Channels of Monetary Influence: A Survey* ROGER W. SPENCER

MONG the numerous controversies surrounding typically involve changes in the rates of return “’, few are further from resolution than the is- on real capital and financial assets as well as changes sue of how money affects the economy. Compounding in the prices of and services. Ways in which the controversy is the Fact that the arguments ad~ changes hi wealth may influence spending include vanced are not divided neatly along so-called mone- movements in leal cash balances and changes in the tarist and nonmonetanst lines. but are separated by of equities. other criteria. There remains eo~siderab1edisagreement about the To be sure, rnonetansts have long taken exception relative importance of these factors in the transmis- to the intellectual straitjacket of the Keynesian sion of monetary inpulses. This is not surprising, given framework which limited the influence of monetary the history of the relative and wealth relations. actions to the response of investment to iiflerest rate Keynes, as ~veI1as prominent who pre- changes. However, the monetarIst alternatives offered ceded him, was ambiguous on the subject. This article have been far from uniform. Certainly, monetary ac- first traces the early development of these two factors tions result in the change of more than one relative and then analyzes more recent work in each area. price — the rate and one type of spending

— investment. However, substantial disagreement HISTORICAL BACKGROUND among rnonetansts (as sveii as other economists) per- Among the better early efforts to explain the sists beyond this point. money~spendinglinkages were those of There is basic agreement that at less than full em- and . Writing around the turn of the p]oyment, chai~gesin the rate of growth of the money celltury, they both maintained a short-run view of the supply affect output and employment before prices, a transmission process which was dominated by interest proposition which may be traced back at least two rate movements and a long-run view in which the key hundred years (Flume [48}), but this tells nothing role was played by changes in real cash balances about how total spending and its components react to ( Money monetary actions, It is necessary to examine the changes in relative prices arid wealth associated with monetary impulses to gail) insight into the money— Fisher and Wicksell spending relalion. Fisher, like other neoclassical writers, determined When the existing money stock (however defined) that output was at its full-employment level in the either exceeds or falls short of the quantity demanded, long run. In the short (or transitional) run, however, wealih and/ui’ relative prices change and this sets off business cycies occurred in Fisher’s time, as ~vell as in 1)0th substitution and wealth effects, as indicated in other penods before and shice. Consequently, macro~ economic’ analysts have continued to attempt exp~a— the a000mpallyrng diagram) The changes in relative nations of this phenomenon. Fisher’s view of the *11w author acknowledges the hdpful comments on earlier depended strongly on “sticky” interest drafts of George Kaufman, Thomas Mayer, John Pippenger, rates.-’ Robert Rasehe, Wililam Rawson, C~aik Warburton, and William Yohe. They are blameless for remaining errors. accepted price theory. Although monetary-induced changes ~The ‘correct” definition of money and the determinants of in relative prices or changes in wealth may genorato both money demand and suppiy firnetions are matters closely re- sui,stituUon and wealth effects, the relative price change has lated to. but beyond the scope of the presetit article. Another often been associated more with substitution effects and the hrnitation is that because of the large number of authors sur- wealth change more with wealth effeets; we will follow that veyed, only the briefest of summaries can be given here, in practice. 2 some cases, this results Ui considerable oversimplification of Sce especially Fisher’s Chapter 4, “Disturbance of Equation complex analyses. and of Purchasing Power During Transition PeiioW, in Substitution and wealth effeets are treated here as essentially Fisher [25]. In later years, Fisher [24] associated severe equivalent to substthition and income effects of generally- swings of the business cycle with changes in debt activity.

Page 8 FEDERAL RESERVE SANK OF ST. LOUIS NOVEMBER 1974

The Monetary Transmission Process

This relative price effect (via interest rates) was set invest at the prevailing . The demand for off by an increase in the money stock relative to the loanable funds wouid then rise as would the “normal” quantity of money demanded. The nominal money or “natural” rate of interest, the rate “at which the supply may he assumed to have increased due to a demand for loan capital and the supply of rise in the gold stock ~md, consequently, bank re- exactly agree” (Wickseil [89], p. 193). If, however, serves. With the additioiml assumption that output the banking community failed to realize that invest- and velocity were fixed initially, a rise in the commod- ment demand had risen, they would maintain the itv price level was expected to be associated with the same market rate of interest through increases in the increase. Because Fisher assumed that flIOflC~supply which, given the usual classical assump- the commodity pi-ice rise preceded the increase in in- tions, would result in commodity price rises. terest rates, with interest costs being viewed as a sig- nificant component of firms’ operating costs, the rise in Note that at this point the money supply has risen, the price kvel produced an increase in firms’ profits. observed interest rates have been kept iow in relation to the normal rate, and business spending has been A continued increase in demand deposits (through the component of which has in- business investment loan demand) relative to cur- creased. After some period of time, the banks’ reserve rency i-esulted in yet further ii~creasesin prices and position deteriorates and monetary growth is curbed. profits. Eventhally. however, excess reserves would The market rate of interest rises to the level of the run out, the interest rate would become “unstuck” and ilatural rate, an action which ]eads to the eliminalion would rise even faster than commodity prices. With of excess aggregate demand and price level increases. the rise in firms’ costs of operation, there would occur a decline in profits arid investment and a sharp in~ In the above short-run dynamic analyses, both crease in banki-uptcies. The downward phase of the Fisher and Wicksell relied on the relative price cycle was reversed when excess reserves again rose mechanism inherent in a money-interest rates-invest- and the interest rate had fallen accordingly. ment framework. However, in their approach to the determination of Iong~runequilibrium, interest rates Wicksell’s well-known “cumulative proee~s” also and investment were replaced by a treatment of the captured cyclical movements of the economy largely role of real cash balances. through interest rate changes. Some initial disturb- ance, such as an innovation or technological break- Fisher’s real balance explanatioll began with an as- through would foster an increase in the desire to sumed doubling of the money supply:

Page 9 FEDERAL RESERVE SANK OF ST. LOUIS NOVEMBER 1974

Suppose, for a moment, that a doubling in the cur- ambiguous. Some critics have contended that he rency in circulation should not at once raise prices, found little or no role for either wealth or relauve but should halve the velocities instead; such a result would evidently upset for each indiv~duaI the ad- price effects while others have credited Keynes with justment which he had made of cash on hand. Prices having advanced a significant role for both. being unchanged, he now has double the amount of money and deposits which his convenience had Keynes’ substitution effect, which was a part of 3 taught him to keep oil hand. a relatively early portfolio choice model, stressed the money-interest rates-investment spending channel. With the apparent increase in wealth, everyone Did Keynes think changes in the rate of growth of the tries to reduce their cash balances by purchasing money supply affected interest rates? There seems to , according to Fisher. Because ve- be little doubt that he did. The principal evidence to locity (V) and output (Q) in the equation of ex- the contrary may be fow~din the following passage change MV = PQ ai-e determined to be fixed in the from The General Thconj of Employment Interest long run, a doubling of the money supply (M) cannot Lind Money: generate any increased holdings of goods and services, hut must result in a doubling of the price level (P). There is the possibility, for the reasons discussed above, that, after the rate of interest has fallen to a Wicksell also saw real balances as the adjusting certain level, liquidity- may become vir- variable on the return path to restoring long-run equi- tually absolute in the sense that ~dmost everyone libritim after the economy had been disturbed by an prefers cash to holding a debt which yields so io\v a rate of interest. In this event th monetary ai~thority exogenous shock. 0 wcmld have lost effective control over the rate of Now let us suppose that for some reason or other interest. But whilst this limiting case might become commodity prices rise while the stock f money 0 practically important in future, I know of no exam- remains unchanged, or that the stock of money is ple of it hitherto. Indeed, owing to the unwillingness diminished while prices remain temporarily un- of most monetary authorities to deal boldly in debts changed. The cash balances will gradually appear to of long term, there has not been much opportunity he too sinai? in relation to the new level of prices .- for a test. Moreover, if such a situation were to I therefore seek to enlarge my balance. This can oniv arise, ft would mean that the public authority its&f be done neglecting for the present the possibility could borrow through the banking system on an of borrowing, etc. thi-cmgh a reduction in my de- irnlimited scale at a nominal [very low] rate of mand for goods and services, or through an increase interest.5 in the supply 4of my own commodity ... or through both together. Note that after raising the possibility that a “liquidity The reduction in demand and/or increase in supply trap” situation could conceivably arise in the future, will cause commodity prices to fall until they have Keynes immediately disavowed its existdilce under reached their equilibrium level. Neither Wicksell nor conditions (the low employment, low interest rate pe- Fisher mentioned the money-rnterest rates-investment Hod of the 1930s) in which Keynesian analysis sug- spending channel of monetary influence in their anal- gesteci it would likely occur. yses of movements to long-run equilibrium. Both fo- Regarding the second part of the money-interest cused on changes in real cash balances without rates-investment channel, there is considerable evi- explaining in detail the substitutlim and wealth proc- dence that Keynes thought investment to be quite esses involved. Although their long-run vs. short-run responsive to inteiest rate changes (Leijonhufvud analyses were similar in many respects, Fisher was [53], pp. 157-185) However, the interest sensifivity probably more noted for his long-mn quantity theory of investment was restricted in the main to long-term views and Wicksell more for his short-run cumulative rates, which changed only siowiy. process. There are a number of wealth effects to be found in Keynes The General Theory which relate to either price-in- Like Wicksell aild Fisher, Keynes’ position on the duced changes in wealth (changes in wealth associ- monetary transmission mechanism was somewhat ated with changes in the absolute price level) or in- terest-inthwed movements in wealth (changes in ~Fisher [25], p. 153. wealth associated with changes in yields). Of the ‘Wicksdl, [901, pp. 39-40. Wicksell’s treatment of the real basic price-induced and interest-induced wealth ef- balance effect is considered superior to Fisher’s because the fects, it has been alleged that “Keynes stated both former avoided the trap of dichotomizing the determination of rehtive prices and the absolute price level. See Patinkin 5 [63]. Keynes [51], p. 207. Bracketed expression supplied.

Page 10 FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974 parts of the wealth effect, emphasized their impor- portance of the two major channels of monetary in- tance, and then let wealth slip through his fingers by fluence, Keynes in effect was inviting his interpreters his failure to build it into his analysis.” (Pesek and to close off the channels completely. [64], p. 21). This criticism is unjustified to the extent that those parts of Keynes’ analyses which sub- sequently enjoyed sustained popularity are riot neces- THE RELATIVE PRICE RELATION sarily those parts favored by Keynes. For example, The most frequently cited of the relative price rela- the “” was not an intrinsic part of Keynes’ tions, money-interest rates1nvestrnent, obviously con- analysis (he denied its occurrence); yet it became sists of a money-interest rates channel and an interest closely associated with his name as one of his major rates-investment channel, Closure of either of these contnbutions. channels would eliminate a basic route through which It is easy to see how Keynes’ wealth effects were molley is presumed to affect spending. This route was overlooked by those analysts quick to interpret and virtually sealed off by early interpreters of Keynes popularize his basic theory, Keynes brought up the (among others) and not re-opened for about a quarter price-induced wealth effect and minimized its signi- of a centuiy. ficance in the same passage: “It is, therefore, on the effect of a falling - and price-level on the de~ Closet! and Re~Openod rnand for money that those who believe in the self- adjusting quality of the must rest the The initial part of the money-interest rates-invest- weight of their argument; though Iamnot aware that ment channel was attacked indirectly through innu- endo rather than directly either by overpowering they have done so. If the quantity of money is itself a function of the wage- and price-level [a variant of theory or evidence. Although Keynes repeatedly the real bills doctrine], there is indeed, nothing to stressed the importance of the money-interest rates hope ill this direction,”6 linkage, J. R. Hicks, the chief architect of the IS-LM “Keynesian” framework, failed to pass along Keynes’ Keynes endorsed interest-induced wealth effects emphasis. In Flicks’ [44] relatively brief arlicle which more vigorously, but made it clear that even these became the most popular condensed version of were of secondary importance. As a man well ac- Keynes, Flicks focused on the liquidity trap as one of quainted with the stock market and windfall gains Keynes’ major contributions upsetfing neoclassical and losses, he thought interest-induced “windfall ef- theory. Nowhere did he indicate that Keynes was un- fects” had only a minor influence on spending habits. aware of any such situation actually having occurred. The adoption of such slogans as “yo~ican’t push on a For if a man is enjoying a windfall increment in string,” or “you can lead a horse to water, but you the value of his capital, it is natura] that his motives towards curreiit spending should he strengthened, cailt make him dñnk” provided popular support for even though in terms of income his capital is worth Hicks’ interpretation of Keynes’ view of the money- no more than before; ..-Apart from this, the mail’ interest rates ehaimel in periods of economic slack. conclusion suggested by experiern~eis, J think, that the short—period influence oi the rate of interest Empirical studies of the late 1930s were the main is secondary and relatively unimportant, except, per7- instrument employed to seal off the interest rates- haps, where unusually large changes are in question. investment channel. Researchers in England and the There is, however, sufflejeilt question about Keynes’ United States published results of surveys in which businessmen were questioned about the importance view of wealth effects, which appear frequenfly in 0 The General Theory, to spark a continuing debate.8 of the interest rate in their investment decisions. A What Keynes actually meant is less significant than his ~‘astmajority indicated that interest rates had little or failure to give either monetary-induced substitution no effect on their decisions to invest. These studies or wealth effects a leading part in his attack against were cited prominently by [39] in his orthodox, classical theory. By vacillating on the im- 1938 American Economic Association presidential ad- dress as evidence of the impotence of monetary pol- UKeynes [51], p. 206. Bracketed expression supplied. icy. Moreover, as Samuelson recently noted, “. . pea- 7 Keynes [51], p. 94. 9 8 See Henderson [42], Meade and Andrews [57], and Ebersole [211. See Keynes [51], pp. 92-93, 319. Among the participants For a humorous criticism of the survey approach, see Eisner in the Keynes wealth effect debate have been Ackley [1], [22j, pp. 29-40. A more recent example of the survey approach Patinkin [63], Pesek and Saving [641, and Leijonhufvud is found in Crockett, Friend, and Shavell [181. [53].

