would have produced better results than the policy actually followed in the past is a difficult matter to test. Friedman [34, pp. 95–8] discusses the difficulties and describes some abortive tests that tend to favour his (4 per cent annual increase) rule. Martin Bronfenbrenner has devised a more elaborate series of tests of alternative rules, including discretionary policy; his results for annual data 1901–1958 (excluding the Second World War) [11] show that a 3 per cent annual increase rule comes closest to the ‘ideal pattern’ defined by price stability, though his subsequent tests on quarterly data from 1947 on [12] suggest the superiority of a ‘lag rule’ relating changes in the money supply to prior changes in the labour force, productivity and velocity. These tests are subject to statistical and theoretical objections, but they open up an interesting new line of research. In the absence of a definitely specified standard of comparison, discussions of the appropriateness of the central bank’s monetary policy tend to fall back on textual criticism of its explanation of its actions or the exercise of personal judgment about what policy should have been (see, for example, the contributions of Weintraub, Samuelson, and Fellner to [57]).
The question of the extent of the stabilizing effect that monetary action may be expected to achieve was first raised, at the formal theoretical level, by Friedman [39], who argued that policies intended to stabilize the economy might well have destabilizing effects because of the lags involved in their operation. Subsequent work and discussion on this aspect of monetary policy has concentrated on the length and variability of the lag in the effect of monetary policy, and has become enmeshed in intricate arguments about the proper way of measuring the lag. Two alternative approaches to the measurement of the lag have been employed, direct estimate and statistical inference. The outstanding example of the first is Thomas Mayer’s study of the inflexibility of monetary policy [79]. Mayer estimates the lag in the reaction of investment expenditure and consumer credit outstanding to monetary policy changes, sector by sector, and, taking into account lags in monetary-policy changes and the multiplier process, concludes that monetary policy operates on the economy much too slowly for its effects to be quickly reversed; from a computation of the effect that an optimally-timed monetary policy would have had on the stability of industrial production over six business cycles, he concludes that monetary policy is too inflexible to reduce the fluctuation of industrial production by more than 5 to 10 per cent on the average [79, p. 374]. W. H. White [125] has since argued that Mayer seriously overestimates the average lag, and that the correct estimate would provide almost ideal conditions for effective anticyclical policy; White also remarks that Mayer’s results do not show the destabilizing effects indicated as possible by Friedman’s analysis.
Statistical inference is the basis of Friedman’s contention that monetary policy operates with a long and variable lag, a contention which figures largely in his opposition to discretionary monetary policy. Friedman’s preliminary references to his results, which are yet to be published in full [42], made it appear that this contention rested mostly on a comparison of turning points in the rate of change of the money stock with turning points in National Bureau reference cycles (that is, in the level of activity); this comparison automatically yields a lag a quarter of a cycle longer than does a comparison of turning points in the level of the money stock with reference-cycle turning points, the comparison that Friedman’s critics regard as the proper one to make. In reply to criticisms by J. M. Culbertson [26], Friedman has produced a lengthy defence of his measure of the lag, together with other supporting evidence [40]. This defence indicates that the measurement of the lag raises much more subtle and fundamental theoretical and methodological issues than appear at first sight; but the majority of monetary economists competent to judge is likely to agree with Culbertson [28] in finding Friedman’s arguments unpersuasive.
Statistical inference is also employed in the study of lags in fiscal and monetary policy conducted for the Commission on Money and Credit by Brown, Solow, Ando and Kareken [14]. These authors claim that Friedman’s comparison of turning points in the rate of change of the money stock with turning points in the level of activity involves a methodological non sequitur, and find from a comparison of turning points in the rates of change of money with the rate of change of aggregate output that the money stock and aggregate output move roughly simultaneously over the cycle. Their own work attempts to estimate the lag between the indication of a need for a change in monetary policy and the effect of the resulting change in policy on output, and finds that a substantial stabilizing effect is achieved within six to nine months. They also find that fiscal policy operating on disposable income is a more powerful stabilizer, achieving as much as half of its effect within six months.
