21

COTTTTMPORARY MACROECONOMICs
MOTVTTARISM AND RnrlOrrlnl EXpECTATIONS

aggregate
Despite a few notable exceptions discussed in chapter 6, money in the
,.rr. *u, not of prime importance to classical writers. There were important debates
but in such contfoabout money, ,rr"h u, the bullionist and currency school arguments,
supply of money' The
versies the chief concern was for the institutions affecting the
as real facto':
determinants of the wealth of a nation were identified by the classicals
by the stock c:
relatedto thdft and productivity. The general price level was determined
dii not focus on real wealth or relative prices' Most indu'-orr.y, but the relaiionship
as "se-:trial nations, moreover, supported gold or specie standards that were viewed
othe:
InJlations corrid and did occur, but they were attributed to wars and
regulating."
"(during
which the gold standard was usually suspended) or to the mone.'
dilasters
theory, the:
prrrrtirrg tendenJies of improvident governments or politicians. In classical
on th;
theory
monetary
and
hand
one
the
on
theory
u di.ho"rorrry exrsted between value
o
consideratiormonetary
by
latter
the
forces;
real
by
other. The former was determined
This began to change in the twentieth century as neoclassical writers-partiu-;moneta:-"
larly Irving Fisher, Knut Wicksell, and A. C' Pigou-began to pvt aggtegate
to pn'-:
money
from
mechanism
transmission
theory ,n"upurwith value theory. The
and t:'
money,
for
demand
the
of
and
the determinants of the velociry of circulation
and
contractioL
expansions
monetary
process
of
general role of interest rates in the
a rather sophistica:;:
Ivere all matters of concern to these writers. A11 the elements of
penned the Ga:;':'
Keynes
before
well
version of the quantity theory wele on hand
rl':
macroeconomics
produce
a
to
Theory.But ideas and events coalesced in the 1930s
deprc":unemployment,
massive
of
(Keynesians believed) could deal with problems
preconceptic-'
sion, und geteral economic malaise. Reflecting Keynes's theoretical
view.
neoclassical
money mitteredvery little or not at all in this revised
the ma:::
The lack of faith in monetary policy as a central stabilizing device in
Keynes-'that
however,
case,
economy persisted through the 1960s. It has been the
recessi::
suggestilns about deficit spending were easily followed during periods of
be;:
have
inflation
periods
of
*h.r.u, surpluses or baianced budgets during
K;-'very
The
extremely ,aie andmost unpopular within the political establishment'
o-'=:
in
nesian principles that made the economy deflation- or depression-proof,
(largt'
words, may have made it inflation-prone. Events of the 1960s, especially the

494

ilFIIFF--"

Chapter Twenty-One

,il

Contemporary Macroeconomics

49s

deficit-financed vietnam war, led to large increases in the money stock, which was
accompanied by serious and persistent problems with inflatron. Predictably, these
events led to a confrontation with Keynesian economics and to a real and practicaT
resurgence of interest in "monetarism," which is based on a refinement of the classical
quantity theory. (In theoretical terms, the quantify theorv was never absent from the
economic intellectual scene.) The purpose of this chapter is to chronicle twentiethcentury developments that became incorporated into contemporary macroeconomics.

The Neoclassical Origins of Monetarism

Despite anoticeable lack of unanimity in early fbrmulations of the quantity theory, each representation established a more or less direct relation berween money and
prices. With a few notable exceptions, such as John Locke and Henrv Thornton, no
writer assigned an explicit role to the interest rate as an important determinant of economic activity. on the other hand, the quantit-u- theorl' \4.as not purelv mechanical,
since increases in the quantity of money were seen by Cantillon, Thornton, Ricardo,
and Mill as affecting the demand for commodities and, through greater demand, as
raising prices. But whereas classical writers otten discussed the forces that would preserve (or destroy) a new equilibrium, they did not explore the adjustment process in
the transition from one equilibrium to the next, nor did they anaTyze the stability conditions of new equilibriums following monetary disturbances . Alargepart of this void
rvas initially fi1led by the neoclassical writers Irving Fisher and Knut Wickseil.

lrving Fisher and the Equation of Exchange

In 1911, Yale university professor Irving Fisher (1867-1941) followed a lead
from John Stuart Mil1 and derived a mathematical framework for expounding the
,,vorkings of the quantity theory. Fisher wrote: MV + M'v' p\ where M is
the stock
=

ofcurrency in circulation; Vis currency's annual velocity ofcirculation, or the rate at

lvhich currency changes hands; M' is the volume of demand deposits held by banks;
v' ts annual demand-deposit velocify olcirculation; pis the aggregateprice level; and
I is an index of the physical volume of transactions. Since our modern definition of
money includes bank demand deposits, the above equation can be rewritten more
simply as MV = P\ hereafter referred to as Fishe r's Equation of Exchange.
Fisher's mathematical expression finds rts verbal ante cedent in Mill, who wrote:

If we assume the quantity of goods on sale, and the number of times those goods are
resold, to be fixed quantities, the value of money wil1 depend upon its quanrirl., together
with the average number of times that each piece changes hands in rhe process, , , . Consequently, the amount of goods and transactions being the same. rhe value of money is
inversely as its quantity multiplied by what is ca11ed the raprdin' of circulatron
fvelociry].

And the quantity of money in circulation is equal to the monev value of all the goods
sold, divided by the number which expresses the rapldity of cir.cularion. lPrutciples of poln
ical Economy, p. a9a)

Fisher realized that his equation of exchange was an accoulrring identity, therercre a truism. But that does not render it useless from the standpoint of economic theorY. In fact, Fisher used it to assert once again the proportionalrr,v between increases
'-o M and increases in
P The equation of exchange, with certain assumptions, subsequentiy became a mathematical expression of the quantity theory. Fisher,s assump:rons were that velocity (v) and the volume of trade (T) were independent of the

*=-.......,={*

:l

496

Part

l'ive V Twentieth-Century

Paradigms

moneysupplyandthatthepricetr.evelwasapassiveratherthananactivevariab'.
M and P as a lol;'
tne st.ict proportionality between
Hence he could ^ri^ara "rnrwas incredibly co::^'
or,rr. a'.i.i*lnants oi v and T
cuslo::run propositro". HiI Jp."ir,.urio.
i;;;" assumed Jttt'*-ta ''y real factors (habit and
p1ete. In
",'""'t",7u'i
technologyandinstitutionalarrangemt"t'1''othatchangesinthestockofmonel';:i'
reil determrnants of V and T'
not cause th"*g;;;"v "i"r"
his mathematrc'"
Effict' More important than of
'
the connectic
AMissingLink: The Real-Balance
Fisher's rdentification
was
theory
quantlty
itrict
T'
renditj.on or tne
increase in prices
'
q.*urr,ny of ,rlorr.y and the ensuing
between un i'r.r"ur.lr-, iir.
is the real-balar:'
equilibrium
,i,," ,turriiity'o?"ior",u.y
missing lirk th;;;;r",
money holdings distr'r::''
way. A";;r;;;; in irrairrarut
this
explained
effect. It can be
and his or her expen:
u,' i,'aiuia"ur s cash !a1a111,
the optimum ..i*io,. between
tures.lnWalrasianterms,mole*o,,.yattheexistingp'1...leve1createsanexci:
seek to reduce th'::
in individ#hJ;. iilt, iidividuals
supply of money balances
if output rema--rl
by increasiug .rf.rrait"tes. Furthermore,will push prices *..
excess money bu1urr."s
tr,e t'.i.u,"d money demand
unchanged

(", ;i;1,;

"ssumed),

untiltheyhaveriseninthesamep."po'tio,astheincreaseinmoney.Inthisu.a.'-'
individual monev balances '':'
new

equilibri*-;;-;;hed

;'*,ff

having

and

*"i;;;;b".urrr.

on1:,J:,::::::iy.Ji1?#l;t';;=
ne''
*ii::Tfltr:li"l:l,.,n'",rorrylaf
'
reai-balance effect fully' He
,rr.
.ifioii
rrot
aia
air.or"r.J ii, rirn",

excess
showed, for example, holv

*or.juuru"ces could

be used to purchase secLr'

ties,therebypushingsecurityprices.t'p-"'atheinterestratedown'Inotherwor:'
i' *o'1"y could cause increased oul'i how an ;;;;;
Fisher never demonstrated
(*.shallsee.momcnlarilvthatWickselitrie...
indirectlrthroughlowcrinteres.,u,.,
bttween inflation' inter''

fill this gupl. iiri.ua, Fisher turned';';;i;;"trelation

ofreal-cash balances'
rates,

expectu'io* and the holdings

a:--.
Inflationandthe,,FisherEffect.,,InseminalworkssuchasThePurchasingPott't,
pi,r.,". L,pr"red the ramifications of actual
Money atld T.he Theory of.Intuut,
expectedinflationanditsinteractionswithnominalinterestratesandthedemand,
realba|ances.Firstconsiderthedemandforreal-moneybalances,whichma\.:

exPressed as follows:

m,,= J'Qt, i)

y' realincome' and i ' the nc::

real balances' is a function of
Fisher '
wherem,,,the demand for
i, tt''," r..iprocal of velociry'.Although Pigou :inal rare ol,inrcrest. Von"y demand
C'
A
as
as completely

ae'una

not elahorate,i i, runttionlti"t' "iton"y laier in this chapter' he did discover ':
considered
Milton Friedman, ,*r"*rt"r,
is the opportunrtl : '
,,O*inal tlterestrate, which
;;;
,hr"";
process
imoortant
"iti"

