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Keynesian Monetary Economics and The Cambridge Approach

The attitude of Keynes towards the Quantity Theory followed closely the work of the Cambridge School of Economists of whom Marshall and Pigou were the most eminent protagonists. Keynes's Tract on Monetary Reform and Treatise on Money follow closely the Cambridge cash-balance approach to money matters. Fisher's arguments were a fundament ally part of macro-economic theory relating to the aggregate demand for money; Marshall and Pigou considered monetary problems from the microeconomic aspect based upon an individual's choices. An individual's desire to hold money was governed by money's universality as a medium of exchange and other choices that presented themselves as alternatives to holding assets in money form. The stress was shifted from Fisher's concept of the quantity of money that people had to hold, to one of the quantities of money that individuals wished to hold. The Cambridge economists used the symbol V to stand for the income velocity of circulation of money rather than the transaction velocity used by Fisher. Marshall, Pigou, and Keynes believed that an individual takes account not merely of the quantity of money but also liquidity (for trans dictionary, speculative, and precautionary motives), real income, and the rate of interest.

A further Equation of Exchange takes account of the concepts of real income and the rate of interest:

p =  M


Where p = price of consumers' goods (not all goods producers goods are not included in this context. The majority of individuals are interested mainly in consumers' goods).

M= money, i.e., the quantity of money existing in a country at a given time.

k= proportion of a community's total income held in money.

R= real income, i.c., the country's output of goods and services in real terms, rather than monetary terms.

KR is the value of the total quantity of money and

KR / M is the value of one pound sterling. Placing the two equations in juxtaposition:

  1. MV = PT;
  2. M/ k = PR

V and k tend to be opposites. The lower the proportion of their real incomes that people wish to hold in money, the higher will be the velocity of circulation and vice versa. As V and k are reciprocals, to examine reasons for changes in the velocity of circulation it is necessary to study the cause of changes in k, i.e., changes in the reasons why people hold money. The holding of money necessitates an opportunity cost or forgone alternative. If people hold money, they must consider that it is worth the sacrifice. There is a multitude of reasons for such sacrifices: the hope of falling prices, changing trade trends, the three Keynesian liquidity motives, etc.

This analysis helps us to see why money has value; people hold it because it is acceptable as a medium of exchange and it is sufficiently useful to be worth sacrificing for other things. It also helps us to see why the Quantity Theory can be considered part of microeconomics or macroeconomics. The desire to hold money is an individual choice (microeconomics), but millions of individual choices add up to a communal choice (macroeconomics).

Keynes' modifications of the Cambridge economists' work are fully treated in his General Theory of Employment, Interest, and Money. It is this treatment that most macroeconomic exponents have followed. Keynes analyzed in exhaustive detail the motives that lead people to hold money; he considered that the 'transactions motive' was the main motive. Keynes further classified the transactions motive as the income motive. He wrote:

One reason for holding cash is to bridge the interval between the receipt of income and its disbursement. The strength of this motive in inducing a decision to hold a given aggregate of cash will chiefly depend on the amount of income and the normal length of the interval between its receipt and disbursement. It is in this connection that the concept of the income velocity of money is strictly appropriate.

Thus the transaction demand for money is likely to be proportional to the level of income. Following the belief of the Cambridge economists that the rate of interest was an important factor, Keynes argued that when there is an anticipated rise in the rate of interest, demand for money will be comparatively high and vice versa. This is the main point where Keynes and Fisher take different paths, for Fisher considered that the demand for money was not affected by the rate of interest. Keynes thought that interest rates should be kept at a low level and that a cheap money policy would facilitate the building of schools, hospitals, council houses, etc., and thus help to bring down the high unemployment that was a feature of the great depression and the world of the thirties. Keynes argued that fiscal policies were more important than monetary policies. Until the late 1970s, many governments tended to follow the Keynesian line, and we had to wait for Milton Friedman's The Quantity Theory of Money, A Restatement, and Studies in the Quantity Theory of Money to throw doubts upon Keynesian treatment. Friedman put more faith in modern monetary policies than in budgetary policies.


We are still too close in time to evaluate properly the work that originated with the Chicago School of new monetarists. Although Friedman has attracted increasing numbers of disciples in the last two decades, and many economists have turned back to a realization of the tremendous importance of the Quantity Theory of Money, Friedman's arch-critics, such as Professor Kaldor and Professor Samuelson, pour cold water upon what they consider to be Friedman's overemphasis upon the influences exerted by the Quantity of Money.

