sign in sign up
<<
Home , Banknote, Currency in circulation, Demand for money, Discretionary policy, Equation of exchange, Gold standard

THEQUANTITY THEORY OF : ITS HISTORICALEVOLUTION AND ROLE IN POLICYDEBATES

One of the oldest surviving economic doctrines is and to the major monetary controversies surrounding the , which in its simplest it. Accordingly, the article (1) examines the content and crudest states that changes in the general and implications of the key propositions of the theory, level of are determined primarily (2) traces the evolution of these propositions from by changes in the quantity of money in circulation. their 17th and 18th century origins to their present This theory dates back at least to the mid-16th cen- embodiment in monetarist doctrine, (3) sketches the tury when the French social philosopher role played by the quantity theory in the Bullionist, first attributed the then raging in -Banking School, and Keynesian policy de- Western to the abundance of monetary metals bates, and (4) outlines the major criticisms leveled imported from the mines of the Spanish colonies in against the theory during the past two centuries. South America. After undergoing considerable re- finement, elaboration, amendment, and extension in WHAT IS QUANTITY THEORY? the late 17th and 18th centuries by , , and , the quantity the quantity is a theory was integrated into the mainstream of ortho- about the cause of in the or dox monetary tradition. Forming the central core purchasing of money. to the of 19th century classical monetary analysis, the quan- changes in of are determined tity theory provided both the dominant conceptual by changes the quantity circulation. When framework for the interpretation of financial events becomes abundant, value or in that century and the chief intellectual foundations power falls, consequently the of com- of orthodox policy prescriptions designed to preserve prices rises. if money the standard. Today the quantity theory sur- scarce, its power rises general prices vives and flourishes in the doctrines of the so-called In , quantity theory that the monetarist school emanating from such institutions of money is the determinant of as the University of and the of St. Louis. Spearheaded by This brief of the however, does , , Allen Meltzer, do it . More just the con- Philip Cagan, and others, contemporary monetarists clusion money governs the theory continue to expound quantity theory propositions consists of set of propositions or similar to those enunciated by their classical prede- lates that that conclusion. most im- cessors. of these refer to the propor- The quantity theory has not gone unchallenged, of M P, (2) active or role of however. As controversial as it is ancient, the quan- in the transmission mechanism, the tity theory has probably stimulated more debate than neutrality money, (4) monetary theory the any other single topic in the field of monetary theory. price and (5) exogeneity of nominal Some of the leading monetary controversies of the money. past two centuries, including the Bullionist and Cur- rency School-Banking School debates of the 1800’s, The Proportionality Postulate The first propo- and the controversy between Keynes and the neo- sition states that P will vary in exact proportion to classical economists in the 1930’s, have revolved changes in the quantity of M, i.e., a given percentage around issues relating to the quantity theory. More- change in the stock of money will result in an identi- over, the debate shows little sign of subsiding. Many cal percentage change in commodity prices. Asso- of the same quantity theory-related issues appearing ciated with the strict classical version of the quantity in the earlier debates figure prominently in the cur- theory, this proposition follows from the assumption rent controversy between the monetarist and post- that people want to hold for transactions purposes a Keynesian schools of thought. constant quantity of real (price-deflated) bal- The purpose of this article is to introduce Eco- ances, M/P, at the ’s full-capacity level of NOMIC REVIEWreaders to this much-debated theory real . Because these cashholders look to the

2 ECONOMIC REVIEW, MAY/JUNE rather than to the mere money demand for . The key link in this process is value of their cash balances, the price level must the relationship between the rate of spending on the vary in direct proportion to the nominal money one hand and the discrepancy between actual and to maintain real balances intact. desired real balances on the other. Variations in the It should be noted that the proportionality postu- rate of spending are seen as the means by which late implies that the demand for real cash balances actual real cash balances are adjusted to the level and its counterpart, the circulation , that people desire to hold. Thus, for example, start- are completely stable. For if velocity or the demand ing from a of monetary equilibrium, an in- for money were unstable, i.e., subject to erratic and crease in the initially will raise real unpredictable shifts, one could not safely predict that cash balances above the preexisting desired level. M and P would change in the same ratio. Suppose, Cashholders will be left with more money than they for example, that a doubling of the nominal money want to hold, thereby prompting them to get rid of supply, M, is accompanied by (1) a halving or (2) the excess via spending for goods. Given that the a doubling of the desire for real balances. The price economy is operating at full capacity, however, the level would have to quadruple in the first case and increased spending will exert upward pressure on remain unchanged in the second if real balances, prices. Spending, prices, and nominal income will M/P, were to attain their desired levels. In fact, continue to rise until cashholders are just satisfied to any arbitrary shift in the amount of real balances hold the nominal money in existence. Equilibrium is demanded would necessitate a percentage change in P restored when P has risen sufficiently to bring real different from that of M. Only if the demand for real cash balances back to the desired level. In brief, the balances remains unchanged will the proportionality direct mechanism relies on the disequilibrium be- relationship hold. It follows, therefore, that the strict tween actual and desired real balances to induce the version of the quantity theory must assume complete spending that ultimately causes prices to change in stability of the if it is to predict proportion to the monetary injection. The sequence that money and prices will show equiproportionate runs directly from money to spending to prices. variations. By contrast, the indirect mechanism refers to the Causal Role of Money A second key proposition process by which a monetary change influences spend- of the quantity theory states that the direction of ing and prices indirectly via its prior effect on the causation or channel of influence runs from M to P, rate. In this process, a monetary injection i.e., monetary changes precede and cause price level first causes the rate of interest to fall, thereby stimu- changes. In this cause-and-effect relationship, money lating spending and thus exerting is seen as the active variable and the price level as the upward pressure on prices. More precisely, the indi- passive or dependent variable. rect mechanism relies on two links: (1) the creation One important implication stemming from the in- of a monetary-induced gap between the expected rate terpretation of money as the active variable is that of on investment and the rate of the proportionality between money and prices refers interest and (2) an investment response to this gap. to an equilibrium condition established via a dynamic The direct and indirect mechanisms provide the two adjustment process, and not to an identity that holds main channels through which the dynamic price ad- at all points in time. The lead-lag, cause-effect rela- justment process works.1 tionship between money and prices implies that a The Neutrality Postulate A third proposition change in M initially creates a disequilibrium between states that, except for transitional adjustment periods, M and P. This disequilibrium then invokes forces monetary changes exert no influence on real economic that cause P to change. Prices continue to change variables, e.g., total output, employment, and the until proportionality is restored and the disequilib- product-mix. These variables, it is argued, are deter- rium is eliminated. mined by basic non-monetary conditions such as For such an adjustment process to occur, however, tastes, , resource endowments, and rates there must be some mechanism, channel, or linkage of technical substitution between factor resources. As through which monetary impulses are transmitted the quantity of money in no way alters these funda- to the price level. Traditionally, two main transmis- mental conditions, it follows that monetary changes sion mechanisms have been identified, namely, the (1) 1Two points of clarification should be made here. First, one does direct expenditure and (2) indirect not necessarily have to be a quantity theorist to accept the validity of the monetary transmission mechanisms. In fact, the indirect mechanisms. The direct mechanism refers to the pro- mechanism today is frequently associated with non-quantity ap- proaches to monetary theory. Second, modern Quantity theorists cess by which the impact of a monetary change is sometimes argue for the direct money-spending mechanism merely as an empirical proxy for a complicated portfolio adjustment p-s channeled to the price level via a prior effect on the in which specific interest rate effects cannot be captured statistically.