This research on the lag in effect of monetary policy has been orientated towards determining the efficacy of monetary policy as a stabilizer, on the assumption that monetary policy is decided with reference to contemporaneous economic conditions. Little if any research has been devoted to the more ambitious task of designing optimal systems of changing monetary policy in a response to movements of relevant economic indicators. A. W. Phillips [95] and more recently W. J. Baumol [8] have shown that what seem like sensible procedures for changing a policy variable in response to changing conditions may well aggravate instability; Phillips has applied the theory and concepts of control systems to the analysis of the effects of alternative operating rules of stabilization policy.
B. The Effectiveness of Monetary Policy
To turn from the instrumental role of monetary policy to the related but broader questions of how monetary action influences the economy, and how effectively, the prevailing tendency has been to approach these questions by analysing how monetary policy, and particularly open-market operations, affect the spending decisions of particular sectors of the economy. This formulation of the problem is a natural corollary of Keynesian theory, and the evolution of the analysis since the war has closely reflected the evolution of monetary theory, though with a perceptible lag; but the analysis has also been strongly influenced by the availability doctrine. That doctrine, the formulation of which was largely the work of Robert Roosa [99], emerged in the later years of the bond-support programme as a solution to the conflict between the belief that a large widely-held public debt obliged the central bank to confine interest-rate movements to narrow limits and the belief that large interest-rate changes were necessary to obtain significant effects on spending.
The doctrine comprised two central propositions. The first was that widespread holding of public debt, particularly by financial institutions and corporations, facilitates monetary control by transmitting the influence of interest-rate changes effected by open-market operations throughout the economy. The second was that small interest-rate changes could, by generating or dispelling uncertainty about future rates and by inflicting or eliminating capital losses that institutions were unwilling to realize by actual sales (‘the pinning-in effect’), achieve significant effects on spending even if the demands of spenders for credit were interest-inelastic—these effects being achieved by influencing the willingness of lenders to lend or, put another way, by influencing the availability of credit to borrowers by altering the terms of credit and the degree of credit rationing. The second proposition has turned out on subsequent investigation to depend on incorrect empirical assumptions about institutional behaviour, particularly with respect to ‘the pinning-in effect’ (see Warren Smith [112]) and on a doubtful asymmetry between the reactions of lender and borrower expectations to interest-rate changes (see Dennis Robertson [97]), as well as to involve some logical inconsistencies (see John Kareken [64], and for a theoretical defence of the availability doctrine, Ira Scott [103]). Nevertheless, the doctrine and discussion of it have helped to popularize the concept of ‘availability of credit’ as one of the main variables on which monetary policy operates.
‘Availability’ actually comprises a number of disparate elements—the liquidity of potential lenders’ and spenders’ assets, the terms on which lenders will extend or borrowers can obtain credit, and the degree to which credit is rationed among eligible borrowers (see Kareken [64]). Emphasis on these factors as influences on spending has provided new arguments for those who favour selective credit controls—specific arguments for controls where the terms of credit rather than the cost of credit seem the effective determinant of spending decisions, as in the case of instalment credit, and a general defensive argument based on the discriminatory character of credit rationing. The most powerful attack on the discriminatory character of allegedly general methods of economic control has come from J. K. Galbraith [45], who has maintained that the use of monetary and fiscal policy has favoured the monopolistic at the expense of the competitive sectors of the economy to an extent comparable to repeal of the antitrust laws. Others have maintained that monetary restraint discriminates against small business. Empirical studies by Bach and Huizenga [6] and Allen Meltzer [82] show that this is not true of bank credit; Meltzer’s study finds that while small firms have greater difficulty in obtaining nonbank credit in tight periods than large firms, this discrimination tends to be offset by extension of trade credit from large firms to small.
