some issues in monetary economics

Some Issues in Monetary Economies*By DAVID I. FAND

Public policies are continuously sought which will assist in guiding the economy betweenthe perils of inflation and the dangers of unemployment and under-production. During thelast five years the perils of inflation have become increasingly apparent, and during the pastyear stabilization actions have been taken to reduce the rate of advance of the price level. Atthe present time there is growing concern that these actions may lead the economy into arecession,

What are the vehicles and avenues of stabilization policy which can best restore the econ-oniy to a satisfactory course, that is, a high and rising level of output and employment witha reasonably stable price level? Unfortunately, students of this problem are not in ~ubstan-tial agreement on an answer. Economists have tended to fall into two conflicting schools ofthought regarding economic stabilization — the income-expenditure approach and the modernquantity theory of money approach.

Until recently, the dominant school has been the modern version of the income-expendi-ture theory which has evolved from the work of John Maynard Keynes in the 1930’s. Policy-makers in the 1950’s and 1960’s generally adopted the theoretical framework of this schoolfor the formulation of economic stabilization actions. Primary emphasis was given to fiscalactions — Federal government spending and taxing programs — in guiding the economy be-tween inflation and unemployment. During the last two decades, proponents of the modernquantity theory of money have increasingly challenged the basic propositions of the income-expenditure school. The modern quantity theory assigns to the money stock the major rolein economic stabilization efforts.

The following paper by David i. Fand, Professor of Economics, Wayne State University,outlines the nature of some of the major points of disagreement between the income-expendi-ture approach to stabilization policy and the modern quantity theory approach. This paperwas presented to a seminar of college and university professors of money and bankingsponsored by the Federal Reserve Bank of St. Louis on November 7, 1969. This paper hasappeared in BANcA NAZIONALE Da LAvoRo QUARTERLY REvIEw, No. 90, September 1969.

in brief summary, Professor Fand analyzes the following four points of disagreementbetween proponents of the income-expenditure school and the modern quantity theory school:

(1) The modern quantity theory of money espouses the view that the Federal ReserveSystem can exercise close control over the nominal money stock. On the other hand,proponents of the income-expenditure school have questioned either the feasibilityor desirability of such control.

(2) Economic analysis based on the income-expenditure approach usually assumes a con-stant price level, thereby abstracting from the distinction between nominal and realmoney balances and between market interest rates and real interest rates. Modernquantity theory advocates maintain that this failure to take into consideration thedistinction between nominal and real magnitudes has frequently led to erroneousstabilization policies in recent - years.

(3) The two schools have very different views regarding the causes of inflation. The1modern quantity theory stresses the influence of changes in the money stock on ag-gregate demand in explaining movements in the price level, while the income-expenditure theory has stressed factors which influence aggregate supply, such aswage movements and other influences on costs of production.

(4) Finally, Professor Fand compares the special assumptions of the income-expenditureschool, which led them to conclude that fiscal actions have a great influence on totalspending, with those of the modern quantity school, which lead to the opposite con-clusion. He points out that most discussions of the influence of fiscal actions ontotal spending implicitly assume that interest rates are held constant by accommo-dative changes in the money stock. On the other hand, in discussing the influenceof fiscal actions, proponents of the modern quantity theory of money assume thatthe money stock is held constant, which results in an offsetting change in interestrates, The first assumption leads to the conclusion that fiscal influence on totalspending is great, while the second assumption leads to the conclusion that inducedchanges in private spending offset a large part of the fiscal influence.

The exposition in the paper is of necessity somewhat technical, and it may be of par-ticular interest to those familiar with the current debate. Extensive footnotes to the paperprovide references to some of the most useful presentations of the various points of view.

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FEDERAL RESERVE BANK OF ST. LOUIS JANUARY 1970

BASIC ISSUES in monetary theory are being de-bated at the present time, and increasing attention isnow being directed to the following rather technicalquestions: Can the central bank control the (nominal)money stock within fairly close limits, or should weadopt the analytically more complete (and neutral)approach of the large scale econometric models andtreat money as an endogenous variable? Can the cen-tral bank implement its policy decisions and calibrateits actions by means of an interest rate criterion — ex-pressed in money market variables — or would it dobetter to usc one of the monetary aggregates as anindicator and target for monetary policy?1 Can thecentral bank lower (or raise) market interest rates if

°Financial support by the National Science Foundation andWayne State University is gratefully acknowledged. in pre-paring the paper for this Review, the author has benefitedfrom the seminar discussion and comments from the Researchstaff at the Federal Reserve Bank of St. Louis.

‘See W. Dewald, “Money Supply vs. Interest Rates as Proxi-mate Objectives of Monetary Policy,” National Banking Re-view, June 1966; P. Cagan, “interest Rates vs. the QuantityTheory: The Policy Issues” and L. Craniley, “The Informa-tional Content of interest Rates as Indicators of MonetaryPolicy” in Proceedings: 1968 Money and Banking Work-shop, Federal Reserve Bank of Minneapolis, May 1968;M. Friedman, “The Role of Monetary Policy,” American Eco-nomic Review, March 1968; P. Hendershott, The NeutralizedMoney Stock — An Unbiased Measure of Federal ReservePolicy Actions (Richard D. irwin, 1968); the Joint EconomicCommittee Hearings on Standards for Guiding MonetaryAction (\Vashington, 1968); D. Fand, “Comment: TheImpact of Monetary Policy in 1966,” Journal of PoliticalEconomy, August 1968; the House Committee on Bankingand Currency Compendium on Monetary Policy Guidelinesand Federal Reserve Structure (Washington, 1968);T. Mayer, Monetary Policy in the United States (RandomHouse, i968). See also A. Meigs, “Financial Stability andinflation,” Bankers Magazine (London: February 1969);A. Meigs, “The Case for Simple Rules,” and L. Gramley,“Guidelines for Monetary Policy — The Case Against SimpleRules,” presented at the Financial Conference sponsored bythe National Industrial Conference Board, February 21, 1969;A. Meltzer, “Controlling Money” in the May 1969 issue of thisReview; L. C. Andersen, ‘Money and Economic Forecasting,”and E. M. Gramlich, “Complicated and Simple Approachesto Estimating the Role of Money in Economic Activity,”Business Economics, September 1969; K. Brunner (ed),Targets and Indicators of Monetary Policy, (Chandler Pub-lishing Co., 1969); and L. C. Andersen “The Influence ofEconomic Activity on the Money Stock: Some AdditionalEvidence,” in the August 1969 issue of this Review.

For an interpretation of the Federal Reserve’s moneymarket strategy — the strategy encompassing instrument vari-ables (e.g., open market operations), money market variables(e.g., free reserves) and monetary variables (e.g., the mone-tary aggregates) — and an interpretation of the proviso clauseas a device for correcting errors in the projected relationbetween money market variables and the monetary variables,see the recent paper by Governor Sherman Maisel, “Con-trolling Monetary Aggregates” in Federal Reserve Bank ofBoston, Controlling Monetary Aggregates (September 1969).(See also 4. M. Guttentag, “The Strategy of Open MarketOperations, ‘Quarterly Journal of Economics (February 1966).

2The hearings in March and April of the U.S. Senate Com-mittee on Banking and Currency on High Interest Rates(Washington, 1969) were directed at the causes of high andrising market interest rates and the extent to which theycould be influenced by the central bank.

such a change is thought to be desirable?2 Canthe authorities better the stabilization performance ofrecent years by giving more emphasis to the behaviorof monetary aggregates?8

These technical questions suggest a number ofmore fundamental questions concerning recent stabi-lization policies. Has the post-1965 inflation been amonetary phenomenon resulting from the extraordi-nary expansion in the monetary aggregates, or hasit primarily been due to an excessively lax, and inap-propriate, fiscal policy?’ Does the theory of fiscalpolicy (and its calculated multipliers) often assumean elastic, permissive, or accommodating monetarypolicy, and does it therefore fail to distinguish be-tween a pure fiscal deficit excluding any money stockeffects, and an increase in the monetary aggregatesaccompanied by a fiscal deficit?5 Is the transmissionmechanism as conceived in the income-expendituremodels a valid one, or may changes in the nominalmoney stock directly affect private expenditures, ag-gregate demand, and price levels?0 Should stabiliza-tion policy continue to stress temporary changes

3For an articulate and influential statement of the fiscal policyapproach to stabilization emphasizing discretionary changesin the full-employment surplus, see W. Heller, New Dimen-sions of Political Economy (Norton, 1966). The key stabiliza-tion role assigned to changes in the full-employment surplusis critically reviewed by C. Terborgh in his The New Eco-nomics (Washington, 1968). For a discussion of the stabiliza-tion roles to be assigned to monetary and fiscal policy seethe Friedman-Heller dialogue, Monetary vs. Fiscal Policy(Norton, 1969).

‘See D. Fand, “The Chain Reaction-Original Sin (CROS)Theory of Inflation,” Financial Analysts Journal (July 1969),and ~‘“A Monetary InterRretation of the Post-1965 Infla-tion in the United States, Banca Nazionale Del Lavoro,No, 89, (June 1969), especially, Section I, “Has MonetaryPolicy Been Tight Since 1965?,” pp. 103-106; and thetestimony by Chairman Martin (Board of Governors) andChairman McCracken (Council of Economic Advisers) inHigh Interest Rates, op. cit., pp. 6-41.

5See L. Andersen and J. Jordan, “Monetary and Fiscal Ac-tions: A Test of Their Relative Importance in EconomicStabilization,” in the November 1968 issue of this Review;the Comment by F. DeLeeuw and J. Kalchbrenner, andReply by Andersen and Jordan in the April 1969 issue ofthis Review; M. Levy, “Monetary Pilot Policy, Growth andInflation” and W. Lewis, “Money is Everything’ Economics— A Tempest in a Teapot” in the Conference Board Recordfor January and April 1969; R. Davis, “How Much DoesMoney Matter? A Look at Some Recent Evidence,” in theJune 1969 Monthly Review, Federal Reserve Bank of NewYork: and L. C. Andersen, “The Influence of EconomicActivity on the Money Stock: Some Additional Evidence,”op. cit.

~The transmission mechanism in aggregative models viewsinterest rates as an indicator of monetary policy, as a measureof the cost of capital, and as a key element in the transmis-sion mechanism. For a criticism, see D. Fand, “Comment:The Impact of Monetary Policy in 1966,” op. cit., especiallySection II, “The Role of Interest Rates,” pp. 825-830; “AMonetary Interpretation of the Post-1965 inflation in theUnited States,” op. cit., especially Section II, pp. 106-113,and Section iV, “Market Interest Rates (Conventional Yields)or Prices (implicit Yields) ,“ pp. 118-119; and “Keynesian

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(discretionary or automatic) in the full-employmentsurplus, as if it were the ultimate weapon, in light ofour recent experience?7

In this paper we take up four specific issues. We firstconsider whether the central bank can actually controlthe money stock. We then consider whether changesin the (nominal) money stock are identifiable withchanges in real cash balances, and whether movementsin market interest rates adequately reflect movementsin real rates. The third question that we take up con-cerns the analytical structure and policy implicationsof the non-monetary theories of the price level. Thefourth and final question is: How do we define, andmeasure, the monetary and fiscal effects that follow aparticular policy?

