previous CHAPTER 1
GENERAL ECONOMIC CONCEPTS
next

Chapters 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

Chapter 1
General Economic Concepts
Chapter 2
What is Policy?
Chapter 3
History of Macroeconomic Policies in the United States
Chapter 4
Policy Goals: Maximum Employment
Chapter 5
Policy Goals: Maximum Production
Chapter 6
Policy Goals: Price Stability
Chapter 7
Policy Goals: External Balance
Chapter 8
Subsidiary Policy Goals
Chapter 9
Conflicting Policy Goals
Chapter 10
The Policy Makers
Chapter 11
The Policy Instruments
Chapter 12
The Decision-Making Processes
Chapter 13
The Policy Indicators
Chapter 14
The General Economic Model
Chapter 15
Monetarist Monetary and Fiscal Policies
Chapter 16
Keynesian Monetary and Fiscal Policies
Chapter 17
Debt Management Policies
Chapter 18
Incomes Policies
Chapter 19
Supply Management Policies
Chapter 20
The Long Wave
Chapter 21
Contemporary Issues
"It is needful also not to charge the native commodities with too great customes, lest by indearing them to the strangers use, it hinder their vent. And especially forraign wares brought in to be transported again should be favoured, for otherwise that manner of trading ... cannot prosper nor subsist. But the Consumption of such forraign wares in the Realm may be the more charged, which will turn to the profit of the kingdom in the Ballance of the Trade, and ... enable the King to lay up the more Treasure...."

Thomas Mun
British Merchant
Englands Treasure by Forraign Trade or The Ballance of our Forraign Trade is The Rule of our Treasure (1664)

  1. Methodologies: Schools of Thought
  2. Assumptions of the Keynesian and Monetarist Schools
  3. Summary
    Readings
    Websites
top    I. Methodologies: Schools of Thought

A methodology is a perspective or framework from which one approaches a problem. Two major methodologies pervade the "soft sciences," especially economics, political science, and the law." A "soft science" (as opposed to a "pure science," like mathematics or chemistry) is one which involves the study of human beings — human beings interacting with other human beings and with nature. Humans, unlike inanimate objects, learn from experience so that temporal responses are not easy to predict. The methodology presupposes certain characteristics about humans to simplify the process of explaining human behavior.

These methodologies or frameworks may appropriately be identified as the Left School and the Right School. The Left School is also known as the Cambridge School, the Mercantilist School, or the Keynesian School. The Right School is also known as the Chicago School, the Classical School, or the Monetarist School. The various methodological constructs of the two "schools" are set forth in the table below.

METHODOLOGICAL CONSTRUCTS OF THE TWO SCHOOLS
Left School (Cambridge-Mercantilist-Keynesian)

Pragmatic realists
Materialists
Social/communal orientation
State/community interests
Social order (conditioned by the "times")
Social law
Centralized decision-making
Totalitarianism (oligarchy)
Federalists
Socialism
Inherent economic instability
Policy solutions
Government planning
Construct/direct/influence
Protectionism (Managed trade)
Equity (fairness)
Inductive reasoning
Normative
Subjective
Based on belief
Prescriptive
Mercantilists
Keynesians
Legal realism
Noninstrumentalism
Broad, vague, fluid
Loose construction of Constitution
Evolving/changing laws and concepts
"Can do" attitude
Free will
Liberal - "liberate from natural order" or "overcome (control) the natural order
Right School (Chicago-Classical-Monetarist)

Axiomatic generalists
Idealists
Axiomatic/individualistic orientation
Individual interests
Natural order
Natural law
Decentralized decision-making
Anarchy (democracy)
Anti-Federalists
Capitalism
Inherent economic stability
No policy solutions
Market forces
Government laissez-faire
Free trade
Efficiency (neutrality)
Deductive reasoning
Positive
Objective
Based on fact
Descriptive
Physiocrats
Classicists (Monetarists, Supply-siders)
Classical law
Instrumentalism
Narrow, rigid
Strict construction of Constitution
Immutable laws and concepts ("fixed in stone")
"Is done" attitude
Predestination (destiny is preordained)
Conservative ("status quo") - restore or return to natural order

The Left School is oriented toward society as a whole. It is not so ideological as the Right School and its members take a more pragmatic, "can do" attitude toward solving problems. The Left School models are more subjective and more open to interpretation. They seek to find the fair or equitable solution to a problem. As a result, affirmative, active policies tend to emerge from the Left School. However, the policies are decided by active deliberations and debate, because they are normative.

The Right School is oriented toward the individual. It believes in natural law and has a deterministic, some would say fatalistic, approach to solving problems. Members of the Right School believe that one immutable set of rules governs the economy and economic behavior and that, once these rules are learned, the role of government is to codify these rules, bring everyone's behavior into conformity with these rules, and, then, laissez faire! As a result, passive, non-active policies tend to flow from the Right School.

Economics is a "social" science. It deals with people. Social sciences do not exhibit the same revolutionary breakthroughs as the pure sciences. Each methodology is omni-present and evolves over time as human beings evolve. At any point in time, however, only one methodology dominates. This methodology is called "orthodoxy" or the "mainstream" paradigm. When the conclusions of the "mainstream" paradigm fail to explain observed behaviors, the "heterodoxy" or "latent" paradigm emerges and the replaces the "mainstream" paradigm. However, each time replacement occurs, the "latent" methodology emerges with an evolutionary, updated twist on its last assumptions about humans and human behavior. Monetarism is contemporary Classical economics and Keynesianism is contemporary Mercantilism; and, just as Classical economics replaced Mercantilism, Keynesianism replaced Classical economics, Monetarism replaced Keynesianism, and now a new version of Keynesianism appears to have replaced Monetarism.

Selection of a methodology creates a pre-scientific bias to one's approach to economic problems. Being an adherent to one methodology absolutely precludes use of the other methodology. As shown in the table above, the characteristics of one school are absolutely the antithesis of the other school. This book examines macroeconomic policies and policy theories through the eyes of economists from both schools.

top    II. Assumptions of the Keynesian and Monetarist Schools

Keynes claimed that Classical economics was but one specific case of Keynes' more "general theory." Keynes was referring to the rigid assumptions of the Classical school, namely, full employment and price flexibility. Keynesian economics, on the other hand, has been dubbed "depression economics," because of its rigid assumptions, namely, fixed prices and quantity adjustments.

Whether one or the other is more general or more specific is less important than is understanding the assumptions each methodology employs to analyze the economy. The underlying assumptions of each school are set forth in the table below. Understanding these assumptions puts the respective Keynesian and Monetarist theories and policy conclusions into proper perspective.

ASSUMPTIONS OF THE KEYNESIAN AND MONETARIST SCHOOLS
Concept Keynesian School Monetarist School
General Equilibrium GNP (E) identity GNI (Y) GNP (E) identity GNI (Y)
Causation Y = f(Ep) E = f(Y)
Basic Framework Flow analysis Stock analysis
Time Dimension Short-run Long-run
The Future Uncertain
(pure uncertainty - not insurable)
Certain, or at least predictable and insurable, in the probabilistic sense
Money Illusion Yes No
Market Adjustments Non-competitive
Fixed prices, wages, interest rates, and foreign exchange rates
Flexible output and employment
Competitive
Flexible prices, wages, interest rates, and foreign exchange rates
Fixed output and employment
Macroeconomic Instability Source: private sector
Solution: public sector (policies)
Source: public sector
Solution: private sector (laissez faire)
Consumption Consumer expenditure Consumption expenditure
Consumption Functions Determinants: disposable income and marginal propensity to consume
C = f(Yd, b)
Determinants: marginal utility, relative prices, and portfolio balance
C = f(Ye, W, P, i, µ)
Investment Capital expenditure Amortized expenditure
Investment Functions Determinants: interest rates, expected profitability, and uncertainty
I = f(i, e(π), μ)
Determinants: real interest rates and marginal product of capital
I = f(i, P, MPK)
Money "liquidity par excellence" "temporary abode of purchasing power"
Money Supply M1 M2
Money Demand Functions Emphasis is on reasons for holding money:
– Transactions motive
– Precautionary motive
– Speculative motive
– Finance motive
Emphasis is on reasons for spending money:
MsV = PT
– Transactions motive only
Money Supply Functions exogenous: Ms = f(monetary authority) and endogenous: Ms = f(Md) exogenous: Ms = f(monetary authority)
Equation of Exchange Equation of Exchange: Income Version
Ms x Vy identity P x Q
Equation of Exchange: Transactions Version
Ms x V identity P x T ⇒ Ms x Vy identity P x Q
Money Market Equilibrium Income Version
Md identity kPQ identity Ms
Transactions Version ⇒ Income Version
Ms identity (1/V)PT identity Md ⇒ Ms identity (1/Vy)PQ identity Md
Causation Two-way causation

ΔMs ⇒ ΔMd ⇒ ΔQ

Money Stimulates Trade Doctrine
Q = f(Ms)|k,P = Ms/kP, where k and P are fixed

Locke's Doctrine
k = f(Ms)|P,Q = Ms/PQ, where P and Q are fixed

Liquidity Trap
k = f(Ms)|P,Q = Ms/PQ, where P and Q are fixed and k = ∞ at some low interest rate

ΔQ ⇒ ΔMd ⇒ ΔMs

Reverse causation
Ms = f(P,Q,Vy) = PQ/Vy, where nothing is fixed

One-way causation

ΔMs ⇒ ΔP

Quantity Theory of Money
P = f(Ms)|Vy,Q = Ms/VyQ, where Vy and Q are fixed

ΔMs ⇒ ΔPQ, s/t Qn

New Quantity Theory of Money
PQ = Y = MsVy or PQ = Y = f(Ms)|Vy
Monetary Policy Transmitted to the products markets indirectly through the financial markets

ΔMs ⇒ Δi ⇒ ΔI ⇒ ΔQ ⇒ ΔLe ⇒ ΔU

Not effective; too many loose links
Transmitted directly to the products markets through all markets

ΔMs ⇒ ΔAD ⇒ ΔY ⇒ ΔP,Q ⇒ Δi

St. Louis School: very effective (discretion)
Friedman: too effective (rules)
Fiscal Policy Transmitted directly to the products markets through all markets

ΔG,T ⇒ ΔB ⇒ ΔI ⇒ ΔY ⇒ ΔQ ⇒ ΔLe ⇒ ΔU

Changes the velocity of Ms

Very effective
Transmitted to the products markets indirectly through the financial markets

ΔG,T ⇒ ΔB ⇒ ΔMd ⇒ Δi ⇒ ΔMs⇒ ΔAD ⇒ ΔY (P or Q)

Requires an increase in Ms to keep interest rates from increasing and crowding out private sector spending

Ineffective, unless accompanied by changes in Ms to keep interest rates from rising

top    General Equilibrium

Both the Keynesian and Monetarist methodologies start with the National Income Accounting Identity to analyze macroeconomic activity. The identity sets the outer boundary for macroeconomic theory and policy analysis.

The National Income Accounting Identity

An identity is a representation of a relationship where both sides are perfectly equal because they have been defined in such a way to be equal. Each side carries equal weight. Neither side is independent (cause) and neither side is dependent (effect). If either side changes, however, an identity states that the other side must change by the same magnitude and in the same direction. When one side changes, the other side changes, but nothing in an identity indicates which side will actively change and which side will passively respond.

The National Income Accounting Identity states that the sum of all spending (E) must equal the sum of all income (Y) or, more simply stated, the sum of all purchases must equal the sum of all sales.

GNP identity E identity Y identity GNI

where GNP is Gross National Product, E is aggregate expenditure on GNP, Y is aggregate income received from expenditure on GNP, and GNI is Gross National Income.

Gross National Product (GNP) is the total market value of all final goods and services (products) produced for an economy over some time period (generally one year), not for resale and not for resale in that time period, regardless of where the output is produced:

GNP identity PQ

where Q is the quantity of real output and P is the general level of prices.

Gross National Income (GNI) is the total income earned by the factors of production (resources) in a country in a given period of time (generally one year):

GNI identity Y identity wL + iK + rR + π + sp + ibt + cca

where w is the wage income earned by labor (L), i is the interest income earned by lenders on loans to businesses to buy capital (K), r is the rental income received by landlords for the use of land and other natural resources (R), π is the profit income earned by entrepreneurs or shareholders, sp is the income earned by sole proprietors, ibt are the indirect business taxes collected by businesses and remitted to the government, and cca is capital consumption allowance or depreciation.

Gross Domestic Product (GDP) is the total market value of all final goods and services (products) produced within an economy over some time period (generally one year), not for resale and not for resale in that time period, regardless of who produced the output. GDP is GNP less net factor income from abroad:

GDP = GNP - net factor income from abroad

GNP or GDP may be viewed either from the Expenditure Approach or the Income Approach and, then, jointly, from the Expenditure and Income Approach.

Expenditure Approach

EXPENDITURE APPROACH (Y identity PQ)
GNP identity GDP + Net factor income from abroad
Final Sales  =  GNP - inventory change (Δ Inv)


Components of Final Sales
Personal consumption (C)
Nonresidential investment (If)
Residential investment (If)
Government spending (G)
Net exports (Xn = X - H)
Gross National Product (GNP) is the sum of all spending on final goods and services (products) produced for an economy over some time period (generally one year), not for resale and not for resale in that time period.

