A Response to Hoover’s “The New Classical Macroeconomics”

Chapter 5: The New Monetary Economics

New classicals have brought about criticisms to monetarism, Keynesian monetary theory, and earlier new classical work for not starting with microfoundations.  Prior to Keynes’ General Theory was written in 1936, the distinction between microeconomics and macroeconomics was unknown.  Rather, there was two economic theories that were prevalent during that time–monetary theory (general price levels) and value theory (relative price levels).  A year earlier than the General Theory, John Hicks discussed monetary theory, which he claimed had its roots in value theory.  The difficult discussion dealt with explaining why people held non-interest bearing money when interest-bearing money opportunities were available.  He concluded that these forms (i.e. non-interest) were held to overcome what he termed as “frictions,” or transaction costs and risk.  The early stages of the quantity theory of money is derived from the Walrasian system where all markets clear because price levels adjust to put supply and demand into equilibrium.  It was eventually discovered that price levels (absolute or general) were ultimately determined by the quantity of money in circulation so as long as the velocity of money in circulation was corrected.  From this stemmed discussions of inflation.  Monetarists, such as Milton Friedman, suggested that in the long run, the growth rate of the money supply only affects the general price level instead of the real output of the economy.  Nevertheless, the inflation phenomenon is one in which there is more money supplied than there is money demanded.

Patinkin took the quantity theory of money a step further by starting to explore real price levels. He noticed that economic activity could be carried on at any absolute price level, but money has a value.  Therefore, its value depends on the aggregate price level, and as a result, Patinkin divides through by the price level to discover the real purchasing power of money and incorporates that data into utility functions.  This allows for the fusion of monetary and value theory because the demand for money is defined to be the same as the demand for any other good because it holds a certain utility value.  In addition, the level of absolute prices is determined in conjunction with all relative prices so as long as there is an “anchor” or standard to set those prices (i.e. gold).  However, the principal criticism for Patinkin’s theory is the absence of a distribution effect.  A distribution effect assumes that if an economic agent had an increase in cash balance then he would increase his supply and demand proportionately and the relative proportions remain unchanged.  This also assumes that every economic agent is alike, which means that it wouldn’t matter who received the increased cash balance.

Gurley and Shaw (1960) look at the finance process.  They define money with two out of the three characteristics as did Patinkin–that is, money is the medium of transactions and its demand is assumed to “arise from uncertainty about the timing of receipts and payments.”  The new definition associated with money under the Gurley-Shaw theory is that money can be termed debt.  Therefore, one person’s assets exactly equals another’s debt.  The two would then cancel out.  Looking at money as a means of exchange, it is useful in transactions given the uncertainty.  This uncertainty is what causes the differences in rates of return of portfolios.  Fama’s paper is important because he claims money exists only because of “government-imposed legal restrictions on other financial assets.”  However, I don’t understand his argument with regard to being able to get rid of fiat money if the government introduces it into the economy and the story regarding ingots and government taxation on spaceships (pages 95-97).

Chapter 5 ends with a discussion of banking and finance and how it relates to the Modigliani-Miller theorem.  According to Hoover, the theorem says that “how a firm finances its real activities has no decisions of other economic agents.”  Fama assumes a few things.  One, there are perfect capital markets (i.e. “no taxes, transactions costs, or danger of bankruptcy).  There is also assumed to be rational expectations.  Third, economic agents are concerned with risk-return ratios as they pertain to changes in wealth.  Fourth, firms ‘investment decisions are made independently of the how the investment is financed.  Lastly, economic agents have the same access to capital markets–that is, if a firm can issue a liability, so, too, can an individual agent.  Debt-equity ratios can be altered by a firm, for example, which will change the real opportunities of return by economic agents.  However, to return the economy to the previous state prior to changes in a firm’s finances, economic agents will have to modify their portfolio composition.  Fama concludes his argument by stating that relative prices are independent of any financial portfolios–that is, relative prices are derived from fiat money or commodities and absolute prices (with inflation built in) are independent of financial assets.  The conflicting idea that I don’t comprehend is that a sophisticated and more developed financial system relies on the presence of money because a financial asset is essentially a claim on something else and the conversion of one asset into another form is done through the transaction of money.  The liquidity of money is of utmost importance because of the “lack of necessary connections between the amount of outstanding claims to goods of conversion.”  That is, money tends to become the good in which “accounts are settled and into which financial assets are ultimately convertible.”  Not following the conclusion, Hoover asserts that, in fact, relative prices are not independent of finance.

Source: Hoover, Kevin D.  1988.  The new classical macroeconomics.  Cambridge, Massachusetts: Basil Blackwell.

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