Archive for the ‘e488-classical’ Category

A Response to Blaug’s “The Neoclassical Theory of Money, Interest, and Prices”

Thursday, January 17th, 2008

This chapter in Blaug’s book closely examines the origins, but more importantly the observable market forces that made for the strength and validity of the quantity theory of money.  Milton Freidman commented on the quantity theory of money as one that had strong observable correlations as the “uniformities that form the basis of the physical sciences.”  That is to say, the relationship between the quantity of money and changes in the price level both in the short-run and long-run occurred almost uniformly and over a wide spectrum of circumstances.  Blaug then goes onto to discuss Say’s Law of Markets that essentially states that there can be no demand without supply.  In a barter economy, production increases not only the supply of goods, but also creates demand for these goods.  The important point to note in a barter economy is that supply cannot exceed demand because supply creates demand and “products are paid for with products.”  A distinction is made, however, that in a monetary economy there is the possibility for an excess supply of commodities (i.e. money), meaning that the increased supply of money will strictly lead to inflation and not more demand because it is important to keep in mind that with inflation, there is more money demanding the same amount of goods.

In the neoclassical period (1870-1930), many individuals were concerned with the short-run implications of the quantity theory of money MV = PT; where M = money supply, V = velocity of money, P = aggregate price level, and T = level of output or real value of the aggregate transactions.  In particular, the individuals were concerned with how to model V and T.  While many believed these to be somewhat constant, Fisher’s Purchasing Power of Money discusses the problems of “transition periods” during which both V and Tare changing.  Nevertheless, criticisms arose during the early twentieth century because the model to show the relationship between the money stock and aggregate price level was deemed too oversimplified.  Out of these criticisms that the demand function for money wasn’t explicitly written, a new model was developed where it was believed that the reason people held cash was out of embarrassment for defaulting on investments.  As a result, V became a constant because it didn’t seem to be a function of either real income or the rate of interest.

The next section in Blaug’s book looks at Wicksell’s linkage between money and prices via the interest rate.  In this portion of the chapter, Blaug discusses Wicksell’s cumulative process.  Wicksell looks at the cumulative process from two extremes–the pure cash system and the pure credit system.  In the pure cash system, money is defined as coins and paper currency, whereas increases in checking deposits are treated simply as increases in the velocity of the banking reserves and the ability for the bank to loan out funds.  Here it is defined that a decrease in the bank rate (the market’s interest rate) will lead to an increase in investment because the marginal product of capital is greater than the marginal cost of borrowing.  This will result in a disequilibrium, causing the demand of capital goods to increase (due to a lower interest rate), consumer goods to rise, and the wages demanded from workers to also rise.  All of this increased demand will lead to a price rise that is considered cumulative in nature.  Nevertheless, this disequilibrium will be corrected by the market because an increase in the price level (i.e. inflation) will be corrected as inflationary pressures deplete reserves (since it is now more expensive to buy the same basket of goods).  This decrease in bank reserves will lead to a higher bank interest rate and the above-mentioned steps will be reversed and equilibrium will be achieved once again.  In the other extreme–the pure credit system (which is supposedly similar to our banking system today), all money is in the form of demand deposits and bank notes.  However, what I don’t understand and would like help with is the distinction between the pure cash system and pure credit system and also what it means for the elasticity of the bank to be infinite (in a pure cash system) and for the elasticity of a bank to be zero (in a pure credit system).

The last large theme of this chapter examined market equilibrium.  According to Blaug, market equilibrium is achieved when three conditions are met: (1) the loan rate of interest is equal to the expected yield of newly created capital (the rate of return); (2) the demand for loanable funds and the supply of savings is equal; and (3) the level of the commodity prices has no tendency to move.  After going through the derivation of a mathematical equations that linked planned and realized investment and saving with planned and realized income, two relationships were realized.  One is that if investment exceeds saving, then earned income is rising.  The other one makes mathematical sense, but not economic sense.  It states that an excess of planned savings or planned investment implies a deficiency of realized income as compared with planned income.

The chapter ended with a look at both expectations as well as a quick glance at both Wicksell and Keynesian models.  With regard to expectations, Wicksell assumed that the “elasticity of expectations of unity”–which meant that a change in current prices is expected to change the future prices in both the same direction and same proportion.  Right away, it can be observed that this upward spiral would be unending and an equilibrium point between supply and demand would never be achieved without the help either anticipated expectations to curb those expectations or outside intervention.  Keynes felt that the economic system could be out of equilibrium even if the market interest rate and the natural rate were at the same levels.  This could occur if the interest rate mechanism didn’t match the demand and consumption plans of households and business firms.   According to Keynes, the way to deal with this disequilibrium is through outside intervention, also known as “automatic stabilizers,” via fiscal policy.

Source: Blaug, Mark.  1978.  Economic theory in retrospect.  3d ed.  Cambridge: Cambridge University Press