Page 11 FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974 pie like Sir said that as far as short-term money is held to bridge the gap between income investme~ilis concerned, interest is of no consequence receipts arni expenditures.” as a cost; and as far as long-term investment is con- Which assets, besides money, are included in the cerned, uncertainty is so great that it completely portfolio? Much of the controversy surrounding the swamps interest, which leaves you with oniy a mini- portfolio choice framework has centered on the an- sonic of intermediate investment that is interest swer to this question. The early portfolio choice e1astic,”~° models greatly limited the range of assets and rates The eventual re-birth of the relative price channel of rethrn. Pigou [65] sketched a rough money-capita] did mt occur until well into the 195Os, although the model, while Keynes [51] added government and seeds were planted kng before. The emergence of private debt to the menu. By assuming perfect sub- portfolio choice models in the 1950s and 1960s ushered stitutability between capital and boilds, Keynes had in, among other channels, the old money-interest only the yield differential between money and one rates4nvestrnent route. other asset (he chose bonds) to explain. Patinkin’s model [63] was similar to Keynes’ in terms of assets Much of the literature dealing with portfolio choice included and yields explained. models has been associated with money demand studies, Portfolio choice theory, however, provides the A major change in the approach to the number of rationale for the holding of any asset in one’s portfolio, assets ~mdyields to he examined occurred in the early including molley. Instead of focusillg on the individ- 1960s. Tohin [77], Brunner and Meltzer [9], and Friedman [28] all expanded the portfolio menu, but ual’s or finn’s income statement which deals with 2 flows, portfolio choice analysis stresses the stock rela- in varying degrees) The differing approaches of tionships which are found on the asset and liability these contemporary monetary economists ~vi11be ex- sides of the balance sheet. The basic assumptions are amined ill some detail. that: (1) other things equal, everyone eqintes the marginal rate of return on each asset hi the portfolio — Three Views on the Relative Price Relation allowing for risk (in terms of variaiice of return and Tobin ([77], p. 36) suggested that “a minimal pro- exclusive of price level movements), costs of acquiring gram for a theory of the capital account” should in- information and of conducting transactions; and (2) clude six assets — all of which, except the capital an increase in the supply of any asset (on a macro stock, are financial assets — and six yields. The num- level) will lower the price of that asset relative to all ber of assets is only slightly greater than the earlier others. The increased supply of the asset leads to models, but a substantial step toward reality is taken diminishing marginal returns per unit of the asset, with the elimination of Keynes’ perfect substitutability thereby motivating the wealth holder to attempt to assumption. The choice of assets is closely restricted substitute or exchange some of the asset whose price to facilitate “purchasing definiteness iii results at the has fallen for some of those whose price has not. risk of errors of aggregation” (Tobin [77], p. 28), If Changes in relative prices are a consequence of increases in the money supply happen to reduce the wealth holders’ efforts to restore equilibrium to their supply price of capital — the rate which wealth hold- ers require in order to hold in their portfolios the portfolio — that is, equate all marginal rates of re- turn. The initial disturbance, a change in the stock of current capital stock below its marginal productiv- any asset, may produce a chain of substitution effects ity, the capital stock will rise, This is the sole linkage as wealth holders react to changing asset yields. t1 To pursue further these distirn~tions would require a de- Although certain types of money have a zero nomi- tailed analysis of mOiiey demand, a project much beyond the scope of this article. The interested reader may wish nal rate of retnrn by law, money continues to be held to consult Pigou [65], Hicks [43], Tobin [77] and Brtrnner— in the portfolio for at least two reasons. First, as op- Meltzer [101. 2 posed to equities, for example (which may carry sub- ‘ Cagan [13} also introduced a sketchy portfolio choice sce- nario. More reeeiillv, he focused on money—interest rate stantial risk along with a relatively high mean rate of influences [14]. return), money holding is less risky. Second, money The relative price meehamsm was also employed by economizes on the use of real resources in the gather- Warburton as early as 1946 to explain the transmission ing of information and in the conduct of transactions. process. ~‘In practice the effects of a change in demand or iii suppiy, either of a specific commodity or of money ( cir- An implication of this latter characteristic is that culating medium), are felt, first in some particular part of the economy and spread from that part to the rest of the economy through the medium of price differentials created °Sawueison [70], p. 41. at each stage of adjustment>’ Warburton [88], p. 85.

Page 12 FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974

between the financial and real sectors. The “if” is nec~ Friedman [28], in his portfolio choice-relative price essary because the increase in the supply of money analysis, is less formal than either Tobin or Brunuer- which kwers the price of money relative to other Meltzer in that he attempts no classification of types assets may simply result in an increased demand of real capital, portfolio assets, or relevant yields. for financial assets, rather than for the capital stock Friedman acknowledges that an increase in the (real assets money supply affects the portfolio of the financial sector first, bift the subsequent increase in demand One infers from Tobin that an increase in the stock may be as likely reflected next in consumer nond~ira- of any of the financial assets in the macro portfolio is bles as in any areas of real capital. Possible scenarios 16 about as likely to stimulate investment expenditures are outlined by Friedman in several places. Ini- as is money) In this view it is unclear as to whether tially, the prices of sources are raised relaUve to the an increase in the money stock can lower the supply prices of services, thereby inducing investment and price of capital directly without setting off a chain of consumer expenditures. substitution effects ranging all through the spectrum of assets with different shades of risk-i-eturn charac- The key feature of this process is that it tends to teristics. It is apparent from Tobin’s comparative raise the prices of sources of both producer and consumer services relative to the prices of the serv- statie framework, however, that no feedback from the ices themselves; for example, to raise the prices of real to the financial sector occurs, houses relative to the rents of dwelling units, or the cost of purchasing a car relative to the cost of rent- The types of real capital which are affected by ing one. It therefore encourages the production of portfolio shuffling are delineated closely by Brunner- such smtrees (this is the stimulus to liwesUnent’ Meltzer [9], although the number of assets and rele- conceived broadly as inch cling a nmch wider range vant yields in the macro portfolio ‘are not. They clas- of items than are ordinarIly included in that teim) and, at the same time, the direct acquisition of sify three types of capital according to the relation services rather than of the source (this is the stimu- between asset prices and output prices — language li’s to consumption relative to savings ) But these somewhat comparable with Tobin’s supply price of reactions in their u nil tend to raise the prices of 14 capital and marginal productiv~ty. services relative to the prices of soijrces, that is, to undo the initial eflects on interest rates [broadly Increases in real capital occur as (not “if”) a rise in defined]. The final result may he a rise in expendi~ tures in all directions without any char~gein interest the stock of base money lowers the relative price of 7 at all.’ base money ai~dthat of its close substitutes, resulting in an increasec1 demand for other assets, those assets being dominated by real capital. “The increase in the A Comparison of Three Views price of financial assets simuitanernisly raises real The Friedman, Tobin, and Brunner-Meltzer views capital’s market value relative to the capital stock’s of the monetary substitution effect are distinguished replacement costs and increases the desired stock rela- by a number of points of agreement and disagree- tive to the actual stock.” (Brunner [5], p. 612). Real ment. The three views are coincident in the following: capital is defined to exclude consumer nondurable 1~ (1) the total response of the financial sector to a goods and services. UtAike Tobin (with regard to change in the money supply occurs before the total his comparative static models), Brunner and Meltzer response of the real sector; (2) money as a medium of ([9], p. 379) view the monetary transmission mech- exchange is of less significance than money as an asset anism as having important feedback effects. with regard to the portfolio choice transmission mech- anism; (3) changes in rates of return or yields on real ‘~Theview that financial or liquid assets other than money (Mi) can about as likely ailed the real sector, is advocated or financial assets are the key e1emei~tsin the trans- more stnmgly by the Radcliffe Committee [17], Gurley mission process. and Shaw [37], and Gramley and Chase [35], in what became known as the New View” (from Tobin [78]). To a large extent, the differences in the three views i-lFrjedrnan’s [28] terminology is prices of services and prices are due not so much to contradictory theories, but of sources as explained in the excerpt from Friedman in the right-hand column of this page. A parallel semantic issue is Tobiri’s preference for the term “demand debt”, Friedman ~°Friedman [28], Friedman-Meiselrnan [33], Friedman- for ‘high—powered money, and Bnuiner—Meltzer for “base Schwartz [34]. Other attempts at pinothg down the open money’. market purchase-bank reserves-interest rates, etc., channels 15 Brunner added the general thought that ‘The wealth, in- can be found in Cagan [13], Davis [191, and Ettir~ [231. come, and relative price effects rnvolvecl in the whole l7Friedman [28], p. 462. Bracketed expression supplied. The transmission process also tend to raise demai~d for non- latter part of this quote represents one of Friedman’s inter- durable goods.” Brunner [5], p. 612. pretaticrns of the feedback effect.

