Macroeconomics is an outgrowth from the main stream of classical monetary theory following Keynes. Keynes changed the emphasis from determination of the level of money prices to determination of the level of output and employment. He also changed the key relationship from demand and supply of money as determining the price level to the relationship between consumption expenditure and income, in conjunction with private investment expenditure, as determining the level of output and therefore employment demanded. The income multiplier replaced the velocity of circulation as the key concept of monetary theory.
The tendency of the past twenty-five years has been to reintegrate Keynesian and classical monetary theory into one general system of analysis. Moreover, as inflation has succeeded mass unemployment as a major policy problem, interest in classical monetary theory has revived, while Keynesians have increasingly emphasized the monetary aspects of Keynesian theory.
The terms macroeconomics and monetary theory involve quite different lines of differentiation of the subject-matter from the rest of economics. Classical theory distinguished between ‘real’ theory – the theory of the determination of the values of factors and commodities in terms of one another – from “monetary” theory – the theory of the determination of the price level or the purchasing power of money. This separation is ‘the classical dichotomy’; and its legitimacy has been a key question in monetary theory since Keynes’s General Theory.
By contrast, Keynesian economics distinguishes between ‘macroeconomics’ and ‘microeconomics’. Microeconomics is concerned with the demand for and supply of individual commodities and factors and the determination of their relative prices and quantities. Macroeconomics is the theory of the determination of economic aggregates and averages – the amount and value of total output, employment, consumption and investment; the price level, the wage level, the interest rate, and the growth rate of the economy.
Because aggregate relationships are sums or averages of microeconomic relationships, it is desirable, though not strictly necessary, that macroeconomic relationships be plausible or logical in terms of microeconomic theory. Early Keynesian theories of inflation assumed ‘money illusion’ – behaviour based on the assumption of stability in the value of money when that value was being reduced by inflation – which is inconsistent with microeconomic rationality. Such inconsistency is not theoretically satisfactory; and the concern to provide a rational basis in microeconomic theory for macroeconomic relationships has affected every aspect of Keynesian macroeconomic analysis, and made it increasingly difficult to draw a clear distinction between macroeconomics and microeconomics.
The proper contemporary distinction is not between two separate branches of economic theory, but between two areas of application or contexts of the theory of rational maximizing behaviour. In the one (the microeconomic) context, it is assumed either that the overall workings of the economic system can be disregarded, or that the macroeconomic relationships are in full general equilibrium. In the other (the macroeconomic) context, it is assumed that the maximizing decisions of individual economic units (firms and households) will not necessarily add up to a macroeconomic equilibrium, but will produce a disequilibrium situation that will in the course of time produce changes in the individual decisions. One should note, however, that for analytical simplicity standard macroeconomic analysis is generally set up so that such a dissituation is described as a situation of short-run
These alternative definitions of the subject-matter suggest two alternative approaches to an organized exposition of it:
(i)to follow the traditional lines of monetary theory and treat macroeconomics as a branch of it built on special but practically useful assumptions;
(ii)to start with macroeconomic theory as developed from Keynes, and treat the neo-classical monetary theory elements that have been introduced subsequently as revisions, qualifications, etc. (The main developments in macroeconomic theory itself have been the Harrod-Domar equation and the Phillips-curve trade-off between unemployment and inflation.)
The first approach is logically more satisfactory, since it permits concentration on basic theoretical issues. The second, however, is more appropriate to the present position of dominance in economic teaching and policy thinking of Keynesian macroeconomic models, and to the preparation that most graduate students will have had. Most of the course will, however, be concerned with monetary theory, on the twin grounds that graduate students should be familiar with the main outlines of macroeconomic models, and that most of the interesting developments since Keynes have been in monetary theory rather than in macroeconomics.
In monetary theory, the basic assumption is that the demand for and supply of money exercise a significant influence on the economy. This raises three perennial issues in monetary theory.
(1) Is money important or are its effects swamped by other factors? There has always been a school of thought which denies any influence to money. This goes back to the classical controversy between the ‘banking’ and ‘currency’ schools. The banking school claimed that the money supply would change in response to demand, so that monetary policy could not influence the economy. In this crude form the contention is obviously wrong, but one variant of it, the so-called ‘real bills’ doctrine, has remained a powerful element in thought on central banking policy. This doctrine asserts that money will take care of itself and cause no problems if loans are made only for productive purposes, and not for speculation. In modern times, this doctrine is reflected in Federal Reserve concern about ‘the quality of credit’, and in British efforts to discriminate between ‘desirable’ and ‘undesirable’ types of bank lending.
The Keynesian revolution raised the same question in a more sophisticated form: more accurately, Keynesian theory raised it in one form and post-Keynesian theory has raised it in another. Keynes’s emphasis on the interest rate as the variable through which monetary policy influences aggregate demand and activity raised the two possibilities (i) that consumption and investment might be completely inelastic with respect to the interest rate, so that changes in the interest rate could not influence aggregate demand, and (ii) that the demand for money might be perfectly interest-elastic, so that monetary policy could not influence interest rates. Post-Keynesian interest theory has introduced a variety of monetary assets in place of Keynes’s simple distinction between cash and bonds, and suggested that if substitutability between money and near-money assets is high, monetary policy may have no real influence. This view is reflected in the Radcliffe Committee’s emphasis on ‘liquidity’ and the Federal Reserve’s emphasis on ‘credit conditions’, rather than the money supply, as the variable the central bank seeks to control.
Whatever form it takes, the contention that money does not exercise a significant influence on the economy is inconsistent with both the empirical evidence and the behaviour of economic policy-makers.
(2) Does money influence real variables (the interest rate, output, employment) on the level of prices?
Classical theory concentrated on the influence of money on prices; Keynesian theory emphasizes the influence on real variables. Subsequent analysis has concluded that this is a question of the relevant time-dimension. Classical theory assumed sufficient flexibility of wages and prices to maintain full employment, in which case money influences prices. Keynesian theory assumed rigidity of wages, in which case money influences quantities. The Keynesian theory is appropriate to the short run; but the question is whether the longer-run analysis of the influence of money on prices can safely be neglected. The inflationary experience of both the United States and the United Kingdom suggests that such neglect may be dangerous.
(3) Does the influence of money on the economy operate through a desired relation between income and interest rates on the one hand and people’s cash balances on the other, adjustments being made through changes in the rate of spending, or does it operate through the influence of money demand and supply on interest rates, adjustment being made through changes in investment and saving? This issue can be summarized in a distinction between ‘cash-balance mechanics’ and ‘interest-rate mechanics’ of the adjustment to monetary disturbances.
Consideration of this issue leads into a basic methodological conflict between those who believe the function of theory is to construct general equilibrium models of the economy, and the “positive economists” (led by Milton Friedman) who believe that the essence of theory is to find simple relationships between key variables. According to the ‘positive’ school, the essence of the quantity theory is the velocity relationship that relates money income to the quantity of money, while the essence of the Keynesian theory is the multiplier relationship between investment and total income; and the issue is whether one or the other relationship has the greater predictive power.
To illustrate, consider th...