GNP = pwqw + pdqd + ... + pnqn

n   
GNP = sum piqi = PQ
i=1  

where Q is a measure of real output and P is the general level of prices. Spending is divided into four types, depending on who is spending. The four spending groups are households (C), businesses (Ig), governments (G), and foreigners (Xn):

Y identity PQ identity C + Ig + G + Xn

Households Household spending is called personal consumption (C). Personal consumption is household spending on domestically produced consumer products. Consumer products are, by definition, final goods, because households buy products for direct satisfaction.

Businesses Business spending is called gross private domestic business expenditure or investment (Ig). Investment is business spending on domestically produced capital goods. It includes spending on fixed capital (If) and changes in inventories (Inv):

Ig identity If + Δ Inv identity If + Iv
    Fixed capital is the buildings, equipment, and machines which businesses buy to produce other products over many production periods. It is consider to be a final good, because it is consumed by the business and not resold. It includes both residential and nonresidential investment. All spending on fixed capital is included in GNP and GDP.

    Inventories are the raw materials and semi-finished goods which businesses buy to process and transform into other products to be resold to other businesses at higher stages of production. During the year, businesses buy raw materials and semi-finished goods and transform them into new products. The transformation process adds value to the raw materials and semi-finished goods. This change in the value added to the raw materials and semi-finished goods is called the net change in inventories. Only the net change in inventories during the year is included in GNP:

    Δ Inv identity Iv

    Both fixed capital investment and inventory investment include spending on replacement capital as well as new capital. Replacement investment (Ir) is spending on capital to replace the portion of the fixed capital stock that has worn out during the year. It is some fraction of the existing stock of fixed capital:

    Ir identity dK

    New investment or net investment (In) is spending that changes the aggregate capital stock. It includes spending on newly produced fixed capital as well as changes in net inventories:

    In identity Kt - Kt-1 = Δ K

    The importance of net investment is that it shows the direction of movement in an economy. A stationary economy (In = 0) is one in which business spending merely replaces that portion of capital stock which has worn out. The resource base is constant. An expanding economy (In > 0) is one in which business spending adds to the capital stock. The resource base is increasing. A contracting economy (In < 0) is one in which the capital stock is wearing out faster than it is being replaced. The resource base is decreasing.

    Gross domestic business investment is the sum of replacement investment plus net investment:

    Ig identity Ir + In identity dK + (Kt - Kt-1) = dK + Δ K
Government expenditure (G) is spending by governments at all levels on final goods and services as well as direct payments to labor for services rendered. (Transfer payments are not part of government spending. They are tax transfers (±T = Tn = - T + R).)

Net exports (Xn) is the balance of trade. The balance of trade is net exports or spending by foreigners on the home country's goods and services (exports) less spending by the home country on foreign goods and services (imports).

Xn = X - H

where X is exports and H is imports.
    Exports (X) are foreigners' expenditures on domestically products produced, foreign travel and tourism in the home country, and transfers of income in the form of wages, interest, rent, and profits by foreigners to residents of the home country. Since exports generate employment and income for the home country, they get added into the GNP accounts.

    Imports (H) are resident expenditures on products produced by foreigners, travel and tourism abroad by residents of the home country, and transfers of income in the form of wages, interest, rent, and profits by residents of the home country to foreigners. Since imports generate employment and income abroad rather than for the home country, they get subtracted out of the GNP accounts.
Only net exports are included in GNP because imports are paid for out of current income and if decision-makers are buying foreign products, which generate income for foreign resources, they cannot be paying for domestically produced products, which generate income and employment at home.

Income Approach

Gross National Income (GNI) is the total income earned by the factors of production (resources) in a country in a given period of time (generally one year):

GNI identity Y identity wL + iK + rR + π + sp + ibt + cca,

INCOME APPROACH
GNP identity GNI identity wL + iK + rR + π + sp + ibt + cca
NNP = GNP - Capital consumption allowance (cca) (Sb) (involuntary)
NI= NNP - Indirect business taxes (ibt) (T)
PI= NNI - Corporate profits taxes (T)
  - Retained earnings (Sb) (voluntary)
- Social security taxes (T)
+ Social security and
other income transfers
(-T)
+ Interest on the public debt (-T)
DPI=PI - Personal income taxes (T)
Sh=DPI - C (C)
  Sh identity repayment of debt (Sh) (involuntary)
  + net [new] saving (Sh) (voluntary)

where w is the wages earned by labor (L), i is the interest earned by lenders to businesses to buy capital (K), r is the rents received by landlords for the use of land and other natural resources (R), π is the profit income earned by entrepreneurs or shareholders, sp is the income earned by sole proprietors, ibt are the indirect business taxes collected by businesses and remitted to the government, and cca is capital consumption allowance or depreciation for the portion of the capital stock that wears out each year.

Net National Product (NNP) is the income which could be made available to the factors of production in a two-sector economy (no government) after allowance is made for the wear and tear on capital during the production process:

NNP = GNP - capital consumption allowance
    Capital consumption allowance (cca) is the wear and tear on capital in the production process. It is a non-income charge since it is not an explicit payment. Capital consumption allowance is a form of forced saving by business (Sb) because it is part of current income that is unavailable for spending.

    Depreciation is the real world accounting technique used to measure the wear and tear on capital on a per period basis. The depreciation of capital may or may not mirror the actual capital consumption, since several different accounting techniques are available to businesses for tax purposes.
National Income (NI) is the income which could be made available to the factors of production if governments collected only indirect business taxes (sales and excise taxes):

NI = NNP - indirect business taxes
    Indirect business taxes (ibt) is a tax (T) which is levied and paid at one point, but is capable of being passed along and born by someone else. Examples of indirect taxes are sales taxes, excise taxes, and tariffs.
Personal Income (PI) is the gross income of households after adjustment is made for corporate profit taxes, retained earnings by business, private transfers, and government transfers:

PI = NI - corporate profit taxes,
- retained business earnings,
± private transfers, and
± government transfers, including social welfare payments
and benefits and interest on the national debt
    Corporate profit taxes are levied by the government on corporate profits (T). These taxes are unavailable to the factors of production.

    Retained business earnings are the portion of after-tax profits that are kept by the corporation and become part of its net worth. They are a form of voluntary saving by business (Sb) Retained earnings are unavailable to the factors of production. The portion of after-tax profits that not retained by businesses are available to the factors of production. They are paid to shareholders as dividends.

    Private transfers are gifts from one individual or institution to another. When income is transferred, it is not spent. Therefore, it is saved. When the transferred income is received, it may be spent or saved. The result of private transfers is net saving (Sn).

    Government transfers redistribute the national income by taxing some individuals or institutions and subsidizing others. Included in tax collections are Social Security payments into the fund. Included in tax transfers are Social Security payments from the fund and interest on the national debt. The result of government transfers is net tax collections (Tn = - T + R).
Disposable Personal Income (DPI) is the portion of GNI that households receive in monetary form. It may be either spent or saved.

Yd = Y - T + R = C + Sh.
    Consumption (C) is what is spent on domestically produced goods and services. (Note: What is spent on foreign goods and services is included as imports in net exports.)

    Saving (Sh) is what is not spent by households on domestically produced goods and services. Saving in no way implies how this portion of unused income is disposed. Ultimately, interest rates and liquidity preferences determine the destination of saving.
The National Income Accounting Identity can be rewritten in terms of the Expenditure and Income Approach.

Expenditure and Income Approach

EXPENDITURE APPROACH identity INCOME APPROACH
Y = f(Ep) identity Ep = f(Y)
GNP identity GNI
C + Ig + G + Xn identity C + Sh + Sb + T
C + Ig + G + Xn identity C + S + T
                    -C  identity -C                     
Ig + G + Xn identity S + T
Injections identity Withdrawals
The two sides of the National Income Accounting Identity must always be equal and the injections must always equal the withdrawals, ex post, after the fact. However, the two sides may not always be equal and the injections may not equal the withdrawals, ex ante, before the fact. Nothing in the equation indicates cause and effect; that is, which side influences the other side. It merely states that if one side changes, the other side must change.

Equilibrium Condition Equilibrium is a state of rest, from which there is no tendency to change. GNP will remain the same, ex post, if injections equal withdrawals, ex ante. As long as spending plans are exactly equal to production plans, everything produced will be sold and there will be no incentive to change the existing pattern of income and production.

Disequilibrium Condition Disequilibrium is a state of unrest, from which there is a tendency to change. GNP will change, ex post, if injections are not equal to withdrawals, ex ante. If ex ante injections are less than ex ante withdrawals (an excess of saving), inventories will accumulate. With an excess of inventories, profits will fall. Businesses will cut back on production, hire fewer workers (in the short-run), and pay out less income. GNP will fall, ex post. If ex ante injections are greater than ex ante withdrawals (an excess of spending), inventories will decumulate. With a decumulation of inventories, profits will rise. Businesses will increase production, hire more workers (in the short-run), and pay out more income. GNP will rise, ex post.

top    Causation

The National Income Accounting Identity as a Functional Equation

A functional equation turns an identity into cause and effect. One side of the functional equation is independent (cause) and the other side is dependent (effect). The variables in the identity now have functional meaning, in that any change in the independent variable(s) (cause) brings about a change in the dependent variable (effect).

The National Income Accounting Identity can be turned into two functional equations. One equation shows that changes in expenditure cause changes in income:

Y = f(Ep)

and the other equation shows that changes in income cause changes in expenditure:

Ep = f(Y)

The Keynesians Versus the Monetarists

Keynesians believe that "demand creates its own supply" or expenditure determines income. They write the National Income Accounting Identity so that income (Y) is a function of planned expenditure (Ep) on all newly produced final goods and services:

Y = f(Ep)

Y = Ep = C + Ig + G + Xn

Monetarists believe that "supply creates its own demand" or income determines expenditure. They write the National Income Accounting Identity so that planned expenditure (Ep) on all newly produced final goods and services is a function of income (Y):

Ep = f(Y)

Ep = Y = w + i + r + π + sp + ibt + cca

Thus, from the very outset of any economic analysis, Keynesians and Monetarists look at the economy from very different viewpoints.

top     Basic Framework

Differentiating Stock and Flow Variables

A stock variable is something that exists at a point in time. If one stops and holds time still, one can observe the world as it is. What one sees at that point is the current stock. For example, at any one point in time, one observes only one set of prices. Anything that can be valued at a point in time by the set of prices at that time is a "stock" variable. Stock variables are found on balance sheets.

At any one point in time, one can locate and value one's assets: homes, cars, stereos, stocks, bonds, and money balances. Businesses list their stocks of cash, accounts receivable, inventory, and fixed capital in their balance sheet statements. The sum of all assets is total wealth.

At that point in time, one may also have liabilities or debts owed to others: mortgages, loans, notes, bonds issued, etc. Net worth or net wealth is total assets (total wealth) minus total liabilities.

Stock variables are money supply, food, clothing, bonds, and savings accounts. As money is exchanged for other assets, and vice versa, income and expenditure adapt passively. Changes in the money supply lead to passive changes in income and output based upon its velocity or rate of "flow" through the economy:

PQ = f(Ms)|Vy

A flow is something that occurs over time. One cannot observe a flow at a point in time, but rather only as time passes. Over time, one earns income and one makes expenditures. What one does not spend, one saves. Saving is loaned to households, who borrow to buy real estate and consumer goods, to businesses, who borrow to buy capital goods, to governments, who borrow to buy social overhead capital and pay military and civilian personnel, and to foreigners, who borrow for the same reasons. One cannot see income, spending, saving, investment, borrowing, or lending, except as time passes. Flow variables are found on income statements.

Flow variables are income, spending, and saving. As income is spent, the stock of assets adapt passively. Changes in velocity lead to passive changes in the "stock" of assets:

Q = f(Vy)|P, Ms

Relationship of "Stock Variables" to "Flow Variables"

While the two terms, stock and flow, have separate and distinct time interpretations, they are linked in the following sense. The difference between two stocks, one at time t0 and the other at time t1, is the net of all flows between t0 and t1.

Suppose a person takes an inventory of everything one has and owes at 12:00 midnight December 31. At that point, he has a house, a car, three cans of beans, a dozen hot-dogs and rolls, and $100 in the bank. The next day is a holiday. He does not work, he earns no income. However, to survive, the person consumes a can of beans and four hot-dogs on rolls. His net wealth has shrunk by the amount of consumption during the holiday. The second day the person works. After work he goes to the bank for $50. With that $50 he takes his girlfriend out for dinner. The third day he works, and after work, he goes home and consumes another can of beans and four hot-dogs on rolls. The fourth day the person works, and after world he goes to the bank to draw out another $50 to spend on dinner. The fifth day the person works, but now he gets paid for all five days — $1,000. The $1,000 is his income. After work, he goes to the bank and deposits $900, talking $100 in cash. He goes to the supermarket and buys food. When he returns home, he once again stops, holds time still, and takes stock of his assets. What he has at this point — a house, a car, one can of beans, four hot-dogs, four rolls, an additional $100 in food, and $900 in the bank — is the net difference in the flow that took place over the last six days.

