The circular flow of income

On the assumption of a constant ratio of income to money, the income process may be pictured as a circular flow in which the stock of money and the flow of income are uniquely related by proportionality, in much the same way as the quantity of water in a closed set of circuits would be related to the recordings on a flow meter set anywhere in these circuits.

The circular character of the income stream implies that the stream feeds on itself. There are qualifications to this, but they do not destroy the main proposition, viz., that income in one period is the main determinant of income in the next period. The process from income in period 1 to income in period 2 may run through different channels. Most income will accrue to consumer households, be spent on consumption goods, and reappear as new income in the form of payments to the factors of production in the consumption goods industry. Other income may find its way to reincarnation through taxes and government purchases of goods and services. A third section of income may run through the capital market, or through savings banks; or it may not change owners at all, as when business profits are ploughed back into self-financed investment.

Rather than concentrating on the circular character of the income flow, the multiplier analysis has put its main emphasis on the lapses from circularity, in particular for new additions to the stream. It has stressed that, on its way around, some income may get lost, never to show its face again as new income. Some savings by consumers may never be invested by anyone else. Some of the tax money paid to the government may be saved by it forever—e.g., in the form of repayment of the public debt—or at least for a long time. Corporations may with hold profits from shareholders without having any short-run plans to use the money for expansion of capacity. The various propensities in the multiplier analysis are designed to account for these “leakages” from the main stream. Since the multiplier analysis is typically nonmonetary (or perhaps we should say a-monetary) in character, it is of no consequence to it whether any shrinkage recorded in the income flow is due to a reduction in the velocity of circulation of a given quantity of money or to a reduction in the quantity of money at unchanged velocity.

By focusing on the monetary side of the same circular process, we can approach the problem from another angle, which makes it more tractable in many situations. The assumption of a constant ratio of income to money obviously implies that the income stream cannot change except as the quantity of money changes. If, therefore, we can explain changes in the quantity of money, we would have a satisfactory explanation of income by means of a monetary analysis.

In contemporary economic analysis, as distinguished from economic theory, there is no lack of “explanations” of changes in the quantity of money. “Money” is an entry, or a combination of entries, on the liability side of the balance sheets of the banking system. Since balance sheets are constructed on the principle that the sum of all assets equals the sum of all liabilities, it is always possible to “explain” the changes in one balance sheet item by adding together (with appropriate signs) the changes in all other balance sheet items. Since the item called “money” represents in many countries a very large proportion of all liabilities of the banking system, one can usually come close to an “explanation” of the changes in money by adding the changes in the asset items in the balance sheet.

In the studies of the “origin of the money supply” that are prevalent in Latin America,¹⁰ this process of “explanation” is formalized to the point of designating the quantity of money that is equal to the (net) foreign assets of the banking system as “money of external origin” and the quantity of money that is equal to the domestic assets of the system as “money of internal origin.”¹¹

We shall follow this analysis in its simplification, viz., that changes in the quantity of money equal changes in (net) foreign assets of the banking system plus changes in domestic credits of the banking system. Thus, for reasons discussed in more detail below,¹² the changes in other liabilities of the banking system are disregarded. But accepting then the statistical identity, what explanatory value does it have?

The assumption of a constant ratio of income to money constitutes in itself an economic explanation of changes in the quantity of money; it implies that money changes proportionally to changes in income. There is no general presumption that the “explanations” based on balance sheet identities contribute any meaningful additional information to the explanation of money and income. Whether they do or not depends on whether they reduce the changes in money to other variables that may themselves usefully be considered as autonomous variables—variables beyond which economic explanations do not in the particular situation want to probe. This question will be considered separately for (1) the purchase of domestic assets and (2) the purchase of foreign assets; and it will be found that, both from an analytical and from a policy point of view, (1) is a useful stopping point of the analysis, while (2) is not.

Domestic credit creation

The decision to treat domestic credit expansion as an autonomous variable is dictated by the purposes of our analysis. To be able to integrate monetary analysis into income analysis, to study the effects of credit policy on income and the payments situation, credit creation must be accepted as an ultimate variable, not to be explained away further in terms of such variables as the desire to invest or the willingness to save.

This treatment of domestic credit expansion might not be reasonable in a purely descriptive, historical study which could, and perhaps should, treat the behavior of the banking system as part of the model. Such a study might, for instance, find that in a certain country bank credit tended to be expanded particularly rapidly after export income or exchange reserves had increased. But from the vantage point of the monetary authorities—and the same holds for the International Monetary Fund—a different approach is the more reasonable one. Credit expansion is subject to the responsibility of the banking system. It may be difficult, perhaps in some circumstances humanly impossible, for the system to withstand demands for credit from the government or from other insistent borrowers; and in such circumstances, the desire to make public development expenditure, or to construct private factories, may be considered, from many points of view, the cause of the expansion in the economy. But for purposes of monetary analysis and monetary policy there is a clear gain in clarity if the responsibility is pinpointed on the credit expansion. The economic development could also have been financed by higher taxes or by a foreign loan. The factories might have been built by restriction of consumption or by the repatriation of capital. In all these situations, the desire to spend for a particular purpose would not have led to a payments problem. In a real sense, the credit expansion is the cause of the payments problem.¹³

As statistically measured, credit expansion is a net concept, the difference between credit outstanding at the end and at the beginning of a period. Part of the repayments that occur during a period may be caused by new loans granted during this or a preceding period. To what extent, then, can the net credit extension be considered as autonomous?

The answer is that credit policy over any but the shortest period of time is essentially a net operation. Some of the bank loans are repaid every day, and new ones are granted every day. The effect of a particular credit policy can therefore be measured correctly on a net basis only. The use of net credit expansion as an exogenous factor makes it necessary to distinguish between the credit granted for one particular large project and net credit expansion during a period. The distinction is particularly important in those cases where the increase in income that results from credit expansion will lead to substantially higher tax receipts by the government and, as a result, a reduction of government borrowing from the banking system. This does not affect the analysis insofar as it deals with an interpretation of the past; credit expansion to business will be found to be offset by a reduction in net credit to the government. But with respect to policy for the future, any “leak” of purchasing power owing to increased tax receipts will have to be taken into account.