FEDERAL RESERVE BANK OF RICHMOND 3 are neutral in their -run effects on real variables. the prices of others, leaving the average price level In brief, money is thought to be merely a veil, ob- unchanged. They hold that it is usually monetary scuring but not affecting the operation of real eco- shocks, not real-sector disturbances, that exert the nomic forces. dominant effect on the general level of prices. Note, however, that the neutrality postulate, like Exogeneity of the Nominal Stock of Money A the proportionality postulate, refers only to long-run fifth condition required by the quantity theory is that equilibrium. During the short-run transition to the nominal stock of money be non-demand deter- equilibrium, monetary changes very definitely can mined. This requirement is a corollary of the propo- have non-neutral effects on real variables. For ex- sition that nominal M is the independent causal factor ample, during the transition period there may be governing P. For if the quantity of money is not an - effects stemming from the failure independent variable, but instead responds passively of some cashholders to get their pro rata of to prior shifts in the demand for it, then quantity additional money and from the impact of unantici- theorists could not claim that it played the active pated price-level changes on the real value of fixed- initiating role in the determination of the price level. dollar financial claims. These distribution effects It should be emphasized that the exogenity postu- will alter the composition of demand and thus the late refers to the nominal rather than the real stock structure of production. Moreover, some commodity of money. The distinction between the two is and factor prices may adjust more swiftly than others crucial. Unlike the nominal stock, the real stock is thereby altering relative prices (market exchange treated by the quantity theory as an endogenous vari- ratios) and thus relative quantities of real variables. able determined by the public’s demand for real bal- The quantity theory does not deny that money ances. As previously discussed, the public, via the changes may influence resource allocation in the impact of its spending on the price level, can make transition period. What it does claim, however, is the real value (purchasing power) of any given that these non-neutral effects are temporary and that nominal stock of money equal to the desired quantity they will vanish in long-run equilibrium when the of real cash balances. In brief, the real money stock economy has adjusted fully to the monetary change. is seen as a dependent variable determined by the public’s decisions to acquire or get rid of cash. Monetary Theory of the Price Level The neu- Such is not the interpretation given to the nominal trality postulate states that changes in the quantity of stock, however. Quantity theorists long have argued money affect only the price level. As stated, how- that, in fact, the nominal stock of money is largely ever, this proposition is not sufficient to rule out the determined by factors independent of those deter- possibility that non-monetary variables may also be the demand for it. Traditionally, the quantity important determinants of P. An additional condition theory has treated the nominal money stock as a must be invoked. Accordingly, a fourth postulate largely exogenous variable. In the days of the gold states that the price level itself tends to be influenced specie standard, a nation’s money stock was regarded predominantly by changes in the quantity of money. as mainly predetermined by the past and current The implication is that price level instability stems production of gold and by the of the external principally from monetary rather than non-monetary accounts (balance of ). Later, when disturbances. Thus, inflation and are largely money had replaced gold, the stock of money was attributed to the erratic behavior of the money stock regarded as exogenously determined by the inde- rather than to non-monetary causes originating in the pendent via its control over a narrowly- real (commodity) sector of the economy. defined base of so-called high-powered money con- It should be noted that the fourth postulate refers sisting chiefly of the central bank’s own liabilities. to the general price level and not to relative prices, This interpretation of the central bank as the exo- i.e., relationships among the prices of individual com- genous controller of the money stock, it should be modities (market exchange ratios). Quantity the- pointed out, assumes the existence of stable links orists readily admit that non-monetary influences- between the base of high-powered money created by e.g., technological progress and change ; the central bank, and the and money crop failures, embargoes, and other disruptions in the supplies of food and raw materials ; power ; generated by the commercial banking system. These excise and the like-can directly affect relative stable links are necessary if the total money supply is prices. But they argue that such non-monetary- to behave exactly as its exogenously determined com- induced changes in the prices of some ponent, the . Generally, quantity the- are often likely to be balanced by opposite changes in orists have argued that these stable links exist.

4 ECONOMIC REVIEW, MAY/JUNE 1974 Quantity theorists also have employed the notion adjustment would continue until all prices had of stable linkages to minimize the problems that changed in equal proportion to the money stock and money substitutes may pose for monetary regulation all quantities had returned to their pre-existing levels. and control. The quantity theory has never denied Especially vivid was the Cantillon-Hume account of that near-moneys may influence spending and prices the short-run non-. Cantillon just as money does. What the theory has denied, pointed out that the dynamic adjustment path would however, is that the volume of money substitutes can be influenced by the way new money was injected into expand or independently of the volume of the system. Specifically, he stated that most mone- money and thus act as an autonomous influence on the tary injections would involve non-neutral distribu- price level. Instead, money and money substitutes tion effects. He argued that, generally, new money are thought to be related via a stable link so that will not be distributed among individuals in propor- variations in the former will be accompanied by tion to their pre-existing share of money holdings. roughly proportional variations in the latter. Some will receive more, and others less, than their proportionate share. The former group will benefit at the expense of the latter and therefore, via their DEVELOPMENT OF THE QUANTITY THEORY money outlays, will play a greater role in determining UP TO THE NINETEENTH CENTURY the composition of output. In short, Cantillon demon- The main outlines of the quantity theory began to strated how initial distribution effects temporarily take shape as early as the mid-16th century when could alter the pattern of expenditures and thus the Jean Bodin first stated his monetary theory of the structure of production and the allocation of re- price inflation then occurring in Western Europe. sources. Later writers lent precision to Bodin’s hypothesis by David Hume described how different degrees of postulating that the value or purchasing power of among income recipients, coupled with money varies in exact proportion to the quantity in time delays in the adjustment process, could cause circulation so that a doubling of M will double P and costs to lag behind prices, thus creating profits and halve the value of the monetary unit. At first the stimulating the formation of optimistic profit expec- proportionality postulate was treated as an identity. tations. Hume believed that both actual profits and As originally stated by John Locke in 1691, the optimistic expectations would spur business expan- postulate asserted that P is always proportional to M. sion and employment during the transition period. In 1752 David Hume introduced the notion of caus- These non-neutral effects were expected to vanish in ation by stating that variations in M will cause the long-run, however. proportionate changes in P. By the time it reached To the Cantillon-Hume list of temporary non- the Classical economists in the early 19th century, neutral effects, 19th century economists added others, the proportionality postulate was understood as a most of which stemmed from the fixity of certain proposition of comparative static analysis, valid only types of contractual payments and from the failure of for the comparison of states of old and new monetary all factor-resource prices to adjust with equal swift- equilibrium after the had fully ad- ness. These additional non-neutral effects included : justed to a change in the money stock. It was recog- (1) the lag of money behind prices which nized that proportionality between M and P tem- temporarily reduces real wages, thereby encouraging porarily would be disturbed during the transition increased demand for labor ; (2) the to period between successive monetary equilibria. output occasioned by inflation-induced reductions in Richard Cantillon and David Hume, both writing real burdens which shift real income from un- in the 18th century, were the first to apply to the productive -rentiers to productive - quantity theory the two crucial distinctions : (1) be- entrepreneurs ; (3) so-called “forced-” effects, tween economic statics and dynamics, i.e., between i.e., changes in the fraction of the economy’s re- long-run stationary equilibrium and short-run move- sources diverted from consumption into capital for- ments toward equilibrium, and (2) between the long- mation owing to price-induced redistributions of in- run neutrality and the short-run non-neutrality of come among socio-economic classes having different money. In what were perhaps the earliest examples propensities to save and invest ; and (4) the stimulus of dynamic process analysis, these writers described to investment spending imparted by a temporary re- the sequence of steps by which the impact of a mone- duction in the rate of interest below the profit tary change spreads from one sector of the economy rate on real capital. to another, altering relative prices and quantities in While acknowledging the existence of these non- the process. Cantillon and Hume pointed out that neutral effects, however, classical quantity theorists

FEDERAL RESERVE BANK OF RICHMOND 5 frequently tended to minimize their importance. This expansion of bank , Thornton described how de-emphasis of transition effects is what distinguished the increased supply of loanable funds temporarily the classical version of the quantity theory from the reduces the loan rate of interest below the profit rate earlier Cantillon-Hume version. Whereas the latter (expected ) on new capital projects. This dis- tended to stress dynamic disequilibrium periods in parity between profit and loan rates stimulates addi- which money matters much, classical analysts focused tional investment spending, thereby exerting upward on long-run equilibrium in which money is just a pressure on product prices, including the price of veil. Whereas Cantillon and Hume thought that investment goods. With investment goods becoming transition periods would be protracted, classical increasingly expensive, however, businessmen require analysts saw them as evanescent. Whereas the Can- more and more loans to finance their purchases. The tillon-Hume analysis stressed the output and em- demand for loans therefore increases, bidding up the ployment effects of inflation, classical analysis virtu- loan rate of interest in the process. Equilibrium is ally ignored, or treated as insignificant, those real reestablished when rising loan demand eventualIy effects. The prevailing view, the position of the most overtakes the initially expanded supply and the influential of the classical economists, especially David money rate of interest rises back into equality with Ricardo, was that these disequilibrium effects were the profit rate. Nineteenth century quantity theorists ephemeral and unimportant, mere qualifications to incorporated both the Cantillon-Hume direct mech- the long-run equilibrium analysis. This opinion may anism and the Thornton indirect mechanism in their have been conditioned by Ricardo’s penchant for explanation of the linkages between M and P. abstract, comparative-static theorizing. Or perhaps it sprang from his desire for an uncomplicated and ROLE OF THE QUANTITY THEORY IN convincing theory to support his charge that inflation CLASSICAL POLICY DEBATES in Britain was solely the result of the Bank of Eng- land’s irresponsible overissue of currency. Such a The first half of the 19th century, an era in which theory would be more effective if it isolated price- the doctrines of the British classical school dominated level effects and abstracted from real effects. Most economic thought, saw the of a concen- likely, Ricardo and other classical economists avoided trated and systematic application of the quantity discussions of any beneficial output and employment theory to policy problems. Having been quickly effects of monetary injections in fear of providing absorbed into the mainstream of classical analysis, crude inflationists with arguments to support their the quantity theory became the standard conceptual case. Whatever the reason, non-neutral transition framework for the analysis of monetary problems effects were slighted. and for the formulation of practical policy recommen- dations. The central monetary problems in England Finally, an advance in understanding of the mone- at that time related to the maintenance of external tary transmission mechanism occurred. This prog- equilibrium and the restoration and preservation of ress accompanied the historical evolution from a pre- the . Consequently, the quantity theory dominantly full-bodied money to a mixed metal- tended to be directed toward the analysis of inter- paper money that occurred in the 18th century. national price levels, gold drains, fluc- Written in the era of full-bodied money, the Cantil- tuations, balance deficits, and related problems. lon-Hume account of the adjustment process had relied solely on the direct mechanism to raise prices. The Quantity Theory and the Price-Specie-Flow In the Cantillon-Hume analysis, an arbitrary influx Mechanism It was only natural that the quantity of gold induces an increase in the rate of spend- theory was applied to these problems of inter- ing until all incomes and prices had risen in propor- national finance. After all, the theory had long tion to the monetary injection. The direct mechan- played a strategic role in the classical theory of ism, however, no longer sufficed as an explanation of . The quantity theory was the the adjustment process after had given way key ingredient in the classical explanation of the to bank notes in the 19th century. The main short- operation of the price-specie-flow mechanism, i.e., coming of the direct mechanism was that it failed to the automatic self-regulating adjustment mechan- explain how bank notes and other forms of paper ism that insures the restoration and preservation money are injected into the system. In his 1802 of equilibrium and that gov- classic, The Paper of , Henry erns the international distribution of the precious Thornton provided the first exposition of the indirect metals. One of the earliest rigorous explanations mechanism. Pointing out that new money created by of the specie-flow mechanism was provided by enters the financial markets initially via an David Hume. In one of the more celebrated pas-