Can the Central Bank Control theNominal Money Stock?

The money stock at any moment in time is theresult of portfolio decisions by the central bank, bythe commercial banks, and by the public (includingthe nonbank intermediaries) 8 the central bank de-termines the amount of high-powered money or mone-tary base, that is, currency plus bank reserves, thatit will supply;°the commercial banks determine the

Monetary Theories, Stabilization Policy, and the Recent in-flation,” Journal of Money, Credit and Banking, August1969, especially Section IV on “Keynesian Theories of Moneyand Interest Rates.” See also C. Kaufman, “Current issues inMonetary Economics and Policy: A Review,” Bulletin No. 57,New York University Institute of Finance, May 1969.

TThe symposium volume Fiscal Policy and Business CapitalFormation (Washington, 1987) contains an informed discus-sion of this subject. See especially the papers by P. Mc-Cracken, C. Harriss, S. Fabricant, and R. Musgrave, andthe comments by C. Haberler and N. Ture. See also H. Stein,“Unemployment, Inflation and Economic Stability” inK. Gordon (ed), Agenda for the Nation (Brookiags, 1968).

8For a discussion of the determinants of the money stocksee M. Friedman and A. Schwartz, A Monetary History ofthe U.S. 1867-1960 (Princeton, 1963), Appendix B on“Proximate Detenninants of the Nominal Stock of Money”;P. Cagan, Determinants and Effects of Changes in the Stockof Money 1875-1980 (Columbia, 1965), Chapter i on “TheMoney Stock and Its Three Determinants”; K. Brunner, “ASchema for the Supply Theory of Money,” InternationalEconomic Review, January 1961; D. Fand, “Some implica-tions of Money Supply Analysis,” American EconomicReview, May 1967.

°The high-powered money concept used by M. Friedman, A.Schwartz and P. Cagan is essentially the monetary baseconcept used by K. Brunner, A. Meltaer, and others. Themonetary base may be defined either in terms of the sources(Federal Reserve credit, gold stock, Treasury items, etc.) oruses (member bank reserves and currency). To comparemovements in the monetary base over time, we need tomake a correction for changes in reserve requirements. Asused here, the monetary base includes a reserve adjustment;that is, it is equal to the source base plus the reserveadjustment.

For a very clear exposition see L. Andersen and J. Jordan.“The Monetary Base — Explanations and Analytical Use’ in theAugust 1988 issue of this Review.

volume of loans and other assets that they will ac-quire and the quantity of reserves they will hold asexcess (and free) reserves; and the public determineshow to allocate their holdings of monetary wealthamong currency, demand, time and savings deposits,CD’s, intermediary claims, and other financial assets.The money stock that emerges reflects all thesedecisions.

It is a natural question to consider whether thecentral bank, by controlling the monetary base, canactually achieve fairly precise control over the moueystock. This depends on whether the link between themonetary base and bank reserves, and between bankreserves and the money stock (the monetary base —

bank reserves — money stock linkage) is fairly tightand therefore predictable. If there is a tight linkagethe monetary authorities can formulate their policiesand achieve any particular target for the moneystock; on the other hand, if there is significant andunpredictable slippage, and the central bank controlover the money stock is not sufficiently precise toachieve a given target, it will necessarily have to for-mulate its policies in terms of other variables that it

can control. The variable used to express (or define)the central bank’s objective, or to implement its policydecisions, must therefore be one that it can controlwithin reasonable limits,’0

The recently recurring idea that the money stockis perhaps best viewed as an endogenous variable,although not a new idea (it would have been ac-ceptable to “real bill” theorists), has received newand powerful support from those who follow the “NewView” approach in monetary economics.” New Viewtheorists have questioned the validity of much ofclassical monetary theory concerning the importanceof money relative to other liquid assets, the unique-

10It is presumably for this reason that some models treatunborrowed reserves as the policy variable (the practicefollowed in the FRB-MIT model and other econometricmodels). These model builders believe that some com-ponents of the monetary base and perhaps the entire base,behave as endogenous variables — as the variables that re-spond to income changes, and are not directly (or com-pletely) under the control of the central bank. They dobelieve that the Federal Reserve can control the volumeof unborrowed reserves.

~For the development of the New View see J. Gurley andE. Shaw, Money in a Theory of Finance (Brookings, 1959);D. Fand, “Intermediary Claims and the Adequacy of OurMonetary Controls” and J. Tobin, “Commercial Banks asCreators of ‘Money,’” in D. Carson (ed), Banking andMonetary Studies (Invin, 1963); H. Johnson, Essays inMonetary Economics (Allen and Unwin, 1967), Chapters1 and 2; ‘N. Brainard, “Financial Intermediaries and aTheory of Monetary Control,” in D. Hester and J. Tobin(eds), Financial Markets and Economic Activity (Wiley,1967); and K. Brunner, “The Role of Money and MonetaryPolicy,” in the July 1968 issue of this Review.

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FEDERAL RESERVE BANK OF ST. LOUIS JANUARt 1970

ness of commercial banks relative to other inter-mediaries, and the extent to which the centralbank can control the nominal money stock.’2 Theyargue that the central bank can control its instruments(open market operations, reserve requirements, dis-count rate) and some money market variables (freereserves, Treasury bill rate); that the commercialbanks supply deposits at a fixed rate; and that thestock of money and liquid assets which emerge — atleast in the short run — largely reflect the public’spreference for demand and time deposits, interme-diary claims, and other financial assets.”

Two schools of monetary economics differ on theuse of the money stock as an indicator or target vari-able, and on the extent to which it is an endogenousvariable and therefore not available to the monetaryauthorities as a stabilization instrument. The non-monetarists believe that the central bank should for-mulate its policies in terms of money market variablesand implement them through operations on the instru-ment variables. They view the money stock as (in part)an endogenous variable, and do not conceive of it as aproper instrument or target variable. The monetaristsbelieve that the central bank can, and should, defineits objectives and implement its policies in terms ofthe money stock. Indeed, these two conceptions ofthe money stock and its role in monetary policy de-cisions summarize some important substantive differ-ences that have emerged in monetary economics:

(1) between the monetarist view that changes in the

nominal money stock may be a causal, active, and

‘2Tobin offers the following description of the New View:“A more recent development in monetary economics tendsto blur the sharp traditional distinctions between moneyand other assets and between commercial banks and otherfinancial intermediaries; to focus on demands for and sup-plies of the whole spectrum of assets rather than on thequantity and velocity of ‘money; and to regard the strue-tare of interest rates, asset yields, and credit availabilitiesrather than the quantity of money as the linkage betweenmonetary and financial institutions and pohcies on the onehand and the real economy on the other.”

He also suggests that this general equilibrium approach tothe financial sector tends to question the presumed unique-ness of commercial banks:“Neither individually nor collectively do commercial bankspossess a widow’s cruse. Quite apart from legal reserve re-quirements, commercial banks are limited in scale by thesame kinds of economic processes that determine the ag-gregate size of other intermediaries.”

J. Tobin, “Commercial Banks as Creators of “Money,’”op. cit., pp. 410-412,

‘3Some monetary theorists have argued that while a skillfulcentral bank can manipulate its controls to keep the nominalmoney stock (M) on target, it is preferable nevertheless tothink of (M) as an endogenous variable. They argue that a“theory which takes as data the instruments of control ratherthan M, will not break down if and when there are changesin the targets or the marksmanship of the authorities. SeeJ. Tobin, “Money, Capital and Other Stores of Value,’American Economic Review, May 1961.

independent factor in influencing aggregate de-mand and the price level, and the nonmonetaristviews ranging from (a) the older “real bills” doc-trine that the money stock responds primarily tochanges in the real economy; (b) the Income-Expenditure theories (associated with the 450 dia-gram) which view money as an accommodatingfactor; and (c) the more recent New View doc-trine that the money stock is best viewed as oneof several endogenous liquidity aggregates;

(2) between the monetarist view that the moneystock — using either the conventional or thebroader definition — is a reasonably well-behavedquantity, and the Radcliffe-type view that rejectsthese measures as narrow and inappropriate, andargues for a broader liquidity aggregate; and

(3) between the monetarist view that the monetarypolicy posture should be gauged by the behaviorof a monetary aggregate, and the Income-Expend-iture theories viewing market interest rates as theproper indicator variable.

Many who question the advisability of operatingmonetary policy in terms of money stock guidelinesalso question whether the central bank control is pre-cise enough to comply with the guideline require-ments. The extent of this control is therefore a keyquestion. Is the money stock best viewed as an en-dogenous variable — determined by the interaction ofthe financial and real sectors — and outside the directcontrol of the central bank? Or is it more nearly cor-rect to view it as an exogenous variable — as a policyinstrument — that the authorities can control, andwhose behavior can be made to conform to the stabili-zation guidelines?

This issue is essentially an empirical one: Does con-trol over the monetary base and other instrumentsprovide the central bank with sufficient powers to fitthe behavior of the money stock into a given stabiliza-tion program? The monetarists, in assigning an im-portant role for the money stock in stabilizationpolicy, assume that the central bank can engineerthe desired behavior of the money stock. The sub-stantive issue can be refonnulated in terms of anempirically refutable hypothesis, as follows: Dochanges in commercial bank free reserve behavior,and do portfolio shifts by the public involving cur-rency, demand and time deposits, and other financialassets, introduce enough variability and enough “noise”to break the monetary base — bank reserves — moneystock linkage, and justify treating the money stock asan endogenous variable — and essentially outside thecontrol of the central bank?

The empirical examination of this issue fits in nat-urally to a framework of money supply analysis which

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I have described in an earlier article.’4 The analysisdeveloped there defines four money supply functionswhich incorporate alternative assumptions concerningportfolio, adjustments.

If we letM the nominal money stockX = a vector of Federal Reserve (monetary policy)

instruments variables (the snonetary base, re-serve requirements, discount rate, Regula-tion Q)

= a vector of endogenous financial variables(e.g., the Treasury bill rate, the Federal fundsrate, the Eurodollar rate, the rate on time de-posits and other intermediary claims)

T,C time deposits, currency, sl,ares and other fi-nancial assets that are close substitutes fordemand deposits

1’ ~‘~‘ a vector of real sector variables (CNP, busi-ness investment, durables, etc.)

a money supply (M.S.) function may be written as:M f (X, rb; T,C; Y).

The four MS. functions that follow reflect alternativeceteris paribas conditions changing the portfolio ad-justments that we permit for both the banks and thepublic:

(1) M.S.(I) is a short-run supply concept. It givesthe money supply response to a change in reserveson the assumption that while banks may chooseto adjust their free reserves, the public can onlycarry out a limited adjustment with respect tocurrency, time deposits and other financial assets.There are several ways to impose certeris paribasconditions on the public’s holdings of currency,time deposits, and other financial assets. Some in-vestigators hold levels of these assets constant,others hold ratios constant, and different investi-gators impose this ceteris paribas condition in amanner most compatible with their model, M.S.U)is of the form Mf(X,rb; T,C:Y), where T and Cspecify our assumptions for currency, time de-posits, and other close substitutes. To use it as ashort-run concept we assume that all variables inthe real sector of the economy, including stocksof real assets and flows such as consumption andinvestment, are held constant, so that it is pri-marily a function of the monetary policy instru-ment variables. Accordingly, if M.S.(I) is fairlystable it provides some support for the view thatthe monetary authorities can achieve fairly pre-cise control over the money stock.