Foreign trade

The suitability of the foreign balance as an autonomous factor has been discussed considerably in the framework of multiplier theory; and, insofar as economic questions ever get resolved, this one appears to have been resolved rather definitely in the negative.¹⁴ The foreign balance has been ruled out as a suitable multiplicand, primarily because it fails to use the worthwhile empirical observation that fluctuations in imports are to a large extent determined by fluctuations in income. Accordingly, a useful model should include the various elements of the balance of payments—especially exports and imports—separately, rather than only their net effects on reserves.

Next to credit creation, exports are the main source—and normally much larger in size—of continuous injections of new income into the circular flow. The sale of goods or services abroad continually captures income from abroad and naturalizes it as income of the factors of production engaged in the export industry. Broadly speaking, this stream of new income tends, of course, to be offset by an outgoing income stream reflecting imports, where incomes are paid out to become the incomes of foreigners and, thereafter, to circulate mostly in their income streams. In a situation of balance of payments equilibrium (on goods and services account, to be precise), the income additions from exports will match exactly the income subtractions from imports and the circular flow of income is not changed—from the point of view of static analysis—by the fact that, through exports and imports, it is linked to a wider set of national flows.

A dynamic analysis has to make allowance, however, for the changes in the income stream that may arise from the export and import sides. On both sides, there may be either autonomous or induced changes. Autonomous changes find their origin outside the domestic income stream itself but the causes may be foreign or domestic. Thus a country’s exports may change because foreign income changes, or foreign import restrictions are adjusted, or a new export industry is established in the country. Imports may change because of changes in the country’s own tariff policy or consumer preferences. All these would be autonomous changes. They could be either stabilizing or destabilizing with respect to domestic income, depending on the rate of income with which they happen to coincide. An autonomous fall in exports would be stabilizing in a period of inflation, destabilizing in a period of internal deflation.

Induced changes in exports or imports respond to changes in the domestic income stream and are always stabilizing. When internal demand falls, the resulting decline in prices may produce some offsetting increase in exports. When income rises, imports will tend to increase too, thus channeling some of the higher income abroad and bringing the level of income in the next period closer to normal. Conversely, when there is an autonomous contraction of income, imports are likely to fall, thus transmitting some of the contraction abroad and mitigating, correspondingly, the contraction of income at home. Imports perform the income-stabilizing function most strongly when the income elasticity of demand is high, so that a relatively large proportion of a high national income flows off abroad, while a large proportion of smaller income is kept within the domestic income flow.

Empirically, for most countries at most times, autonomous changes tend to dominate exports, while induced changes account for most of the variations in imports. The following analysis will for simplicity assume that these observations hold not merely as empirical generalizations, but rigidly. This simplification is justified also because—if one does not forget its nature—it does not entail a loss in generality of the conclusions. For at the level of abstraction at which we operate, an autonomous increase in imports is equivalent in effect to an autonomous decline in exports; and any marginal effect of income (or domestic prices) on exports may be allowed for, in numerical calculations, by a corresponding increase in the coefficient indicating the marginal effect of income (or domestic prices) on imports.¹⁵

In the simplified model used in this paper, it is assumed that exports minus imports equals changes in reserves. The whole array of other items—invisibles, capital items, transfers, and, most importantly, errors and omissions—which lie between the trade and the reserve items in the balance of payments is disregarded. For any practical application of the analysis it would, of course, be necessary to find a suitable way of assimilating each of these items with exports, imports, or reserve movements.

Credit, exports, and the income stream

When we speak of credit as an addition to the income stream, we pass over an intermediate stage, the purchase by the borrower of goods. If these goods are totally domestic goods, the increase in domestic income will be as large as the credit expansion. If they have an import component, the domestic income creation will be proportionally smaller. And if, as the marginal case, the import component is 100 per cent—if the investment financed by credit expansion is wholly in imported commodities or foreign exchange balances—the domestic income component vanishes and the credit expansion is fully absorbed by increased imports. In that case, we might say that potential income is lost fully by an autonomous increase in imports of equal size.

The same qualification holds with respect to exports. They, too, create domestic income only insofar as they do not represent imports. Where exports have a high import component, the income creation per dollar of exports is small; and where exports are merely re-exports, the domestic income component vanishes. An increase in exports would be matched by an autonomous increase in imports.

The assumption of a constant velocity of circulation eliminates another complication, viz., the extension of credit or the purchase by the banking system of existing domestic assets which does not lead to expenditures on goods and services by the borrower or seller of the assets. An operation of this nature would be equivalent to an increase in the quantity of money without an increase in income, i.e., a reduction in the velocity of circulation. So would a purchase by the banking system of existing foreign exchange holdings from the private sector. This is not to suggest that either of these transactions cannot occur, but that in our simplified system they have no place and, for that reason, may provisionally be left out of account.

Lasting increase in value of exports

For some reason outside the country, e.g., a rise in world market prices, exports increase by, say, 20 million at an annual rate. Income increases by the same amount. As a result, the demand for money increases. If the income velocity of circulation in this country is 4 times per year, the desired increase in the quantity of money will be 5 million. The additional exports provide the required additional money approximately at the rate at which it is required. There may be a temporary shortage of money if the exporters have to lay out money before they receive payment—e.g., to collect crops at higher prices or to hire additional workers. That situation will clear up soon, however; at the end of one income period of exports, enough money will have been received to continue business at the higher level. From here on, the extra earnings of the export industry can be spent and, under our assumptions, will be spent.

Most of the additional expenditure is likely to be directed toward domestic goods and services, thus increasing money income in the country. If there is sufficient excess capacity and demand is directed toward the output of the industries that have excess capacity, the increase in money income may represent mainly, or even entirely, an increase in real income, prices rising little or not at all; if, on the other hand, there is no spare capacity, the rise in money income will merely represent a rise in prices. Part of the additional spending will be directed toward imports, stimulated by the higher real income (if production could expand), or by the rise in prices in the country as against the price level abroad (if there is no possibility of expansion of production), or by some combination of the two. It will be recalled that the effect on imports of a 1 per cent rise in real income has been assumed to be about the same as the effect of a 1 per cent rise in the domestic price level (on the assumption that prices abroad remain constant); hence, the fraction of an increase in income that is spent abroad may be taken to be independent of the extent to which the expansion in money income was a “real” or a “price” phenomenon.

Assume that under the particular circumstances the fraction spent abroad (the marginal propensity to import) is one fifth; then income in the second quarter will run at the quarterly rate of 9 million above the original level: 5 million exports plus 4 million induced home expenditure.

In order to have the required money to handle the extra business of 4 million a quarter, the economy as a whole will have to save 4 million during the quarter. Either the recipients of the 4 million additional income will have to wait before they increase their spending, or others will have to save money to the extent that the first group does increase its spending.