Before studying the key propositions of monetary ism, it is worth considering Professor Friedman's attitude to the Keynesian approach. According to Friedman, Keynes did not deny Fisher's Quantity Equation of Exchange. Keynes contended that it was the part of total spending that was independent of current income, e.g., government expenditure and business investment, that was more important than changes in the quantity of money: the Great Depression was caused principally by too little investment, and the unfruitful use of capital. Friedman has argued that further studies of the economic history of the twenties and thirties have established that bad monetary policy has to be given a large share of the blame for the Great Depression. Friedman believes that if Keynes had known the main cause of the depression he would have provided a different interpretation of events. According to Friedman the Great Depression owed a great deal to a reduction in the quantity of money. Friedman declared: In the United States, there was a reduction in the quantity of money by a third from 1929 to 1933. This reduction in the quantity of money made the depression much longer and more severe than it otherwise would have been. Moreover, and equally important, it turned out that the reduction in the quantity of money was not a consequence of the unwillingness of horses to drink. It was not a consequence of being unable to push on a string. It was a direct consequence of the policies followed by the Federal Reserve system. (The Counter-Revolution in Monetary Theory, First Wincott Memorial Lecture, 1970.)

He has also contended that from 1929 to 1930 and from 1930 to 1933, the Federal authorities failed to act as was intended by providing liquidity for the banking system. Careful, conservative banks failed because the public at large tried to convert their deposits into currency. The important point is that it is clear that at all times during the Great Depression, the Federal Reserve had it within its power to prevent the decline in the quantity of money and produce an increase. It was not that monetary policy had been tried and found wanting. It had not been tried or tried perversely and had forced an incredible deflation on the American economy and the rest of the world.

When the quantity of money declined by one-third, velocity declined also. When it rose, velocity rose. Far from velocity offsetting movements in the quantity of money, it reinforced them.

Monetarism attaches great importance to the quantity of money, interest rates, open market operations, and all aspects of monetary policy. Control of the quantity of money can be used to control the growth of nominal income. The main principles of the new monetarism may be summarized in 10 points:

  1. There is a consistent though the not precise relationship between the rate of growth of the quantity of money and the rate of growth of nominal income; if the quantity of money is increased then nominal income will increase and vice versa.
  2. The close relationship between the increase in the quantity of money and the increase in the rate of income growth is not noticeable in the very short run because these changes take about six to nine months to become effective.
  3. A changed rate in the growth of nominal income shows up first in output and is hardly discernible in price movements in the short run. If the quantity of money is reduced, then there will be a decline in output and in the rate of growth of nominal income after a period of about six to nine months has elapsed.
  4. The effect on prices will probably take place after another six or nine months. So there is a 12 to 18 months delay between the rate of monetary growth and the rate of inflation. The cause-and-effect relationship between monetary growth and prices may even take five to ten years to work itself out, but there is a definite and inevitable relationship between monetary growth and prices.
  5. Inflation can only be produced by an increase in the quantity of money, e.g., gold discoveries, increases in currency and bank deposits, an extension of credit instruments, etc. Therefore, according to the new monetarists, inflation is always solely a monetary phenomenon. Fiscal policy, by itself, is not a direct cause of inflation.
  6. Indirectly, government spending will be inflationary if it is deficit-induced, i.e., by the creation of new money either by printing more notes or extending borrowing facilities.
  7. Only the monetary authorities (the Chancellor of the Exchequer, the Bank of England, and the Treasury) can increase directly the quantity of money, and indirectly the proportion of assets that people hold as cash. An increased rate of monetary growth will lead, in the first place, to an increase in the amount of cash that people hold concerning their other assets. The holders of this surplus cash will attempt to rectify the imbalance by buying other assets and these attempts will tend to raise the price of non-monetary assets, subsequently reducing interest rates. Expenditure upon new assets will be encouraged. The new monetarists are concerned with a more comprehensive range of assets and interest rates than the Keynesians. Friedmanites attach more significance to the desire to hold real estate, consumer durables, and similar assets. Thus they consider that the market rate of interest is merely one part of the whole ambit of interest rates.
  8. A change in monetary growth will affect interest rates. An increase in monetary growth will tend to lower interest rates at first, but subsequently, interest rates will rise as spending increases and loans are demanded especially in the face of price inflation.
  9. The new monetarists believe that it is vital to distinguish between the nominal rate of interest and the real rate of interest; e.g., if a loan is negotiated and the nominal rate of interest is fixed at a rate of 7.5 percent flat on the original sum borrowed, if the loan is repaid on an installment basis, over periods of 6 to 36 months. the real rate of interest is 13.5 to 13.75 percent depending on the period of the loan. Another important distinction is between the actual real rate of interest prevailing at the time of the loan and the anticipated real rate of interest; e.g... individuals will be loath to loan money at 5 percent a year if they consider that prices are likely to rise by more than 5 percent a year. Full comprehension of this point provides the best understanding of why is so very difficult to check an inflationary spiral once it is underway. growth and general monetary policy are of utmost importance. Large changes in the quantity of money bring instability to an economy and should be avoided wherever possible... Monetarists contend that a steady, automatic rate of increase in the quantity of money would be the best way of establishing persistent economic growth.

