Money matters if variations in the money stock exert a systematic effect upon macrovariables that economists feel are important. Two categories of macrovariables exist : real and monetary. Real variables comprise the level of output, employment, real wages, and real interest rates. In general the criterion used for evaluating the importance of money is whether or not it influences the real equilibrium profile of the economy. If variations in the money supply have no effect on the real system then money is neutral or money does not matter. While some economists also recognise the influence of money on some nominal measures, notably the rate of inflation, the importance of this is seen in the context by which variations in inflation (caused by variations in the rate of growth of the money supply) destabilise the economy and knock it from its equilibrium growth path.
......We may conclude that it is of no manner of consequence, with regard to the domestic happiness of a state, whether money be in greater or less quantity.The debate regarding the role of money in the economy finds its origins in the quantity theory of money, an identity developed to illustrate the classical dichotomy - the idea that the real variables in the economy, such as real interest rates, relative prices and real income, are determined by real forces and that monetary forces only affected nominal quantities. Thus, in the classical model money was said to be neutral or money is a veil.
The income version of the quantity theory states that
MV = PY
where M is the nominal stock of money in the economy, Y is real income, P the price level and V the velocity of money in circulation defined as the average number of times per unit time that the money stock is used in making income transactions i.e. V = PY/M
Thus, the quantity theory is a mere tautology i.e. the total value of output equals the stock of money in the economy multiplied by the number of times it is used in transactions. For the equation to become a theory of the price level, restrictions must be placed on V and Y and an assumption regarding the determination of M must be made. Y, real output, was seen as being determined by real factors such as the size of the capital stock and the labour force, the state of technology, etc and was assumed to be at its full employment level. V was seen as determined by the payment and expenditure practices in the economy and therefore was assumed to be independent of variations in M. M is assumed to be determined independently of PY. With V and Y predetermined and M exogenous, P is the only endogenous variable in the system. In the long run variations in M are reflected in equiproportionate changes in P. Hence in the long-run money does not matter.
M = kPY
where k is the reciprocal of the velocity of circulation of money.
Given the initial situation where peoples portfolio holdings are in equilibrium i.e. peoples desired holdings of money balances equal their actual holdings. Assume the money supply increases so that peoples holdings of money balances exceeds their desired holdings. As a result, people will try to off-load their excess money balances and bring their portfolios back into equilibrium by means of increased expenditure. However, as an aggregate net excess money holdings can not be reduced as one mans spending is another mans receipts. One man can reduce his nominal money balances only by persuading someone else to increase his. If price and income are free to adjust, the increase in total expenditure will initially have an effect on output because of slow adjustment of prices (i.e. short-run non-neutrality), but ultimately prices will be bid up to the level where the real stock of money in the economy is restored to its original level.
A more sophisticated analysis of the effects of monetary policy was later developed by Marshall and Wicksell,. They pointed out that by engaging in an open market operation to buy bonds, the monetary authority will normally be obliged to pay a higher price for bonds. This will bid up the price of bonds and depress interest rates. Thus in the short run they recognised that money did matter in that it determined a real variable, namely the rate of interest. In the short run, the rate of interest will be below the natural rate of interest.  This will increase investment and reduce saving and produce what Keynesians regard as an inflationary-gap, i.e. the aggregate demand for output as a whole exceeds the maximum amount of output that the economy is capable of producing. In consequence the level of prices will rise, increasing money demand as consumers require more money to make a given level of transactions. The increase in money demand will restore the rate of interest to its natural rate (assuming that the increase in money supply was a once off). The net effect will be a higher price level. In the long run money will be neutral.
M=M1 + M2 = kY + f(r-r*, r*)
Where M equals total money demand, M1 equals money demand for transactions purposes, M2 equals money demand for speculative purposes, r equals actual rate of interest and r* equals the normal rate of interest (i.e. what investors perceive as being the long-run rate of interest).
The theory of liquidity preference is based on the idea that individual wealth holders have a certain opinion regarding what constitutes the normal rate of interest r*and hold either money or bonds in order to reap capital gains from movements in r. If an individual believes that the present rate of interest exceeds the normal rate of interests he expects r to fall and bond prices to rise therefore he will move entirely out of money and into bonds. Conversely, for r<r* he holds only money. This implies that an individuals demand for money is discontinuous at the normal rate of interest. Since bond traders opinions regarding the nominal rate of interest are heterogeneous, summing individual liquidity preference schedules yields a downward sloping speculative demand for money curve.
For a given r Keynes believed that the speculative demand for money would be highly elastic at r= r*.The elasticity of money demand at an observed value of r depended on how homogenous the expectations of different holders of money are and how firmly they are held. At more extreme levels people will tend to converge in expectations. Thus at very low rates of interest, absolute liquidity preference may exist. Under such circumstances monetary authorities will effectively have lost control of monetary policy. As Keynes (1936) pointed out circumstances can develop in which a large increase in the quantity of money may exert a comparatively small influence on the rate of interest. The reason for the loss of control of monetary policy is as follows. If the monetary authorities sought to increase the supply of money by buying bonds this would tend to raise bond prices and lowering rates of return. However,only an infinitesimally small reduction in interest rates is required to entice holders of bonds to substitute into money because of a consensus among bondholders that interest rates will rise in the future.
The monetarist position was based on Friedmans restatement of the quantity theory of money. Monetarists analysis is highly similar to the classical analysis and reaches similar conclusions. Friedman introduced the idea of Permanent Income into his demand for money function. He regarded this as a crucial difference between his model and that of the Keynesians (where current income was the relevant variable), in that money demand will be less volatile because it will respond less to changes in transitory income. Friedmans restatement was that money demand was a function of the current price level, the rates of return on bonds and equities, the rate of inflation and the stock of wealth (calculated from permanent income).Thus, money demand (and also velocity) is a stable function of these variables.