6 ECONOMIC REVIEW, MAY/JUNE 1974 sages in British economic literature, Hume ible into gold. The suspension of specie payments was started out by assuming a five-fold overnight in- followed by a rise in the price of bullion, foreign ex- crease in the domestic money supply. Proceeding change, and commodities in terms of paper currency. to trace the consequences, he argued that wages A debate then arose centering on the following and prices would rise in proportion to the mone- issues: Was the pound depreciated? Was there in- tary change, thereby making British goods more flation in Britain and if so, what was its source? expensive than foreign goods, and thus causing The Bullionists, led by , argued imports to rise, exports to fall, and gold to flow that currency depreciation and inflation did exist, out. The external gold drain, in turn, would tend to that the overissue of bank notes by the Bank of moderate prices in Britain and raise them else- England was its cause, and that the premium quoted where. Hume held that the trade-balance deficit on bullion (the difference between the market and the and the specie outflow would continue until the old price of gold in terms of paper money) was purchasing power of gold was the same every- the proof. Price indexes not being in use then, the where, imports and exports were in balance, and Bullionists used the gold premium as we use price the terms of trade were identical to those that indexes today to measure the extent of inflation. would reign under a purely regime. The Bullionists arrived at their conclusions via the It is readily apparent that Hume’s explanation following route: the quantity of money determines embodies most of the key elements of the quan- domestic prices; domestic prices affect the exchange tity theory. The proportionality postulate is rate; and the exchange rate between inconvertible stated explicitly. The most prominent element, paper and gold standard determines the however, is the interpretation of money as the premium on gold. It follows, therefore, that the de- active causal variable-disturbing initial equili- preciation of the exchange rate below gold parity brium, driving up prices, generating a trade im- (i.e., below the ratio of the respective old mint prices balance, forcing an efflux of specie, and eventu- of gold in each country) and the existence of the ally restoring equilibrium. The short-run non- premium on bullion both constituted evidence that neutrality of money emerges in the form of the prices were higher and the quantity of money greater alteration of the terms of trade or relative prices in Britain than would have been the case had the of exports and imports. And the long-run neu- country still been on the gold standard. trality of money is manifested in the restoration In short, the depreciation of both the internal and of the pre-existing barter ratios. These same the external value of the paper pound was attributed quantity theory elements comprised the analyti- solely to the redundancy of money, and the Bank of cal framework within which classical economists England was reproached for having taken advantage discussed the events and policy issues surround- of the suspension to expand its note issues recklessly. ing the leading monetary controversies of the day. Thus, like present day monetarists, Bullionists lo- cated the source of inflation in the central bank. But The Bullionist Controversy The two great mone- the Bullionists went even further, charging that the tary debates of the classical era were (1) the Bullion- Bank was also responsible for the external specie ist controversy that took place in the first two decades drains that led to the restriction of cash payments. of the 19th century during and immediately after the Bullionists claimed that the redundancy of notes, by and (2) the Currency School- forcing up domestic prices relative to foreign prices, Banking School controversy during the middle de- had caused the trade balance to become adverse, thus cades of the century. The Bullionist controversy was forcing gold to leave the country. Here is the quan- provoked by events following a major policy shift in tity theory view of money as the active disturber of 1797. In that year, under the stress of the Napole- . onic Wars, Britain left the gold standard for an in- The same quantity theory reasoning underlay the convertible paper standard. A series of gold drains, Bullionists’ policy prescription for restoring converti- coinciding with heavy military outlays abroad, ex- bility. Bullionists held that the sole prerequisite for travagant borrowing, and extraordinary the restoration of specie payments at the old mint wheat imports, had virtually exhausted the Bank of price was the contraction of the note issue. The as- England’s . The depletion of the Bank’s sumption was that the reduction in the money supply thus forced the suspension of specie would lower internal prices, remove the trade deficit, payments. The Bank was released from its obligation bring the exchanges back to par, and eliminate the to exchange gold for currency at the fixed mint price, premium on bullion. With sufficient reduction of i.e., bank notes were no longer automatically convert- the note issue, could be restored without

FEDERAL RESERVE BANK OF RICHMOND 7 fear that an external drain of gold would again de- only through rigid adherence to the “Currency Prin- plete the country’s bullion reserve. ciple” of making the existing mixed gold-paper cur- rency behave exactly as would a wholly metallic Control of the Money Supply In the main, the currency, i.e., by requiring to expand and theory employed by the Bullionists in locating the contract one for one with variations in gold reserves. source of inflation was the same quantity theory that Given the desirability of making paper money behave they had inherited from their pre-classical predeces- exactly like a metallic one, however, by what means sors. It would be wrong, however, to assume that or device was this result to be achieved? By the the Bullionists did not add anything to the theory. mere requirement of gold convertibility alone? Or Their specific contribution related to the question of by the imposition of even stricter rules and regula- the control of the money supply. They were the first tions on the note issue? These questions constituted to develop the idea that the stock of money, or at one of the central issues of the controversy. least the currency component, could be effectively regulated via the control of a narrowly defined mone- Safeguards to Note Overissue : Convertibility vs. tary base. This point was first brought out in their Regulation The Bullionists had argued earlier treatment of the relation between the volume of Bank that convertibility as such would be sufficient to in- of England notes and the note issues of the country sure that banknotes would respond automatically to banks. The money supply at that time consisted of gold flows in conformity with the principle that the gold coin and the note liabilities of both the Bank of mixed currency should behave like a metallic one. England and country banks. The link between the Convertibility alone, Bullionists thought, would be an entire money supply and the ’s note adequate safeguard against overissue. If too many component might have appeared tenuous because of notes were issued, they reasoned, then according to the possibility of the country bank note component the quantity theory the value of the notes would fall expanding and contracting independently of Bank of and the foreign exchange rate would depreciate. England notes. But the Bullionists denied this possi- People would then convert notes into gold for export, bility on two grounds. First, the country banks and the consequent loss in specie reserves would tended to keep as a reserve Bank of England notes force the Bank to contract its note issues. equal to a relatively constant percentage of their own Members of the Currency School, however, re- note liabilities. Second, any overissue of country garded convertibility as an inadequate check to over- bank notes (and consequent rise in local prices rela- issue. They feared that even a legally convertible tive to prices) would drain Bank note re- currency would be issued to excess with the serves from the countryside to London via a regional unfortunate consequences rising domestic balance of payments or specie-flow mechanism, there- relative to prices ; balance of by forcing the country banks to contract their note ments ; foreign exchange gold outflow issues. For these reasons, asserted the Bullionists, depletion of reserves ; ultimately, suspension country bank notes would be passively tied to Bank convertibility. The of reserve would of England notes by a virtually rigid link and could be they noted, the external drain expand or contract only if the Bank’s own issues did. coincided an internal as domestic This is the origin of the quantity theory view that dents, alarmed the possibility suspension, control of a narrowly-defined base of “high-powered sought convert paper into gold. money” implies virtual control of the money supply. Lags and Policy Responses The Currency-Banking Debate The second great apprehensions of Currency School 19th century debate in which the quantity theory from its that the actions of Bank of played a leading role was the Currency-Banking had been and destabilizing. controversy over the question of the regulation of the destabilization argument the adverse of time on the policy response gold bank note issue. This debate took place in the 30- outflows to exchange movements. Specifi- year period following Britain’s return to the gold the Currency argued that lags standard in 1821. The main policy objectives of this existed changes in volume of out- period included maintenance of fixed exchange rates standing consequent changes prices and and the automatic gold convertibility of the pound. exchange rate. to these the exchange Members of the Currency School, applying the pre- would be in registering effect of note cepts of their Bullionist forebears, held that such overissue in signaling need for corrective preservation of the gold standard could be secured contraction. by the rate indicator,