In the third quarter, however, income can rise another step, as the necessary savings of money to handle the second quarter rate of income have been made. Thus in the third quarter, assuming again one fifth of the new increase to be spent abroad, income will go to 12.2 million (5+ 4 + 3.2), where it will have to remain for another quarter.

This process continues until income approaches its equilibrium level of 25 million per quarter (100 million per year) higher than before. The final increase is related to the initial increase by a multiplier of 5, which is the inverse of the figure assumed for the marginal propensity to import (0.2). At the final rate of income, imports will be 20 million per year above their original level: they will have increased as much as exports. There will no longer be a balance of payments surplus, and the quantity of money will be constant. It can be constant only at its equilibrium level, where it equals one quarter’s income, or 25 million above its original level. Since no change in the domestic assets of the banking system has been assumed, the increase in the money supply must have been accompanied by an equally large accumulation of foreign exchange reserves.

Thus the 20 million increase in exports has had the following effects:

• A. Income has gradually increased to a level 100 million higher. This level is determined by the increase in exports (20) and the assumed marginal propensity to import (0.20), viz., $\frac{20}{0.20}=100$ If (a) the marginal propensity to import equals the average ratio of imports to income,¹⁹ and (b), initially, exports equal imports, then income in the new equilibrium position will have increased in the same proportion as exports.

• B. Imports have gradually increased to a level that is higher by the same absolute amount as exports, i.e., 20 million. This finding does not depend on any numerical assumption; it follows from the qualitative assumption that, apart from the need for increased money, all additional income received is respent. Thus income will continue to rise until the export surplus is eliminated.

• C. The quantity of money has gradually increased by 25 million. This increase is determined by the increase in income, as derived in A above, and the assumed ratio of money to annual income (0.25). If the increase in money is related to the increase in exports, it is found—again on the two assumptions suggested in A—that $\mathrm{a}\mathrm{s}\mathrm{e}\mathrm{}\mathrm{i}\mathrm{n}\mathrm{}\mathrm{m}\mathrm{o}\mathrm{n}\mathrm{e}\mathrm{y}\mathrm{=}\mathrm{i}\mathrm{n}\mathrm{c}\mathrm{r}\mathrm{e}\mathrm{r}\mathrm{a}\mathrm{s}\mathrm{e}\mathrm{}\mathrm{i}\mathrm{n}\mathrm{}\exp \mathrm{o}\mathrm{r}\mathrm{t}\mathrm{s}\mathrm{}\mathrm{\times }\frac{\mathrm{i}\mathrm{n}\mathrm{c}\mathrm{o}\mathrm{m}\mathrm{e}}{\mathrm{i}\mathrm{n}\mathrm{p}\mathrm{o}\mathrm{r}\mathrm{t}\mathrm{s}}\mathrm{\times }\frac{\mathrm{m}\mathrm{o}\mathrm{n}\mathrm{e}\mathrm{y}}{\mathrm{i}\mathrm{n}\mathrm{c}\mathrm{o}\mathrm{m}\mathrm{e}}\mathrm{=}\mathrm{i}\mathrm{n}\mathrm{c}\mathrm{r}\mathrm{e}\mathrm{a}\mathrm{s}\mathrm{e}\mathrm{}\mathrm{i}\mathrm{n}\mathrm{}\exp \mathrm{o}\mathrm{r}\mathrm{t}\mathrm{s}\mathrm{\times }\frac{\mathrm{m}\mathrm{o}\mathrm{n}\mathrm{e}\mathrm{y}}{\mathrm{i}\mathrm{m}\mathrm{p}\mathrm{o}\mathrm{r}\mathrm{t}\mathrm{s}}$

• D. Although there is no lasting improvement in the balance of payments, the fact that the adjustment of imports to the increase in exports is lagged does produce an increase in reserves. This increase must be equal to the increase in the quantity of money, since there is assumed to be no change in the third item in the balance sheets, domestic credit.

These findings give particular importance to a “new” ratio in economics, that between money and imports. This empirical ratio is used here as an indicator of the order of magnitude of the ratio of the (marginal) desire to hold money to the marginal propensity to import. This new ratio for 48 countries, together with the component ratios for 44 countries, is given in Table 2.

Table 2.

Median Values, 1950–54, of Ratios of Money to Income (MO/Y), Imports to Income (M/Y), and Money to Imports (MO/M), by Countries¹

¹Figures have been derived from data in Appendix I, Table 3. For each country, the median of the 1950–54 values was selected for the ratio of money to imports; for the two other ratios, the figures were then taken for the same year.

Table 2.

Median Values, 1950–54, of Ratios of Money to Income (MO/Y), Imports to Income (M/Y), and Money to Imports (MO/M), by Countries¹

	MO/Y	M/Y	MO/M
Australia	.41	.24	1.7
Austria	.33	.22	1.5
Belgium	.53	.34	1.5
Brazil	.37	.13	2.8
Burma	.19	.21	0.9
Canada	.28	.24	1.2
Ceylon	.25	.38	0.6
Chile	.16	.10	1.6
Colombia	.20	.18	1.1
Costa Rica	…	…	0.6
Cuba	.43	.34	1.3
Denmark	.34	.31	1.1
Dominican Republic	.18	.27	0.7
Ecuador	.14	.15	1.0
Egypt	.44	.23	1.9
El Salvador	…	…	1.0
Finland	.14	.22	0.6
France	.43	.15	2.9
Germany	.23	.17	1.4
Greece	.17	.17	1.0
Guatemala	.13	.16	0.8
Honduras	.13	.27	0.5
Iceland	.28	.64	0.4
India	.19	.06	3.0
Indonesia	.09	.13	0.7
Iran	…	…	1.4
Iraq	…	…	0.8
Ireland	.33	.41	0.8
Israel	.28	.22	1.3
Italy	.40	.16	2.5
Japan	.24	.14	1.7
Mexico	.14	.13	1.0
Netherlands	.45	.50	0.9
New Zealand	.39	.31	1.3
Norway	.51	.38	1.4
Pakistan	.17	.08	2.2
Paraguay	.19	.10	1.9
Peru	.20	.29	0.7
Philippines	.15	.15	1.0
Portugal	.44	.22	2.0
Sweden	.33	27	1.2
Switzerland	.60	.26	2.4
Thailand	.19	.22	0.9
Turkey	.22	.10	2.3
Union of South Africa	.30	.33	0.9
United Kingdom	.41	.25	1.7
United States	.44	.04	11.0
Venezuela	.21	.31	0.7

¹Figures have been derived from data in Appendix I, Table 3. For each country, the median of the 1950–54 values was selected for the ratio of money to imports; for the two other ratios, the figures were then taken for the same year.