Page 13 FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974 rather shades of emphasis among similar approaches. folio analysis. Like Tobin, they attempt to organize Because Tobin insists on a formal separation of the the pattern of response of the real sector to monetary capital account (stocks) from the production and in~ impulses and eventually constnict a formal model come account (flows), he is led to highlight different (Brurrner”Meltzer [12]). They also emphasize the sig- aspects of the portfolio choice process than Friedman nificance of real capital in the process with only minor and Brunner-Meltzer.18 references to such spending components as consumer nondurable goods and services. Tobin gives the impression that portfolio choice analysis adds little to the Keynesian (not Keynes’) Like Friedman, Brunner-Meltzer do not attach If” view of money-interest rates-investment. Given a con- considerations to the money-real sector linkage, nor do sumption function dependent on income, but not they stress long substitution chains relating money wealth or relative prices, consumption can be affected and other financial assets. Their view is also similar by monetary actions only after investment via the to Friedman’s in that they: (1) emphasize financial standard Keynesian . In his portfolio choice sector~rea1 sector feedbacks; (2) do not denigrate analysis, the potential end result of the shu~ingof 10 money as an indicator of monetary actions; and (3) portfolios is a change in real capital; feedback ef- stress relative prices, of which yields on securities are fects from the real to the financial sector do not fit only a part. Brunner points out that “Every change in into Tobin’s capital account approach. Tobin specific- relative prices of assets (that is, durables) with differ- ally draws attention to the insignificance of money’s ent temporal yield streams involves also a change in property vis a vis its zero nomi- suitably defined interest rates.”21 nal rate of return in his portfolio analysis and gener- ally denigrates money’s “uniqueness”. Changes in in their money demand theory, Brunner-Meltzer money may set off a chain of portfolio reverberations [10] dwell on the medium of exchange property of which results in a change in desired real capital, or it money, but this property does not appear specifically may not. in their formal model [12] of the transmission mech- anism. Relative prices in the 1972 model take the Friedman’s avoidance of formal, structural models form of asset (illeluding securities) prices and output which specify any unique monetary transmission prices, but no distinction is made between investment process has probably contributed significantly to the and consumer goods prices. Finally, in spite of their charge that monetarists’ views of how money works 2 criticism of IS-LM models which reflect a “Keynesian” are locked in a “black box”. ° Friedman’s informal approach to the transmission mechanism, they grant tracing of possible monetary channels, ~stresses the that if changes in the stock of government debt were point that consumer spending is as likely to be the real presumed to have no effect on wealth, “our model sector component first to respond to monetary acions could be pressed into the standard, ISWM frame- as is investment spending, Although changes in yields work” (Brunner-Meltzer [11], p. 953). are the key to portfolio adjustments, “These effects can be described as operaling on ‘interest rates,’ if a In summation, these three approaches to tracing more cosmopolitan interpretation of ‘interest rates’ is monetary inipulses are probably not as different as adopted than the usual one which refers to a small they at first appear. Once the semantic issues are put range of marketable securities” (Friedman [28], aside and the preferences for formal vs. informal p. 462). models are understood, the Tobin, Brunner-Meltzer, Friedman approaches to the relative price channels Brunner-Meltzer tread a path between Tobin and of monetary influence are quite similar. It remains to Friedman in their methodological approach to port- be resolved, however, if more is to be gained by 18 Tobin’s admittedly heroic abstractions from reality, ”Treatment of the capital account separately from the proS ductioi~arid income account of the economy is only a first Friedman’s apparent presumption that the channels step, a simplification to be justified by convenience rather are too complex to be captured in any economic than realism” (Tobin [811, p. 15). It appears, however, that Tobin’s efforts at moving toward greater realism (Tobin [8-4]) are h~hibitedby the “General Equilibrium Approach” 2lflrunner [8], p. 27. FIe adds that “The general role of (Tobin [81]). interest rates does not distinguish therefore between the 19J~ an informal analysis Tobin added consumer durables to Keynesian and non-Keynesian posiUons. The crucial differ- ence occurs in the range of the interest rates recognized to the list of “storable am’ durable” goods —~ or real capital — influenced in the monetary transmission process. See Tobin operate in the proeess. The Keynesian position restricts this range to a narrow class of financial assets, whereas the rela- [SO]. tive price theory inckdes interest rates over the whole 20 Friedrnan’s formal model [30], [31] sheds little light on spectrum of assets and liabilities occurring in balance—sheets specific monetary transmission linkages, of households and firms” (Briinner [8], p. 27).

Page 14 FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974 model, or Brunner~Me1tzer’sapproach somewhere be- Subsequently, additional arguments were employed tween these two in terms of answering the q~eslions to buttress the credit view.22 One of these of the academic fraternity and the general public of was that default risk increased relatively more for how money works. loans than for securities in tight credit periods. An- other was that the banking industry is oligopolistic Other Developments in the and is better off to restrict the volume of loans rather Relative Price Relation than lend out to the point required by the compe~- tive market solution. Two extensions of the relative price relation which, although out of the mainstream of monetary trans- Legal interest ceilings have been invoked more re- mission research, merit elaboration are (1) credit ra- cently ii~explanations of the working of credit ration- tioning and (2) the overshoot, or feedback, phenome- ing. The basic idea is that a financial institution might non. The former involves the allocation of resources be perfectly willing to lend to a borrower at X percent by price and nonprice criteria, and the latter is a in accord with such cdteria as size of loan, default consequence of the dynamic adjus&nent of the eco- risk, and compensating balance requirements, but if nomy to a monetary shock. usury or other laws set a ceiling at Y percent which happens to be below X percent, the prospective Credit Rationing — So long as the price mechanism borrower will not obtain the loan. Tie may be able to functions in an open market with complete factor and obtain fimds from some other source, such as from a product homogeneity, resources (including credit) lending facility in a state whose ceiling is higher, or are rationed by price. In so-called “imperfect” mar- from an effectively iinregulated private individual. kets, however, non-price discriminatory practices There are, however, considerable costs of information abound. Among borrowers who are the same in every involved in addition to the higher interest costs which respect b~~tone, net worth for example, lenders may may cause the potential borrower to drop out (that is, advance one borrower credit at an X percent rate and he rationed out) of the funds market. another borrower zero credit at any interest rate. At least, that is one implication of the term “credit ra- Interest ceilings also affect the flows of funds into tioning”. As used here, “global” credit rationing is de- financial and i~onfinancia1 iflstituth)ns, When market fined to indicate a reduction in (the rate of) total interest rates rise above rates payable (considering spending due to a rise in the non-observed interest lipñdity, nsk, maturity, and tax factors) by savings price of loans. institutions and state and local governments, many’ savers put their funds into less regulated securilies Traditionally, “local” credit rationing has been asso- unirkets. The bypassed institutions accordh~g1y cut ciated with the behavior of commercial banks in ex- back their lending activities. Whether the re-channel- tending loans in a period of “tight credit”. Arguments ing of credit results in a reduction of total spending, for commercial bank credit rationing were advanced however, is another matter — one which is rarely in 1951 by Robert Roosa [68]. He asserted that in treated in the credit rationing literature. periods of falling security prices (rising interest rates), bankers prefer to pass over relatively more lucrative One study, for example, found that Regulation Q commercial loans and continue to hold on to their ceilings encouraged savers to bypass commercial securities in order to avoid a recorded capital loss. banks in certain tight credit situations, allegedy forc- Moreover, Roosa contended that banks preferred to ing commercial banks to curtail credit extensions.23 hold securities as a means of countering the uncer~ Since bank credit is only one component of total tainty fostered by the monetary authorities during credit, it cannot be assumed that a reduction in total critical, high-interest rate periods. credit or total spending could be attributed to the Paul Sarnuelson [69] objected to this analysis on workings of Regulation Q. According to the authors of the study, the reduction of credit available to com- the grounds that it did not conform to the usual tenets of -maximizing behavior of the flu-rn. He argued mercial bank customers “would presumably occur to the benefit of customers of other intermediaries that the ustrnl way of rafioning anything in “short supply” was to allow a higher price to do the ration- ing. Samuelson would not agree that over any other ~Lindbeck [55], Hodgrnari [47], and Kane [50] are among those who have substaitially advanced the credit rationing than a very brief period, bankers would hold their literature. assets in relatively low-yielding securities, while ra- 2~ Federa1Reserve Regulation Q places a eeiling on interest tioning a set volume of loans at a fixed interest rate. rates payable by member banks on time and savings accounts.