ECONOMIC REVIEW, MAY/JUNE 1974 the Bank would continue to expand its specie-displac- notes to gold with a 100 percent , ing note issues long after the appropriate time for the money stock would be regulated and, conse- contraction. quently, the stability of the external value of the In sum, the Currency School contended that long pound would be achieved automatically. time-lags affected the Bank’s policy response to gold Money Substitutes and the Effectiveness of drains. Because of these delays, the Bank’s reactions Monetary Control The Currency School also to external drains often came too late to protect the contributed to the quantity theory doctrine that specie reserve and served instead to weaken public money substitutes cannot impair the effectiveness of confidence in the Bank’s ability to maintain converti- monetary regulation. This proposition is based on bility. Moreover, when the Bank finally did apply two underlying presumptions : (1) that money, the restrictive policies to stem the gold losses, these specific control instrument, can be clearly identified policy actions tended to coincide with and to exacer- and unambiguously distinguished from money sub- bate the financial panics and liquidity crises that stitutes and (2) that money and near-money are inevitably seemed to follow periods of currency and related via a stable link so that variations in the credit excess. In short, the Currency School alleged former will be accompanied by predictable variations that the Bank’s policy actions had accentuated, rather in the latter. These points were brought out in the than alleviated, economic disturbances. These Cur- Currency School’s treatment of bank notes versus rency School arguments foreshadowed by more than other forms of circulating media. At a time when 100 years Milton Friedman’s doctrine that the prev- bills of exchange and bank deposits were being em- alence of long lags in the response of spending and ployed increasingly as instruments of exchange, Cur- prices to changes in the money supply, and, to a lesser rency School advocates concentrated solely on notes. extent, in the policymakers’ response to changes in They insisted that money be defined to include only the economy, tend to render discretionary stabiliza- and notes and that monetary regulation be tion efforts destabilizing. What was needed to pre- confined to notes. They felt justified in excluding vent the recurrence of gold drains, exchange depreci- near-money -bills of exchange and bank deposits- ation, and domestic , the Currency from their policy analysis. They thought that the School thought, was convertibility plus strict regu- entire superstructure of money substitutes could be lation of the volume of Bank notes. regulated effectively by control of the money (bank note) base. In particular, they thought that the Policy Prescriptions of the Currency School The limitation on note issues constituted an ultimate con- Currency School was successful in exacting its ideas straint on the creation of deposits. Hence, rigid con- into legislation. The famous Bank Charter Act of trol of the former implied equally rigid control of the 1844 embodied the prescription that, except for a latter. Thus, if notes could be controlled, there would small fixed amount of notes that the Bank could issue be no need for explicit control of deposits. They against government securities, new notes could be defended their sharp distinction between money emitted only if the Bank had received an equivalent (coin and notes) and near-money (deposits and bills) amount of gold. In modern terminology, the Charter on two grounds. First, the low circulation velocity of- Act established a marginal gold reserve requirement near-moneys rendered those instruments quantita- of 100 percent behind note issues. With notes rigidly tively insignificant relative to notes as exchange tied to gold in this fashion, external gold drains would media. Second, in times of financial crises near- be accompanied by reduction of a like amount of moneys were poor substitutes for money strictly notes domestically. speaking, because only the latter would be accepted The quantity theory clearly underlay the Currency in final . Here, in the Currency School’s School’s prescription for stabilizing prices, securing analysis, is the origin of quantity theorists’ tendency convertibility, and preserving the gold standard by (1) to make a sharp delineation between money and tying the note issue to gold. For this prescription other liquid and (2) to deny that near-moneys was based on the postulate that money stock changes can frustrate the effects of changes in the money cause price level changes. The Currency School held supply. that the channel of influence ran from domestic note overissue to rising prices to a weakened trade balance and deterioration of the foreign exchanges and, ulti- ANTI-QUANTITY THEORY VIEWS mately, to gold outflows. Similarly, domestic price A Catalogue of Criticisms There has long been a rises would be reversed and the foreign exchanges body of doctrine opposed to the quantity theory. strengthened by reducing the note issue. By tying At one time or another each of the following criti-

FEDERAL RESERVE BANK OF RICHMOND 9 cisms have been leveled against the theory. These the Bullionist debate in the form of the Antibullion- criticisms are neither mutually exclusive nor are they ists’ critique of the Bullionists’ policy analysis. At always consistent : There is some overlapping and least two contra-quantity theory arguments can be some conflict. identified in the Antibullionist position. First is the rejection of a monetary for a non-monetary ex- (1) Modern Keynesians argue that the quantity theory is invalid because it assumes an automatic planation of economic disturbance. In opposition to tendency to full employment. If resource unem- the Bullionists’ contention that both the gold prem- ployment and excess capacity exist, a monetary expansion, if effective, may produce a rise in out- ium and the depreciation of the paper pound were put rather than a rise in prices. More generally, attributable to the overissue of currency, the Anti- money may be more than just a veil. Monetary changes may have a permanent effect on output, bullionists maintained that the rise in the prices of interest rates, and other real variables, contrary to bullion and foreign exchange were due to an unfavor- the neutrality postulate of the quantity theory. able balance-of-payments stemming from non-mone- (2) Post-Keynesian economists also contend that the quantity theory erroneously assumes the sta- tary causes, notably domestic crop failures and heavy bility of velocity and its counterpart, the demand military outlays abroad. Moreover, Antibullionists for money. In fact, velocity is a volatile, unpre- dictable variable, influenced by expectations, un- denied that excessive was the cause certainty, and by changes in the volume of money of the gold outflow and suspension of convertibility. substitutes. The erratic behavior of velocity makes it impossible to predict the effect that a given Similarly, they doubted that mere contraction of the monetary change will have on prices. Changes in note issue would be sufficient to permit resumption. velocity may offset (negate) or accentuate the price-level impact of a monetary change. They argued that reduction of imports and curtail- (3) Nineteenth century proponents of the so-called ment of war-related foreign expenditures were the argued that, contrary to the essential prerequisites for the restoration of the gold quantity theory, the money supply is an endogenous variable that responds passively to shifts in the standard. This argument is the essence of the anti- demand for it. One implication is that monetary quantity theory view that economic disturbances stem changes cannot influence prices. Being demand- determined, the stock of money cannot exceed or from non-monetary causes and require non-monetary fall short of the quantity of money demanded. And cures. with the quantity of money supplied always identi- cal to the quantity demanded, no situation of Second, Antibullionists employed the real bills excess supply or redundancy of money can ever doctrine to assert the impossibility of an excess develop to stimulate spending and force up prices. In short, there is no transmission mechanism run- supply of money ever developing to exert upward ning from money to prices. pressures on prices. The real bills doctrine states (4) In fact, claimed real bill advocates, the chan- that just the right amount of money and credit will nel of influence runs in the opposite direction. Causation flows from prices and income to money, be created if bank loans are made only for productive rather than vice versa. Income and prices deter- (nonspeculative) purposes. Defending the Bank of mine the demand for money, which, in turn, deter- mines the money supply. And since the money England against the Bullionists’ charge of note over- supply is the result and not the cause of variations issue, Antibullionists argued that excessive issues in income, prices and spending, it follows that monetary changes cannot be the source of inflation, were impossible as long as the Bank’s note liabilities deflation, and other economic disturbances. Hence, the quantity theorists’ monetary interpretation of were based on sound , i.e., were inflation, balance of payments disequilibrium, and issued only to finance genuine production and trade. business cycles must be wrong. Analysts should instead seek for the sources of economic disruptions The real bills criterion, Antibullionists contended, in real (non-monetary) causes. would insure that the volume of currency would adapt (5) A host of critics, both modern and old, have itself automatically to the needs of trade. Bank maintained that, contrary to the quantity theory, a monetary injection cannot always be relied upon notes issued to finance the production of goods would to stimulate spending and increase prices. A mone- be extinguished when the goods were marketed and tary expansion may be ineffective for at least three reasons. First, the new money may simply be the real bills were retired (loans were repaid) with absorbed into idle hoards. Second, spending may the sales proceeds. Since money creation would be be interest-insensitive, i.e., unresponsive to changes in interest rates induced by the monetary expan- limited to the expansion of real output, no inflation sion. Third, as previously mentioned, the money could occur. Here is the origin of the contra- stock may be demand-determined, in which case there can be no excess supply of money to spill quantity theory notion that the stock of money is over into the in the form of an solely demand-determined and therefore can have no excess demand for goods. independent influence on spending and prices. Many of these criticisms originated in the contra- Anti-Quantity Theory Views of the Banking quantity theory doctrines of the 19th century adver- School The main attack on the quantity theory, saries of the Bullionists and the Currency School. however, was launched by the Banking School in its Antibullionist Opposition to the Quantity Theory debate with the Currency School. Led by Thomas Opposition to the quantity theory emerged early in Tooke, John Fullarton, and James Wilson, Banking

