The Role of Money in Stabilization Policy in Developing Countries
Author: Yung Chul Park
Publication Date:
01 Jan 1973
eISBN:
9781451947403
Language:
English
Keywords:
SP; company; EEC-AAC arrangement; EEC country; nominal rate; credit market; bank credit; quantity theory; monetary policy; Demand for money; Personal income; Bank credit; Money markets; Monetary base
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THE PAST TWO DECADES have witnessed a number of significant developments in the field of monetary theory, three of which are particularly salient in discussing the role of money in developing countries (henceforth referred to as LDCs). One development was the formulation of monetary theory as a part of capital theory, which treats money as an asset that is an alternative to other financial and real assets. This capital theoretic approach to monetary theory stresses substitutions among assets and views monetary policy as operating initially by changing the relative quantities of money and of other assets, these alterations in turn causing changes in the rate of return on these securities and eventually influencing the demand for real assets.1 Consistently with this approach, the theory of the demand for money has also developed along the same lines as the demand for other assets, commodities, and services.2

Abstract

THE PAST TWO DECADES have witnessed a number of significant developments in the field of monetary theory, three of which are particularly salient in discussing the role of money in developing countries (henceforth referred to as LDCs). One development was the formulation of monetary theory as a part of capital theory, which treats money as an asset that is an alternative to other financial and real assets. This capital theoretic approach to monetary theory stresses substitutions among assets and views monetary policy as operating initially by changing the relative quantities of money and of other assets, these alterations in turn causing changes in the rate of return on these securities and eventually influencing the demand for real assets.1 Consistently with this approach, the theory of the demand for money has also developed along the same lines as the demand for other assets, commodities, and services.2

THE PAST TWO DECADES have witnessed a number of significant developments in the field of monetary theory, three of which are particularly salient in discussing the role of money in developing countries (henceforth referred to as LDCs). One development was the formulation of monetary theory as a part of capital theory, which treats money as an asset that is an alternative to other financial and real assets. This capital theoretic approach to monetary theory stresses substitutions among assets and views monetary policy as operating initially by changing the relative quantities of money and of other assets, these alterations in turn causing changes in the rate of return on these securities and eventually influencing the demand for real assets.1 Consistently with this approach, the theory of the demand for money has also developed along the same lines as the demand for other assets, commodities, and services.2

A second development, the integration of monetary theory with the theory of economic growth, has inspired a number of growth models in which the role of money is explicitly incorporated. These neoclassical and Keynesian monetary growth models show that changes in the growth rate of the money supply—the relevant variable in the context of economic growth—do influence the time profiles of the capital/labor ratio, the real wage rate, and the real rate of return on capital.3

A third development was the analysis of the nature of the connection between financial development and economic growth—a development inspired by the pioneering work by Gurley and Shaw. The writings of Gurley and Shaw and their subsequent elaboration by others4 show that financial development (1) encourages savers to hold their savings in the form of financial, rather than unproductive tangible, assets; (2) ensures that real investment is allocated efficiently to the socially more productive uses; and (3) provides incentives to increased savings, investment, and production. Hence, an obvious policy implication of financial development in LDCs is that policymakers should encourage the proper formation and expansion of financial institutions.5

Despite these developments in monetary theory and equally impressive developments in the economics of LDCs, little attention appears to have been given to the role of money in LDCs. In the field of economic development and planning, Harrod-Domar growth models, Lewis-Fei-Ranis labor surplus models, Leontiff fixed coefficient models, static and dynamic linear programming models, and Chenery two-gap models have been widely used for analysis and policy recommendations.6 But these models either completely ignore, or at best assign a marginal role to, money and the financial sector of the economy. Also, in treating the role of money in stabilization policy, some economists use Keynesian models of effective demand that disregard either the financial sector or the supply of real output, while others apply, in a straightforward fashion, various quantity theory models to the analysis of short-term monetary problems of LDCs.

In view of these considerations, it would be worthwhile to examine the role of money in LDCs and, more importantly, to integrate some of the recent developments in monetary theory with the economics of LDCs, but this would be an enormous task and certainly could not be achieved in a single study. Therefore, we limited ourselves to the role of money in stabilization policy in LDCs. However, it is hoped that our study may also shed some light on the role of money in other contexts.

Section I is a brief discussion of the structural characteristics and institutional elements of the financial sector of LDCs. Section II discusses the specification and stability of the demand function for money and the issue primarily related to it, the transmission process of monetary influences. Section III discusses the ability of the monetary authorities to control the supply of money. Section IV attempts to construct a general model that we consider appropriate for LDCs. Section V contains concluding remarks.

I. Structure of the Financial Sector of Developing Economies

Perhaps the most significant feature of a typical LDC is its economic dualism, that is, the coexistence of a modern sector and a traditional sector within the domestic economy. The modern sector may be identified with the exchange economy (the monetized sector) and the traditional sector with the subsistence economy (the nonmonetized sector).7 The modern or monetized sector, in turn, comprises the organized and unorganized markets.8

Income originating in the nonmonetized sector still forms a significant part of national income in many LDCs. According to the estimate made by Goldsmith in 1964, the monetization ratio was less than 65 per cent in 9 out of 36 LDCs, and in 26 countries it was below 85 per cent. In contrast, the ratio was higher than 85 per cent in most of the advanced countries.9 The predominant sources of nonmonetized income are agriculture, small enterprises, households, property, and domestic services.

The organized and unorganized money markets10

The organized money market consists of institutional agencies of credit: central banks, commercial banks, and financial intermediaries such as insurance companies and long-term lending institutions in urban areas and various cooperative credit societies in rural areas. The relative importance of the organized money market may be measured by one or all of the following four ratios, although none of these is perfect: (1) the ratio of currency to the supply of money (defined both narrowly and broadly); (2) the ratio of domestic credit to gross national product (GNP);11 (3) the ratio of assets of all financial institutions to GNP;12 and (4) the ratio of the net issues of financial institutions, which are defined as the first difference of the assets of these institutions for a given period of time, to GNP.12

In analyzing LDCs, it would be quite reasonable to assume that money, broadly defined to include time and savings deposits, is virtually the only financial asset available to savers that is at all liquid. Hence, the first two ratios may be used, as a first approximation, as a measure of the growth of the organized money market (see Tables 1 and 2).

Table 1.

Selected Less Developed Countries: Ratios of Currency to Money, Defined both Narrowly and Broadly

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Source: International Monetary Fund, International Financial Statistics.
Table 2.