(2) To construct M.S.(H) we remove some of theseportfolio restrictions by permitting the public toadjust their holdings of currency and time depos-its, and the terms on which banks supply timedeposits to reflect the underlying preferences. Thisfunction is of the form f(X,ro:Y), and does not

tm4See D. Fund, “Some Implications of Money Supply Analysis,American Economic Review, May 1967.

contain any arbitrary assumptions about currency,time deposits, or the rate paid on time deposits.It is derived by assuming: (a) that the banksmay adjust their free reserves and the rate paidon time deposits; and (b) that the public’s hold-ings of currency and time deposits will be deter-mined by their demand function for these assets.Although M.S.(1I) does permit a greater degreeof portfolio adjustment. it still is a short-run andrestricted function because it assumes that thereal sector variables and all other financial assetsare held constant.

(3) To construct M.S.(IIl) we permit portfolio ad-justments throughout the entire financial sectorand solve all the equations in the financial sectorsimultaneously. The Treasury bill rate and otherrates whiel, are endogenous variables in the finan-cial sector will therefore be determined, and nolonger enter as independent arguments in themoney supply function. MS. (Ill) is a reducedform equation of the form M = g(X:Y) where allendogenous financial variables will have valuesdetermined by the simultaneous solution of thebehavior equations in the financial sector. Thisfunction measures the supply response due to achange in the monetary base or some other policyinstrument, assuming that all the variables in thefinancial sector adjust simultaneously.

(4) Finally, we define M.S.(lV) in the form ofM “ g(X), a reduced-form equation which mea-sures the movements in the money stock in re-sponse to adjustments in both the real and thefinancial sector. To derive this money supply wemust solve all the structural equations in the finan-cial and real sectors simultaneously to obtain thereduced form. The real sector variables are nolonger treated as exogenous variables, but are nowdetermined simultaneously with all the endogen-ous financial sector variables. This reduced-formMS. gives the equilibrium stocks of money as afunction of the monetary base and other monetarypolicy instrument variables. This is the naturalMS. function to construct for those who viewthe money stock as passive and responding to realsector developments, and to those who view themoney stock as an accommodating variable, whosechanges may be necessary in order to validatechanges in the real economy.5’

This brief review of the four money supply functionssuggests that it is possible to test some of the substan-tive points that have come up in the recent “controlover the money stock” discussions. For example, MS. (I)postulates that we can predict the effect of changesin the monetary base (and other instruments) on themoney stock, assuming that the public’s portfolio ad-

‘tm

The M.S.(IV) function as written implies that an increasein the monetary base will affect the money supply if it in-duces some real sector changes. A “real bills’ proponentmight therefore prefer to write it as follows:

M”f(Y) and X=g(Y);where M and X are both determined by the real sectorvariables in Y.

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justments are restricted; M.S.(II) postulates that wecan predict the effect of a change in the monetarybase (and other instruments) on the money stock,even allowing the public to adjust their currency andholdings of demand and time deposits; while M.S.(IH)

postulates that we can predict the money stock re-sponse, even allowing the public to adjust their entireportfolios. These three MS. functions assume thatcommercial bank free reserve belmavior and the pub-lic’s behavior with respect to currency, demand andtime deposits are stable; and that the substitution ofintermediary claims and liquid assets for money con-forms to behavior that can be incorporated into astable MS. function. Econometric estimates of thesethree functions provide some evidence for testing thereliability of the monetary base — honk reserve —

money stock linkage.’6

Those who follow the “real bills” view — that themoney stock is determined by the real sector variables— or the view in many income-expenditure models —

that the money stock is an accommodating or permissivevariable — presumably deny the possibility of con-structing such functions, In their view these three MS.functions do not allow any changes in fiscal policy or inthe real sector variables; they permit- only restrictedchanges in the financial sector variables, and theyemphasize the monetary base and the central bank’sinstrument variables. Accordingly, they should pre-dict that the first three M,S. functions highlightingthe instrument variables are unstable and lack con-tent; indeed, their approach to monetary theory im-plies that only M.S.(IV), which incorporates changesin the real sector, contains the relevant independentvariables.

An analysis of these four money supply functions hasimplications for the use of the money stock as an inde-pendent and major instrument in stabilization. Thosewho argue that money is, at least in part, an en-dogenous variable, and who question the precisionwith which it can be controlled, assume (implicitlyperhaps) that no statistically significant supply func-tion can be estimated relating the money stock to themonetary base and other instrument variables. More-over, if such a function is estimated it would have to bea reduced-form function, and a variant of the MS. (IV)concept, incorporating feedbacks from the real sector.‘6

A comparison of the three MS. functions enables us toevaluate the quantitative effects of these portfolio shifts onthe money stock. Consider a given change in the monetarybase, or any other instrument variable, and compare themoney stock response in these three functions. The calcu-lated differences reflect the portfolio adjustments that weintroduce as we move from M.S.U) to M.S.(lII) —i.e.,shifts among currency, demand and time deposits, and thesubstitution of intermediary claims for money — and thusprovide a measure of these effects on the money stock.

In an earlier study, we compared estimates of theM.S. functions calculated from different econometricmodels. We found that the elasticities and multipliersfor the first three M.S. functions based primarily onfinancial variables appear to he stable enough tojustify further effort towards their refinement andimprovement. We also found that “There are atpresent too few studies available to calculate reliableMS. (IV) elasticities. But the available evidence,meager though it may be, does not point to anysuperiority of MS. (IV) over MS. (I)~and does notappear to favor a real view over a monetary view.Those who take the view that money is passive,responding primarily to the real economy, have torecognize that this is an assumption rather than apreposition derived from empirical evidenee.”~

Our findings also suggest that the money stockbehavior could be made to conform to a specifiedstabilization program. For example, by controllingmovements in the monetary base, monetary authoritiescan control quite adequately movements in the moneystock. The chart below illustrates a rather closerelationship between the monetary base and themoney stock.

*afl*Scale Money~Stoc1c-and Monetary Basesilkontoif Dollar. ‘°‘~ -ftdI,on ttD~jIutsia’ —~“ —— —‘ 2au

~co

!£

II ........,.,,,,,,,,,.,.,....

S~

a a~

.t..t~

ass1i~

~LL..J ~-

J~,,,,,-~-----

~ ;:~.• ~~j:i;~,’~j~~705

~ “

-......,,- ~s~

~ ~ .,,,~,~

-~~

31a’t44t~”:

I-.“-=

~--

,o~’

rsee D. Fand, “Some Implications of Money Supply Analysis,”op. cit., p. 392. The calculated elasticities and multiplierssuggest that the short run MS. functions — such as the MS.(I) and MS. (II) — are reasonably stable. These are pre-liminary findings, derived by using the steady-state solutionsto simplify the analysis; they are subject to revision andrequire the construction of significance tests.

Page 15


‘While this research is far from conclusive itis consistent with, a number of other findings.’8

It is difficult to maintain the view that the moneystock is sufficiently endogenous so that it is outsidethe direct control of the authorities, without gettingdangerously close to a “real bills” position. Ac-cordingly, the focus of the “control over the moneystock” discussion will shift, in my opinion, to the moreinteresting question — and the more relevant and lessideological question — concerning the length of theperiod needed to give the Federal Reserve Systemsufficient control to achieve a given money stockguideline. Assuming that a “reasonable” degree of pre-cision has been defined, can the particular guidelinerequirements be achieved in a week? a month? aquarter? Or must we extend the period in order toovercome false signals, “noise,” forecasting errors andother disturbances.”° It would appear that the de-gree of precision desired is not independent of thetime period required for the execution of policy, andit is reassuring to note that recent discussions havebeen directed increasingly at these points.

The Income-Expenditure Theory and theQuantity Theory:

Nominal and Real QuantitiesThere is considerable agreement on the proposition

in monetary theory that the real value of the moneystock is an endogenous variable, determined by theinteraction of the financial and real sectors, and there-fore outside the control of the monetary authorities.This is in sharp contrast to the theoretical (and prac-tical) disagreements concerning the extent to whichthe central bank can control the behavior of the

18See the references to Andersen, Brunner, Cagan, Dewald,Friedman and Schwartz, Meigs, and Meltzer in footnotes1, 8, and 11.

~~This formulation of the problem has come up in severalrecent papers. Covemor Maisel emphasizes this point asfollows:“This growth of money supply in any period is the resultof actions taken by the Federal Reserve, the Treasury, thecommercial banks and the public. Over a longer period, theFed may play a paramount role, but this is definitely notthe case in the short run. To the best of my knowledge, theFed has not and probably would have great difficultiescontrolling within rather wide limits the growth of the nar-rowly defined money supply in any week or month.”

See Sherman J. Maisel, ‘tontrolling Monetary Aggregates,”op. cit. For some other discussions of this issue, see A. J.Meigs, “The Case for Simple Rules,” op. cit.; L. Gmamley,“Guidelines for Monetary Policy — The Case Against SimpleRules,” op. cit.; the Hearings on Standards for Guidin~Monetary Action, op. cit.; A. Meltzer, “Controlling Money,’op. cit. See also L. Kalish, “A Study of Money Stock Con-trol, Working Paper No, 11, Federal Reserve Bank of St.Louis, for an interesting attempt to develop confidencelimits for measuring the money managers’ success in con-trolling the money stock.

190

ISO

170

60

15”

14O ‘40

130 1301962 1963 1964 1965 1966 1961 1968 1c69 1970

LyII

(nominal) money stock. In CII Iliibrium, tl stock ofreal cash balances has a value — analogous to, say,the real wage — which the stabilization authoritiescannot readily influence, except in those special easeswhere nominal and real variables move together. Theabove chart demonstrates that such is not always theease. For instance, the nominal money stock was un-changed during the latter half of 1966, while realmoney balances activity declined.

Income-expenditure theorists in their macroeconomicmodels often use nominal balances when the analysisrequires real balances. This substitution of a nominalquantity (which can be easily changed) for a real quan-tity (with a determinate equilibrium value) has twoconsequences: it suggests that an increase in nominalbalances will always tend to lower market interestrates; it also implies that changes in market ratescorrespond to, and reflect, changes in real rates. Thisprocedure is sometimes justified by a special inter-pretation of the demand for money, an interpretationthat is often attributed to Keynes’ General Theory.

It is therefore useful to recall the transformation ofthe demand for money in Keynes’ General Theory.Instead of defining a demand for a quantity of realbalances, the demand for money (or real balances)was transformed into the liquidity preference func-tion and a basic detenninant of the interest rate: theliquidity preference function together with the (real)quantity of money determines the interest rate; and

Page 16


since Keynes assumed explicitly that the price levelwas given, he could move from nominal to real bal-ances to detennine the market (or nominal) interestrate, the real interest rate (or return on capital), andthe equilibrium quantity of real balances.2°The post-Keynesian income models follow the General Theoryin treating tIle demand for money as a liquidity pref-erence function, but they do not determine explicitlythe equilibrium quantity of real cash balances. Thefailure to define an equilibrium value for the realmoney stock opens up the possibility of treating boththe real and nominal money stock as policy varia-bles,21 and as close substitutes.