The emphasis on the availability of credit as a determinant of expenditure has led to a critical re-examination of the business-attitude survey findings that formerly were used as evidence that business investment is insensitive to monetary policy. In addition, monetary theorists have tended to raise their estimates of the sensitivity of business investment to changes in the cost of credit. These reassessments have been based on the opinion that investors’ expected profits are more finely and rationally calculated than used to be thought, rather than on any impressive new empirical evidence of such sensitivity. The most definite new empirical evidence there is confirms the long-time theoretically established sensitivity of residential construction to interest-rate changes, and even this sensitivity has been attributed in part to the influence of ceiling rates on federally-guaranteed mortgages on the willingness of institutional lenders to lend on such mortgages [128, p. 51]. The failure of empirical research to disclose such sensitivity may, as Brunner has suggested [18, p. 613], be the consequence of too simple a theoretical approach, the attempt to relate a flow of expenditure on assets to the cost of credit without adequate recognition of the range of alternative assets or the complexities of stock-adjustment processes. The new approach to monetary dynamics described in the previous part suggests that a more sophisticated theory of real investment is necessary for successful empirical work; on the other hand, some of the empirical work described in Part II suggests that better results might be achieved by working with changes in the quantity of money than by attempting to determine the influence of changes in interest rates on particular categories of spending.
The discussion of the effectiveness of monetary policy just described has been concerned with monetary policy operating in a given institutional environment. Since the middle 1950’s a new debate has been opened up, concerned with the fact that traditional methods of monetary control are primarily directed at commercial bank credit, and the possibility that institutional change stimulated by monetary restriction may reduce the effectiveness of traditional techniques of monetary control. The main debate has been concerned with Gurley and Shaw’s contention [50, pp. 537–8] that the growth of financial intermediaries, prompted in part by the competitive handicaps imposed on commercial banks for purposes of monetary control, progressively provides close substitutes for money the presence of which weakens the grip of monetary policy on the economy; and with their suggestion that the controlling powers of the central bank should be extended beyond the commercial banks to other financial institutions.1 The debate has ranged over a wide territory, including such matters as whether existing controls over commercial banks are really discriminatory, given that banks enjoy the privilege of creating money (Aschheim [3] and Shelby [107]) and whether imposition of credit controls on financial intermediaries would in fact improve the effectiveness of monetary policy or the competitive position of the banks (David Alhadeff [1]). From the point of view of monetary policy, the central issue is not whether financial development leads to a secular decline in the demand for money—by itself, this would increase the leverage of monetary policy (Shelby [107]) and could readily be assimilated by the monetary authorities ([128, pp. 80–1] and Axilrod [5])—but whether the liabilities of financial intermediaries are such close substitutes for money that monetary restriction is substantially offset through substitution for bank deposits of other financial claims backed by only a small fractional reserve of money—in short, whether financial intermediaries substantially increase the interest-elasticity of demand for money. This is an empirical question; and the empirical evidence so far is that shifts by the public from money into thrift assets in periods of monetary restraint have not had a significant influence on velocity ([128, pp. 78–80]; see also Smith [110]).
C. The Adequacy of the Tools of Monetary Policy
The revival of monetary policy as an instrument of short-run stabilization has provoked a great deal of discussion not only of the use and effectiveness of monetary policy, but also of the use and efficiency of the Federal Reserve’s traditional instruments of monetary control—open-market operations, rediscount rates, and reserve requirements. Controversy about open-market operations has centered on the ‘bills only’ policy—the policy of conducting open-market operations in Treasury bills only, adopted by the Federal Reserve in 1953, modified later to ‘bills usually’, and abandoned in 1961. Both the availability doctrine and the assets approach to the theory of interest rates imply that the central bank can obtain differential effects on credit conditions according to the maturity of government debt in which it chooses to conduct open-market operations, and can alter the structure of interest rates by switching between short and long maturities. The bills-only policy therefore appeared to most academic economists as an undesirable renunciation by the central bank of an important technique of monetary control, and the reason given for it—the desire to improve the ‘depth, breadth and resiliency’ of the government bond market by eliminating arbitrary central bank intervention in it—as a shallow excuse masking the unwillingness of the Federal Reserve to risk unpopularity with the financial community by overtly subjecting it to capital losses. The surrender of power entailed in bills-only was probably greatly exaggerated by many of its opponents: Winfield Riefler [96] has pointed out that the central bank’s choice of securities only contributes about one-eighth of the total effect of its open-market operations, the remaining seven-eighths being determined by the asset choices of the banks whose reserves are altered by the operations; and has produced some evidence that substantial changes in the maturity composition of the public debt have had little effect on the rate structure. On the other side of the argument, Dudley Luckett [76] has shown that the empirical evidence fails to indicate any improvement in ‘depth, breadth and resilience’ since bills-only was adopted.
