Some Current Issues on the Transmission Process of Monetary Policy
Author: Yung Chul Park

THERE IS WIDESPREAD AGREEMENT that money is of some importance in determining the course of economic events. There is, however, substantial disagreement concerning the extent to which money matters (that is, the size of the money multiplier). Monetarists argue that changes in the stock of money are a primary determinant of changes in total spending. On the other hand, nonmonetarists, although they may readily admit that money matters, also regard changes in the various components of aggregate demand as having an important influence on the level of economic activity; they, therefore, place as much emphasis on fiscal policy as on monetary controls. In fact, a spectrum of views on the importance of money ranges from “money matters little” at one extreme to “money alone matters” at the other extreme. An important question is the extent to which these differences in opinion may be traced to differences in models of the monetary process (that is, the transmission mechanism explaining how monetary influences affect real output, employment, and the price level). The objective of this paper is to examine this question by reviewing critically the analytical bases for the different views among monetarists and nonmonetarists;1 only casual reference will be made to the vast and growing empirical literature. Since the transmission process is an integral part of the entire operational structure of the economy, the survey cannot be carried out without discussing divergent views on how the economy in general operates. While this may lengthen the paper, it will help us to analyze the mechanism in a proper context. The review begins in Section I with a discussion of post-Keynesian developments, followed in Section II by an analysis of the nonmonetarist views of the neo-Keynesians and the neo-Fisherians. The monetarist view is elaborated in Section III, and a summary and concluding remarks comprise Section IV.

Abstract

THERE IS WIDESPREAD AGREEMENT that money is of some importance in determining the course of economic events. There is, however, substantial disagreement concerning the extent to which money matters (that is, the size of the money multiplier). Monetarists argue that changes in the stock of money are a primary determinant of changes in total spending. On the other hand, nonmonetarists, although they may readily admit that money matters, also regard changes in the various components of aggregate demand as having an important influence on the level of economic activity; they, therefore, place as much emphasis on fiscal policy as on monetary controls. In fact, a spectrum of views on the importance of money ranges from “money matters little” at one extreme to “money alone matters” at the other extreme. An important question is the extent to which these differences in opinion may be traced to differences in models of the monetary process (that is, the transmission mechanism explaining how monetary influences affect real output, employment, and the price level). The objective of this paper is to examine this question by reviewing critically the analytical bases for the different views among monetarists and nonmonetarists;1 only casual reference will be made to the vast and growing empirical literature. Since the transmission process is an integral part of the entire operational structure of the economy, the survey cannot be carried out without discussing divergent views on how the economy in general operates. While this may lengthen the paper, it will help us to analyze the mechanism in a proper context. The review begins in Section I with a discussion of post-Keynesian developments, followed in Section II by an analysis of the nonmonetarist views of the neo-Keynesians and the neo-Fisherians. The monetarist view is elaborated in Section III, and a summary and concluding remarks comprise Section IV.

THERE IS WIDESPREAD AGREEMENT that money is of some importance in determining the course of economic events. There is, however, substantial disagreement concerning the extent to which money matters (that is, the size of the money multiplier). Monetarists argue that changes in the stock of money are a primary determinant of changes in total spending. On the other hand, nonmonetarists, although they may readily admit that money matters, also regard changes in the various components of aggregate demand as having an important influence on the level of economic activity; they, therefore, place as much emphasis on fiscal policy as on monetary controls. In fact, a spectrum of views on the importance of money ranges from “money matters little” at one extreme to “money alone matters” at the other extreme. An important question is the extent to which these differences in opinion may be traced to differences in models of the monetary process (that is, the transmission mechanism explaining how monetary influences affect real output, employment, and the price level). The objective of this paper is to examine this question by reviewing critically the analytical bases for the different views among monetarists and nonmonetarists;1 only casual reference will be made to the vast and growing empirical literature. Since the transmission process is an integral part of the entire operational structure of the economy, the survey cannot be carried out without discussing divergent views on how the economy in general operates. While this may lengthen the paper, it will help us to analyze the mechanism in a proper context. The review begins in Section I with a discussion of post-Keynesian developments, followed in Section II by an analysis of the nonmonetarist views of the neo-Keynesians and the neo-Fisherians. The monetarist view is elaborated in Section III, and a summary and concluding remarks comprise Section IV.

I. Post-Keynesian Analysis: The Wealth Effect, Credit Rationing, and Portfolio Balance

The cost-of-capital channel

The main process by which monetary forces influence the real economy in Keynesian income/expenditure models is through the cost-of-capital channel. In a simple Keynesian framework, monetary policy operates through changes in the rate of interest. The change in the volume of money alters “the” rate of interest—a rate of interest usually approximated by the long-term government bond rate—so as to equate the demand for money with the supply. The change in the rate of interest affects investment and possibly consumption; the change in aggregate demand, in turn, has a multiple effect on equilibrum income. Thus, the rate of interest is viewed as a measure of the cost of capital, as the indicator of the stance of monetary policy, and as the key linkage variable between the real and financial sectors.

In addition to the cost-of-capital channel, post-Keynesians also recognized two other channels, namely, the wealth effect on consumption expenditure and the credit rationing linkage between the financial and real sectors.

The wealth effect

The post-Keynesian view

One of the most significant post-Keynesian developments has been the emphasis on net private wealth as well as income as a factor influencing real flows of expenditures. The connection between net wealth of the private sector and consumption was first pointed out by Pigou 2 and Haberler,3 and in a more rigorous manner by Patinkin,4 in the form of the real cash balance effect: changes in the real quantity of money could affect real aggregate demand even if they did not alter the rate of interest. The central feature of the real cash balance effect is the assumption that the stock of money is a component of the net wealth of the economy. However, the stock of money that these economists considered as part of net wealth was not the usually defined concept of narrow money (currency outside banks plus demand deposits) but rather the monetary base, or, in Gurley and Shaw’s terminology, outside money alone.5 The justification for excluding demand deposits (inside money) as part of wealth is that these deposits are claims of the public on the banking system that are counterbalanced by the debts of the public to the banking sector. Therefore, when the balance sheets of all economic units are consolidated, inside money disappears and, hence, should not be considered as part of wealth.

This justification, however, brings out immediately the question of why the same logic should not be applied to outside money, which is, after all, the noninterest-bearing debt of the government. If, indeed, outside money is government debt, as it has been treated in the post-Keynesian literature,6 a consolidation of the balance sheet of the private and government sectors must result in the cancellation of outside money as an item of net wealth. It then follows that a change in outside money cannot exert a wealth effect, since the change cannot cause a simultaneous change in net wealth. To establish that the change in outside money does indeed have economic consequences, one has to provide an explanation other than that outside money is part of wealth. The explanation that has had widest support has been that the government, unlike other debtors, is unconcerned about the size of its debt and makes its economic decisions accordingly.7 Thus, the only effect of the change in outside money is the effect of the increase in assets of the private sector. This explanation reduces the wealth effect of changes in outside money to a distribution effect of a wealth transfer between the private and government sectors. This explanation also suggests that the traditional distinction between inside and outside money is based not on a measure of wealth applicable to all types of asset but rather on asymmetric responses of various economic decision-making units to changes in assets and debts.8

Later developments have extended this wealth effect beyond money to other forms of wealth, such as the real market values of equities and interest-bearing government debt. It is fairly easy to appreciate the wealth effect or distribution effect associated with outside money. However, it is not evident whether the same argument could be applied to interest-bearing government debt. There is an important difference between the two assets. Unlike outside money, the interest burden on interest-bearing government debt must be financed by future taxes. Hence, if the private sector discounts its future tax liabilities in the same way in which it discounts future interest receipts, the existence of government bonds represents an asset as well as a liability to the public and will, therefore, not generate any net wealth effect.9 However, if the public considers only a constant fraction of total interest-bearing government debt as a liability, then an open market purchase of government bonds will increase net private wealth and thereby directly affect aggregate demand.

At the theoretical level, the link between the net wealth of consumers and real consumption has been refined as in the life cycle hypothesis of Ando, Brumberg, and Modigliani, which holds that consumers allocate consumption over their lifetime, given initial net worth, a rate of time preference, and expectations regarding labor income.10

The Keynesian approach uses the rate of interest on long-term bonds as the representative rate on all types of earning asset. This implicitly assumes that equities, government bonds, and private debt are all perfect substitutes for one another.11 As a result, the Keynesian analysis considers only substitution between money and bonds important but ignores entirely the substitutability between money and real assets or real expenditures. The intellectual importance of the real cash balance effect lies in the fact that it allowed the possibility of substitution between money, on the one hand, and real expenditures, on the other hand, in macroeconomic analysis.12 This fact has, to a great extent, contributed to the explicit treatment of real capital goods in portfolio analysis and to a re-emphasis on the role of money.

The Pesek and Saving thesis

In a recent book by Pesek and Saving,13 the authors argue that commercial bank demand deposits (inside money) should also be treated as part of the net wealth of the economy, because demand deposits are an asset produced by banks and sold by them to the public in exchange for the latter’s statements of indebtedness.14 Demand deposits, unlike outside money, carry an “instant repurchase clause”—an obligation by the banks to repurchase them with outside money. But this characteristic, Pesek and Saving argue, does not affect the basic fact that demand deposits are part of net wealth.

If Pesek and Saving’s thesis is valid, then their analysis will have important implications for the effects of monetary policy. Their analysis literally means that monetary authorities can directly create or destroy nominal private wealth at will through monetary policy. This, in turn, implies that monetary policy can affect aggregate demand directly and in theory can have strong effects on the level of economic activity. For instance, a central bank’s open market purchase of government bills, given the money supply multiplier, will generate a multiple expansion of the initial Increase in outside money. The increase in money supply should be considered an increase in nominal private wealth, which will, in turn, increase consumption expenditure. This means that the open market operation has a direct wealth effect in addition to the conventional liquidity effect15 and the interest-rate-induced wealth effects (capital gains or losses on government bonds and equities) on total spending. For this reason, Pesek and Saving’s argument deserves careful examination.

Pesek and Saving’s view is based on the principle that the economically relevant measure of wealth is the capitalized value of a stream of net income. When this measure of wealth is applied to outside money, it is shown that outside money is a component of net wealth because it yields a net flow of services to the user—not because the government is unconcerned with its outstanding debt. The flow of services of outside money is the saving of time in barter transactions, which stems from the role of money as a medium of exchange. The saving of time may be used either for leisure or for the production of capital goods. Hence, outside money generates a positive stream of income; the capitalized value of this income is then an addition to the net wealth of the economy. The same reasoning applies to demand deposits, the basic difference between government fiat money and demand deposits being one of institutional arrangements. The arrangement is that government fiat money is produced by the government, whereas demand deposits are produced by the government agents, namely, commercial banks that have received the monopoly right of producing money. From this point of view, there is no difference between outside money and demand deposits. To put it differently, inside money also represents a stream of net income, since demand deposits, as a medium of exchange, yield a flow of services that banks have agreed to provide. For inside money, however, the net income takes the form of the earnings of the banks through the process of money creation or intermediation. The capitalized value of the earnings is then an increase in the net wealth of the economy.16

To elaborate further on this point, let us assume that a commercial bank receives $5,000 of demand deposits and that the bank is subject to a reserve requirement of 20 per cent. The bank then retains $1,000 in cash reserves and creates demand deposits amounting to $4,000 by lending this amount to the private nonfinancial sector of the economy. Suppose that there is a single rate of interest, say, 5 per cent, in this economy. This means that, ceteris paribus, the bank is earning an additional $200. The present value of this interest earning, given the 5 per cent interest rate, is $4,000, which is exactly equal to the increase in demand deposits held by the public. This present value represents an increase in the net worth of the bank. Since the bank is a private one, the increase should be reflected also in the balance sheets of its stockholders; ceteris paribus, the increase in the net worth of the bank will be reflected in an increase in the market value of the bank’s stocks, which is equivalent to an increase in the public’s wealth.