The Keynesians Versus the Monetarists

Keynesians analyze economic behavior and activity in terms of flow variables. They look at the economy "over time." Keynesian economic participants respond to flow disturbances and changes in "flow" variables. Stocks adjust passively in the Keynesian framework. Keynesian macroeconomics policies are designed to control velocity (flow).

Monetarists analyze economic behavior and activity in terms of stock variables. They look at the economy "at a point in time." Monetarist economic participants respond to stock disturbances and changes in relative prices. Flows adjust passively in the Monetarist framework. Monetarist macroeconomic policies are designed to control the supply of money (stock).

top     Time Dimension

Differentiating the Short Run from the Long Run Periods

The short-run time period is a period of imperfect adjustment to a situation perceived as temporary. The short-run is the period in which a demand disturbance alters the capacity utilization rates of existing plant and equipment or a supply disturbance temporarily alters the consumption/saving ratio of households.

The long-run time period is the period in which all economic participants have had the opportunity to evaluate existing economic events and to realize any and all possible adjustments permanently.

While the two time periods have different effects, they are inextricably linked in the sense that the long-run is nothing more than the sum of its short-run periods and short-run disturbances may ultimately alter long-run behavior. In the long-run, short-run demand and/or supply disturbances permanently alter the buy level and composition of demand as well as the quantity of all resources available for production and the pattern of resource usage.

Short Run and Long Run Adjustment Processes

Short-run adjustments In the short-run, the resource base remains relatively fixed and businesses produce more or less in response to perceived temporary shifts in the consumption/saving ratio. The consumption/saving ratio changes aggregate demand. Changes in the consumption/saving ratio may be caused by either a change in money supply or a change in income velocity.

When the consumption/saving ratio increases, economic participants spend relatively more than they save. Inventories are involuntarily decumulated. To replace lost inventory, businesses increase production. They hire more workers. Employment increases and unemployment decreases. Capacity utilization increases and excess capacity decreases. As capacity utilization increases, marginal and average costs begin to rise, necessitating price increases.

When the consumption/saving ratio decreases, economic participants save relatively more than they spend. Inventories are involuntarily accumulated. To run off inventories, businesses decrease production. They lay off workers. Employment decreases and unemployment increases. Capacity utilization decreases and excess capacity increases. When costs are cut sufficiently, prices respond in kind.

A supply-side shock will also alter the consumption/saving ratio in the short-run. In the short-run, households will continue to spend more or less of their income to maintain a certain level of comfort. When a supply-shock forces up prices, the higher cost consumption is paid for by sacrificing saving. The consumption/saving ratio increases. When a supply-side shock reduces prices, economic participants respond in the short-run by consuming the same amount and adding the surplus income to saving. The consumption/saving ratio decreases.

Long-run adjustments In the long-run, businesses respond to changes in the consumption/saving ratio by altering the size of their production facilities. Businesses either add to capacity in response to an increased consumption/saving ratio or eliminate excess capacity in response to a decreased consumption/saving ratio. As capacity utilization rates increase, businesses seek to expand. Aggregate demand increases as businesses seek to spend down money balances to acquire new capital goods. Eventually, capital costs and interest rates increase. As the new capacity is added and brought on-line, capacity utilization rates decrease. This new capacity reduces cost pressures. Price and interest rate increases top out, stabilize, and eventually fall. The more new capacity is added, the less additional capacity is needed. This slow down in investment reduces pressures on capital prices and interest rates. As capacity utilization decreases, businesses seek to become "leaner and meaner." Aggregate demand falls as businesses close older, less productive facilities and divest and sell off excess capital. Capital costs and interest rates decrease. Price decreases bottom out, stabilize, and eventually rise as aggregate demand returns to its long-run equilibrium level.

In the long-run, households respond by restoring the velocity of the money supply and the consumption/saving ratio to a more "normal" level. On the one hand, if a short-run supply shock permanently raises prices, households are forced to cut consumption to restore velocity and the consumption/saving ratio to more "normal" lower levels. Households cannot live on credit and consume in excess of their income indefinitely. Eventually, this consumption must be paid for with increased saving. On the other hand, if a short-run supply shock permanently reduces prices, households adjust upward their consumption levels to improve their comfort. This increased spending raises velocity and the consumption/saving ratio to more "normal" higher levels. Additional consumption is financed from saving.

As the economy expands and contracts, the composition of demand and the pattern of resource allocation is changed to reflect the new economic circumstances. During an expansion, not all industries experience the same demand growth. In fact, the demand for some output may actually contract as economic participants substitute newer, better models as well as new products. During a contraction, not all industries experience the same contraction in demand. In fact, the demand for some output may actually be growing as economic participants readjust their buying patterns in response to changes economic circumstances.

The Keynesians Versus the Monetarists

Keynesians use a short-run time frame to explain the levels of income and employment over the course of a typical business cycle. Their primary concern is over temporary changes in the velocity of money supply which changes as the consumption/saving ratio changes. Velocity increases when the consumption/saving ratio increases and velocity decreases when the consumption/saving ratio decreases.

Monetarists use a long-run time frame to explain the levels and patterns of demand and resource allocation that emerge after all possible adjustments have been realized. In the long-run, velocity is assumed to be stable (or at least, predictable). Monetarists primary concern is over temporary changes in the money supply which alter the long-run equilibrium consumption/saving ratio.

top     The Future

The future plays an important role in most human activities. In economics, it is no different, for the economic actions taken today are the basis for the economic fortunes or disasters of tomorrow. Yet, most economic actions are taken based on a perception of the future that is not known ahead of time. Therefore, decisions are made and actions are taken in anticipation of an uncertain future.

Two Kinds of Uncertainty

True uncertainty or non-measurable uncertainty Neither of these uncertainties is measurable. True uncertainty is incapable of quantification and insurability. Thus, it cannot be easily included in a model without making subjective valuations of how economic participants respond to disappointing expectations about the future. In a world with true uncertainty, economic participants must remain more liquid in anticipation of disappointments down the road. Not all assets are perfect substitutes for one another; but rather, they are only imperfect substitutes. Segmentation is based on the assets' liquidity properties.

Probabilistic uncertainty or predictable uncertainty or risk Each of these can be measured. All events are known and can be assigned weights or probabilities that sum to 1.0, such that a definitive and calculable outcome is possible. Such definitive and calculable outcomes are certain in the sense that they can be predicted with some measure of confidence. This type of uncertainty or risk is very often insurable against disappointment, e.g. life insurance, fire and theft insurance, etc. Predictability and insurability take the guess world out of decision-making. Economic participants are never subject to disappointment, because they know what the future holds. Therefore, they can buy and sell all assets (both real and financial) without fear of becoming illiquid in the future. Assets are perfect substitutes for one another (Axiom of Gross Substitution).

Probabilistic uncertainty also provides a manageable methodology for models that draw conclusions about the real world. These models are often justified on the grounds that
  1. they eliminate subjective factors,
  2. they ease the mathematical and verbal exposition, and
  3. a world of disappointed expectations results in a level of turbulence beyond the skill of model builders to analyze.
The Keynesians Versus the Monetarists

Keynesians believe that the future is not measurable or known in any probabilistic sense. For Keynesians, time moves in only one direction — forward (calendar time). While the past may be known for certain, the future is not. Since money is always needed to enter the [real and financial] markets, not all assets are perfect substitutes for one another. Only money is perfectly substitutable for all other assets. Economic participants will always set aside and hold some money for precautionary purposes. How much economic participants hold in this capacity is a "measure of their uncertainty about the future." To Keynesians, a monetary production economy operating with complete certainty (or probabilistic uncertainty) is a contradiction in terms. Keynesian theory emphasizes the reasons for holding money, otherwise known as "money sitting."

Monetarists believe that the future is certain or at least calculable or known in the probabilistic sense. Therefore, in the Monetarist framework economic participants have no need to hold money for precautionary purposes. All assets are perfect substitutes for one another (Axiom of Gross Substitution). Monetarists sympathize with Adam Smith, who said, "A man must be perfectly crazy who, where there is tolerable security, does not employ all the stock which he commands, whether it be his own or borrowed of other people, in some one or other of [these] three ways: for his own present consumption, for future profit from production, or future profit from lending." Monetarists believe money is to be spent. Accordingly, if people have a little more, they will spend a little more if they have a little less, they will spend a little less. Monetarist theory emphasizes the reasons for spending money, otherwise known as "money on the wing."

top     Money Illusion

Money illusion is the valuation of income and assets in money terms, without adjusting for price changes. People who have money illusion ignore changes in purchasing power, even as prices are changing. They focus on money income (Y) and nominal money supply (Ms), not real income (Y/P) or real money supply (Ms/P). They can be duped into working more hours for less real income.

People who have no money illusion know exactly what the purchasing power of their income and assets is. They focus on real income (Y/P) and real money balances (Ms/P). They cannot be duped into working more hours for less real income.
    Example 1 Assume that you are currently earning $40,000 per year in salary. Your boss tells you that she is giving you a 50% raise and that your new salary will be $60,000. If you have money illusion, you walk away elated. If you have no money illusion, you ask yourself, "How much are prices expected to increase over the next year?" If prices are expected to increase at their current rate of 2.5%, you walk away elated. Today, you are earning $40,000 to buy $40,000 worth of goods and services. Next year, you will be earning $60,000 to buy $41,000 worth of goods and services. Your boss has just given you a 46.3% increase in purchasing power. If, however, prices are expected to increase by 100%, you walk away sad and dejected. Today, you are earning $40,000 to buy $40,000 worth of goods and services. Next year, you will be earning $60,000 to buy $80,000 worth of goods and services. Your real income will be only $30,000 and you will have lost 25% in purchasing power.

    Example 2 Assume that you are currently earning $40,000 per year in salary. Your boss tells you that she has to cut your salary by 25% and that your new salary will be $30,000. If you fail to take the pay cut, she will be forced to fire you. If you have money illusion, you tell your boss to "go take a hike," tell her "that you can find a better job elsewhere," and quit on the spot. If you have no money illusion, you ask yourself, "How much are prices expected to decrease over the next year?" If prices are expected to decrease by 50%, you walk away elated. Today, you are earning $40,000 to buy $40,000 worth of goods and services. Next year, you will earn $30,000 to buy $20,000 worth of goods and services. Your boss has just given you a 50% increase in purchasing power. (Remember, the alternative was to fire you!) If, however, prices are expected to decrease by only 10%, you walk away sad and dejected. Today, you are earning $40,000 to buy $40,000 worth of goods and services. Next year, you will earn $30,000 to buy $36,000 worth of goods and services. Your boss has just given you a 50% increase in purchasing power. You will have lost 17% in purchasing power.
The Keynesians Versus the Monetarists

Keynesians believe that people have money illusion. They are slow to react to price increases and refuse to take pay cuts, even though prices may be falling. The presence of money illusion partly justifies the stickiness of prices when demand falls, so that market adjustments are in quantities, not prices.

Monetarists believe that people have no money illusion. They respond very quickly to price increases and realize the rationality of taking pay cuts when prices are falling. The absence of money illusion partly justifies the stickiness of quantity when demand changes, so that market adjustments are in prices, not quantities.

top     Market Adjustments

Competitive markets are identified by four basic characteristics of market structure:
  1. large number of buyers and sellers
  2. price takers
  3. homogeneous product
  4. perfect knowledge of the market
  5. no barriers to entry or exit
However, for competitive markets to clear continuously, both quantities and prices must be perfectly flexible. They must be free to both rise and fall. If competitive market conditions are not present, prices will not be so flexible. If prices are fixed or inflexible, then all market adjustments must be through changes in quantities. If quantities are fixed or inflexible, then all market adjustments must be through changes in prices. If prices and/or quantities are not flexible, imbalances are created and markets do not clear properly or continuously.

Most markets are not competitive. Most sellers have monopolistic power and the ability to set their own prices. Other sources of price stickiness include fixed wage bill, labor unions, minimum wage, efficiency wages, continuous supply contracts, menu costs, increasing returns to scale, high ratio of fixed to variable costs, and balance sheet effects. When demand falls, these businesses prefer to change quantities rather than prices. Therefore, prices tend to be sticky downward and prevent markets from clearing.

The Keynesians Versus the Monetarists

Keynesians assume imperfectly competitive markets and other rigidities that keep prices from changing as fast as quantity. Businesses change quantity rather than price as a response to changes in demand.

Monetarists assume pure and perfectly competitive markets. They rely on price and wage flexibility to allocate resources and distribute output around the economy without creating too much inflation or too much unemployment.

top     Macroeconomic Instability

Sources of Instability

The macroeconomy can become destabilized by a number of forces affecting either aggregate supply or aggregate demand. Before the Industrial Revolution, when countries still relied heavily on agriculture as the main source of employment and income, instability derived primarily from changes in aggregate supply caused by changes in weather or climatic conditions. Short crops would drive prices up one year. Bumper crops would drive them down the next year. Even today, economies experience imbalances generated from the supply side, for example, when OPEC meets and resets oil prices. However, once production was brought inside, under the factory roof, and it was protected from the vagaries of the weather, instability derived primarily from changes in aggregate demand, that is, changes in consumption, investment, net exports, and government spending.