While much of the discussion of bills-only has been concerned exclusively with Federal Reserve policy, the fundamental issue involved was the division of responsibility for the maturity composition of government debt held by the public between the Federal Reserve and the Treasury. Bills-only assigned this responsibility, and the associated responsibility for smoothing the impact of debt-management operations on the market, to the Treasury. One school of thought, represented for example by A. G. Hart [57, pp. 257–8], has maintained strongly that this is an inappropriate division of responsibility, since the Federal Reserve has both the powers and the continual contact with the market required for the purpose and the Treasury has not. (The limited ability of the Treasury to conduct open-market operations has been demonstrated by Deane Carson’s study [21] of debt management after the adoption of bills-only.) Others have seen the source of the trouble in the Treasury’s debt management practices, particularly the practice of issuing debt in large blocks at irregular intervals, at fixed prices and with maturities ‘tailored’ to market requirements. Carson [21] and Friedman [34, Ch. 3] have proposed similar schemes for replacing present practice by a system of auctioning long-term government debt issues; Culbertson [25] and Friedman [34, Ch. 3] have propounded plans for regularizing the timing and composition of debt issues to reduce the market disturbance of government financing. The difficulties the Treasury has experienced with debt management in the postwar period, in consequence not only of bills-only but of other developments adverse to easy Treasury financing,1 have led many economists to become sceptical of the practicability of a countercyclical debt-management programme. Such a programme, which would involve issuing long-term debt in booms and short-term debt in depressions, would in any case have a countercyclical influence only in so far as the interest-rate structure is sensitive to change in the composition of the debt, and this sensitivity seems to be too small to yield important stabilizing effects (see Riefler [96] and Meiselman [81]).
Though the growth of the public debt has definitely established open-market operations as the chief instrument of day-to-day monetary control, the revival of monetary policy has been accompanied by a revival of rediscounting and the use of rediscount rates as a control instrument. Controversy over rediscount policy has mainly been concerned with whether rediscount policy is a useful auxiliary instrument of control or whether the possibility of rediscounting creates an unnecessary and troublesome loophole in the control over member banks afforded by reserve requirements and open-market operations. It can be argued (see Friedman [34, pp. 34–5]) that rediscount rates are a treacherous control instrument, since their restrictiveness depends on their relationship with shifting market rates of interest, and that the growth of bank holdings of public debt and the postwar development of the federal funds market make it unnecessary for the Federal Reserve to continue to perform the function of lender of last resort for its members.1 There has also been some argument about whether control of the rediscounting privilege gives the Federal Reserve undesirable arbitrary authority over member banks.