The argument so far is based on the assumption that the costs of producing (or servicing) demand deposits are negligible. However, in reality the commercial banking industry has operating costs just like any other industry and is fairly competitive. To the extent that there are operating costs connected with demand deposits (or outside money, for that matter), the whole value of demand deposits is not necessarily part of the net wealth of the economy. In the extreme case where the banking industry is fully competitive and is not subject to government controls and regulations, Patinkin shows that the capitalized value of the banks’ operating costs (the sum of the present values of the current operating costs and of the imputed annual interest charge on the fixed assets) is equal to the value of demand deposits and that, consequently, demand deposits should be excluded from net national wealth.17 The implication of the perfect competition case is, of course, that the true origin of the net worth of the banking sector is in its monopoly right of creating demand deposits.

However, if the assumption of zero costs of managing demand deposits is unrealistic, so is the assumption of perfect competition in the banking sector. A reasonable assumption would then be that, since entry into the banking industry is restricted by the necessity of obtaining a license, the present value of the income from creating demand deposits should be regarded, in part, as a component of net private wealth. This conclusion in turn raises an important question as to whether the conventional specification of the economically relevant wealth equation for theoretical as well as empirical studies is a proper one, and if it is not, how it should be modified.18

Net private (nonhuman) wealth (W) is generally defined as the sum of outside money and the market values of interest-bearing government debt and of the existing stock of physical capital:

W = PK + Mo + B,

where P = price level; K = real stock of capital; Mo = outside money; B = supply of government bonds.19

The market value of real assets or equities (V) has been defined, for instance, as

V=100(YcdRd),

where Ycd = corporate dividend payments; Rd = dividend/price ratio on common stock (percentage).20

On the other hand, Pesek and Saving define real nonhuman wealth for the purpose of general analysis as

W=MP+ynrn+grg,

where M = nominal quantity of money (narrow definition of currency plus demand deposits); P = price level; yn = real nonhuman income; g = real nonhuman income yielded by government securities; rn = capitalization rate applicable to real nonhuman income; rg = capitalization rate applicable to real government interest payments.21

Brunner and Meltzer, following Pesek and Saving’s reasoning, also explicitly introduce the net worth of the commercial banking sector into their definition of nonhuman wealth:

W = PK + B + (1 + σ)Mo,

where σ = the banking system’s net worth multiplier; σMo = the net worth contribution of the banking sector, or the capitalized value of net earnings of the banking system.22

The basic difference between the definition of Pesek and Saving (or of Brunner and Meltzer) and the conventional one is, of course, that the former includes demand deposits (in whole or in part) as a component of net private wealth whereas the latter does not. At first sight, it may appear that the appropriate definition of wealth is the specification of either Pesek and Saving or Brunner and Meltzer. But that is not so. It was pointed out that any increase in the net worth of the banking sector would, ceteris paribus, lead to a corresponding increase in the net worth of the nonbanking private sector in the form of an increase in the market value of bank stocks. This means that the value of demand deposits in Pesek and Saving’s definition, or the net worth contribution of the banking sector (σMo) in Brunner and Meltzer’s is already included in the market value of equities (PK, V, or Yn/rn) to the extent that demand deposits (in whole or in part) are part of net wealth; adding the net worth of the banking sector to the market value of equities amounts to a double counting of the market value of commercial bank stocks. For this reason, the wealth definitions of Pesek and Saving and of Brunner and Meltzer should probably be rejected. One might then conclude that the conventional definition of net wealth is economically appropriate regardless of the validity of Pesek and Saving’s thesis and that the direct wealth effect of monetary policy implied by their analysis has been accounted for in traditional analysis without being explicitly recognized.

Credit rationing

Keynesian income/expenditure models assume a well-functioning competitive capital market in which desired investments are equilibrated to desired savings through the mechanism of the interest rate. In these models there exists a single short-run equilibrium rate of interest that simultaneously measures the rate of return to lenders, the cost of borrowings, the internal marginal rate of return from investments, and the opportunity cost of holding money. No one would question that the assumption of perfectly competitive capital markets is unrealistic; in reality, capital markets are not well functioning and the price allocation mechanism may not work. It is, however, the proposition of the credit rationing channel that the Keynesian view of the transmission process of monetary policy and its consequences may have to be modified when market imperfections in capital markets are properly taken into consideration.

The most widely accepted view of the credit rationing channel appears to be the following proposition: under imperfect capital markets, interest rates charged to borrowers by financial intermediaries, including commercial banks, are controlled by institutional forces, not by market forces, and tend not to change even when there is a change in the demand for funds, so that lenders ration the available supply of credit (by various nonprice terms). Accordingly, the demand for credit is limited “not by the borrowers’ willingness to borrow at the given rate but by the lenders’ willingness to lend—or, more precisely, by the funds available to them to be rationed out among the would-be borrowers.” 23 Under these circumstances the single short-run equilibrium rate of interest in the perfect capital market framework is replaced by a plurality of rates—one for the lending units (depositors) and another for the rationed borrowers. This proposition implies that monetary policy could affect total expenditures directly by changing the degree of credit rationing and consequently the volume of lending, even if monetary controls did not change interest rates appreciably or if aggregate demand was interest inelastic. It also implies that insofar as “sticky” lending rates prevail, monetary policy would be less effective if it were geared to control the power of banks to create money rather than the actual money supply.24

While the credit rationing phenomenon has been well known, it has proved to be rather difficult to deal with effectively in macroeconomic analyses. One difficulty is that what is observed as credit availability is actually only a temporary disequilibrium situation in the capital market, one that may cause changes in interest rates in other parts of the capital market to levels that will eventually clear the market. Another difficulty is the empirical problem of measuring and identifying the degree of credit rationing. In most cases the specific details of credit rationing are not observable or recorded, so that indirect—often unsatisfactory—means must be used to represent credit rationing.

Portfolio balance approach

A more fundamental and basic development in monetary theory subsequent to Keynes’ liquidity preference theory has been the capital theoretic formulation of the demand for money. This analysis emphasizes money as an asset that can be compared with other real as well as financial assets; its emphasis is on what is called portfolio balance. The analysis of portfolio and balance sheet adjustments has been extended beyond the Keynesian two-asset (money and bonds) models to include various financial and real assets other than bonds and has been integrated with varying degrees of complexity into the Keynesian income/expenditure framework.

The portfolio approach to monetary theory involves a new view of how the influence of monetary policy is transmitted to the real economy. The general view that has been emerging from the writings of both neo-Keynesians and monetarists stresses the impact of monetary policy changes on the composition of assets held by the public and the influence of these changes on interest rates on these assets and ultimately on the rate of return from investing in the production of new physical assets. In the portfolio view, the impact on the real sector of an initial monetary disturbance is the result of changing relative prices among a wide array of financial and real assets. An increase in the supply of money, following an open market purchase of government securities, results in excessive holdings of money relative to other forms of wealth. Holders of wealth will be induced to exchange these excessive balances for other assets, which will in turn raise asset prices and lower rates of return across the board. As a result, an increase in the supply of money may eventually stimulate new investment in many directions.

This broad description of the transmission mechanism appears to be acceptable to both monetarists and nonmonetarists. There is, however, considerable disagreement as to the major variables and interest rates that must be defined in order to take account of all the ways in which monetary policy works out its effects. In what follows, focusing on this aspect, we will review and compare the views of nonmonetarists and monetarists on the transmission process of monetary policy.

II. The Nonmonetarist View

Neo-Keynesian analysis: the Yale school view

It is always misleading to classify economists, who do not necessarily have common views about the subject matter concerned, under a single label as we do in this paper. It should be understood that the nomenclature is introduced solely for the convenience and clarity of exposition. Some economists whom we consider neo-Keynesians could take substantially different positions on particular issues. With this risk in mind, we summarize what appear to be the major arguments and findings of neo-Keynesians, or the Yale school.

(1) Neo-Keynesians consider that the stock of money, conventionally defined, is not an exogenous variable completely controlled by the monetary authorities but is partly an endogenous quantity that reflects the economic behavior of financial intermediaries and nonfinancial private economic units.25

(2) The sharp traditional distinctions between money and other assets and between commercial banks and other financial intermediaries are not warranted. Instead, monetary analysis should

focus on demands for supplies of the whole spectrum of assets rather than on the quantity and velocity of “money”; and to regard the structure of interest rates, asset yields, and credit availability rather than the quantity of money [or the rate of interest] as the linkage between monetary and financial institutions and policies on the one hand and the real economy on the other.26

This argument has been known as the New View, a view that clearly is related to, if not similar to, the Radcliffe Committee’s position some years ago. In fact, Johnson claims that the Yale school has provided the intellectual foundations of the Radcliffe position on monetary theory and policy.27

(3) Proposition (2) implies that the crucial distinction in a neo-Keynesian framework is between the financial sector and the real sector rather than between the banking system and the rest of the economy or between liquid and illiquid assets. The construction of the financial sector reflects the theory of portfolio management by economic units. The theory takes as its subject matter stocks of assets and debts, and their framework is the balance sheet; the decision variables in this sector are stocks.28 The real sector deals with flows of income, saving, expenditures, and the production of goods and services. Its accounting framework is the income statement, and the decision variables are flows. The two sectors are linked by “accounting identities—e.g., increase in net worth equals saving plus capital appreciation—and by technological and financial stock-flow relations.” 29 This, together with proposition (2), implies a rather complicated relationship between the two sectors in the linkage sequence. Some attempts have been made to synthesize the two sectors with varying degrees of simplification, but none of them seems satisfactory. Considering the emphasis on and the amount of attention paid to the building and analyzing of the interactions within the financial sector, it is indeed surprising to find that there has been no satisfactory attempt to bridge the gap. In our discussion we will consider perhaps the most widely accepted of these attempts, the synthesis developed by Brainard and Tobin.30

(4) While there is still considerable debate on the link between the real and financial sectors, there appears to be a consensus among neo-Keynesians that monetary policy operates through changes in the market price of equities that represent claims on existing real assets, such as plant and equipment.31 The prime indicator of stance and the proper target of monetary policy is thus “the required rate of return on capital,” or the equity yield. “Nothing else, whether it is the quantity of ‘money’ or some financial interest rate, can be more than an imperfect and derivative indicator of the effective thrust of monetary events and policies.” 32 In a neo-Keynesian framework, an expansionary monetary policy, for example, raises the price of equities (that is, reduces the yield on equities), thereby generating a positive discrepancy between the valuation of real assets on these markets (the price of equities) and their costs of production. The discrepancy provides an incentive to expand production of these capital goods. Suppose that the existing plant and equipment of a corporation that could be reproduced for $1 million is valued at $2 million in the stock market. This margin between the market valuation and the cost of reproducing the existing capital goods will then stimulate new investment in these goods.33 On this reasoning, the stock market plays a significant role in influencing economic activity, and indeed changes in the Dow-Jones averages give some measure of the stance of monetary policy.34

The most serious criticism that may be made of the neo-Keynesian analysis is that despite the very complex financial sector, incorporating detailed specifications of asset preferences, its transmission mechanism remains naïve and simple. The synthesis by Brainard and Tobin assumes that the equity rate is the major link between money and the level of economic activity. Compared with the Keynesian transmission process, this simply involves replacing the rates of interest on financial assets by the equity yield—a yield that is now taken to represent the influence of monetary forces. Also, neo-Keynesians appear to ignore the relative importance of borrowing costs and, hence, the importance of debt financing in business firms.

