Essays in Monetary Economics (Collected Works of Harry Johnson)

Harry G. Johnson

• Publisher: Routledge
• Year: 2013
• ISBN:
  9781134623631
• Edition: 1
• Topic: Economics
• Subtopic: Economic Theory
• Index: Economics

Reprinting the second edition (which included a new introduction explaining developments which had emerged since first publication) this book discusses explorations in the fundamental theory of a monetary economy, a theoretical critique of the 'Phillips Curve' approach to the theory of inflation and the theory of the term structure of interest rates in terms of the theory of forward markets pioneered by David Meiselman.

PART ONE

MONETARY THEORY

CHAPTER I

MONETARY THEORY AND POLICY*

In order to isolate a field of study clearly enough demarcated to be usefully surveyed, it is necessary to define monetary theory as comprising theories concerning the influence of the quantity of money in the economic system, and monetary policy as policy employing the central bank’s control of the supply of money as an instrument for achieving the objectives of general economic policy. In surveying the field thus narrowly defined fourteen years ago, Henry Villard [123] began by remarking on the relative decline in the significance attached to it as compared with the offshoot fields of business cycle and fiscal (income and employment) theory, a decline related to the experience of the 1930’s, the intellectual impact of Keynes’ General Theory [66], and the inhibiting effects of the wartime expansion of public debt on monetary policy. While this division of labour has continued, and has indeed been accentuated by the emergence of the cross-cutting field of economic growth and development as an area of specialization, the field of money has been increasingly active and has received increasing attention in the past fourteen years.

This recent activity in the money field can be explained in part by the general logic of scientific progress, according to which disputed issues are investigated with the aid of more powerful theoretical tools, and the implications of new approaches are explored in rigorous detail. Thus, in monetary theory, the issues raised by Keynes’ attack on ‘classical’ monetary theory have been worked over with the apparatus of general equilibrium analysis developed by J. R. Hicks [60] (to the gradual eclipse of the Robertsonian and Swedish period analysis once considered most promising), and Keynes’ emphasis on treating money as an asset has been followed by subsequent theorists as a means of bringing money within the general framework of the theory of choice. In larger part, the revival of interest in money is a reflection of external developments—the postwar inflation, the consequent revival of monetary policy, and the persistence of inflation in the face of unemployment—together with recognition of the problems posed for both policy and theory by certain institutional characteristics of the modern economy (notably the widespread holding of liquid assets) and by potential conflicts between the diverse policy objectives now accepted as responsibilities of governmental policy.

The interest of professional economists in these matters has also been directly enlisted in the preparation of testimony and studies for a succession of large-scale enquiries into monetary policy and institutions, most recently the Radcliffe Report in Britain [127] and the Report [128] of the Commission on Money and Credit established by the Committee for Economic Development in the United States.¹ Finally, recent work on both theory and policy has been strongly influenced by the increased postwar emphasis on (and capacity for) econometric model-building and testing, and stimulated by the availability of new data—especially Raymond Goldsmith’s data on saving [47] and financial intermediaries [48] in the United States, the Federal Reserve System’s flow-of-funds accounts ([126] and subsequent publications), and Milton Friedman and Anna Schwartz’ historical series of the United States money supply, forthcoming in [42].

While the impact of Keynes’ General Theory has been so great that most of recent theory and research on money can be classified either as application and extension of Keynesian ideas or as counter-revolutionary attack on them, it seems preferable in a survey of the field to organize the material according to the main areas of research rather than according to the issues Keynes raised. Readers interested in the present status of Keynes’ contributions to economics are referred to anniversary assessments by William Fellner and Dudley Dillard [32], James Schlesinger [102], H. G. Johnson [61], and R. E. Kuenne [71]. This survey deals with four broad topics: the neutrality of money; the theory of demand for money, which becomes the theory of velocity of circulation when the demand for money is related to income; the theory of money supply, monetary control, and monetary dynamics; and monetary policy. The theory of interest has been surveyed in a companion article by G. L. S. Shackle [105], and the theory of inflation is to be surveyed in a subsequent article in this Review by Martin Bronfenbrenner and Franklyn Holzman.

I. THE CLASSICAL DICHOTOMY AND THE NEUTRALITY OF MONEY

From the standpoint of pure theory, the most fundamental issue raised by Keynes in the General Theory lay in his attack on the traditional separation of monetary and value theory, the ‘classical dichotomy’ as (following Don Patinkin [94]) it has come to be called, according to which relative prices are determined by the ‘real’ forces of demand and supply and the absolute price level is determined by the quantity of money and its velocity of circulation. Keynes’ attack has been followed by a protracted, often confused, and usually intensely mathematical investigation of the ‘consistency’ or ‘validity’ of the classical dichotomy, the requirements of a consistent theory of value in a monetary economy, and the conditions under which money will or will not be ‘neutral’ (in the sense that a change in the quantity of money will not alter the real equilibrium of the system—relative prices and the interest rate). In the course of the controversy at least as much has been learned about the difficulty of extracting theoretical conclusions from systems of equations as has been contributed to usable monetary theory. The argument, it should be noted, has been concerned throughout with a monetary economy characterized by minimal uncertainty, whereas Keynes was concerned with a highly uncertain world in which money provides a major link between present and future (on this point see Shackle [105, p. 211]).