, i"{;:;::;?i;1ff'fif#iio* ri,n.. saw rhat t,,e nominatinterest rate was the pr:
r ateor i''ttt"'t' *t'iJ-T,i:::,1::i,?[,iltlYlli*.:
uct of two factors : 1) the reat
ca11ed thrlft and proc'::;Hiffi,lX':"J;Iu;';;; ;;"my (whar the ciassicals
(

expectectinnarion,rate:l'""ry1;:::iT.*j:il'^i"#:,;::..'
the expe'
:lliillr:::1ill:::"ffi;H',*,
foliows:
i"1*
ir'"r,"i:::l:'^:'i::1":X":.':uars
as
expressed
te'ms' Fisher's concept may be

tivity), and (2)

the

,:,:e. lrL general, slmptifiea

:_ -tP*

Chapter Twenty-One

Contemporary

Macroeconomics

4g7

where i is the nominal rate of interest, r is the real tate

of interest, and F is the expected
tate of inflation. Naturally, when the expected rate equals
the actual rate of inflation,
the nominal interest rate is equal to the real rate.

The logic of Fisher's equation is quite c1ear. Lenders insist

on a nominal rate of
interest that is equal to the real rate plus whatever inflation
i, .rp..t"a to be over the
course of the lending period. If the expected rate of inflatron
is s|ercent per year and
the real rate of interest is 4 percent, lenders would generallv
ue unwilting to lend funds
at less than 9 percent. If, ex post, the rate of inflaiion
turns oulto be 10 percent, the
borrower has obtained funds at a llegatiw real rate of interest
and lenders will adjust
their expectations about inflation in succeeding periods. Thus,
inflationary expectations affe* nominar i11e1e;t rates. The implicattns of the .,Fisher
effect,, wiil be con-

sidered in more detail below, but rt is important to nore

that Frsher discovered a
mechanism that could make inflation ,.lpiperperuating.
H,ie; rares of monetary
expansion may thus lead, initiarl.v, to lower nominal interest
rates (through an
increase in the suppry of loanable funds), but eventualrv
higher pnces lead, through
inflationary expectations, to increases in the nominal iate,"and,io
higher inflation.
This principle has become a stock_in_t rade of modern
monetarists.

Knut Wickselland Modern Monetary Theory

While some neoclassical macroeconomists remained true
to the Marshall ian tradition. the task of extending the Walrasian framework to monetary
theory fell to the
Swedish economist Knut wicksen (rg5r_1926). wicksen
quasi_mechanistic
formulations such as Fisher's. He performed two items
"p;; surgery on the quanof mino.
tity theory that brought it into the iealm of modern monetary
ecoromics. First, wick_
sell took a hint from_ Thomas Tooke (1r7g-rg5g), un
critr. or the quantity
theory, and asserted that prices are determined by incom.
"uily irru, money
ii...
works
through income to determine the aggregate price revel;.
seconi, wicksell used the
t\'vo-rate analysis of Henry Thornton to underline the rore prayedby
the interest rate
in monetary theory.I
In his restatement of the quantiry theory, wicksell made an important
step
toward integrating monetary theory with varue theory. He
constructed an aggregate_
demand-aggregate-suppry framework for investigating
changes in prices, as demon_
strated in the following passage:
Every rise or fa1l in the price of a particular commodity presupposes
a disturbance of the
equilibrium berween the supp11, of and demand for that com-oauy,
whether the distur_
bance has actually taken place or is merely prospective.
What is true in this respect of
each commodily separately must doubtles, t. ,.,r.
of all commodities collectively. A general rise in prices is thererore onlv conceivabre on the ,,rpporirio.,
that the general
demand has for some reason become. or rs expected
to be.o-., greater than the
supply' ' ' ' Any theory of monev u'orthv of the name musr
be able to show horv and whv
the monetary or pecuniary demand ror goods e_rceeds
or fal1s short ,r;h;;;;;; ;;;#:
in given conditions. (Lectures,II. pp. t_:9_tOO;

- What is especially noteworthy in thrs passage is the g.av in w.hich Wicksell made
the transition from the partial-equilibrium approach
of rraurrnurt-ii..., suppty equals
I A leading student of
wickse11, Professor Carl uhr, has concluded thar

wickseli was probably never

exposed to Thornton's writings directly but that he
had srudied the currency debate between Tooke
and
Ricardo at length and was most likely exposed to Thornton's
ideas through Ricardo (Economic Doctrines of
Knut Wicksell, p. 200). On Thornton,s analysrs, see chap.6 of
thrs book.

ry

4g8

Part Five

Twentieth-Century Paradigms

framewor''
demand for a single product) to the aggregate-supply-aggregate-demand
that he s-:
challenge
the
to
later employea f/feynes. Moreover, Wicksell responded
exceeds cl
demand
monetary
down in the last sentence quoted above: he showed how
balances
cash
on
money
in
fa1ls short of aggtegaterrrppty through the effects of changes
understanding c:
Real Balances. The passage that most vividly describes Wicksell's
plesen:i
appears below. Keep tn mind that the analysis wicksell
the real-balance effect
pertains to the effects of a

decrease

in the stock of money:

money is diminished u'h-'

Let us suppose that for some leason or other . . . the stock of
gradually appear to be '-'
will
balances
prices remain temporarily unchanged. The cash
case I can rely on a hlg:':
in
this
that
(It
is
true
.
.
small in relation to ihe new level ofprices..
being unabie to meet:of
risk
the
run
I
meanwhile
But
future.
the
1evel oflreceipts in
of ready mone\ ' '
obligations punctually, and at best I may easily be forced by shortage
I
therefore seek :
profitable')
fbrego some pu.chases that would other-wise have been
present
the possibilin
the
for
enlarge my balance. This can only be done-neglecting
a reduction tnmy demand for goods and services, oI through ':-

borrowing, etc.-through

increaseinthesupplyofmyowncommodity...olthroughbothtogether.TheSam.]]

fact nobody will succe t true for all other owners and consumers of commodities. But in
balance; for the s : -'
cash
his
increase
in reabzingthe object at which each is aiming-to
51s6k 6f m6ner :
of individual cash balances is limited by the amount of the available
in demand ''':
reduction
universal
the
hand,
the
other
with
it.
On
rather is identical
lalL in '
a
continuous
about
bring
necessarily
will
commodities
of
increase in suppl-v
balar:'.
cash
the
at
which
prices. This c#or1v cease u,hen prices have fa11en to the level

ire

regarded as adequate' (Interest and Prices,

pp 3940)

in l':'
In this u,ay, Wicksell filled in what Don Patrnkin called the "missing chapter"
as the equilibra: ',:
classical monetary theory by exposing the reaT-balance effect
(see Pati'nl -'
mechanism that ensures siuUitiry in the wake of monetary distur'bances

'

Money, Interest and Prices).

)iy emphasizing the relation between savings and investment in his

aggregate-> - - '
(as a mone":]
ply-aggrefate-demand analysis, Wicksell also rescued the interest rate

Wicksell dic :
variable) fiom the oblivion into whrch it had sunk after Thornton'
he used the tw'o-.'":
accept the interest rale as a purely monetary phenomenon, but
Moreover, he r'-interest.
of
rate
the
of
theories
thesii to synthesize r,ror,,orr.tu.y
element c'
main
the
rate
actual
the
and
rate
the divergence between the natural
dynamic analYsis.
been criticize;

have
The cumulative Process, Neoclassical monetaly theorists
of the H: '- '
conclusion
mechanical
comparative-static,
the
complacently accepting
of neoclassical mone '
Mi11-Fisher quantity theory (t.e.,2M = 2P). Although a number
frequently failed," ir: ::
theorists seemed tohave g.asped the real-balance effect, "they
of the way in r'' :' "
fessor patinkin s words, ';to provrde a systematic dynamic analysis
markets r'':'
the monetary increase geneiated real-balance effects in the commodity
(lvloi"'
propelled the economy from its original equilibrium position to its new one"
ir:':'
the
on
focused
which
analysis,
dynamic
iof . wi.tr.1l was the exception. His
"cumulative
process"
the
he
called
what
rate as the poinr of deparruri, constirutes
what is important to note beforehand in wicksell's dynamic process is tha: :.discrepancies be- ' '
benveen the noimal and actual rates ofinterest reveal short-run
"

;gslegatesupplyanddemand.Thismakestheinterrelationbetweenmoneyan;:
*;, ::arke rs .rpii.it. The cumulative process is illustrated in the following passa='