10 ECONOMIC REVIEW, MAY/JUNE 1974 School analysts challenged the validity of virtually ing School developed its own non-monetary theory all of the propositions of the quantity theory. They of the price level. stated explicitly denied that monetary expansion or contraction would that the general level of prices was determined by affect prices. They argued that changes in the supply incomes (wages, rents, profits, etc.), and not by the of money and credit could not be expected to influ- quantity of money. Tooke’s argument was that factor ence spending and prices for two reasons. First, new incomes, rather than money, are the sources of ex- money may simply be absorbed into idle balances penditures that act on prices. This is an early ver- without entering the spending stream. Second, the sion of the income-expenditure approach to mone- supply of money is determined by the needs of trade tary theory, an approach that formulates its analysis and thus can never exceed demand. in terms of the determinants of The first point was brought out in the discussion of rather than in terms of the quantity of money or the gold hoards. The Banking School alleged that great velocity of circulation. The income-expenditure ap- accumulations of idle money existed in the form of proach was later developed by Keynes, and continues hoards of precious metals. These hoards supposedly to be a characteristic feature of Keynesian macro- were held mainly by the banks as excess bullion re- economic models. serves. The full impact of gold flows, it was argued, Tooke did not explain how these price-determining would be absorbed entirely by those hoards without factor incomes themselves were determined but left affecting the amount of . Im- the question of their origin open to a variety of ports of monetary gold would augment the hoards possible interpretations. His theory of price inflation without causing an increase in the circulating media is therefore also suggestive of recent -cost-push or inducing a rise in spending. Similarly, an outflow and structural theories that (1) link inflation to some of gold would be withdrawn from the bullion hoards, arbitrary non-monetary element in the institutional but would have no effect on the monetary circulation environment, e.g., autonomous increases in wage in- or the volume of expenditure. comes, production bottlenecks, particular supply in- The second point was brought out in the Banking elasticities, institutional price rigidities, etc., and (2) School’s discussion of the real bills doctrine and the stress the inflationary role of the competitive struggle law of reflux. Like its Antibullionist predecessors, for relative shares in the national income. the Banking School contended that currency over- Factor incomes were not the only price-influencing issue was impossible as long as banks restricted their forces discussed by the Banking School. Changes in loans to self-liquidating commercial or agricultural profit anticipations also were mentioned frequently. paper. But the Banking School went further than What was stressed, however, was the non-monetary the Antibullionists, arguing that even if the real bills nature of these expectational influences. This empha- criterion were violated, the law of reflux would oper- sis reflects the contra-quantity theory tendency to ate to prevent overissue. If notes were emitted in attribute price level movements to non-monetary excess of legitimate working capital needs, the public forces rather than to changes in the money supply. would not wish to hold the excess notes and would The Banking School also disputed the quantity deposit them, use them to repay bank loans, or re- theory view of money as an exogenous or indepen- deem them for coin. In any case, the excess notes dent variable. Banking School writers argued that the would be returned immediately to the banks. In stock of money and credit is a passive, endogenous, brief, the real bills criterion together with the reflux demand-determined variable-the effect, not the mechanism would provide a sufficient check to over- cause, of price changes. Contrary to the Currency issue. Notice how the Banking School, in rejecting School’s contention that the channel of influence runs the possibility of an excess supply of money and from money to prices, the Banking School argued credit, also denied the validity of the monetary trans- that the channel of causation runs in the opposite mission mechanism propounded by the quantity direction. That is, when prices, total money income, theory. According to the latter, an excess supply of and aggregate demand are increasing, the demand for money is what induces the excess demand for goods loans would rise and the banking system would that bids up prices, i.e., following a monetary injec- accommodate the increased loan demand by supply- tion, people try to get rid of undesired additional ing additional credit and circulating media. In the money holdings by spending them. This adjustment determination of the volume of currency in existence, mechanism, however, was implicitly denied by the the non-bank public (borrowers) played the active Banking School’s insistence that the supply of money role and banks (issuers of money) the passive or is always identically equal to the demand for it. accommodating role. Implicit in the Banking In its opposition to the quantity theory, the Bank- School’s view of passive money are three anti-quan-

FEDERAL RESERVE BANK OF RICHMOND 11 tity theory propositions : (1) changes in economic banknote issues. But the Banking School held that activity precede and cause changes in the money banks should not be constrained by a rigid rule:, supply (the so-called reverse-causation argument), because the optimum quantity of money would be (2) the supply of circulating media is not inde- forthcoming automatically if the banks themselves pendent of the demand for it, and (3) the central regulated their note and deposit liabilities by re- bank does not actively control the money supply but sponding to the needs of trade. Third, on the ques- instead accommodates or responds to prior changes tion of the rationale of , the Banking in the demand for money. School regarded attempts to regulate prices via Concerning the problem of money and money sub- monetary control as both futile and pointless. In stitutes, the Banking School disputed the quantity the first place, the money supply (especially the note theory view that control of the former implied control component) is an endogenous variable not subject to of the latter. Contrary to the Currency School’s exogenous control. And even if the narrow money stress on a narrowly-defined money supply, the Bank- supply could be controlled, the total paper circulation ing School tended to emphasize the overall structure (total credit), a more comprehensive magnitude that of credit. The Banking School criticized the Cur- is interchangeable with money, cannot be so con- rency School’s attempts to draw a hard and fast line trolled. Finally, the Banking School argued that to between money and near-money. The Banking School propose regulation of the price level via control of argued that the ready availability of bank deposits, money and credit is to put the cart before the horse. bills of exchange, and other forms of credit instru- For it is prices that determine the quantity of money ments that could circulate in lieu of money would and credit, and not vice versa. defeat the Currency School’s efforts to control the entire credit superstructure via control of the bank- THE NEO-CLASSICAL REFORMULATION note base. The Banking School thought that the volume of credit that could be erected on a given Despite the Banking School’s criticisms, the monetary base was large, variable, and unpredictable. quantity theory emerged from the mid-19th century The total volume of credit, it was argued, is inde- Currency-Banking debate to command widespread pendent of, as well as quantitatively more significant acceptance. Moreover, in academic circles at least, than, the money stock. Here is an early example of it continued to reign as the dominant monetary two more anti-quantity theory notions, i.e., (1) the theory until the 1930’s. Several factors may have difficulty of making a watertight distinction between contributed to the success of the theory. For one money and near-moneys, and (2) the ineffectiveness thing, the Currency School’s policy recommendations of policy attempts to stabilize prices via control of of fixed exchanges, maintenance of the gold standard, the stock of money in a that can currency convertibility, and strict control of bank- produce an endless array of money substitutes. notes became part of British monetary orthodoxy in The contra-quantity theory views of the Banking the second half of the nineteenth century. Since the School strongly influenced its position on at least quantity theory had provided the theoretical founda- three important policy questions. First, on the ques- tion for these policy prescriptions, it was only natural tion of free versus regulated banking, the Banking that it also was elevated to the rank of established School advocated more free trade and less regulation orthodoxy. Then, too, there may have been some de- in banking than did the Currency School. The Bank- cline in the prestige of the opposing real bills doctrine. ing School thought that the quantity of money and Long before the end of the century quantity theorists credit would best govern itself automatically through had exposed the fallacies of the real bills criterion as the force of people’s self-interest. Thus, if the supply an automatic regulator of the money supply. Quantity of money is determined by the needs of trade and is theorists had demonstrated that as long as the loan automatically regulated by the reflux mechanism, rate of interest is below the expected yield on new there was no need for intervention in the form of gov- capital projects, the demand for loans would be in- ernment legislation such as that proposed by the satiable. In such a case the real bills criterion Currency School. Second, on the question of rules would provide no effective limit to the quantity of, versus discretion in the control of the money supply, money in existence. Probably the most important the Banking School generally was in favor of dis- contributing factor, however, was the rigorous mathe- cretionary judgment of bankers as opposed to rules matical restatement of the quantity theory provided of government. The Currency School had advocated by neo-classical economists around the turn of the that be replaced by a fixed rule, century. Representing a substantial refinement, sys- i.e., the 100 percent marginal reserve requirement for tematization, and extension of the earlier Classical