The Neo-Fisherian view

All the major empirical studies have found that the demand for money and velocity are responsive to interest rates, although the choice of rates between short-term and long-term is not clear cut. However, neither Keynes’ speculative motive of holding money nor Tobin’s portfolio selection theory provides a rational explanation of the nonzero interest elasticity of the demand for money in an economy where there exist short-term securities—such as time deposits, savings and loan shares, treasury bills, high-grade commercial paper, and negotiable certificates of deposit for large investors—that dominate money. When these assets are readily available, the public—faced, for example, with a low current rate of interest and an expectation of capital losses owing to an expected rise in the current rate of interest—will be induced to shift from long-term to short-term securities, but not to money. This is so because these short-term assets possess the same properties as money—near perfect liquidity and no risk of default—while yielding a positive rate of return.35

Given these short-term securities, changes in the current rate of interest and expectation of capital gains or losses no longer explain the substitution between long-term securities and money but the substitution between long-term and short-term securities.36 Therefore, the only plausible theory of the demand for money that is consistent with the existing empirical evidence seems to be the transactions cost approach of the demand for money, developed by Baumol and Tobin.37 The basic hypothesis of this approach, which has been labeled as neo-Fisherian, is that “the demand for money is basically related to the flow of transactions and arises from a lack of synchronization between receipts and payments, coupled with the transactions costs involved in exchanging money for short-term assets.” 38 This hypothesis implies that (i) the wealth variable does not appear in the demand for money function, since money is held primarily to facilitate transactions and that (ii) the demand for money is sensitive to short-term interest rates.

The financial sector of the Federal Reserve-MIT econometric model embodies the neo-Fisherian hypothesis.39 In the financial sector of the model the reciprocal of velocity (the Cambridge K) is related to the rates of interest on short-term assets relative to transactions costs. Assuming no significant variation in transactions costs, the demand for money is then expressed as Md = K(i)Y, where i = a set of available rates of return on short-term assets, Y = nominal gross national product (GNP), and M is narrow money.40

Within the neo-Fisherian framework, changes in the quantity of money have their direct impact on short-term interest rates.41 Through the process of portfolio substitutions, changes in short-term interest rates affect in turn the long-term interest rates, equity yields, and possibly other rates of return on real assets.42 Changes in these variables then influence aggregate demand for goods and services. This transmission process indicates that the full effect of monetary policy is subject to a considerable lag, because it takes time for changes in monetary policy to be reflected in long-term interest rates and equity yields and also requires additional delay for this rate change to be reflected in various components of aggregate demand.43

III. The Monetarist View

The theoretical framework used by nonmonetarists to explain how monetary and fiscal policies affect economic activity is a variant of the Keynesian income/expenditure model. While nonmonetarists are rather explicit in their theoretical argument, monetarists have not been very precise in providing a convincing explanation of how money affects the economy and how changes in the supply of money could have markedly more potent and direct effects than changes in fiscal variables. Instead, their argument seems to be based on several kinds of empirical evidence, the most widely publicized being the findings of the reduced form equation studies. These studies relate changes in GNP to the simultaneous and lagged changes in the supply of money and a budget variable or autonomous expenditures.

In this section we will discuss the views of Friedman, Brunner and Meltzer, and other monetarists. The general view that emerges from the writings of these monetarists is that “changes in the money stock are a primary determinant of changes in total spending, and should thereby be given major emphasis in economic stabilization programs.” 44 In addition to this, monetarists emphasize the following three points: (1) The monetary authorities can dominate movements in the stock of money over time and over business cycles. (2) Movements in the quantity of money are the most reliable measure of the thrust of monetary impulses. (3) Monetary impulses are transmitted to the real economy through a relative price process (portfolio adjustment process), which operates on a vast array of financial and real assets.45

Friedman: the monetary theory of nominal income

Professor Milton Friedman, as the chief architect of the monetarist view, is responsible for the intellectual revival of the quantity theory in the postwar period—a revival that has for some years provoked a good deal of commentary and critical interpretation. Much of this controversy has been attributed to his failure to make explicit the theoretical framework that encompasses his views on the role of money. In two recent articles,46 he has responded to this criticism, but it is not clear to what extent he has succeeded in answering his critics.47

Friedman’s theoretical framework in the most recent expression of his views is a Keynesian income/expenditure model, which, he claims, is acceptable to both monetarists and nonmonetarists.48

The model is given as follows:

CP=f(Yp,r)(1)
IP=g(r)(2)
YP=CP+IP(3)
Md=PL(YP,r)(4)
Ms=h(r)(5)
Md=Ms(6)

where Y = money income; C = consumption; I = investment; r = the rate of interest; P = the price level; Ms = supply of money; Md = demand for money.

Equations (1)-(3) describe the real sector of the economy, while equations (4)-(6) outline the monetary sector. In this model, real consumption expenditure is explained by real income and the interest rate (equation 1) and real investment is explained by the interest rate (equation 2). Equation (3) is the equilibrium condition in the commodity market, or the income identity. Real money balances are a function of real income and the rate of interest (equation 4), while the nominal supply of money is assumed to be an increasing function of the interest rate (equation 5). The equilibrium condition in the money market is given by equation (6).

The model consists of six independent equations with seven endogenous variables (C, I, Y, P, Md, Ms, r), so that the system of equations cannot determine simultaneously the solution values of these variables. One of these variables must be determined exogenously by relationships outside the system. Friedman discusses three different ways of solving the system that correspond to three different macroeconomic theories. The first two methods are well known in the literature; they are the income/expenditure theory and the quantity theory approach. The difference between the two theories is the condition that is added to make the model determine the solution values of the seven endogenous variables. The Keynesian income/expenditure theory assumes that the general level of prices is determined outside the system—the Keynesian assumption of price or wage rigidity (P = Po). Given this assumption, the system of equations determines simultaneously the solution for the level of income and the rate of interest, as usually described in the familiar Hicksian IS/LM apparatus.49 The quantity theory approach, on the other hand, assumes that real income is determined outside the system—the classical assumption of full employment. This assumption allows a dichotomy of the system into the real and monetary sectors, with the result that the demand for and supply of money functions determine the price level.50 Friedman takes the view that the quantity theory model is valid for long-run equilibrium, so that, in the long run, variations in the rate of change in the quantity of money will change only the rate of inflation and not growth of real output.51

According to Friedman, neither the quantity theory nor the income/expenditure theory model is satisfactory as a framework for short-run analysis. This is so, Friedman claims, mainly because neither theory can explain “(a) the short-run division of a change in nominal income between prices and output, (b) the short-run adjustment of nominal income to a change in autonomous variables, and (c) the transition between this short-run situation and a long-run equilibrium described essentially by the quantity-theory model.” 52

The third alternative way to determine the system of equations is given by the monetary theory of nominal income—a theory that, Friedman claims, is superior to either the income/expenditure or the quantity theory as an approach to closing the system for the purpose of analyzing short-period changes. This third approach synthesizes Irving Fisher’s ideas on the nominal and real interest rates and Keynes’ view that the current market rate of interest (long-term) is determined largely by the rate that is expected to prevail over a long period. The Keynes and Fisher synthesis is then integrated into a quantity theory model together with the empirical assumption (i) that the real income elasticity of the demand for money is unity and (ii) that a difference between the anticipated real interest rate and the anticipated growth rate of real income is determined outside the system.53 The result is a monetary model in which current income is related to current and prior nominal quantities of money.

The monetary model may be described as follows: 54

The monetary sector

Given the assumption of unitary real income elasticity of the demand for money, equation (4) can be rewritten as

Md=F(r)Y(4)

In order to simplify the exposition of the model, let us assume that the supply of money is determined exogenously:

Ms=M(5)

Then equations (4)′, (5)′, and equilibrium conditions (6) yield

M=F(r)Y(7)

Equation (7) can be written as

Y=1F(r)M=H(r)M(8)

The Fisherian distinction between the nominal and real rate of interest is given by the following identity:

r=q+(1pdpdt)(9)55

where q = the real rate of interest; (1pdpdt)= the rate of change of the price level.

From equation (9), it also follows that

r*=q*+(1pdpdt)*,(10)

where the variables with an asterisk refer to anticipated (or expected) values.

Following Keynes’ argument that market rates of interest are determined largely by speculators with firmly held expectations, Friedman assumes that

r=r*.(11)56

From the identity, Y = yp, it follows that

(1pdpdt)*=(1YdYdt)*(1ydydt)*(12)

Combining equations (10), (11), and (12) we obtain

r=q*g*+(1YdYdt)*,(13)

where g*=(1ydydt)*= the anticipated rate of growth of real income.

Substitution of equation (13) into (8) yields

Y=H[q*g*+(1YdYdt)*]M(14)

Equation (14) states that the level of income Y is determined by q*, g*, (1YdYdt)*, and M. Friedman assumes that the difference between q* and g* is a constant. In a static framework, the expected rate of growth of nominal income (1YdYdt)* may be treated as a predetermined variable. Then equation (14) determines the level of nominal income for a given supply of money without any reference to the real sector of the model.57 In a dynamic framework, however, it would be natural to regard (1YdYdt)* as determined by the past history of nominal income. Since the past history of nominal income is in turn a function of the past history of money as implied by equation (8) for earlier dates, equation (14) becomes a relation between the level of nominal income at each point in time and the past history of the quantity of money.

This dynamic character of the model may be better understood by analyzing an example given by Friedman. Take the logarithm of equation (14) and differentiate with respect to time.

This gives

1YdYdt=sddt(1YdYdt)*+1MdMdt,(15)

where s=1HdHdr= the slope of the regression of log H on the rate of interest.

Suppose that the expected rate of growth of nominal income is determined by an adaptive expectation process:

ddt(1YdYdt)*=β[1YdYdt(1YdYdt)*](16)58

Substituting equation (16) into equation (15) and solving for (1YdYdt), we have

1YdYdt=(1YdYdt)*+1(1βs)[1MdMdt(1YdYdt)*](17)

When

(1YdYdt)*=1MdMdt, equation (17) gives the quantity theory result that nominal income changes at the same rate as money supply.

Friedman states that his monetary model of nominal income corresponds to the broader framework implicit in much of the theoretical and empirical work that he and others have done in analyzing monetary experience in the short run and is consistent with many of their empirical findings.59

However, Friedman’s model sheds little light on his view concerning the precise mechanism through which changes in the quantity of money affect income. This is so because the model is designed primarily for empirical analysis of the relation between money and income. What this model reflects is rather his view on the appropriate empirical approach to evaluating the role of money—a view that is in sharp contrast to the more common one held by nonmonetarists. Contrary to the impression that one might gather from his model—possibly a rigid and mechanical connection between money and income—his view on the transmission mechanism in a conceptual framework is a complicated portfolio adjustment process that involves many uncertain channels and impinges on a wide array of assets and expenditures. The process 60 following an exogenous change in the supply of money begins with changes in the prices and yields of financial assets and spreads to nonfinancial assets. These changes in the prices of financial and nonfinancial assets influence spending to produce new assets and spending on current services. At the same time, these changes alter real wealth of the public relative to income and thereby affect consumption. This is, in a simple fashion, the way in which the initial impulse is diffused from the financial markets to the markets for goods and services. The exposition stresses portfolio adjustment and is strikingly similar to that described by many economists.

The transmission process is also essentially consistent with the Keynesian liquidity preference doctrine as to how money affects income. As in the income/expenditure theory, interest rates play a key role. This being so, it has been pointed out that Friedman cannot be saying anything different from Keynes 61 and that there is no clear reason why one should look at money supply as a target as Friedman insists rather than at interest rates directly.62 However, these criticisms miss the fundamental points of Friedman’s view. The difference between Friedman and the nonmonetarists concerning the transmission process is not whether changes in the supply of money operate through interest rates but rather (i) the range of interest rates considered and (ii) the empirical approach to estimating the actual influence of monetary policy. Friedman argues that the impact of monetary policy is likely to be understated in magnitude and narrowed in scope in the Keynesian income/expenditure theory. One reason is that, since monetary policy impinges on a broad range of capital assets and a correspondingly broad range of associated expenditures, the Keynesian practice of looking only at recorded market interest rates, which are only part of a much broader spectrum of rates, makes one underestimate the actual impact of monetary policy. The rates of interest that influence investment decisions are for the most part implicit yields and hence not observable, so that one cannot hope to obtain useful results by looking at relations between market interest rates and the categories of spending associated with these rates. Also, recorded market interest rates may not provide an appropriate measure of the cost of capital, since these interest rates are not real rates of interest that reflect the basic forces of productivity but nominal rates that are influenced by the expected rate of inflation. Moreover, monetary influences may work through channels that we have not been able to identify. In fact, it may not be possible to trace through any particular channel, as monetary policy operates through an extremely complicated process of portfolio adjustments.