Selected Less Developed and Developed Countries: Ratio of Domestic Credit to Gross National Product

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Sources: International Monetary Fund, International Financial Statistics.

National income.

Gross domestic product.

The ratios of currency to the supply of money and of domestic bank credit to GNP suggest the presence of some growth in the organized money market in a majority of LDCs. In the early postwar years, the ratio of domestic bank credit to GNP was less than 15 per cent in most LDCs,13 but by 1970 it had exceeded 25 per cent in many countries, and a rising trend is expected. Nevertheless, the two ratios are still much lower in developing than in industrial countries.

The unorganized money market, which itself is not homogeneous, is made up largely of indigenous bankers, moneylenders, traders, landlords, and commission agents, some of whom combine moneylending with trade and other activities. These participants in the market are largely outside the direct control of the central bank. There is, of course, no way of measuring the size of the unorganized market, but it is reasonable to assume that it supplies the bulk of the credit requirements of the agricultural sector, which is the predominant sector in most LDCs. According to the various estimates available in India, the share of the unorganized market in the total credit supply appears to range from 50 per cent to 70 per cent.14 In particular, the unorganized market accounts for more than 90 per cent of the total credit in the agricultural sector.15

The organized and unorganized money markets are not linked directly, but this does not necessarily mean that the latter is completely immune from the policy actions of the monetary authorities. In urban areas, the two markets are joined through commercial banks. Indigenous bankers and private moneylenders carry on their activities, including rediscount-ing, through commercial banks; in rural areas, cooperative credit societies perform the role of intermediary between the two markets. Thus, in theory, the unorganized money market has recourse to the organized sector as a marginal source of credit and, consequently, the monetary authorities could have some influence on the unorganized market through the regulation of the organized market. However, in practice, insofar as these private lenders are not subject to the direct control of the monetary authorities, the effects of the central bank’s policy actions on the unorganized market would be marginal.

Capital markets and the structure of interest rates

Capital markets in many LDCs display all the characteristics of a narrow market. The absolute number of buyers and sellers is few, and hence the maximum average frequency of transactions is low. This attribute may be inevitable in the markets of small or poor countries. Dealers, who bear the risk of fluctuations in the capital value of the securities and provide a continuous market, are totally absent: security brokers are often merely intermediaries. Finally, there is no wide spectrum of owners and ownership motives.16 In the market for government securities (often the broadest market in LDCs), more than 80 per cent of the marketable securities is held by the central and commercial banks, insurance companies, and provident funds.17 Furthermore, the prices of government securities have been consistently supported by the central banks, through open market operations. Private securities markets exist, but, again because of their narrowness, these markets hardly perform the vital role of mobilizing savings and allocating them to investment.

The structure of interest rates in the organized sector is highly diversified, with a wide range of rates, various tax privileges, and concessionary rates to particular sectors of the economy.

Interest rates on bank deposits vary for different terms and are usually subject to ceilings regulated by the central bank; on average, the rates range from 3 per cent to 6 per cent in many LDCs.18 The most important rates on loans are those on bank advances, loans by the long-term lending institutions, and yields on securities; they have been maintained below 10 per cent in most LDCs.

A characteristic feature of the structure of interest rates in most LDCs is that, despite the scarcity of capital, the rates in the organized credit market have been maintained far below the equilibrium rates, through the imposition of ceilings and implementation of combinations of selective and discretionary control on credit and concessionary finance.19 The interest rates may in fact have been negative in real terms, considering the higher rates of inflation that these countries have experienced in recent years. Not surprisingly, changes in the rates in the organized credit market seldom reflect the money market conditions in LDCs. The low interest rate policy has also brought about many undesirable consequences. One such consequence has been the distortion in resource allocation between the modern and traditional sectors that has aggravated the unequal access to scarce credit that is suffered by small economic units in the traditional sector. Another consequence has been the impediment of the long-term growth of an integrated domestic money and capital market.20

II. Some Theoretical Issues on the Importance of Money in LDCs

Demand for money

In recent years the number of empirical studies on the demand for money in LDCs has grown, as more reliable and consistent data have become available in these countries.21 These studies basically attempt to resolve the following issues: (1) the most appropriate definition of money; (2) the arguments that enter the demand function for money; and (3) the statistical stability of the demand function for money over time. Owing mainly to the lack of consistent time-series data over a sufficient span of years, researchers have found it difficult to examine the third issue. Thus, attention has been focused on the first two issues. There appears to be a general consensus that the most appropriate definition of money is a narrow definition that includes currency outside the banks and demand deposits. On the second issue, most of the empirical studies show that real income is the most important determinant of the demand for real cash balances, although the available evidence is rather conflicting on the magnitude of the real income elasticity of the demand for money. However, there is no conclusive evidence as to whether the demand for money is influenced by either long-term or short-term interest rates. Studies by Biswas [16], Gujarati [48], Adekunle [2], and Singh [103] show that the demand for money is not sensitive to either short-term or long-term interest rates. On the other hand, Sastry [97], Gupta [49], and Imam [60] (p. 364) find that the interest elasticity of the demand for money is statistically significant. The cross-section study by Adekunle [1] also shows that the demand for real cash balances is interest elastic in LDCs.

However, the results of these studies should not be taken too seriously. The reason is that the interest rates used for these studies are rates on short-term treasury bills or on long-term government bonds. Considering the virtual nonexistence of well-developed capital markets and the fact that interest rates are not determined by the free play of the market, these rates cannot be taken as a representative yield on assets alternative to money. Therefore, on the basis of the results of the studies just quoted, one cannot determine that the rate of interest affects the demand for money in LDCs.

The studies based on the monetary experience in several LDCs that have had rapid inflation, as well as the experience of Malaysia and Singapore, may present more meaningful and interesting results. In those countries that have experienced a hyperinflation, such as Argentina, Brazil, Chile, and Korea, it has been shown conclusively that the demand for real cash balances is sensitive to the expected rate of inflation, which, in the absence of any meaningful interest rates, is used as a proxy measure for the cost of holding money.22 If the fluctuations in the real rate of interest are not substantial over time, the expected rate of inflation may be a reasonable measure of a representative nominal interest rate.