The substitution of nominal balances for real balancesinmany post-Keynesian income-expenditure models hasextremely important consequences. To assume thatnominal and real balances may be interchanged is toassume that the authorities have the power to printreal capital and wealth: it exaggerates the control ofthe authorities over real interest rates (and rates ofreturn); and it necessarily abstracts from any directeffects of money on prices (note that the link be-tween the money stock and prices requires that wedistinguish between nominal and real values). Thistendency to abstract from the price level, to freelysubstitute nominal and real variables, and to equatemarket interest rates with real rates (of return) re-flects the analytical failure to define equilibrium con-ditions for real balances, and is a striking feature ofthe post-Keynesian income models.

In sharp contrast to the income-expenditure theory,we have the following postulates concerning realbalances in the modern quantity theory: (1) themoney demand function defines the demand forreal cash balances; (2) the quantity of real cashbalances is an endogenous variable and not underthe control of the monetary authorities (except forthe very short run); and (3) changes in nominal

20For an elaboration of this thenie see D. Fand, “KeynesianMonetary Theories, Stabilization Policy and the Recent In-flation,” op. cit., Section II on “The Demand for Moneyand Liquidity Preference: Real Balances and Interest Rates,”which discusses the changing role of real cash balances inthe Keynesian and quantity theories, the shifting emphasisfrom the price level to the level of employment, and thetransformation of the money demand function into a liquiditypreference function.2tFor a penetrating analysis emphasizing the originality andgenerality of the Keynes theory, in contrast to the rigidities,traps, and elasticity pessimism in many of the post-Keyne-sian income models, see A. Leijonhufvud, On KeynesianEconomics and the Economics of Keynes (Oxford, 1968).See also D. Fand, “Keynesian Monetary Theories, Stabiliza-tion Policy and the Recent Inflation,” op. cit., Section IIIon “Three Keynesian Liquidity Preference Theories,” andJ. Tobin’s seminal article on “Money, Capital, and OtherStores of Value,” op. cit., for his illuminating analysis of anaggregative model with three assets.

balances will generally have effects on market interestrates, on income, and on prices.22 For the analysis oftransition periods it assumes that an increase innominal balances will have a compound effect on in-terest rates — including a short-run liquidity (Keynes)effect, an income effect, and a longer-run (Fisher)price expectation effeet.23 The modern quantity theoryalso assumes that the demand for money is quite stable,and that a velocity function (derived from the moneydemand function) may provide a useful link between(changes in) money and (changes in) money in-come; and, in contrast to the earlier quantity theory,postulates a stable velocity function, but allowsmarginal velocity to differ from average velocity.

Taken together, these quantity theory propositionshave two important implications. They suggest: (1)that the monetary authorities do not control real in-terest rates or the stock of real balances, even if theycan always control the stock of nominal money andthereby influence nominal or market interest rates;(2) that money is an important variable for explain-ing changes in prices, since the equilibrium quantityof real balances links changes in nominal money withchanges in the price level. Accordingly, the modernquantity theory uses the money demand function topredict the level of money income and prices if out-put is given, or changes in money income if outputvaries with changes in the money stock.

The modem quantity theory and income-expendituretheory thus differ sharply in their analysis of the moneydemand function. In the modem quantity theory itserves as a velocity function relating either money andmoney income, or marginal changes in money andmoney income (if both output and marginal velocityvary with the money stock); in the income-expendituretheory, it serves as a liquidity preference theory of in-

2mSee L. Mints, Monetary Policy for a Competitive Society(McGraw-Hill, 1950); M. Friedman (ed), Studies in theQuantity Theory of Money (Chicago, 1958), and The Op~timurn Quantity of Money (Aldine, 1969), especially Chap-ters 6-9; H. Johnson, Essays in Monetary Economics (liar-yard, 1967), Chapters 1-3; D. Patinkiri, Money, Interestand Prices, 2nd ed. (Harper, 1965), Chapter XV; andC. Warburton, Depression, Inflation, and Monetary Policy,(Johns Hopkins Press, 1966).

23For a more explicit statement of the relation betweenchanges in the nominal money stock and interest rates seeM. Friedman and A. Schwartz, Trends in Money, Incomeand Prices (forthcoming); M. Friedman, Dollars and Deficits(Prentice Hall, 1968); P. Cagan and A. Gandolfi, “TheChannels of Monetary Effects on Interest Rates,” AmericanEconomic Review, May 1969; W. Gibson and G. Kaufman,“The Sensitivity of Interest Rates to Changes in Money andIncome,” Journal of Political Economy, May 1968;D. Meiselman, “Bond Yields and the Price Level: The GibsonParadox” in Banking and Monetary Studies, op. cit.; andD. I, Fand, “A Monetarist Model of the Monetary Process,”forthcoming in the Journal of Finance.

Page 17


terest rates, or of changes in interest rates (if the pricelevel is given and determined independently of themonetary sector). Accordingly, the modem quantitytheory focuses on discrepancies between actual anddesired real balances, distinguishes between (exoge-nous) nominal balances and (endogenous) realbalances, emphasizes monetary aggregates rather thaninterest rates, and highlights nominal money as theoperational policy variable; the income-expendituretheory focuses on discrepancies between actual andfull-employment output, abstracts from price levelchanges, emphasizes an interest rate transmissionmechanism, views the monetary aggregates as endo-genous variables, and highlights the full-employmentsurplus as the operational policy variable.24

Viewed as general theories of income determination,both theories have deficiencies. The modem quantitytheory seeks to explain prices, or money income, butoften abstracts from the level of employment; theincome-expenditure theory seeks to explain the levels ofemployment, but often abstracts from the price level;this difference in focus mirrors the change in the analyt-ical roles of real balances and interest rates in thetwo theories. The quantity theory emphasis on realbalances as an endogenous variable implies that theattempt by the monetary authorities to raise the moneystock may cause prices to rise, and also cause nominal

and real interest rates to diverge. In contrast, the in-come-expenditure theory, by dc-emphasizing the endo-geneity of real balances, implies that real balances andinterest rates can be controlled (within limits) by the

24The mnemonic statements that money is or is not importantdo not bring out the essential monetary differences betweenthe income and quantity theories. In some ways the income-expenditure theory attaches greater significance to moneythan does the quantity theory. Thus, the income-expendituretheory assumes that it is often possible to permanently lowerinterest rates, or rates of return, by an increase in nominalmoney, while the quantity theory is more inclined to viewnominal money changes as having a permanent effect mainlyon money income and prices. Yet because quantity theoristsare often analyzing situations where inappropriate monetarypolicies may have caused severe difficulties (e.g., in the1930’s), they may foster the impression that erron in mone-tary policy are always associated with such drasticconsequences.

One other paradox may he noted. Many ineome-expendi-lure theorists treat the nominal money stock as an endog-enous variable because they believe that this approachassumes less and is therefore more accurate. But while thistreatment of the money stock is most appropriate in thisformal sense, it may apparently also lead to substantiveerrors. For example, the large scale econometric modelstreat the nominal money stock as an endogenous variable,but do not restrict the movements in real balances by well-defined equilibrium conditions. The assumption that anincrease in nominal balances will increase real balances mayhave been responsible for some of the forecasting errors andpolicy mistakes in 1968. This assumption may involve a moreserious error, substantively and analytically, than treatingthe nominal money stock, formally, as an exogenous variable.

authorities — an impression that is reinforced by theirfailure to distinguish between nominal and real rates.

The analysis of money, interest rates, and prices inthe post-Keynesian income theories may explain sev-eral of the troublesome features of recent stabilizationpolicy: the use of market interest rates as an indicatorof monetary policy; the tendency to minimize theprice level consequences of excessive monetarygrowth; the failure to recognize the impact of infla-tionary expectations on market interest rates; the re-luctance to distinguish between nominal and realquantities; and the conviction that the rise in marketinterest rates since 1966 was due to an increaseddemand for money, and not the result of excessivegrowth in the money supply.25

The failure of income-expenditure theorists to con-sider the impact of accelerated (excessive) monetarygrowth on rising (or high) market interest rates, and todistinguish between market and real interest rates, isespecially relevant for analyzing the post-1965 inflationand the stabilization difficulties since June 1968. Thesurprising failure of the Revenue and ExpenditureControl Act of June 1968 to cool the economy thusfar could be explained by noting that the fiscal “re-frigeration” effect was offset by the monetary “boiler”effect.26 The authorities, while fighting inflation withthe surcharge, also wished to lower interest rates andmove toward a tighter fiscal and easier monetary policyduring this period, and this led to a very substantialincrease in the monetary aggregates.

Many who favored monetary expansion after theJune tax package based their case on the desirability(and social necessity) of lowering market interestrates. In retrospect, it seems difficult to suppose thatan increase in nominal money will raise real balances,lower interest rates, curtail disintermediation, facilitateresidential construction, and somehow not raise ag-gregate demand or prices. But an increase in the

25For a recent, and very useful, statement of the incometheory approach to stabilization, incorporating a commit-ment to economic growth and viewing it as a key aspect ofgovernment policy, see W. Heller (ed), Perspectives onEconomic Growth (Random House, 1968). Because thecontributors to this volume are outstanding, it may not beinappropriate to mention that the chapters dealing withstabilization policy and monetary theory provide examplesillustrating the several questionable tendencies just sum-marized. Obviously these tendencies are not just limited tothose whose understanding of the income theory may bequestioned. It is for this reason that I do not regard thesecharacteristics as analytical errors, but think ot them as“methodological commitments” that may have becomeburdensome, and perhaps analytically oppressive.

26See the cogent analysis by A. Wojnilower, “Blowing Hotand Cold,” First Boston Corporation (September 1968).

Page 18


money stock which takes place in the midst of aninflation will not only raise prices but also raise marketinterest rates. Nevertheless, if true, it suggests thatan incredibly optimistic theory — based on a refusalto acknowledge the endogeneity of real cash balancesand its implications for diverging nominal and realrates — may have contributed directly to the infla-tionary pressures which are still continuing; and it mayalso have contributed to our 1966 stabilization diffi-culties, if the authorities believed that monetary ex-pansion would bring about lower interest rates.27

The stabilization difficulties that we have experi-enced since 1965 may he related to two questionablepropositions about money, which are implicit in manyincome-expenditure models: (1) that the authorities canaffect real balances if they can control the nominalstock of money; and (2) that the authorities can in-fluence real rates through central bank operationswhich change nominal market rates. Although bothof these propositions are generally accepted, theyhave only a limited validity, and may lead to seriouspolicy errors when applied to a high-pressure economysuch as the United States in the post-1965 period.

