The Neoclassical Theory of Money, Interest and Prices

18 01 2008

Blaug, Mark. Economic Theory in Retrospect, 5th Edition, Chapter 15, “The Neo-Classical theory of Money, Interest and Prices,”613-628.

An Introduction to the Quantity Theory of Money

Until the 1930s, the dominant theory used by economists to explain shifts in price levels was the quantity theory of money: MV = PT

M = quantity of money in circulation; V = velocity that a unit of money is transacted; P = price level; T = real value of aggregate transactions

For this equation to hold true, three assumptions are made: 1) MV must cause PT rather than the opposite; 2) changes in V and T cannot be due to monetary factors; and 3) the nominal stock of money must be determined by an exogenous force (such as a central bank) as opposed to public demand for money.

The theory assumes a stable value for V, which means that price levels (P) vary in exact proportion to changes in the money supply (M). If they are in disequilibrium, two transmission mechanisms exist to balance them: 1) the direct mechanism- people use additional money to buy more goods, which drives up prices; and 2) the indirect mechanism- an increase in the money supply drives down interest rates, which increases consumption, which in turn drives up prices until interest rates return to equilibrium.

Though every classical economist (Malthus, Thornton, Bentham, McCulloch, John Stuart Mill, and Torrens) except for Ricardo and James Mill acknowledged that changes in the money supply could impact economies in the short-run, classical economists emphasized the “neutrality of money,” implying that changes in the money supply have no influence on real economic variables (output, employment, etc.) in the long-run. This is what ultimately distinguished classical economists from neoclassical economists in terms of quantity theory. By the mid-20th century, the strict long-run neutrality of money had all but disappeared. Quantity theory would transform from an explanation of changes in purchasing power to a theory of how the money supply influenced aggregate demand (represented by MV), prices, and output.

The Evolution of Quantity Theory

Fisher and Marshall— In Fisher’s Purchasing Power of Money, he acknowledged that the equation of exchange only held in long-run equilibrium and that transition periods occurred in which the value of V would change. However, he argued that such changes were due to frictions in the economic system. Ultimately, he over-emphasized the concept of money to spend (motion theory) rather than to hold (rest theory).

Marshall moved the theory of money demand more toward ordinary demand analysis rather than treating it only as a unit of exchange. Money related to national income rather than to the value of goods transacted. Marshall also shifted focus from money’s annual rate of turnover to the proportion of income that people hold in the form of money.

Wicksell— Wicksell carefully restated the indirect mechanism which had only been touched upon by Marshall. He intended to account for the Gibson Paradox while also defending quantity theory. The Gibson Paradox was first observed by Thomas Tooke between 1838 to 1857, indicating that price levels and interest rates moved in the same direction which contradicted monetary theory. Wicksell approaches the issue by first conceptualizing a pure cash system in which only coins and paper currency are used. In such a regime, a fall in interest rates would raise the volume of investment per unit of time and prices of capital would rise. In the economy were fully employed, the entire wage-price level would rise and this inflationary upsurge would cause a drain in the circulation of money. Since banks cannot issue more loans due to reserve requirements, they must raise interest rates to cut off inflation. Wicksell next conceptualizes a pure credit system in which there are no limits to bank reserves. Under such a regime, monetary authorities would be free to determine price levels at will.

He argued that if interest rates were lower than the expected yield of investments, this would create a disequilibrium that would be inflationary unless this money were saved and not used for consumption. He developed three criteria of monetary equilibria: 1) loan rates must equal the expected yield of newly created capital; 2) demand for loans must equal the supply of savings; and 3) the general level of commodity prices must be stable.

There were several shortcomings to Wicksell’s model. Firstly, he did not consider how economic growth involves increased productivity, which impacts price levels. For stable prices, the money supply must increase with the rate of increase in productivity, because higher output causes prices to fall. He also did not incorporate changing expectations into his model. In static equilibrium, producers would assume that increases in the price of capital are only temporary and will come back down. As such, they would wait until prices fell to invest, causing investment to sink below normal levels. Wicksell also failed to include cost or yield variables in his money demand function, and he only considered an economy at full employment without considering monetary impacts on employment and output.

Keynes— In criticism of Wicksell, Keynes argued that when there are unused resources in an economy, changes in spending are more likely to impact employment and output rather than prices. In addition, he reversed the assumptions of quantity theory, by making prices fixed and output flexible while also denying the stability of V. He demonstrated that an increase in the money supply could be offset by a fall in V, causing spending and income to stay the same. He also separated demand for money into active cash balances and inactive cash balances, which for the first time included the opportunity cost of holding cash. Replacing the direct mechanism with the multiplier, Keynes’s main policy implication promoted fiscal policy as a superior tool to monetary policy in fighting economic downturn.

Friedman— Milton Friedman countered Keynes’s analysis with a complete specification of relevant constraints and opportunity cost variables for his money demand function. His independent variables included a broad definition of wealth which consisted of the present value of expected future receipts from all sources. He considered all types of wealth as possible substitutes for cash holdings.

Questions and Comments

I am having trouble fully understanding the cumulative process described by Wicksell.

How did Wicksell ultimately explain the Gibson Paradox?  Was the positive correlation between inflation and interest rates due to the fact that Tooke only looked at nominal interest rates?

If we lump together classical and neoclassical economists and compare them with Keynesian economists, I suppose two main differences are demonstrated in this article: 1) classical economists tend to favor monetary policy while Keynesian economists favor fiscal policy; and 2) classical economists focus on long term equilibria while Keynesian economists emphasize short term equilibria.


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One response to “The Neoclassical Theory of Money, Interest and Prices”

20 01 2008
joeberger (16:13:24) :

If i read it correctly, Wicksell was trying to illustrate an instance where the Gibson paradox did not hold true. He was saying that interest rates and price levels do not always have to move in the same direction because at some point, banks can no long issue loans and must use the interest in order to curb inflation. I think he was trying to show that raising the interest rate would lower price levels and therefore the Gibson paradox could not completely discredit monetary theory. This was an excellent refresher on quantity theory. I was unaware that classical economists believed that while the money supply can affect the economy in the short-run, over the long-run the “neutrality of money” would hinder the money supply from impacting real output and employment.