The work of the new monetarists has been useful in drawing attention to at least three important principles that will have a lasting effect:

  1. The Radcliffe Report was wrong to play down the effect of the money supply:
  2. We, therefore, follow Professor Kahn, in the evidence that he submitted to us, in insisting upon the structure of interest rates rather than some notion of the 'supply of money as the center-piece of monetary action. (Committee on the Working of the Monetary System, Cmnd 827, HMSO.)

  3. Bank money is an aspect of monetary policy that the Government should control more closely.
  4. Monetary forces should be utilized to stabilize the economy.

In 1980, the then Industry Secretary, Sir Keith Joseph argued that 'Just as people can price themselves out of a job so they can price themselves into a job! In so doing he was merely restating in everyday English a fundamental feature of classical, i.e., pre-Keynesian economics. Yet the fact that he felt able to make what 15 years earlier would have been a statement of economic heresy indicates how radically the economic pendulum had once again shifted. Indeed, the history of economic policy over the past century is the story of economic succession: of Keynesian economics replacing the classical view and, more recently, of Keynesian orthodoxy giving way to a revision of the classical monetary theory.

It is necessary for the student to attempt his synthesis of Keynesian and new monetarist principles and to accept what appeals to him as the most satisfactory aspects of each school as solutions to the monetary problems of the modern world. Since 1960, the UK authorities have followed the guidelines of the Radcliffe Report in an attempt to make monetary and budgetary policies dovetail. The simplified schema of an open macro-economic system (see Fig. 16.6) has been suggested by R. F. Alford, in Money in Britain 1959-1969, ed. by Croome and Johnson (Oxford). 'In terms of this schema, the strategy of the UK authorities has been to act directly upon interest rates through the Bank rate and operations in the gilt-edged market,' but the new monetarists believe that more use could be made of the quantity of money as a policy instrument for influencing aggregate demand. The student will have realized that controlling the quantity of money is an operation of many facets and the monetarists appear to oversimplify the issues involved. The excessive rate of inflation experienced by the UK and other leading industrial countries necessitates the use of all possible corrective devices including controlling the rate of increase in the money supply and the use of credit instruments generally .

macroeconomic system

Figure 16.6 Simplified schema of an open macroeconomic system. (Source: R. F. Alford in 'Money in Britain 1959-1969', edited by Croome and Johnson, Oxford, 1970.)

The Monetarist-Keynesian Debate

Frequently, the monetarist-Keynesian debate is presented in terms of a strict dichotomy between monetarist theory and practice on the one side, and Keynesian theory and practice on the other. Such a division is a gross simplification of reality. Nevertheless, it can certainly be argued that while Keynesianism and monetarism are not opposed extremes, they are significantly different in terms of theory and application. This is especially true given the historical movement of the economic pendulum. At the beginning of the twentieth century, Keynesian economics did not exist, hence our macro-economic framework was a direct descendant of the classical perspective. Monetarism is an important element of classical economics.

The inter-war depression, and the failure of successive governments to cure it with their traditional economic tools, gave rise to the Keynesian revolution which dates effectively from 1936. In his General Theory of Employment, Interest, and Money, Keynes turned classical economics theory upside down. Where classical economists advocated reduced spending, Keynes advocated increased spending: where current economic orthodoxy argued for wages to be reduced Keynes argued for wages to be raised. Initially, such ideas were hardly understood, let alone accepted, yet by 1945 Keynesian theory had become an institutionalized part of our economic landscape. It seemed, in fact, with the growing success of Keynesian economics, that classical economics had been proven not to work in practice. Events conspired to produce dissatisfaction with Keynesian orthodoxy and a growing call for radical change. Professor Milton Friedman's revision of monetarism provided an attractive alternative.