Page 15 FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974 and/or of those firms uble to raise funds directly in demand for credit will tend to reverse the initial fall the rnarket.”24 in interest rates. If spending is continually stimulated, demand pressures will force up the price level and If it is presumed that credit rationing at one insti- price anticipations which, in t~irn,add upward pres- tution is not offset by increased loan activity eIse~ s~resto interest yields. where, then “global” credit rationing, which is accom- panied by a slowiiig in the rate of total spending, The extent to which interest rates overshoot their occurs. Because all observed interest rates do not nec- equilibrium value is dependent on many factors, in- essarily capture a i-ise in the relative price of credit cluding initial conditions and the duration and degree as represented by greater information and transac- of monetary stimulus. It should be noted that the rise tions costs (which are assumed to include such costs in the price level lowers the real value of monetary as increased compensating balances), interest rate assets. At the higher price level, the quantity of money changes alone would not give a complete picture of demanded is less in real terms. Also, the rate of in- the effectiveness of monetary actions. In certain tight crease of the money supply tends to slow automati- credit situations, interest rates rise to slow down cally due to “feedback effects through the monetary spending. But after some point at which interest yields mechanism” (Friedman and Schwartz [34], p. 562). are confronted by legal rate ceilings, interest rates Thus, prices, interest rates, money, and general eco- would not give a correct pictme of the true cost of nomic activity are all subject to the overshoot credit. An important implication of this analysis is that phenomenon. interest rates likely emit inconsistent signals with re- Similar dynamic analysis has been offered by Brun- spect to monetary influences on spending via relative ner-Meltzer. Through changes in wealth and relath’e price changes. prices, they postulate that monetary impulses alter the magnitude of and rate of return on the capital stock. Overshoot Effect — The “overshoot effect” is analo- “Variations in the stock of real capital, of income ex- gous to the previously-mentioned feedback effect, in pected from human wealth, or the yield expected from which the real sector reacts hack upoH the financial real capital affect the allocation pattern of financial sector, with the onginal disturbance having come assets, trigger the interest rnechathsm, and generate a from the financial sector. Although the overshoot may feedback to the asset prices of real capital.” Thus, occur by way of relative price or wealth influences, monetary impulses not oniy affect the real processes the vast majority of the hteratllre on this topic is b~treal impulses feed back to financial processes.”26 couched in a relative price framework. The term Brunner also noted the role of price anlicipations in “overshoot” is indicative of the tendency of the initial the feedback process and postulated that without adjustment of such economic vanables as interest continuing morley growth acceTeration, initial output rates and income to exceed the steady-state kvels. and employment gains would be offset over lime.27 Friedman is often identified as the current leading advocate of this thesis, hut the argument has its roots Tobin’s basic comparative static framework revealed in studies by Fisher, Wicksell, Keynes, and Tooke.25 no role for the overshoot effect. On at least two occa- sions (Tobin [82], [84]), however, lie engaged in Friedman [28], [29], [33~pointed otit in several dynamic analysis. On both occasions he pointed out places that changes in the money supply and interest that initial disturbances in the real sector which affect rates are inversely related for oniy a short period. A the money supply (endogenity of money) are a plau- rise in the money supply, for example, is associated sible explanation of observed money-income relation- with a fall in interest rates initially. After some period ships. in one instance ( Tobin and Brainard [84], of time, the fall in interest rates will have slimulated p. 119), lie noted that an exogenous change in bank spending and the demand for credit. The rise in the reserves would produce an adjustment path of the yield on real capital which overshoots and oscillates. ~Jaffee and Modigliani [49], pp. 871-72. Although Jaffee and Modigliani suggest that credit rationing of commercial 20 banks is offset by increased loan aetivity in other areas, the Brunner—Meltzer [9], p. 379. reverse does not necessarily hold. The FRB-MiT model, 27 Bruoner [71, p. 13. Friedman ([29], p. 10) made the same with which Modigliani has been closely associated, finds a point regarding monetary acceleration via a comparison of credit rationing effect through non-commercial bank savings the market rate—natural unemployment rate institutions not offset by increased commercial bank activity. with the market interest rate-natural interest rate. See deLeeuw and Gramheh [20]. 25 The feedback effects noted in the formal Brurnier-Meltzer Sce Fisher [25], Wicksdll [89] (natural interest rate vs. model [12] are started by an initial dLsturbance in the out- market interest rate), Keynes [511 (the Gibson paradox), put market, and thus are not quite comparable to earlier and Tooke [86] (the Ricardo-Tooke Conundrum). analysis.