A. The Integration of Monetary and Value Theory

The early history of what is often described as ‘the Patinkin controversy’ is not worth recounting in detail; an annotated bibliography of it may be found in Valavanis [122], and Patinkin’s own summary in [90]. It began with Oskar Lange’s argument [72] that Say’s Law (which in this context is the principle that people sell goods only for the purpose of buying goods) logically precludes any monetary theory, since in combination with Walras’ Law (that the total supply of goods and money to the market must be equal to the total demand for goods and money from the market) it implies that the excess demand for money on the market is identically zero regardless of the absolute price level, which therefore is indeterminate. Patinkin took up this charge, shifting the object of criticism to the classical assumption that the demand and supply functions for commodities are homogeneous of degree zero in commodity prices (that is, a doubling of all commodity prices will leave quantities demanded and supplied unchanged—in other words, quantities demanded depend only on relative prices). This criticism was refined and its mathematical formulation clarified in response to subsequent critical contributions, of which the most important was Karl Brunner’s demonstration [17] that a consistent monetary theory could be constructed without assigning utility to money.

In its final form at this stage [90], Patinkin’s criticism of the classical dichotomy was that there was a logical contradiction between classical value theory, in which demands and supplies of commodities depended only on relative prices and not on the real value of people’s cash balances, and the quantity theory of money, in which the dependence of spending on the real value of money balances provides the mechanism by which the quantity of money determines a stable equilibrium absolute price level, a contradiction which could be removed neither by resort to Say’s Law nor by abandonment of the quantity theory in favour of some other monetary theory. But, Patinkin argued, the contradiction could be removed, and classical theory reconstituted, by making the demand and supply functions depend on real cash balances as well as relative prices; while this would eliminate the dichotomy, it would preserve the basic features of classical monetary theory, and particularly the invariance of the real equilibrium of the economy (relative prices and the rate of interest) with respect to changes in the quantity of money.

The integration of monetary and value theory through the explicit introduction of real balances as a determinant of behaviour, and the reconstitution of classical monetary theory, is the main theme and contribution of Patinkin’s monumentally scholarly work, Money, Interest, and Prices [93]. The first part of the book (‘Microeconomics’) develops the theory of the real balance effect (the effect of a change in the price level on the real value of money balances and hence on expenditure) in terms of a Hicksian exchange economy in which the individual starts each week with an endowment of commodities that must be consumed within the week and a stock of fiat money, and plans to exchange these for commodities to be consumed during the week and cash balances with which to start the next week. The demand for cash balances is a demand for real balances, derived rather artificially from the assumption that though equilibrium prices are fixed at the beginning of the week, cash payments and receipts are randomly distributed over the week and the individual attaches disutility to the prospect of being unable to pay cash on demand. A rise in prices lowers the real value of an individual’s initial cash holding and, provided that neither goods nor real balances are ‘inferior’, reduces his demand for both (implying a less than unit-elastic demand curve for money with respect to its purchasing power); but a proportional rise in prices accompanied by an equiproportional increase in the individual’s initial money stock does not alter his behaviour. Extended to the market as a whole, the first property ensures the stability of the money price level, the second yields the quantity theory result that a doubling of everyone’s money stock will double prices but leave the real equilibrium unchanged. When lending and borrowing by means of bonds are introduced, this latter result requires a doubling of everyone’s initial bond assets or liabilities as well as his money holdings. Patinkin’s chief criticism of the classical economists has now been reduced to their failure to analyse the role of the real balance effect in ensuring price level stability; the charge of definite inconsistency can only be fairly pinned to a few specific writers of later vintage.

Carefully worked out as it is, Patinkin’s analysis of the real balance effect is conceptually inadequate and crucially incomplete; both defects are attributable to an unsatisfactory analysis of stock-flow relationships. The conceptual inadequacy is inherent in the lumping together of the stock of cash and the week’s income of goods into a total of disposable resources and the application of the conventional concept of inferiority to the possible effects of changes in this hybrid total on the quantities of real balances and goods demanded.¹ The incompleteness is inherent in Patinkin’s restriction of his analysis of the effects of a disturbance to the single week in which it occurs. Archibald and Lipsey [2] have shown that over succeeding weeks an individual whose real balances differed from their desired level would accumulate or decumulate balances by spending less or more than his income until real balances attained the desired level, at which point expenditure would once again equal income. Thus, they argue, the real balance effect is a transient phenomenon, relevant only to short-run disequilibrium situations. If positions of long-run equilibrium are compared, the effect of a change in the quantity of money does not depend on its initial distribution (since individuals will redistribute it among themselves in adjusting their real balances to the desired level) and the demand for money with respect to its purchasing power has the classical unitary elasticity; finally, real balances can be dropped from the equations determining equilibrium, which can be written as functions of relative prices only.

On the basis of this last result, Archibald and Lipsey attacked the Lange–Patinkin charge of inconsistency in classical theory, and showed that a consistent system could be constructed using demand and supply functions homogeneous of degree zero in prices, supplemented by the quantity equation, though this system would not conform to Walras’ Law when out of equilibrium. Earlier, Valavanis [122] had disputed Patinkin’s apparent victory in the dichotomy debate, and shown that if the (in my opinion,...