Lee’s study on the demand for money in Malaysia and Singapore indicates that the money and capital markets of these countries are linked directly to the London markets. Funds flow freely between the two markets, and, in a way, the markets in Malaysia and Singapore are an outpost of the London markets. As a result, their interest rates closely follow the movements in the rate in London. The demand function for money is found to be sensitive to the treasury bill rate in London, which is used as approximation of the interest rate in Malaysia and Singapore.23

An important feature of the demand for money in most LDCs has been its pronounced seasonal pattern, which has its origin in the monetary organization in which the primary sector accounts for a substantial part of national produce. The demand for money, therefore, broadly follows the agricultural season. During the busy season, which extends over the postharvest trading period, the financing of trade in agricultural commodities (marketing, distribution, and storage) leads to an increase in the demand for money for transactions purposes. During the slack season, the demand for money undergoes a seasonal reduction. The seasonal pattern has been losing some ground lately, but it still remains an important factor for monetary policy.

The relevance and usefulness of the Keynesian income/expenditure and quantity theory in LDCS

Many people have questioned the applicability and usefulness of Keynesian monetary theory to LDCs and its subsequent development during the past two decades on various planes.24 Critics argue that the Keynesian monetary theory is “unrealistic” to LDCs because the generalizations of the theory are based on a setting that is entirely different from that of LDCs. They also argue that the theory is “irrelevant” to the central monetary problems of LDCs because it is geared to the preoccupations of advanced countries.25

As an alternative framework of analysis, some of these critics also argue that the quantity theory approach26 is perhaps more applicable, if not more feasible, than the Keynesian income/expenditure theory for analyzing the monetary problems of LDCs. No one would seriously deny that the institutional and structural characteristics as well as monetary problems of the two types of economy are vastly different. However, it seems to be debatable whether these differences imply that the Keynesian theory becomes meaningless in a discussion of the monetary problems in LDCs. In what follows, we will try to show that, despite these characteristic differences, the Keynesian theory is essentially applicable to the analysis of monetary problems of both advanced and developing countries; in general, the arguments presented in support of the quantity theory approach in LDCs are incorrect.

In the literature on economic development, two main arguments have been adopted for the relevance of the quantity theory approach in LDCs. One argument is based on the lack of financial development in these countries, and the other on the classical view of the dichotomy between the real and monetary sectors of the economy.

The first argument stresses the underdeveloped nature of the financial sector of developing economies, particularly the nonexistence, or primitive state, of money and capital markets and the paucity of financial assets.27 In most LDCs, the variety of financial assets—treasury bills, government and industrial securities, and equities—is extremely limited, the markets for these assets are narrow, and consequently the proportion of these assets in net private wealth is low. There is money, on the one hand, and there are real physical assets, on the other hand; there is little in between. Treasury bills, government bonds, prime industrial bonds, marketable shares—all these assets that form the transition between money and real assets in countries with fully developed financial systems play a minor role in the asset structure of LDCs.28

In these conditions, it is argued that the desired holdings of money are predominantly transactions balances, which are likely to be insensitive to the interest rates on financial assets, and, therefore, that the classical quantity theory is valid, that is, the income velocity of money may be regarded as constant in the short run.

Most economists supporting the first argument accept the validity of the Keynesian income/expenditure theory as it is applied to the advanced countries. Therefore, their argument can be interpreted as implying that the Keynesian monetary theory is applicable and relevant only to the advanced countries with sophisticated and mature money and capital markets, whereas the quantity theory is relevant to developing economies without such markets.

It is not disputed here that the money and capital markets are underdeveloped and that financial assets are scarce in LDCs. However, the crucial question is whether this financial underdevelopment negates the dependency of the demand for real cash balances on the opportunity cost of holding money. We will argue that it does not.

The fundamental flaw in the first argument is the assumption that only financial assets, not the real assets, are an important substitute for money—which seems to be an incorrect interpretation of the Keynesian theory of the demand for money. The Keynesian theory does not consider real assets as a poor substitute for money; on the contrary, it simply follows the classical theory of portfolio selection in perfectly competitive markets, that is, real and financial assets are perfect substitutes for each other in wealth portfolios.29 Recent developments in the portfolio approach to the demand for money also suggest that real assets are a good substitute for money and should be introduced explicitly along with financial assets in monetary analysis. A more meaningful approach to determine the relevance of the quantity theory assumption in LDCs would then be to identify the assets that the public considers good substitutes for money and then to examine the extent to which changes in the nominal rates of return on these assets influence the demand for money. In the absence of a variety of financial assets, the asset choice of the owners of wealth in LDCs will be restricted to holding either money or real assets, such as property, the stocks of consumer durable goods and agricultural commodities, inventories of raw materials, gold and jewelry, agricultural and handicraft tools, houses and land, and land improvements.

As we have seen, studies by Hynes [58], Deaver [27], Diz [31], and Campbell [20] show that the elasticity of the demand for money with respect to the expected rate of inflation is, beyond any reasonable doubt, statistically significant in some LDCs, especially those that experienced a rapid inflation. If the expected rate of inflation is a reasonable proxy variable for the nominal rate of return on real assets, then the empirical evidence of these studies could be interpreted as implying that real assets are a substitute for money and that the first argument is therefore essentially invalid.

The proponents of the argument that rests on the classical view of the dichotomy between the real and financial sectors of the economy concede that the interest rate is an important variable in the demand function for money. They distinguish themselves from other non-monetarists, however, in assuming that the real rate of interest, or, alternatively, real income, is determined outside the financial sector and can be regarded as constant for analyzing short-run fluctuations.30 Given this assumption, it can be shown, within a simple Keynesian income/ expenditure model, that a change in the quantity of money leads to a proportional change in the absolute price level in the short run; in a dynamic framework, it can also be shown that nominal income is related to current and prior quantities of money.31 Thus, the validity of this argument hinges entirely upon whether the crucial assumption of the dichotomy can be rationalized in LDCs. Like many other issues in monetary theory, the question is again empirical. Since in most LDCs the interest rates that are determined by the free play of the market are not observable or recorded, there is no way of knowing whether the real rates remain fairly stable in the short run.32 At the theoretical level, however, the validity of this assumption may be questioned if it can be shown that real income is an endogenous variable influenced by both the real and financial sectors of the economy. As the following paragraphs indicate, there are reasons to believe that the level of real income is an endogenous variable determined within the system in LDCs.