Apart from the debate concerning the desirability of rediscounting, a number of writers have criticized the asymmetry of the present reserve-requirement and rediscount-rate system, under which member banks receive no interest on reserves or excess reserves but pay a penalty rate on reserves borrowed to meet deficiencies, and have proposed payment of interest on reserves or excess reserves. Tobin, for example [57, pp. 276–9], has recommended payment of interest at the discount rate on excess reserves, and coupled this with the recommendation to terminate the prohibition of demand-deposit interest and the ceilings on time- and savings-deposit interest, arguing that the justification for intervention in the fixing of deposit rates—to protect depositors by preventing excess competition among banks—has been removed by federal deposit insurance.2
The power to change reserve requirements gives the central bank a method of changing the quantity of bank deposits alternative to open-market operations. The chief differences between the two methods3 are, first, that reserve-requirement changes, being discontinuous, are apt to have disturbing effects on securities markets requiring auxiliary open-market operations; and second, that credit expansion by open-market purchases is less costly for the government and less profitable for the banks than credit expansion by reduction of reserve requirements (and vice versa). The discontinuity and disturbing effects of reserve-requirement changes, dramatically exemplified by their misuse in 1936–7 (see Brunner [15]), have led most economists to believe that they should be used sparingly if at all, especially in restraining credit expansion. The differential effects of the two methods of control on governmental interest costs and bank profits have been the focus of controversy over the policy of lowering reserve requirements followed by the Federal Reserve since 1951. In the course of time the balance of the argument has tilted in favour of reduction of reserve requirements, as the postwar sentiment against high bank profits derived from interest on the public debt has given way to the more recent fear that banks are unduly handicapped by reserve requirements and interest ceilings on deposits in competing with other financial intermediaries.
The controversy has raised the more general issue of how the secular growth of the money supply should be provided for. George Tolley, who first raised this issue [118], has shown that the choice between open-market operations and reserve-requirement variation involves some intricate theoretical issues, since in addition to its implications for debt management and the ease of government financing this choice influences the efficiency of allocation of resources to the provision of the supply of deposit money.
Some attention has also been given to the efficiency of the present system of reserve requirements as an instrument of monetary control. Frank Norton and Neil Jacoby [88] have revived the 1930’s Federal Reserve proposal to relate required reserve ratios to deposit turnover rates as a means of introducing an automatic offset to changes in the velocity of circulation. The preponderance of professional opinion, however, seems opposed to any system of reserve requirements that discriminates between banks or affects their profits differentially, and in favour of the removal of inequities among banks by the standardization of reserve requirements.
The main impression that emerges from this survey of monetary theory and policy is not only that the field has been extremely active, especially in the past few years, but that it has been on the move towards interesting and important new developments. To summarize what is already a summary is a difficult task, and prediction of the direction of future scientific progress is a risky business; but in the literature surveyed in the preceding sections, two broad trends are evident. One is the trend towards the formulation of monetary theory as a part of capital theory, described in Part II (and implicitly in Part I). As mentioned in Part III, this trend has only just begun to manifest itself in the formulation of monetary dynamics. More important, almost nothing has yet been done to break monetary theory loose from the mould of short-run equilibrium analysis, conducted in abstraction from the process of growth and accumulation, and to integrate it with the rapidly developing theoretical literature on economic growth (important exceptions are the models of Tobin [113] and Enthoven [52, App.]). The other trend is that toward econometric testing and measurement of monetary relationships. As is evident from Part IV, econometric methods have barely begun to be applied to the study of relationships relevant to the management of monetary policy.
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81. D. MEISELMAN, The Term Structure of Interest Rates. Englewood Cliffs, N.J., forthcoming.
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83. L. A. METZLER, ‘Wealth, Saving and the Rate of Interest’, Jour. Pol. Econ., April 1951, 59, 93–116.
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85. H. P. MINSKY, ‘Central Banking and Money Market Changes’, Quart. Jour. Econ., May 1957, 71, 171–87.
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90. D. PATINKIN, ‘Dichotomies of the Pricing Process in Economic Theory’, Economica, May 1954, 21, 113–28.
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* Reprinted from The American Economic Review, Vol. LII, no. 3, June 1962, pp. 335–84; one of a series of survey articles sponsored by the Rockefeller Foundation.
1 For a list of Congressional documents bearing on monetary policy, see Friedman [34, pp. 103–40]; to Friedman’s list should be added the Staff Report on Employment, Growth and Price Levels [129] and the accompanying Staff Studies.