Page 16 FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974

Even the standard IS-LM framework can be al- Real human wealth, vie, is determined by the tered so as to give interest rate and income over- present value of one’s expected lifetime income, a shoots.28 It can be shown that differences in the ad- concept related to permanent income or even dispos~ j~istmentpattern of investment to interest rates and able income (with the appropriate lags), but not di- money demand to interest rates are capable of pro- rectly related to monetary actions. Real consumption ducing interest rate and income overshoots. If invest- (c) is assumed to be a function of both types of ment is dependent at all on the current interest rate, wealth as described by a sharp drop in interest rates can cause investment to WNH expand and income to rise; if money demand is a c = e(wn function of income, there ensues a rise in money cle- mand which reacts hack on interest rates. The human wealth concept forms the typical Keyne- sian element in the consumption function. The ida- It is possible to conjecture fairly complicated reac- lion between nonhuman wealth (divided by the price tion patterns to relative price changes, even without level), and consumption is probably less well such complications as an accelerator effect, or changes accepted. in the absolute price level. Even working within a simple analytical framework, it would be difficult for Because the arguments for the D and 9 elements policymakers to attempt to stahiTize incomes or inter- est rates if they did not know whether the adjustment of the wealth effect are closely intertwined, they will paths were monotonic or cyclical. Considerable empiri- he discussed together as “Real Balance Effects”. The PlC section follows under the heading “Equity Effects”. cal verification of the overshoot or cyclical process in 29 the “real” economy has been provided. Real Balance Effects THE WEALTH RELATION As mentioned earlier, Keynes discussed several dif- The monetary channel of influence which operates ferent real balance effects, but made little use of them through changes in wealth is best approached by in his general framework. Ironically, it was the work examii~ation of the linkages between wealth and of a prornindilt Ke3mesian interpreter which sparked consumption. Although the substitution effect, in some renewed interest in real cash balances. Pigou, who generally receives the lion’s share of the credit for versions, is seen to work through consumer spending 3 as well as investment, the wealth effect has been reviving real cash balances, °was disturbed by Alvin typically limited to the consumer sector. One (lefini- Hansen’s stagnation thesis. tion of nonhuman money wealth is Flansen [40] charged that even with flexible prices and , a perpetual state of less than full employ- WNH PK + D + ment could we]! be the natural resting place for the where economy. Such neoclassical economists as Pigou were willing to concede that an assumption of inflexible P pflce of real capital prices and wages could be consistent with the thesis K stock of capital ( EK ~—market value of equity) of a less than full employment state, but only given D monetary base p1~sfraction of bank debt not this important assumption. Pigon demonstrated that counted in PK the rise in real cash balances associated with a falling Grit government debt (one dollar multiplied by the number of securities outstanding, each of which price level and unchanged money stock would in- is assumed to be a consol) crease consumer spending, reduce saving, and thereby pennit the rate of interest to rise above some assumed = market interest rate market value of out- “liquidity trap” level. standing debt), By associating consumption with real cash balances, Monetary factors affect each of these components of Pigou drove a wedge into the small opening left for nonhuman money wealth in varying degrees. by the Keynesians of the late 1930s. Because consumption comprises a much larger per- 8 ~ See Laidler [52], Smith [73], Thimer [74] and Tucker centage of total spending than business fixed invest- [87]. 29 See Silber [72] and Christ’s ([161, pp. 444-45) revie\v of 30 large econometric models. Pigou [66]. See also Haberler [38] aiid Scitovszky [71].

Page 17 FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974 ment, the potential for monetary policy to affect total tary infimmee, so long as no liquidity frap exists, was spending was greatly expanded. Pigou and others who through his portfolio choice-relative price route. fonnulated real cash balance theories in the early Exactly what should he included in the “D” portion 1940s did not claim much empirical significance for of the real balance wealth definition has been the this effect. Their c(JncCrll was only to show that it was subject of debate in more recent years. In most cases, theoretically plausible for the economy to return to private debt typically is assumed to cancel out. I-low- full emp1oymet~tunder the assumption of price and ever, Pesek and Saving [64] maintained that because wage flexibility. They did not take up Keynes’ wind- no interest is paid for demand deposits, wealth fall effect or any other aspect of the monetary wealth (which accrues to hank stockholders) increases in effect. Thus, their concern was limited to the “D” proportion to demand deposits. Thus, they would portion of the nonhuman wealth definition, with the count both inside money (demand deposits) and out- relevant debt typically taken to he the governments side money (monetary base) in net private wealth, demand debt (or monetary base). contrary to the traditional view which counts only Don Patinkin took up the discussion of real cash outside money. To include all inside money as wealth, 31 balances in the post-war period He also ignored however, would likely result in some double counling. the hflerest-induced wealth effects and focused on If the inside money benefits to banks are capitalized theoretical rather than empirical considerations. Patin- in the value of the banks’ stock, as are the typical kin’s chief contribution to the chani~e1sof influence gains to nonbai~kfirms, the same inside money would controversy was to spell o~itthe hiterplay between the he found in the “D” portion and the “PlC” portion of positive real cash balance effect and the negative real the wealth equation. To the extent that demand de- cash balance effect which combine to produce propor- tionality between money and prices (the “quantity posit gains are not capitalized instantaneously, there should be some allowance made for the addifion of theory>’) between periods of short-run equilibrium32 inside money to net wealth, The effect on spending Prominent among those disputing the usefulness of would be through additional outlays by bank the real cash balance approach have been Flicks and stockholders. Hansen, who also downgraded the monetary relative price channel. 1-Tansen’s [41] criticism of the real bal- What about government securities (G) held by the p~ibIic?Do these represent private wealth? They only ance effect was limited to a short note in which he represent private wealth to the extent that the public agreed that the effect could theoretically bring a halt does not anticipate offsettmg future tax increases to to a downturn. but could not generate the spending required to attain full employment. eliminate such debt. The term in the wealth Hicks devoted more effort to wealth considerations, equation may have some effect on spending thro~igh: as demonstrated by the important role of wealth in (1) changes in the magnitude of G; (2) changes in his landmark book, Value and Capital [45]. However, the composition of C; and (3) changes in r. neither in Value and Capital nor subsequently did he attach much significance to a monetary weallh effect, One source of controversy concerning changes in Flicks omitted real balance effects in Valne and Capi- wealth has been the relation between G and D. The tal and only thirty years later did he find any use for two have frequently been summed (interest-bearing the concept at all.33 The dominailt channel of mone- debt plus non-interest hearing debt) in empirical and theoretical investigations of the effects of “liquidity” 3t on the economy. If it can be assumed that C and D Patinkin [63]. Patinkin’s first articles on real cash balances appeared in the late 1940s. are good substitutes, their composition is of less con- 2 ~ Thepositive real balance effect associates the demand for real ba1arn~es (positively) with money and the negative While this did not lead him to reconsider also the assmuip- real balance effect associates the demand for real bal- tion that the wealth effects of interest changes cancel, it ances (inversely) with prices. The demand for goods is may \veil be that the same remark applies also to this related to one’s holding of real cash balances. problem.” (Leijonhiifvud [53], p. 275). 3 a Leijonhufvjd noted Hicks’ lack of consideration for either Hicks eventually took note of the real cash balance ver- price-induced or interest-ind~~cedwealth effects h~ Value sion of the wealth effect in a review of the first edifion of and Capital. “It is interesting to note that the first edition of Patinkin’s book. Hicks missed the point initially that a rise in Va/tie and Capital did not take the real balance effect into real cash balances stimulates spending, as he later admitted account. In the second editioi~, Hicks responded to the in his Critical Essays ([46], p. 52). In 1967 he recognized critieisms of Lange and Mosak on that issue by admitting: the existence of a ‘liquidity pressure effect’ — but thought ‘I ~vas too much in love with the simplification which comes it had merit only in restraining an expanding economy. from assuming that income-effects [Pigou effects] ca~eeI This concept, of course, is a variation on the monetary pol- out when they appear on both sides of the market’ (p. 334). icy ‘can’t push on a string” thesis.

