MONEY IN THE INCOME-EXPENDITURES MODEL

Let us look first at the role of money in the income-expenditures model presented in Chapters 6 and 7. J. M. Keynes, the father of the incomeexpenditures approach back in the 19 30’s, said that money matters, but not very much. Money generally plays only an indirect part in determining aggregate demand. In the Keynes model, consumers’ spending depends primarily on households’ disposable income, not on the stock of money they have. Investment spending, however, depends on the relationship between the marginal efficiency of capital and the interest rate, and the interest rate in turn is set partially by the stock of money. Since the interest rate is the price people pay to borrow money, more money will lower the interest rate, other things equal, by increasing the supply side of the supply and demand equation. Thus, he recognized that putting more money into the system could lower the rate of interest, and thus indirectly could stimulate investment. Conversely, less money would (other things equal) raise the interest rate and thereby restrict investment.

The way money fits into the income-expenditures model can be easily seen from the following causal chain. If the government adds more money to the system, it affects g.n.p. as follows:

+ M—> — i—> + I—> + g.n.p.

where M stands for money, i stands for interest rate, I stands for investment, and g.n.p. is aggregate spending. Note that in this approach more money does not directly stimulate consumption spending; its only effect is through lowering the interest rate and thereby stimulating investment.

Moreover, Keynes argued, variations in interest rates are generally smaller than variations in the marginal efficiency of investment. The marginal efficiency depends on expectcrtions of profits and other factors in the future, which may shift widely. Thus, moderate changes in the stock of money, bringing about only moderate changes in interest rates, generally have a relatively unimportant influence on total investment spending. Keynes argued that investment spending is thus relatively insensitive to changes in interest rates. But this degree of sensitivity is a factual issue, on which the evidence is mixed. Some of the relevant information is presented later in this chapter.

If we accept this analysis of the place of money in the determination of aggregate spending, then government-induced changes in the stock of money may influence aggregate spending somewhat, but only indirectly.

THE QUANTITY THEORY.--.

THE CLASSICAL ECQNOMISTS

By contrast, the classical economists—the long tradition from Adam Smith through David Ricardo and Alfred Marshall, up to the decade of the 1920’s—gave money a central role in explaining aggregate spending. They had two main points. First, the amount of money will determine aggregate money spending; and second, variations in aggregate money spending will affect the price  level but not real g.n.p. except for temporary aberrations.

First, if people have more or less money, they will spend more or less. People don’t hold money for its own sake, but for what it will buy. In general, the rate at which they spend the money they get will be stable, or change only gradually. Thus, changes in the amount of money will generally lead to proportional changes in total spending.

Second, these variations in total spending will mainly just bid the price level up or down, without changing the level of real output and employment. The classical economists argued that a free-market economic system would ordinarily tend to be self-equilibrating at approximately full employment. They reasoned that whenever resources are unemployed or unsold, their market price will move down until it falls low enough so that everything offered is hired or sold. There may be temporary deviations from full employment and, indeed, these deviations may involve booms and depressions. But they will be aberrations, explained largely by special external factors such as wars or famines; by cumulative, herd-like sweeps of expectations that lead to gluts of overproduction or to depressions; and especially by the erratic behavior of the monetary system. Over the long pull, the economic system will always tend toward full employment. More or less money will change spending proportionately, and more or less spending will lead to a correspondingly higher or lower price level, not to a change in real output.

In terms of our earlier diagrams, this classical position can be put as follows. The economy will always tend to operate on its production-possibilities frontier—i.e., at full employment. Thus, in Fig. 5-1 the economy’s short-run aggregate supply curve is, as a practical matter, not OAB, but instead a vertical line rising from the horizontal axis at 0Q3. This is because the economy will tend to operate at full employment whatever the level of aggregate demand is. If aggregate demand falls, prices will fall but output and employment (real g.n.p.) will be unchanged; if aggregate demand rises, prices will rise but real g.n.p. will remain unchanged. Money-induced fluctuations in aggregate spending would lead primarily to fluctuations in the general price level. This was called the “quantity theory of money,” because in it the quantity of money roughly determined the price level.

To be sure, the classical economists didn’t think that money affected only the price level. They knew that price inflation and deflation are often interrelated with the over-all level of economic activity, that financial crisis means unemployment and bad business as well, and that inflation often means price speculation and a disruption of productive relationships. Increasingly, they came to see that if, in fact, prices did not move flexibly up or down in relation to changing aggregate demand, such changes in demand would have a direct impact on the level of real g.n.p. and employment. Thus, economists gradually came to see that changes in price levels, production, and employment were all interrelated parts of the same process. We turn now to look in more detail at how the classical (monetary) econ-~ omists explained the role of money.