Chapter Twenty_One

Contemporary

Macroeconomics

4gg

If the banks lend their money at materially lower rates

than the normar rate as above
defined [e'g, in Thornton-see figure 6-1],
then in the first place saving will be
discouraged and for that reason there will be
an increased demu.ri for gooas and
services for
present consumption In the second
p1ace, the profit opportunities
of entrepreneurs will
thus be increased and^thedemand for goods and serr.rces, u, *a1
as for raw materials
abeady in the market for future prod.rctl.r,
*,i11 er.identrl. increase to the
same extent as
it had previousrv been held in check by the higher.";.
;i.;;;;;.t*ing
ro
the increased
income thus accruing to the workers, landorrne.s.
and rhe
of raw materials, etc.,
the prices of consumption goods wi.t1 begin
";;.;is stil
to rise. . . . \\/hat
more important is
that the rise in prices, whether smal1 or great
at firsr. can ne'er cease so long as
the cause
which gave rise to it continues to operatJ;
rn other o'o.ds. so l";;,
the loan rate remains
below the normal rate. (Lectures,Il, pp 195-196)
By pointing out that the effects of the cumulative
process malr be irreversible
wicksell also hinted at the rore played by expectations
in macroeconomic analysis. He
maintained that entrepreneurs who had been
able to pay higher wages and raw mate_
rial prices when the roanrate was be10w the
natural rate w11, ,,even

reverts to the normar naturar rate,

if

lthel bank rate

on an average be abie to offer the same

high price,
because they have reason to expect the
same increased prices for ii.i. o*n products
in
the future" (Lectures, rr, p. 196j. Thus, if
banks maintailn artficialiylow interesr
rares,
thev merelv rempt enrrepreneurs to bid
up,h. p;i;;;;f ;'#;;."*
materials, and
thus the prices offinal goods.
Despite his innovations, wicksell's monetary
analysis continued al0ng the same
lines as laid down by the crassical economists.
He set out, in fuclr, todefend the quan_
tiry theory againsr irs critics, and he did so
for the long-run ,;i;;;of that theory. yet
he elaborated a process of adjustmentbetter
than anlone nua Jo.r. before. He arso
gave a prominent role to the interest
rate andto aggregatedemand in explaining
aggre_
gate adjustments to changes in money-a
feature shared by Keynes,s macroeconomics.

The Cambridge Equation

we learned in chapter r5 rhat Marshar founded
a Cambridge tradition inpartiarequilibrium analysis near the end of the nineteenth
century. This tradition extended to
monetary theory as werl, arthough Marshafs
tortuous a"r"v i"-p"ulishing his ideas
robbed his monetary theory of most of its
noverty by the time ii appearedin print.
Nevertheless, Marshalr's desire to integrate
m_onetary theory and varue theory
was
characteristic of the Cambridge tradition.
As Keynes wrote in his biography of Marshall: "He always taught that the value of money
is a function of its supply on the
one
hand and the demand for it, on the other, as
measured by ,the avetagestock of
command over commodities which each person
cares to keep in ready form,,, (pigou,
Memorials, p.
29).

Ironically, the Cambridge economists never

succeeded as fu1ly as wicksell in
inte,
grating monetarv and value theories.
But Marshall,,,;;;L;.;;;-al'-u,ra framework
didlead to the famous cambridge equation,
and in so doing. rt provided for the
first
time a focus on the demand ro. ..rorrey as welr
as its supply. ir, ,rii, ,.rp.ct Marshal,s
monetary economics is the spiriru al father of
the Keynesiun tt .o.f or tiquiarty prefer_
ence (see chapter 20) as well as the modern
formulation of the demand for money
as a
part of a general theory ofasset choice.
Marshall asserted that the demand for money (i.e.,
the desired quantity of cash
balances) could be expressed at any time
as a fraction of income, which ied
to the

500

Part Five

Twentieth-Century Paradigms

formulation rL'-'
familiar Cambridge equation, summarized here as M = KPT.In this
The rigrr'"
variable'
exogenous
an
to
be
assumed
the stock of -orJy, *ni.t Marshall
Kis t::supplied:
money
of
quantity
the
of
hand side of the eiuation is an expression
ar:
balances
of
cash
form
the
in
hold
to
seeks
fraction of income that the community
K
-'r
Analytical1y,
output.
total
is
7
and
price
level;
demand deposits; P is the general
exchang'
of
equation
Fisher's
tn
V
of
ieciprocal
the cash-balance equatio. is the
as a fundamental tru::Thus, both Fisher and Marshall accepted the quantity theory
money while negle;"
of
function
and both concentrated on the medium-of-exchange
ing the interest rate.
mo.:-'
Neglect of the interest rate led to some serious shortcomings in neoclassical
i:-'
between
interdependence
the
of
neglect
'
etary aialysis, the chief of which was the
ri
the
but
seen,
have
as
we
pitfall,
this
prod.r.t and money markets. Wicksell avoided
p::'
possibly
money
for
demand
the
on
groupz
exclusive emphasis by the Cambridge
real balances a: '
vented their systemaiic analysis of the way in which changes in
the cash-ba1an:'
because
curious
is
This
transmitted into the commodity market.
other words ..
in
reartanged,
be
It
can
effect is inherent in the Cambridge equation.
for monef i demand
excess
an
or
KPT)
(E'
M
=
express an excess supply of money
effect'
=kpr - M,either oneof which is capable of generating areal-balance
apply the ::'
not
group
did
patinkin
Cambridge
the
professor
found it curi.ous that
failec . '
never
they
since
economy,
the
of
of stabilrty conditions to the monetaly sector
in ;:--'
obtrusive
especialiy
is
discrepancy
do so in examining the product markets. This
theory:
monetary
neoclassical
of
case of Walras, as Patrnkin noted in his critique
by elabcr:' .
Walras \,vas a man who never tired of establishing the stability of his system
play
should ' '
into
called
be
would
ing on the corrective forces of excess supply that
be ca-'' would
that
demand
excess
of
forces
the
and
price 1ie above its equilibrium va1ue,
determines
"'
the
market
how
he
explained
it
when
did
He
it
lie
be1ow.
into play should
how the ma: "
he
explained
when
it
again
he
did
prices
of
commodities;
equiibrium
he did it a third time u :- '
determines the equilibrium prices of productive services; and
prices
of capital goods. Bur . '
equilibrium
the
he explained how the market determines
the equilibrr-' determines
market
the
how
to
explain
he
attempted
did not do it when
p' 168)
(Money'
"price" of paper money. And Walras is the rule, not the exception

monetary theory a: -'

Oversights of this nature tended to preserYe the separati.on of
of Ker::
predecessors
some
However,
century.
value theory well into the twentieth
and :--'
income,
money,
between
relation
dynamic
made headway by explaining the
business cYc1e.

Modern Monetarism: Theory and Policy

:.'With the preceding as background, we now return to the main theme of
morJ;'
of
the
chapter and attempt to demonstrate how some of the basrc elements
position are straightforward extensions of earlter wolks on the quan:-

-or.ru.ir,

policy plesc:l-theory. As pointed out previously, the populaflty of monetarism as a

her';'
tion was preceded by continuous and persistent contributions (wen during the
:perhaps.
of Keynesianism) to the development of the quantity theory. No writer,
1a;'
Nobel
'
defenied the monetarist position in more forceful and elegant terms than
"monetarists."
ate Milton Friedman, ,rhor. ideas have shaped a generation of
-

I rlo:g t

rth N{arsha11, this group included

A. C Pigou and D H- Robertson

Chapter Twenty-One

Contemporary

Macroeconomics

501

Friedman's Theory of the Demand for Money

In 1956 (during the utter dominance of Keynes's ideas u'ithin the academic community) Chicago economist Milton Friedman published a set of lnnor.atir.e essays

elaborating and modifying the quantity

of Money).

the orv of moner' (Sr:r.l:i-. :it ihe QLtrtrtrirl, Theoiry

essay entitled "The euantin. Theorr- oi \Ioner,: A Restatement,,
Studies) Friedman set out a neu, r-ersion of the demand for money, and

In his

(contained in

gave it the f,ollowing expression:

ffi,,

= u.(Y-..

tr.

r P-. P.:,t

where the demand for money is presented as a functron (u) of permanent income (y),
the proportion of human to nonhuman u,ealth (rr). the nittittol interest rate
Oi,
expectedchanges in the rate of change in the price 1er.e1 (p,). the acrua1 pnce
level (pj,

and the preference function for moner. r'is-a-r'is other goorls (rr), Friedman offered
this
specification as a theory of money demand, and set it up in testable form.
An elaboration of all of the independent variables in Friedman's equation would
take us too far afield here. (The interest ed reader is invited to read the original
essay.)
But several points about the equation are of principal importance.
Unlike the older version of the quantity theory, Friedman's restatement is essentially a theory of demand for money, not a theory of prices. In this respect, his
approach to monetary theory is similar to Keynes's. There is an important difference,
however. Friedman's restatement of the quantity theory begins wlifr a basic premise
from capital theory: that "income" is the yield on capital. This means that the concept

of income Friedman uses in his construction of the quantity theory is different from
that used by Keynes in his income-expenditure model. Friedman calls his income
measure "permanent income," which is to say that he treats income as a discounted,
present-value stream of payments derived from an existing stock of
wealth, including
hurnan weaith. Human wealth consists of "qualitative" improvements such as
education and training. Keynes neglected wealth almost entirely, which was more appropriate to the type of short-run analysis he was interested in than to the long-run
anatysis
Friedman favors.3 In the long run, permanent income is a more appropr:iate variable.
Friedman does not argue that the demanrl for cash balances oi its reciprocal,
velociry is constant, as earlier naive formulations of the quantity theory sometimes
implied. But he does argue (citing empirical support) that money demand is a stable
and predictable function of the independent variables. This implies that money
is stili
the crucial vatiable in predicting prices (as well as short-terrr fluctuations in output
and employment, as we shail see). In other words, according to Friedman, rf velocity
is
predtctabTe, changes in the rate of monetarl, expansion wrl1 explain changes
in the rate

of inflation (or deflation) as well as short-term alterations rn output and employment.a

upon closer examination, it is obvious that Fnedman,s moner.-demand equation
is an elaboration of the money-demand function u'e examined .uili.. in thrs
.hupt...
3 Keynes's matter-of-fact

justification for short-run analvsis n.as that rn rhe rone run.

