Alan Dunne
Junior Sophister

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.

The Quantity Theory, the Classical Dichotomy and the Neutrality of Money

......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.[1]
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.[2]

The income version of the quantity theory states that


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.

Short-Run Non-Neutrality

It should be noted that the neutrality of money is dependent on a number of conditions- price/wage flexibility, an absence of money illusion, an absence of distribution effects and price and interest rate expectations of unitary elasticity. If the assumptions are violated money will not be neutral. These assumptions are most likely to be violated in the short run. This was recognised by the quantity theorists. Hume recognised that prices do not rise proportionately to the increased quantity of money and that in the intervening period this stimulates production.[3] This transmission mechanism can best be seen by reference to the Cambridge Cash Balance version of the quantity theory of money.

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[4]. Assume the money supply increases[5] 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.[6] 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. [7] 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.

the monetarst - keynesian debate

In the thirty years following the General Theory Keynesian economics became known first and foremost as a theory of effective demand emphasising the role of fiscal policy in stabilising output. Monetary policy was subordinated to the role of maintaining interest rates at a low level in order to stimulate investment. Indeed, in most instances (e.g. UK pre-1968) the government targeted the rate of interest and allowed the money supply to react passively. Despite the almost universal acceptance of Keynesian principles, a small number of economists, particularly in the Chicago School, kept faith in the significance of the quantity theory of money. Friedmans restatement of the quantity theory as a theory of money demand combined with the statistical evidence indicating a strong correlation between monetary fluctuations and changes in the level of business activity in the short-run, and in the price level in the long-run, were the building blocks for monetarism. While classical analysis had shown that money supply fluctuations may have real effects in the short run, in the 1960s Keynesians and Monetarists were debating their relative positions of money does not matter at all versus money is all that matters.[8] The debate focussed on two interrelated issues:the stability of the money demand function and the transmission mechanism

The Money Demand function

The Cambridge Cash Balance equation states that M=kPY. The central difference between Keynesians and Monetarists is that for Keynesians a change in M will in certain circumstances, most notably in the case of the liquidity trap, lead to increased hoarding[9]of money reducing the velocity of money, V ( increasing k). This is the extreme position and in general most moderate Keynesians while subordinating the role of monetary policy would acknowledge some effect of a change in M on Y (however, changes in the velocity will reduce the impact of such effects). Monetarists, arguing along a similar line to the classical economists, see increases in the monetary supply impinging mainly on Y in the short-run but on P in the long-run (V and k are assumed to be stable functions). To see these effects we must analyse their respective theories of money demand.

Keynes Liquidity Preference Theory

One of Keynes critical departures from classical economics was his theory of the rate of interest which incorporated his liquidity preference theory of money demand. This theory is an extension of the Cambridge Cash Balance equation to include a speculative demand for money.

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.[10] 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.

Keynesian Transmission Mechanism

The implication of the theory was that people would not hold a fixed proportion of their wealth in cash. People will tend to hoard based on their evaluation of the costs and benefits of liquidity.[11] In this situation an increase in the money supply will mean people will hold more money maintaining interest rates at their present value and reducing the velocity of money.[12] Thus, in this case the traditional Keynesian cost of capital effect is not operative.[13] However, Keynes acknowledged that while this limiting case might become practically important in the future, I know no example of it hitherto. Nevertheless, while the possibility of a liquidity trap can be questioned, it seems Keynes remained convinced of only a minor role for monetary policy.[14] He states that it seems unlikely that the influence of banking policy on the rate of interest will be by itself sufficient by itself to determine an optimal rate of investment. I conceive, therefore, that a somewhat comprehensive socialisation of investment will prove the only means of securing an approximation to full employment.[15] However, it would be false to suggest that the Keynesian position is encapsulated by money does not matter just because of the theoretical possibility of the existence of a liquidity trap. Regardless of whether the liquidity trap exists[16]the interest inelasticity of investment is a more important barrier to an influential monetary policy. Money may matter in its effect through alternative transmission mechanisms such as wealth effects and credit availability.

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.[17] 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.