Solutions to Instability

The solutions to macroeconomic instability depend upon the sources of instability. If the sources are supply-side changes, especially, fluctuations in agricultural output due to weather-related phenomena, the instability will probably reverse itself during the next growing season and the government should do nothing — laissez faire. The U.S. government can do nothing about oil price changes. However, if the sources are demand-side changes, the solutions depend upon whether changes in the private sector or changes in the public sector are to blame. If the source is a change in spending by households, businesses, and foreigners, then the private sector is to blame and the government is the solution. If the source is a change in spending or taxing by government, then the public sector is to blame and the solution is to get government to stop — laissez faire.

The Keynesians Versus the Monetarists

Keynesians believe that the private sector is the source of macroeconomic instability and that the government is the solution to correcting or offsetting the private sector instability. Keynesians favor active government involvement to keep the economy steady on a non-inflationary growth path.

Monetarists believe that the private sector is inherently stable and that it will automatically correct for its own imbalances, if left alone. Monetarists favor no government involvement in the economy, except for providing traditional services like national defense and the post.

top     Consumption

Consumption (C) is household spending on newly produced domestic products. By definition, all consumer products are final products.

Consumer Expenditure Versus Consumption Expenditure

Consumer expenditure is the actual amount spent annually by households on consumer products, regardless of economic life. Some consumer goods are durable and some are non-durable. Non-durable goods must be replaced on a regular basis. Spending on non-durable goods constitutes a relatively stable flow of spending and generates a relatively stable income and employment from the production of those goods. Durable goods, however, have an economic life beyond one year. They do not have to be replaced on a regular basis. Spending on durable goods constitutes a relatively unstable flow of spending and generates a relatively unstable income and employment from the production of those goods.

Consumption expenditure is the annualized flow of household spending on consumer products. It is the amount of consumer expenditure "amortized" across the economic life of the products. Amortized spending constitutes a relatively stable flow of spending and generates a relatively stable income and employment from the production of those goods.

The following example illustrates the difference between consumer expenditure and consumption expenditure. Assume that households own $50.0 trillion in physical assets or physical wealth at the beginning of the year and that the average life of physical assets is 10 years. The amortization (depreciation) rate is 10% and the annual amortization of the assets is $5.0 trillion. Assume also that households spend $10.0 trillion during the year. They spend $6.0 trillion on non-durable goods and $4.0 trillion on durable goods. Consumer expenditure for the year is the annual outlay on nondurbale goods, $6.0 trillion, plus the annual outlay on durable goods, $4.0 trillion, or $10.0 trillion. Consumption expenditure for the year is the annual amortization of the assets, $5.0 trillion, plus the using up of the non-durable goods, $6.0 trillion, plus the annual amortization on the new durable goods, $400 billion, or $11.4 trillion. At the end of the year, households have $50.0 trillion less $5.0 trillion plus $4.0 trillion less $400 billion or $48.6 trillion in physical assets or physical wealth. Assume that, next year, households spend another $6.0 trillion on non-durable goods, but they increase their spending on durable goods to $6.0 trillion. Consumer expenditure for the year is $12.0 trillion, an increase of $2 trillion. Consumption expenditure for the year is the annual amortization of the assets, $4.86 trillion, plus the using up of the non-durable goods, $6.0 trillion, plus the annual amortization on the new durable goods, $600 billion, or $11.46 trillion, an increase of only $60 billion. Consumption expenditure is more stable than consumer expenditure. As a mathematical truism, income and employment, as measured by consumption expenditure, are more stable than income and employment, as measured by consumer expenditure.

The Keynesians Versus the Monetarists

Keynesians use consumer expenditure as the measure of household spending. Consumer expenditure is "lumpy" and varies widely from year to year, because of spending on durable goods. Only the actual amount spent annually provides income and employment to the factors of production. As a result, GDP and employment are unstable from year to year, because consumer expenditure is unstable.

Monetarists use consumption expenditure as the measure of household spending. Consumption expenditure measures the "use" or "using up" of consumer goods or wealth over time rather than the per period consumer expenditure. As a result, income and employment are more stable from year to year, because consumption expenditure is more stable than is consumer expenditure.

top     Consumption Functions

The Income Effect Versus the Wealth Effect

The income effect is the effect that a change in income has on consumption. According to Keynes,
"The fundamental psychological law...is that men are disposed, as a rule and on the average, to increase their consumption as their income increases, but not by as much as the increase in their income."
When households receive income, they allocate it between consumption and saving according to the marginal propensity to consume out of income (b):

C = f(Y) = bY, where b = ΔC/ΔY and 0 > b > 1

If income increases, household spending increases by the marginal propensity to consume out of income. What is not spent is saved and is added to household savings (accumulated wealth). If income decreases, household spending decreases by the marginal propensity to consume out of income. Households finance any spending in excess of income out of past savings (accumulated wealth) or by borrowing from the past savings (accumulated wealth) of others. What newly produced products they buy is irrelevant. The stock of real and financial assets adjusts passively to aggregate spending as dictated by the marginal propensity to consume.

The wealth effect is the effect that a change in wealth has on consumption. When household assets increase, they allocate a portion of the increase to new consumption according to the marginal propensity to consume out of wealth (g):

C = f(W) = gW, where g = ΔC/ΔW and 0 > g > 1

When households receive income, it immediately becomes part of their money supply (an asset, one type of wealth). The portfolio balance approach states that households hold (or acquire) alternative types of assets to maximize their satisfaction or total utility. Utility maximization occurs when the marginal utility (or return) from the last dollar spent on each asset is the same:

(MU/P)money = (MU/P)1 = (MU/P)2 = (MU/P)3 = ... = (MU/P)n

(MU/1)money = (MU/P)1 = (MU/P)2 = (MU/P)3 = ... = (MU/P)n

where the price of money is always 1 unit. As long as prices remain the same, households will spend new money balances to acquire all types of assets (real and financial), according to their utility schedules for real goods and services and their desired returns from financial assets to maximize their total satisfaction. If they have too many real assets, they will buy more financial assets. If they have too many financial assets, they will buy more real assets. Once their portfolios of all assets is satisfactory, they will stop spending. Thus, the flow is passive and incidental to the adjustment of their stock positions. If relative prices change, households will once again evaluate the marginal utility or return from alternative assets and adjust their portfolios accordingly. Again, the flow is passive or incidental to the stock adjustment.

The marginal propensity to consume out of income is considered to be relatively stable; however, it is a large percentage of income, e.g., 90%, so that the change in spending from even a small change in income can be very unstable. The marginal propensity to consume out of wealth is considered not to be stable, but it is generally only a small percentage of wealth, e.g., 3% to 15%, so that the change in spending from even a large change in wealth can be very stable. The wealth effect tends to be smaller (3%-6%) for changes in stock prices and larger (12%-15%) for changes in home prices.

The Keynesians Versus the Monetarists

THE CONSUMPTION FUNCTION

C



Ca - bTa
consumptionfn C = Y

C = (Ca - bTa) + b(1-t)Yd
  Ylow          Yb        Yhigh Yd
D = Dissaving = (Y - C) < 0      S = Saving = (Y - C) > 0
Keynesians believe that the income effect dominates consumption decisions and that consumption (consumer expenditure) is primarily a function of current disposable income:

C = f(Yd) = Ca + (b)Yd

As current disposable income changes, households spend more or less, depending on whether current disposable income is rising or falling. In the diagram to the right, the income effect moves households along the consumption function from Ylow to Yhigh, and back again, as income changes.

Monetarists believe that the wealth effect dominates consumption decisions and that consumption (consumer expenditure) is primarily a function of wealth and relative prices.

C/P = f(W; Pa/Pb) = (g)W/P

As wealth changes, the marginal utilities of holding different assets changes and forces households to sell some assets and buy other assets until the marginal untility from the last dollar spent on all assets is the same. Households spend more or less, depending on whether wealth is rising or falling. Wealth is a non-income variable, included in autonomous consumption (Ca). In the diagram above, the wealth effect shifts the consumption function up and down as wealth increases and decreases.

top     Investment

Investment (I) is business spending on newly produced capital goods. By definition, all fixed capital is a final good. Investment spending also includes changes in inventories.

Capital Expenditure versus Amortized Expenditure

Capital expenditure is the actual amount spent annually by businesses on fixed capital goods and changes in inventories (analogous to consumer expenditure). Capital expenditure is "lumpy" and varies widely from year to year, because fixed capital goods are durable and need not be replaced every year. Only the actual amount spent annually provides employment and income to the factors of production. As a result, GDP and employment are unstable from year to year, because capital expenditure is unstable.

Amortized expenditure is the annualized flow of business spending on fixed capital goods and inventories (analogous to consumption expenditure). It is the amount of capital expenditure "amortized" by businesses. The amortized amount is smoothed out over time. As a result, GDP and employment are relatively stable from year to year, because amortized expenditure is relatively stable.

The difference between capital expenditure and amortized expenditure is the same as the illustration for consumer expenditure and consumption expenditure above. Assume that businesses own $50.0 trillion in fixed capital goods at the beginning of the year and that the average life of fixed capital goods is 10 years. The amortization (depreciation) rate is 10% and the annual amortization of the fixed capital is $5.0 trillion. Assume also that businesses spend $10.0 trillion during the year. They spend $6.0 trillion on inventories and $4.0 trillion on fixed capital goods. Capital expenditure for the year is the annual outlay on inventories, $6.0 trillion, plus the annual outlay on fixed capital, $4.0 trillion, or $10.0 trillion. Amortized expenditure for the year is the annual amortization of the fixed capital goods, $5.0 trillion, plus the using up of the inventories, $6.0 trillion, plus the annual amortization on the new fixed capital goods, $400 billion, or $11.4 trillion. At the end of the year, businesses have $50.0 trillion less $5.0 trillion plus $4.0 trillion less $400 billion or $48.6 trillion in fixed capital goods. Assume that, next year, businesses spend another $6.0 trillion on inventories, but they increase their spending on fixed capital goods to $6.0 trillion. Capital expenditure for the year is $12.0 trillion, an increase of $2 trillion. Amortized expenditure for the year is the annual amortization of the fixed capital goods, $4.86 trillion, plus the using up of the inventories, $6.0 trillion, plus the annual amortization on the new fixed capital goods, $600 billion, or $11.46 trillion, an increase of only $60 billion. Amortized expenditure is more stable than capital expenditure. As a mathematical truism, income and employment, as measured by amortized expenditure, are more stable than income and employment, as measured by capital expenditure.

top     Investment Functions

Determinants of Investment

The amount of investment depends upon demand growth (y), expected profitability (e(π)), and interest rates (i).

I = f(y, e(π), i) = d1Y + d2e(π) + d3i, where d1 = ΔI/ΔY > 0, d2 = ΔI/Δe(π) > 0, and d3 = ΔI/Δi < 0

Investment demand is positively related to demand growth and expected profitability, but negatively related to interest rates. If interest rates rise or fall, investment decreases or increases, as businesses move up and down along the investment demand function in response to the interest rate change. If demand growth and profitability expectations change, the investment demand function shifts. If demand grows faster and businesses have expectations of greater profits, the function shifts out. If demand grows slower or contracts and businesses have expectations of lower profits or losses, the function shifts in.

THE INVESTMENT FUNCTION

investment
Investment and Interest Rate Sensitivity

The elasticity of the investment demand function is the sensitivity of investment to changes in the interest rate. It is measured by the absolute value of the percentage change in investment given a percentage change in the interest rate:

|eI| = % change I
% change i

The investment demand function is elastic ( |eI| > 1), when small changes in the interest rate encourage large increases in investment (IM). The investment demand function is inelastic ( |eI| < 1), when large changes in the interest rate bring about only small changes in investment (IK).

The Keynesians Versus the Monetarists

Keynesian economics has often been referred to as "depression" economics. In a depression, demand growth is slow or contracting. Businesses have a lot of excess capacity and their actual stock of capital is generally larger than their desired stock of capital. Businesses' expectations about the future are pessimistic and businesses are highly uncertain about the future of their markets and their profits. They tend to be highly unresponsive to changes in interest rates (0 < eI < 1), because they are simply not interested in accumulating more capital at this stage of the business cycle. In the diagram to the right, the Keynesian investment demand function (IK) is highly insensitive to changes in interest rates.

Monetarist economics is a contemporary version of Classical "full employment" economics. When an economy is at full employment, demand is generally growing very fast. Businesses are operating at their capacity limitations and their actual stock of capital is generally smaller than their desired stock of capital. Businesses' expectations about the future are optimistic and they feel extremely certain about the future of their markets and their profits. They tend to be highly responsive to even small changes in interest rates (1 < eI < ∞), because they are definitely interested in accumulating more capital at this stage of the business cycle. In the diagram to the right, the Monetarist investment demand function (IM) is highly sensitive to changes in interest rates.

top    Money

Money (M) is a generalized claim on all other assets, both now and in the future. Money is a concept and does not change.

The Functions of Money

Unit of account Money measures value (how much something is worth). Price states how many units of money must be paid over to legally discharge a contractual obligation.

Medium of exchange Money serves as generalized purchasing power or value in exchange for all other assets. Tendering it always legally discharges a contractual obligation.

Standard of deferred payment Money is the medium in which contracts are written today for payment or repayment in the future. The contract states how many units of money must be paid over to legally discharge a future contractual obligation. The contract may be for production of a product or money on loan.