we are all dead.,,
Modern monetarists are tempted to reply that the reason we are dead in the long
run is because Keynesian policies have ki11ed us with inflation and excessive government.
Although Friedman's statistical evidence has sparked much contror.ersv. his roie as
a leading monetary
theorist is undisputable. on this point, at least, other leading monetary theorists
agree. Harry Johnson
has written that "Friedman's application to monetary theory of the basic prrnciple
. . . that

income is the
yield on capital, and capital the present value of income-is probably the most
important development in
monetary theory since Keynes, General Theory,,(,,Monetary Theory and fofcy,,, p.
:SO;.

,_=_-.*{lrr

,llflF::"'

502

Part Five

Twentieth-Century Paradigms

and nomir:''
can be simplified to include only income (current, not permanent)
e'-'
justice
Friedman's
to
do
not
does
simplification
this
interest rates fy and i). While
easier' F - :
gant Conception, it will make our elementaly explanation of "monetarism"
money demand a:.
example, when the Frsher effect and Friedman,s Conception of
emerges'
i'nflation
of
combined, a very luci.d explanation

It

A Simplified Monetarist Explanation of Inflation

to the sum -- '
Recall that Fisher argued that the nominal interest late was equal
questic:'
raises
the real interest rate andThe erpectrcl inflation rate. This immediately
is the : about how expectations are formed. one popular theory about expectations
formed
are
-- '
called adaptite expectations theory, which states that price expectations
price
experie::--'
past
the basis of pasi experience with inflation, with more recent
future pfl-:
weighing more heavily than that of the distant past. Uncertainty about
and Lr;' '
wages
dominates expectatio;s. Laborers, for example, contract for future
fur- '
about
nesses set future prices on the basis of some (uncertain) expectations
forn:'be
will
prices. The adaptive expectations theory says that these expectations
principally by the most recent past experience'
price expectali' -:
Remember that the nontinal interest rate is partly a function of
nominal inte:."
and that the demand for cash balances is in turn a function of the
money, wh:::
rate. I{i.gher nominal rates mean higher opportunity costs for holding
means a reducerl demand for cash balances (and vice versa)'
A simplified explanation for inflation may thus be given utt\tzittg the concept' -'
money-dem"::
adaptive expectatio;s, the Fisher effect, and Friedman's (modified)
the cen:: '
f'unction. Assume (1) that there is a constant rate of money expansion by
(and
equr" ''
bank; (2) that expected inflation rates and actual inflation rates are equal
equais
lent to the rate of -or.rury expansion), (3) that the nominal interest rate
is constant =
the real rate plus the rate of inflation (or monetary expansion), which
real incon.
(5)
that
and
equal;
are
balances
of
cash
holdings
desired
that actual and
incre ':
'
growing at a constant rate. Given these conditions, assume a once-and-for-a11
in the rate ol monetarY exPansion'
aC"The initial results of the increase in monetary expansion are to lncrease
dep"'
leve1s and to initially
'
cash balances of indrviduals and firms above their desired
tempora:
increased,
have
funds
loanable
(because
interest
of
the nominal rate
The excess of ;reducing the reai rate of interest-the "Wicksell effect" if you will)
and all other as=:
balances leads to increased spending on commodities, securities,
incre'::Actual prices begin to rise (as do nominal wages somewhat) d*e to the
Caus price
increases,
the
to
time,
"adapt"
a
afier
Expectations,
nomrnui spending.
u:end
not
does
process
The
rise.
to
initially,
fe11
which
rate,
the nom]nal inteiest
(1) the new rate of inflation is equal to the new and higher rate of monetary e\::
differe : ' '
sion; (2) the nominal interest rate has increased by an amount equal to the
equ;
between the old and the new inflation rate; (3) actual cash balances are agaln
1; '
formel
its
to
restored
is
interest
of
(4)
real
rate
the
and
desired cash balances;
:
nerr'
the
that
before
than
lower
will
be
held
balances
cash
of
'' '
Notice that the level
:
higher
a
means
which
rate,
interest
nominal
hrgher
a
of
of money growth because
"

"

ol holding money.
What are the implications of this process for economic policy? Some are obr.- '- How often have we heard that "tight money and high interest rates are the caus.,
n
inflation"? Many businesspeople and politicians adhere to this naive view' The

'

iriilll

Chapter Twenty-One

Contemporary

Macroeconomics

503

tarist version of events tells us that exactly

the opposite is the case. while monetary
expansion initially lowers the nominal interest
rate, inflation and the Fisher effect
take
over and eventually cause nominal interest
rates to rise. The oniy way that interest
rates could be depressed over rong periods
is to enact rrigrr.. l"a^rrigher rates of
mon_
etary expansion, a very dangerous poiicl, in
the yietv of tonetarists.
Friedman has agtgd!lat, alwiys and everl-rvhere, inflation is a monetary phenom_
enon, and he has convincingly d.-orrrt.rt.d
this propositio, ro. tt . united States
in a
massive empirical study (conducted wlth
Arna ichivartz) entitled A Monetary History
of the united States, rg67*1960. As in the
earlier and more oriu. u.lriors of the
quantiry
theory, inflation can be explained b1, increased
r.elocrn, (reduced money_demand
growth), reduced income growth, o, u.,
ir...ured rate of monetar,v expansion. In the
contemporary monetarist's view, there are
limits to ,t . g.oroah-of velocity_people
can economize just so much on cash balances.
Further."the growth in income and
employment is, in the longer run, determined
by rear forces un?otn.. factors (see the

following section)' The remaining culprit is

monetary expa,siort.Ultimatelv the
monetarist interpretation of inflation, as we shafl
see momentaril.v, is that rt is produced
by
erratic discretionary changes in money growth
rates.

Inflation and Unemployment: The Monetarist

Reaction

Modern monetarism extends to the probrems

of employment and income growth
and to theirrelation to.inflation. In 195b,
in a famous paplr estabtishing an ,.effect,
that bears his name, British economist
A. w phrlrips aiicrssea a .!tutio, befween
the
rate of unemployment and inflation ("The
Relatio, b.t u..., u.r*proy-ent
and the
Rate of change of Money Wage Raies in
the United Ki"gd;;, tg61-1g57,,).5 The
"Phillips curve" described an inverse relation
between the unemployment rate andthe
inflation rate such that higher and higher inflation
.u,., *... [qrrir.a to reduce the
unemployment rare by a g_iven p"r..riug..
If correct, ,h;, ;;;d;;esenr the urtimate
policy maker's

dilemma. Immediately, [roblems of definition

u.ir", .rp""iarly con_
cerning unemployment. Does the u.s. eco.romist
accept the Labor Department,s def_
inition, the Council of Economic Advisers, conception,
or what?
Actuar macroeconomic events such as stagflaiion
*"rrtrruiy red to strong doubts
about the predictive nature of the Phillips
curve. Stagflation l, ui*
used to describe
a period characteristic

of high inflation

combined

with economic

stagnation,
unempioyment, or economic recession. In
the 1960s. it *u, tnorght that the phillips
curve, which was associated with Keynesian
economics, made stagflations impossible
because-high unemployment lowers demand
for goois ura ,.r-ii..r, which lowers
prices. This resurts in row or no inflation.
Howev.-er, in the tsios ana 19g0s,
when
presented with actual sragflation, economists
began to iru.rtig;r.1ie philiips relation
more closely.