1 For example, inferiority of real balances implies that if an individual’s initial stock of real balances is reduced, his initial commodity endowment being unchanged, he will reduce his planned consumption in the current week sufficiently to increase his planned real balances. By shortening the week and reducing the individual’s weekly endowment of commodities proportionately, a procedure which leaves the rate of flow of the individual’s income unchanged, it can be made impossible for the individual to cut his commodity consumption sufficiently to increase his planned balances. ‘Inferiority’ of real balances is therefore not invariant with respect to the time-unit of the analysis. Further, inferiority of real balances would imply that any disturbance to an individual’s initial equilibrium would be followed by a ‘cobweb’ adjustment of his real balances and consumption in succeeding weeks, a pattern difficult to rationalize. I am indebted to the oral tradition of the University of Chicago Money and Banking Workshop for these points.
1 Goods are produced as well as exchanged; net saving and investment occur but their effects on wealth and productive capacity are abstracted from; for analysis the economy is aggregated into four markets, those for labour services, commodities, bonds, and money. Patinkin uses the dynamic development of this model to investigate Keynes’ theory of involuntary unemployment, a subject not considered here; his analytical methods have been adopted by several subsequent writers.
1 Absence of money illusion means that behaviour depends on the real and not the money values of income, balances, and bonds; absence of distribution effects, that behaviour is unaffected by redistributions of total real income, balances, and bonds among individuals, such as result from price-level changes; homogeneity of bonds, that behaviour is affected only by the net creditor position of the private sector, not by the totals and composition of its assets and liabilities; absence of government debt or open market operations, that the net creditor position of the private sector consists in its holding of fìat money, or that, if government debt fixed in real terms is introduced (the Metzler case discussed below), its quantity does not alter when the quantity of money changes. The assumption of absence of distribution effects might seem unnecessary, on the Archibald–Lipsey argument, but that argument does not apply to this model, which by construction cannot be in full stationary equilibrium: see Ball and Bodkin’s criticism of Archibald and Lipsey, which the latter accept [7, pp. 44–9].
2 The Pigou effect in modern usage is the effect on the demand for goods of a change in private real wealth resulting from the effect of a change in the price level on the real value of net private financial assets, the latter consisting of net government debt outstanding (including fìat money) and the part of the money supply backed by gold; it is the real balance effect corrected for the presence of government debt and money issued against private debt.
1 Their insistence on the determinacy of the price level, in contrast to what they take to be the implication of Patinkin’s approach (which they term ‘net money doctrine’) [52, p. 76], rests on an understandable misunderstanding. Patinkin’s analysis of price-level stability throws the emphasis on the wealth effect of a change in real balances resulting from a price-level change, an effect which only exists when money is a net asset; but it also provides for a substitution effect. Gurley and Shaw’s demonstration that the substitution effect is sufficient to determine the price level therefore does not conflict with Patinkin’s analysis (for Patinkin’s views, see [91, pp. 100–9], though it does show that Patinkin’s emphasis on the wealth effect is misplaced and misleading. The broader implications of this point are discussed below.
1 In an elegant recent article [86] R. A. Mundell, has extended Metzler’s analysis by considering explicitly the tax remissions resulting from open-market purchases of government debt. He assumes that corporate taxes are capitalized in the price of equities but that personal income taxes are not capitalized (there being no market for human capital); he allows for the effect of corporate taxation on the incentive to invest; and he demonstrates that Metzler’s conclusion is valid if income taxes are remitted, but reversed if corporate taxes are remitted. The nonmarketability of human capital seems an inadequate reason for assuming that people do not feel richer when income taxes are reduced; consideration of the incentive effects of tax changes introduces an interesting new aspect of the neutrality problem but one that lies at a somewhat lower level of abstraction.
1 These terms are intended to distinguish the two main (and historically long-established) schools of thought in monetary theory, one of which formulates its analysis in terms of the quantity of money and its velocity of circulation and the other in terms of the determinants of money expenditure, without ensnaring the exposition in the rights and wrongs of Keynes’ protracted quarrel with what he understood by ‘the quantity theory’. As this section explains, neither the quantity theory nor the Keynesian theory is now what it was in the 1930’s; in particular, the modern quantity theorist is committed to neither full employment nor the constancy of velocity, and his theory is a theory of the relation between the stock of money and the level of money income, that is, a theory of velocity and not of prices and employment.
