Journal of Monetary Economics 25 (1990) 177-183. North-Holland

THE NEW PALGRAVE MONEY A Review Essay

Alvin L. MARTY*

Buruch College, Cip University of New York, New York, NY 10010, USA

The new Palgrave volume on Money (W.W. Norton, New York, 1989) collects the essays on money scattered throughout the four heavy tomes of the New Palgrave: A Dictionary of Economics, edited by John Eatwell, Murray Milgate, and Peter Newman. The 43 essays are of varying length, generally less than 7 pages and range from such topics as ‘Monetary Cranks’ (David Clark) to the ‘Bullionist Controversy’ (David Laidler).

The volume opens appropriately with the most lengthy essay (37 pages), Milton Friedman’s ‘The Quantity Theory of Money’. What is of special interest are Friedman’s comments on rational expectations, on the Phillips curve, and how his views now differ, if at all, from those held in his earlier work.

For Friedman, money is a capital good like land, which yields a utility flow. The price of money is the reciprocal of the price level and not the rate of interest, which is the price of credit. Friedman traces the confusion between these two costs of money to fractional reserve banking under which, changes in the money supply partly occur through the banks role as a financial intermediary. Friedman does not discuss the view advanced by Bernanke (1983) that a deterioration in banks’ intermediary role was a factor, indepen- dent of the fall in the money supply, depressing the 1930s’ U.S. economy. Bernanke notes that although Canada did not experience bank runs in the 1930s Canada’s large external debt was made more burdensome, under fixed exchange rates, by the world-wide price deflation. This was a factor, according to Bemanke, impairing the intermediary function of Canadian financial insti- tutions linking debtors and creditors. However, if in the United States the authorities had increased high-powered money sufficiently to offset the reduc- tion in the money multiplier and to maintain the nominal stock of money, price deflation would, in the main, have been avoided. Any impairment of the

*I thank Phillip Cagan, Donald Gordon, Herschel Grossman, David Laidler, and Anna Schwartz for helpful suggestions and disagreements. The usual caveat on responsibility holds in full.

0304-3932/90/$3.50 Q 1990, Elsevier Science Publishers B.V. (North-Holland)

178 A. L. Marty, The new Palgrave money

intermediary function in both the U.S. and in Canada was ultimately due to inept monetary policy in the United States.

If money is treated as a capital good, one may draw average and marginal schedules relating the services of money to its quantity. A developed monetary theory, comparable to the theory which exists for the real side, would guide us in shifting these schedules under a change in parameters. Such a developed theory does not exist. On the real side, for example, but not on the money side, a classification of technical innovations exists: neutral, capital-saving, or labor-saving. A comparable monetary theory would help us to understand the empirical results noted by Friedman that heightened uncertainty about the real economy increases the demand for real balances; whilst uncertainty specifically generated by a mean preserving increase in the variability of inflation reduces demand (Friedman, p. 13).

More than two decades ago, Friedman (1956) asked why money is more important than pins. One reason is that money is a more pervasive asset - the number of weeks income commanded by money is greater than pins. Friedman and Schwartz (1982) predicted that as the economy develops, the real income elasticity of demand for money, initially greater than unity, decelerates towards unity. If the income elasticity were to remain unity, velocity would become independent of the growth of real output per capita, although it would still be influenced by opportunity costs of holding money such as anticipated inflation.

Recently, Bordo and Jonung (1987) substitute institutional factors for the income elasticity, and conclude that velocity follows a U-shaped pattern. No prediction is made that the rise in velocity in developed economies will ultimately taper off. If it does not, in time, money becomes like pins. ‘This total, the community’s cash balances, deserves pride of place as a control item. As the means of payment, cash balances are the most widely distributed financial asset. A good market for money therefore exists, enabling rapid adjustment to changes in the amount supplied and demanded.’ [Marty (1961)]. A continual reduction in the ratio of money to income would thin the market for cash balances, making the dynamic response to changes in the demand and supply for money much more sluggish. Whether money, in these circum- stances, could remain an instrument of policy is an open question.

Phillip Cagan contributes an essay on ‘Hyperinflation’ and notes that in his early classic work [Cagan (1956)] expectations were modelled as adaptive. Inflation tax revenue can then be continuously augmented by increases in monetary growth which produce actual inflation rates greater than expected ones. Such serially correlated expectation errors were later criticized as ‘irra- tional’ since they implied that people ignored dollar bills lying in the street.