While theoretical and empirical studies on the behavior of real interest rates in LDCs are rather scarce, there is a long line of argument that real income is likely to be supply determined,33 independently of aggregate demand conditions and, hence, of the financial sector. If this is a reasonable approximation to reality in LDCs, a quantity theory framework for short-run monetary analyses would be appropriate. This is so because, even in a Keynesian income/expenditure model, if the level of real income is given, changes in the quantity of money raises only the price level.34

Those who take the view that real income is supply determined in LDCs base their argument on the following characteristics of developing economies. First, most LDCs have little or no industrial base, and agriculture is the predominant sector of the economy. Since the supply of agricultural output generally is extremely inelastic with respect to prices, any expansion in aggregate demand will result in a steep rise in prices with little or no increase in real output.

Second, even if there are some capital and consumer goods industries, one cannot expect an automatic transfer of excess labor from the agricultural to the industrial sector following a general expansion in effective demand. One reason is that unemployment in LDCs usually takes the form of disguised unemployment in agriculture, and agricultural labor is often unskilled and hence unsuitable for the industrial sector. Third, even if surplus labor were available in the industrial sector, it is argued, its availability may be of no consequence because the basic problem of industries is shortage of capital, which seldom remains idle. Hence, an increase in effective demand cannot generate additional capital and so cannot be translated into a rapid increase in employment and output. The underlying assumptions of this argument then are that the elasticities of substitution between the two primary factors are practically zero and that the degree of capacity utilization is not an important consideration in LDCs. In short, physical capital is a factor of production in LDCs that presents a crucial bottleneck.35

In reality, however, most LDCs have an industrial base and have experienced a rapid growth in this sector during the past two decades, as shown by the increasing proportion of industrial output in total GNP. As we will see, one could also question the assumption that physical capital is the constraining factor of production in LDCs.

A recent empirical study of the Chilean economy by Berhman [9] shows that the estimates of the sectoral elasticities of substitution between capital and labor are significantly nonzero, suggesting considerable flexibility in the substitution of labor for capital.36 Berhman’s study also demonstrates that relative prices and the level of aggregate demand play fairly general and substantial roles in determining sectoral capacity utilization rates. It then follows that proper monetary and fiscal policies may have considerable impact on the level of real output.37 Indeed, if the experiences of Chile, Pakistan, Korea,38 and other LDCs are any indication of the general characteristics of the industrial sector in LDCs, the assumption that the supply of real income is price inelastic in the short run should be rejected. So should the assumption that the real interest rate is fairly stable in the short run. Such an assumption would be of little applicability in economies where changes in prices and aggregate demand result in variations of employment, which in turn affect the real rate of return on capital.

The transmission process and the relative importance of monetary influences in advanced and developing countries

The conclusion of the preceding section was that the Keynesian income/expenditure theory would be applicable to both advanced and developing countries. This conclusion, if acceptable, suggests that the transmission process of monetary changes would also be similar in both types of economy; that is, the effects of changes in the quantity of money would be transmitted to the real economy through the substitution-effect (the cost of capital), wealth-effect, and credit-rationing channels.

In a typical developing economy, an exogenous increase in the quantity of money will lead initially to an excess demand for various financial and real assets, but mostly for real assets in the absence of financial assets. Given the supplies of real assets, the excess demand will then, ceteris paribus, raise the prices of these assets. If the nominal wage rates are not affected initially by the increase in the price level, the increase in the demand for real assets will generate a positive discrepancy between the prices of real assets and their cost of production. If the real assets in question are producer goods and consumer durable goods, the discrepancy will provide an incentive to expand production of these goods. On the other hand, if the real assets under consideration are gold, gold ornaments, jewelry, land and land improvements, and the stocks of agricultural commodities (whose supplies are either fixed or extremely price inelastic in the short run), an increase in the quantity of money will, through similar channels, lead to a steep rise in prices of these assets with little increase in supply.

Monetary impulses work their effects on the level of income primarily through a chain of asset-substitution relations. However, changes in the quantity of money may impinge on real spending directly through the other two channels. To the extent that a monetary increase is associated with a simultaneous increase in wealth,39 the monetary change also directly affects aggregate demand through its wealth effects on consumption and investment expenditure. To the extent that a monetary expansion relaxes the degree of credit rationing exercised by commercial bankers, the expansion will directly increase consumption and investment expenditure.

Among the three channels of monetary influences, the credit-rationing channel is likely to be the most direct and powerful source of transmission of monetary changes to the real economy in LDCs. One possible explanation for this is the existence of an almost insatiable demand for credit at the prevailing interest rates in the organized credit market that remains continuously unsatisfied. Given such a strong demand, commercial banks in LDCs will be forced to ration the available supply of credit among the would-be borrowers by various nonprice terms. As noted before, interest rates, including the borrowing cost in the organized money market, have been kept at a level far below the true cost of capital in most LDCs. In these circumstances, real spending—in particular, business investment—will be constrained not by the cost of borrowing but by the unavailability of credit. Another explanation is that business firms in the industrial sector in LDCs rely more heavily on external financing than do those in advanced countries.40 Since much of the external finance available to them originates in the commercial banking sector and financing in the unorganized money market would be prohibitively expensive, business investment expenditure in LDCs would be extremely sensitive to the degree of credit rationing.

The preceding discussion on the transmission process may also shed some light on the relative importance of money in advanced and developing countries. In particular, the substitution-effect channel implies that a given change in the quantity of money may have a larger effect on spending and income than the change would have with sophisticated financial structures and well-developed money and capital markets. This follows from the fact that in the absence of a variety of financial assets the only alternative of holding money as a form of wealth would be real assets, which is true in many LDCs. When the financial asset structure is simple, the impact of a change in the quantity of money will not be diffused among the various money substitutes but will be transmitted directly to the markets for real assets. In other words, changes in the quantity of money would be more likely to impinge directly on real expenditure in LDCs than in advanced countries.41 For a similar reason, one could also argue that the lag involved in the transmission process of monetary changes would be relatively shorter in LDCs. This is so because the length of the chain of asset-substitution relations depends on the range of available financial assets and because the broader the range of alternative financial assets, the longer will be the length of the chain of transactions and, hence, the longer the time lag in the transmission process.42

Changes in the quantity of money would also have more pronounced and quicker effects on private investment expenditure in conditions where the modern industrial sector is relatively smaller, investment opportunities are often greater, and price inflation is more pronounced. These conditions are indeed some of the characteristic features of many LDCs. Therefore, it may be argued that desired investment spending would be more sensitive to changes in the quantity of money in LDCs than in the industrial countries.43

In view of these considerations, one may conclude that the role of money in influencing the level of economic activity is likely to be more important in LDCs than in advanced countries.

