MONEY, AGGREGATE DEMAND, AND THE PRICE LEVEL

Chapters 6 and 7 explained aggregate demand with little mention of money. There, spending depended largely on incomes received. Butwe receive ourincomes in the form of money. and somehow it seems that money must be too important to leave out. This chapter puts money into the model.

Since spending does appear to depend largely on incomes received, we need to ask how more or less money will raise or lower incomes. Some economists say the relationship is simple—just create more money and it will almost automatically circulate through the system, creating more income and aggregate demand as it is spent. If either consumers or businesses get more money, they’ll spend more. But it’s not clear that the answer is so simple.

This chapter has five main sections.The first summarizes the major facts about money and its relationship to g.n.p. and prices during this century. The second explains the minor role which money plays in the “Keynesian” income-expenditures model developed in Chapters 6 and 7. The third and fourth sections go back into intellectual history to look at the analysis of the “classical” economists who accorded money a central role in explaining aggregate demand and prices. The fifth pulls both Keynesian and classical models together in a “modern synthesis,” which recognizes that both have important elements of truth.

THE FACTS

What are the facts about money in relation to gross national product and the price level? Figure 8-1 summarizes these relationships since 1900.

FIG. 8-1 The money stock hasrisen about 51/4 per cent annually,
and money g.n.p. a little faster.G.n.p. in constant dollars has grown
only about 3 1/2 per cent annually,however, and a price rise of about
2ผ per cent per annum accountsfor the difference. Has the excess of
money supply over the growth inreal g.n.p. caused the inflation?
(Sources: Federal Reserve Board,U.S. Departmentof Commerce,
and National Bureau of Economic Re- search.)

The bottom line shows the growth in the stock of money, averaging 5 3/4 per cent per annum since 1900. The next two lines show that “real” gross national product (that is, g.n.p. in constant prices) rose at about 3 1/4 per cent per annum over the same period, while money g.n.p. rose at about 5ฝ per cent annually. The top line shows that the price level rose by an average of about 2 1/4 per cent annually, the difference between money gross national product and real gross national product.

It is clear that the increase in the money stock on the average paralleled closely the growth in money g.n.p.; and that about two-thirds of the growth in money g.n.p. was growth in real output while about one-third was inflation.

Deviations from these average (trend) growth lines are as interesting as the trends themselves. The big inflation of World War I is clearly visible. The money stock shot up from 1915 to 1920 as new money was created to finance the war, and prices soared roughly apace. About 1927, the money stock began to fall below the economy’s 3+ per cent real long-term growth rate, and the long depression of the 19 30’s began two years later. The great collapse (in both output and prices) came between 1929 and 1933, when the money supply was contracting severely.

World War II was different from World War I. Again, much of the war was financed by newly created money. But widespread price and wage controls held inflation to a creep during the war, and it was not until their removal after 1946 that prices rose rapidly. Thus, the inflationary pressure generated by new money was more spread out than during World War I. Strikingly, the growth in the money supply leveled off around the mid-1950’s; it rose only about 1 per cent a year over the next several years. This period included the “weak” recoveries of 1956—57, 1959—60 and 1961—62, and the recessions of 1958 and 1960—61. The money supply began to grow more rapidly again in 1963, and so did g.n.p

Some economists infer from these facts that the money supply exercises a powerful effect on the level of real output and prices. They argue that when the money supply rises much faster than the growth in the economy’s real output potential, inflation results. Growth in the money supply parallel to growth in potential real g.n.p. (about 3+ per cent per annum over the past half century) would go far to ensure stable economic growth. But others say that this is too simple an analysis of a highly complex problem, and that it overstates the role of money.