Rapid inflation has its origins in the printing of money to raise revenue which the authorities could not or would not raise by ordinary taxation. Cagan stresses that fiscal dependence of money creation must end, if currency

A. L hiurty, The new Palgrave money 179

stabilization is to be successful. Cagan’s point is strengthened when we note that in the L.D.C.s, currency reform is often packaged with financial liberal- ization, implemented by reducing banks’ required reserves and hence the base of the inflation tax. Unless fiscal dependence on inflation is ended, the authorities may be tempted to offset the reduction in the tax base by a higher inflation tax rate.

A helpful extension of Cagan’s essay would inform the reader that money creation can raise some revenue without causing inflation, if real income is growing, and that an identical quantity of revenue may be raised at a low tax rate (monetary expansion) and a high tax base (real balances) or alternatively at a low base and high rate. The high tax rate is stable under rational expectations. If, under adaptive expectations a stable inflation is possible, it is on the socially desirable portion of the LatTer Curve at a low inflation rate.

Don Patinkin’s contribution ‘The Neutrality of Money’ explores ways in which alternative rates of money growth can raise or lower the steady state capital-labor ratio. This breakdown of superneutrality due to Tobin-Mundell effects is a theoretical curiousum made even less relevant by the payment of interest on deposits. Abnormal monetary growth (such as occurs during hyperinflations) does bite on real variables since it cost resources (and leisure) to economize on real balances. Even in this case, I know of no empirical evidence that points to an effect on capital-labor ratios. I take it, there is a substantial consensus, that, in the long run, normal rates of monetary growth are approximately superneutral.

For both monetarists and Keynesians, the pons asinorum of monetary theory remains the short-run effects of money on real variables. Consider, for example, Milton Friedman’s account of the short-run Philips curve. Starting from long-run equilibrium in which expectations are correct, let an increase in monetary growth produce a larger rise in prices than in money wages. Workers deflate money wages by last periods’ lower prices (expectations are one period autoregressive), erroneously believe real wages have risen, and offer to supply more labor. Although each employer correctly perceives the decline in his product’s real wage rate, each mistakenly believes his product’s price has risen relative to other prices and demands more labor. After one period during which workers and employers sample prices, misperceptions are corrected, and the economy reverts to long-run equilibrium at the natural level of employ- ment.’

‘Friedman models expectations as adaptive and his subsequent appraisal of rational expecta- tions is cautious. One implication of rational expectations is that errors are not serially correlated so that, on the average, expectations are correct. But what operational meaning can be given to this implication? Friedman and Schwartz (1982) point out that from 1886-96 it was widely anticipated that the United States might depart from the gold standard. Such expectations were in fact not fulfilled. However, asks Friedman, in what sense can behavior prompted by such beliefs imply serially correlated errors? Another of his examples is the Mexican peso. There was some probability that the convertibility of the peso into the dollar might not continue. How can we

180 A. L. Mur(y, The new Palgrave monq

Friedman’s account implies an inverse correlation between output and the product real wage which has not been detected empirically [but see Sumner and Silver (1989)]. And how can the persistence of cyclical deviations from the

natural rate be explained by errors which can be corrected by looking at money supply statistics - a criticism which can also be directed at the Lucas model in which only white noise in the money supply process has an effect (lasting one period) on output. 2 Herschel Grossman points out in his spirited essay on ‘Monetary Disequilibrium and Market Clearing’ that not only does the empirical evidence reject the hypothesis that innovations in real activity are uncorrelated with contemporaneous measures of current and past changes in money, but also no correlations can be detected between innovations in real activity and revisions in preliminary estimates of monetary aggregates, these revisions being a measure of the unperceived components of the money

supply. Some of these criticisms of equilibrium models under imperfect information

apply to contract models. For example, Stanley Fischer’s contracts (1977) make the schizoid assumption that prices are flexible, but staggered money wages are set with rational expectations for two periods to clear the labor market. An unanticipated but fully observed nominal shock, such as an increase in velocity, reduces the product real wage and increases the demand determined employment of those workers locked into the contract. Even a serially persistent shock has an effect only for the duration of the last contract, since the degree of persistence is known to all parties. As in equilibrium models, nominal shocks imply that the product real wage and output vary inversely. (This is not the case if the shock is real. However Fischer’s suggestion that, even in this case, policy be used to reduce the variability of real output seems misguided.) Fischer’s assumptions about contracts can be faulted on the grounds that with full information about shocks, a first-best

label the behavior of those who choose not to hold high yield Mexican savings accounts during the period of convertibility as reflecting serially correlated errors?