Friedman once again rose to the occasion

and offered an eregant alternative
conception of both unemployment and the short-run phillips
.,.r.r.. I-, his 196g presiden_
tial address to the American Economic Association
1,,The Role of Monetary policy,,)
Friedman argued that the. long-run Phillips
relation was vertical ui ,o*. natural tate
of
unempl0yment. That is, in the rong run,
any particular rate of monetary expansion
and inflation has littie or nothing to ao
*itt the natural unemployment rate.
The ques_

s Actually,
as rhe tirle ol rh'
in his reration
i,',',Tii',.'.X',t;rT,:l*:T,:;:1,[:TIJi:.,T,,,."'".il:L,1,?,1#;;l*::T
see Fisher's

"f,l

""."..

essay'A Statistical Reration betweJn Unemployment

and price Changes,, (1926).

frI

504

Part Fj.ve

Twentieth-Century Paradigms

was defined by Friedman

tion of what constitutes the natural rate of unemployment
the following terms:

ir

with the existing real conditioi:'

It relers . . . to that rate of employment which is consistent
in the labor market' t'r'
obstacles
removing
by
lowered
in the labor market. It can be

obstacles' The purpose of t1.re

reducing friction. lt can be raised by introducing additional
aspects of the employmen'
concept is to separate the monetary from the nonmonetaly
the word natural in co"'"
using
in
had
situation-precisely the same purpose that wicksell
p
228)
nection with the rate of interesl' (Price Theory'

InFriedman,sConception,then,thenaturalrateofunempioymentisdeterminedb.,
and demand for labor' These factors wouL;
a7l real conditions affectirrythe supply
of unionj'zation, minimurninclude all institutional urrlrrg.*.rrir,-roch as the degree
the status of worker educatiol
wage 1aws, the proportion of women i.n the workforce,
and so on.

may be higher or lou'e:.

In the short run, however, the actual unemployment Iate
possible we need merely Ieturn I'
than the natural rate. To see intuiti.vely how this is
changing only tht
our analysis of money and inflation in the previous section,
assumptionstatedtherethatoutputandemploymentremainConstantovertheadjus:.

ment to a new rate of monetary expansion'

Thekeytounderstanaingtt,eShort-run-inflation_unemploymentrelationist.

businesspeople's and wor'i-'

note that after anincrease in the rate of money expansion,
Specifically, as individl:experience.
piice
actual
ers, price expectations di.verge from
of goods and service s
prices
the
balances,
als begin to rid themselves Jf excess cash
demand (and prlce) for the':
rise. Individual entrepreneurs perceive an increase in

ownproducts(notarlincreaseinthegeneralprrcelevel)andP-t?q"""more'simuli:' ;:
laborers be willing
,'.o.,,iy hiring more labor at a lower actgalrealwage. Why wili
tends to dri''';
inflation
but
,rrpply"-o...-labor? (Nominal wages may rlse somewhat'
downrealwagesJindicatingareducedquantityoflaborinput!)Theansweristil:.:
are' in Keynesian terms' unde
laborers' perceptions of priJes lag behind-workers
fooi laborers into thinking th'
money illusion in other words, increased nominalwages

more labor' Consequently'

real wages have increased, and therefore they supply
"tit,
catch on a':
ptoy,,.irt falls below the natural rate until laborers (and businesses)
unemploymt't. ut
There is, therefore, a short-run inverse relation between

..ul1.r*.
at the natural rate '
inflation, but in the long run the Phillips relation is vertical
'
run employment and outp:'
unemployment. Monetai"ists thus argue that in the long
money-suppgr"*ir, are determin edby realfactoi affectirrgi.nput markets. Altering
and employment. Nevertheless, mone',lrowth rates only tempoiarily affects output
prices change.
i.rpply changes have long_term effects on the tate at which

Monetarist Economic PolicY

The existence ot '-:.

Monetarist theory also carries a strong policy message'
various kinds e:-'
of
lags
,,expectations component" in the argumenl means that
and outsidelags - '
inside
within the implementation of monetary policy. There are both
time to reci '.
takes
it
because
the monetarypolicy of a central bank. Inside lags exist
employment, and prict '
nize adverse macroeconomic developments affecting output,

andtoadministerappropriatecorrectivemeasures'Monetarypolicymayhave,.
fisca1 policy, it does flot h:' :
adr.antage over fiscal poiicy in this regard because, unlike
1ag may present d $te z ':
go thlough a political/legislative process. But the outside
to

Chapter Twenty-One

Contemporary

Macroeconomics

505

problem' Milton Friedman first

called attention to the length
of time it takes before
actual changes in monetary expansion
or contraction a.e feit on the ,,tatget,,variables
of inflation, output, and employm"rr,

1i..., the outside lag).

Adiustment of expectati,ori i, u ti-.-.onsuming
p.oLrr. wh,e a number of stud_
ies present conflicting evidence
orr rt. rnuU.r, there is likeiy a si
berweenmoneraryallradons;;;;;;1;;#;;;ffi

l6J,T;J:fff
narily rhought to be the first target
afieTt.ed, with ,rr. zun Er..i,
"H,lr:Ji
of monerary
sion on the rate of inflation flr;1";;;J"rer,
expan_
taking as iong as a year and
Comparatively little is known,
a
ho*;;'.., about thJro.,rurizrr'of expectations half.
other factors affecting the iength
and
or trr.rl lags. Thus, i, ;;-;l;;, rhat

a good dear of
uncertainty surrounds the conJuct
and effectiveness of monetary policv.
Because monerarv policv does
nor ,"r.. pr".. i" ;lil",,,:;;;';",
of the Fed_
eral Reserve Board must be considerea.
ine,pea s arrempr,o ,urr., inrerest
rates (such
as the federar funds rate)-i.e.,
to keep ,t *itrri. u..r,uii.unr'.jnr,
1ed to very costly
mistakes' when interest rates climb
d.r. to market factors irch as excessive
govern_
ment borrowing, the Federal Reserve
often reacts with a monetary
expansion that
temporarily lowers the interest ratebutlays
the groundwork f;;;.* upward
pressures
on inrerest rates in the future
1pr""ea"a, of.co*rrse, by hL;;';;flation rates).
This

:#31'#,#i#,ff

?,

#ff *:l';, Ti,Jr-'

rares. Ar this point in rhe new

Reserve policy have fair^ed to

u,,j -o,,-

.,,..i,, F,i.;;;,,',;

,"i11.;;;:ffiT:Ir.l:ffi:ffi'.li1l:#nl;:Tffii

u.t""i"r."at base, monetarists

vlew monerary poricy from a"rru"g.1;lnstitutiorat
"rules-versus-discretioni
;.;;;.;;*. They srrongry
quesrion whether discretionary
pori.y-giren rhe sta_te

;;;;;;. turure knowredge

of macroeconomic processes-can
ever create stab,ity."fNot surprisingry,
the Federar
Reserve policy makers resist
this uff.gutior.
Authority, The United states operates under
an independent monetary
authority' The members of the Federai
n"r..u.
Board areappointed by the president
of the United States-with the advice
urJ
Rules versus

.orr.rr, or the senate_but once chosen,

they operate independently of the
uoay foriti". Friedman ;;
rhis arrangement a
threar to individual liberty becaut"
it putr'u ,.1e* few *
oi*"
,,,or, important
thing that affects the pnce lever and
"h;;;;
nation,s money.
we might expect Friedman to be"-fmy-"rrr-the
rJio such a view o, ,rr. ruri,

of philosophical
persuasion a10ne, but his argument
against an independent monetary
authoriry receives
added force from investigation
of hislo.i.a ,,or.,u ry d.ata.For
exampie, in his lengthy
study with Anna Schwart.z, M:netct2)
History of the trnirca sntes,F;i;;_",
revealed rhat
during the Great Depression the
Fejeral no"ru" Board allorvea
tt . Loney stock of the
united states to fa, by one-third,
which he contends caused the Depression
much longer than it would have
to last
in the p."r".r." of a proper
response.
A deeper acquaintance with monetarl,
ru"t, i,
Ied Fried_
man to assert that severe depressions
have always been accomprni.A
Ul sharp reduc_
tions in the money stock and.th*
trr".p ,Juctions ir^,rr. ,rrffi-stoct
haue always
been accompanied bv depressions.
end of the spectrum, Friedman
that severe inflations have always
feers
b..r, uc"o-panied by rh".;
in the money
stock and vice versa. with respect
ro trr" cr.", Depression, Friedman
concluded:
The Great Depression in the
United states, far from. being a sign
of the inherent instability of the private enterprise sysrem,
o u t.rtu*..rt to how
-u.t iu.- .un be done by mis-

-;";;;;
il";Jffi;.i.rrr*i.,

o;r;;;;.,

i;;ses

*dli

s06

Part Five

Twentieth-Century Paradigms

o:
takes on the part of a few men when they wield vast powel over the monetaly system
p.
50)
Freedom'
and
(Capitalism
conntry.