View Table

Table 2.

Median Values, 1950–54, of Ratios of Money to Income (MO/Y), Imports to Income (M/Y), and Money to Imports (MO/M), by Countries¹

	MO/Y	M/Y	MO/M
Australia	.41	.24	1.7
Austria	.33	.22	1.5
Belgium	.53	.34	1.5
Brazil	.37	.13	2.8
Burma	.19	.21	0.9
Canada	.28	.24	1.2
Ceylon	.25	.38	0.6
Chile	.16	.10	1.6
Colombia	.20	.18	1.1
Costa Rica	…	…	0.6
Cuba	.43	.34	1.3
Denmark	.34	.31	1.1
Dominican Republic	.18	.27	0.7
Ecuador	.14	.15	1.0
Egypt	.44	.23	1.9
El Salvador	…	…	1.0
Finland	.14	.22	0.6
France	.43	.15	2.9
Germany	.23	.17	1.4
Greece	.17	.17	1.0
Guatemala	.13	.16	0.8
Honduras	.13	.27	0.5
Iceland	.28	.64	0.4
India	.19	.06	3.0
Indonesia	.09	.13	0.7
Iran	…	…	1.4
Iraq	…	…	0.8
Ireland	.33	.41	0.8
Israel	.28	.22	1.3
Italy	.40	.16	2.5
Japan	.24	.14	1.7
Mexico	.14	.13	1.0
Netherlands	.45	.50	0.9
New Zealand	.39	.31	1.3
Norway	.51	.38	1.4
Pakistan	.17	.08	2.2
Paraguay	.19	.10	1.9
Peru	.20	.29	0.7
Philippines	.15	.15	1.0
Portugal	.44	.22	2.0
Sweden	.33	27	1.2
Switzerland	.60	.26	2.4
Thailand	.19	.22	0.9
Turkey	.22	.10	2.3
Union of South Africa	.30	.33	0.9
United Kingdom	.41	.25	1.7
United States	.44	.04	11.0
Venezuela	.21	.31	0.7

¹Figures have been derived from data in Appendix I, Table 3. For each country, the median of the 1950–54 values was selected for the ratio of money to imports; for the two other ratios, the figures were then taken for the same year.

It is found that the ratio varies from about one half to three (leaving out of consideration the ratio of eleven for the United States). Both the component ratios show some tendency to rise with a country’s income level; but, for the ratio of money to imports itself, such a tendency, if it does exist, is not very obvious (see Appendix I).

The magnitude of the ratio makes a large difference in the reserves that a country will tend to accumulate as exports rise and also, as will be shown later, in the amount of credit it can safely create. For countries at the lower range of the scale of this ratio, an autonomous increase in exports would, by itself (i.e., if it were not accompanied by internal credit expansion), lead to an increase in money and reserves equal to something like one-half year’s additional exports; for countries at the other end, the increase would be closer to two or three years’ additional exports. For many countries with a ratio rather close to unity, the increase would be in the order of one year’s additional exports.

Lasting autonomous reduction in imports

As suggested above, the effects of an autonomous reduction in imports can be considered, on the level of abstraction on which we operate here, as equivalent to an increase in exports. This is true independently of the character of the measures that produce the reduction in imports: increased tariff, quantitative restrictions, or exchange depreciation. Given the immediate effects of these measures on imports, the ultimate effects may be expected to be the same as those derived in the preceding section for an increase in exports of the same size. There will be the same increases in income, money, and reserves over time. The resulting increase in induced imports—approaching in magnitude the autonomous reduction in imports—implies that measures to reduce imports do not have a lasting effect on the balance of payments. They do, however, have a lasting effect on the level of income; and their temporary effect on the balance of payments during the transition period may be of great importance in restoring a country’s reserve position.

Lasting increase in rate of credit expansion

Assume that credit expansion by the banking system, which in previous years had been zero, is brought to 5 million a year. It is assumed²⁰ that the full 5 million is spent by the borrowers to pay out as income, e.g., in connection with investment activities or government deficit spending. The initial and the ultimate income effect is here the same as that of an increase in exports of the same magnitude. The effects on imports and money—both being related to income—are also the same. The effects on reserves, however, are totally different, as the negative effect of additional imports is not offset by a positive effect of increased exports. There will be a continuous loss of reserves, which will gradually build up to an annual rate equaling the injection of credit—the quantity of money approaching a constant.

In the transitional period while this equilibrium rate is being approached, however, the loss of reserves will be smaller than the total credit expansion by an amount which, on the basis of the figures for the money-import ratio used above,²¹ would be somewhere between six months’ and three years’ credit expansion, depending on the country. To that extent the additional income injected by credit expansion will have been saved in the form of money to handle the higher level of income; for the remainder of the credit expansion, the increase in domestic assets has been offset by a loss in foreign assets.

It follows from our system that, as income approaches the new equilibrium level, the quantity of money also approaches its corresponding equilibrium level, based on the specified ratio of money to income; no further condition is necessary to bring income and money in line. This also entails that no further additional condition on income and money is possible without disrupting the assumption of a constant velocity of money. On this account, the assumption made earlier that all credit expansion is spent is a necessary assumption.

Suppose, for a moment, that this assumption would not be fulfilled, and that those who borrow 5 a year systematically spend only 3, keeping the remainder as additional cash balances in anticipation of the needs of larger business. The multiplier process would then start with 3 instead of 5 as the multiplicand, and income would build up to 15 rather than 25. Money corresponding to an income of 15 would be added to the public’s holdings, but in addition borrowers would be putting aside an extra 2 every year. Thus after, say, five years, income would have risen by approximately 15, and money not by about 3.75, but by 3.75+(5 x 2) = 13.75. The marginal velocity of circulation over the five-year period would appear as slightly over 1, against a previous average of 4.

Thus the assumption of full spending of credit creation is a necessary corollary of the assumption of constancy of the velocity of circulation. This does not mean, of course, that it must be assumed that individual borrowers spend all their borrowings. But deviations of individuals in one direction must be offset by deviations of other individuals in the opposite direction if the basic assumption of a constant income-money ratio is to remain valid.