For all these reasons, Friedman considers that even the most complex structure of a general equilibrium model cannot be expected to capture actual monetary influences adequately. A more reliable empirical approach would be to pursue the methodology of positive economies, the essence of which is to select the crucial and simple theoretical relationships that allow one to predict something large (such as GNP) from something small (for instance, the supply of money), regardless of the intervening chain of causation. One such relationship is claimed to be the velocity function relating income to money, which is the essence of the quantity theory; another is the multiplier relationship relating income to autonomous expenditure, which is the essence of the income/expenditure theory.63

Friedman argues that the velocity function (that is, the relationship between money and nominal income) has been shown, on average, to be more stable and less affected by institutional and historical change than the multiplier relationship and that, consequently, the velocity function may be the key relationship in understanding macroeconomic developments.64 It then follows that a much more promising approach to the question of evaluating the effects of monetary policy on the economy is to try to relate changes in income directly to changes in the quantity of money. Friedman’s monetary model of nominal income seems to reflect this point of view.

Friedman’s view, however, raises two important issues. One issue is concerned with the conditions under which one could derive a simple relationship between income and money. It has been argued frequently that Friedman’s view is valid only if the demand for money is not significantly influenced by the rate of interest. As indicated earlier, Friedman now states clearly and repeatedly that the rate of interest is an important determinant of the demand for money. If indeed the demand for money depends on the rate of interest, then one cannot—critics of Friedman argue—hope to find such a simple relationship between money and income, unless one specifies an independent theory of the determination of the rate of interest.

The Keynes and Fisher synthesis that Friedman incorporates into his monetary model appears to be one such independent theory. It is an independent theory in the sense that the determination of the nominal rate of interest depends on relationships outside the system of six equations. According to Friedman’s monetary model, the rate of interest is determined solely by the anticipated rate of growth of money income (1YdYdt) *, given the assumptions that r = r* and that q* – g* = ko. While these assumptions are crucial to a model that allows one to relate current money income directly to current and prior quantities of money, it should be realized that they are also responsible for several defects of the model. One serious defect is that the model rules out liquidity or substitution effects of a change in the quantity of money on the interest rate.

In Friedman’s monetary model, a change in the rate of change of money supply (1MdMdt) directly affects the rate of growth of nominal income (1YdYdt) (see equation 17) with little direct effect on change in the interest rates, that is, the change does not initially produce the liquidity effect but immediately produces an income effect. The change in 1YdYdt then causes a change in the expected rate of growth of nominal income (1YdYdt) * (equation 16) which in turn influences the nominal rate of interest (equation 13). In other words, the change in the rate of change in money supply affects market rates of interest only as it influences the courses of current and expected nominal income and, in consequence, the expected rate of inflation. This process does not appear to be supported by the existing empirical evidence on the effects of changes in money supply on the interest rates and income.65 Nor does it seem to be consistent with Friedman’s own earlier exposition on the transmission mechanism of monetary policy, in which he argues that a change in the supply of money has its first impact on the financial markets and much later on the market for goods and services.66

However, the failure of the model to explain the liquidity effect is clearly not a point of disagreement with Friedman, for he admits that the model neglects the effects of changes in the nominal quantity of money on interest rates.67 Yet, it is not clear to what extent he appreciates the analytical significance of relaxing either of his two critical assumptions to permit a strong liquidity effect in the model. Relaxation of these assumptions would mean that Friedman’s model would be modified in such a way that the rate of interest is determined within the model through the interaction of demand for and supply of money together with other behavioral relationships in the real sector of the economy. Such a modification would then suggest that one may not utilize velocity to derive a simple relation between money income and the quantity of money.

The other issue that Friedman’s monetary model raises is whether the methodology of positive economics embodied in the model is a scientifically acceptable method. The general consensus seems to be that the methodology is seriously inadequate. We shall return to this topic in some detail in the final section of this paper.

Brunner and Meltzer

The transmission process described by Brunner and Meltzer is basically a process of portfolio (balance sheet) adjustment, which is, on a general level of discussion, shared by both neo-Keynesians and other monetarists.68 The difference between Brunner and Meltzer and other economists, if any, may be found in the different degrees of emphasis on the importance of real capital in the mechanism. Brunner and Meltzer point out that the analysis of portfolio balance reveals that changes in the level of output emerge fundamentally from this balance sheet adjustment, particularly in response to the public’s decision to adjust its real capital holdings. In order, then, to capture the total effects of monetary policy changes, it is necessary to specify the appropriate stock/flow relationship centered on real capital goods, since changes in the asset price of real capital relative to its output price form a crucial linkage in the transmission process. Accordingly, they distinguish four classes of output—output for real consumption and for Types I, II, and III of capital goods—and also consider various financial assets together with the stocks of real capital disaggregated into the three types.

Type I capital goods are those that have separate market prices for equity claims on existing stock and for new output. (Examples under this category would be machinery, plant, and equipment.)69 Type II capital goods have a single price for existing assets and new output of comparable quality (housing and automobiles); Type III has a price for new output only, and there is no market for existing assets or claims to them (consumer durables, such as washing machines). Corresponding to these different types of capital goods are different paths through which monetary policy can affect the real economy. An increase in the supply of money, for example, will, through portfolio substitutions, lead to an overall increase in the asset prices of all these types of real capital goods. The increase in the equity price for Type I real capital relative to its output price accelerates the actual rate of accumulation of this type of capital goods.70 The increase in the asset price of Type II capital, ceteris paribus, stimulates the production of Type II capital goods. Furthermore, the rise in the asset prices of real capital and the fall in the rates of return on financial assets result in an increase in the market value of public wealth, which, in turn, raises the desired stock of Type III capital and consumption expenditure. The total effects of the expansionary monetary policy will then be the sum of these influences.71

The income/expenditure theory as represented by the conventional IS/LM framework, in Brunner and Meltzer’s view, fails to accommodate the public’s stock/flow behavior bearing on its real capital position, which they consider crucial in the transmission process. Because of this failure, Brunner and Meltzer argue that the Keynesian approach of relating investment expenditure to interest rates in some financial assets as a measure of the costs of borrowing—supplemented by the wealth effect—can hardly capture the actual impact of monetary policy and that, thus, the Keynesian approach should be rejected.

A more satisfactory approach that would be consistent with Brunner and Meltzer’s view would require a structural model of general equilibrium—a model that specifies the whole spectrum of real and financial assets and the explicit relations between the production of new real capital goods and the existing ones. In a recent unpublished paper,72 Brunner and Meltzer attempt to construct such a model. However, in formulating the model they choose to ignore entirely the markets for Types II and III of real capital goods and focus on the market for Type I real capital, the equity market. The result of this modification, or simplification, of their view is a model that is, in all important aspects, analogous to the neo-Keynesian model discussed in the Appendix.

Therefore, the model suggests that Brunner and Meltzer—contrary to their claim—accept the Keynesian view on the nature of the transmission process; what they seem to reject is the heuristic simplification of reality with regard to the range of assets considered in the Keynesian income/expenditure theory.

Other monetarists

Some monetarists indicate that changes in monetary policy variables may operate through some direct channels that have not been explicitly taken into consideration in the income/expenditure theory, and suggest that these channels may account, to some extent, for the powerful impact of monetary policy that has been shown in some empirical studies. The possible direct channels that have been mentioned in the literature include (i) the direct substitution relationship between money and real assets and (ii) the financial constraint effect. We will show that the first channel is not direct at all and that the second channel is probably no more than some version of the credit rationing channel.

Direct substitutability between money and real assets: the Fisherian view

As was pointed out in Section I, in Keynesian income/expenditure models, real capital goods do not appear as an asset in the portfolio because they are assumed to be a perfect substitute for long-term bonds. Owing to this assumption, the direct substitution relationship between money and real capital as opposed to the same relationship between money and bonds is not explicitly recognized. Several economists seem to misinterpret this Keynesian position as implying that money is a direct substitute for only financial assets, such as bonds, but not for real assets. A reaction to this misinterpretation has in turn led to the recent argument that money is a good (close) substitute not only for bonds but also for real assets and that, consequently, monetary policy operates “directly” in a framework in which real assets are explicitly introduced along with other assets. This argument is said to represent the monetarist view 73 or to be associated with the ideas of Irving Fisher and other classical economists.74 For the lack of better terms, we will call this argument the Fisherian view.

Although it seems doubtful, money may indeed be a good substitute for real capital goods. However, the basic question is whether this assumption leads to the conclusion that a change in the quantity of money affects real spending directly or not. In fact, it will be shown that the substitution relationship between money and real assets has no relevance whatsoever to the question of whether monetary policy works directly or indirectly. In order to show this and to elaborate further on the Fisherian view, we will begin our discussion by quoting three authors who support this view.

The monetary view assumes that money (or liquidity) is a direct (and good) substitute for real assets.75 Since money is held primarily as a temporary abode of purchasing power it is quite reasonable to expect an OMO [open market operation] to affect spending on real goods, directly. In other words, since money is a good substitute for real assets, the increased volume of money in the portfolio will be spent on goods and services.76

Monetarists favor a transmission mechanism in which an increase in money may directly affect expenditures, prices, and implicit yields on physical asets. They suggest that money may be substituted not only for bonds but also for other assets, and that individuals may re-establish portfolio equilibrium by purchasing either a financial or a physical asset.77

In contrast to Keynes, Fisher believed that close substitution occurred between money and real capital, so that people in a Fisherian model respond to an increase in the supply of money by purchasing real commodities.78 In the Fisherian model, with close substitution between money and real capital, people respond to the increase in the supply of money by purchasing goods.79

All these assertions assume a high degree of substitutability between money and real assets. Given this assumption, it is then argued that changes in the supply of money,80 through the process of portfolio substitutions, directly affect spending on real assets (or real goods or real commodities). However, it is not clear whether these economists mean that changes in the quantity of money directly affect (i) “flows” of real expenditures on goods and services (the flow of consumption and investment expenditures, namely, the flow of aggregate demand) or (ii) spending on “stocks” of secondhand real capital goods, such as plants, equipment, machinery, and houses. If they mean the former, (i), the argument is simply incorrect. If they mean the latter, (ii), the argument is no more than an explanation of the initial effect of changes in the quantity of money on balance sheets, namely, the substitution effect. The argument has nothing to say about how the initial substitution effect is translated into an effect on the income account—the essential aspect of the transmission process of monetary policy. It will be also shown that, regardless of whether the Fisherian view refers to (i) or (ii), the assumption most relevant to the argument is not whether money is a good substitute for real assets but whether any asset that the monetary authority deals with in the open market is a close substitute for real assets.