Page 18 FEDERAL RtSERVE SANK OF ST LOUIS NOV!MBEA 1074 cern than their sum.3 Early empirical investigations As far as the real-balance effect, especially that part of wealth effects pllblished shortly after the accumiña- which pertains to “D” is concerned, there is little in- tion of much government debt in World \Var II often dication that Tobin Brunller—Meltzer, or Friedman tested the real balance effect as the sum of G and envision monetary influences as having much impact 37 ~ Many found a strong relation between liquid through this channel. In at least two cases, however, wealth and consumption. If this can be called a direct these leading monetary economists have found a strong channel, a more indirect route, via interest rates. has role for the money-equity channel. Their views on the been envisioned by others. money-equity route will be discussed after mention of lobin [79] emphasized aggregate monetary wealth some of the earlier proponents of this channel. and its compositnm with respect to the effect on in- terest rates. Not oniy does an increase in monetary .Equity Effect wealth relative to real assets lower the supply price of How can monetary actions affect the market value capital and thereby induce investh~ent, but an in- of equity, “PK”? One aUS\VCr was provided by Lloyd crease in short-term government debt relathe to long- Metzler, who re-opened the equity channel in 1951 tei-m debt (110 change in aggregate deht) may achieve which had been described earlier by Keynes. Metzler the same result. These actions are closer to fiscal poi- [58] was probably the first whose formal debt management policy than to what is nor- icy or model inclilded the investment-borrowing costs than- mally labeled monetary pohey. nel and both aspects of the wealth channel — real To the extent that monetary actions affect the cash balances and private equities38 Metzler, how- yields on government debt, there is~~~ninterest-inì- ever, made the unusual assumption that the Federal duced monetary wealth effect on consumption. If ex- Reserve increases the money stock through purchases pansive monetary actions lower the “r” component of of privately held common stock. ~proportionateIy more than “G” in the wealth defini- An increase in the money stock (in the Metzler model), given full employment, results in a propor- tion, nonhuman money wealth rises, as does (under tional increase in prices and this no change in con- typical assumptions) consumption. Of course, a mone- sumption with real balances remaining constant. The tary overshoot effect would reverse the fall in interest Federal Reserve’s purchase of common stock lowers rates and subseqiwntly ~vorkin the opposite direction net private wealth (the volume of securities in private on consumer expenditures. Also, if the rise in the price hands falls) and consequently, consumer spendii~g. of securities (fall in interest rates), induces those The fall in consumer expenditures is accompanied by wealth holders who have not yet purchased securities a rise in saving, a fall in the rate of interest, and the to pay a higher price for their securities, this particu~- conseqi~entincrease ill capital intensity. Criticism of lar group may curtail their outlays for consumer 36 Metzler’s model centered on his unusual assumptions, goods. which, among other results, gave a negative associa- tion between monetary growth and consumer HProponents of the “New View” also add non—government, non-bank liabilities, such as savings and loan shares, to the spending. total. See Brunner [6]. The Radcliffe Committee [171 found a role for money to The more orthodox conjecture, that monetary affect spending if it added to total liquidity, to include growth, the market valuation of equities, and con- funds made available by non—bank financial institutions. John Gurley noted that the Committee “believes that changes in these [interest] rates have had little direct effect inversely, related to the author recently that an inverse rela— on spending; and it does not think that there is any direct, lion is more likely in the depression state, such as the 1930s. close connection between the money .suppiy and spending. than today. But while money is shoved out of the house through the 37 front door, for all to see, it does make its reappearance ’Like Friedmari (1970, pp. 206-7) we believe that the surreptitiously through the back door as a part of general rea~-ba1aneeeffect is one of several explanations of long—run liquidity: and the most important source of liquidity is the chai~gesin the IS curve. We agree, also, that the short—run large group of financial institutions.” Gurley [36], p. 685 miportance of the real—balance effect is small &rnugh to Bracketed expression supplied. neglect in most develcpecl economies where real balances 35 are a small part of wealth. In our analysis the size of the See Patinkin’s empirical chapter [63]. Lerner [54] theo- traditional real—balance effect depends on the proportion of rized that continued growth of government debt, as in money to total nonltuniaii wealth, a factor that is less than World War II, would eventually induce sufficient con- .05 for the United States” ( Bronner and Meltzer [11], sumer expenditures as to eliminate any excess of savings over p 847). investment at full—employment income, lie did not attempt ~Tinbergen provi led the first empirical test of an equities— an empirical test, however. 34 consumption relation. Dividing cons~imption into that by See Leijonhufvud ([53], pp. 241-42) for a discussion of income earners and non-workers, he found that “a fall in this effect. , who recognized the potential capital gains had already caused a decline in consumption of interest-induced changes in wealth to affect consumption between 1928 and 1929” (Tinbergen [75], p. 78).

Page 19 FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974 sumer spending are all positively related, has bed It is not likely that Friedman would credit any sort given theoretical and empirical support by Franco of monetary-induced nonhuman wealth effect as hav- Modigliani. Modigliani [59], [60] advaticed formal ing that much influence on spending. The relalive theoretical models in 1944 and 1963. He recognized a price channel dominates his discussion of the channels role for wealth-consumpt1on influences in his revised of monetary influence ir~numerous articles (Friedman model of the economy (called the “rnid-50s” model) [28], [33], [34]). In more recent studies in which which he acknowledged had been omitted from the Friedman developed a formal , he 1944 model. His new consumption equabon was omitted wealth from the consumption function, using 41 CC(X,~,r.[~~2 oniy C/p = f(I, r). One indication that nonhuman where wealth is of some significance in his view of the transmission process emerged in a recent article in X = real income which he attempted to delineate initial and subse- = Modigliani’s life-cycle aggregate labor income quent shifts in the IS-LM apparatus.42 variabl&9 r = the rate of return on (or cost of) capital Until recently, Tobin apparently shared Friedman’s

12 = the net worth of the private sector. lack of enthusiasm for monetary-induced wealth effects p on consumption. His omission of wealth influellees on The two latter monetary-related terms, the borrowing consumption may be found in his informal models of the early 1960s as well as his more detailed models of cost variable and the wealth variable, appeared in 43 much the same form in the FRB-MIT model of the the late 1960s. It is not so mllch that Tobin denied a later 1960s, a model with which Mochghalli has been wealth effect, rather that he preferred to keep stock closely identified. and flow variables separate. Thus, consumption (and saving) were functions of flow variables specifically

The money-equities-consumption channel in the income — and not wealth, a stock concept. “The pro- FRB-MIT model hinges on the substitutability of pensity to consume may depend upon interest rates, bonds and stocks. If an increase in demand for, say, hut it does not depend directly on the exisfing mix of Treasury securities, by the Federal Reserve results in asset supplies or on the rates at which these supplies lower yields and higher prices for these securities, are growing.”41 other investors could ~vc1Ibe discouraged from pur- chasing the now higher-priced Treasury securities, but In a significant departure from most of his previous securities whose price was not initially affected by studies, Tobin [85] stressed the importance of wealth the Federal Reserve action. To the extent that de- effects in an article co-authored with Dolde in 1971. mand is shifted to equities from Treasury securities They considered the “two major recognized channels because of their higher price, there is a rise in com- of monetary influence on consumption: (A) changes in wealth and in interest rates, (B) changes in liquid- mon stock prices, which is reflected in a rise in PK. 45 ity constraints.” They recognized the historical sig- The higher equity prices represent capital gains to 1 equity owners. The wealth effect portion of this proc- ~ Friedrnan recognized the inadequacy of the above con- ess is the inducement to spend on the part of equity sumption function ([30] p. 223) and ([311, p. 331) “in a hill statement” ([30j, p. 223), because it excluded owrn~rsbecause of their increased net worth. Over a wealth, but he stated he was attempting to stick to Key- sixteen-quarter period, the equity channel represents nesian short-period analysis. In a much earlier study, Fried~ man [261 endorsed the real balance effect more vigorously. 45 percent of the enlire monetary influence on total 2 4 ~ Fdedman ([321, p. 916) (liscussed shifts in IS-LM curves spending in the FRB-MIT model. ° (first_round effects vs. subsequent effects) in a manner con- sistent with the view that wealth influences subsequent 39 shifts. Friedman did not mention “wealth” but Blinder- ModiglianiBrnmberg [621 in 1954 related consumption to Solow [2] interpreted his discussion in that context. 3 one’s expected income over his life span. The discounted ~ See Tobin’s early models [77], [78] and later models value of ‘permanent” income is human wealth, or = w. [81], [84]. He did mention monetary influences o’~saving! consumption in “Money, Capital, and Other Stores of Value Nefther Modigham~Bruniberg nor Friedman [27] related [77], and gave the relation somewhat more prominence in monetary-ii~duced nonhuman wealth to consumption at this the earlier “Rejative Ineome, Absolute Income, and Saving early stage. [76]. WdeLeeuw and Gramlich [20], p. 487. Other simulations by 1 ’Tobin [811, p. 16. Modigliamof the FRB-MIT model indicate an even stronger 4~ equities eflect when alternate forms of the money—equities— Tobin-Do1de [85], p. 100. Tobin’s comments concerning consumption equations are run. Modigliani [61], however, the volatility of the marginal propensity to consume, espe- did not accept these as realistic. cially with respect to the 1968 tax surcharge, provide a