Friedman therefore advocates afl altelnative that has long been in the Universi:'
of Chicago tradition. He favors automatic rules in place of independent monetal.-"
authoriry. Friedman compales the past performance of the Federal Reserve Board:-the actions of a nervous teenager learning to drive: when pressing on the accelelat'
(i.e., increasing the money stock), our nervous fyro frequently gives the car too mu':
tc
gas; *hen stepping on the brakes (reducing the money stock), he or she pushes Rathe
predictable.
are
and
overbraking
Lard. In a phrase, monetary overacceleration
:than proceedrng smoothly on a path of economic glowth, the economy is subject
proces'
the
in
individuals
harming
fesults,
fits ana starts-inflation and/ ot depression
To counteract this tendency, Friedman ploposes that the Federal Reserve Boa:*
be directed by 1aw to increase the money stock month by month at an annual rate -:
between 3 and 5 percent. A rate of increase in this range is consistent, in Friedmar '
view, with attai11;ble economic growth in the United States and relative price stabiL' '
Moreover, it would eliminate the destabilizing effects of, say, a 12 petcent increase
the money supply one month and a 3 percent increase the next'
Neediesslo say, the rules-versus-authority question is controversial among aca;:'

micians. Friedman's result of stable economic growth under the monetary r; '
depends cruci.ally on the stability of velocity. While his statistical evidence suppo:--:

'
this assumption, his critics either dispute that evidence or challenge Friedman's statis:
r::
long
the
in
be
stable
may
cai procedures. Some critics contend that while velocity
'
it is not stable in the short run. They therefore argue lhat discretionary monetar)' !''
:is
Friedman
velocity.
in
icy is required to head off short-run, destabilizing changes
have ''
stranger to controversy, but when all is said and done, monetarism could hardly
:'
interventior
government
more effective spokesman.6 lFor yet another view of why
-'
Forcs
The
the
box,
like1y to produce bad results-based in palt on monetalism-see
Ideas: Ritional Expectations, or "You Cant Fool A11 of the People A11 of the Time'

Supply Siders snd Monetsrists-The Bottom Line, This chapter and the preceC-::
one iilustrat e that a great debate rages ovel the fundamentals of macroeconom' - '
Specifically, the Keynesians and post-Keynesians support discretionary manipulair- '
oi fiscal or budget policy as the principal tool for macroeconomic stabilization ri -'monetary policy in an auxiliary role. Keynesian discretionary polic-

discretionary
sometimes referred to as "demand management." In the Keynesian view, the ec'
omy is in constant need of manipulation and tinkering, and the success of po1i.c1' m- '
sures rely on a strong govelnmental apparatus. Monetarists view the problem from ':-'
other way around. They see the economy as basically stable and self-regulat-:':
(e
requi.ring litt1e if any government intervention. The ploper role of government s-: '
environn-"
stable
and
provide
apredictable
is
to
Reserve)
ciaity ttit of the Federal
within which unfettered economic processes can work efficiently to maximize ;-'
nomic well-being. Mrnrmal govefnment, balanced budgets, deregulation of busi:.'
and industry, and a monetary growth rule are allpart of the monetarist policy "p':'
age.,, Nevertheless, both monetarists and post-Keynesians have emphasized ::,
"demand side" of the economy in their policy prescriptions.
.

6 Frredman,s razor-sharp intellect and tenacious debating ski11s have 1ed some admirers to compare ill:.
ir ' '
the philosophcr Nietzsche, of whom H. L. Mencken said, "when he took to the floor to argue
timc to send for ambulances" (in Breit and Ransom, The Academic scribblers, p. 259).

Chapter Twenty-One

V Contemporary Macroeconomics

The Force of ldeas: Rational

erpu.t"Oonll__"You Can't Fool All of the e""pf. afl-"ittr.

ti_",,

Inasmuch as economics deals

with human behavior, expecktions
are fundamentar
purchase a home will anticipate

;[i;l;]f]'1,:Ji:"I5,*

ff [ ;:J:rilf.*' ff

to economic
its rong-run earnlnr.
o.o,o".,s and the
,,

e m a n d s,,
o *
;;
: I : ::: ii
"
";'iir":
group rransaction wiil
have an effect on the actuar
inflation
.r.",
on."
lntuitively' you might think that

wage

:: :lii: *]l *,ji :1* ::

;;;";, through to prices.

].u[.*ura-rooking. crearrv thel

unknown) future' Bur untir
"rp"..u,;onl
the rsiot
the past' For example, it was
common practice to posit rhat
next yerr.. rnflation rate would
be a
and past rates rhis
was djctared by rhe rwin
rearization
'J',rp.ion
expectations directly,
but reasonable

".*o.;'*.'r.a","J";;.?;;;;;:: ;i;:;",h:T.!::t:l

;:fHrt il:]ffi,:t:'||tt

based largelf

,o ,rpjor. that they will

.;;";;;r".t":rve

The flaw in this reasoni

to

be fatse.

ut:i':l

that people would go on believing

what they knew
this ,,irrational,, ari,,_o.. tn-tr.^ rozn- r

s"uurutu.onorllg]:i!i:*
llsts were troubled by

argued that it wourd o"

!":."-:

,"

be

;,;;;;;;:1if'1il1il:ilf:,i[.:.:L""1::l'J*:.T::
,

il#;:ffi:'r::HffiT::1rT: il,T.::::il'n
ln the 1970s

.r'" u",t inro,^',".iol ,,

hand, and

.r,", ir,o."

Robert Lucas (Nobel laureat".

i99sy,demonstrared the importance
of this simpre
varidity or gove.";;;;
,noa"rs or the economy based
on the past behav_

;:::,T:::":ii["Jff: ;i:

jl j:,".#"'if"liff

"i""ffi ;T.ii.J:":j.",,"T,"#;.y*r*:;**1",:mru:

idea has widespread force,

but ir exened a
, tiln,:
r th e r zo, go,",.'.il
r;
",,,,n.,rn,
tion' an idea vigorousrv attacked
"ru ff ; Jr, i*:I.ff ffi lrrtriffi
uy l'.titton'r.iuJ,.,J,
,

Hf f ] j:,[.1

1u, pointed

I
|

inT,i:',[1fl:1',".r::T*'*1r"'*'"s
";;;;;"",.
good.
krlled the arSument for

But Friedman
",j.,,il,r,..i.pter).
Bv oPPtf
et
apprvins
ttt& Ia'lonal
;i;;i-",p".tations,
expectations,
Lucas

theorv' a shoft-run inflationary

monerary poricy

,"ol.r?iil:r::JXlnlexpectations
goods signars ,.,".r". i"1ir#",:".r.rT:J#:ilfi,!r::

ear y,

r.ii.J"_.r'between

rhey

ffi

LTi ."JIJ.X H.ff

boost

#,.I; ffi,,I*_:*..J"Ili#;hi:

Ievel' ln the rong-run, under

rationar
can o"
""p!.,*""r,.here
peopre cannot'oe
rootei'to,ever.

;::ffi:Jffi::n:ffi

wil

,"*" ,,.#

inflation and

their mistakes. once

:i:;:,ml*::li

";;

U
are usefur as a",,.,sh,.,
:
warning against naive g"r".r;";;;oricy.
,,I*"
But * *nr, ,ir ,i-r-ir" y". forcefur
rational expectations theo.ry
ideas,
raises many ada;tiolal questions.
,"* .." 5.oectations formed?
When are governments to be berieved,
*,.,* .*ra,,utes efficient inrormationi How
do peopre

l;fJ:HHi::-can

economic models capture tr,"

ririt"a

abirity of peopre

use

to

understand how

Partly as a consequence of
rational_expectations view,
economists are
with the issues of credibitity and,the
ar now preoccupied
,r.trin,htii."--:.:'::::':-]ll*l
ltonoT'sts
sovernments
keep their promises, and
long? We now recognize
tong?
recosnize more
for how
,"."::'"::',,:i:l:?llY-3
expricitrv
a dilemma: arthough tough

*.i r."..iL"=JJ:'::ix.fi:?,fl;:i:1I':;:;".

j::lT

poricies."ventrattf i.,rg,n" benefits

of il;;.;,;;,
popularity by encouraging a short
poriticians can gain
burst of ,Rrtio"r'tt-,rt t"rpo.r.ily
o..r.ll.."r"s and employ_
this temptation
,r,.,.'.,"ai#ri.i.,i

;"r*,.al
etc fin the ,,,.Ji*,*, ,i::ffi::TJ,,H::ff,f:;j;:,,1"',:.,;',r,
il::13:'-L*'J;Jft:11.o

{nr

o.

,.,,

rt is rikery rhat
n

ilIa,.u,u ,,0

"j,*,0,

507

508

Part Five

Twenti.eth-Century Paradigms

stagflation occurred in the United Kingdom in the 1960s and 1970s and in the
Ulited States in the early 1970s. The difficulty of flrtting stagflation within a Keynesian
1980s
framework 1ed to a gleater acceptance of monetarist theories in the 1970s and

To some extent the pendulum has swung back in the opposite direction as monetalisr
period of lou
had increasing difficulty predicting the demand for money and the long
of the 1990s-a kind of reverse of stagflation
|nflation and high

"-ployrrr.r1t

c'

Nevertheless, the possibility of stagflation continues to command the attention

economists in the twenty-first century.
But in between these pendulum swings an alternate view of the macroeconom\
si':'emerged over the 1970s and the 1980s from writers who acquired the name supply
monetarthe
of
orientation
demand-side
the
and
ers. Rejecting Keynesian economics
policies have o:ists, the r1rppty siders concentrated on the effect that macroeconomic

incentives to save, invest, and acquire capital. Recognizing that the inflation of th'
sidels
1970s was blamed in part on reduced growth in labor productivity, the supply
market'
emphasized factors affecting technology and the labor
Supply siders promotelax and spending cuts and a balanced budget as a maitto sa\
fiscal tonic. The net result, it is hoped, will be the creation of greater incentives

'

and invest, thus propelling the economy forward. The deregulation of industr-'
rncludrng ,edrceJ business "standards" regulation, an emphasis on private labol,training programs, and reduced social welfare subsidies that create disincentives -work and save are also part of most of the supply siders' policy prescriptions.