To substantiate these points, let us consider an open market purchase of government bills by the monetary authority. The immediate consequence of this operation is that owners of wealth are willing to hold more money relative to other assets in their portfolios because of their adjustment to the fact that the bill rate has been reduced. However, at this stage the interest rates on other assets have not been reduced. They will seek to correct this disequilibrium situation by converting money into other financial and real assets and so will tend to raise the prices of real assets and to reduce interest rates on financial assets. Unless the open market operation simultaneously changes the public’s net worth or its income—which it does not—the initial effect of the operation is not on income at all, but on the prices of existing assets. This effect, the substitution effect, is then subsequently transmitted to the real sector, and only at this stage are the levels of income and employment affected. On this transmission process of the substitution effect, the Fisherian view has little to say. Neither the explicit treatment of real assets in the public’s portfolio nor the degree of substitutability between money and real assets alters the nature of this process, although both factors may have different quantitative implications for the impact of monetary policy. Specifically, the introduction of real assets into the public’s portfolio suggests that the substitution effect of the open market operations may affect the implicit rates of return on physical assets, including consumer durables, and need not be restricted to a set of conventional interest rates on financial assets as in Keynesian income/expenditure models. A more adequate treatment of these yields in the specification of the consumption and investment functions may show that the influence of monetary impulses on the level of economic activity could be stronger and more rapid than has been found in the past empirical studies.

The Fisherian view could, of course, be interpreted as meaning that changes in money supply directly affect spending on “stocks” of real assets, not the “flows” of goods and services. Even in this case it is ambiguous whether the assumption of a high degree of substitutability between money and real assets has any particular bearing on the conclusion. When the monetary authority purchases treasury bills in the open market, it is making more funds available for the public to purchase a wide variety of financial and real assets. The pertinent question to ask in this regard would then be which asset (or assets) the public will “first” turn to. The presumption is that they would attempt to acquire first the assets comparable to those that they have sold to the monetary authority, namely, the assets that are close substitutes for treasury bills, not for money. This means that owners of wealth will purchase real assets first, if they regard bills as better substitutes for real assets than for other marketable financial assets, such as government and private bonds.

In the opposite situation, they would react to the operation by acquiring various financial assets rather than real assets and only when, or if, the prices of these financial assets have gone up sufficiently would they turn to equities, real property, and other capital goods. This means that if bills and real assets were poor substitutes for each other, the substitution effect of the open market operation on the demand for real assets, ceteris paribus, could be negligible, and hence a statement such as “people trade money directly for real capital goods” would lose much of its significance. The discussion so far suggests that the crucial factor in the Fisherian view is not, ceteris paribus, the substitution relationship between money and real assets but that between bills (or any assets that the monetary authority deals with in the open market) and other assets that are not money. Indeed, if money and real assets were very good substitutes for each other, the public would have less inducement to acquire real assets as a result of an open market operation. This is so because the public considers real assets to be similar to money, which is abundant relative to other assets in their portfolios, and, hence, less attractive candidates for portfolio diversifications; that is, for reducing the overall risk of the portfolio.

The Fisherian view—the second interpretation—also seems to suggest that the initial increase in money supply following the open market operation leads immediately to an increased demand for real assets and that, then, the interest elasticity of the demand for real assets is irrelevant.81 This argument would appear to be incorrect. The open market purchase of bills initially reduces the rate of interest on bills, otherwise the public would not be satisfied with the new portfolio composition. The reduction in the bill rate, ceteris paribus, will increase the demand for alternative financial and real assets. In these conditions, if the public responds to the lower bill rate by purchasing real assets instead of other financial assets, it must mean that the demand for real assets is not only elastic to changes in the bill rate but also much more sensitive to the bill rate than is the demand for financial assets other than treasury bills.82 This is, of course, another way of saying that treasury bills are better substitutes for real assets than for financial assets.

On the question of substitutability between all types of asset, there seem to be two opposing views. Tobin argues that all categories of government debt (money, treasury bills, long-term bonds, etc.) are good substitutes for one another, since their risk characteristics are quite similar, but they are poor substitutes for equities and other real capital goods because the risks associated with these two types of asset are substantially independent.83 This view suggests that open market operations may not be powerful stabilization weapons, since relatively larger changes in interest rates are required to produce any given change in equity yields.

Friedman and Meiselman take the view that money is a temporary abode of purchasing power, which makes it a poor substitute for both real and financial assets. However, they argue that there is a high degree of substitutability among various financial and real assets.84 If the Friedman and Meiselman view were correct, we would expect a stronger impact of changes in money supply than Tobin would claim.

The financial constraint: the crowding-out effect

A group of economists at the Federal Reserve Bank of St. Louis has for some time been engaged in the estimation of reduced form equations to evaluate the impact of money on economic activity. They estimate the response of GNP to monetary and fiscal actions by statistically relating GNP to a set of exogenous variables, such as the supply of narrow money (or the monetary base) and high-employment federal government expenditures and receipts.85 The response of GNP to monetary actions was stronger, quicker, and more reliable than its response to fiscal actions. Their results would be more convincing if they could provide some explanation of how such actions affect total spending. They suggest that the reduced form equations they tested are potentially consistent with both Keynesian and quantity theory models.86 In some of their recent writings, they seem to suggest that the potency of monetary policy comes from its ability to alter the financial constraint of the economy. According to Andersen, Federal Reserve actions influence total spending in two ways. First, its purchases and sales of government securities change the monetary base (high-powered money), which in turn varies the financial constraint of the economy, resulting in an immediate impact on total spending. A further impact results from the induced changes in income, interest rates, and prices, as the economy moves to a new equilibrium level of total spending. But the first impact accounts for a relatively fast response of economic activity to monetary actions.87

The ineffectiveness of fiscal actions is also explained by this constraint. Given the financial constraint, “government spending unaccompanied by accommodative monetary expansion, that is, financed by taxes or borrowing from the public, results in a crowding-out of private expenditures with little, if any, net increase in total spending.”88 According to Andersen, “a financially constrained economy … is one in which a decision to spend more than current income (i.e., borrow) by one economic entity can only be fulfilled by a reduction in the level of spending out of income by another entity.” 89 Without explaining what the financial constraint represents, Andersen goes on to claim that the Federal Reserve System is an economic unit that is capable of varying this constraint through its monetary policy. Further research on this concept will undoubtedly result in a precise definition of the financial constraint. However, it is also clear that even when the term is defined the idea of the constraint has the distinct flavor of the credit rationing channel of post-Keynesians. At this stage, it is then fair to say that the economists at the Federal Reserve Bank of St. Louis do not appear to have developed any new channel of monetary policy that other economists did not recognize.

IV. Concluding Remarks

The main purpose of this paper has been to review divergent views on the transmission process of monetary policy. The review indicates that at the level of general description there appear to be no significant differences in the transmission process of monetary influences among a variety of monetary economists. Both monetarists and nonmonetarists appear to support some version of the portfolio adjustment process as a framework to describe the effects of monetary policy on the real economy. The disagreement between them on this process centers on the range of assets and interest rates that should be considered and the technical relationships involving the stocks of real assets and the flows of real expenditure corresponding to these assets. The range of assets and interest rates considered by nonmonetarists is rather limited, whereas monetarists stress a broad range of assets and the expenditures associated with these assets. Also, both monetarists and nonmonetarists emphasize the wealth effect channel and, in various forms, the credit rationing channel.

From these observations one might conclude that the question of the relative effectiveness of monetary and fiscal policy is essentially an empirical issue, not a theoretical one. Although the issue has evoked a great deal of empirical study in recent years, the controversy still is far from being settled. The evidence from several of the large-scale econometric models—the estimation method favored by nonmonetarists—is that monetary variables are, in general, less important than fiscal variables in influencing aggregate expenditures.90

On the other hand, monetarists have produced an imposing volume of empirical evidence of several kinds in support of their central proposition. One kind of evidence draws on historical case studies, such as the one by Friedman and Schwartz,91 and the experience of a number of countries with easy-money policies that led to inflation after World War II. A second type of evidence is the “statistical stability” of the demand function for money in several industrial countries, notably in the United States. Some monetarists view the demand function for money as the crucial relationship in the understanding of macroeconomic developments. The stability of this function is then presented as evidence in favor of the traditional quantity theory as opposed to the income/expenditure theory, and the function is then used to explain and to predict the level of money income.92 The demand function for money may well be of central importance to economic activity. However, insofar as the money demand is sensitive to interest rates, evidence for which has been demonstrated beyond any reasonable doubt in all of the major empirical studies on the demand function for money, one has to provide a theory of the determination of interest rates along with its interrelationship with a theory of income determination to prove that money indeed matters. A third type of empirical evidence bearing on this question is the reduced form equation studies, which invariably show that the quantity of money is far more significant than various exogenous components of aggregate demand in explaining the movements in money income.

The debate on the reduced form approach, or the direct estimation method, also reflects a sharp disagreement between nonmonetarists and monetarists on the methodological questions of how best to estimate the effects of monetary and fiscal actions on the level of economic activity. As noted above, nonmonetarists favor estimation through large-scale econometric models. Monetarists, however, argue that the channels through which monetary policy operates are so diverse and complicated that it is inherently impossible to identify and to measure them with structural equation models, no matter how detailed they may be. Basically, for this reason, they contend that a more reliable method would be the direct estimation technique whereby final demand variables, such as money GNP, are regressed upon monetary and fiscal variables.

No one would deny the complexity involved in the channels of monetary policy; however, the important questions are whether this complexity justifies the use of the reduced form approach and, if it does, whether the approach is a scientifically acceptable method. Judging by the prevailing standards of academic economics, indeed, the direct estimation approach is seriously inadequate as an empirical methodology.93

One of the most serious weaknesses of the approach is that the structural model from which a reduced form equation is derived may not be consistent internally. The direct estimation approach completely ignores a priori restrictions on the coefficients of the independent variables of the equation, for example, the restrictions that are built into general equilibrium models through identities, lags, omitting variables, etc. Because of the absence of these restrictions, there is no way of knowing whether the structural model is consistent internally.94 If it is not, the reduced form equation is no more than a linear equation relating an “alleged” endogenous variable, such as money GNP, to a set of “alleged” exogenous variables with no meaningful economic causations between the endogenous and exogenous variables.

Another equally damaging weakness is the problem of selecting exogenous monetary and fiscal variables. Depending upon which variable one assumes to be exogenous—monetary base, free reserves, narrow money, or broad money on the monetary side and the various definitions of autonomous expenditures on the fiscal side—one can take a “money mostly” stance, a “fiscal policy mostly” stance, or a “both matter” stance.95

In response to the first defect, some monetarists have begun to extend their efforts in specifying the details of the structural models that underlie the various reduced form equations that they estimate. These models are invariably some version of Keynesian income/expenditure models.96 Therefore, the response may be an open admission that monetarists are increasingly compromising with the Keynesian income/expenditure theory, which they had set out to question. The response also suggests that monetarists are, in compromising with nonmonetarists, burdening themselves with another difficult task, namely, giving a convincing explanation as to why such a great divergence exists in empirical evidence between the reduced form and structural model approaches. A satisfactory answer has yet to come.

In view of these assessments of the monetarist view, it appears that one cannot read too much into the results of various reduced form equation studies. These assessments also suggest that a more promising road toward the settlement of the controversy concerning the relative strengths of fiscal and monetary actions lies in further development and refinement of existing econometric models. In this regard, the monetarist view suggests a number of factors that have been inadequately treated in existing models and that may account partly for the sluggish response of monetary influences in these models.

We may point out two such factors relevant to our subject matter. One possible factor is the failure of existing econometric models to include implicit rates of return on real capital and consumer durables. The other is the failure to distinguish between nominal and real interest rates in some of these models. The rates of interest used in these models are nominal rates that are affected by the expectation on future prices. However, interest rates that are relevant to the consumption and investment functions are clearly the real rates of interest that are relatively unaffected by changes in the level of prices. It has been shown empirically that high nominal interest rates are accompanied by a high rate of increase in money supply—an easy stance of monetary policy—and vice versa.97 This is so because a high growth rate of money supply causes a rise in current prices and then the expectation of future inflation, which ultimately leads to a higher nominal rate of interest. It is, therefore, questionable whether nominal interest rates are meaningful indicators of the monetary posture, except perhaps in the very short run.

When these and other factors 98 are properly taken into consideration, it is quite possible that econometric models may turn up a much sharper and more rapid response of monetary influence than has been shown in the past.