Despite these reservations, Friedman applauds the policy implications of rational expectations. Monetary policy operates by fooling people. If expectations are rational, people catch on. The more rapidly people learn, the more vertical is the short-run Phillips curve. The application of these observations to Friedman’s own account of the short-run Phillips curve raises subtle problems of interpretation.

‘Some of these criticisms are even more telling against the recent attempt by Ball, Mankiw, and Romer (1988) to prove that the greater the anticipated inflation, the more readily an economy adapts to nominal shocks and the steeper is the short-run Phillips Curve. This is in contrast to Lucas’ hypothesis that only the variance of inflation (nominal shocks) relative to real shocks steepens the curve. Why should having an exponential term greater than zero in expectations and in contracts imply a more flexible adjustment to nominal shocks? Why single out final rather than factor prices? Consider two economies: in Alpha, output per man and money wages rise at 3 percent. in Beta they rise at 6 percent. In both economies, the average growth of final prices is zero. Do these different anticipated trends in factor prices have effects, even though both economies have zero anticipated growth of final prices?

A. L Marty, The new Palgrave money 181

contract would equate the disutility of labor with its social marginal productiv- ity while optimal risk sharing would lead to constant real wage payments in different states of nature. Nominal shocks would then have no real effects. [See Barro (1977).]

These models raise the issue whether private contracts could be indexed against shocks. Can not the private sector as well as the authorities fine-tune against perceived shocks? What is the externality or market failure which makes it more efficient for the authorities to offset fully perceived shocks, rather than private agents?

These are the wrong questions. There are substantial transaction costs of indexing contracts against a wide variety of potential shocks which, it may be noted, are imperfectly perceived and indexing doesn’t work unless all relevant parties index - there is a coordination problem here which is buried in many models under the representative agent assumption.3

Similar reservations motivate Duncan Foley’s ‘Money in Economic Activity’. Concerning the policy ineffectiveness propositions of rational expectations, Foley writes: ‘It is unclear how general these results are, especially, in circumstances where there are important differences in information and beliefs in different segments of the public, and where the cost of learning the true structure of the economy (if such a structure actually exists) are significant.’ Foley’s skepticism appears directed at rational expectations per se, rather than at the assumption of market clearing. I do not share Foley’s skepticism regarding rational expectations per se. It has proved fruitful in contract models, and no other model of expectations has or, I conjecture, will take its place. But we should keep in back of our minds, that these models assume single-valued expectations, that the structural coefficients are assumed deter- ministic when in reality they are stochastic [Brainard (1967)], and that all agents including the authorities are assumed to know the underlying structure of the economy. There is a danger that these assumptions bias economists and policy makers into believing that more is known about the economy than is justified. The immanent logic of rational expectations models, with or without contracts, leads subtly to the conclusion that policy actions are ineffectual because the private sector can either accomplish the same ends or neutralize the actions of the authorities through indexation. Policy is either ineffectual or redundant. These implications contrast with an older but still compelling view that knowledge of the economy is sufficiently opaque so that fine-tuning can do harm.

David Lindsey and Henry Wallach sensibly discuss ‘Monetary Policy’ and encapsulate a neat nontechnical discussion of rules vs. discretion. Suppose the

‘Let an unanticipated but perceived decline in the money stock occur. If we were initially in equilibrium, the loss to any one agent of not adjusting is of the second order, but the social loss (under imperfect competition) is first order [Akerlof and Yellen (1985)]. There is an externality here: If I don’t reduce my price, aggregate real balances are lower.

182 A. L. Muriy, The new Pulgraue money

authorities try to reduce unemployment by increasing the money supply. When private-sector expectations are rational, time-consistent discretionary policy leads to higher rates of inflation than would a binding rule. On the average, there is no reduction in unemployment.

I would have preferred a greater emphasis by Lindsey and Wallach on the intertemporal budget constraint linking monetary and fiscal policy. After all, any excess of spending over ordinary tax receipts must be made up either by issuing bonds or high-powered money. It may well be that in the United States the relevant real rate of interest is below the rate of growth of output, so that monetary policy can, for a time, ignore the constraints set by fiscal policy. Unpleasant monetarist arithmetic need not imply that today’s restricted growth of money will lead in the future (or even now) to higher inflation. But an examination of the budget constraint has proved useful in explaining why, under rational expectations, a given budget deficit can be associated with different inflation rates. If, for example, the seignorage from money creation approaches an upper limit, the public may expect future fiscal discipline, which produces lower inflation now. [See Drazen and Helpman (198Q.l