In an underemployed economy, nominal quantitiesand nominal rates may move with real quantities andreal rates, and real balances may be sufficiently flexi-ble to be treated as a policy variable. But in a high-pressure economy with rising prices, nominal and realquantities no longer coincide; the real (value of the)money stock cannot be treated as a policy variable,and an increase in the money stock will not only raiseprices but will raise market interest rates as well. Asimilar question arises regarding the behaviorof interestrates. In a slack economy market interest rates and realrates move together; but in a high-employment econ-omy with rising prices, market rates and real rates maydiverge (see accompanying table), Indeed, in a periodof price inflation, constant real rates are necessarilyassociated with rising market rates, so that movementsin the market rates cannot always correspond to realrates.

The endogeneity of the real (value of the) moneystock, as indicated by the divergence between nominaland real balances and by the divergence betweenreal and market interest rates, is thus a manifestationof an economy approaching full utilization. And we

27The fear of overkill articulated by influential sources in thesummer of 1968 may have served to reconcile the views ofthose who favored the tax increase primarily as a stabiliza-tion measure to cool the inflation with the views of thosewho favored the tax increase to shift the policy mix toachieve lower interest rates and stimulate socially desirablecapital expenditures.

1963 1964 1965 1966 1967 1968 1969 1970of cot S~cofIof~oo.,,obt ,a.,’froo,flo’,.ttc& ,.g,.i.io.,oofooot.,o h,f.,.s,,of,i

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need to investigate empirically when movements ininterest rates and in money balances begin to d.Lvcrge,and whether the divergence between real and nom-inal interest rates is related to the divergence betweenreal and nominal balances.28

Many investigators have commented on the mone-tary lag, and have suggested that because of thislag we would expect very sharp movements in inter-est rates — as the initial response to changes in themoney stock. It is not clear how the monetary lagmay be affected by the divergence between marketand real interest rates and between nominal and realbalances. Knowledge of the conditions when real andnominal balances diverge, of the process that causesinterest rates to diverge, and of the mechanism throughwhich the monetary lag operates, should be useful inimproving stabilization policy. It would also help ree-

28Somewhere between the slack economy and the inflationaryhigh-pressure economy there is a change in the relation be-tween nominal and real balances and between nominal andreal rates. Responsible policy officials must therefore identifyand take account of the divergence between nominal andreal rates, especially if they follow an interest rate criterionand use money market rates in the implementation of mone-tary policy decisions.

Page 19


oneile the income-expenditure and modem quantitytheories and thus help complete the work initiated byKeynes by providing us with a truly general theoryof employment, interest and money.

The Non-Monetary Theories ofPrice Level and Inflation

It is hardly an exaggeration to say that we do nothave a satisfactory theory of the price level or of in-flation, The post-Keynesian income and modem quan-tity theories provide different income determinationmodels: the income-expenditure theory emphasizes theconsumption function and other income-expenditurerelationships; while the modern quantity theory em-phasizes the demand for money and portfolio adjust-ments.29 As theories of national income both theorieshave limitations, as we have just noted, and neithertheory provides us with an articulated theory of theprice level and a basis for allocating a given change innational income into the fraction due to real outputand the fraction due to price level changes.

The modem quantity theory, in the absence of anexplicit theory of the price level, nevertheless assumesa link between money and prices, and views move-ments in the absolute price levels and inflationary (ordeflationary) pressures as reflecting current and pastchanges in the money stock. The income-expendituretheory de-emphasizes any direct link between mone-tary assets and prices, and highlights non-monetaryfactors in explaining upward movements in the pricelevel and inflation. This is particularly evident in therecent large scale econometric models (Brookings,Michigan, Wharton, FRB-MIT), which do not in-corporate monetary (or fiscal) variables directly toexplain the price level; they base the prediction equa-tions for the absolute price level on concepts andempirical regularities that may be appropriate formicro-analysis and for the determination of relativeprice movements.50

29The capital-theoretic orientation of the post-Keynesian quan-tity theory, emphasizing portfolio choice and the substituta-bility of mooey for other assets, has been heavily influencedby the Keynesian Liquidity Preference theory. Unlike theolder quantity theory based either on the payments rela-tions of the transactions approach or the store of value re-lations of the Cambridge approach, it follows the Keynesiantheory in treating the demand for money as a problem incapital theory, focussing on the composition of the balancesheet and the selection of assets. See J. Tobin, ‘A DynamicAggregative Model,” Journal of Political Economy, April1955, and “Liquidity Preference as Behavior Toward Risk,’Review of Economic Studies, February 1958; and M. Fried-man (ed), Studies in the Quantity Theory of Money, op. cit.501n their progress report on the Federal Reserve-MIT model,F. DeLeeuw and E. Gramlieh summarize the findings of theeconometric models as follows:“The evidence from several of the large econometric mod-

As an illustration, consider the recent (preliminary)FRB-MIT model of the price-wage-labor sector whichfollows the other large scale models in basing priceson unit labor costs, other markup factors, and intro-duces additional variables to pick up the influence ofdemand shifts or oligopoly pricing.3’ This is essen-tially a non-monetary theory of the price level, Itseems to suggest that a general excise or uniform salestax (10 per cent on all commodities) would raiseprices; yet an income tax, designed to yield the samedollar amount, would presumably lo\ver prices andcertainly not cause them to rise, But a conclusionthat a uniform excise tax raises the price level, whilean income tax which produces equivalent revenuewould lower prices seems paradoxical. Moreover, sincethere are no explicit specifications given for the moneystock we have the following strange results:

(1) an excise tax may he inflationary even when therevenue is impounded and the stock of money isreduced; and

(2) an income tax is deflationary when the stock ofmoney is maintained, or even when allowed togrow at an accelerated rate. This paradox illus-trates the difficulties of explaining absolute pricelevel movements with concepts that are appropri-ate for relative price analysis, and of using an

els — the Wharton School Model, the Commerce Depart-ment Model, the Michigan Model, and to a lesser extentthe Brookings Model — is that monetary ,forces are ratherunimportant in influencing total demand.

See F. DeLeeuw and E. Cramlich, “The Channels ofMonetary Policy,” Federal Reserve Bulletin, June 1969.

The Brookings model is presented in J. Duesenberry, etal., The Brookings Quarterly Econometric Model of theUnited States (Chicago, 1965); The Michigan model is pre-sented each year at a conference and later published in avolume. The Economic Outlook for 1969 gives the 1969model presented at the November 1968 conference. TheFRB-MIT model is described in F. DeLeeuw and E. Cram-lich, “The Federal Reserve-MIT Econometric Model,” Fed-eral Reserve Bulletin, January 1968, and in “The Channelsof Monetary Policy, Federal Reserve Bulletin, June 1969.The Wharton model is presented in M. Evans and L. Klein,The Wharton Econometric Forecasting Model (Universityof Pennsylvania, 1967).

S1F DeLeeuw and E. Cramlich in “The Channels of Mone-tary Policy”, op. cit., describe it as follows:“Prices are assumed to be a variable markup over wages,with excise taxes completely shifted onto consumers. Thevariables determining the markup are the productivity trendwhich allows producers to maintain profit shares even thoughwages rise faster than prices, fann and import prices whichmeasure other costs, and the ratio of unfilled orders toshipments, which indicates demand shifts.’

For a criticism of the price level equations in the Brook-ings model see Z. Criliehes, “The Brookings Model Volume:A Review Article,” Review of Economics and Statistics,May 1968, especially his discussions of prices and wages,pp. 221-223, and the rejoinder by C. Fromm and L. Klein,especially pp. 237 and 238. For a more recent attempt todevelop price equations without bringing in monetary fac-tors explicitly see 0. Eekstein and C. Fromm, “The PriceEquation,” American Economic Review, December 1968.

Page 20

FEDERAL RESERVE SANK OF ST. LOUIS JANUARY 1970

aggregative theory that does not incorporate anydirect influence of money on prices.32

The drift towards non-monetary theories of theabsolute price level is not a new development in the1960’s; it has been going on steadily since the end ofWorld War II. And though these theories may havedescriptive (or analytical) relevance in suggestingeither the initiating factors, or the process in particu-lar price level movements, they are not easily inte-grated into a coherent set of anti-inflationary policies.Moreover, if the absolute price level is indeed a func-tion of unit labor costs, markup factors, new or un-filled orders, and other non-monetary factors, then itdoes sharply limit the scope of the traditional stabili-zation measures which are geared to a demand infla-tion. In addition, the focus given to the non-monetaryaspects by the theorists of the “new inflation” mayhave also diverted attention from the “classical infla-tion” due to expansive monetary-fiscal policies. Theconjuncture of all these factors may help explain ourinability to identify and deal effectively with the post-1965 inflation in the United States.

The following six-stage sketch of inflation theory,which summarizes its evolution since World War II,ifiustrates the shift in emphasis away from the effectsof aggregate demand on prices, toward an emphasisof the effects of costs and aggregate supply. Thepurging of monetary variables from inflation (andprice level) theory is also pointed out. One inferenceemerging from this sketch is that more attentionneeds to be given to the monetary aggregates andtheir effect on aggregate demand, if we wish to im-prove our ability to forecast price level developmentsand deal more effectively with inflation.33

(1) The “inflationary gap” analysis developed byKeynes during World War H focused on an econ-omy where prices were rising because of an excessof aggregate demand over supply. Unlike the

32For a discussion of this issue see H. Brown, “The Incidenceof a Ceneral Output or a Ceneral Sales Tax’ in AEAReadings in the Economics of Taxation (Irwin, 1959); E.Rolph, Theory of Fiscal Economics (University of California,1954); R. Musgrave, The Theory of Public Finance (Mc-Graw-Hill, 1959); and A. Morag, On Taxes and Inflation(Random House, 1965).

33Professor C. Haberler is an outstanding exception to thistendency. His Inflation: Its Causes and Consequences (Wash-ington, 1966), first published in 1961, emphasized the needfor coordinated monetary and fiscal policy in fighting ademand inflation,

For a survey of inflation theory see M. Bronfenbrennerand F. Holaman, “Survey of Inflation Theory,’ AmericanEconomic Review, September 1962; H. Johnson, Essays inMonetary Economics (London, 1967), especially Chapter 3;and S. Rousseas (ed), Inflation: Its Causes, Consequencesand Control (New York University, 1968).

classical quantity theory formulation, it did notassume any particular link from money to ag-gregate demand, but was intended as an improvedtheory of an excess-demand inflation. This ap-proach fell into disfavor when the postwar em-ployment forecasts for 1946 and 1947, based oninflationary gap analysis, turned out very badly,and it was widely recognized that the income-expenditure relations were not properly specifiedin monetary terms. Not surprisingly, this analysiswent out of style at the end of the 1940’s.

(2) Since the early 1950’s, the post-Keynesian incomemodels have typically emphasized the role of ag-gregate demand in employment while dc-empha-sizing its impact on price level movements. Oneof the earliest cost inflation theories — the wage-push model — was accepted by many neo-Keyne-sians as an explanation of the creeping inflationof the 1950’s; and it seemed to be a consistentapplication of the Keynesian doctrine that a cutin the money wage will cause prices to fall (bythe same amount) and will not, therefore, stim-ulate employment in the depressions. The Key-nesian view that the real wage is determinedindependently, and not influenced by changes inthe money wage, would also seem to suggest thatrising prices are due to rising wages. Later ver-sions of cost inflation models stressed markuppricing, seetoral shifts, and administered (non-market clearing) prices. And since creeping infla-tion was generally associated with a reduction inaggregate supply due either to rising factor costsor to shifts in demand, it seemed to follow quitenaturally that a reduction in aggregate demandwas not an appropriate policy for fighting inflation.