This version of money demand is obviously very similar to the quantity theory of money the crucial difference being that the velocity of money in the monetarist model is a stable function i.e. it is determined by a limited number of variables which evolve slowly overtime, whereas in the classical model it is taken as a numerical constant. However, like the classical model, the monetarist money demand function is assumed to be relatively stable as individuals are again assumed to hold a relatively stable amount of money in cash. Furthermore, it assumes that certain factors that influence the money supply do not effect money demand. The impact of this is that variations in money supply will have important effects.
It is often said that the main differences between the monetarists and Keynesians surround empirical magnitudes. If this is the case, an examination of the evidence may give some insight into what school may offer the best theory.
In the US a number of empirical studies found a statistical relationship between money and the level of economic activity. Firstly, the pioneering work of Friedman and Schwartz (1963) was one of the building blocks of modern monetarism. Using US data from 1867 to 1960 they investigated the length and variability of the time lag involved in the influence of money. Their most crucial finding was that peaks in the rate of change of the money supply preceded peaks in the level of economic activity by an average of 16 months and the corresponding figure for troughs was 12 months. The implications drawn from the results were not only that variations in the stock of money caused fluctuations in the business cycle but also that since the lags were long and variable a constant rate of money growth was the optimal monetary policy.
However, a number of problems exist regarding the study. Most importantly, Friedman and Schwartz compared the rate of change of the money supply with the level of business activity. However, for any time series of data the rate of change will peak before the level does, so that even if, in terms of levels both cycles were exactly contemporaneous the peak in the rate of change of the money supply would precede the peak in the level of business activity. Thus the study can be criticised on the basis of invalid statistical techniques.
Even allowing for this statistical error temporal precedence does not necessarily imply causality. Firstly, changes in the money suppply may be reacting to changes in money demand caused by increased income. This will be true in the case where the monetary authority targets the rate of interest and allows the money supply to react passively. Tobin (1970) derived the Keynesian type model in which the money supply was demand determined and yet the turning point of the rate of change of the money supply actually led the peaks and troughs in nominal income. Also in a Friedman type model where the money supply was exogenously determined and the demand for money was a function of permanent income the turning points in the rate of change in the money supply actually lagged those of nominal income.
Secondly, both variables may have been influenced by another variable (e.g. the budget deficit) with money reacting more rapidly than income. An increase in the budget deficit must be financed by printing money or issuing bonds, and ceteris paribus this will lead to an increase in the money supply also having an impact on income. In this instance the transmission mechanism by which the budget deficit affects income may run through money but the exact transmission mechanism will be subject to the same disputes already mentioned.
Thirdly, if planned expenditures fall people will demand less money and the money supply will fall. In this instance the subsequent fall in expenditure is not caused by the fall in the money supply. Instead the causation runs from expenditure to the money supply. This point also illustrates the general Keynesian proposition of variations in M do not cause variations in Y but that the reverse holds.
Further studies in the US attempted to model the individual influence of monetary and fiscal variables on income. Both studies came out strongly in favour of the importance of monetary policy but both were subject to criticism on methodological grounds and often the results changed dramatically when a different model was used.
In the 1960s debate centred on one particular transmission mechanism - portfolio adjustment. In the context of portfolio adjustment, Keynesians were portrayed as regarding monetary policy as impotent because of the existence of the liquidity trap, whereas monetarists were portrayed as believing in a black box transmission mechanism. Both positions are an exaggeration. Keynesians recognize that changes in the money supply may have effects through wealth effects and increased credit availibility. Monetarist theories of portfolio adjustment are now very similar to Keynesian theories (such as Tobins). Monetarists also emphasise the important influence of monetary policy on wage and price expectations Thus, monetarists and Keynesians have tended to converge to some degree, although differences of emphasis still exist.
The empirical evidence has proven that the money supply not only effects the level of business activity but is also influenced by it. This means that it is difficult to test empirically for the monetary effects on activity because allowance must be made for the feedback effect of economic activity on the money supply. The extent to which variations in the money supply are demand-determined is strongly influenced by the reactions of the monetary authorities. Thus, to model the feedback effect it is necessary to model Central Bank behaviour. Attempts to do this have been relatively unsuccessful. This presents a problem in assessing empirical evidence regarding the role of money in the economy. However, Cagan (1987) points out that while the concurrent mutual interaction between money and economic activity remains difficult to disentangle, the longer the lag in monetary effects the less likely that the feedback from activity to money can account for the observed association.
A new challenge to the money matters school came from the body of new classical economics. Based on their theory of rational expectations new classical economists, most notably Sargent and Wallace, believed in the idea of policy irrelevance. With regard to monetary policy since agents make rational decisions, only unanticipated changes in the money supply will effect output. Since individuals are rational, anticipated increases in the money supply will be reflected in higher price expectations, and compensatory wage bargains will ensure that real wages remain constant. Furthermore, the assumption of perfect price and wage flexibility implies that any increases in the money supply will be reflected in higher prices in the short run (i.e money is neutral even in the short run).
New classical views are difficult to test empirically. For example, it is very difficult to measure what part of a monetary policy can be regarded as anticipated and unanticipated. However, since their predictions are based on the restrictive assumptions of flexible prices and wages, in the short run, this tends to suggest that monetary policy will have some impact. Apart from the new classicists, most modern economists would acknowledge that the basic postulates of the quantity theory still holds - in the long run prices respond and moneyis neutral, but in the short run prices are slow to respond to demand fluctuations and money does matter.
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