Store of value Money stores purchasing power over time. Most people do not spend all of their money right away. However, when they do want to spend it (buy something new, pay off an old debt, consummate a maturing contract), they expect it to buy the same amount of product as when it was received.

The Keynesians Versus the Monetarists

Keynesians view money as liquidity par excellence. They emphasize the medium of exchange function of money and money's ability to get a buyer into the market here and now. Liquidity is the ease of marketability, exchangeability, or resalability of one asset for another. Liquid assets generally do not store value well, but they can buy anything at any time.

Monetarists view money as a temporary abode of purchasing power. They emphasize the spending power of money and money's need to store value over time until the buyer is ready to enter the market. A temporary abode of purchasing power stores purchasing power until such time as the buyer wants to enter the market. Assets that serve as good stores of purchasing power are generally not the most liquid assets.

top    Money Supply

Money supply (Ms) is the asset or group of assets that society sets aside for buyers' claims. While the concept of money is universal and immutable, the supply of money is not. At one time or another, grains, cattle, salt, wool, arrowheads, beads, shells, fishhooks, and metals have been used as money. Whale teeth served as money in the Fiji Islands, tobacco functioned as money in the American colonies, and cigarettes performed the function of money in POW camps during WW II and the Korean and Vietnam conflicts. In today's economic setting, token coins, paper notes, and demand deposits are acceptable monies. Some would go so far as to include savings accounts, money market mutual fund, and T-bills. What is included in the money supply depends upon various social and technical conventions and upon which part of the definition of money is emphasized.

Types of Money Supplies

Full-bodied money is commodity money — commodities (cotton, corn, tobacco, precious metals). However, because commodities have value in use (intrinsic value), their intrinsic values change over time. Except for the precious metals, commodities make poor money supply assets.

Representative full-bodied money is paper money. The intrinsic value of paper is 0. It has little or no value in use. It has value only in exchange. However, the exchange value of the paper is the intrinsic value of the underlying commodity and, since intrinsic values change over time, so does the value of the paper. Therefore, representative full-bodied monies, like their underlying commodities, tend to make poor money supply assets.

Fiat money is full-bodied, representative full-bodied, or paper money authorized by decree of the government. Fiat money is legal tender good for all debts public and private. Its exchange value is the value imputed by the government decree. Fiat money may have value in use, but the government decree that the fiat money can be used to pay taxes (and everyone must eventually pay taxes) generally gives it preferential value in exchange, especially if its exchange value is decreed to be greater than its intrinsic value. Therefore, fiat monies tend to make good money supply assets.

Credit money is a debt — a note, an IOU. A note is a written promise to repay a debt. The paper has virtually no intrinsic value — little or no value in use, but the note can be negotiated and exchanged for any amount up to the debt. The note's exchange value is greater than its intrinsic value. It has no value in use, only value only in exchange. Therefore, credit monies tend to make good money supply assets.

Axiom of Gross Substitution

The axiom of gross substitution states that all assets are perfect substitutes for all other assets. If all assets are prefect substitutes for one another, then the economy boils down to barter. All assets store value and any one of them can be exchanged for anything else at any point in time. If all assets do not store value equally, then they cannot be perfect substitutes for one another. They cannot be exchanged for everything else at any point in time. When assets are not perfect substitutes for one another, the economy needs to identify and segregate those assets which have the greater degree of substitutability to serve as money to exchange for all other assets with lesser degrees of substitutability.

Substitutability is the degree to which one asset may be readily exchanged for another asset. It is similar to liquidity, which is the ease with which one asset may be exchanged for another with little or no change in value. The substitutability or liquidity of assets is determined by analyzing the siz (6)properties of all assets:
  1. Portability The asset is easy to carry around. The asset must be light in weight and small in bulk relative to its value.

  2. Recognizability The asset is easy to identify and its value is easily recognized. The asset must be capable of standardization at a point in time. All units must be identical or homogeneous.

  3. Durability The asset is durable and does not deteriorate or depreciate over time. The asset must be capable of standardization over time.

  4. Divisibility means that the asset is capable of being divided into smaller units without losing value. The value of the asset must equal the sum of its parts.

  5. Non-reproducibility The asset is not capable of being reproduced on demand or counterfeited.

  6. Predictability of value The asset has a fixed price.
The assets that have the most of these properties are the most substitutable or the most liquid assets. They require no intermediate transaction and can be used on the spot to obtain other assets. Some assets, like cash, are perfect substitutes for all other assets. The liquidity or elasticity of substitution of cash for other assets is infinite (esubs = ∞). Other assets, like old jogging sneakers, are probably not substitutable in any circumstance. Their liquidity or elasticity of substitution is zero (esubs = 0). Other assets may have limited liquidity or substitutability in certain circumstances, like an old car on a trade-in. Their elasticities vary between zero and infinity (0 < esubs < ∞).

Which asset or group of assets best serve(s) the functions of money?

Medium of Exchange An asset or group of assets must have the most liquidity or the highest degree of substitutability (1 < esubs ≤ ∞) to serve as a medium of exchange. These assets have an instantaneous command over all other assets and allow individuals to go directly into the market without any intermediary transaction. However, they generally contain little or no protection against loss of purchasing power between receipt and expenditure and, as a result, are not necessarily good stores of value.

Store of Value That asset or group of assets which best protects purchasing power between receipt and expenditure. As a store of value, these assets will have either a rate of return or price appreciation. However, they may also depreciate in value between receipt and expenditure and/or require an intermediate transaction for entry into the market. As a result, they are not ncessarily good media of exchange. Their liquidity or degree of substitutability is very low (0 ≥ esubs < 1)

The Federal Reserve maintains, calculates, and monitors a variety of definitions of money supply based upon the substitutability or liquidity of the assets.

HOW THE FEDERAL RESERVE MEASURES THE MONEY SUPPLY

Currencythreequal + Coins minted by the US Treasury
+ Federal Reserve notes issued by Federal Reserve Banks
Currency outside the Treasury and Federal Reserve (CT)threequal + Currency held by the public (Cp)
+ Currency in bank vaults (Cb)
Total reserves for the banking system (RT)threequal + Currency in bank vaults (Cb)
+ Bank reserve deposits at the Federal Reserve (RF)
Monetary Base (B)threequal + Currency (CT)
+ Bank reserve deposits at the Federal Reserve (RF)
M1threequal + Currency in the hands of the public (Cp)
+ Demand deposits and other freely checkable accounts at depository institutions (D)
+ Traveler's checks
M2threequal M1
+ Savings deposits (S)
+ Small-denomination time deposits at depository institutions (T)
+ Money market deposit accounts (MMDA)
+ Personal money market mutual fund balances (MMMF)
+ Overnight repurchase agreements at commercial banks (RP)
+ Overnight Eurodollars held by US residents at Caribbean branches of Fed member banks (ED)
M3threequal M2
+ Large-denominated time deposits at all depository institutions (T)
+ Term repurchase agreements at commercial banks and S&L associations (RP)
+ Term Eurodollars (ED)
+ Institution-only money market mutual fund balances (MMMF)
MZMthreequal M2
+ Institutional money market mutual fund balances (MMMF)
- Small-denomination time deposits at depository institutions (T)
Lthreequal M3
+ Term Eurodollars held by US residents (ED)
+ Banker's acceptances (BA)
+ Commercial paper (CP)
+ Treasury bills and Other Treasury securities maturing within one year
+ US savings bonds

The Keynesians Versus the Monetarists

Keynesians believe that not all assets are equally capable of storing value and that the elasticity of substitution of all assets ranges from zero to infinity (0 ≤ esubs ≤ ∞). Keynesians believe that only financial assets, not real assets, are capable of storing value. Orderly, well-organized spot markets exist for financial assets, but not for real assets. Substitution may occur between and among financial assets, but not between and among real assets, and only some financial assets are capable of universal substitution. Therefore, the Keynesian money supply consists solely of cash and checking accounts or what the Federal Reserve defines very narrowly as M1.

Monetarists believe that all assets are equally capable of storing value and that the elasticity of substitution among all assets is infinite (esubs = ∞). Monetarists presume that, in the long run, orderly, well-organized spot markets exist for all assets so that all assets are perfect substitutes for one another. Therefore, the Monetarist money supply includes the Keynesian money supply plus a host of other assets that act as temporary stores of purchasing power, e.g. savings accounts, CDs, etc. or what the Federal Reserve defines more broadly as M2. In the limit, all other assets can serve as stores of purchasing power so that the Monetarist economy reduces to the Classical (barter) system, where money is simply a "veil" that determines the absolute level of prices (Axiom of Gross Substitution).

top    Money Demand Functions

The shape and position of the money demand function depend upon the reasons why people want to hold money. These reasons are the transactions motive, the precautionary motive, the speculative motive, and the finance motive.

THE MONEY DEMAND FUNCTION

stability
The most obvious reason for holding money is to spend it. Thus, every time money income is received, a portion will be held as money to make ordinary disbursements. When income increases, people spend more and the demand for money for transaction purposes increases. When income decreases, people spend less and the demand for money for transaction purposes decreases. Since spending increases and decreases as income increases and decreases, money held as transactions balances is a positive function of income:

Md = f(Y) = k1Y, where k1 > 0.

Precautionary Motive

People hold money as a precautionary measure in case of an emergency. Money held as precautionary balances is generally held in some ratio to income to provide for a given standard of living in an emergency, e.g., the average family of four living in an urban area should have set aside six months of income in liquid assets as a contingency. Additional money will be held as precautionary balances depending on the state of expectations about the future and the degree of uncertainty about the economy. If the economy is doing well, jobs are plentiful, workers are advancing, incomes are increasing, and money is easy to get, the demand for money for precautionary purposes will be small. However, if the economy is not doing so well, the job market is weak, promotions are not forthcoming, incomes are stagnant or falling, and workers are afraid that they might lose their jobs, the demand for money for precautionary purposes will be much greater. Thus, money held as precautionary balances is positively related to income and uncertainty:

Md = f(Y, µ) = k2Y + zµ, where k2 and z > 0.

Stability in the money demand function is the degree to which the money demand function remains in place and is predictable for long periods of time (M0). Instability is when the money demand function shifts around erratically from M2 to M1 and then back to M2. Changes in income and uncertainty create instability in the money demand function.

Speculative Motive

Financial asset prices vary inversely to their fixed returns and these returns vary over some "interest rate cycle." People hold money to speculate on asset prices (buy low, sell high or sell high, buy low) as interest rates move over their cycle.

Bonds are an example of a fixed return asset. Bonds come with a fixed-rate per annum coupon payment. Their alternative, cash, earns nothing. Bond prices rise as interest rates fall and bond prices fall as interest rates rise. As interest rates rise, the opportunity cost of holding cash increases and individuals economize on cash and buy bonds. When interest rates reach some perceived peak, cash is drawn down to zero and everyone holds bonds. Holding bonds affords individuals both high interest income and future capital gains (when interest rates fall). As interest rates fall, the opportunity cost of holding cash decreases and individuals sell their bonds, take their capital gains, and hoard cash to wait for the next cycle. When interest rates reach some perceived low, and no additional capital gains can be made from holding bonds, all bonds are sold and everyone holds cash. At this point, the demand for money is perfectly elastic at imin.

THE MONEY DEMAND FUNCTION

moneydemandfnelasticity
Elasticity of the money demand function is the sensitivity of the quantity demanded of money to changes in the interest rate. It is measured as the absolute value of the percentage change in the quantity of money demanded given a percentage change in the interest rate:

|em| = % change qD(Ms)
% change i

The more elastic is the money demand function (MdK), the more responsive the quantity demanded is to small changes in the interest rate. The less elastic is the money demand function (MdM), the less responsive the quantity demanded is to small changes in the interest rate.

Two real world assumptions increase the elasticity of the money demand function, but keep it from becoming perfectly elastic: differential expectations about the direction of interest rates and the number and variety of available financial instruments.

First, not all individuals think alike or hold identical expectations about the direction of interest rates (where an economy is on its interest rate cycle). As interest rates rise, different individuals with different interest rate expectations will decumulate money held for speculative purposes at different rates and buy bonds. As interest rates continue to rise, various individuals will begin to think that rates have peaked and that bond prices have reached bottom. They will hold all bonds and no cash. As interest rates rveerse themselves and fall, bond prices will rise. Different individuals with different interest rate expectations will start to sell off their bonds and accumualte money for the next interest rate cycle. As interest rates continue to fall, other individuals will believe that interest rates have fallen to their lowest levels and will sell all of their bonds, take capital gains, and accumulate money to speculate on the next interest rate cycle.

Second, individuals are not limited to just two alternatives: cash and bonds. They have a variety of financial assets with varying degrees of risks and returns from which to choose. Varying risk-return preferences draw individuals through the spectrum of interest-bearing assets. This variety smoothes out the demand for money function and makes it more interest-inelastic. To the extent that switching involves transaction costs — transportation to and from the bank, brokers commissions, etc. — and some element of risk, nominal interest rates will have to be higher; but the same principles for the speculative motive hold. The higher the return from other financial assets, the less money individuals will hold. The lower the return from other financial assets, the more money individuals will hold. Thus, the demand for money balances for speculative purposes are negatively related to interest rates, subject to imin and any liquidity trap:

Md = f(i) = - lli, where ll < 0, s/t imin.