APPENDIX

We will develop a simple neo-Keynesian model99 and utilize it to illustrate the neo-Keynesian view on the transmission process of monetary policy. The model consists of four markets: the real output, money, bond, and equity markets. The price level is assumed to be fixed. The model may be described by the following system of equations:

Output market

1.C=C(i,rk,Y,W)
2.I=hY(rrk),or,alternatively,I=I(i,rk,Y,Ko)
3.Y=C+I

Money market

4.Md=L(i,rk,Y)W
5.Ms=D(i,rk)Mo
6.Md=Ms

Bond market

7.Bd=B(i,rk,Y)W
8.Bs=Bo
9.Bd=Bs

Equity market

10.Vd=V(i,rk,Y)W
11.Vs=πKo
12.Vd=Vs

Definitions

13.π=rrk
14.r=a0+a1YKo
15.W=Mo+Bo+πKo

The notations are

article image

In the output market, the real aggregate demand function is the sum of two components—consumption and investment expenditure. Equation (2) is an investment function that expresses investment as an increasing function of the difference between the marginal product of capital and the equity yield; the investment function implies that the major determinant of real investment is the general level of equity prices relative to the replacement costs of physical assets they represent. Y is used as a scale value. Equation (2) rests on the assumption that firms rely only on equity financing. If we allow firms to borrow to finance their capital, the rate of interest may become an independent determinant of investment and can be introduced into equation (2). The alternative shown in equation (2) reflects this consideration.

The financial sector of the model describes the portfolio behavior of the economy, namely, the way in which owners of wealth distribute their net worth among the available assets and debts. The financial sector is organized around the three asset markets—the money, bond, and equity markets. The demand for each asset depends upon the rate of interest on bonds (i), the equity yield (rk), real income, and real net private wealth. The supply of money, equation (5), is assumed to be an increasing function of the rate of interest and the equity rate. The market value of equities, equation (11), is related inversely to the equity rate, given the stock of capital (the marginal product of capital). In equation (9) we assume that government bonds are short term, so that their market value is independent of i. Equation (14) is the relationship between the marginal and the average product of capital. Equation (15) is the definition of net private wealth.

The total of the desired holdings of the three assets by owners of wealth is constrained to be equal to net private wealth, W. Hence, only two of the three asset market equilibrium equations (equations 6, 9, and 12) are independent; the remaining one can be derived from the other two and the definition of wealth. Suppose that equation (12) is redundant. Then the 12 equations (equations 1-9 and 13-15) determine the equilibrium values of 12 endogenous variables (C, I, Y, Md, Ms, and Bd, Bs, W, i, rk, q, r).

In this model, changes in rk and i are the sole linkages through which financial events, including monetary policy, are transmitted to the real sector. The rate of interest loses much of its significance as the strategic variable in the Keynesian system and is replaced by rk. Therefore, if consumption and investment are independent of i, the extent to which a given monetary control is effective is evaluated in terms of its ability to influence rk, not i. Of course, whether such a change in rk would have any sizable impact upon aggregate demand is an empirical question.

Le processus de transmission de la politique monétaire : quelques questions d’actualité

Résumé

L’auteur se demande si la controverse soulevée au sujet de l’influence qu’exerce la monnaie sur les faits économiques pourrait résulter de divergences d’opinion quant au processus de transmission des impulsions monétaires. Il montre que divers spécialistes de questions monétaires ne conçoivent pas de manière très différente ce mécanisme de transmission. Qu’ils soient monétaristes ou non monétaristes, ces économistes sont partisans d’un modèle d’ajustement des portefeuilles, bien qu’ils n’en adoptent pas tous la même version. Le désaccord entre les deux écoles est d’ordre méthodologique et porte sur le meilleur moyen de déterminer les coefficients indispensables pour mesurer l’efficacité respective des politiques monétaire et budgétaire. Les monétaristes sont partisans de modèles de forme réduite, dans lesquels on effectue une régression de certains aspects de l’activité économique par rapport aux variables monétaires et budgétaires; des études entreprises à ce sujet montrent que l’évolution des revenus monétaires dépend beaucoup plus de la quantité de monnaie que des dépenses exogènes. L’approche des monétaristes est au contraire structurale et fait intervenir de grands modèles économétriques. Ces modèles montrent que si influente que soit la politique monétaire, son impact est toutefois moins important qu’on ne pourrait le croire au vu de certaines analyses utilisant des modèles de forme réduite. L’auteur estime que cette dernière approche n’est pas acceptable d’un point de vue scientifique et que seule l’approche structurale devrait être utilisée pour déterminer l’efficacité respective des politiques monétaire et budgétaire. Il lui apparaît donc souhaitable d’accroître encore la précision et la portée des modèles économétriques existants, et en particulier leur secteur financier.

Algunas cuestiones de actualidad sobre el proceso de transmisión de la política monetaria

Resumen

El presente trabajo tiene por objeto averiguar si la controversia respecto al papel que desempeña el dinero como factor determinante del curso de los acontecimientos económicos puede atribuirse a divergencias de opinión sobre el mecanismo de transmisión de las influencias monetarias. Este examen pone de manifiesto que no existen diferencias significativas en la manera en que muchos economistas monetarios conciben el mecanismo de transmisión: tanto los monetaristas como los no monetaristas se muestran partidarios de una u otra versión del modelo de reajuste de la cartera de valores. El desacuerdo entre ambos grupos se centra en la cuestión metodológica de cuál sea la mejor forma de calcular los coeficientes pertinentes, que son cruciales en la evaluación de la eficacia relativa de las políticas monetaria y fiscal. Los monetaristas se muestran partidarios del método de la forma reducida, que consiste en hallar una regresión de las medidas de la actividad económica sobre las variables monetarias y fiscales; los estudios basados en este método demuestran que, para explicar las variaciones del ingreso monetario, la cantidad de dinero tiene mucho más importancia que el gasto exógeno. Por otra parte, los no monetaristas se muestran a favor del método estructural, en el cual se emplean grandes modelos econométricos; las pruebas obtenidas de estos modelos indican que la política monetaria tiene un gran efecto, pero no tan grande como el que le atribuyen algunos estudios de forma reducida. El autor mantiene que el método de la forma reducida no es aceptable científicamente y que la cuestión de la eficacia relativa de las medidas monetarias y fiscales debe resolverse mediante el método estructural. Por lo tanto, conviene ampliar y perfeccionar los modelos econométricos actuales, especialmente en lo que respecta a sus sectores financieros.

*

Mr. Park, economist in the Financial Studies Division of the Research Department, is a graduate of Seoul National University and of the University of Minnesota.

1

Readers are also referred to other excellent reviews on this topic and on recent developments in monetary economics: Maurice Mann, “How Does Monetary Policy Affect the Economy?” Federal Reserve Bulletin, Vol. 54 (1968), pp. 803–14; Allan H. Meltzer, “Money, Intermediation, and Growth,” The Journal of Economic Literature, Vol. VII (1969), pp. 27–56; Harry G. Johnson, “Recent Developments in Monetary Theory—A Commentary,” in Money in Britain, 1959–1969, ed. by David R. Croome and Harry G. Johnson (Oxford University Press, 1970), pp. 83–114; Warren L. Smith, “On Some Current Issues in Monetary Economics: An Interpretation,” The Journal of Economic Literature, Vol. VIII (1970), pp. 767–82; Harry G. Johnson, “The Keynesian Revolution and the Monetarist Counter-Revolution,” American Economic Association, Papers and Proceedings of the Eighty-third Annual Meeting (The American Economic Review, Vol. LXI, May 1971), pp. 1–14.

2

A. C. Pigou, “Economic Progress in a Stable Environment,” Economica, New Series, Vol. XIV (1947), pp. 180–88.

3

Gottfried Haberler, Prosperity and Depression (New York, Third Edition, 1946), pp. 242, 403, and 491–503.

4

Don Patinkin, “Price Flexibility and Full Employment,” in Readings in Monetary Theory, ed. by Friedrich A. Lutz and Lloyd W. Mints (New York, 1951), pp. 252–83.

5

Outside money is defined as the money that is backed by foreign or government securities or gold, or fiat money issued by the government, whereas inside money—commercial bank demand deposits—is based on private domestic securities. See John G. Gurley and Edward S. Shaw, Money in a Theory of Finance, The Brookings Institution (Washington, 1960), pp. 363–64.

6

See James Tobin, “Money, Capital, and Other Stores of Value,” American Economic Association, Papers and Proceedings of the Seventy-third Annual Meeting (The American Economic Review, Vol. LI, May 1961), pp. 26–37; James Tobin, “Commercial Banks as Creators of ‘Money’,” Chapter 1 in Financial Markets and Economic Activity, ed. by Donald D. Hester and James Tobin, Cowles Foundation, Monograph 21 (New York, 1967), pp. 1–11, also included in Banking and Monetary Studies, ed. by Deane Carson (Homewood, Illinois, 1963); James Tobin, “Money and Economic Growth,” Econometrica, Vol. 33 (1965), pp. 671–84; Gurley and Shaw, Money in a Theory of Finance (cited in footnote 5); Don Patinkin, Money, Interest, and Prices: An Integration of Monetary and Value Theory (New York, Second Edition, 1965).

7

The government, the argument claims, ignores the real value of its debt because it can pay its debts by issuing new debts; the government is able to do so since (1) it controls the supply of money and (2) it possesses the taxing power. See Harry G. Johnson, “Monetary Theory and Policy,” in his Essays in Monetary Economics (Harvard University Press, 1967), p. 24.

8

For a further elaboration on this point, see the following section.

9

Patinkin, Money, Interest, and Prices (cited in footnote 6), p. 289.

10

Albert Ando and Franco Modigliani, “The ‘Life Cycle’ Hypothesis of Saving: Aggregate Implications and Tests,” The American Economic Review, Vol. LIII (March 1963), pp. 55–84; Franco Modigliani and Richard Brumberg, “Utility Analysis and the Consumption Function: An Interpretation of Cross-Section Data,” in Post Keynesian Economics, ed. by Kenneth K. Kurihara (Rutgers University Press, 1954), pp. 388–436; Franco Modigliani and Albert Ando, “The ‘Permanent Income’ and the ‘Life Cycle’ Hypothesis of Saving Behavior: Comparison and Tests,” in Consumption and Saving, Vol. II, ed. by Irwin Friend and Robert Jones (Wharton School, University of Pennsylvania, 1960), pp. 49–174.

11

Tobin, “Money, Capital, and Other Stores of Value” (cited in footnote 6), p. 30.

12

Milton Friedman, “Postwar Trends in Monetary Theory and Policy,” in Money and Finance: Readings in Theory, Policy, and Institutions, ed. by Deane Carson (New York, 1966), p. 187.

13

Boris P. Pesek and Thomas R. Saving, Money, Wealth, and Economic Theory (New York, 1967).

14

Ibid., Chapter 4, “Bank Money as Wealth,” pp. 79–102.

15

The liquidity effect, or the substitution effect, refers to changes in interest rates that are brought about by changes in money supply via a liquidity preference relation.

16

Reviewing the book by Pesek and Saving, Patinkin points out that the true origin of the net worth of the banking sector lies not in the production of demand deposits per se but in the monopoly right of producing demand deposits, which this sector has received from the government. See Don Patinkin, “Money and Wealth: A Review Article,” The Journal of Economic Literature, Vol. VII (1969), pp. 1140–60. See also the reviews by Meltzer, “Money, Intermediation, and Growth” (cited in footnote 1), pp. 32–36, and Smith, “On Some Current Issues in Monetary Economics: An Interpretation” (cited in footnote 1), pp. 769–70.

17

Patinkin, “Money and Wealth” (cited in footnote 16), pp. 1147–54.

18

Once the monopoly is broken and perfect competition is restored in the banking sector, the monopoly profits (earnings) of banks will be transferred to the owners of demand deposits in the form of nonpecuniary services. See Meltzer, “Money, Intermediation, and Growth” (cited in footnote 1), p. 34.

