How does money affect
macroeconomic equilibrium(a)?
The most serious challenge that the existence of money
poses to the theorist is this: the best developed model of
the economy cannot find room for it. The best developed
model is, of course, the Arrow-Debreu version of Walrasian
general equilibrium.
(Frank Hahn (1981))
How does money affect
macroeconomic equilibrium(a)?
1.- Does money largely, or just respond to,
developments elsewhere in the economy? Is money
“active” (exogenous (to whom?) and determined prior
to other variables) or “passive” (endogenous) as in
structuralist inflation theory?
2.- Do changes in the money supply mostly affect the
volume of activity, or the price level? What are the
channels via which money has its impacts on
quantities and prices?
3.- Should we concentrate the analysis on changes in
“money” (banking system liabilities) or “credit”
(banking system assets)?
Causal
status of
money/cred
it
Endogenous
(passive)
Exogenous
(active)
Main effects of money/credit
On prices
Via Money
Via Credit
On quantities
Via Money
Via Credit
Hume
Thornton
Wicksell
Schumpeter
Malthus
Banking
School
Marx
Kaldor Minsky
Real Business
Cycle School
Ricardo
Currency
School
Mill
Monetarist
“Caps”
Keynes
“Hats”
Law
Hats and Caps were the first “structuralist” and
“monetarist” position in macro theory
(Kindleberger, 1984).
They debated in the Sweden Parliament in middle
1700s. The Hats were policy activists, urging credit
creation to spur the Baltic Trade. The Caps
countered with arguments that excessive spending
could lead to inflation, payments deficits, and
related ills.
Investment could be spurred by low interest rate
ensured by usury law or credit creation. The importance
of credit was stressed by John Law, who sought to
stimulate French growth early in the eighteenth century
by setting up development banks.
Speculative booms! Mississippi Bubble!
Minsky who established that banks actively create credit
which can have a strong influence on output via
“Keynesian” channels. Instability.
Caps, Hats, and Law (1700s) all argued as if money and credit
could be controlled by the relevant authorities. Part of the
intellectual reaction against mercantilism took the form of
making money as well as the trade surplus endogenous in
the short run. In Hume’s (1750) model aggregate demand
depends on the real money stock (M/P) while output (X) is
predetermined. The expansion in the money supply (M^) is
given by specie inflow resulting from the trade surplus: B=XD, in this sense money is passive or endogenous. Because
money drives the level P via the equation of exchange,
money expansion M^ is an inverse function of P and thereby
of M itself. An increase in M, produces a increase in prices, so
the trade balance worsen and M starts to decrease because,
prices go down, exports sell better –the trade deficit declines
toward equilibrium.
Malthus vs. Ricardo
Malthus: A precursor of the “structuralist” Banking School,
he thought that the money supply and/or the velocity
adjusted endogenously to meet demand, or the “need of
trade”.
Ricardo: a superb monetary theorist, differed from Malthus
in accepting supply-side determination of output, the
nineteenth-century version of Say´s Law. He naturally
followed the monetarist trail, most notably in 1810 when he
attacked “excessive” British note issue to finance the war
against Napoleon. His logic was based on the quantity theory
and purchasing power parity (PPP) –standard components of
all subsequent monetarist model.
Ricardo’s main policy recommendation was a Friedmanite
rule called the “currency principle,” recommending that the
outstanding money stock should be strictly tied to gold
reserves. … and its supply should only be allowed to
fluctuate in response to movements of gold.
The Currency school:
Peel´s Charter Act 1844 for the Bank of England: put a limit
on the issue of notes against securities.
In 1847 there was a run against English banks, the Bank of
England acted (correctly) as Walter Bagehot in the 1870s
christened a “lender of last resort”. It pumped resources into
commercial banks in danger of collapse. “To big to fall”
John Stuart Mill codified the doctrine of “loanable found”
which underlies much subsequent mainstream thought.
Following Henry Thornton Mill thought the interest rate
would adjust to erase any difference between aggregate
saving and investment. This theory undergirds Say’s Lay by
bringing in changes in the interest rate to ensure full
employment investment-savings balance.
Loanable theory “incorporates” Patinkin´s “dichotomy” in
that money can affect only the price (and presumably the
wage) level, without any influence on the volume of
production. This is the ultimate monetarist position, with
echoes in both Irving Fisher’s suggestion that monetary
policy should be actively deployed to control prices and
Milton Friedman’s argument against active policy.
Schumpeter
Circular Flow vs. Developing
Development only occurs when an entrepreneur makes an
innovation and shift production coefficients or the rules of
the game. He/she gains a monopoly profit until other people
catch on and imitate, and the economy moves to a new
circular flow.
The key analytical questions about this process refers to both
the financial and the real sides of the economy –how does
the entrepreneur obtain resources to innovate? An
endogenous money supply and redistribution of real income
flows are required to support his efforts.
Wicksell extended loanable funds theory by proposing that
inflation is a “cumulative process” based on the discrepancy
between new credit demanded by investors and new deposit
supply from desired saving (corresponding to a zero rate of
inflation) at a rate of interest fixed by the banks. (!-Inflation
Targeting)
Suppose that the banks set the interest rate too low. Then
the excess of new credits over new deposits leads to money
creation; via the equation of exchange at presumed full
employment, the consequence is rising prices. Inflation is the
outcome of endogenous monetary emission, driven by credit
creation.
The Banking School.
The group is known (Thomas Tooke, John Fullarton, James
Wilson, and J. W. Gilbart, among others) for espousing the
doctrine of “real bills.” In the early nineteenth century, the
banking system devoted most of its efforts to accepting (at a
discount) paper issued by merchants in pursuit of trade. The
Banking School’s doctrine stated that the banks should
discount all solid, nonspeculative commercial paper, that is
true or real debts. Adam Smith was an early proponent of
the doctrine.
The Banking School.
“Law of Reflux”: there would be a contraction of the
money supply in response to too aggressive attempts
to expand it.
Financial innovation. Minsky.
Kaldor (1982) & Radcliffe Committee:
“If… more money comes into existence than the public,
(?) at the given or expected level of incomes or
expenditures, wishes to hold, the excess will be
automatically extinguished-either through debt
repayment or its conversion into interest-bearing
assets.”
Marx.
M-C-M’
Exploitation arises as money M is thrown in circulation of
commodities C (incorporation labor power and the means of
production), which yields a money return M’: surplus value is
M’-M.
Access to M gives capitalist a leg up in the economy, making
their extraction of surplus possible. At a more applied level of
abstraction, Marx roughly adhered to Banking School ideas,
at times arguing that velocity varies to satisfy the equation of
exchange.