Discontinuous changes in autonomous variables

In view of the similarities found for the effects of lasting changes in different autonomous variables, the effects of a discontinuous change in these variables may be discussed briefly.

The effects follow simply from well-known multiplier propositions.²² A discontinuous autonomous increase in income (from exports, import restrictions, or credit expansion) will lead to a temporary expansion in income that will gradually subside. The aggregate increase in income, over time, will equal the autonomous increase divided by the marginal propensity to import. The quantity of money will first increase along with income, then decline to its original level. Aggregate imports over time will equal the value of the autonomous increase. If the autonomous factor is an increase in exports, or import reduction, reserves will first increase and then return to their original level; if it is credit expansion, reserves will decline over time by an amount equal to the credit expansion.

In arriving at this last conclusion, no account has been taken of the effect of an increase in one country’s imports on the income of the rest of the world and thereby on its own exports. It will easily be seen that the omission of this further refinement is of negligible significance for all countries except the United States. It is true that, if we adhere strictly to our assumptions, not all the money created by credit expansion in country A can flow out through additional imports. The outflow will stop when a new equilibrium situation is reached, in which the money supply of the rest of the world will have increased in the same proportion as in A. Country A will then have a slightly higher income than before the credit expansion and correspondingly higher imports, which will be offset by an equal increase in exports as income abroad is also slightly higher. Thus A would, in the end, not lose all of its credit creation in reserves, but a fraction less. The magnitude of this fraction would be the ratio of its money supply to the money supply of the whole world. For the United States, which has about 60 per cent of the world’s money supply, this correction is important. But next in order are the United Kingdom, which has only about 7 per cent of the world’s money supply, and France, which has 5 per cent. There are only a few other countries for which the correction would be as much as 2 per cent.²³

Pattern of income, money, and imports over time

As shown in the preceding sections, the effect of each of the three autonomous factors on income, money, and imports is the same. Changes in each of these variables may therefore be understood as a function of the sum of changes in exports, in import restrictions (measured numerically as the amount of imports kept out by price, exchange rate, or prohibitive measures), and in credit expansion.

The effects of these autonomous variables are most conveniently derived from the findings on discontinuous changes. The patterns of exports, import restrictions, and credit expansion may be seen as a set of autonomous causes that vary discontinuously over time and whose fluctuations determine the rate of income and imports, stocks of money, and reserves at any moment of time. Income, money, and imports depend positively on the sum of the three variables, exports, import restrictions, and credit expansion.

Since the process of adjustment takes time, the fluctuations in income, imports, money, and reserves will lag behind those of the autonomous variables. Income during any period is thus a weighted average of the current and past values of the sums of the autonomous variables, with the sum of the weights equaling $\frac{\mathrm{1}}{\mathrm{m}\mathrm{}\arg \mathrm{i}\mathrm{n}\mathrm{a}\mathrm{l}\mathrm{}\mathrm{p}\mathrm{r}\mathrm{o}\mathrm{p}\mathrm{e}\mathrm{n}\mathrm{s}\mathrm{i}\mathrm{t}\mathrm{y}\mathrm{}\mathrm{t}\mathrm{o}\mathrm{}\mathrm{i}\mathrm{m}\mathrm{p}\mathrm{o}\mathrm{r}\mathrm{t}}$. The value of imports is a weighted average of the current and past values of the sums of the autonomous variables, with the sum of the weights equal to 1. The magnitude in terms of years of the average lag of income and imports depends on the marginal propensity to import and on the velocity of circulation of money. The greater these two parameters, the smaller the lag. A method for computing this lag is derived in Appendix II. Application of this method shows that, for plausible values of the two parameters, the lag may run from half a year to well over a year. This theoretical finding is well in accordance with empirical observations frequently made in dealing with problems of financial policy:

1. An expansion of exports during a substantial period tends to produce a rate of reserve increase that is not maintained thereafter; if actions are taken on the assumption that the export surplus will persist (e.g., in the form of credit expansion), serious balance of payments difficulties may arise.

2. Credit creation will have its full effects on a country’s reserves only over a considerable time; in the early stages, the effects may appear both minor and harmless.

3. Measures to combat payments problems by means of restriction of credit expansion will normally become effective only slowly and gradually.

The change in reserves equals current exports minus the weighted sum of past values of the autonomous variables, with the sum of the weights equaling 1. The stock of money depends on the weighted average of the sum of the autonomous variables, with the sum of the weights equal to $\frac{\alpha }{m}$ (equals the ratio of money to imports if the marginal propensity to import equals the average propensity). Reserves are equal to the stock of money minus the total credit expansion. These relationships are summarized in Table 1.

Discussion of some of the conclusions reached

It may be useful to check the conclusions reached against some of the literature on the subject. The first observation is that the balance of payments conclusions are substantially those of the classical economists. The existence of an equilibrating mechanism by which an increase in exports produced its own offset, and the proposition that an increase in money beyond the proper quantity would be drained off through purchases of gold and silver, were, indeed, among the most essential of their findings.

But the classical economists did not typically study the details of these processes over time, through variations in income, imports, money, and reserves. Nor did they have the equipment to arrive at numerical magnitudes—or, more modestly, orders of magnitude—for the changes that could be expected in the course of these processes. For these reasons alone, a somewhat more precise restatement of the classical tenets, in a more modern form, may be appropriate.²⁴

Another justification may be found in the alarming naiveté so often found in analytical studies of particular countries. When such studies deal with past events, they all too often show surprise that an increased flow of exports, which produced a large balance of payments surplus the first year that it occurred, does not continue to produce such a surplus in later years. When a country is running a balance of payments deficit, it is far too often believed that any measure or event that will increase exports or decrease imports (oil discoveries, higher world market prices, the entry into production of some import-replacing industry, etc., etc.) will by itself relieve the deficit. The correct view, according to our conclusions, is that these events will by themselves produce a temporary, but not a lasting, improvement in the balance of payments. They will, of course, produce a lasting increase in the country’s income. This increase will, at least in part, be an increase in real income, depending on the elasticity of supply; to that extent, it may facilitate taking the additional measures necessary to eliminate the deficit permanently. If, for example, the deficit was due to an unbalanced government budget, a higher national income may make it easier to raise taxes and thus to eliminate the payments deficit via the elimination of the budget deficit.