Page 20 FEDERAL RESERVE BANK OF ST. Louis NOVEMBER 1974 nificance of the Pigou effect, but wealth changes in which includes consumer spending) in that model is their study were associated with capital gains (equity influenced by, amollg other factors, nonhuman wealth. effect). Their liquidity effect referred to the cost of Their nonhuman wealth variables include real capital, converting nonliquici assets to liquid form in a world the monetary base, the stock of government debt, and of imperfect capital markets. The level of the penalty the value of commercial banks position ex- rate of interest (a relative price) inhibits or encour- cluded from real capital (Pesek and 5av h~geffect). ages conversion of nonliquid to liquid assets. Formal economic models now routinely include 48 Using a Modig1iani~Brurnberglife-cycle model, they wealth and/or substitution effects cm consumption. concluded that wealth (equity values), interest rates, Few, if any, of the ernpiricaIIy-oriei~ted, structural and the liqudity constraint all have important influ- models permit all the wealth effects on consumptiofl ences on consumer spending. Their model was basi- described above. For example, the FRE-MIT mode] cally a reduced form, in that they did not provide the (Board of Governors [3]) has an equities effect but linkages between monetary policy actions and mone- no real balance effect; the \Vliarton Mark III model tary effects. (McCarthy [56]) has a real balance effect but no equities effect. Only when model builders make al- Bmnner and Meltzer have long included a promi- lowance for all possible monetary effects are so-called nent role for wealth effects in their view of the mone- structurally rich models as likely to reflect as sigmfi- tary ti-ansrnission process. “PK” is the component of cant a rnoney~spending impact as reduced form nonhuman wealth mentioned most favorably in their models. There is, of corn-se, a good possibility that yet analysis. For example, in discussing the chain of undiscovered wealth, relative price, and even mone- events following an injection of base money, Brunner- tary income effects will be fotrnd in the monetary Meltzer noted that “the resulting rise in the market charniels of the future. value of the public’s (nonhuman) wealth raises the desired stock of capital III and the desired rate of 46 real consumption.” They further stated that relative SUMMARY price effects also operate to increase real consumption following the expansive monetary action. This article surveyed the rehthve price and wealth changes set in motion when the quantity of money At a later date Brunner again stressed the impor- supplied changes relative to money demanded. Rela- tance of “PK” relative to the real balance effect in the tive price ~md wealth changes were viewed as major transmission process. “The dominant portion of the elements of the molletary transmission mechanism wealth adjustment induced by a monetary impulse around the turn of the century (in rudimentary fash- occurs beyond a real balance effect and depend.s oi~ ion) and in recent years, hut in much of the inter- the relative price change of existing real capita]. The vening period their role was subjected to considerable monetarist analysis of the trai~smissionmechallism de- question. termines that this portion of the total wealth effect thoroughly swamps the real balance or even the finan- Fisher and Wicksell favored one approach in which cial asset effects,”47 wealth was the dominant monetary force ai~danother in which relative prices were of more significance. Real balances are included, however, in Brrniner Keynes amplified 1)0th views, but his major interpret- and Meltzer’s [12J formal model. Total spending ers were not SO inclined. It is, in fact, ironic that J. R. Hicks, who fomiulated the IS-LM interpretation ohe as to why he chose to include wealth in the coflsump~ of Keynes, downgraded both monetary wealth and tion funetjon. Now if it had been true that the income— How theory of consumption ‘vas a resounding success, and relative price influences, despite his pioneering re- that its indications were being borne out all the time, then search into basic wealth [45] and portfolio choice we wouldn’t need to go into the wealth theory or the life— eyele theory and all that. We wouldn’t need to seek a fields [43], fundamental theory about why savings ratios are what they are and how they relate to various parameters. But we all Real balance wealth effects were revived by Pigou, know that the cash income theory is not a resounding sue- PatinkiH, and others while Metzler re-formulated the cess.” Tobin [83], p. 159. 46 Brunner and Meltzer [91, p. 377. Capital III refers primarily equity wealth effect. Tobin, Brunner-Meltzer, and to certain types of consumer durable goods. Exampks of the Friedman advanced the poi-tfolio choice-relative price other two types of capital delineated by Bruoner and Melt— effect in the early 196Os, and with the exception of zer are maehiriery and equipment (Type I) arid houses (Type II). 47 48 Brunnor [7], p. 5. See, for example, Christ [15] and Rasehe [67].

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Friedman, have also highlighted the equity wealth effects may be on, say, conslimer durable goods ex- effect. pendithres, and under another set, state and local government purchases. To follow explicitly the chan- These hardly exhaust all the ways in which mone- nels of monetary influence whenever there occurs a tary impulses affect spei~ding.For example, an income change in the quantity of money supplied relative to effect occurs when the Treasury draws clown its bank the quantity demanded, one would have to know as balances to purchase goods and services. A decline in a minimum the cause of the change in the money Treasury deposits relative to demand deposits in- supply, all re1eva~trelative prices, and the impact of creases the money supply (other things equal) and other exogenous events on spending units. Add to this income. the effect of feedback forces, both relalive price and AIternative~y,a rise in the money supply may be wealth, and it becomes less surprising that the con- associated with a change in relative prices and no tents of the monetary black box have been difficult to change in wealth. For example, a fall in unravel. relative to demand deposits increases the molley sup- ply and lowers bank loan rates, but there is no rise The complexity of the forces at work, however, does not mean that one should despair of forecasting in real balances — if defined oniy as outside money the effect of molletary iiilluences on total spending — and no change in Government debt. and rely on (presumably) more elementary tools to Thus, depending on how the money supply is guide economic activity. The effects of other policy 49 caused to change relative to money demand, sonic actions are also difficult to trace with certainty effects on spending are set in motion, but not neces- 19 sarily all. Moreover, the fact that initial conditions, to 1t has become clear hi recent years that simply fo,ecasting the result of effects on total spending requires melude all relative prices, are never the same suggests more than reliance on some variation of the deceptively that under one set of circumstances initial monetary simple relafions YC+I+G and C=C(Y—T), These

Page 23 FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974

The likelihood is that all possible channels of mone- tio~ (C). \Vhat does not appear in these simple relations tary or other policy adions have not been spelled out ate the vector of relative prices, the type of government spending invoKed, how the government spending is to be completely in any one model. There remains much financed, and whether the tax changes are presumed to room for research which wodd narrow the gap be- he temporary or pernialactit. tween economic reality and economic models. Fiscal policy acLioiis way also influence wealth and inter- est rates in addition to income, the income effect presmoably berng what is referred W as the direct eflect of fiscal aetions relations imply a direct link between government spending on spending. Although monetary aud fiseat channels of in- G) and total spending ( Y), and between dis~osab1e in- fluence are both complex, only monetary actions have typ- come (Y — T), which includes tax changes, and consump- ically been viewed as operating within a black box.

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