1 Ralph Turvey [121, p. 33], following Richard Selden [104, pp. 209–10], argues that the interest-elasticity conclusion does not extend to aggregate behaviour because a change in the interest rate will have the opposite effect on the demand for cash of a unit facing a maturing debt and having the alternatives of holding cash in the interim or spending it and borrowing later. This argument involves an elementary confusion between saving behaviour and asset management: savings effects of interest rate changes aside, the unit in question would have the same alternative of investing its idle cash at interest, and react the same way. Turvey also argues [121, pp. 28–30] that an increase in the level of a unit’s transactions will raise transactions demand only in a probability sense, since there may be an offsetting change in the timing-structures of the unit’s payments and receipts.
1 This phrase has reference to the pattern of rates on loans of successively longer maturity; statistically it is represented by the ‘yield curve’, which charts the yields on government debts against their maturities. In the English literature the problem appears as that of the relation between the long and the short rate of interest (the bill rate and the bond rate), a reflection of the institutional fact that the British government obtains its short-term financing predominantly by three-months bills of exchange, and has a substantial volume of perpetual debt (‘consols’) outstanding.
2 The sensitivity of the rate pattern to changes in the relative quantities of short-term and long-term debt is the crucial empirical issue in some recent controversies about monetary policy, especially the ‘bills only’ policy.
3 Shackle’s survey of interest theory [105], to which the reader has been referred in the introduction, unfortunately makes very little reference to rate-structure theory, presumably because it has not been discussed recently in English journals. The interested reader is referred to Conard’s useful book [24].
1 These brief remarks do justice neither to Friedman nor to other consumption theorists, a number of whom have been working towards similar theories (see Johnson [61]).
1 To keep the bibliography within reasonable bounds, the references below are confined as far as possible to authors who have supported their theories with empirical research, or to recent writings.
1 The phrase is Milton Friedman’s.
1 Gurley and Shaw believe that present methods of credit control discriminate against banks in their competition with nonbank intermediaries, weakening the effectiveness of monetary policy over the long run, and unlike most of their critics are prepared to contemplate extensions of the central bank’s regulatory powers.
2 Patinkin’s review [91] of the book translates Gurley and Shaw’s argument into his own language and interprets the effect of financial intermediation as an increase in the liquidity of bonds which decreases the demand for money and increases its interest-elasticity. Alvin Marty’s review [78] makes the interesting theoretical point that the introduction of a substitute does not necessarily increase the elasticity of demand. Neither reviewer notices that Gurley and Shaw infer increased elasticity only in the special case of an unfunding of government debt, and present a satisfactory reason for it [52, pp. 162–6].
1 For discussion of the earlier literature, see Villard [123] and Selden [104]; a useful survey of the econometric studies preceding their own work is given by Bronfenbrenner and Mayer [13]. The more traditional type of research on transactions velocity has been continued by a number of contemporary economists, notably George Garvey [46].
1 An interesting exception is Harold Lydall’s derivation of the demand for money from the hypothesis of a constant ratio of liquidity to wealth [77].
1 In [74] Latané uses a linear relationship between income velocity and the rate of interest, V = 0.77r + 0.38, where V = Y/M, the quantity of money divided into income. This yields the demand function for money, M = Y/(0.77r + 0.38). Using the definition W = Y/r, this can be written equivalently as
1 Gurley and Shaw also state as a prerequisite of monetary control that the authorities take steps to ensure the moneyness of bank deposits; the necessity for this is debatable.
2 Patinkin goes on to argue that price-level determinacy requires fixity of one nominal quantity and one yield, and would be secured by fixity of the nominal quantity of (non-interest-bearing) outside money; and that therefore Gurley and Shaw should have considered the means by which the central bank changes the price level, instead of the powers required to determine it. This argument raises the question discussed earlier, of the usefulness of founding monetary theory on the real-balance effect.