19

See, for example, Franco Modigliani, “The Monetary Mechanism and Its Interaction with Real Phenomena,” The Review of Economics and Statistics, Vol. XLV (Supplement, February 1963), p. 80.

20

Frank de Leeuw and Edward M. Gramlich, “The Channels of Monetary Policy,” Federal Reserve Bulletin, Vol. 55 (1969), p. 481.

21

Pesek and Saving, Money, Wealth, and Economic Theory (cited in footnote 13), pp. 289–90.

22

Karl Brunner and Allan H. Meltzer, “Fiscal and Monetary Policy in a Non-Keynesian World” (unpublished paper, 1970).

23

Modigliani, “The Monetary Mechanism and Its Interaction with Real Phenomena” (cited in footnote 19), p. 98.

24

Ibid., p. 100.

25

Financial Markets and Economic Activity (cited in footnote 6), “Foreword,” p. viii. See also Lyle E. Gramley and Samuel B. Chase, Jr., “Time Deposits in Monetary Analysis,” Federal Reserve Bulletin, Vol. 51 (1965), pp. 1380–1406; John H. Kareken, “Commercial Banks and the Supply of Money: A Market-Determined Demand Deposit Rate,” Federal Reserve Bulletin, Vol. 53 (1967), pp. 1699–1712; J. A. Cacy, “Alternative Approaches to the Analysis of the Financial Structure,” Federal Reserve Bank of Kansas City, Monthly Review (March 1968), pp. 3–9; Richard G. Davis, “The Role of the Money Supply in Business Cycles,” Federal Reserve Bank of New York, Monthly Review (April 1968), pp. 63–73.

26

Tobin, “Commercial Banks as Creators of ‘Money’” (cited in footnote 6), p. 3.

27

Johnson, “Recent Developments in Monetary Theory—A Commentary” (cited in footnote 1), p. 101.

28

Financial Markets and Economic Activity (cited in footnote 6), “Foreword,” pp. v-vi.

29

Tobin, “Money, Capital, and Other Stores of Value” (cited in footnote 6), p. 28.

30

William C. Brainard and James Tobin, “Pitfalls in Financial Model Building,” American Economic Association, Papers and Proceedings of the Eightieth Annual Meeting (The American Economic Review, Vol. LVIII, May 1968), pp. 99–122.

31

Neo-Keynesians assume that capital goods have two separate market prices: the prices of existing (secondhand) capital goods represented by the price of equities and the output prices of these goods (or the prices of newly produced capital goods).

32

Brainard and Tobin, “Pitfalls in Financial Model Building” (cited in footnote 30), p. 104.

33

For further discussion on this investment behavior, see Brainard and Tobin, “Pitfalls in Financial Model Building” (cited in footnote 30), p. 112; Hyman P. Minsky, “Private Sector Asset Management and the Effectiveness of Monetary Policy: Theory and Practice,” The Journal of Finance, Vol. XXIV (1969), p. 229; W. L. Smith, “A Neo-Keynesian View of Monetary Policy,” in Controlling Monetary Aggregates (Proceedings of a monetary conference in Massachusetts), Federal Reserve Bank of Boston (June 1969), p. 106; Ralph Turvey, Interest Rates and Asset Prices (London, 1960); James Tobin, “An Essay on Principles of Debt Management,” in Fiscal and Debt Management Policies, Commission on Money and Credit (Englewood Cliffs, New Jersey, 1963), p. 150; James Tobin, “Monetary Semantics,” in Targets and Indicators of Monetary Policy, ed. by Karl Brunner (San Francisco, 1969), pp. 173–74.

34

Tobin, “Monetary Semantics,” (cited in footnote 33), p. 174.

See the Appendix for a systematic discussion on the neo-Keynesian transmission process of monetary policy.

35

See Smith, “On Some Current Issues in Monetary Economics: An Interpretation” (cited in footnote 1), pp. 774–75.

36

The Keynesian speculative demand for money ceases to be an explanation of holding money but becomes the basis for an expectational theory of the term structure of interest rates.

37

William J. Baumol, “The Transactions Demand for Cash: An Inventory Theoretic Approach,” The Quarterly Journal of Economics, Vol. LXVI (1952), pp. 545–56; James Tobin, “The Interest-Elasticity of Transactions Demand for Cash,” The Review of Economics and Statistics, Vol. XXXVIII (1956), pp. 241–47.

38

Franco Modigliani, Robert Rasche, and J. Philip Cooper, “Central Bank Policy, the Money Supply, and the Short-Term Rate of Interest,” Journal of Money, Credit and Banking, Vol. II (1970), p. 167. The neo-Fisherian model of the demand for money developed by these authors is basically the one in the Federal Reserve-MIT econometric model.

39

Robert H. Rasche and Harold T. Shapiro, “The F. R. B.-M. I. T. Econometric Model: Its Special Features,” American Economic Association, Papers and Proceedings of the Eightieth Annual Meeting (The American Economic Review, Vol. LVIII, May 1968), pp. 123–49.

40

Ibid., p. 137.

41

However, if the monetary authorities dealt in the long-term bond market, changes in the quantity of money resulting from open market operations would affect the long-term interest rate directly.

42

The process through which changes in short-term interest rates affect long-term interest rates may be explained directly by an equation from the term structure of interest rates based on the expectations hypothesis. This approach allows us to omit the equations of supply and demand for many financial assets. The Federal Reserve-MIT model follows this approach, relying on the term structure hypothesis developed by Franco Modigliani and Richard Sutch, “Innovations in Interest Rate Policy,” American Economic Association, Papers and Proceedings of the Seventy-eighth Annual Meeting (The American Economic Review, Vol. LVI, May 1966), pp. 178–97.

43

In the Federal Reserve-MIT model the costs of capital are defined to be linear combinations of various long-term interest rates and the dividend/price ratio. The effect of monetary policy is felt immediately in the short-term interest rates. Through the term structure equation, changes in short-term rates affect the long-term rates with a time lag. The long-term rate in turn affects the cost of capital directly as one of its components and indirectly through the dividend/price ratio. The cost of capital influences the demand functions for final output with an additional time lag. See Rasche and Shapiro, “The F. R. B.—M. I. T. Econometric Model” (cited in footnote 39), p. 146. See also de Leeuw and Gramlich, “The Channels of Monetary Policy” (cited in footnote 20), pp. 485–90.

44

Leonall C. Andersen and Keith M. Carlson, “A Monetarist Model for Economic Stabilization,” Federal Reserve Bank of St. Louis, Review, Vol. 52 (April 1970), p. 7. An important qualification of this is Friedman’s view that, notwithstanding the importance of money, monetary policy—because it operates with a long and variable lag—should not be used for short-run stabilization. Instead, money should be allowed to grow at a constant rate over time.

On the general view of monetarists, see Milton Friedman, The Counter-Revolution in Monetary Theory, first Wincott Memorial Lecture, delivered at the Senate House, University of London, September 16, 1970, Occasional Paper 33, Institute of Economic Affairs (London, 1970); Karl Brunner, “The ‘Monetarist Revolution’ in Monetary Theory,” Weltwirtschaftliches Archiv, Band 105, Heft 1 (1970), pp. 1–30.

45

Karl Brunner, “The Role of Money and Monetary Policy,” Federal Reserve Bank of St. Louis, Review, Vol. 50 (July 1968), pp. 9, 18, and 24.

46

Milton Friedman, “A Theoretical Framework for Monetary Analysis,” Journal of Political Economy, Vol. 78 (March/April 1970), pp. 193–238; “A Monetary Theory of Nominal Income,” Journal of Political Economy, Vol. 79 (March/April 1971), pp. 323–37.

47

Prior to this, Patinkin had shown conclusively that Friedman’s reformulation of the quantity theory was an elegant exposition of the modern portfolio approach to the demand for money, which can be seen as a continuation of the Keynesian liquidity preference theory. (See Don Patinkin, “The Chicago Tradition, the Quantity Theory, and Friedman,” Journal of Money, Credit and Banking, Vol. I, 1969, pp. 46–70.) In recent writings, Friedman himself has acknowledged that his reformulation was much influenced by the Keynesian liquidity analysis. (See Friedman, “Postwar Trends in Monetary Theory and Policy” (cited in footnote 12), p. 188.) See also Milton Friedman, “Money: Quantity Theory,” International Encyclopedia of the Social Sciences, Vol. 10 (New York, 1968), pp. 432–47.

48

See Friedman, “A Theoretical Framework for Monetary Analysis” (cited in footnote 46), pp. 217–18.

49

The price rigidity assumption, P = Po, allows equations (1)(3) to define one relation between r and real income (IS curve) and equations (4)(6) to define a second such relation (LM curve). Their simultaneous solution gives the rate of interest and real income.

50

Given the level of real income, YP=y,, equations (1)(3) determine the rate of interest. Equations (4)(6) then yield an equation relating the price level to the quantity of money.

51

In conditions where the rate of growth of real output is determined independently by real forces in the economy, conditions that are assumed to prevail in the long run, changes in the money supply will dominate only changes in the price level, notwithstanding the fact that the demand for money is interest sensitive. Specifically, Friedman argues that in the long run monetary policy cannot control real variables—the real rate of interest, the level of unemployment, and real income—but can control only nominal quantities—the price level, money rate of interest, and nominal income. See Milton Friedman, “The Role of Monetary Policy,” in his The Optimum Quantity of Money and Other Essays (Chicago, 1969), p. 105.

Critics of Friedman have frequently pointed out that his extreme view of the role of money is valid only if the demand for money is insensitive to interest rates, implying a close linkage between the stock of money and income. In the light of the above discussion and his recent reformulation on the demand for money, this kind of criticism seems no longer valid. See also Milton Friedman, “Interest Rates and the Demand for Money” in his The Optimum Quantity of Money and Other Essays, pp. 141–55.

52

Friedman, “A Theoretical Framework for Monetary Analysis” (cited in footnote 46), p. 223. Both theories analyze short-run adjustments in terms of shifts from one static equilibrium position to another without explaining a dynamic adjustment process involved in such a change in equilibrium positions.

53

This assumption is the counterpart of the third approach of the full employment and rigid-price assumptions of the quantity theory and income/expenditure theory.

54

See Friedman, “A Monetary Theory of Nominal Income” (cited in footnote 46), pp. 325–32.

55

Notice that both the simple quantity and income/expenditure theories assume a stable price level; hence, real and nominal rates of interest are the same.

56

Suppose that a substantial number of asset owners have the same expectation on the future rate of interest and hold the expectation firmly, then the demand for money will become perfectly elastic at the current rate of interest that is equal to the expected rate of interest, namely, when r = r*. Money and other earning assets (bonds in the Keynesian analysis) would become perfect substitutes; the demand for money has a liquidity trap at r = r*. In this situation, the monetary authorities would not be able to change the rate of interest by changing the quantity of money; no matter what the monetary authorities do with the supply of money, asset owners will force the current rate of interest into conformity with their expectations on the future rate of interest. Friedman argues that this is the basic idea behind the Keynes’ short-run liquidity trap. See Friedman, “A Theoretical Framework for Monetary Analysis” (cited in footnote 46), p. 214.

57

Once we make the distinction between the nominal and real rate of interest, the rate of interest relevant to the consumption and investment functions is the real rate of interest, q. Hence, the equations describing the real sector of the model are modified as

Cp=f(Yp,q)(1)
Ip=g(q)(2)
Yp=cp+Ip(3)

Assume that the realized real rate of interest q is constant,

q=q*=qo(15)

Then equations (1)′(3) become a self-contained system of three equations with three unknowns: Cp,Ip,, and Yp. The price level would then be determined by substituting Yp obtained from the real sector and Y from the monetary sector into the following identity, Y = yP.