The Monetarist Transmission Mechanism

As a result of the stable demand function monetarists believe in a more direct transmission mechanism of M on Y, unlike the Keynesians. They argue that the crucial difference between themselves and the Keynesians lies in the range of assets considered as substitutes for money. They believe that every asset, including physical assets, has a rate of return (yielded in the form of a flow of services in the case of physical goods) and that every asset is substitutable for money whereas Keynesians believed that only financial assets were close substitutes. [18] The crucial issue ...... is not whether changes in the stock of money operate through interest rates but rather the range of interest rates considered.[19] Thus, since monetarists believe that all assets are substitutes for money an increase in the money supply can lead agents to offload excess money holdings by purchasing capital goods. Thus a direct link is said to exist. However, this is only one possible portfolio adjustment[20] and the specifics of the transmission mechanism have proven difficult to model. Hence monetarists have often been labelled as believing in a black box transmission mechanism.

Black-box monetarism

However, to many people the direct link is implausible because of the mechanism by which increases in the money supply occur. Unlike the classical system increases in the money supply occur through banking operations, therefore using the analogy of dropping money from a helicopter and analysing the effects on spending as Friedman (1969) did is not the same as analysing the effects of an open market operation . The helicopter example did much to provoke claims of a black box transmission mechanism in monetarism. Furthermore, Friedmans riposte to such criticism that if anybody asks what is the mechanism by which an increase in the money supply brings about an increase in prices, what David Hume has to say answers that question about as well as anybody else I know[21]did little to dispel such criticism. Trevithik points out that it is ridiculous to view variations in the total volume of bank deposits as having the same effects to those of increases in the supply of gold in 18th century England.[22] However, monetarists now interpret the transmission mechanism along similar lines as Keynasians such as James Tobin.

The Empirical Evidence

The basic differences among economists are empirical not theoretical[23]

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[24] 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.[25]

Consensus ?

While the major issues have not been resolved by empirical evidence, both schools positions are now more modified. Both Neanderthal Keynesians, denying that monetary authorities have any control over the money supply ,and Neanderthal Monetarists denying any efficacy of fiscal policy even in the short-run, have been left far behind.[26] Blaug (1980) argues that in one sense the Monetarists have won - governments now take greater account of fluctuations in the money supply. Keynesianism has developed to take account of the several channels through which monetary disturbances influence the economy. In a more profound sense, however, monetarism has lost. Blaug argues that monetarism never succeeded in clarifying the causal mechanism that produced their empirical results, sometimes even denying that the results required interpretation in the light of supporting causal theory.[27] Monetarists now recognise that the money supply can only be regarded as exogenous in the long-run.

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.


While monetarists and Keynesians have modified their positions as a result of the theoretical debate of the 1960s, the exact impact of money on the level of activity is still disputed. The instability of money demand and the unpredictability of the velocity of money in the early 1980s, and the abandonment of the monetarist experiment in the UK and US in the 1980s were the basis of the criticisms of monetarism.

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.


Blaug, M (1980) The Methodology of Economics

Cagan, P (1987) Monetarism in Eatwell (ed) The New Palgrave

Dennis, EJ (1981) Monetary Economics

Friedman, M (1956) The Quantity Theory of Money : A Restatement in M. Friedman (ed) Studies in the Quantity Theory of Money

Friedman, M (1969) The Optimum Quantity of Money and Other Essays

Friedman,M (1987) The Quantity Theory of Money in Eatwell et. al (ed) The New Palgrave

Gowland, D (1991) Money, Inflation and Unemployment

Keynes, JM (1936) The General Theory of Employment, Interest and Money

Morgan, B (1977) Monetarists and Keynesians

Patinkin, D (1987) The neutrality of money in Eatwell et. al. (ed) The New Palgrave

Pierce, D and Tysome, P (1985) Monetary Economics

Pigou, AC (1917) The Value of Money in Quarterly Journal of Economics 32, November

Tobin, J (1970) Money and income: post hoc ergo propter hoc Quaterly Journal of Economics

Trevithick, J (1992) Involuntary Unemployment