Finance Motive

Finance Motive When individuals want to buy something beyond their current means, they must borrow to finance the purchase. This desire to spend in excess of current income results in an increase in the demand for money from financing. The demand for finance is positively related to income (from which repayment is made) and negatively related to interest rates (the opportunity cost of financing):

Md = f(Y, i) = k3Y + l2i, where k3 > 0 and l2 < 0.

The Keynesians Versus the Monetarists

Keynesians believe that money is wanted for all four reasons:

Md = f(Y, i, µ)

The Keynesian money demand function is very unstable, because changes in income and changes in uncertainty tend to dominate the location of the money demand function. The Keynesian money demand function (MdK) is also considered to be very sensitive to changes in the interest rate (1 < em < ∞), because of the speculative motive. At some minimum interest rate (imin), the opportunity cost of holding money balances is considered to be zero, since the interest rate or yield on bonds is not sufficient to cover the risk and transaction costs of conversion. At this point, the money demand function becomes perfectly elastic (em = ∞), and the economy is in a "liquidity trap." In the absence of a pure liquidity trap, the Keynesian money demand function (MK) is highly elastic (em > 1).

Monetarists believe that money is wanted only for the transactions motive:

Md = f(Y)

The transaction motive is tied to income. As a result, the Monetarist money demand function (MdM) is considered to be relatively stable or predictable (at least in so far as income is stable or predictable) and it is not very sensitive to changes in the interest rate (em ⇒ 0), because it is tied to income, not interest rates.

top     Money Supply Functions

The money supply function (Ms) relates the quantity of money supply to interest rates. The supply of money is determined partly exogenously or autonomously by the central monetary authority and partly endogenously or induced by economic activity and economic participants.

Exogenous Determination of the Supply of Money

Exogenous determination of the money supply is when the amount of money supply in circulation can be determined independent of economic activity. The central monetary authority has the ability through use of its policy tools to determine the exact amount of money supply in circulation. In the U.S., Federal Reserve credit — open market operations (OMO) and lending at the discount window (d), the term auction facility (TAF), or one of the other newly created credit facilities (CFs) — determines the monetary base (high powered money) (B) and reserve requirements (r) determine the amount of loans banks can make to expand the money supply from the monetary base.

Ms = f(OMO, d, TAF, CF, r)

Given the manipulation of these policy tools, the money supply is perfectly inelastic at some maximum amount (Ms0) from base B0.

THE MONEY SUPPLY FUNCTION

i-rate
          moneys
Federal Reserve Credit (OMO, d, TAF, CFs) When the Fed buys securities, lowers the discount rate, or increases credit extension at TAF and other CFs, the base expands from B0 to B1 and the money supply expands from Ms0 to Ms1 (the solid line ___ shifts right). When the Fed sells securities, raises the discount rate, or decreases credit extension at TAF and other CFs, the base contracts from B0 to B2 and the money supply contracts from Ms0 to Ms2 (the solid line ___ shifts right).

Reserve Requirements (r) When the Fed lowers reserve requirements, base B0 can be expanded all the way to Ms1 (the dotted line - - - shifts right). When the Fed raises reserve requirements, base B0 can be expanded only to Ms2 (the dotted line - - - shifts left).

Endogenous Determination of the Supply of Money

Traditional theory assumes that the money demand function and the money supply function are independent of one another, so that an autonomous change in the money supply by the central monetary authority will change the interest rate and the quantity demanded of money by predictable amounts. Interdependence of the money demand function and the money supply function refers to the ability of changes in the money demand function to cause changes in the quantity supplied of money. The supply of money is partially a function of the demand for money.

Endogenous determination is the effect that changes in economic activity and the actions of economic participants have on the money supply. Endogenous determination (sometimes called reverse causation) occurs when a change in economic activity causes a change in the demand for money and the change in the demand for money changes the supply of money. The two sides of the money market are no longer independent of one another, but rather they are interdependent on one another.

Endogenous determination is especially prevalent in five situations: a fractional banking system, an open economy, an economy in which the government can freely issue and circulate its own coin and currency independent of the central monetary authority, the existence of foreign reserves and lender of last resort faciltiies, and the substitutability of money assets for one another. Each of these situations allows for an economic participant other than the central monetary authority to change the monetary base (from B0 to B1 or B2) and the amount of money (from Ms0 to Ms1 or Ms2).

The first situation is when banks are not required to back all of their deposits with reserves. In a fractional banking system, commercial banks can alter the money multiplier and the money supply with their excess reserve holdings and lending policies. Commercial banks can expand the money supply from any given monetary base (B0) by responding to an increase in loan demand and contract the money supply with the same monetary base (B0) when loan demand falls or loans are repaid and not renewed.

The second situation is when the economy is open to monetary transactions with other countries. In an open economy with cross-border transactions, part of the original domestic money supply flows in and out of the country in response to trade and capital flows. When the country has a trade surplus or relatively high interest rates, money flows in to the country and the money supply and the monetary base increase. When the country has a trade deficit or relatively low interest rates, money flows out and the money supply and the monetary base decrease. Money also flows into and out of a country because of various unilateral transfer payments, like private gifts, public gifts (economic and military aid), interest paid to foreigners holding the domestic government's securities, and reparations payments.

The third situation is when the government can freely issue and circulate its own coin and currency independent of the central monetary authority. New issues increase the money supply and the monetary base. Redemption of old issues decrease the money supply and the monetary base. [NOTE: The U.S. Constitution gives Congress the power only to mint coin, not to print currency. However, the Treasury may issue gold and silver certificates backed or represented by its stock of the precious metals.]

The fourth situation is when commercial banks have access to reserves outside of their immediate reserve deposits. This access occurs when an economy is open and banks have access abroad to borrow from foreign reserves, as U.S. banks do in the Eurodollar market (and vice versa), or when they have the facility to borrow domestically at a credit facility of the central monetary authority.

The final situation is when money assets are substitutable for one another and individuals change the composition of the money supply assets they are holding. When they shift from cash to demand deposits to time deposits and back again, they change the money multiplier. Any monetary base can then be expanded to a larger or smaller money supply, depending on the asset shift. A switch from cash into demand deposits increases the multiplier and a shift from demand deposits into cash decreases the multiplier.

The Keynesians Versus the Monetarists

Keynesians believe that the demand for money and the supply of money are interdependent. They assume that the money supply is determined partly exogenously by the central monetary authority and partly endogenously by the demand for money and bank lending policies. As economic activity rises and falls, changes in the demand for money cause changes in the supply of money.

Monetarists believe that the supply of money is independent of the demand for money. They assume that the supply of money is determined exogenously by the central monetary authority and that the demand for money is driven by individuals' tastes and preferences as reflected in their utility schedules and the system of relative prices of other assets. They also assume that, although private economic activity and economic participants may influence the money supply, the central monetary authority has the ability, through use of its policy tools, to offset private sector fluctuations to control the amount of money in circulation.

top     Equation of Exchange

The equation of exchange shows a relationship among the money supply, its circulation, and what money can buy.

Ms x V identity P x T,

where Ms is the supply of money, V is the velocity or rate of circulation of the money supply, P is the general level of prices of all transactions, and T is the number of transactions. Its precise form depends upon the type of production economy.

Types of Production Economies

credit
A barter production economy has only real assets. Buyers and sellers exchange real assets for real assets. Real assets have intrinsic value (value in use) as well as extrinsic value (value in exchange). A barter economy has NO money and NO financial assets. It consists solely of a "real" sector and has no "financial" sector.

The barter economy is a system of relative prices. All assets are valued in terms of all other assets. Buyers and sellers must know the relative prices of all assets (Pa/Pb). As the number of assets increases, the number of relative prices increases geometrically (n(n-1)/2). Prices continually vary in response to supply and demand.

The barter economy requires a double coincidence of wants. The buyer must have a real asset, which the seller wants, in exchange for what the seller has for the buyer. Otherwise, trade involves intermediate transactions until the buyer and seller have acquired what each other wants. Specialization and division of labor is very difficult. People do not always want to work for the real assets that the employer is giving as compensation. Even the government is reduced to collecting taxes as real assets and, then, it has only these real assets to spend.

A barter economy has a very low investment rate. Real investment (capital formation) must come directly from real saving. Any capital formation that does occur generally comes from the owner. For example, a farmer must set aside some of his crop from this year to get the seeds to plant next year. Tying up real saving in real investment is extremely risky. Fixed capital is difficult to accumulate, because businesses that manufacture fixed capital do not necessarily manufacture the same equipment that they use in the manufacture of the new capital. If they did, they would have to take time away from the manufacture of the new capital to make their own equipment. Because saving must precede investment, the whole process is tedious and time-consuming.

A barter economy has a very little borrowing and lending. Future repayment requires a contract written in terms of real assets that are acceptable to both parties; but, the value of these real assets may change drastically by the time future payment is due. As a result, growth and development occur at an extremely slow rate.

credit
A monetary production economy occurs when buyers and sellers agree to set aside one or more real assets to serve the functions of money (e.g., gold). Money is a generalized claim on all other assets. The asset or assets which serve as money are called the money supply (Ms). Buyers must always have money to exchange for the seller's real assets. The rate at which money is spent or circulates to buy real assets is called velocity (V).

The equation of exchange shows the relationship between money, its velocity, and the things that are being bought. The transactions version explains how the supply of money, circulating through the economy, generates an equal and offsetting volume of nominal transactions:

Ms x V identity P x T,

where Ms is the supply of money, V is the velocity or rate of circulation of the money supply, P is the general level of prices of all transactions, and T is the number of transactions. The income version shows how the supply of money, circulating through the economy to buy newly produced final products, generates an equal and offsetting volume of income for the resources:

Ms x Vy identity P x Q identity Y

where Ms is the supply of money, Vy is the income velocity of money, P is the general level of prices for newly produced final products, Q is the volume of real output of newly produced final products, and Y is nominal income paid to the resources. In the above diagram, the simplest form of the equation of exchange is illustrated by M1 x V1 identity P1 x Q1 identity Y.

The introduction of money improves upon the barter production economy.
  1. Money establishes a uniform set of ABSOLUTE prices. Money becomes the standard for valuing all other assets (Pa/monetary unit = Pa/1). Prices are measured in absolute terms and people have only to compare the absolute prices to determine value.

  2. Money is a generalized claim with fungible properties. It separates the sale of a product or asset from the purchase of a product or asset and eliminates the double coincidence of wants. Anyone, including governments, can use anyone else's money to enter any market to buy any product or asset.

  3. Money allows for increased specialization and division of labor. Any individual can go to work for any employer, receive an income in the form of money, and then spend that money in any market at any time.

  4. Money facilitates borrowing and lending. Contracts for principal and interest are written in money terms. Both parties know exactly what the future value of the contract is, because the value of money does not change.

  5. Money simplifies the investment process. Nominal investment comes from nominal saving (the accumulation of money by surplus income units). The investor does not have to be the saver.

  6. The introduction of money gives government a uniform tax basis for levying and collecting taxes. All tax bases can be measured in money and governments can tax and spend money just like the private individuals and businesses.
In a functional monetary production economy, money circulates through the real sector to buy newly produced products and to create employment and income.

M1 x V1 identity P1 x Q1 identity Y

In a dysfunctional monetary production economy, some money circulates to buy capital sinks.

M2 x V2 identity P2 x Q2

Capital sinks include land, objets d'art, sacred cows, relics, and underground activities like prostitution, drugs, and gambling. Capital sinks do not create income and employment. They are simply asset transfers. They drain money from its circulation in the production economy.

credit
A credit production economy has real assets and financial assets. Financial assets have no intrinsic value. Their value is determined by the amount printed on them. They have value in exchange, but no value in use. In a credit production economy, buyers and sellers set aside one or more real and/or financial assets to serve as money.

In a credit production economy, money may be borrowed and loaned in anticipation of spending. To induce hoarders to become lenders, borrowers must offer a return to compensate the lender for the opportunity cost of hoarding, either speculating or buying into capital sinks, and for the risks associated with lending. The higher these opportunity costs and risks, the higher the return which must be paid as compensation. However, when high returns must be paid to lenders, even higher returns must be earned from the use of money. The higher the required return in use, especially, in investment, the fewer the number of capital projects which will be profitable and, hence, undertaken and the slower the rate of both velocity and capital accumulation for growth and development. Velocity can be increased by reducing risk and increasing liquidity for the lender. Reduced risk and increased liquidity can be accomplished through intermediation in the form of either semi-direct (mutual funds) or indirect finance (financial intermediaries like banks and thrift institutions). In fact, the vital roles played by financial intermediaries are to make that which is more risky less risky and to make that which is less liquid more liquid.

In a functional credit economy, money circulates from the real sector through the financial sector and back to the real sector to create income and employment.

M1 x V1 identity P1 x Q1 identity Y

In a dysfunctional credit economy, some money circulates in the real sector, but some money circulates only in the financial sector for speculation and never finds its way back to the real sector.

M3 x V3 identity P3 x Q3

Like capital sinks, speculation does not create income and employment. It is simply an asset transfer and drains money from its circulation in the production economy.