12 ECONOMIC REVIEW, MAY/JUNE 1974 analysis, the neo-classical reformulation added sub- prices. With velocity, V, and transactions, T, both stantially to the intellectual appeal and scientific pres- regarded as constants, Fisher’s tige of the theory. could be expressed in a form, P = (V/T) M = (con- stant) M, showing a constant proportional relation- Neo-Classical Contributions The neo-classical re- ship between average prices and the money stock. formulation of the quantity theory consisted of at Embodying the proportionality postulate, this ex- least three separate contributions. First, there was pression implied that a policy-engineered percentage the mathematical framework that neo-classical econo- change in the money stock would cause the same per- mists employed to expound and empirically test the centage change in the price level. key propositions of the theory. This mathematical The second neo-classical contribution was the framework took two alternative forms, namely formalization, elaboration, and extension of the (1) ’s famous equation of exchange, Bullionist-Currency School ideas on control of the MV = PT, where M is the stock of money, V is money supply. Irving Fisher, A. C. Pigou, and other velocity of circulation, P is the price level, and T is neo-classical analysts demonstrated that monetary the physical volume of market transactions ; and control could be achieved in a fractional reserve (2) the celebrated cash balance equation, banking system via control of an exogenously de- M = kPy, where M is the stock of money in circula- termined stock of high-powered money. They argued tion, k is the desired cash balance ratio, i.e., the ratio that the total stock of money (coin and notes) and of the nominal money supply to nominal income, P bank deposits would be a constant multiple of the is the price level of the national product, and y is monetary base. Underlying their argument were the real national income or the national product valued assumptions that banks desire to hold a fixed pro- at constant prices. Using these equations, neo-clas- portion of their deposits as reserves and that the sical analysts were able to spell out precisely the con- public desires to maintain a constant ratio of cash ditions that must hold if the proportionality postulate holdings to demand deposits. In short, they argued is to be valid. that the stock of money is governed by three proxi- As explained by the neo-classical quantity theorists, mate determinants : (1) the high-powered monetary these conditions included constancy of the velocity of base, (2) the bank’s desired reserve-to-deposit ratio, money and of real output. Neo-classical economists and (3) the public’s desired cash-to-deposit ratio, and held that velocity was a near-constant determined by that the monetary base dominates the latter two de- individuals’ cash-holding decisions in conjunction terminants. with technological and institutional factors associated Finally, neo-classical quantity theorists stressed with the aggregate payments mechanism. More the short-run non-neutrality of money, a topic that specifically, it was argued that individuals would had been relatively neglected in the classical analysis. try to keep non-interest-bearing transactions balances Neo-classical writers integrated the quantity theory to the minimum necessary to finance day to day into their analysis of business cycles, showing how purchases and to provide a reserve for contingencies. changes in the quantity of money were a major The minimum balances that individuals would need cause of booms and slumps and how monetary regu- to hold, and by implication, the rate of circulation of lation of the price level was a prerequisite to the money, would depend on such factors as the state of stabilization of economic activity. development of the banking system, frequency of re- So influential was the neo-classical formulation of ceipts and disbursements, length of the payment the quantity theory that it continued to serve as the period, degree of synchronization of cash inflows and standard in use up to the outflows, rapidity of transportation and communica- 1930’s. In that decade, however, it encountered tion, etc. Since these factors were thought to be heavy criticism and, discredited, was supplanted by subject to only gradual, evolutionary change, both the Keynesian income-expenditure model. velocity and the Cambridge k, it was argued, could be treated as virtual constants in the neo-classical quantity equations. Output and transactions, too, THE KEYNESIAN-MONETARIST CONTROVERSY were regarded as constants determined by full-ca- The Bullionist and Currency-Banking controversies pacity utilization of available resources and tech- represent the leading 19th century examples of the nology. recurrent debate over the quantity theory. The lead- The policy implications of the neo-classical for- ing example of the debate in the present century, mulation were clear : monetary policy could be ex- however, is the controversy that has been raging pected to exert a powerful, predictable influence on since the mid-1930’s between the anti-quantity theory

FEDERAL RESERVE BANK OF RlCHMOND 13 forces composed of , his im- for and for two reasons. mediate followers, and later neo- or post-Keynesians First, monetary injections might be absorbed im- on the one hand, and their pro-quantity theory an- mediately into idle hoards without lowering interest tagonists, the monetarists, on the other. The debate rates sufficiently to stimulate investment spending. erupted in 1936 with Keynes, in his classic, The This conclusion was based on Keynes’s theory of an General Theory of Employment, Interest, and absolute for liquidity at low interest rate money, leveling a barrage of criticism at the levels, i.e., the case of the so-called . quantity theory. The theory of the liquidity trap stated that under certain circumstances - e.g., a severe depression The Keynesian Attack Keynes’s attack on the characterized by an abnormally low rate of interest quantity theory consisted of five interrelated ele- and by virtually unanimous expectations of capital ments. First, he argued that the quantity theory losses owing to anticipated rises in yields and. assumed an automatic tendency of the economy to declines in bond prices - idle cash balances become operate at full capacity, an assumption patently at perfect substitutes for bonds in wealthholders’ port- odds with experience in the depressed 1930’s. Only folios. That is, when the anticipated capital loss on if production and employment are fixed at full ca- bonds is large enough to at least offset the low cur- pacity, said Keynes, would monetary-induced changes rent interest return, there would be no inherent ad- in spending manifest themselves solely in price level vantage to holding bonds rather than zero-yield cash,. changes. But, he added, if the economy were operat- Consequently, the quantity of money demanded ing at less than full employment, with idle resources would become insatiable, i.e., infinitely sensitive to to draw from, changes in spending would affect out- the slightest change in the rate of interest. In this put and employment rather than prices. Thus, in liquidity trap case, only minute reductions in interest much of his analysis of the economics of depression, rates would be necessary to induce portfolio op- Keynes reversed the assumptions of the quantity timizers to hold virtually any amount of additional theory, treating prices as rigid and output as flexi- cash injected into the system. Increases in the ble. He rationalized his assumption of price rigidity money supply, therefore, would be ineffective in re- by arguing that prices are governed by wage costs, ducing interest rates and thus in stimulating invest- and that union bargaining strength and other in- ment spending via the . Here is stitutional forces prevent wages from being down- the reappearance of the Banking School argument wardly flexible even in depressions. Thus his argu- that a monetary expansion cannot be counted on to ment reflected the anti-quantity theory view that the stimulate spending because the new money may price level is determined by autonomously given simply disappear into idle hoards. Second, Keynes factor costs rather than by the quantity of money. argued that even if monetary injections were success- Second, Keynes criticized the particular version of ful in lowering market interest rates, those injections the quantity theory expressed in the neo-classical still would not stimulate economic activity if invest- quantity equations on the grounds (1) that it was ment spending was unresponsive to changes in in- a tautological identity rather than an empirically terest rates. To summarize, Keynes argued that refutable hypothesis, and (2) that it erroneously either a liquidity trap or an interest-insensitive in- treated the circulation velocity of money as a near- vestment expenditure schedule could render a mone- constant. Keynes contended that, in actuality, the tary expansion ineffective in a depression. In terms velocity variable in Fisher’s equation of exchange of Fisher’s equation of exchange, MV = PT, a rise was extremely unstable and that it might passively in M would be offset by a fall in V, leaving total adapt to independent changes in the other elements spending, PT, unchanged. With variable velocity of the equation. Thus, said Keynes, the impact of absorbing all the impact of money stock changes, any change in M might be absorbed by an offsetting none would be transmitted to nominal income. The change in V and therefore would not be transmitted rigid links between money, spending, prices, and to P. Likewise, any change in income or the volume nominal income postulated by the quantity theory of market transactions might be accommodated by would be severed or severely weakened. a change in velocity without requiring any change Fourth, like Thomas Tooke, Keynes argued that in the money supply. the income-expenditure analysis was superior to the Third, Keynes revived the Banking School con- quantity theory as an analytical model. Keynes’s clusion concerning the futility of using monetary model emphasized the determinants of expenditure policy to regulate economic activity. Keynes held rather than the quantity of money. Moreover, it that monetary policy would be an ineffective cure stressed a new non-monetary adjustment mechanism

14 ECONOMIC REVIEW, MAY/JUNE 1974 - the so-called income - rather than the mittee’s revival and restatement of the Banking old direct and indirect monetary linkages. Speci- School’s position on the problem of money and near- fically, Keynes argued that there is a multiplier re- moneys. Representing the apogee of post-Keynesian lationship between autonomous expenditure (i.e., skepticism of the relevancy of the quantity theory, non-income-induced expenditures, e.g., government the Radcliffe Report concluded (1) that money is a outlays for armaments or public works projects) and practically indistinguishable component of a virtually total income, such that a dollar change in the former continuous spectrum of financial assets ; (2) that the will stimulate a two or three dollar change in the velocity of money is a mere arithmetic computation latter. The Keynesian emphasis on the determinants devoid of volitional meaning or economic content; of spending rather than the stock of money was and (3) that attempts to regulate spending via clearly in the tradition of Thomas Tooke. The chief monetary control are inherently futile in a financial policy implication of the Keynesian income-expendi- system that can economize on money by producing ture analysis was that would have a more a limitless array of money substitutes. Liquidity, or powerful impact on income and employment than the total of all assets performing some monetary would monetary policy. Accordingly, Keynesians function, was said to be the key determinant of argued that chief reliance should be placed on gov- spending. This variable, it was argued, could ex- ernment budgetary ( and expenditure) policy pand or contract independently of the narrowly- rather than on monetary policy to stabilize the econ- defined money supply. In the Radcliffe view, at- omy. tempts to reduce inflation via contraction of the Finally, Keynes adhered to a non-monetary ex- money supply could be frustrated by a compensatory planation of the , arguing that the increase in money substitutes, which in the equation downswing had been triggered by a collapse of of exchange would appear as a rise in the velocity capital spending stemming from the disappearance of money. To summarize, the Radcliffe view re- of profitable investment opportunities, and that the stated, albeit in modern terms, the old Banking contraction had been intensified by a collapse of School arguments (1) that it is hard to draw the confidence. Here is a restatement of the Anti- line between money and near-money, (2) that the bullionist-Banking School notion that economic dis- volume of credit that can be erected on a given turbances arise from exogenous shocks originating monetary base is virtually unlimited, and (3) that in the real sector rather than from erratic behavior the supply of credit is an endogenous variable re- of the money supply. sponding to the demand for it.