Conclusion
t:-.
The French have a saying that "the more things change, the more they remain
macl-modern
of
an
evaluation
to
same." This maxim appears especially appropriate

economic urrd -or"tury theory. Supply-side economics and the fundamentals modern rational expectations theory (the idea without its technical accoutremen::
were the stock-in-trade of Adam Smith and many of the other important class:;''
factors - '
economists! Underlying their conception of the wealth of a nation were the
in
as Li*''
labor productivity and capital formation. They coupled this with a belief
ph--to
the
government "policy making" as possible. These principles are very close

ra:- - '
sophicai and theoretical conceptions of modern supply siders, monetarists, and
,rul arpa.tutionists. As such, contempolary macroeconomics and monetary the':
the,v h. :
upp"ui to be returning to the timeless concerns of any economy. However,
retrrrrred far richer. We now know, thanks in large measure to the Keynesian interi*:'
ratic: l
ancl to the refurbishment of neoclassical ideas by Milton Friedman and the
econom\
'- '
aggregate
the
of
workings
the
about
more
expectationists, a great deal
economicsmonetary
including
as
of,
such, modern macroeconomics--conceived
a major and ongoing study of the contemporary economist'

References
Breit, William, and Roger Ransom, The Academic Scribblers, rev. ed. New York: Holt, 1981
1';'
Flsher, Irving. 'A Statistical Relation between Unemployment and Price Changes,"
JoL"
Cuve,"
Phillip's
the
"I
Discovered
as
(J:i/i]e
Reprinted
1926).
tional Labor Review
Po lit ic al E c o no ruy, v ol. 8 1 (March/ A pril 197 3), pp' 49 6-5 02'
1963 1191L)
Tl.re Purcltasing Power of Money. New York: A. M" Kelley, Publishers,
The Theory of Interest. New York: Macmillan, 1930.

Chapter Twenty-One

Contemp orary

Macroeconomics

SOg

Friedman, Milton studies

in tlte Quantity Theory of
'
Money. Chicago:The university
press, 1g56.
of Chicago
capinrism and Frcedom'
Chicago: The Universiry
orChicago press, Ig62.
";,I:i;::;'aY:,:::;:,':,:,:,:?;=
e'","i,,"iii*1'oi ,a r,,u."r,
,,68) pp r-i7

3i{*'

;*rv
?fr,TlilH
:,
ff:;':|,
,,Monerirv

Johnson, H. G.
pp. 335-384.

iir*i^"d

=#lf

Mill,

or t /, e (rn

ied

s tures, r 8 6 z- I s 6 ,.pdnceton,

Nr:

policy,,, American
"'LLr) ^tttcttLan Economic
rconomic Rt
Ret,iew, vol. 52 (June
1962),

J. S. principles of potitical
Economy, W.J.
't' J' Ashley
(eo'J Nerv
l\e\\ york:
York:
^Jrrrtv (ed.).

- 'r'

A. M. Kelley, publishers,
pricx,2d ed New york:
Harper & Ror.ii 1g65.
Phillips, A. W ,,The Rel1ti..
fr.t*".r'r"J_r"r_.nt

.^-, 1?65.1'.tSoS1.
rarmkln'
Don' Money, Interest

and

and the

ol
wage
irr)l Economtcd.vor zsRare
61.16u..:l::f::jr"rey
(ed.). tr,**ni,
C
1e58), pp zss-iT.
fjro".o,
iiw,iu,,,n.i,
i7!"I{!;f)*',f,9"I:T!.r
uha Carl c.i*,'"'i*
1925.
Rates in rhe United

Kurgdom isJ,_

orctrines of Ktlut w,rlrrlr,Li!l2n:_Macmrilan,

Universirv of California press,
i;;;;;),,;;";::;,,,,,.DerKeley:
i962.
Economv,2 vols., r. n"'urj"r'r.al.

Wicksetl, Knut. Lectures

""
Keganpaur, 19t;;': "'Political

Interest and prices, R.

F. Kahn (trans.).

London: Routledge &

London: Macmlrtan, 1936.

Notes for Further Reading

An excellent survey of monetary
theory that in some
in this chapter is contaiLd_*

X,ri,l,i{^i:dt
.

respects

para,els
one presented
il
, n;;i,",;;;;;,";;)mi,s. the
rn,om, and Mone_
oH: Me.,iii i;;;;';.," b-;;;,r;;;ol.ri.,,.nrn.,
.uist,
rheory

rary rheory (Corumbus.

from

a,Ir,.,,,,

,"i, il*',i'li,'roun,

o,r.-

t."irii), i,,,,,

Space does nof permit

our doing justice to rhe
many ralenrs of

n:ft:'*r;iri:.fi

Hisrorv or
(New york: Mac-

ln.

f
ixtf;s:*i,*xti,$*##"ilft:,#u.::!"i;;
"1nra, iiri)N"#;;\, wttey, 19t67).il;;#
urr.rr-"rri'"ffi*t

studies in rhe Tradition

an instructive and perceptiv.

,rr.r..iiJ"r

volume also contains

by p. A. Samuer_

*"ri"**en

r*il?; :ffi,,"";:t.8[lia{t;;ii;*,,; )!:;:f: iw Lr a,.. r:i;;;

,li'{i.T,'t-:,:tT:;,,{r,!ry;;1ru:ii*i:;iii:I:i.:x[ j:iiljqi,:iJ]ii
ncertainty,"

Political Economv, vol. 12

(spr;g *r1r.,, ,r.'url,j,

,trl'ffi;,1:i:li ,*t,;rffit;f,':#uantirv

(arter rhe Grear Dep'esrionr

a,
money' see N. T. skasps. "The

tf;r

uirtoiy

rheorisrl lournatorrhe Hivory

oJ

orEco.

u"io;;;"#":','"'ff:r:,.'.j"[ff""J:i:?:ffi]ril.Ti:I

Method"i"g,.:ri'R""r, orr.
r_ur..n.."iurgrrrini Anri-ouantirv
"j

::: ::!l: ::,: : r,r u, i, * u, il) ii ",, z sp,, i di;

il.
i.ryry,ul
leader
oranti-quantiw theory senrim.,,
in ,r.,. Jr"Xri'#:lLilT;H,X;*',o "rc,-',*r"'rra ,,-,'.
possibrv the
besisingre;"..";i;;;;;;^",
wickser

Doctrines

ofKnut wickseil

j;

u,rJ rri, ideas is rJhr,s

(seen.r...".J.i.i
Economic
*3_r_13 , i;i;;;,:';;;;
,ii^,,,. , Cornerstone in
"1r" ,.*i.r.r.lf .,
rsS,i'; ,.,,rii".
trrr,.,,r. process

Modern Economic Theorv (oslo,

1#,:ffiI1;r.fffi1x

in Theory

X:";::;g:,ii,;:,j;i-j::,1::"j::;.,f:f#;i),1_::,,,;;.;;,h"i
'i"r,iior,r^^r,
,,Capirrr^rr,*.f

Claes-Henric Siven.
,ra
rory of Potiricat Economv.
u?,
Business Cycle," The iuroleln.Journa/of

w;o;,1;IJIri:ff1 Jr:.:r1:,,r;,1
t,rs*irr.. iii)i."*.-r_rr_2,,
i.^rriu",rr.*or, ,.wicksell.s
rhe uir,'ori, o1,ty"*,,
pp' 375411; E. J. Ner,
iil)rir:iJ,.
, ,or,,r_n r995;,
"wicksell's tt'";;rurLulation,,,
to,,nolof potiicat Economy.
vol. J5

",4..*r

510

Part Five

Twentieth-Century Paradigms

(August1967),pp.386_394;andJacobMarschak,..Wicksell,sTwoInterestRates,,,SL.'-:';
Resiarch,vol. 8 (November 1941)' pp' 469478'

are discussed by Lars Jonung, "K::Some other aspects of Wicksell,s macloeconomics

'
political
Economy,.rcsl.21 (Spring 1989), pp' 2741
wicksell on urr.1nJrov* efLt," History of
-":
E:'
yrag9f"'
Political
of
History
Real
Coleman, "wicksell on Technical Change and

william

355-366' Mauro Boiinovsky' "Wicksell on Deflation

omy, vol.17 (Fa1i f SAS), pp'
'a'"nomv'vol30(Summer

Historv"fioiitii"i

f-:'

i1

.'