The Equation of Exchange is an Identity

An identity is a representation of a relationship where both sides are perfectly equal because they have been defined in such a way to be equal. Each side carries equal weight. Neither side is independent (cause) and neither side is dependent (effect). If either side changes, however, an identity states that the other side must change by the same magnitude and in the same direction. When one side changes, the other side changes, but nothing in an identity indicates which side will actively change and which side will passively respond.

The equation of exchange is an identity. It holds by definition. As an identity, the equation of exchange states that effective aggregate demand must equal aggregate supply, or, more simply stated, the sum of all purchases must equal the sum of all sales. When purchases change, sales must change. When sales change, purchases must change. However, the identity does not say which side is cause and which side is effect. It does not say whether the seller makes the offer and the buyer accepts or the buyer makes the offer and the seller accepts. It just delineates a relationship where both sides must change simultaneously or not at all.

COMPARISON OF THE TRANSACTIONS VERSION WITH THE INCOME VERSION

Transactions Version
Ms x V indentity P x T


Income Version
Ms x Vy indentity P x Q


All transactions: Final goods and services

Intermediate goods

Resale goods

Financial transactions

Underground economy

Unrecorded legitimate transactions

Illegitimate transactions
Gross National Product (GNP): Total market value of all newly produced final goods and services for an economy during the year

Gross Domestic Product (GDP): Total market value of all newly produced final goods and services within an economy during the year

GDP = GNP - net flow of factor income
GNP =

+ Consumption

+ Investment

+ Government spending

+/- Tax transfers

+ Exports

- Imports

The transactions version explains how the supply of money balances, circulating through the economy, generates an equal and offsetting volume of nominal transactions:

Ms x V identity P x T,

where Ms is the supply of money, V is the velocity or rate of circulation of the money supply, P is the general level of prices of all transactions, and T is the number of transactions. All assets become completely interchangeable (Axiom of Gross Substitution).

The income version shows how the supply of money, circulating through the economy to buy newly produced final products, generates an equal and offsetting volume of income for the resources:

Ms x Vy identity P x Q identity Y,

where Ms is the supply of money, Vy is the income velocity of money, Q is the volume of real output of newly produced final products, and Y is nominal income paid to the resources. Since GNI includes only transactions for newly produced final products, the money supply so circulating yields GNP (= PQ), where Q is the quantity of newly produced final products and P is a measure of their prices.

GNP identity Ms x Vy identity P x Q identity GNI

GNP identity GNI

Not all assets, especially, real and financial assets, are completely interchangeable. Money is an asset separate and distinct from all other assets, both real and financial assets.

top     Money Market Equilibrium

Money market equilibrium is an identity (a variation of the equation of exchange) that shows money "sitting" rather than "circulating":

Ms identity ( 1
Vy
)PQ identity kPQ identity Md

where "k" is the inverse of velocity: k = 1/V. "k" is often called the Marshallian k, after the 19th century economist, Alfred Marshall, who first used it. "k" is used by both schools. However, it is constant, stable, or predictable in the Classical and Monetarist models and it is variable or unstable in the Lockean and Keynesian models.

top     Causation

Causation is the direction of action and reaction among the variables. Causation makes certain assumptions about what is cause and what is effect. The process of making assumptions began in the 16th century with the argument that the inflow of gold and silver from the Americas was causing inflation in Europe. The conquistadors who followed Columbus to the Americas sent back to Spain large amounts of gold and silver that they obtained from plundering the Aztec and Incan empires and from mining. As this metal was coined, the amount of money in circulation rose, and at the same time prices began a slow, century-long rise.

The equation of exchange can be rewritten in functional form to show causation. As a functional equation, the equation of exchange shows which variables are independent (the "actors") and which variables are dependent (the "reactors"). The equation of exchange can be turned into many different functional equations. Each equation is used by a different methodological school. The only equation that both schools use in common is the Marshallian money market equilibrium equation, which is really an identity.

The Keynesians Versus the Monetarists

Keynesians are contemporary Mercantilists (15th to 18th century "economists"). The Mercantilists believed that economies needed a certain amount of money to support the "needs of trade." This Mercantilist belief is more commonly known as the Money Stimulates Trade Doctrine:

Q = f(Ms)|Vy, P or Q = MsVy
P

where velocity (Vy) and prices (P) are considered to be constant, and the absolute amount of money supply (Ms) in circulation determines the real output (Q). Taking the natural log of the Money Stimulates Trade Doctrine formula and then its derivative over time:

ln(Q) = ln(Ms) + ln(Vy) - ln(P)

d{ln(Q)}/dt = d{ln(Ms)}/dt + d{ln(Vy)}/dt - d{ln(P)}/dt

%ΔQ = %ΔMs + %ΔVy - %ΔP

%ΔQ = %ΔMs + 0 - 0

yields the conclusion that a percentage change in the money supply (%ΔMs) leads directly to an equal and offsetting percentage change in real output (%ΔQ), ceteris paribus (if velocity and prices are constant). This functional version of the equation of exchange removes money as a "veil," since the amount of money supply in circulation has a direct impact on the real sector of the economy.

The Mercantilists understood all too well, from their experience with the hyperinflations in Spain and Portugal, that too much money could be bad for an economy. Too much money could cause inflation (%ΔMs ⇒ %ΔP). However, they firmly believed that too little money was far worse. Too little money hampered the ability of people to buy wares from the merchants. The Mercantilists believed that a certain level of money supply was necessary to support a certain level of "trade" (real output) and that a percentage change in the money supply led directly to an equal and offsetting change in real output, ceteris paribus.

John Locke was a 17th century philosopher, who wrote about monetary economics. Locke shared the economic "theories" of his Mercantilist contemporaries. However, he took the Mercantilist "Money Stimulates Trade Doctrine" one step further. He observed that money was used not only as a medium of exchange (money circulating), but also as a store of value (money sitting), and that the velocity of money decreased when people hoarded money. He opined that economies could possibly never have enough money to support the needs of trade, if money was hoarded as a store of value. The Lockean Version of the equation of exchange states that

Vy = f(1/Ms)|PQ or Vy = PQ
Ms

where nominal output (PQ) is constant (does not change), because any increase in the money supply (Ms) is offset by a decrease in its circulation (Vy) or an increase in hoarding (k):

k = Md = f(Ms)|PQ or k = Md = Ms
PQ

Locke believed that one reason for hoarding money was low interest rates and, in contravention of traditional Mercantilist thinking, he warned governments not to set interest rates too low or people would simply hoard more additional money and not lend it.

THE LIQUIDITY PREFERENCE FUNCTION

interest
rate


imin
investment
Money supply
Keynes converted Locke's observations into his now famous liquidity preference function. The liquidity preference function shows the negative relationship between the quantity of money people want to hold (Md) and the interest rate,

k = Md = f(i)

The liquidity trap is that portion of the liquidity preference function where the demand for money becomes perfectly elastic at some low interest rate (imin). The actual minimum rate depends upon historical context and cannot be determined a priori. At or below this minimum rate, spending stops, lending stops, and nominal output (PQ) stays constant, because people prefer to hold all money. Even if the central monetary authority throws money at economic participants (pure quantitative easing), they prefer to hoard it rather than spend or lend it, so that a liquidity trap makes stimulating a weak economy very difficult.

Keynes hypothesized that people prefer liquidity to return. Liquidity gets people into the market place in an emergency; returns do not. If people have the choice between holding cash (liquidity) and bonds (returns), they will generally prefer to hold cash rather than bonds, because bonds must be sold to raise cash to get into the market and this intermediary step of converting bonds to cash to get into the market may hurt bondholders.

Bondholders will be hurt, if they need to sell their bonds prior to maturity and interest rates have risen since purchase. They will suffer capital losses that may wipe out all of their interest returns. Hence, people will give up liquidity (divest themselves of cash) to buy bonds only when interest rates are sufficiently high to cover the risk of an adverse movement in interest rates after purchase (along with the risks of lending and the transaction costs of moving back and forth between cash and bonds). When interest rates are perceived to be too low (imin), they will refuse to buy bonds and will hoard cash.

The liquidity trap is a variation of the Lockean version of the equation of exchange, using the Marshallian k (the demand for money) rather than the velocity of money, to explain why increasing the money supply does not necessarily stimulate trade. Nominal output cannot increase without an increase in spending. Yet, spending will not increase unless interest rates fall. The central monetary authority, however, cannot push down interest rates by increasing the money supply, because people refuse to buy bonds with the new money. They hoard it. Hence, interest rates do not fall; spending does not increase; and output flounders. A central monetary authority cannot be successful in lowering interest rates and stimulating a weak economy, if people prefer to hoard the additional money rather than spend it.

Finally, the Keynesians believe in two-way causation, namely, that economic activity has a feedback effect on the money supply. Keynesians call this feedback effect reverse causation. However, reverse causation is essentially equivalent to endogenous determination of the money supply. With reverse causation, a change in any of the variables — prices (P), real output (Q), or velocity (Vy) — causes the demand for money to change and a change in the demand for money causes the money supply (Ms) to change. The money supply is no longer an exogenous variable to be controlled by the central monetary authority, but rather it is an endogenous variable, determined by the level of economic activity and the demand for money. The whole process is outside the control of the central monetary authority and impedes the ability of the central monetary authority to influence output or prices.

Monetarists are contemporary 19th century Classical economists. The Classical economists believed in one-way causation: money supply determines prices. The Classical economists espoused the Quantity Theory of Money:

P = MsVy
Q
or P = f(Ms)|Vy, Q

where velocity (Vy) and real output (Q) are assumed to be constant, and the absolute amount of money supply (Ms) in circulation determines the absolute level of prices (P). Taking the natural log of the Quantity Theory formula and then its derivative over time:

ln(P) = ln(Ms) + ln(Vy) - ln(Q)

d{ln(P)}/dt = d{ln(Ms)}/dt + d{ln(Vy)}/dt - d{ln(Q)}/dt

%ΔP = %ΔMs + %ΔVy - %ΔQ

%ΔP = %ΔMs + 0 - 0

yields the conclusion that a percentage change in the money supply (%ΔMs) leads directly to an equal and offsetting percentage change in prices (%ΔP), ceteris paribus (if velocity and output are constant). This version of the equation of exchange is rather rigid. It makes money a "veil" that determines only the absolute level of prices and has no affect on the level of real output or trade.

Monetarists (and supply-side economists) also believe in one-way causation, but they are less rigid about the impact that money supply has on nominal income. Monetarists espouse the New Quantity Theory of Money:

PQ = Y = MsVy or PQ = Y = f(Ms)|Vy

where velocity (Vy) is assumed to be constant, and the absolute amount of money supply (Ms) in circulation determines the absolute level of nominal output (PQ). Taking the natural log of the New Quantity Theory formula and then its derivative over time:

ln(PQ) = ln(Ms) + ln(Vy)

d{ln(PQ)}/dt = d{ln(Ms)}/dt + d{ln(Vy)}/dt

%Δ(PQ) = %ΔMs + %ΔVy

%Δ(PQ) = %ΔMs + 0

yields the conclusion that a percentage change in the money supply (%ΔMs) leads directly to an equal and offsetting percentage change in nominal output (%Δ(PQ)), ceteris paribus (if velocity is constant or, at minimujm, stable and predictable). This modified version of the equation of exchange allows for changes in the money supply to affect real output. However, the impact of money on real output depends upon its relationship to natural output.

Natural output is the maximum sustainable amount of output that an economy can produce without an increase in the rate of inflation. It is the equivalent of full employment. If actual output is below natural output (Qa < Qn), then an increase in the money supply will increase real output (%ΔMs ⇒ %ΔQ). As actual output comes closer to natural output (Qa ⇒ Qn), the impact of an increase in the money supply is felt less in additions to output and more in rising prices (%ΔMs ⇒ %ΔP).

The Value of Money

The value of money is its purchasing power:

Ms = 1
P

When prices go up, the value of money goes down. When prices go down, the value of money goes up.

top    Monetary Policy

Monetary policy is the act of manipulating the money supply and/or interest rates to influence macroeconomic activity.

The Keynesians Versus the Monetarists

Keynesians believe that monetary policy is transmitted to the products markets indirectly through the financial markets by the affect that a change in the money supply has on interest rates:

ΔMs ⇒ Δi ⇒ ΔI ⇒ ΔQ ⇒ ΔLe ⇒ ΔU

An increase in the money supply decreases interest rates and the decrease in interest rates increases investment in new capital goods by businesses. The increase in business spending on new capital goods induces capital goods manufacturers to hire more workers to produce the new capital goods. The capital goods producers pay out additional income to the new workers who then spend part of their additional income on consumer goods (according to the marginal propensity to consume out of income). The increase in spending on consumer goods draws down inventories and induces consumer goods businesses to order more consumer goods. Consumer goods producers hire more workers to produce the new consumer goods. The consumer goods producers pay out additional income to the new workers who then spend part of their additional income on additional consumer goods (according to the marginal propensity to consume out of income). The cycle repeats itself. Because the marginal propensity to consumer out of income is positive, but less than one, these cycles eventually peter out as the economy reaches a new, higher income and output level.

