A Keynesian perspective on money.

Monetarism is an analytical system whose roots go deep into the history of economic thought. It is the modern version of the quantity theory of money which, in turn, is an integral part of classical and neo-classical economic theory. The quantity theory of money viewed inflation as being solely the result of prior increase in the quantity of money in circulation: an x per cent increase in the quantity of money would ultimately produce an x per cent increase in the price level. Classical economist admitted that, in the short period, the increase in the money supply would stimulate output and employment, but that in the longer run it would be entirely dissipated in the form of higher prices, with output and employment returning to their former levels.

The quantity theory of money dominated thinking on economic policy from the mid-eighteenth century, throughout the nineteenth century and down to the early 1930s. The early formulation by David Hume was refined in the nineteenth century, the locus classicus of the modern presentation of the quantity theory being Irving Fisher's The Purchasing Power of Money (1911).(1) Later, a group of Austrian economists, the followers of Ludwig von Mises, elaborated the policy implications of the quantity theory. The main consequence of monetary expansion brought about through low interest rates was, they averred, a distortion in the structure of production which could last only for a long as the inflationary process continued. Sooner or later, natural forces would reassert themselves, the rate of interest would return to its initial level, and the processes of production which were profitable only at the lower rate of interest would be abandoned. The readjustment which inevitably followed the previous expansion of credit inevitably involved an abnormally high unemployment rate.

Another, less sophisticated, version of this approach to economic matters was particularly influential in Britain in the 1920s: the so-called Treasury View. According to this view, policies of public works expenditure or of encouraging additional investment by bank credit expansion and low interest rates are self-defeating since they simply divert saving from its 'normal' channels.

This approach to macroeconomic policy pervaded the thinking of academic economists and financial and economic advisers to governments right down to the Great Depression and into the early 1930s. It was challenged in the writings of John Maynard Keynes who, after several earlier attempts,(2) provided, in his General Theory of Employment, Interest and Money, a fully articulated alternative to the quantity theory of money. Keynes's theories have themselves recently been challenged by the followers of the new monetarism, who have successfully revived the old ideas of the quantity theory, dressing them in the apparel of modern formal analysis.

In this chapter we shall attempt to describe and criticize monetarist theory from a Keynesian perspective. In the course of this, we shall provide what, in our view, is a more convincing explanation of the determinants of aggregate demand. We shall also, at the end of the chapter, offer an alternative explanation of the chronic inflationary process which appears to have become endemic in capitalist economies since the Second World War, and has recently shown a definite tendency to accelerate.

The effects of increases in the supply of money on aggregate demand

Monetarists argue that if it can be shown that a stable relationship exists between the money stock (however measured) and money national income, it follows that the most effective way of controlling the course of money income over time is to regulate the growth of the money stock. On the basis of econometric research, the monetarists claim that a well-determined statistical relationship exists (though with a variable time-lag) for a wide variety of countries for differing periods.

However, the existence of a stable relationship between the amount of (credit) money and the level of expenditure on goods and services, even if it existed--which is by no means universally accepted by econometricians--is not sufficient, in itself, to establish the main contention of the monetarists. This requires in addition 1. a demonstration that the money stock is in the exogenous variable and the level of prices and wags the endogenous variables andnot vice versa; 2. that changes in the money supply cause, directly or indirectly, a proportionate change in expenditure on goods and services; 3. that changes in the level of expenditure on goods and services affect mainly prices and not output--in other words, that the level of production in general is determined by factors which are independent of the level of monetary demand.

The above conditions may be satisfied in some situations but these are not typical of modern capitalist societies. They are more likely to be satisfied 1. when the increase in the money supply is directly linked to a corresponding change in the level of incomes; 2. when it occurs under conditions in which the economy is under

pressure of scarcities of various kinds (as, for example, in

wartime), when the requirements of additional production in terms

of manpower, etc. cannot be satisfied.

David Hume and the classical economist wrote at a time when money consisted mainly of valuable metals such as gold and silver, whose supply could be expanded only by incurring certain costs. On Ricardo's supposition it was the labour cost of producing gold which determined the gold value of commodities in general, since any difference in the profit earned in producing gold and in producing other commodities led to a shift of resources in one direction or another until the discrepancy was eliminated.(3) It was recognized, of course, that not all countries are gold producers. However, in those countries in which the production of gold increases there is a corresponding rise in incomes, the spending of which, directly or indirectly, creates a surplus of exports over imports in other countries. This surplus is equivalent to an increase in the demand for commodities and has therefore much the same effect as if the rise in gold production had occurred within the country in question.

These propositions are not applicable to money substitutes such as bank notes or bank deposits which cost nothing to produce and do not generate incomes in the process of coming into existence. However, the followers of the so-called 'Currency School' believed either 1. that the circulation of bank notes etc. is in substitution for the use

of metallic money, so that its existence does not add to the

effective amount of money; or 2. whilst acknowledging that the existence of 'credit money'

alongside 'commodity money' enlarges the effective volume of

money, that the former is inevitably in a relation of dependency

to the latter as long as paper money is freely convertible into gold

on demand.

The 'prudence' of bankers--their need to preserve their own solvency --will in itself ensure a definite relationship between the underlying amount of gold in the vaults of banks and the amount of credit money in circulation.

In the present century, long before the gold standard was abolished, it was recognized that the purchasing power of money in terms of commodities has little to do with the 'intrinsic' value of gold as a commodity (whether this is determined by the cost of production of new gold, as Ricardo argued, or its marginal productivity or utility in industrial and other non-monetary uses), but that on the contrary the value of gold in terms of commodities depends on the purchasing power of the various currency units into which gold is convertible. The modern version of the quantity theory of …