Benjamin Friedman’s magisterial essay focuses on ‘Capital, Credit, and Money Markets.’ A number of paragraphs end with the litany: government bonds are net wealth. Despite this emphasis, curiously enough, the author does not refer directly to the Ricardian Equivalence Theorem. The pure theorem rests on a host of restrictive assumptions. For example, intergenerational altruism must be effective (no corner solutions) and there must be no break in the altruistic link between generations. Taxes must be lump sum, and the rate of interest used to discount future tax liabilities must equal the yield on government securities. If the pure theorem held, government borrowing would be precisely equivalent to taxing. Why then would government ever resort to deficits?

The theorem should be taken as a framework for thinking about real world deficits. Few economists believe that when tax rates are reduced, the fall in revenue is fully offset by an increase in private-sector savings leaving global savings unchanged. But, how large is the offset? Do the factors qualifying the pure theorem support traditional Keynesian ways of thinking? The Ricardian framework has fruitfully led to regarding deficits as a device which permits distortionary taxes to be smoothed intertemporally in order to minimize deadweight losses.4

This selective review reflects those articles which were of special interest to me. The Palgrave Money is filled with a large number of short essays that are of antiquarian interest. These essays are likely to survive the passage of time.

4For Barro and Gordon (1983), discretionary monetary policy, because of the time-inconsistent constraint, results in excess growth of the money supply, whereas fiscal policy is led as though by an invisible hand to deficits that minimize deadweight losses. What accounts for this difference?

A.L. Mar@, The new Palgrave money 183

Developments in pure theory go at a heady pace. The mainly theoretical essays will, in all probability, be of limited interest in the future. It would be unfair to expect the Palgrave Money to be at the cutting edge of recent developments. For this, one is better directed to Blanchard and Fischer’s Lectures on Macroeconomics (1989) or the more narrowly focused Monetary Economics (1989) by Bennett McCallum (who coauthors with Goodfriend an excellent theoretical essay on money demand for Palgrave). After all, how many go to the old three-volume Palgrave for current theory? But there will always be those who are interested in the rise and decline of controversies and theories. For them Palgrave will remain a lasting source of information and comfort.

References

Akerlof, George and Janet Yellen, 1985, A near-rational model of the business cycle with wage and price inertia, Quarterly Journal of Economics 100. Suppl.

Ball, Laurence, N. Gregory Mankiw, and David Romer, 1988, The new Keynesian economics and the output-inflation tradeoff, Brookings Papers on Economic Activity 1.

Barre, Robert J., 1977, Long term contracts, sticky price and monetary policy, Journal of Monetary Economics, July.

Barre, Robert J. and David Gordon, 1983, A positive theory of monetary policy in a natural rate model, Journal of Political Economy, Aug.

Bemanke, Ben, 1983, Non-monetary effects of the financial collapse in the propagation of the Great Depression, American Economic Review, June.

Blanchard, Oliver J. and Stanley Fischer, 1989, Lectures on macroeconomics (MIT Press, Cambridge, MA).

Bordo, Michael and Lam Jonung, 1987, The long run behavior of the velocity of circulation: The international evidence (Cambridge University Press, Cambridge).

Brainard, William, 1967, Uncertainty and the effectiveness of policy, American Economic Review, Papers and Proceedings, May.

Cagan, Phillip, 1956, The monetary dynamics of hyperinflation, in: M. Friedman, ed., Studies in the quantity theory of money (University of Chicago Press, Chicago, IL).

Drazen, Allan and Elhanan Helpman, 1988, Inflationary consequences of anticipated macroeco- nomic policies, Quarterly Journal of Economics, forthcoming.

Fischer, Stanley, 1977. Long term contracts, rational expectations and the optimal money supply rule, Journal of Political Economy, Feb.

Friedman, Milton, 1956, The quantity theory of money: A restatement, in: Studies in the quantity theory of money (University of Chicago Press, Chicago, IL).

Friedman, M. and Anna Schwartz, 1982, Monetary trends in the United States and the United Kingdom (University of Chicago Press, Chicago, IL).

Marty, Alvin L., 1961. Garly and Shaw on money in a theory of finance, Journal of Political Economy, Feb.

McCallum, Bennett T., 1989, Monetary economics theory and policy (MacMillan, New York, NY).

Sumner, Scott and Stephen Silver, 1989. Real wages, employment, and the Phillips curve, Journal of Political Economy, June.