The reverse happens when the money supply is decreased. A decrease in the money supply increases interest rates and the increase in interest rates decreases investment in new capital goods by businesses. The decrease in business spending on capital goods induces capital goods manufacturers to lay off workers and produce fewer capital goods. The capital goods producers pay out less income to the workers who then reduce their spending (according to the marginal propensity to consume out of income). The decrease in spending on consumer goods leaves inventories to accumulate on store shelves and induces consumer goods businesses to order fewer consumer goods. Consumer goods producers lay off workers and produce fewer consumer goods. The consumer goods producers pay out less income to the workers who then reduce their spending (according to the marginal propensity to consume out of income). The cycle repeats itself. Again, because the marginal propensity to consumer out of income is positive, but less than one, these cycles eventually peter out as the economy reaches a new, lower income and output level.

Keynesians believe that monetary policy is not very effective because the transmission has too many loose links that can break. First, interest rates may not respond as predicted to a change in the money supply. If interest rates do not respond, investment spending will not resond. Interest rates will not resopnd, if the economy is in a liquidity trap. Second, even if interest rates respond as predicted to a change in the money supply, investment may not respond. Investment will not respond if businesses have a lot of excess capacity and they are pessimistic about the future. If interest rates or investment do not respond to a change in the money supply, consumer spending will not respond. If spending is not responsive to a changes in the money supply, income and output will not change and employment and unemployment will not change.

Monetarists believe that monetary policy is transmitted directly to the products markets through all markets by the affect that a change in the money supply has on portfolio balance:

ΔMs ⇒ ΔAD ⇒ ΔY ⇒ ΔP,Q ⇒ Δi

An increase in the money supply increases assets. However, it unbalances asset portfolios. People have more money than they desire. The marginal utility from holding money balances decreases. To restore equilibrium to asset portfolios, people spend down the new money. As they spend down the new money, the marginal utility from holding money balances rises, the marginal utility from holding other assets falls, and prices rise. Spending continues until asset portfolios are once again in equlibrium (the marginal utility from the last dollar spent on all assets is the same). In the process, people buy some real assets and some financial assets.

The amount of each asset that is bought depends upon the utilities people attach to the assets and relative prices. If interest rates are higher (financial asset prices lower), people will buy more financial assets and less real assets. Financial asset prices will rise relative to real asset prices and interest rates will fall. If interest rates are lower (financial asset prices higher), people will buy more real assets. Real asset prices will rise relative to financial asset prices and interest rates will rise.

The reverse happens when the money supply is decreased. The decrease unbalances asset portfolios. People have less money than they desire. The marginal utility from holding money balances increases. To restore equilibrium to asset portfolios, people divest themselves of real and financial assets. As they sell their assets and accumulate money, the marginal utility from holding money balances falls, the marginal utility from holding other assets rises, and prices fall. Divestiture continues until asset portfolios are once again in equlibrium (the marginal utility from the last dollar spent on all assets is the same). In the process, people sell some real assets and some financial assets.

The amount of each asset that is sold depends upon the utilities people attach to the assets and relative prices. If interest rates are higher (financial asset prices lower), people will sell more real assets and less financial assets. Real asset prices will fall relative to financial asset prices and interest rates will fall. If interest rates are lower (financial asset prices higher), people will sell more financial assets. Real asset prices will rise relative to financial asset prices and interest rates will rise.

As long as prices are free to rise and fall, the transmission has no links that can break and monetary policy is very effective. However, at this point, the Monetarist School doctrine becomes muddied. The Monetarist School is divided into two sub-schools: the St. Louis School and the Chicago School.

The St. Louis School is an activist policy school. It believes that monetary policy is very potent and that the central monetary authority should actively pursue discretionary changes in the money supply to achieve macroeconomic goals.

The Chicago School believes that monetary policy is too potent and that the central monetary authority should NOT pursue activist, discretionary changes in the money supply. According to the Chicago School, activist, discretionary changes in the money supply may be destabilizing for the macroeconomy. The Chicago School, organized by the late Milton Friedman, advocates "rules." Friedman's Golden Rule would eliminate the central monetary authority (e.g., the Federal Reserve) and replace it with a robot that keeps its foot on the money supply accelerator at a rate of growth of exactly 5.0% per year. If output grows on average by 3.0% per year and velocity is constant or predictable, then the central monetary authority can keep inflation within bounds of 2.0% per year with no more than a 5.0% growth rate for the money supply:

%ΔP = %ΔMs + %ΔVy - %ΔQ

2.0% = 5.0% + 0.0% - 3.0%

top    Fiscal Policy

Fiscal policy is the act of manipulating the bottom line balance on the national government's budget to influence macroeconomic activity. Manipulation of the bottom line balance may be achieved by changing government expenditures or tax collections.

The Keynesians Versus the Monetarists

Keynesians believe that fiscal policy is transmitted directly to the products markets through all markets by the affect that a change in the government's budget balance has on the velocity of money:

ΔG,T ⇒ ΔB ⇒ ΔI ⇒ ΔY ⇒ ΔQ ⇒ ΔLe ⇒ ΔU

Fiscal policy bypasses the financial markets. It assumes a given amount of money supply in circulation and seeks to change the rate at which it is circulating through the products markets.

The federal government can increase velocity and stimulate the economy by running a budget deficit. The deficit can be achieved either by increasing government expenditures or by decreasing tax collections. The government then finances the excess expenditures by borrowing from the idle money balances of savers and/or bank reserves. When the federal government borrows from the idle money balances of savers, it increases velocity. When it borrows from the banks, it may increase the money supply or velocity, depending on whether or not the banks have excess reserves. If the banks use excess reserves to buy the Treasury securities, then the money supply increases. If the banks use borrowed reserves to buy the Treasury securities, then velocity increases.

The federal government can decrease velocity and slow down the economy by running a budget surplus. The surplus can be achieved either by decreasing government expenditures or by increasing tax collections. The government then absorbs the excess revenues and lets them sit idle. Velocity decreases.

Monetarists believe that fiscal policy is transmitted to the products markets indirectly through the financial markets and is, therefore, only effective if accompanied by an accommodating change in the money supply:

ΔG,T ⇒ ΔB ⇒ ΔMd ⇒ Δi ⇒ ΔMs⇒ ΔAD ⇒ ΔY (P or Q)

The Monetarists believe that the problem with the Keynesian fiscal policy argument is that the Treasury is not necessarily borrowing from the idle money balances. If savers sell private issues to buy new Treasury securities, then private issue prices decrease and their yields rise. As private issue yields rise, businesses are forced to come to market with new issues with higher interest rates. The businesses who cannot afford to borrow at the higher interest rates, are crowded out of the market. Monetarists believe that government deficit financing simply substitutes public sector spending for private sector spending with out generating any new real output. The only way out of this crowding out is for the central monetary authority to monetize the new Treasury debt by giving banks new reserves to buy the securities.

top    Summary

Macroeconomic theory is divided into two schools of throught: the Left School and the Right School. The Left School is more commonly known as Keynesians and the Right School is more commonly known as Monetarists. Each school of thought has its own unique and distinct framework. All macroeconomists and their theories fall into one of these two schools. Adoption of one school for development absolutely precludes membership in the other school. The rest of this book is devoted to explaining macroeconomic policies through each of these two methodologies.

top    Readings

The Economic Consequences of the Peace, John Maynard Keynes, Harcourt Brace Jovanovich, New York, 1920

A Tract on Monetary Reform, John Maynard Keynes, Macmillan, London, 1924

A Treatise on Money, John Maynard Keynes, 2 Vols., Macmillan & Co., Ltd, London, 1930

The General Theory of Employment Interest and Money, John Maynard Keynes, Harcourt, Brace and Company, New York, 1936

A Monetary and Fiscal Framework for Economic Stability, Milton Friedman, American Economic Review, 38, June 1948: 245-264

A Study of Aggregate Consumption Functions, Robert Ferber, National Bureau of Economic Research, New York, 1953

Rational Expectations and the Theory of Price Movements, John A. Muth, Econometrica, 29(6) 1961: 315-35

A Monetary History of the United States, 1867-1960, Milton Friedman and Anna J. Schwartz, Princeton, Princeton University Press, 1963

New Dimensions of Political Economy, Walter W. Heller, Harvard University Press, Boston, 1966

Monetary versus Fiscal Policy: A Dialogue, Milton Friedman and Walter Heller, W.W. Norton & Co., New York, 1969

A Theoretical Framework for Monetary Analysis, Milton Friedman, Journal of Political Economy, 78(2) 1970: 193-238

Money and the Real World, Paul Davidson, New York: Halsted, 1972: ch. 12

Essays in Positive Economics, Milton Friedman, Chicago: University of Chicago Press, 1974

Milton Friedman's Monetary Framework: A Debate with his Critics, Robert J. Gordon, ed., Chicago: University of Chicago Press, 1974

Rational Expectations, the Optimal Monetary Instrument, and the Optimal Money Supply Rule, T. J. Sargent, and N. Wallace, Journal of Political Economy 83(2) April 1975: 241-254

A Keynes-Friedman Money Demand Function, Paul A. Meyer and John A. Neri, American Economic Review, LXV(4) Sep 1975: 610-23

Rational Expectations and the Theory of Economic Policy, Thomas Sargent and Neil Wallace, Journal of Monetary Economics, 2 1976:

Rational Expectations and the Role of Monetary Policy, Robert Barro, Journal of Monetary Economics, 2 1976:

The Monetarist Controversy or, Should We Foresake Stabilization Policies? Franco Modigliani, American Economic Review, LXVII(2) Mar 1977: 1-19

Monetarism: A Historic-Theoretic Perspective, A. Robert Nobay and Harry G. Johnson, Journal of Economic Literature,XV(2) Jun 1977: 470-85

Monetarists and Keynesians, Brian Morgan, Halsted, New York, 1978

The Way the World Works, Jude Wanniski, Touchstone, 1978

Some Aspects of the Development of Keynes's Thought, Richard Kahn, Journal of Economic Literature, XVI(2) Jun 1978: 545-59

After Keynesian Macroeconomics, Robert Lucas and Thomas Sargent, in After the Phillips Curve: The Persistence of High Inflation and High Unemployment, Federal Reserve Bank of Boston, Boston, ch. 19

A Revised Perspective of Keynes's General Theory, Ivan C. Johnson, Journal of Economic Issues, XII(3) Sep 1978: 561-82

A Critique of Friedman's Critics, Lawrence A. Boland, Journal of Economic Literature, XVII(2) Jun 1979: 503-22

Defining Money for a Changing Financial System, John Wenniger and Charles M. Sivesind, Quarterly Review (FRBNY), IV(1) Spring 1979: 1-8

Hick's Contribution to Keynesian Economics, Alan Coddington, Journal of Economic Literature, XVII(3) Sep 1979: 970-88

Rational Expectations and Economic Policy, Stanley Fischer, ed., 1980

Two Illustrations of the Quantity Theory of Money, Robert E. Lucas, Jr., American Economic Review,LXX(5) Dec 1980: 1005-14

Keynes's General Theory: A Different Perspective, Allan H. Meltzer, Journal of Economic Literature, XIX(1) Mar 1981: 34-64

Monetarist Principles and the Money Stock Growth Rule, Bennett T. McCallum, American Economic Review, LXXI(2) May 1981: 134-38

Monetarism, Keynesian, and New Classical Economics, Jerome L. Stein, American Economic Review, LXXI(2) May 1981: 139-44

The Structure of Monetarism,Thomas Mayer, New York: W.W. Norton & Co., 1978

Tobin and Monetarism: A Review Article, Robert E. Lucas, Jr., Journal of Economic Literature, XIX(2) Jun 1981: 558-67

Monetary Trends in the United States and the United Kingdom: Their Relation to Income, Prices, and Interest Rates, 1867-1975, Milton Friedman and Anna J. Schwartz. Chicago: University of Chicago Press, 1982

Monetary Policy: Theory and Practice, Milton Friedman, Journal of Money, Credit and Banking, 14(1) 1982: 98-118

Monetary Policy: Theory and Practice: A Comment, Fred J. Levin and Ann-Marie Meulendyke, Journal of Money, Credit and Banking, 14(1) 1982: 399-403

Monetary Policy: Theory and Practice: A Reply, Milton Friedman, Journal of Money, Credit and Banking, 14(1) 1982: 404-06

Cracks on the Demand Side: A Year of Crisis in Theoretical Macroeconomics, Edmund S. Phelps, American Economic Review, LXXII(2) May 1982: 373-81

Foundations of Supply-Side Economics: Theory and Evidence, Victor A. Canto, Douglas H. Joines, and Arthur B. Laffer, Academic Press, New York, 1983

Did Financial Innovation Hurt the Great Monetarist Experiment? James L. Pierce, American Economic Review, LXXIV(2) May 1984: 388-91

Keynes and the Modern World: A Review Article, Walter S. Salant, Journal of Economic Literature,XXIII(3) Sep 1985: 1176-85

Rational Expectations and Inflation, Thomas J. Sargent, 1986

An Operational Measure of Liquidity, Steven A. Lippman and John J. McCall. American Economic Review, LXXVI(1) Mar 1986: 43-55

Models of Business Cycles, Robert E. Lucas, Jr., Blackwell Publishers, 1987

top    Websites



previoustopnext