III. The Ability of the Monetary Authorities to Control the Stock of Money in LDCs

The specification and stability of the supply function for money

In discussing the role of money in LDCs up to this point, we have assumed implicitly that the monetary authorities can determine the growth of the money supply. This is an assumption that requires a careful re-evaluation in the light of the recent controversy between monetarists and nonmonetarists on the question of the monetary authorities’ ability to control the stock of money.

Monetarists, in general, argue that the monetary authorities can exercise effective control over the stock of money; others, especially those who share the new view of monetary theory, argue that the determination of the stock of money is part of the simultaneous solution for all variables in the financial and real sectors of the economy. In this view, the stock of money is determined not only by the policy actions of the monetary authorities but also by the behavior of the public in various asset and commodity markets and is not subject to close control by the monetary authorities. Monetarists do not necessarily deny that both the real and financial sectors influence the stock of money; rather, their argument is that the behavior patterns of the public and the banking system are stable and predictable enough to permit the monetary authorities to control the stock of money. The issue between monetarists and nonmonetarists is therefore empirical.

The question is related primarily to the specification and stability of the supply function for money and may be further illustrated by the following relation:

(1)M=m⁢A

where M is the stock of narrow money, m is the money multiplier, and A is the monetary base defined as the net monetary liabilities of the central bank.

This equation can be easily derived by using the following definitional equations:

(2)M=D1+C
(3)A=R+C
(4)R=k⁢(D1+D2)
(5)C=λ⁢D1
(6)D2=σ⁢D1
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By substituting equations (4) and (5) into equation (3) we obtain

(7)A=k⁢(D1+D2)+λ⁢D1

Substituting equation (6) into equation (7), we get

(8)A=k⁢(D1+σ⁢D1)+λ⁢D1

Equation (8) may be written as

(9)A=[k⁢(1+σ)+λ]⁢D1

or, alternatively,

(10)D1=1k⁢(1+σ)+λ⁢A

Using equation (10) we can define currency in terms of the monetary base

(11)C=λk⁢(1+σ)+λ⁢A

Substituting equations (10) and (11) into equation (2), we have

(12)M=1+λk⁢(1+σ)+λ⁢A

Equation (12) and constructs of this general form are often identified as the supply functions for money. However, they are devoid of any assumptions regarding the willingness of any economic unit to supply either currency or demand deposits. Equation (12) is not a supply function for money but simply an equilibrium condition specifying that the total demand for currency and bank reserves equals the total quantity outstanding.44

Given equation (12), the controversy between monetarists and non-monetarists would concern (1) which of the variables entering that equation can be controlled by the monetary authorities or, if some of these variables are not controllable, whether their independent influences on the money supply may be offset and (2) whether the functions explaining these variables are stable and predictable.

The λ ratio is determined by the public’s preference for currency versus demand deposits, which in turn depends on the interest rates, income, and, in the long run, such institutional factors as the degree of monetization, the growth of the banking sector, and income distribution. The σ ratio depends, among other things, on the interest rates paid on time deposits and the interest rates in the unorganized money market. The k ratio would depend very much on the reserve requirements for demand and time deposits, since commercial banks in LDCs are likely to expand their loans to the maximum level permitted by their reserve assets.

The sources of the monetary base are central bank credit to the government, central bank credit to commercial banks,45 and central bank net holdings of foreign assets. Central bank credit to the government is dominated by the budgetary operations of the government, on which the monetary authorities have little influence. The second source of the monetary base has been used as an instrument of money control in many LDCs.

Foreign exchange reserves of the central bank are influenced primarily by the variations in the external position of the economy, that is, fluctuations in exports, imports, and capital movements. Hence, the monetary authorities would have little direct control over this source of the monetary base, nor does this source appear to be stable in the short run. On the contrary, considering the characteristic feature of the external sector of most LDCs that rely on the export of a few agricultural products and the import of capital, LDCs are likely to be more susceptible to externally generated swings in the balance of payments and thus subject to larger fluctuations in their foreign exchange assets than are advanced countries.46

The preceding discussion shows that the determinants of the stock of money, except possibly for the k ratio and central bank credit to commercial banks and government, are essentialy endogenous variables that depend on income, interest rates, wealth, and other factors.47 Nevertheless, the authorities could still presumably control the stock of money at will but by a complex process of implementing various monetary measures at their disposal. In reaching this conclusion, we have to assume that the monetary authorities can offset the influence of the foreign balance, fiscal deficits and, for that matter, any variations in the money multiplier (m) on the quantity of money by employing policy instruments. This, however, could hardly be possible in LDCs, because most monetary policy instruments available to the monetary authorities there are severely limited in their effectiveness.

Instruments of and scope for monetary policy48

The most serious institutional factor that limits the role of, and scope for, monetary policy in LDCs is, of course, the lack of development in the financial structures of these economies. In most LDCs, a large part of the stock of money, ranging anywhere from one half to four fifths, is held in the form of currency (see Table 1). This reduces the capacity of the banking sector to create additional credit on the basis of an increase in its reserves and, correspondingly, limits its power of multiple credit expansion. Moreover, the segment of the economy that is susceptible to central bank influence—the modern sector—is relatively small, and the traditional sector is virtually outside the reach of central bank actions. Also, because of the lack of financial development, in particular the nonexistence of money and capital markets, most of the traditional monetary instruments are subject to many technical limitations. Thus, the discount rate—the classical instrument—can hardly be expected to be an effective instrument for regulating the cost of credit in an environment where tremendous divergencies exist in interest rates in the organized market and also between the organized and unorganized markets, owing to the lack of integration in the money and capital markets.49 Again, in countries where there are no articulated and broadly based securities markets, open market operations cannot be effective in influencing either the cost or volume of credit.50

Only the variation of reserve requirements of commercial banks51 and, more importantly, direct control of central bank credit to commercial banks are potentially powerful and effective instruments of monetary policy.52 However, it is not clear to what extent the monetary authorities could pursue these measures in practice in view of the asymmetry in the implementation of monetary policy in LDCs. The monetary authorities in most LDCs are likely to have relatively little difficulty in expanding the stock of money whenever the situation dictates such an action; however, it would not be so easy to contract the supply of money. The problems and nature of this asymmetry can easily be seen. Suppose that an increase occurs in the supply of money as a result of government fiscal deficits. Much of this initial increase and the resulting secondary expansion of the supply of money will be absorbed by the unorganized credit sector, and much of this expansion will be dissipated in speculation, hoarding, conspicuous consumption, and investment, thereby generating inflationary pressures in the economy. Faced with this situation, the monetary authorities may attempt to tighten up credit conditions. Since, however, the authorities have little influence on the unorganized sector of the economy, the impact of any restrictive monetary measures will be felt in the organized market and subsequently in the industrial sector of the economy. In other words, any reduction in credit contraction will be mostly at the expense of the industrial sector. Such a policy may be economically desirable but politically unacceptable in many LDCs where the growth of the industrial sector is often the primary objective of the government. Thus, the monetary authorities have been under constant pressure to maintain adequate credit to this sector even if general economic conditions call for a restrictive stance for monetary policy.