'lt
1998)'pp'219-215'concludedthat$'c:':'

to revise some aspects of his cumulative pro;:"

wide deflation of the 1920s caused wicksell
Wi;;-'
see Torsten Gardlund, The Life of Knut
mode1. For Uiog.ufii"ut details on Wickse1l,
1920s,"

(Cheltenham, UK: Edward Elgar' 1996)'

tnhis Money' Credit' and coftti':' '
Alfred Marshall',s monetary theories are best described
publishers, 1960 119231). Perhaps the_best spokesman for the C'-'
(New york: A. rlt. Kellev,
A. C. Pigou: "The value of Money," QuLt':''
bridge group was Marshall's student Pigou. bee
l9ll),pp. 38-65; ..The Monetary Theory of the T:,:Journal of Economics,vol. 32 (Nove mber
pp 183-194; and "Marginal Utiliry and Elas: '
Cycle," Eroro*ir lo',"al,vo: 39 (June 1929)'

Walker' l=

(May 1936),p' 532'D' A'

ties of Deman d,,, euarterly Journal of Economirt,ta.50
Papers, vol 28 (June 1989)'
Economi'
Australian
nes,s Anticipation-of Monetarism,"
later developments'
attempts to place Keynes at the forefronl of

pp 1-

DonPatinkin,,'Mo,,y,InterestdndPrices(seeReflerences)isvaluableontwo:::i".!1'
theory and value theory, and (2) the su::
a monumental eflort to fu11y integlate monetaly
antecede:-::
.rr.fu1 i"tf*-ution on the historical
mentafy notes at the end of iUe Oott provide
po" is heavy going for undergraduates and
text
the
while
neoclassical *orl.rury theory.
with much profit'
even graduates, the notes might be read
A s*-:''
and its iatellite ideas is vast and growing'
monetarism
modern
on
literature
The
'
Infla::-'
and
Money
McCulloch',s
Huston
J.
is
introduction accessible to the genelal reader
mone
''
the
of
yorklAcademic , l9l5). A more extensive treatment
Monetarist App,ro.Z 1N.*
lr '
may b1 foundin L. Auernheimer and R. B. Ekelund,
inflation
approach to n1orr.y'urra
1982)'
iisentiab of Money and Banking (New York: Wiley'
Therelationbetweenmodernmonetarj.smandclassicaleconomicsgenerally,andD..

Humeinparticular,isinterestinglyhandledbyThomasMayer,^"DavidHumeandMol.".
(August 1980)' pp' 89-101' J' Daniel Hami:': :
ism." Quarteily Journal of Economics' vol' 95
of P:
,,Labe1s and Substance: Friedman's Restutemenf of the Quantiry Theory"' History
Economy,vo1.31(Fa1l1999),pp.44947i-,emphasizesFriedman,sallegiancetoMarsh..:-.
cash balances approach H'-': :
the Cambridge
methodology and value theory, and his use of

KeChao,..MiltonFriedmanandtheEmergenceofthePermanentlncomeHypothesis,,.F';',
developmtnl of o1e
35 (Spring 2003)' pp 71-lO4' explains the
of Potitical tirono,ny,

vol'

..Friedman

.-

t'

an; : '.
quantity theory. Gilies Dostaler,
linchpins of Friedman s Iestatement of the
Thoug'
'
of
Economic
Hlstorl
of
the
iuropean Jou*tal
nes: Divergences and Convergences ," The
5(Summer1998),pp,317 34.l,Comparesthet',vogiantsoftwentiethcenturymacroeconc:-.
in the Friedmal-s;hwatz
1'. tHistory to# u -orr.tarist view is beautifully exposed
has stirred up o $oo; ---:

The Great Depress ion, analyzed from this Yafilage,

Schwartz, TheGreatContraction (Prin:. 'SeeMiltonFriedmanandAnnaJ.
of Controvefsy.
Peter Temin,s DidMonetary Factors CL;:.-.
NJ: Princeton u,,*..,ity Press, 1966); then read
1976)'
Great DepressiorZ (New York: Norton '
fashionby Rodner ],...
Rational.*p..tutio,,, theory is explained in a clear, nontechnical
Econont:'
,A
ctrita's Guide to Rational Expectations," Journal of
Mictrail Carter,
(see Refererrces).

dock and

ature,vol.20(Marchoaz1,pp.39_5l.Althoughcomplexinitsadvanceformulatior.
see T' Sargent, "R::
expectations developed rapidiy over the 1970s:

'

theory of rational
.
Natural Rate of unemploymerlt ' Bi '
Expectations, the Real Rate of Intelest, and the
PapersinEconomticActivity2(1973),pp.429_472;T.SargentandN.Wallace,.,RationalE.--:.'
policy,,, Journal of MoyetaTEconomics, uol...2 (Apn1 _
tions and tne r:treory oiB.o',o*i.

pp.159_184;u,,on.,B.Lucas,.AnEquilibriumModeioftheBusinessCycle,,,Journalc.:

.'

ChapterTwenty-One
ml Economy. vol. g3 (Decem
ber 1975), oo.

:,|s'r,ll.,l',Hvforhesis ;'*,',;;,;'

;;_::#::

#,:,.,":,::

V ContemporaryMacroeconomics

5ll

;:*;))!;',i1'*;f;T,ij,:;erL

resrs orrhe Rarional

,.,.]r}'j.Ti,iTlxJ5"fiUjr:ijf}),,ff',l;o"ul,L';,1,',0,;f'.1n"'

orrn",:,;:il:":.,,i:i,i,i;".;i,li"JllHr:il;i:',1ff,T#ir"{.jq?Xii{iri
ffJf#,i:;rr1,1l::*r-;, ,nisi;; ;;l;, ,"e arso B Hr Frieaml cserueBankEi, i"",i
r.sr

jxil.:ii

:,,'";W;;#HIti',,t::i,:^:'ff;;';i;i!::'{,f
Su

For a general introducrin. ,^.r^^

^^

pp ry si

showing

::i;;e:x:x;Jfli

or s upprr

de econ

o m ir
n e n?) n i*', i,i
o:!,i
?:::'
,nis, ,o",,,lzl
,i,' ,,:,i,,,.i,{,#:::T:ii::::-;;i,:r^rvarci,
";:
d

e..,

-s

Tf.l.,_l#.;}"lT

t; ;;r*.:;*. * :i r:".. ., ;;
ni:l*
r:f ; fl#l[.i]::
! andit1
to work
invesl
governmenr. r..
:i::

;;,; i; Ii,

increased

o. i"ni'uls
Laner and R. D. Ransn "^
',rr:))":,"i
Formal'..rr.r.lriliJ;:rtr:T;lTJli:
Model of rhe
,i):
;i
i)i*^;';i
5gg.r"rv:
and rhe .;r,"?r,),
r;
.,,1, ;, ;:
y#jl.?

Business.*i.
Revenues.

.u i,,,,

.,

;;,j;l,.,

! iii;:ffi

iH,:*'

ii

irlii

i: :
r-,*
f
U,
,il;'.:li.,!il*1,.1r,,",'.,i,,11*::i*i*:,,;i"!*

'i{;!{::,K\::l"lli;l:,'';l,;
a productivity problemJn
overview ,trn"
o.oi,."t
r;{.:.#;,',^;ffi

rh. u

s ...*r,

j:f

#*.

,rror. An exce,enr

fti;;'.*t'''-'*)"iii't'il)
:[I*rmyji*,
ff
;,
#
;*T;: : :'i.'i';: ::ff ""i:' ;'J;
;: ffi y
"' Tf **.1# lt ^'""p
quantitv theorv in,n".r
t

p re m b e ;

*n.",',ir,','r'lolilrtjo"'the
rs
Economv.rn;;;;;;;ri' the subject

or a spareor

s50r'rri t"ooor, utong

prr.rr, ,ri .o"nll;il inwith rhe monerarisr
Histo,y potirtcat
of
oi,,,ri,;;,1;;; ,;;,.,;*, a*.rp,..,,

;Utj::i;n:ili,;:y:i,IU?:T::il:Jl..tr1.r ',,::.,illf,lTJ?:f
j:;;id;#"JL,H1#ltttffi

:,r

y,:.,lilv rheory or von"y i,

<r ar

Dh) ;; ; ;;-l

:f
narure see ; E.no,.^,.,,
it#*.,*i'*t
;; ;;,;;';il1"'i',"J|iiill:
ii,o Ji,ii
i,,', 0 : i,,i" )n',11,L,,

;;i ;i,:[y"iffi ]'::::. tl1,r0conrriburions ro

:

papers abour C. F.
Bickerdike
l;;-Joi1tt,"rtwo
patory
developments re,

:s,.k.,a,k";',*ffi

jl,#:7;::f
n::'!

u,, u -

theorerica,

y v ot

,n"r.,r,ir#rrl

pp. 161-l73. Bel-ore ;'a*

oJ Polirical Econonry,
vot.
,ri" seminar
."-'",, :,,":::'l
wrirings or rri"i_,un,'.,ii"i1,"{i!r,{rl,l,;
defender ormonerarism.
].,
b,,r on dese, u;;
;:,Y,'#

"i:!::LxjH:[:;,*i:.lv;;';#H
,r:rrer re80).

;HJ

['il, :IJl i;*U ;}#

f lh.,"i6.
ilf of monerarjsm
the fires
"t,'l:X[]l;
when ir was mosr
cr.g,lir',jilr;'*:rt
th: Grear Depres ston."
the,Devetopmenr
or Monerarism
Hisrory of potirirot ?1::: i'o
:,i::,
"i)iiii'
o.*..n inl.,
u.npopular to do so:
see T. F.

or
,l#'J; #j,.#:j,ji,:I
^,,.1 ^!'!i!ir. :::,j,i llil,,l"', rhe developor R. Brenner's
r,,.".r."'r,r)';':j';i;;;iitopic
rr,.
i"r.?p, ;; i;::l:J^id
'ton
t t:cailom!,
vol. I I (Fali le ,9). pp

*,'

3o5{0i

and Monetary