The wide acceptance of the thesis that thecreeping inflation of the 1950’s (viewed as thetypical inflation of advanced industrial countries)was basically an aggregate supply phenomenonhad two important consequences: it rationalizedthe view that monetary policy should play only avery minor role in fighting inflation; and it also lentsupport to the view that the stabilization authori-ties should focus directly on the behavior of wagesand prices and explore new stabilization tech-niques such as incomes policies, wage-price guide-posts, and possibly including indicative planningand other techniques of supply management.34

(3) Reinforcing the idea that creeping inflation wasan aggregate supply phenomenon, and requiringtherefore a national wage-guidepost (or incomes)policy, was the growing skepticism about whethermonetary policy could play any constructive rolein stabilization. First, there was a general concernthat a restrictive monetary policy would reduceoutput but not succeed in lowering prices; second,it was suggested that the monetary authoritiesmay not always be able to control the stock of

3See the Joint Economic Committee volume on The Relationof Prices to the Economic Stability and Growth (Washing-ton, 1958) for a fairly comprehensive compendium of non-monetary inflation theories that were developed to explainthe creeping inflation of the l05

0’s.

Page 21


privately held liquid assets through their controlof the money stock; and finally, that aggregatedemand was functionally related to the total vol-ume of liquid assets and not to one componentof this total — such as the narrow money stock.35

(4) The cost inflation models assume that creepinginflation (unlike galloping inflation) is an aggregatesupply phenomenon and not due to an increase inaggregate demand. They differ only in the specificmechanism that they single out: some focus onunions and wage-push; others on markup pricing,on market power and bargaining strength, andon administered prices. But they all assume anautonomous rise in factor costs, a reduction inaggregate supply, and a rise in prices, eventhough aggregate demand is stable. Similarly,although the demand-shift inflation model doesnot initiate the process with an autonomous risein factor costs, it follows the cost models in ex-plaining the price rise without introducing anynotion of excess demand.

(5) At the close of the 1950’s, Samuelson, Solow, andothers developed the “trade-off” analysis of creep-ing inflation. They start with a Phillips Curve — afunction relating unemployment and percentagechanges in money wage rates — and derive fromthis a trade-off function — which relates unem-ployment and the rate of price change. They sug-gest that the unemployment rate at a stable pricelevel may be unbearably high and socially unac-ceptable, and that we may have to accept a givendegree of inflation (a specified rise in the pricelevel) if we wish to lower the unemployment rate.If this trade-off function, incorporating a dynamicmoney-illusion effect, applies to the steady-stateand is not just a temporary phenomenon, itimplies that the degree of inflation is related tothe level of unemployment that society willtolerate. It also suggest that we may haveinflationary recessions — even substantial unem-ployment does not necessarily guarantee us a sta-ble price level. From an analytical point of viewthis theory is a radical departure from traditionalanalysis in assuming that real variables (the levelof employment and of output) are not independ-ent of nominal variables (the price level), evenin the long run.

36

35For a good example of the growing skepticism about therole of monetary policy in stabilization and the acceptanceof the “New Inflation” theory see The Joint Economic Com-mittee Staff Report on Employment, Growth and PriceLevels (Washington, 1959).

See the review by H. P. Minsky, “Employment, Growthand Price Levels: A Review Article,” The Review of Eco-nomics and Statistics, February 1961, and the analysis ofthe inflation theory in the “Staff Report,” in C. Habemler, op.cit. See also C. C. Kaufman, “Current Issues in MonetaryEconomics and Policy: A Review,” op. cit., for a discussionof the monetary issues.

~~Although the trade-off function between unemployment andinflation is widely accepted, its interpretation does poseseveral questions for inflation theory: Are the trade-offestimates, interpreted as long-run steady-state relations,

(6) FInally, some economists have recently attemptedto analyze inflation in terms of a disequilibriummodel — thus generalizing the earlier Keynesianwage-push theory to cover sellers’ inflation andadministered (non-equilibrium) prices. In theirmodel actual prices, and especially wage rates,are very often somewhere between the demandand supply price, and do not, therefore, satisfyeither the demand function or the supply func-tion; market prices and wages are detennined intheir view by market power and relative bargain-ing strength. In this model it is possible to haveboth buyers’ and sellers’ inflation.37

This review of inflation theory illustrates the pro-liferation of non-monetary price level and cost infla-tion theories since the end of World War II, stressing(a) autonomous increases in factor costs, (b) shiftsin demand, (c) administered prices and marketpower, (d) the trade-off function between unem-ployment and price level changes, and (e) mar-kets in disequilibrium. These “new inflation” theoriesreflect a growing consensus among income-expendituretheorists throughout this period that monetary variablesare not the causal, independent, or active factorsaffecting output, employment, or prices. The wide-spread acceptance of these new inflation theories,both in the academic world and in business circles,seemed to vindicate the monetary views of the in-

consistent with our accumulated experience with inflation?Are the trade-off estimates, which assume a lonE learningperiod, consistent with our theories of anticipated inflationsand expectational behavior? Does the trade-off analysissuggest any role for monetary policy in avoiding or incombating inflation by shifting the trade-off function? Andis such a role consistent with the growing volume ofempirical studies of the monetary sector?

The Samuelson and Solow article developing the trade-off analysis by utilizing the Phillips Curve is given inP. Samuelson and R. Solow, “Analytical Aspects of Anti-Inflation Policy,” American Economic Review, May 1960 andempirical estimates of the Phillips Curve and the trade-offfunction are presented in George L. Perry, Unemployment,Money Wage Rates, and Inflation (Cambridge: The M.I.T.Press, 1966); Ronald C. Bodkin, The Wage-Price-Produc-tivity Nexus (Philadelphia: University of PennsylvaniaPress, 1966); and Roger W. Spencer, “The Relation Be-tween Prices and Employment: Two Views, in the March1969 issue of this Review. See the discussion of PhillipsCurves and trade-off functions in A. Burns and P. Samuel-son, Full Employment, Guideposts and Economic Stability(Washington, 1967); and Solow’s paper, “Recent Contro-versy on the Theory of Inflation: An Eclectic View,” inS. %V, Rousseas, op. cit.; see C. Haberler, “Stability Growthand Inflation, a chapter in a forthcoming volume dealinwith these issues, and D. Fand, “On Phfflips Curves anTrade-off Functions,” a paper presented to the CanadianEconomics Association meetings, Toronto, Canada, June 5,1969 for a discussion of the Phillips (U,W) function, andits relation to the Samuelson-Solow (U,I) trade-off function.

37For a statement of this disequilibrium model see A. P.Lemer, On Generalizing the General Theory,” AmericanEconomic Review, March 1960. For a different interpreta-tion, see A. Leijonhufvud, op. cit.

Page 22


come-expenditure theorists, and helped explain theexperiments — in the United States and in WesternEurope — with new inflation weapons such as incomespolicies, wage-price guideposts, indicative planningand other elements of supply management.

Nevertheless, the failure to introduce monetaryvariables in the analysis of the price level and ininflation theory does seem strange. Whatever rele-vance or validity these non-monetary theories mayhave had in explaining, or in providing, effectivepolicies for coping with the creeping inflation of the1950’s, they are clearly inappropriate for the inflationof the 1960’s. A credible explanation of our recentinflation surely must take account of excess demandand the high rates of monetary expansion since 1965.Whether or not this rate of monetary expansion wasinevitable, given the Vietnam War, it surely playeda major and substantial role in our recent inflation.

The tendency to exclude any direct influence ofmoney on prices and to stress real (non-monetary)factors in explaining the absolute price level has gen-erated an intellectual climate in which it is easy toneglect the behavior of the monetary aggregates. Andwhen income-expenditure theorists highlight the effectof monetary policy on interest rates, they necessarilyminimize the effect on prices, for this is implicit in al-lowing real balances to behave as if they were a policyvariable. In consequence, when they were faced withthe need to explain the creeping inflation and pricelevel movements of the 1950’s, they sought to locate thecause among the aggregate supply variables such aswage-push, markups, sellers’ inflation, or in demandshifts. Admittedly, this inflation theory was not de-signed to serve as the analytical model for analyzinga demand inflation such as that we have experiencedsince the Vietnam escalation in 1965. Nevertheless,the stressing of real factors in the theory of the pricelevel has made it difficult for many income-expendituretheorists to see the relevance of the substantial growthin the money stock in the recent inflation, even whilefreely conceding that it is a classical demand inflation.Our experience since 1965 suggests that we direct oarattention to the money stock and its effect on aggregatedemand and prices. It also suggests that the emphasisgiven to real factors in explaining the post-1965 infla-tion and to discretionary fiscal policy for coping withit, and the relative neglect of the monetary aggre-

gates, is an inheritance from the past that needs tobe re-examined.38

385ee D. Fand, “The Chain Reaction-Original Sin (CROS)Theory of Inflation,” op. cit.; “A Monetary Interpretation ofthe Post-1965 Inflation in the United States,” op. cit.; and“Keynesian Monetary Theories, Stahilization Policy, and theRecent Inflation,” op. cit.

Fiscal Policy Assumptionsand Related Multipliers

The theory of fiscal policy highlights the directincome-generating effects of government deficits andsurpluses and the stabilization aspects of the cumula-tive multiplier expansion process; but the theory oftenignores the interest rate or capital market effects, andinvariably abstracts from any associated money stockeffects. The simplest presentation may be summarizedas follows: an increase in government spending isviewed as a direct demand for goods and services;reductions in tax rates are viewed as directly affectingconsumer spending, investment, and aggregate demand;and the initial increase in spending is viewed as settingoff a cumulative expansion as given by the multiplierprocess.39 More advanced discussions go beyond the45° diagram, introduce the Hicksian IS-LM analysisto account for the capital market effects of changes infiscal policy; but even this more advanced analysistypically abstracts from the money creation aspectsthat may be associated with a cumulative expansion.

A widely quoted statement describing the “Work-ings of the Multiplier” in the Economic Report of thePresident for 1963 illustrates this tendency to omitthe capital market and money creation aspects.4°The direct income-generating effects of the deficit arestressed, but no indication is given whether the risein income requires stable interest rates, an elasticmonetary policy, or a deficit financed through thebanking system. Thus, the case for a discretionarytax cut and a reduction in the full-employment surrplus, as presented by the Council of Economic Ad-visers (CEA) in 1963, does not bring in any explicitdiscussion of the method in which the deficit is fi-nanced. Their position is stated as follows:

Tax reduction will directly increase the disposableincome and purchasing power of consumers andbusiness, strengthen incentives and expectations,and raise the net returns on new capital investment.This will lead to initial increases in private con-sumption and investment expenditures. These in-

39The volume of readings, American Fiscal Policy: Experi-ment for Prosperity (Prentice-Hall, 1967), edited byL. Thumow, is a good example. With very few exceptions, theindividual papers either abstract from, or ignore, monetaryfactors, and do not cite any empirical evidence to justifythe strategic role assigned to discretionary changes in thefull-employment surplus. It appears that such justificationwas not felt necessary, because the very substantial growthin CNP since 1964 was widely interpreted as the result ofthe 1964 tax cut and reduction in the full-employmentsurplus.40See the section, “Workings of the Multiplier” in the Eco-nomic Report of the President for 1963, This is reprinted inA. M. Okun (ed), The Battle Against Unemployment(Norton, 1965), pp. 88-97.