Post-Keynesian Extensions To Keynes’s list of The Monetarist Counterattack Quantity theo- anti-quantity theory arguments, neo-Keynesian eco- ists responded to the Keynesian attack with counter- nomists writing in the inflationary environment of arguments based on theoretical developments and the post-World War II period added others. One empirical research. Chief among the theoretical de- was the view that inflation is predominantly a cost- velopments contributing to the resurgence of the push phenomenon associated with union bargaining quantity theory were (1) the theory of the real strength, monopoly power, administered or mark-up balance or wealth effect, and (2) Milton Friedman’s pricing policies, and other non-monetary institutional reformulation of the quantity theory as a theory of forces that contribute to autonomous increases in the demand for money. labor and other factor costs. Another was the view, The theory of the real balance effect was used to espoused by “cheap-money” advocates, that ex- demonstrate that money matters, at least in principle, pansionary monetary policy could be used to peg even in the extreme Keynesian case where the interest interest rates at low levels, thus minimizing the in- rate channel is blocked by a liquidity trap and/or an terest burden of the public debt. An alternative ver- interest-insensitive investment spending schedule. sion of the same argument, associated with the The key assumptions of the analysis were that real approach to policy questions, held balances are a component of wealth and that wealth that monetary policy could help peg the unemploy- is an important determinant of consumption and in- ment rate at permanently low levels. These latter two vestment spending. According to the real balance arguments conflict with the neutrality proposition argument, prices would fall in a depression, thereby that holds that money can have no permanent in- raising the purchasing power of wealth held in money fluence on real variables. form, The price-induced rise in the real value of Perhaps the strongest anti-quantity theory views, cash balances would then stimulate spending directly however, were those contained in the Radcliffe Com- until full had been attained. As

FEDERAL RESERVE BANK OF RICHMOND 1.5 the wealth effect operated independently of changes since those shifts may be caused by changes in the in interest rates, closure of the indirect channel could independent variables of the velocity function. not prevent the restoration of full employment. It Quantity theorists also attempted to refute Key- was but a short step from the analysis of the price- nesian criticisms with empirical research. Two types induced wealth effect to the argument that a rise in of empirical studies were utilized. The first was a real balances and hence spending could be accomp- reexamination of American financial history, the lished just as easily via a monetary expansion, there- main contributions being Friedman and Schwartz’s by proving the potential potency of monetary policy A Monetary History of the , 1867-1960 even in a depression. and Cagan’s Determinants and Effects of Changes in In sum, the real balance argument weakened the the Stock of Money, 1867-1960. Both volumes Keynesian attack in several important respects. At amply demonstrated the significant independent role the theoretical level, it offered both an avenue of played by money stock changes in U. S. business escape from the Keynesian liquidity trap and a means cycles. One of the main conclusions of the Fried- of thwarting the interest inelasticity of the invest- man and Schwartz study was that a rapid and large ment spending schedule, thus contradicting the reduction in the money supply played the dominant Keynesian doctrine of underemployment equilibrium. causal role in the of the 1930’s. Moreover, it cast doubt on the Keynesian view of This finding led to the criticism that the Keynesian money as a specific substitute solely for bonds. It interpretation, which had attributed the depression created this doubt by emphasizing the relation be- to a collapse of investment demand, was a misreading tween real balances and spending, thus suggesting of the facts of experience. The Cagan volume demon- that money was a general substitute for a wide range strated, as did the Friedman and Schwartz study, of . Finally, it suggested that the that throughout much of U. S. monetary history the Keynesian view of the monetary transmission mecha- supply of money was independently determined. This nism was seriously incomplete. evidence seemed to refute the Banking School-Rad- The second important theoretical development was cliffe doctrine that the stock of money is demand- Milton Friedman’s restatement of the quantity determined. theory, a reformulation that emphasized two novel The second type of empirical research advanced features. First, the quantity theory was reinterpreted in defense of the quantity theory took the form of as a theory of the demand for money rather than statistical tests, conducted in the early 1960’s, com- as a theory of the determination of the level of prices paring the predictive accuracy of Friedman’s version and nominal income. Second, the essence of the of the quantity theory against the rival Keynesian quantity theory was said to be the existence of a income-expenditure theory. In these tests, the stable functional relationship between the velocity of quantity theory consistently out-performed the Key- money (or its counterpart, the quantity of real nesian theory. Recent studies, however, have cast balances demanded) and a small number of inde- doubt on the validity of the basic methodology under- pendent variables that determine it. lying these tests. Hence, the findings should be re- The reader will notice how Friedman’s reformula- garded as inconclusive. At the time, however, the tion was designed to rebut many of the Keynesian. tests seemed to support the quantity theory. criticisms. In denying that the quantity theory was Associated with the resurgence of the quantity a theory of income determination, Friedman freed it theory has been a rise in the monetarist approach to from the Keynesian criticism that it assumed full em- policy problems. The monetarist view contains ployment. And in stating the quantity theory as a several elements. It regards monetary policy as demand-for-money function capable of being em- having a powerful long-run impact on nominal in- pirically tested, Friedman countered the Keynesian come. By contrast, it regards fiscal policy as having contention that the theory was a mere tautology. a negligible and a perverse long-run Finally, Friedman’s treatment of velocity as a stable impact on economic activity. Monetarists, further- functional relationship refuted the Keynesian argu- more, argue that the quantity of money, rather than ments (1) that velocity is a mere arithmetic calcula- the level and structure of interest rates, is the ap- tion devoid of economic content ; (2) that the propriate variable for the to quantity theory assumes velocity to be constant; and regulate. And finally, monetarists hold that the ex- (3) that velocity is an unstable magnitude subject istence of long and variable lags makes it difficult to to erratic, unpredictable shifts. In Friedman’s for- predict the short-run impact of monetary changes; mulation, fluctuations in velocity are perfectly con- therefore, discretionary stabilization policy should sistent with the idea of a stable functional relation, be abandoned in favor of a rigid rule whereby the

16 ECONOMIC REVIEW, MAY/JUNE 1974 money supply grows at a fixed percentage rate cor- The survival of these 19th century monetary responding to the long-term growth rate of real out- postulates serves to link the older with more modern put. These monetarist policy prescriptions have explanations of the quantity theory. It is, therefore, gained increasing recognition in recent years. fitting to close the article with a brief comparison of the chief conclusions of the classical and the monetarist versions of the theory. The classical ex- SURVIVAL OF THE CLASSICAL QUANTITY THEORY planation, it will be remembered, stressed: (1) the IN THE MODERN MONETARIST APPROACH neutrality of money in long-run equilibrium, (2) the This article has sketched the evolution of the temporary non-neutrality of money in the transition quantity theory of money from its fragmentary pre- period, (3) the causal role of money in the transmis- classical beginnings, through its crystallization and sion mechanism, (4) the monetary theory of price consolidation in classical monetary analysis, and movements, (5) long-run proportionality between finally to its culmination in the recent rise of mone- money and prices, and (6) exogeneity of the money tarism. Among the milestones in this long process of supply. Moreover, the classical policy analysis historical development were : (1) Bodin’s hypothesis yielded the additional conclusions that the money concerning the cause of the 16th century price revo- supply can be effectively regulated through the con- lution ; (2) the Cantillon-Hume two-fold distinction trol of its note component alone and that time lags between (i) equilibrium statics and disequilibrium render discretionary monetary stabilization efforts dynamics, and (ii) the long-run neutrality and short- destabilizing, thus necessitating the imposition of a run non-neutrality of money, both distinctions neces- fixed rule. sary to an understanding of the causal role of money ; In line with the classical notion of the long-run (3) the classical economists’ application of the neutrality of money, monetarists still argue that the theory to policy questions concerning the regulation long-term expansion path of output is determined by of the money supply ; (4) the mathematical restate- real factors, e.g., resource endowments, technology, ment of the theory by Irving Fisher and other neo- and the productivity of labor and capital. It is argued classical economists ; and, finally, (5) Milton Fried- that changes in the money stock can have no long- man’s recent reformulation of the quantity theory run impact on these real determinants of output. as a theory of the demand for money. Consequently, in long-run equilibrium money is To some extent, however, this evolution has been merely a veil. Monetarists, furthermore, adhere to illusory. Despite the apparent growing sophistica- the classical doctrine that the real rate of interest is tion and complexity of the theory, there has been no determined by the non-monetary forces of produc- radical change in its basic tenets since the early tivity and thrift. They reject the neo-Keynesian 19th century. After having gained firm roots in view that the monetary authorities can permanently classical monetary tradition, the fundamental postu- alter the real rate of interest (and thus the pace of lates of the theory experienced little subsequent al- capital formation and the growth rate of output) via teration. Since the classical period, most of the im- changes in the money supply. Likewise they reject provements in the theory have consisted of its the neo-Keynesian notion that an expansionary periodic and increasingly rigorous reformulation in monetary policy can permanently peg the rate of un- order to conform with the latest innovations in eco- employment at low levels. There can be no long-run nomic theorizing or to meet the increasingly severe relation, say the monetarists, between a monetary standards of empirical testing. Examples include variable and real variables, such as the interest rate (1) Fisher’s reformulation of the theory in terms and the rate of unemployment. of the equation of exchange, which corresponded to Monetarists adhere to the classical doctrine of the the emerging use of mathematics in neo-classical eco- temporary short-run non-neutrality of money. They nomic analysis, and (2) Friedman’s restatement, stress that any sudden change in the money supply which utilized the latest developments, in capital or its rate of growth will have a significant frictional theory and incorporated the or portfolio ap- impact on output, employment, and perhaps the proach to the demand for money, and which facilitated product-mix. AS the chief reason for these non- statistical estimation and testing.2 These refinements neutral transition effects, they cite the distortion of changed the outward appearance of the theory with- relative prices owing to the failure of some prices out altering its underlying postulates. to adjust as fast as others to the monetary change. They point out that prices do not adjust fully and 2 It should be noted that the balance-sheet or asset-portfolio approach is not of monetarist origin. This approach was first developed by instantaneously to an unanticipated monetary change Keynes and J. R. Hicks in the mid-1930’s and was elaborated sub- sequently by and others. because it takes time for people to perceive the change

