Blaug’s Economic Theory in Retrospect: Chapter 14
Blaug, Mark. 1978. The neoclassical theory of money, interest, and prices. In Economic Theory in Retrospect, Third edition, 645-664. Cambridge University Press, London:
Blaug’s chapter on neoclassical monetary theory, overall, is extremely technical but concise. He explains how neoclassical theory stemmed from its classical predecessor and how it developed over time. In particular he focuses on Fisher’s transaction approach and Wicksell’s cash balance approach.
The quantity theory of money was primary monetary theory until the 1930’s, stating that as the money supply increases, prices increase. However, the theory fails to recognize the dual uses of money; it is both a means of exchange and of storing value. Furthermore, it assumes that the velocity of circulation (V) is a constant, and lacks a mechanism explaining how the money market returns to equilibrium. Classical quantity theory is only good for explaining how money supply influences prices in the long run. Neoclassical quantity theory focuses on the short run, and assumes that V is unstable during a transition period between equilibria.
Fisher’s work was one of the first to treat V as though it were inconstant. He primarily assumed that the supply of money was equal to the percent of aggregate income held as cash adjusted for price. His work did not allow for changes in interest, price, or price level as he assumed that these changes were only temporary deviations from the equilibrium. As was the issue with classical quantity theory, the only purpose for currency was to prevent people from spending beyond their means.
Wicksell’s theory augmented Fisher’s work by explaining the relationship between money and price in terms of the interest rate. Wiksell differentiated between currency and credit, referring to the former exclusively as money and the latter as bank deposits. Credit is more elastic, and has a better response time to changes in the interest rate. When discussing interest, he often referred to a “natural rate”, which he took to mean the marginal efficiency of new capital. Since the marginal efficiency of new capital can only be predicted, Wicksell describes a “cumulative process” that addresses discrepancies between the market interest rate and expected returns from investment. In the cumulative process, disequilibrium occurs when there is an increase in net investment. The bank interest rate will then have to increase so net investment remains less than or equal to voluntary savings. In a monetary equilibrium, the loan rate will correspond with the expected returns on new capital, the demand for capital equals the supply of savings, and prices will not move. In this case, money is neutral and has no impact on the price level.
In one time period, if investment exceeds savings then output will not be translated into disposable income, and there will be inflation. If savings exceeds investment, output will have a lower money value. To stabilize price, the market rate of interest will be determined based on the supply and demand of loan funds. Demand for loan funds is the sum of the demand for investment and inactive cash. The supply for loan funds is the sum of personal and business savings and bank credit. An increase in technology leads to an increase in productivity which would lead to variation in prices. To prevent this, the money supply must increase or output will stagnate.
Wicksell’s cumulative process fails to mention the stabilization of forced savings, the real balance effect, and changes in expectations. He assumes that expectations are determined based on the previous period, and that changes in prices will lead to future, equal changes in prices. If this is the case, there will be eternal equilibrium instability in the money market. In reality (not in Wicksell’s argument), firms expect lower prices in the future and lower returns, and will therefore choose to invest less causing investment and price to hover around an equilibrium level.
Keynes separated the saving/investment equilibrium from the employment equilibrium. In an economy with underemployment, fiscal measures should be taken to change output and prices in the short run. He adds to the previous model further by including government spending. Inflation occurs when demand exceeds output, leading to the real balance effect: people will decrease their spending because of the decreased value of their money, leading to increased savings. Prices will increase after an increase in the money supply, and banks will raise the interest rate to slow investment. The increase in cash transactions will help slow inflation.
Blaug concludes by walking through Wicksell’s Lectures. Wicksell states that V is constant in a pure-cash economy, and that it is a function of the liquidity preference in a pure-credit economy. The demand for money should be divided into that of an individual and of the market. An individual’s demand for money is negatively correlated to prices. Demand for money in the market place is positively correlated with prices, as it results from an increase in the supply of commodities. The normal interest rate is determined by returns on real capital, equilibrium in the supply and demand of savings, and has no effect on the price level. When the market rate decreases, voluntary savings decrease and forced savings increase. Finally, Wicksell disliked the gold standard in banks as it forced them to appease both domestic and international prices for gold.