Page 23


creases in spending will set off a cumulative expan-sion, generating further increases in consumptionand investment spending and a general rise in pro-duction, income and employment.

The analysis of the 1964 tax cut presented by ArthurOkun in 1965 explicitly justifies the omission of anycapital market or monetary effects,41 Although Okunaccepts the view that significant changes in the cost oravailability of credit would have an important influenceon business investment, he does not make allowancefor these factors in his quantitative estimates of themultiplier. He rationalizes his procedure as follows:

in practice, dealing with the period of the lastyear and a half, I cannot believe that the omiss!onof monetary variables can make a serious differ-ence. By any measure of interest rates or creditconditions I know, there have been no significantmonetary changes that would have either stimulatedor restrained investment to a major degree.

He does concede that “the maintenance of stable in-terest rates and stable credit conditions requires mone-tary action” and that at least to this extent, “monetarypolicies have made a major contribution to the ad-vance.” But in his view, “that contribution is appro-priately viewed as permissive rather than causal,”Okun’s analysis, presented in August 1965, attributingthe GNP expansion to the tax-cut multiplier, was astrict fiscal policy interpretation, in contrast to other(monetary and eclectic) interpretations that werepresented at that time.42 His analysis was not modi-fied when it was published in 1968.~~

If the fiscal approach, with its multiplier analysis,emphasizes the deficit or surplus and relegates boththe interest rate and the money creation aspects to a

~‘Okun’s analysis of the 1964 tax cut was presented at the1965 meetings of the American Statistical Association. Hispaper, “Measuring the Impact of the 1964 Tax Reductionhas been published in W. Heller (ed), Perspectives onEconomic Growth, op. cit., pp. 25-51.

42See D. I. Fund, “Three Views on the Current Expansion” inC. Horwich (ed), Monetary Process and Policy: A Sympo-sium (Irwin, 1967), analyzing the views of the fiscal pro-ponents, the monetary proponents, and those who take aneclectic position. See also A. F. Burns, The Management ofProsperity (Columbia University Press, 1966); M. Friedman,“The Monetary Studies of the National Bureau,” reprintedas Chapter 12 in his The Optimum Quantity of Money,pp. 261-284; B. Sprinkel, “An Evaluation of Recent FederalReserve Policy” in the Financial Analysts Journal, August1965; and C. Morrison, “The Influence of Money on Eco-nomic Activity,” in the 1965 Proceedings volume of theAmerican Statistical Association.

~~Okun, in a note added in June 1967 to his 1965 analysisof the tax cut, does concede that “any analysis of fiscalimpact that covered the more recent period could no longertreat monetary policy as a passive supporting force, norcould it continue to ignore the influence of higher levels ofaggregate demand on prices.” See W. W. Heller (ed), op.cit., pp. 27-28.

secondary role, the monetary approach emphasizesthe money stock effects. To the monetarist, the im-pact of fiscal actions will depend crucially on howthe government deficit is financed: expenditures fi-nanced either by taxing or borrowing involve a trans-fer of resources (from the public to the government),with both interest rates and wealth effects on privateportfolios, but the net effect of a temporary changein fiscal policy on spending may be ambiguous. Simi-larly, the effect of a reduction in taxes on privatedemand, financed through borrowing, will depend on(1) the extent to which it is viewed as a permanent,or temporary, tax cut, and (2) its effect on marketinterest rates. Accordingly, the direct income-generat-ing effects of a deficit — the pure fiscal effect — maybe quite small and uncertain. On the other hand, ifthe deficit is financed through money creation by thebanking system — if the deficit is monetized — the ef-fect is unambiguously expansionary.

Many income theorists recognized that the multi-plier analysis based on the 45° diagram was inade-quate, and modified their analysis to take account ofinterest rate effects through the Hicksian IS-LM frame-work. But even this modification, while a step in theright direction, does not really make allowance forthe money creation aspects of defleits. What is neededis a macroeconomic model, where the monetary ef-fects of the deficit are taken up by introducing anexplicit government budget restraint. Recent studiesalong these lines suggest that many of the standardpropositions about the multiplier need to be revised.~~

Aside from these theoretical reasons, the need toseparate out the monetary effects from the fiscal ef-fects has been highlighted by the recent Andersen-Jordan study, testing the relative effectiveness ofmonetary and fiscal actions in stabilization.45 Their re-

44See L. S. Ritter, “Some Monetary Aspects of MultiplierTheory and Fiscal Policy,” Review of Economic Studies,February 1956; C. Christ, “A Simple Macroeconomic Modelwith a Government Budget Restraint,” Journal of PoliticalEconomy, January 1968; and J. M. Culbertson, Macroeco-nomic Theory and Stabilization Policy (McGraw-Hill, 1968),pp. 462-464.

See also K. M. Carlson and D. S. Kamnosky, “The In-fluence of Fiscal and Monetary Actions on Aggregate De-mand: A Quantitative Appraisal,” Working Paper No. 4,March 1969, Federal Reserve Bank of St. Louis; and K. M.Carlson, “Monetary and Fiscal Actions in MacroeconomicModels: A Balance Sheet Analysis,” an unpublished manu-script, for an interesting attempt to define and estimate themonetary effects of fiscal policy actions.

~5The Andersen-Jordan results are presented in “Monetaryand Fiscal Actions: A Test of their Relative Importance inStabilization,” op. cit. See also the Comments ot DeLeeuwand Icalchbrenner, and the Reply by Andersen and Jordan,op. cit. and R. G. Davis, “How Much Does Money Matter:A Loolc at Some Recent Evidence,” op. cit.; the earlierstudy by M. Friedman and D. Meiselman on “The Relative

Page 24

FEDERAL RESERVE BANK or st. LOUIS JANUARY 1970

suits, while preliminary and subject to further testing,do suggest that the theory of fiscal policy (in theincome-expenditure framework), with its emphasis ondiscretionary changes in the full-employment surplus asthe key stabilization instrument, may be incorrect oronly partially correct. Thcir findings also suggest thatthe tax and expenditure multipliers, as estimated inmany income models, tend to confound a ceteris paribusfiscal action (excluding money stock efFects), with amutatis mutandis fiscal action (incorporating bothmonetary and fiscal effects).

The need to revise the standard multiplier theoryand to develop mnorc discriminating empirical testsof the relative effectiveness of mnonetary and fiscalactions is recognized even among fiscal policy advo-cates. There is a significant mnodific-ation of themultiplier theory in the Economic Report of thePresident for 1969, stressing two points in particular:(1) “the results of this multiplier process are affectedby the amount of unused resources available in theeconomy”; and (2) monetary policy does affect themagnitude of the multiplier:

Developments in financial markets may influencethe magnitude of the multiplier. Increases in de-mands for goods and services will tend to enlargecredit demands. Unless monetary policy permitssupplies of funds to expand correspondingly, in-terest rates will rise and credit will become lessreadily available. In that event, some offsetting re-duction is likely to take place in residential con-struction and other credit-sensitive expenditures.Generally this will be a partial offset, varying ac-cording to how much the supply of credit is per-mitted to expand.4°

There is therefore a growing consensus that multi-plier theory needs to separate out the monetary ef-fects from the pure fiscal effects, in order to developmeaningful tests of the relative contribution of mone-tary and fiscal policy in stabilization. In particular,we need to define and measure monetary variablesso as to separate out exogenous changes in the moneystock, resulting from actions taken by the monetaryauthorities — from endogenous money stock changes— resulting from shifts in the demand for money, soas to remove the identification problem in a mannerthat is acceptable to the income-expenditure theorists.We also need to define a pure ceteris paribus fiscal

Stability of Monetary Velocity and the Investment Multi-plier in the United States, 1897-1958” in Stabilization Poli-cies (Prentice Hall, 1963), and the subsequent discussionof this study by F, Modigliani and A. Ando, and byT. Mayer and M. DePrano in American Economic Review,September 1963.

46See The Economic Report of the President for 1969, p. 72.

action with restrictions on the growth rate for themonetary aggregates that is acceptable to the mone-tarists. A revision of multiplier theory along theselines \vould enable us to distinguish analytically, andestimate, ceteris parthus fiscal and monetary multi-pliers, and thus bridge some of the gap between theincome-expenditure theory and the quantity theory.But it requires that we find an acceptable method toseparate out endogenous and exogenous changes inthe money stock, and to estimate empirically themoney stock effects of deficits and surpluses.

Fiscal deficits are obviously often associated with,if not directly responsible for, substantial increases inthe monetary aggregates. Our recent experience re-minds us once again that a fiscal deficit, financed bythe banking system, will tend to accelerate the growthin the money stock; while a fiscal surplus, whetherimpounded or used to retire debt, \vill tend to deceler-ate the money stock growth. And if the fiscal deficitis financed in part through accelerated monetaryexpansion, as was the case since the Vietnam escala-tion in 1965, the growth in GNP reflects the combinedeffects of fiscal and monetary action.

Monetary policy, measured in terms of the moneystock, typically changes in the same direction as fiscalpolicy. Accordingly, what we observe in most periods(like the 1964 tax cut) is the effect of a combinedaction incorporating both monetary and fiscal elements.It is therefore fortunate for the development of sta-bilization theory that they were working in oppositedirections on two occasions in recent years — thusproviding an interesting test case. In 1966 a sharpincrease in the deficit was matched by a very substan-tial tightening in monetary policy; and the crunch inthe latter half of 1966 and the mini-recession in early1967 clearly demonstrate the power of monetary pol-icy. Similarly in 1968, the very substantial increase inthe full-employment surplus enacted in the June 1968Revenue and Expenditure Control Act (and givingrise to widespread fear of overkill ) was apparentlyoffset by the preceding and subsequent growth inthe monetary aggregates. In these cases, the mone-tary forces seem to have been the stronger ones, notrelatively minor (or permissive) factors that can onlyaccommodate (or validate) fiscal policy actions. Hencethere has been renewed interest in their relative con-tribution to stabilization.

This, then, brings us to our first question: How dowe define the ceteris paribus fiscal action if monetarypolicy and fiscal policy often move in the same three-tion? The income-expenditure theorists, who define this

Page 25

FEDERAL RESERVE BANK OF ST. LOUIS

as a fiscal action with interest rates heldconstant, are calibrating monetary policy ina manner which is consistent with their viewof the transmission mechanism. On this defi-nition, a ceteris paribus fiscal deficit may re-quire a very substantial increase in the stockof money, and appears to the monetarist as amutatis mutandis effect. To the monetarist, aceteris paribas deficit requires a given moneystock growth rate, which may lead to a risein the interest rate; and to fiscal policy advo-cates, this appears as an offsetting actionsince the risc in interest rates (which theyuse to calibrate the posture of monetarypolicy) is restrictive and tends to offset theincome-generating effects of the deficit. Theceteris paribas effect for deficits or surpluses,as defined by the monetarist , will necessarilydiffer from the definition adopted by the fiscalpolicy advocates. This point is illustrated ina recent study of monetary and fiscal in-fluences on economicactivity for the period1919-69.~~The evidence sunimarized in TableI indicates that when we regress economicactivity on fiscal policy, the relation is fairlygood. If, however, we include a monetaryaggregate variable in the regression, we find, as shownin Table II, that the ceteris paribus fiscal effect, asdefined by the monetarist, is either statistically insig-nificant or has the wrong sign. The evidence sum-

marized in Tables I and II illustrates the problem ofseparating out the fiscal effect from the effect due tothe monetary aggregate.