1 An excess demand for money does not necessarily imply an excess supply of securities, since it may be accompanied by an excess supply of goods.
1 Patinkin recognized these difficulties in the discussion of dynamic stability in his book [93, pp. 157–8], and admitted that they made stability a matter of assumption rather than of proof; but he overlooked them in applying his dynamic apparatus to the liquidity-preference loanable-funds controversy.
1 In describing a mathematical model of this theory, Brunner admits two possible situations of partial equilibrium—stock equilibrium and flow disequilibrium and the converse—but nevertheless asserts that the stock relation determines momentary price in both. This inconsistency, which was presumably prompted by his intention to contrast the adjustment processes of markets dominated respectively by stocks and flows, is the source of the dilemma Shackle finds between stock and flow equilibrium as the determinant of price [105, p. 222].
2 Cliff Lloyd [75] has argued that the presence of two equilibrium equations for a stock-flow commodity may invalidate the Hicksian proof of the equivalence of the loanable-funds and liquidity-preference theories. It may be noted that the Clower–Bushaw theory provides a formal solution to the apparent dilemma created by Brunner’s alternative partial equilibria.
3 In one passage [105, p. 223] Shackle outlines a solution to his dilemma along these lines, but does not pursue it further. The Brunner–Clower theory can (with some difficulty) be interpreted as a special case of the general theory, one in which the price at which a stock is held is independent of the current rate of change in the stock.
4 This observation refers to the literature on the Keynesian general equilibrium system, and not to the specialist work on consumption and investment, where the treatment of saving and investment as processes of adding to stock has become well established since the war.
1 While this approach can be described as new in relation to the time-period included in this survey, it can from another point of view be regarded as a development of certain strands in Keynes’ thought [65, Vol. I, pp. 200–9] [66, Ch. 11].
1 This account refers, of course, to developments in the United States (compare Paul Samuelson [57, pp. 263–9]). A parallel evolution of opinion has occurred in other countries, though in Britain prevailing opinion, as reflected notably in the Radcliffe Report [127, Ch. 6], has remained sceptical of the efficacy and usefulness of monetary policy; this difference in prevailing opinion is partly responsible for the generally critical reception of the Report by U.S. commentators. Limitations of space make it necessary to confine this section to developments in the United States.
1 This can always be done by giving priority to one objective and defining the others in terms that implicitly impose consistency with the favoured objective; an example is the concept of ‘sustainable economic growth’ promulgated by the Federal Reserve System.
2 One example of this type of evasion is the affirmation that balance-of-payments difficulties should not be allowed to hinder the achievement of domestic policy, an affirmation rarely accompanied by specification of any obviously efficacious solution to these difficulties. Another is the expression of trust that policies designed to increase the competitiveness and efficiency of the economy will eliminate the possibility of conflict between high employment, price stability, and adequate growth. Both are contained in the Report of the Commission on Money and Credit [128, p. 227, p. 45].
1 A related but different argument has been advanced by Hyman Minsky [85], to the effect that monetary restriction stimulates financial innovations that progressively reduce the demand for money, increase the velocity of circulation, and threaten to make the money market unstable; Minsky recommends extension of the lender-of-last-resort function to the whole market and not merely the commercial banks. Arguments similar to those of Gurley and Shaw and Minsky may be found in Smith [112].
1 For a comprehensive survey of these developments see Erwin Miller [84].
1 The controversy has aroused some interest in the Canadian innovation of setting the discount rate at a fixed margin above the weekly average tender rate on Treasury bills. In England, where the rediscount rate is the chief instrument of monetary policy, recognition of the loophole in monetary control afforded by rediscounting has led to the promulgation of the theory that the liquidity ratio of the commercial banks and the supply of bills, rather than the cash ratio and the quantity of central bank deposits, determine the amount of commercial bank deposits.
2 The fact that this justification was fallacious to begin with has not prevented the Commission on Money and Credit from endorsing the continuation of control of these rates [128, pp. 167–8].