Friedman considers this way of combining the monetary and real sectors as highly unsatisfactory for two reasons: the assumption of a constant real rate of interest is likely to introduce serious errors, particularly through the real sector, and the consumption function (1) ignores several important arguments, such as wealth and expected rate of inflation. See Friedman, “A Monetary Theory of Nominal Income” (cited in footnote 46), p. 330.

58

Equation (16) is analogous to

(1YdYdt)T*=Teβ(tT)(1YdYdt)tdt,

which means that the expected rate of growth of nominal income at T is a weighted average of past growth rates of nominal income, the weights (eβ(tT)) declining exponentially where t is the time of the observation weighted. See Edgar L. Feige, “Expectations and Adjustments in the Monetary Sector,” American Economic Association, Papers and Proceedings of the Seventy-ninth Annual Meeting (The American Economic Review, Vol. LVII, May 1967), pp. 463–67.

59

Friedman, “A Monetary Theory of Nominal Income” (cited in footnote 46), pp. 324 and 334.

60

Milton Friedman and Anna J. Schwartz, “Money and Business Cycles,” The Review of Economics and Statistics, Vol. XLV (Supplement, February 1963), pp. 59–63; Milton Friedman and David Meiselman, “The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1877–1958,” Stabilization Policies, Commission on Money and Credit (Englewood Cliffs, New Jersey, 1963), pp. 217–22; Milton Friedman, “The Role of Monetary Policy,” in his The Optimum Quantity of Money and Other Essays (cited in footnote 51), p. 100, and The Counter-Revolution in Monetary Theory (cited in footnote 44), pp. 24–25.

61

Nicholas Kaldor, “The New Monetarism,” Lloyd’s Bank Review (July 1970), p. 9.

62

H.C. Wallich, “Quality Theory and Quantity Policy,” Chapter 10 in Ten Economic Studies in the Tradition of Irving Fisher (New York, 1967), p. 260.

63

This is Johnson’s interpretation of Friedman’s view. See Johnson, “Recent Developments in Monetary Theory—A Commentary” (cited in footnote 1), pp. 86–87; see also Johnson, “The Keynesian Revolution and the Monetarist Counter-Revolution” (cited in footnote 1), p. 9.

64

See Friedman and Meiselman, “The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1877–1958” (cited in footnote 60).

65

In examining the relationship between changes in the rate of change in money supply and changes in the commercial paper rates, Cagan found that an increase in the monetary growth rate initially exerts a negative liquidity effect on the interest rate. The negative effect is then offset by positive income and price effects within about one year, following the increase in the monetary growth rate. See Phillip Cagan, “The Channels of Monetary Effects on Interest Rates” (mimeographed, National Bureau of Economic Research, 1966).

Friedman himself acknowledges that change in the rate of change in the quantity of money will have no appreciable effect on the rate of change in money income for six months to nine months, on average, in the United States. See Friedman, “A Monetary Theory of Nominal Income” (cited in footnote 46), p. 335.

In a recent study by Gibson, however, the initial liquidity effects are shown to be fully offset by positive effects only after a period of three or five months, depending on which definition of money one uses. See William E. Gibson, “Interest Rates and Monetary Policy,” Journal of Political Economy, Vol. 78 (May/June, 1970), pp. 431–55.

66

See footnote 60.

67

See Friedman, “A Monetary Theory of Nominal Income” (cited in footnote 46), p. 333. He also states that the model cannot explain satisfactorily the movements of interests and velocity in the first nine months or so after a distinct change in the rate of monetary growth. (Ibid., p. 335.)

68

For a more detailed discussion, see Karl Brunner, “The Report of the Commission on Money and Credit,” The Journal of Political Economy, Vol. LXIX (December 1961), pp. 605–20; Karl Brunner, “Some Major Problems in Monetary Theory,” American Economic Association, Papers and Proceedings of the Seventy-third Annual Meeting (The American Economic Review, Vol. LI, May 1961), pp. 47–56; Karl Brunner and Allan H. Meltzer, “The Place of Financial Intermediaries in the Transmission of Monetary Policy,” American Economic Association, Papers and Proceedings of the Seventy-fifth Annual Meeting (The American Economic Review, Vol. LIII, May 1963), pp. 372–82; Karl Brunner, “The Relative Price Theory of Money, Output, and Employment” (unpublished, based on a paper presented at the Midwestern Economic Association Meetings, April 1967); Brunner and Meltzer, “Fiscal and Monetary Policy in a Non-Keynesian World” (cited in footnote 22).

69

The transmission mechanism identified in the analysis of the neo-Keynesian position centers around Type I capital goods.

70

This process is analogous to the one described and emphasized by neo-Keynesians.

71

Brunner and Meltzer, “The Place of Financial Intermediaries in the Transmission of Monetary Policy” (cited in footnote 68), pp. 374–77. Brunner and Meltzer do not emphasize the interest rate effect on the desired stock of Type III capital but only the wealth effect.

72

Brunner and Meltzer, “Fiscal and Monetary Policy in a Non-Keynesian World” (cited in footnote 22).

73

William L. Silber, “Monetary Channels and the Relative Importance of Money Supply and Bank Portfolios,” The Journal of Finance, Vol. XXIV (1969), p. 82.

74

Burton Zwick, “The Adjustment of the Economy to Monetary Changes,” Journal of Political Economy, Vol. 79 (January/February 1971), pp. 78, 79, 81, and 82.

75

William L. Silber, “Portfolio Substitutability, Regulations, and Monetary Policy,” The Quarterly Journal of Economics, Vol. LXXXIII (1969), p. 197.

76

Silber, “Monetary Channels and the Relative Importance of Money Supply and Bank Portfolios” (cited in footnote 73), p. 82.

77

David I. Fand, “A Monetarist Model of the Monetarist Process,” The Journal of Finance, Vol. XXV (1970), p. 281, footnote 13.

78

Zwick, “The Adjustment of the Economy to Monetary Changes” (cited in footnote 74), p. 79.

79

Ibid., p. 80.

80

A change in the supply of money has an income effect or a wealth effect, in addition to a substitution effect, depending upon how the increase has come about. For instance, if the increase in money supply is the result of an export surplus, the increase will be added directly to current income, thereby generating an income effect. A wealth effect will occur when the process of increasing the supply of money also increases the net worth of the public. An example would be financing the government deficit by printing money. Neither Fand nor Zwick specifies any other change (in either income or wealth) that accompanies a change in the supply of money. However, in order not to complicate the main issue, we will assume, throughout our analysis, that changes in the supply of money are entirely the results of the monetary authority’s open market operations, so that they exert only substitution effect.

81

“The key argument of the monetary view is that a change in money supply affects real spending directly without having to change interest rates on financial assets although it clearly affects the implicit interest rates on real assets,” Silber, “Monetary Channels and the Relative Importance of Money Supply and Bank Portfolios” (cited in footnote 73), p. 82. “Because money is traded directly for goods, monetary factors exert a direct effect on output and prices. Interest rates … respond indirectly to monetary policy through the direct effect of monetary policy on the demand for loans or bank credit,” Zwick, “The Adjustment of the Economy to Monetary Changes” (cited in footnote 74), p. 82.

82

A similar point has been made by Richard G. Davis, “How Much Does Money Matter? A Look at Some Recent Evidence,” Federal Reserve Bank of New York, Monthly Review, Vol. 51 (June 1969), p. 129.

83

Tobin, “An Essay on Principles of Debt Management,” in Fiscal and Debt Management Policies (cited in footnote 33), p. 106.

84

Friedman and Meiselman, “The Relative Stability of Monetary Velocity and the Investment Multiplier in the United States, 1877–1958” (cited in footnote 60), pp. 218–20. In a joint article with Schwartz, however, Friedman states that this may not necessarily be so: “We should expect it [the open market operation] to have its first impact on the financial markets, and there, first on bonds, and only later on equities, and only still later on actual flows of payments for real resources. This is of course the actual pattern.” See Friedman and Schwartz, “Money and Business Cycles” (cited in footnote 60), p. 61.

85

See Leonall C. Andersen and Jerry L. Jordan, “Monetary and Fiscal Actions: A Test of Their Relative Importance in Economic Stabilization,” Federal Reserve Bank of St. Louis, Review, Vol. 50 (1968), pp. 11–24; see also Andersen and Carlson, “A Monetarist Model for Economic Stabilization” (cited in footnote 44), pp. 7–25.

86

Leonall C. Andersen, “An Evaluation of the Impacts of Monetary and Fiscal Policy on Economic Activity” (a paper presented at the annual meeting of the American Statistical Association, Business and Economic Statistics Section, session on Methodology and Evaluation of Economic Forecasting and Forecasts, New York, August 21, 1969).

87

Leonall C. Andersen, “A Monetarist View of the Linkages between Federal Reserve Actions and Economic Activity” (unpublished paper, May 1970), pp. 17–20.

88

Andersen and Carlson, “A Monetarist Model for Economic Stabilization” (cited in footnote 44), p. 8.

89

Andersen, “An Evaluation of the Impacts of Monetary and Fiscal Policy on Economic Activity” (cited in footnote 86).

90

A notable exception is the Federal Reserve-MIT quarterly econometric model for the United States. It shows that monetary policy has a powerful effect, although less powerful than suggested by monetarists. See de Leeuw and Gram-lich, “The Channels of Monetary Policy” (cited in footnote 20).

91

Milton Friedman and Anna Jacobson Schwartz, Monetary History of the United States, 1867–1960, National Bureau of Economic Research, Studies in Business Cycles, No. 12 (Princeton University Press, 1963).

92

See Karl Brunner and Allan H. Meltzer, “Predicting Velocity: Implications for Theory and Policy,” The Journal of Finance, Vol. XVIII (1963), pp. 319–54.

93

Johnson, “The Keynesian Revolution and the Monetarist Counter-Revolution” (cited in footnote 1), p. 12.

94

A good example of the internal inconsistency of a reduced form equation may be found in the recent study by Andersen and Jordan, “Monetary and Fiscal Actions: A Test of Their Relative Importance in Economic Stabilization” (cited in footnote 85). They show that the impact coefficient of government expenditure on the level of money income is less than unity. Given that money income should rise by at least the same amount as the increase in government expenditure, Andersen and Jordan’s finding means that some private endogenous spending is falling by a larger amount as a consequence of the government expenditure. Since they do not specify the structural model of their reduced form equation, one cannot determine what expenditure is falling and why. One possible reason for such a low impact coefficient may be that the structural model is not consistent internally. See Edward M. Gramlich, “The Usefulness of Monetary and Fiscal Policy as Discretionary Stabilization Tools,” Journal of Money, Credit and Banking, Vol. III (1971), p. 514.

95

Ibid., pp. 523–24.

96

This type of response can be found in a series of unpublished articles by Andersen in which he develops a Keynesian income/expenditure model and then derives from the model a reduced form equation. See Leonall C. Andersen, “Influence of Monetary and Fiscal Actions in a Financially Constrained Economy” (unpublished paper, May 1971).

97

See, for example, William P. Yohe and Denis S. Karnosky, “Interest Rates and Price Level Changes, 1952–69,” Federal Reserve Bank of St. Louis, Review, Vol. 51 (December 1969), pp. 18–38; William E. Gibson, “Price Expectations Effects on Interest Rates,” The Journal of Finance, Vol. XXV (1970), pp. 19–34; Gibson, “Interest Rates and Monetary Policy” (cited in footnote 65).

98

For other factors, see David I. Fand, “The Monetary Theory of Nine Recent Quarterly Econometric Models of the United States: A Comment,” Journal of Money, Credit and Banking, Vol. III (1971), pp. 450–60.

99

This model, with some variations, is based on the work of Brainard and Tobin, “Pitfalls in Financial Model Building” (cited in footnote 30).

IMF Staff papers: Volume 19 No. 1
Author: International Monetary Fund. Research Dept.