The same line of reasoning will indicate that the belief that import restrictions can correct a balance of payments deficit is inaccurate, unless there is evidence that these restrictions will lead to a specific increase in saving, e.g., if the restrictions are known to be temporary. As shown above, such restrictions will have an initially favorable effect on the payments situation, which will disappear reasonably soon as the effects through the expansion of income make themselves felt. If restrictions were to have the same effective restrictive effect in terms of the value of the commodities kept out, they would have to be continually made more severe as the effectiveness of earlier restrictions wore off.

With respect to the effects of credit creation on the balance of payments, the classical views are not commonly heard at present. The opinion recently expressed by E. M. Bernstein that for “a country like the Philippines, which constitutes a very small part of the world monetary economy,… it can be said with approximate accuracy that an inflation of 100 million pesos [1 peso=US$0.50] will result in a balance of payments deficit equivalent to US$50 million,”²⁵ does not, it is believed, reflect a point of view commonly held in the profession. According to the above analysis, this opinion is correct even without the conditions specified in the text, viz., that there is full employment and that the rise in prices is proportional to the increase in the quantity of money.²⁶

Two prevailing schools of thought will, however, come up with different answers: both those who discuss expansion in terms of the multiplier and those who put their faith in an approach through the income velocity of money. The former group tends to take it for granted that there is, in any system, some marginal nonspending, i.e., marginal saving in forms other than money that does not lead to expenditure by someone else, as a result of which, obviously, not the whole credit expansion would eventually find its way into imports. But the question is whether there is indeed such marginal nonspending; as we have seen, there can be none, after the adjustment period, if the velocity of circulation is a constant.

It is perhaps a little more surprising that most approaches based on the quantity theory also manage to come to conclusions that are wrong or at least without applicability. The error—not a logical but a practical error—is due to the tendency to base these analyses implicitly or explicitly on a closed economy. This simplification is far more serious in velocity analysis than in multiplier analysis. In the latter, it is equivalent to disregarding one out of a number of “leaks” which are a function of income; the others, such as savings and taxes, are being allowed for. The numerical results are thus in the right direction, although they are too large. But to ignore imports in velocity analysis is to overlook the one and only leak there is in the system. Hence the conclusions are not only quantitatively, but also qualitatively, wrong. It is inferred that a single injection of credit leads to a lasting increase in income,²⁷ and that continuous injection of the same amount of credit per period leads to an ever increasing rate of income.²⁸ Both types of conclusions are based on a monetary multiplier equal to the inverse of the velocity of circulation. They fail to see that for open economies the income velocity approach cannot lead to conclusions that are even in the qualitative sense correct without being spliced on to income analysis; and that, when this is done, the ultimate value to which income approaches does not depend on the velocity of circulation at all, but only on the marginal propensity to import.

It is true that, by basing the analysis not on a given expansion of credit but on the assumption of a fixed increase in the quantity of money, velocity conclusions can be recast in a form that is formally correct. But since imports subtract from this quantity of money, the assumption implies, for an open economy, a continual offsetting of imports by new credit expansion. ²⁹

This brings us to the applicability of the quantity theory of money. Its weakness is not so much the assumption of a constant V, an assumption which, at least for the less developed countries, is probably as good as that of the constancy of any other coefficient. Nor do difficulties arise from the side of P and T; for the purpose of studying payments problems, the extent to which credit expansion leads to an increase in prices and the extent to which it leads to a rise in real income may not make too much difference. The basic difficulty, it would seem, is with M itself.³⁰ For an open economy, an increase in M, unlike credit expansion, is not a useful autonomous variable to take as the multiplicand, because through the multiplier process an autonomous increase in M leads to a subsequent reduction of the same magnitude in M.

Long-run expansion of internal credit by monetary system

The analysis in Part III can be used to derive an estimate of the amount of internal credit expansion by the monetary system which an economy can afford. It should be stressed that the estimate refers not to credit expansion in general but only to credit expansion by the monetary system. The total new credit that can be extended in an economy depends on (1) the amount of income saved and (2) the extent to which saving is channeled into investment through credit institutions. The amount of new credit extended per year can be enlarged by increased saving or by an increased use of credit intermediaries. Accordingly, there is no narrow limit beyond which total credit cannot expand; and, on the whole, an increase in credit indicating increased saving, or even an increased use of intermediaries of a given amount of saving, is likely to be a healthy sign.

The situation is different, however, for saving through the monetary system, insofar as this saving takes the form of increased holdings of money. Since, with a constant velocity of circulation, money cannot increase faster than output without a rise in prices, and since price increases are generally not desired, more than a moderate amount of saving in the form of money is, on the whole, an unhealthy sign.³¹

The distinction between an unhealthy expansion of credit that leads to too large an increase in money and a healthy one that is indicative of an increased flow of savings into financial intermediaries is necessarily somewhat tenuous. The difficulty arises from the inevitable arbitrariness of any definition of money which draws a sharp line between money and what is called quasi-money in International Financial Statistics—assets which, unlike money, are used primarily as a store of value but, because of the ease with which they can be turned into money, perform some of the functions of precautionary balances, and perhaps even of the less active part of transactions balances. There is no satisfactory way to avoid this difficulty.

But it is made serious both in substance and in the treatment of the problem at hand if the same institutions that have large monetary liabilities also owe large quasi-monetary liabilities. It complicates the problem of substance, because the possibility of having both money and quasi-money (e.g., a checking account and a savings account, or a sight deposit account and a time deposit account) in the same bank tends to increase the ease of transfer from money to quasi-money and thus to blur further the line of distinction between the two.

At the same time, the distinction between the monetary system and other financial intermediaries becomes blurred. Where, as in France, the deposit banks have virtually no nonmonetary deposits, that distinction is easy. But where, as in Germany, the deposit banks have time deposits twice the size of their sight deposits and bonds outstanding in an amount equal to their sight deposits, the distinction between the monetary system and other intermediaries cannot be made on an institutional basis.

The fact that a community holds, in addition to money, large amounts of quasi-money is an important economic factor, both as to its causes and as to its effects. But whether the public holds these quasi-monetary assets in the commercial banks or in other institutions is primarily an institutional question, which is of a much lower order of importance. In the theoretical approach that is used in this paper it seems proper, therefore, to make a distinction by economic categories rather than on an institutional basis. Accordingly, we discuss the ability to expand internal credit not of the empirical banking system of each country, but of its monetary system. The latter is defined, in balance sheet terms, as all the liabilities of the central bank plus the monetary liabilities of the commercial banks and any other institutions that may have such liabilities (e.g., the postal checking system in some European countries). The asset side of the balance sheet is represented by all the net foreign assets of the institutions covered plus the amount of their domestic assets that is required to add up to the total of monetary liabilities. The remaining domestic assets are notionally split off as if they were held by some savings banks which also owe the corresponding amount of nonmonetary liabilities.