IV. Toward a Monetary Model for Developing Countries

Overview

The main conclusion to be drawn from the discussion in Sections II and III is that meaningful monetary analyses in LDCs require a structural model complete with a financial sector in the spirit of the Keynesian income/expenditure theory.53 This may be true in principle. However, one must realize that the differences in structural characteristics and institutional elements between advanced and developing countries are so extensive that any straightforward application of the models of advanced countries to LDCs would be grossly unrealistic. If the models that have been successful in advanced countries were to be made useful for LDCs, they should be modified to reflect these differences. In formulating models for developing economies, one must also realize that the structural and institutional differences among LDCs are as varied as those among advanced countries. Therefore, it would be impossible to build a model appropriate to all LDCs. What model builders should do then is to look for some broad characteristics that are common to all LDCs, characteristics that differentiate these economies from those in advanced countries, and to incorporate them into a Keynesian income/expenditure model. We have already discussed the characteristic features of LDCs; in this section, we attempt to show the ways in which some of these features may be incorporated into a model. The focus is on the financial structure of LDCs. Only a skeleton of the real sector of the economy will be introduced, as it becomes necessary to specify the interaction of the real and monetary sectors.54

The model

In building a model concerned with policy analysis, there is in principle no limit to the level of disaggregation and the number of refinements that one could incorporate. However, if data are limited, as in most LDCs, the specification of the model should be as simple as possible and consistent with the availability of data. Keeping this in mind, we will formulate a general model that could possibly be estimated, with proper modifications, at least in some LDCs.

Glossary of definitions and notations

– Bar represents that the variable in question is exogenous

d Superscript represents demand

s Superscript represents supply

t Time

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Financial sector

The financial sector of the economy is built around the organized and unorganized monetary sectors. The organized sector in turn consists of the markets for currency, demand and time deposits, and bank credit to the private sector.

A-1. Currency Market

(1)Δ⁢(AP)=Δ⁢(CP)+Δ⁢(RP)
(1′)Δ⁢(AP)=Δ⁢(S¯aP)+Δ⁢(B¯P)+Δ⁢(FP)
(2)Δ⁢(S¯gP)=Δ⁢(B¯P)+Δ⁢(FP)+Δ⁢(CP)+Δ⁢(RP)
(3)Δ⁢(FP)=Δ⁢X¯P−MP+Δ⁢(F¯fP)
(4)Δ⁢(RP)=Rd⁢[iL,DP;k,id,ig,(RP)t−1]
(5)Δ⁢(CP)=Cd⁢[i,y,W;ib,(CP)t−1]

A-2. Commercial Bank Deposits and Credit Market

(6)Δ⁢(D1P)=D1d⁢[i,y,W;ib,(D1P)t−1]
(7)Δ⁢(D2P)=D2d⁢[i,y,W;ib,(D2P)t−1]
(8)Δ⁢(DP)=Δ⁢(D1P)+Δ⁢(D2P)
(9)Δ⁢(DP)+Δ⁢(B¯P)=Δ⁢(RP)+Δ⁢(S¯bP)+Δ⁢(LP)s
(9′)Δ⁢(LP)s=Ls⁢[iL,DP;k,id,ig,(DP)t−1,Δ⁢(S¯bP),Δ⁢(B¯P)]
(10)Δ⁢(LP)d=Ld⁢[i−iL,Δ⁢yy,y;(LP)t−1]
(11)Δ⁢(LP)⁢d=Δ⁢(LP)s

A-3. Real Asset Market

(12)Δ⁢Vd=Vd⁢[i,iL,y,W;ib,Vt−1]
(13)Δ⁢Vs=Δ⁢(Q¯+q⁢K¯)
(14)Δ⁢Vd=Δ⁢Vs

A-4. Definitions

(15)q=rkr
(16)i=r+E*
(17)rk=a0+a1⁢yα⁢K
(18)Et*=β⁢(P˙P−Et−1*)=Σi=0n⁢β⁢(1−β)i⁢(P˙P)t−1
(19)W=AP+Q+q⁢K

Equations (1) and (1’) identify the sources of the monetary basis (A). Equation (2) is the equilibrium condition for the currency and bank reserves market. Equation (3) shows that the foreign exchange assets held by the central bank result from trade and capital flows (F¯⁢fP).

Equations (4) and (5) are the behavioral equations explaining the demand for reserves by commercial banks and the public’s demand for currency. The demand for demand deposits (D1) and time deposits are assumed to be a function of the rate of interest, income, real wealth, and other exogenous variables—equations (6) and (7). Since the supply of bank deposits (D1 and D2) is infinitely elastic, equations (6) and (7) are also the equilibrium conditions for the bank deposits markets. The total volume of bank deposits (D) is defined in equation (8). The supply function for bank credit—equation (9’)—may be derived by substituting equation (4) into the balance sheet identity of the commercial banks—equation (9). The public demand for bank credit—equation (10)—is assumed to be an increasing function of the difference between the rate of interest and the bank loan rate, real income, and the rate of change in real income, which is regarded as a proxy for the business expectation variable.55 Equation (11) is the condition for equilibrium in the bank credit market.

The demand for real assets is a function of the rate of interest, the bank loan rate, real income, and wealth—equation (12). Equation (13) defines the market value of real assets, which is the sum of the real value of the stocks of commodities and the market value of physical capital goods. Equilibrium in the real asset market is represented by equation (14). Equations (15) through (19) are the definitions of the price of physical capital goods, the relation between the nominal and real rates of interest, the marginal product of capital, the expected rate of inflation, and real wealth.

The financial sector of the model contains five conditions for equilibrium in the markets for currency and bank reserves, bank deposits, bank credit, and real assets—equations (2), (6), (7), (11), and (14). By Walras’s law, only 4 of these 5 equations are independent. Assume that the equilibrium condition for the real asset market—equation (14)—is redundant and also that y, P, and the level of imports (M) are given. Then, the 18 equations describing the financial sector form a self-contained system determining 18 endogenous variables (A, F, R, C, i, iL, D, Du D2 Ls, Ld, Vd, Vs, r, rk, q, E*, and W). Some of the features of the financial sector of the model need explanation.