FEDERAL RESERVE BANK OF RICHMOND 17 and adapt to it. Eventually, however, actual money ices and new assets. These asset price and yield and price level changes are fully recognized and changes, in turn, generate changes in the demands future changes in these variables are correctly an- for flows and new asset stocks and hence in ticipated. Consequently, actual price changes in all the prices and/or outputs of the latter items. sectors of the economy adjust completely to price Although the monetarist analysis differs from the experience and price expectations, thus eliminating classical in the role it assigns to the portfolio-ad- the temporary distortions to real variables. The justment process, it nevertheless agrees with the same points, of course, have been accepted by quantity classical view of the strength of the transmission theorists since Cantillon and Hume. mechanism. Modern monetarists maintain that the: As for the active role of money in the transmission linkages connecting money to spending are numerous, mechanism, monetarists stress that money stock thereby permitting the full impact of a monetary changes precede and cause changes in nominal na- change to be transmitted to prices and nominal in- tional income. Similar to their Bullionist and Cur- come. Monetarists argue that the portfolio-adjust- rency School forebears, monetarists view money as ment or asset-substitution effects of a monetary the chief source of economic disturbance and as the change have a powerful influence on spending be- predominant cause of price level changes. They at- cause they operate over such a wide range of assets tribute both the Great Depression of the 1930’s and and interest rates. It should be noted in passing the post-1965 inflation to the erratic behavior of the that the question of the appropriate range of assets money supply. Inflation, they state, is always and and interest rates to be considered in the analysis of everywhere a monetary phenomenon. Since money the transmission mechanism is a key point in the is the main disrupter of economic equilibrium, it fol- monetarist-Keynesian controversy over the spending lows that proper control of the money supply is the impact of monetary changes. Unlike the monetarist key to reducing inflation and depression. model, Keynesian models tend to concentrate on a The active role of money is also stressed in mone- narrow range of assets and interest rates. Conse- tarists’ theoretical analysis of the monetary adjust- quently, the transmission process is forced to go ment process. Here the motivating force is always through an extremely narrow channel, thereby chok- seen to be discrepancy between actual and desired ing off some of the spending impact of a monetary real cash balances, i.e., an excess supply of money. change. No such limitation exists in the monetarist If people have more money than they desire, they model, which concentrates on a wide range of assets will spend the excess for assets, including securities, and interest rates. In the monetarist analysis, in- investment goods, and consumption goods. The in- dividuals are seen as disposing of their excess money creased spending eventually leads to higher prices, balances over a broad spectrum of existing assets, in- thereby bringing actual real balances back to their de- cluding bonds, equities, durable producer goods, sired level and thus eliminating the initial excess sup- durable and semi-durable consumer goods. ply of money. The emphasis in the monetarists Modern monetarists also agree with classical analysis is clearly on the causal role played by money quantity theorists on the question of the exogeneity in the adjustment to new equilibrium. of the money supply. Like the Bullionists and mem- On the related issue of the transmission mechanism, bers of the Currency School, monetarists contend the monetarist analysis tends to emphasize interest that the central bank can exercise effective control rate effects more than did the classical analysis, which over the nominal money stock by controlling a nar- tended to highlight the direct impact of monetary rowly defined base of high-powered money (currency changes on commodity expenditure. Despite a great plus ). More specifically, monetarists deal of lip-service paid to the notion of the direct maintain that the supply of money is determined by effect, monetarists now acknowledge that the trans- three distinct variables, including (1) the monetary mission mechanism operates primarily through a base (controlled by the monetary authority), (2) complicated portfolio or balance sheet adjustment the reserve/deposit ratio (determined by the de- process involving numerous interest rate channels cisions of commercial bankers subject to legal re- and affecting a wide range of assets and expenditures. serve requirements), and (3) the currency/deposit Specifically, the monetarist views monetary changes ratio desired by non-bank individuals. The latter as generating shifts in the composition of asset port- two determinants form the sole components of the folios or balance sheets, thereby inducing changes so-called which, when multiplied in the prices and yields of existing financial and non- by the monetary base, yields the money supply. financial assets (including producer and consumer Monetarists contend that the money multiplier forms durable goods) relative to the prices of current serv- a fairly stable link between the base and the money

18 ECONOMIC REVIEW, MAY/JUNE 1974 stock, thus permitting the central bank to exercise ef- on a rigidly proportional relationship between mone- fective control over the money supply. It is true that tary changes and price level changes. As previously the money multiplier itself is not under the direct mentioned, the proportionality postulate follows from control of the central bank. Commercial bankers and the classical assumption of constancy in the quantity the public, via their decisions regarding the desired of real cash balances demanded by moneyholders. reserve/deposit and currency/deposit ratios, de- If real cash balances are to remain unchanged fol- termine the size of the multiplier. But monetarists lowing a change in the nominal money stock, then a argue that the money multiplier and its component rise in M must necessarily be accompanied by an ratios are sufficiently stable and predictable to per- equiproportional rise in P to keep real balances, mit firm control of the money stock via control of M/P, the same. Unlike classical quantity theorists, the monetary base. however, monetarists do not interpret the quantity On other policy issues relating to money control. of real balances demanded as a numerical constant. monetarists echo the views of their 19th century Instead, they view it as a stable function of several predecessors. Today’s monetarists are no less critical variables, including wealth, real income, expected real of the central bank than were Ricardo and other rates of interest (the of money hold- Bullionist writers of the 19th century Bank of Eng- ings), and the anticipated rate of inflation (the de- land. Similar to Ricardo, who pointed out that by preciation cost of cash balances). Depending on pegging the interest rate, the central bank may lose movements in these variables, the quantity of real control of the money supply, modern monetarists in- balances demanded may alter from time to time. For sist that interest rates are a misleading guide to mone- example, if a monetary injection leads to a rise in tary policy. Like the Currency School, which argued the anticipated rate of inflation, the quantity of real that convertibility was an insufficient safeguard to balances demanded will fall. People will want to overissue because of time-lags that might bring hold a smaller quantity of real balances than before the central bank’s gold reserve near to exhaustion, because of the rise in the depreciation cost of money modern monetarists argue that the existence of long holdings. In consequence, prices will rise in greater and variable lags in the relation between money, in- proportion than the change in the money stock. The come, and prices, as well as the lack of understanding greater-than-proportionate rise in P is necessary to of those lags, militates against the use of discretionary achieve the desired reduction in real balances, M/P. monetary policy. The effect of these lags, mone- Nevertheless, the difference between monetarists tarists hold, is to make the short-run response of and classical quantity theorists on the proportionality income to monetary changes erratic and hard to pre- question is not very great. Monetarists insist that, dict. It follows, therefore, that short-run stabilization under normal conditions, the quantity of real balances policy is at best difficult and at worst likely to be demanded is a definite and stable magnitude. Real perverse and hence should be avoided. Following balances demanded may fall slightly when the money the example of the Currency School, monetarists supply increases, or rise somewhat when the money advocate that the central bank’s discretionary man- supply falls, or perhaps even undergo some alteration agement be replaced by a rule-in this case a rule in the absence of monetary change. But these changes fixing the annual percentage growth rate of the are not expected to be very large. In short, while money stock at a steady figure roughly corresponding desired real balances are no longer viewed as a con- to the long-term growth rate of output. stant, they are seen normally as being subject to only Monetarist doctrine departs from the strict classical very moderate changes. Under such conditions any quantity theory on at least one major point, i.e., the monetary change will be accompanied by near-pro- proportionality postulate.3 Monetarists do not insist portional change in prices. Practically speaking, therefore, monetarists would probably accept the pro- 3 There are other differences of course. For example, modern mone- tarists employ a more comprehensive measure of the money supply- position of near-proportionality between money and defined to include demand deposits as well as notes and coin-than did their classical predecessors. Moreover. modern monetarists also prices in the long run. favor flexible foreign exchange rates whereas the Currency School advocated fixed rates. Thomas M. Humphrey

FEDERAL RESERVE BANK OF RICHMOND 19