With respect to the monetary system, it was found in Part III that every credit expansion leads ultimately to a corresponding loss in reserves. From this, it might seem to follow that a country could not afford any permanent expansion of internal credit without endangering its balance of payments. To prevent a lasting deterioration in the balance of payments, any credit expansion in one period would, it might seem, have to be offset by a credit contraction in a later period. On closer analysis it will be clear, however, that this conclusion is not generally correct. We have seen that a lasting expansion in the rate of exports will lead to an increase in reserves. If the country is willing to forego part of this increase in reserves, it can afford a secular expansion of credit for every secular expansion in exports.

But should not reserves also increase secularly as exports and imports go up? Yes, they should; but the reserve increase that comes about automatically without credit expansion as exports increase is normally larger than the country would require in relation to that expansion of its trade. The automatic increase in reserves associated with any increase in exports would be equal to that increase times $\frac{\mathrm{q}\mathrm{u}\mathrm{a}\mathrm{n}\mathrm{t}\mathrm{i}\mathrm{t}\mathrm{y}\mathrm{}\mathrm{o}\mathrm{f}\mathrm{}\mathrm{m}\mathrm{o}\mathrm{n}\mathrm{e}\mathrm{y}}{\mathrm{i}\mathrm{m}\mathrm{p}\mathrm{o}\mathrm{r}\mathrm{t}\mathrm{s}}$. For most countries this ratio is in the order of 1 or more. Countries do not, however, typically hold reserves equal to a year’s exports (or imports); as exports increase, they do not need to add a full year’s increase to their reserves. On the basis of a very cursory inspection of the ratios of reserves to imports of many countries of the world, it would seem that reserve ratios of the order of 50 per cent were found to be adequate by many countries, and smaller ratios by some. Where, then, export increases would by themselves tend to build up reserves by more than this, the country could afford to exchange part of its increase in reserves for domestic capital goods by means of credit expansion.

For some countries, however, where imports are a very large proportion of domestic variables (e.g., national income and the quantity of money), the ratio of money to imports may approach the desired ratio of reserves to imports. In a few countries shown in Table 2, the ratio of money to imports approaches 0.5; if these countries wanted to hold reserves of the order of 50 per cent of imports, they would not be able to afford any significant internal credit expansion, however much their exports might increase.

In general terms, the ratio of domestic assets to foreign assets of the banking system that an economy can afford, as a long-run proposition, is indicated by the formula

where	a = ratio of money to income
	m = ratio of imports to income
	k = the desired ratio of reserves to imports. 32

View Table

where	a = ratio of money to income
	m = ratio of imports to income
	k = the desired ratio of reserves to imports. 32

Thus a country where $\frac{\alpha }{m}=3$ can, on this basis, have adequate reserves and yet an internal credit expansion five times its foreign exchange reserves, if k is taken at 0.5.

With the same numerical degree of “reserve adequacy,” a small underdeveloped country with a large import ratio and a high velocity of circulation can afford much less credit expansion. For m=0.3, α =0.2 (velocity =5), and k = 0.5, the ratio becomes 1/3, or the ratio of domestic credit to money becomes 1/4. This agrees with the finding of E.A. Birnbaum that, for small underdeveloped countries with reserves that seemed adequate, the reserves were in the order of two thirds of the money supply, so that only one third of the money supply was matched by domestic credit.³³

Cyclical variation of credit expansion

The preceding section set the limits for credit expansion in the long run. In the shorter run, in response to fluctuations in exports, the measure of the proper expansion of credit is more ambiguous, since the objectives of internal and external stability are likely to come in conflict. When export proceeds are cyclically high, considerations of internal stability and the prevention of inflation might require a reduction in credit expansion below the long-run normal; but balance of payments considerations would permit a larger than normal credit expansion. Similarly, in a depression, internal considerations would lead to an offsetting policy, while balance of payments reasons might necessitate a reduction in internal credit expansion.

There is, therefore, no single objective short-run test for a proper credit policy in response to cyclical variations, even on the assumption that cyclical variations in exports can be distinguished from long-run changes. To the extent to which they consider offsetting policies possible or desirable, countries can reasonably have different attitudes. Some may be willing to have external fluctuations permeate their economies, riding high on high tides—hoping perhaps that these may prove to be a lasting rise in level rather than a mere cyclical wave—and, if disappointed by a return of low tides, go through a period of restriction. Other countries may prefer to put primary emphasis on the stabilization of the internal economy, accumulating reserves in good years and running them down in bad years.

The maximum extent to which a policy of riding with the tide could reasonably be pursued would be to expand credit on the assumptions that (1) the increased level of exports would persist, but (2) the increase in reserves corresponding to a higher level of trade should be accumulated. The total credit expansion permissible on this basis is $(\frac{\alpha }{m}-k)$ times the increase in exports; for $\frac{\alpha }{m}\cdot \mathrm{\Delta }$ exports is the reserve increase that will take place in the absence of credit expansion, and k is the desired reserve ratio (in terms of exports or imports) that should remain after credit expansion.

Introduction

The preceding analysis has been based entirely on the assumption of a constant ratio of income to money. The analysis should now be broadened by allowing explicitly for other factors that may also play a role in determining the holdings of money, and whose changes will therefore be reflected in changes in the ratio of money to income.

Changes in this ratio may be attributable to two sets of causes: (1) changes in factors, other than income, which affect the desirability of holding money; (2) changes in the (opportunity) cost of holding money, i.e., in the rate of interest. The first might be considered shifts of a demand curve for money (at constant levels of income); the second, movements along such a demand curve in response to changes in interest rates.