The markets for government securities and equities. In specifying the financial sector, we ignore these markets completely, for they do not exist in most LDCs, or, if they do exist, the volume of securities traded in them is rather insignificant.

Stock adjustment assumption. We assume that in any given period asset holders in this economy, including commercial banks, adjust their holdings of each asset by a fixed proportion, say, b, of the movement they would need to make to reach their desired holdings of the asset in question.56

The markets for real assets and unorganized credit and their interatcion with the organized monetary sector. Our discussion in Sections I and II points to the importance of explicitly introducing both the unorganized credit and real asset markets in models for LDCs, but such an integration would be extremely difficult for theoretical as well as empirical reasons. The most serious theoretical problem that one must face in describing the unorganized credit market is the extent to which the rates of interest prevailing in the unorganized market might be considered as market determined.

It is often pointed out that the lenders in the unorganized market are subject to geographical as well as functional delimitations of operations : that is, the lenders are heterogeneous in their operations, scattered all over the economy, and seldom have any contact with either the lenders or borrowers in a different locality. However, in some LDCs it has been shown that links do exist not only among the lenders operating within each sector, rural and urban, but also betwen the lenders in one sector and those in the other.57 It may also be true that the smaller the economy, the less stringent will be the geographical and functional delimitations. The indigenous credit agencies in some LDCs also have a system and definite procedures regarding their lending policies.58 If the latter view prevails, one could assume that changes in the interest rates in the unorganized market reflect to some extent the credit conditions in both the organized and unorganized money markets. The empirical problem is, of course, the absence of the statistics on either the volume of credit or the interest rates in this market. Even if they were available, they would be unreliable.

The major difficulties in specifying the real asset market would be (1) what assets should be included in defining real assets and (2) whether the nominal rate of return on these assets can be defined and observed. As noted in Section II, real assets that people consider close substitutes for money are producer and consumer durable goods, agricultural equipment, the stocks of agricultural products, houses, and gold and jewelry. Given the unavailability of reliable data, most of these assets cannot be taken into account. Also, the nominal rate of return on these assets often is not recorded, so that one must rely on a proxy measure for this variable.

For these reasons, in order to account for the markets for unorganized credit and real assets, one would have to make some unrealistic and often heroic assumptions. We assume that we could observe a representative interest rate, which could, in actual estimation, be approximated by a weighted average of the various interest rates prevailing in the unorganized market, and that changes in this interest rate reflect the stance of monetary conditions in both the organized and unorganized sectors. This representative interest rate will then enter the demand for currency, bank deposits, and commercial bank credit. In other words, the organized and unorganized markets are linked together through the representative interest rate in the unorganized money market. We also assume that this representative rate always moves closely with the nominal rate of return on real assets. In theoretical terms, this is equivalent to the assumption that promissory notes, private bills, and other private securities traded in the unorganized money market are indistinguishable from real assets. Asset holders in this economy allocate their wealth among currency, bank deposits, private securities in the unorganized market, and real assets. According to our assumption, the latter two forms of asset are perfect substitutes for each other. In this way, we can dispose of the unorganized money market altogether in our analysis.

Determination of the bank loan rate. In our model, the bank loan rate of interest is an endogenous variable determined simultaneously with other variables in the system. Thus, the supply of bank credit is assumed to be an increasing function of the loan rate, iL. However, in view of our discussion in Section I, a more reasonable assumption would be that the bank loan rate is an exogenous variable controlled by the monetary authorities. On this assumption, in our analysis we would be able to eliminate the bank credit market as well, by relying on Walras’s law. Perhaps this modified version of the financial sector is a more realistic portrayal of most LDCs.

Determination of the nominal rate of return on real assets. Once we make the assumption that the representative rate of interest in the unorganized money market moves closely with the nominal rate of return on real assets, it is possible to represent i by the nominal rate of return on real assets. Since we cannot observe r directly, we must look nized money market is defined as i = r + E*, where r is the real rate of return on real assets. Since we cannot observe r directly, we must look for a reasonable proxy for this variable. One method suggested by De Leeuw is to measure the real return on physical assets by the ratio of actual capital spending to a weighted average of real GNP (permanent real income in Friedman’s terminology).59 Other possible ways to represent the real return would be the rate of profit and the ratio of investment to income; none of these, however, is satisfactory.

Real sector

B-1. Aggregate Demand for Real Output

(20)H=Hd⁢[r,y,W,Δ⁢(LP)s]
(21)GP=T¯P+Δ⁢(S¯gP)
(22)X=X¯
(23)MP=Md⁢[H,Δ⁢(LP)s]
(24)y=H+GP+X¯P−MP

Equation (20) expresses private expenditure as a function of real income, real wealth, the flow of commercial bank credit, and the real interest rate. Equation (21) is the government budget constraint relating government expenditure (G) to the two sources of financing, namely, tax revenues and borrowing from the central bank. Exports are an exogenous variable—equation (22)—and imports are a function of private expenditure rather than income60 and the flow of bank credit—equation (23).

The aggregate demand side of the model is then completed by the identity equation—equation (24)—defining real income.

Supply of real output

(25)yc=F⁢(K¯,Ns)
(26)y=ɸ⁢(α⁢K,Ne)
(27)P=P⁢(Z⁢Ney)
(28)Δ⁢Z=Z⁢(Δ⁢P,Δ⁢Nu)
(29)Nu=N⁢s−Ne
(30)α=Hyc
(31)Y=P⋅y

Equation (25) defines the capacity output, yc, and equation (26) is a production function of actual real output. The demand function for labor is represented in the form of a price equation—equation (27)—and the supply of labor in a wage adjustment equation—equation (28).

Nu is the level of unemployment defined as the difference between the actual supply of labor and employment—equation (29). The degree of capacity utilization is defined as the ratio of private expenditure to capacity output—equation (30).

As mentioned at the beginning of this section, the supply of real output is introduced to close the system and to show the ways in which financial variables affect the real economy of the model. The specification is sketchy, and some elements of the labor market, in particular the Phillips curve in equation (28), are more relevant to advanced countries than to LDCs. Yet, we believe that the foregoing system of equations brings out the essence of the manufacturing sectors of LDCs. This observation together with the predominance of the agricultural sector in LDCs suggests that perhaps the system on the production side requires a two-sector model, one for the agricultural and the other for the industrial sector.