This difference in concepts helps explain the exist-ence of a fairly pronounced communications gap.What a monetarist regards as a ceteris paribus deficitmay entail a rise in interest rates, and wifi thereforeappear as an offsetting action to the fiscal advocate;what a fiscal advocate regards as a ceteris pan bus fiscaleffect may entail accelerated growth in the moneystock, and will therefore appear as a mutatis mutandismonetary effect to the monetarist. This applies es-pecially to the analysis of the 1964 tax cut.

The money stock effects of deficits and surplusesneed to be quantified if we are to obtain a realisticformulation of the government budget restraint. Oncethis is done we may be able to estimate the differen-tial effects of non-monetized and monetized deficits,and obtain acceptable estimates of fiscal multipliers —for the ceteris paribas and for the mutatis mutandiscases. We would also like to derive such estimatesfor the monetarist who calibrates monetary actions in

~7Miehael Keran, ~Monetary and Fiscal Influences on Eco-nomic Activity — The Historical Evidence in the November1969 issue of this Review.

JANUARY 1970

Table II

INDICATORS OF MONETARY CAM) AND FISCAL (AE)INFLUENCES ON ECONOMIC ACTIVITY (AY)

AY = ~u -+~a1 AM -;- a AE(Quarterly First Differences — Billions of Dotlars)

Time Periods Lags~ or or AM az AE(sum) (sum) D-W

11/1919 — /69 1-6 1.92 2.89 .07 .32(2.34) (4.31) (.28) 1.15

11/1919.— 11,29 t-3 .36 5.62 ‘‘ .35

(.51) (3.16) 1.58

111/1929 .—.- 11.39 I 5 .51 5.40 7.97 .39

(.54) (3.41) (1.95) 1.86

111:1939. — IV/46 1.5 6.32 1.21 .35 .66

(1.39) (.59) (.81) 1.60

/1947 — IV/52 f-la 3.65 13.82 3.37 .72(.84) (3.51) (4.12) 2.74

1/1953 — 1/69 1-4 1.42 8.85 —-.84 .47

(.74) (4.70) (1.07) 1.71

Note Regre~~ioncns’ffic’ient., arw the top figures; their statiatic~appear belowrich t’,.t’ tbere,.s . Er ci,,ss,! by parcHthe. .~. 1t~is ti,. per rent C, I vpriationthe Icrunden t uu’rnl,Ic’ wh ch is extrialneci by var jar it’ ISP in tlit’ odej’t’!,Uentyarsahi.’. U. \\ is th.’ Pu !~1oI,—watson ‘tiLts, tic.

Lags are selt’cto,I on tIre beats or minimum standard error, s~justedfor degreesof Ireedo,n.

l’i%CiLl ariable nns Ittsi 1. i 1919. ~9 I,neau. e tincr,’s.’r, I ftc’ standar,i errortb, cstisn’i C.

Table I

IMPACT OF FISCAL INFLUENCES (AEI

ON ECONOMIC ACTIVITY (AY)= f0 -f f1 AE

(First Differences — Billions of Dollars)

tags fir f~AE (sum) R2/D-W

11/1919 .-— 1/1969 t-6 3.83 .81 .13

(5.16) (3.01) .9611/1919—11/1929 1-7 1.73 3.27 .41

(2.44) (2.78) 1.58

111/1929 — 11/1939 1-10 —-3.45 18.28 .14(225) (2.18) 1.49

111/1939 — IV/ 1946 1-4 4.29 .53 .61(2.91) (2.11) 1.43

l/1947—IV/1952 1.4 9.38 1.49 .09(3.91) (1.76) .81

I’ 1953—11/1969 1-3 6.08 1.71 .08(2 95) (2.15) 1.13

Not, : Itrgrc.teion c,,c’ffrci. rite an, the tup figurt, their val.jesapj ear below curls cooffich at, curiae, d by parentlr a., p it.~I the percent uI variation, In the dependc-nt variable whichis cxi lamed by variations in the indopendant variable. D-W isthe Durbin-Wateon statistic.

Sekcted on the basis of minimum standard errcr of estimatt’,adjusted for degrees of freeclons.

Page 28


terms of the money stock growth, and for the fiscaladvocates who calibrate monetary policy in termns ofinterest rates. Once this is done, we may be able totranslate the results obtained in these two frame-works. This should help bridge the communicationgap, and it may also help reconcile the two opposingpoints of view.48

ConclusionIn this paper we have discussed four issues in

monetary theory which seem central to many of therecent discussions and debates concerning monetarypolicy. The first issue is the extemit to which the cen-tral bank can control the nominal money stock. Thisissue has been raised by those who find it more na-tural to formulate Federal Reserve policy in tenns ofmoney market and instrument variables, by thosewho follow the interest rate transmission mechanismspecified by the income-expenditure theory and preferan interest rate criterion for policy making, and bythose who believe that the money stock is, in part, anendogenous variable and therefore question whetherit can serve as an indicator or target variable. We havetried to formulate these different viewpoints in termsof a money supply function, and reported results ofempirical tests which compared the short-run moneysupply functions (excluding feedbacks from the realsector) with a longer-run, reduced form money supplyfunction (allowing for feedbacks). Our preliminaryfindings seem to suggest that the central bank hassufficient control of the money stock to make it conformto a given set of guidelines, but that its control maybe weaker (and less precise), the shorter the timeperiod available to achieve a given objective. Thiswould suggest that the degree of precision expectedof the monetary authorities is not independent of thetime period that they have to achieve the policyguidelines.

48A technique that enabled us to separate out exogenouschanges in the money stock due to monetary policy fromendogenous changes induced by the real sector wouldalso enable us to estimate a ceteris paribus fiscal action interms of exogenous money stock behavior. This approachwould, in principle, be acceptable to the fiscal advocates.See K. M. Carbon and D. S. Karnosky, op. cit.

The full-employment surplus (om deficit) is generallyaccepted as the best measure of fiscal policy, in preferenceto the actual surplus (or deficit), which is affected by thelevel of activity and behaves therefore more nearly like anendogenous variable. But the full-employment surplus isavailable only for the income and product budget and istied to an income-expenditure framework. It may be de-sirable to experiment with ‘similar” concepts (separatingout endogenous effects) for the cash budget and the new,and comprehensive, liquidity budget, to determine whichof these budgets provides the most useful measure of fiscalpolicy.

The second question that we have explored is therelation between nominal and real quantities in theincome-expenditure theory and modem quantitytheory. The stabilization difficulties that we have ex-perienced in the last several years may be related totwo propositions about money which have beenwidely accepted in many of the income models. Theseare: (1) that the authorities can influence real balancesif they can control nominal balances; and (2) thatthe authorities can influence real interest rates (andrates of return) by operations which change nominalmarket rates. Both of these propositions may lead toserious policy errors when applied to a high-pressureeconomy such as the United States in the post-1965period.

The third topic that we have considered is varioustheories of the price level and related frameworks foranalyzing inflation. We find that there has beena tendency since World War II to divorce moneyfrom prices, to stress real factors in explaining theabsolute price level, and to neglect even substantialmovements in the monetary aggregates. Moreover,when income theorists highlight the short-run effectof money on interest rates — the liquidity effect — andtreat it as a permanent effect, they necessarily mini~mize the effect on prices. This corresponds to treatingreal balances as if it were a variable that could beinfluenced by the monetary authorities. Having ruledout any direct link between money and prices, incometheorists necessarily explain the post-1965 rise in theprice level by bringing in aggregate supply variables,other real sector developments, Vietnam escalation,and inappropriate fiscal policy, but continue to ab-stract from the very substantial growth in the moneystock and other monetary aggregates.

The fourth problem that we have considered is thatof defining cetenis panibus and mutatis mutandis fiscaleffects. A cetenis panibus fiscal deficit — holding moneystock growth constant — allows interest rates to riseand will therefore appear as an offsetting action toa fiscal advocate; while a cetenis paribus fiscal deficit —holding interest rates constant — allows money stockgrowth rates to increase, and appears as a mutatismutandis effect to the monetanist. These concepts needto be defined both for the monetarists and the fiscaladvocates, in order to translate the results obtained inthe two frameworks. This may help bridge some of thecommunications gap in stabilization theory, and alsohelp reconcile the two points of view.

This article is available as reprint No. 51.

Page 27

Reprint Series

YEB. TIlL: YEARS eeit,1tn ortu:Ie.~si/7/)eOriItr~ iu the KEV5F.\V h00~>piecer1 to he helpful to

hottEr. etheeotiouoi io~tittetiou~.ht,.rirte.rc orooiri~otiou.r.ouP otlie,~.To satisfq the deotoitil for the.realleles, our reprint series has heen made a.t:ailahle ott n1qftest. •i’lme fallomeimmu ortiele.s- hareheen ar/PeP to tire’ series itt tIre post near. i’leose imtdieate tire title our! mutinEer of artiele in itoorr’e’(jtiest to~Rrnerrr’e!t Deptitreirt. l~ere’ro!Bese ire j3rrrr/c of St. i,oitis P.O Box -•/-/2. St. Lotos

.\io. 03! tiE

NUMBER TITLE OF ARTICLE ISSUE

35. A Program of Budget Restraint March 196936. The Relation Between Prices and Employment: Two Views March 1969

37. Monetary and Fiscal Actions: A Test of Their Relative Importancein Economic Stabilization — Con:rnent and Reply April 1969

38. Towards A Rational Exchange Policy: Some Reflectionson the British Experience April 1969

39. Federal Open Market Committee Decisions in 1968 —A Year of Watchful Waiting May 1969

40. Controlling Money May 1969

41. The Case for Flexible Exchange Rates, 1969 June 1969

42. An Explanation of Federal Reserve Actions (1 933~68 July 1969

43. International Monetary Reform and the Crawling Peg’ February 1969

Comment and Reply July 196944. The influence of Economic Activity on the Money Stack — Comment;

Reply; and Additional Empirical Evidence on theReverse-Causation Argument August 1969

45. A Historical Analysis of the Credit Crunch of 1966 September 1969

46. Elements of Money Stock Determination October 1969

47. Monetary and Fiscal Influences on EconomicActivity — The Historical Evidence November 1969

48. The Effects of Inflation 1960-681 November 1969

49. Interest Rates and Price LevelChanges, 1952-69 December 1969

50. The New, New Economics and Monetary Policy January 197051. Some Issues in Monetary Economics January 1970

some issues in monetary economics

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