Other demand factors

Changes of the type listed in the first group appear to occur frequently in the short run, particularly in response to sudden large purchases or sales of assets by the banking system. A large increase in exports or a large government deficit may increase the quantity of money more than in relation to income, as decisions to spend the larger income, either at home or for imports, are delayed. A large reduction of money, e.g., through an increase in inventories of imports or through capital flight, may lead to an increase in velocity as the economy continues its normal rate of current expenditure in spite of the inadequacy, by normal standards, of its cash balances. For some of the countries, the data in Chart 1 and Appendix I, Table 3, show changes in velocity that are probably due to such causes. Thus the very large export increases related to the Korean war produced high ratios of money to income at the end of 1951 in Australia and Pakistan. A large import of short-term capital brought about a high ratio in Mexico in 1950. A speculative wave of importing in the same period explains the declines in the ratios in Germany and the Netherlands at the end of 1951. But these deviations from a more normal relation between income and money apparently do not last.³⁴ As the figures for the countries mentioned indicate, velocity returned to normal in a relatively short period.

Insofar as these demand factors are of a temporary character, the conclusions reached earlier in this paper would continue to be valid except with respect to their timing. Thus, if a large increase in exports leads to a temporary increase in the willingness to hold money (compared with income), income and imports will initially rise less, and money and reserves more, than would have been expected. But when the relationship of money to income returns to normal, these discrepancies will disappear.

It would seem that, generally, these other demand factors operate as a moderating force on both expansionary and contractionary processes. Even without changes in velocity there are difficulties of analysis and economic policy owing to the fact that the effects of these processes tend in any case to be lagged. Insofar as fluctuations in the velocity of money increase this lag, they may make proper analysis and proper policy even more difficult. Credit expansion may then proceed even longer, without much effect on the balance of payments. High export prices may lead to an even more impressive accumulation of reserves. Thus policies may be continued in the first case, or initiated in the second case, that are more inflationary than the economy will be able to stand when the normal velocity returns. Similar difficulties of interpretation may lead to excessively deflationary policies in other situations. Thus an import boom may temporarily continue even though cash balances have been reduced well below normal. In such a situation, additional deflationary measures to protect the reserves may seem necessary (in particular when the reserves have been decreased to a very low level and no secondary reserves are available), although it may be expected that the process may reverse itself as cash balances are restored to normal.

The policy issues involved are made more difficult in both inflationary and deflationary situations by the ever present possibility that the ratio of money to income may have changed permanently. After all, these ratios are, as we have seen, quite different for different countries; and they have changed for individual countries over time,³⁵ although usually only slowly.

Changes in response to rate of interest

In most of the less developed countries, the transition from money to other assets is fairly abrupt. On the one hand there is money; on the other hand there are real assets—land, buildings, stocks of international goods, perhaps gold and foreign balances. There is little in between. Treasury bills, government bonds, prime industrial bonds, readily marketable shares—all these assets that form the transition between money and real assets in countries with fully developed financial systems play a minor role in the asset structure of most of the less developed countries. Money is held for one purpose, transactions; real assets are held as the store of value. There may be occasional fluctuations in the holdings of money for the reasons discussed in the preceding section. But there is little room for short-run changes between money and real assets on the basis of changes in the rate of interest. In fact, in such countries there usually is no true market—neither a money market nor a capital market—in which a rate of interest is formed by the interplay of demand and supply forces.

The situation is different in the developed countries, where there is a continuous range of other assets yielding interest at the expense of liquidity. Here, moreover, money holdings are normally rather large, compared with income, giving more room for adjustments in response to the opportunity cost of holding money. In these circumstances, it seems logical to expect a reasonably clear influence of the interest rate factor on cash holdings in addition to the influence of income. In a recent unpublished study by William H. White, strong evidence that the velocity of circulation responds to changes in interest rates was found for six developed countries: Canada, Denmark, Sweden, Switzerland, the United Kingdom, and the United States. The relationship was found to be less close, but still present, for eight other countries: Australia, Belgium, Brazil, India, Mexico, the Netherlands, Norway, and Uruguay. Some of these, it will be noted, are less developed countries. Of the countries for which data are available, three—Chile, France, and Peru—did not show a relationship between interest and velocity.³⁶

Changes in velocity are equivalent in their effect to injections into or subtractions from the income stream. Therefore, in circumstances where the velocity depends on the rate of interest, it is necessary to take changes in interest rates into account both for analytical and for policy purposes.

In studying the interest rate mechanism it is necessary to distinguish between the central bank and the commercial banks. The creation of credit by the central bank depends on its own decision (sometimes, to be true, taken under pressure); the size of the creation of credit by the commercial banks is normally left to their discretion, the central bank influencing the degree of ease or stringency of the commercial banks by means of its net purchases of exchange, its own credit expansion, its open market operations, and changes in reserve requirements. While these supply conditions affect the willingness of the banks to lend at different interest rates, demand conditions, such as business activity and profit expectations, affect the desire to borrow at different interest rates. The interplay of these demand and supply factors determines, at the same time, the amount of credit creation and the rate of interest.

If the central bank desires to change the amount of credit expansion by the whole banking system, this will normally lead to a change in the rate of interest (unless the supply and demand factors adjust themselves or are adjusted in such a manner as to make this unnecessary). By itself, a contractionary policy will lead to a rise in the rate of interest, an expansionary policy to a fall in the rate. But these changes in the rate will tend to induce changes in money holdings that will in part neutralize the initial policy.

Assume that in a particular situation it is felt necessary to reduce the additions to the income stream originating in the monetary system from 600 last year to 200 this year. To bring this about in the face of a constant or rising demand for credit, the reserve positions of the banks are tightened and the rate of interest rises. Now, insofar as businesses and consumers reduce their ratio of cash balances to turnover because of the high cost of money, the intent of the monetary authorities is frustrated. Assume, for instance, that, in response to the increase in the rate of interest for the total quantity of money of 2,000 million, the velocity of circulation is increased by 10 per cent. This is equivalent in its effect on income to a credit injection of 200 million. Thus the net effect on income achieved by the authorities is only half what was intended, and also only half the amount that the figures on credit expansion and the money supply might lead one to believe had, in fact, been achieved. In the face of the interest elasticity of demand for money in this imaginary country, the authorities would have had to tighten the reserve position of the commercial banks considerably more to achieve the desired net effect on income creation.

Changes in the velocity of circulation, whether resulting from changes in demand factors or from changes in the rate of interest, will have to be taken into account in the explanation of income and imports. For this purpose, they will have to be treated as equivalent to an increase in the quantity of money at constant velocity. But there is room for a certain difference in expectation when the change in velocity is due to a variation in interest rates, compared with the situation in which it is attributable to a change in demand factors. For when velocity has risen in response to an increase in the rate of interest, the change may be expected to be lasting as long as the rate remains high, while changes in velocity not attributable to changes in interest seem to have a tendency to reverse themselves.