While we believe that our model captures the main features of LDCs, the level of disaggregation may be excessive for the model to be useful and applicable. Depending on the characteristics of the LDC in question, however, the model could be simplified considerably. As discussed earlier, it would be more realistic to assume that the bank loan rate is exogenously determined. This would then allow us to disregard the bank credit market. Moreover, in those LDCs where the industrial base is small relative to the rest of the economy and the existing industrial capacity is utilized fully, it would be reasonable to ignore the real sector of the economy by assuming that real income or the real rate of interest is stable in the short run. Then equations (1) through (11), (18), and (22) will be a self-containing system. This submodel would be in essence an open economy version of Friedman’s monetary model of nominal income61 with a banking sector. In other LDCs that have a fairly large industrial sector with substantial underutilized capacity and where price controls are in effect, one may ignore the supply of real output, and the remaining equations of the model would then form a Keynesian model of effective demand.

V. Concluding Remarks

The purpose of this study has been to analyze the role of money and monetary policy in the context of short-run stabilization policy in LDCs. The theoretical considerations presented in Sections II and III lead to the following conclusions:

1. In most of the LDCs where the variety of available financial assets is limited, real assets are likely to be a close substitute for real cash balances and hence the demand function for real cash balances would be sensitive to the nominal rate of return on real assets. Empirical studies on the demand for money in LDCs support this conclusion.

2. The effects of changes in the stock of money are transmitted to the real economy in part by portfolio substitution but primarily by credit rationing, which appears to be the most direct and powerful channel of monetary policy.

3. A given change in the supply of money will have a larger and quicker effect on spending and income in LDCs than in advanced countries. This is so in part because the transmission process is direct and subject to a shorter time lag, and because business firms rely on external financing more heavily than do those in advanced countries.

4. The stock of money—whichever definition one might choose—is not a variable that the monetary authorities could control at will; it is an endogenous variable determined by central bank actions as well as by the behavior of the public and commercial banks in various asset markets. Moreover, monetary policy instruments are limited in scope, role, and effectiveness because of the underdeveloped financial structure and other institutional obstacles.

These conclusions in turn suggest that proper analyses of the role of money in LDCs require a structural model complete with a financial sector in the spirit of the Keynesian income/expenditure theory: the model in Section IV reflects this point of view.

However, there is an important qualification to this conclusion. The construction of structural models for policy and forecasting purposes is difficult in most LDCs, where detailed knowledge of the structure of the economy and consistent and reliable data are limited. Even in advanced countries where these problems are relatively less severe, the performance of econometric models has been less than satisfactory. One might then rightfully question whether the model-building effort is worthwhile at all in LDCs.62 The only answer to this type of skepticism is that other approaches are no better.

Approval of the structural approach in itself should not therefore imply that other approaches are not meaningful. On the contrary, despite their limitations, various quantity theory and reduced-form-equation approaches are informative and serve useful purposes, especially in forecasting and predicting. They are in many ways complementary to the structural approach. Vigorous efforts are thus desirable for developing and refining structural models in LDCs, while at the same time other approaches should also be pursued.

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*

Mr. Park, a graduate of Seoul National University and the University of Minnesota, was an economist in the Financial Studies Division of the Fund’s Research Department when this paper was prepared.

1

See Johnson [62], p. 94. The numbers in square brackets refer to items listed in the References, pp. 412-18.

2

See Friedman [41], p. 189.

3

For the literature on the theory of monetary growth, see Stein [106], pp. 265-67; Meltzer [76], pp. 40-56; Levhari and Patinkin [69] and [70]; Harkness, [56] and the comment on the same paper by Ramanathan [92]; Foley and Sidrauski [39].

5

Patrick [83], pp. 177-78.

8

The money market is defined as a market for financial assets that are close substitutes for money and that mature in one year or less. The capital market is defined as a market for financial assets other than money and near-money, namely, a market for long-term claims or securities. Any separation of the money market from the capital market is arbitrary, although it is customary to draw the line at a maturity of one year.

9

The monetization ratio is measured by the share of subsistence output in gross national product. See Goldsmith [43], p. 25-30.

10

On this subject, readers are referred to articles by U Tun Wai [111] and [112].

13

In most developing countries, commercial banks supply about three fourths of the short-term credit in the organized market.

14

See Chandavarkar [22], p. 62, and Desai [29], p. 10.

17

Porter [89], p. 49. See also Ghosh [42].

18

Chandavarkar [22], p. 71. However, in several countries that pursued a high interest rate policy (China, Korea, and Indonesia), deposit rates in recent years have been more than 20 per cent per annum, ibid., pp. 78-98.

19

This characteristic may be attributable to several factors. One factor is the desire of the monetary authorities to have an interest rate structure similar to that prevailing in the advanced countries. A second factor is the frequently held argument that it is necessary to have low and stable interest rates in order to promote a country’s economic development. A third factor is the notion that savings are insensitive to changes in interest rates. A fourth factor is the system of laws and agreements that establishes interest rate ceilings at levels below those that would prevail under free market conditions. See Emery [35], pp. 7-9.

20

See Myint [77], pp. 326-27.

22

See the studies by Hynes [58]; Deaver [27]; Diz [31]; and Campbell [20].

23

See Lee [68], p. 289.

24

In this discussion, the Keynesian monetary theory will be understood to be the Keynesian liquidity preference theory embodied in the Hicksian IS-LM framework and its subsequent developments in recent years.

25

These lines of criticism have been adopted against economic theory in general. See Myint [78], pp. 477-78 and 3-5.

26

The quantity theory approach will be defined broadly as any approach that analyzes the behavior of money income, prices, and possibly other variables exclusively in terms of the financial sector without any reference to the real sector of the economy.

28

Polak [86], p. 39.

29

See Tobin [109], p. 30.

30

See Friedman [40]. Suppose that the real sector of the economy is described by the following three equations: (1)C=C⁡(y) (2)I=(r,y) (3)y=C+I where C, I, and y are real consumption, investment, and income, respectively, and r is the real rate of interest. These equations summarize the real sector of Friedman’s monetary model of nominal income. (Ibid., p. 329). Substituting equations (1) and (2) into equation (3), we obtain equation (4): y = Φ (r). Therefore, fixing the real interest rate is equivalent to assuming that real income is also constant. This may not be necessarily true, however, if one incorporates either a wealth or the expected rate of inflation variable in the consumption function.