The monetarist-Keynesian debate is often presented in political terms. Those on the political right are thus deemed to favor monetarism with its great stress upon market efficiency, while those on the political left are said to associate themselves with Keynesian economics. However, such stereotyping is misleading. In 1976, for example, the year in which Professor Milton Friedman won his Nobel Prize for Economics, James Callaghan announced to the Labour Party Conference, that 'You could no longer spend your way out of a recession. Six years earlier, Conservative Prime Minister Edward Heath had undertaken policies that paid scant regard to a centrally controlled money supply policy. There are three main points of contention between monetarists and Keynesians.

  1. Whether attempts to define the money supply will result in uncontrolled developments of money substitutes.
  2. Whether or not the velocity of circulation (V) fluctuates and, if so, by how much.
  3. Whether changes in the money supply cause changes in money national income or whether they are a result of changes in money national income (PY).

Keynes was extremely critical of the Quantity Theory approach relating to how the price level may be affected by an increase in the money supply. He contended that the velocity of circulation of money may be variable (as some quantity theorists are prepared to admit), and also that its variation is unpredictable. The behavior of the velocity of circulation will depend upon the complex interrelationships of a vast number of elasticities, some of which vary with the degree of capacity utilization, i.e., on the extent to which there is unemployed labor and capital in the economy. (However, Keynes did not deny the existence of a stable velocity of circulation in the long run.) What he was calling into question were its practical relevance and the policy implications. A major issue between Keynesians and monetarists is their perspectives regarding changes in the money supply and changes in the level of prices.

It is useful to examine the theory and evidence regarding the velocity of the circulation of money. On theoretical grounds, there are several objections to the notion of a constant velocity of circulation. Firstly, if interest rates increase, the opportunity cost of keeping money idle increases. Consequently, both individuals and firms may well economize in their transactions of cash holdings. In addition, the traditional Keynesian demand analysis would suggest a fall in the speculative demand for money. Overall then, an increase in interest rates, producing a decrease in the demand for money, permits a given money stock to finance a larger volume of expenditures. Idle balances will be progressively transferred to active balances and the velocity of circulation will increase. The monetarist view, in contrast, denies the importance of the speculative element and, instead, stresses the transaction dimension. They do concede, however, that interest rates have an important bearing on the overall demand for money. Interest rates represent the opportunity cost of holding money. The implication for the quantity theory is thus clear-if M3 is decreasing and interest rates rising then the velocity of circulation tends to increase, hence offsetting the decrease in the money supply.

Secondly, in times of a restrictive monetary policy, commercial banks as profit-seeking institutions may well operate in opposition to government policy. Again, higher interest rates make lending money more attractive and thus commercial banks have the incentive of selling government securities to make loans available for customers willing to pay higher rates of interest. Many economists have argued that the ability of commercial banks to increase the velocity of circulation renders a restrictive monetary policy highly suspect in terms of effectiveness. A relationship can be postulated between the rate of interest and the velocity of circulation normally measured by:

Final domestic expenditure

             Money stock

In Fig. 16.7, it will be seen that at QV, the interest velocity curve becomes perfectly inelastic. This exists because velocity, it is assumed, eventually reaches a maximum after which interest rate increases will not affect the velocity of circulation.

The third source of velocity instability is the growth of non-bank financial institutions. Even if bank lending is kept in check, increased expenditure may be financed by sources not under the direct control of the Government. We are faced with problems caused by the seemingly endless ability of various financial institutions to escape monetary control.

The IS/LM Model

In the context of a fully employed economy, under what circumstances will an increase in the supply of money not lead to an increase in the price level? The answers to this question will have far-reaching repercussions on the entire monetarist-Keynesian debate. Firstly, however, we need to introduce the traditional framework for macroeconomic analysis known as the IS/LM model.

This model developed by Hicks (1937) to illustrate Keynes' general theory, is a graphical version of a simplified general equilibrium macro-model. It combines real macroeconomic variables, represented by savings and investment (the IS curve), and monetary variables represented by the supply and demand curves for money (the LM curve).

To understand the derivation of the IS curve, it is necessary to concentrate on the real goods market, and in particular on the investment demand function and the consumption function. To understand the derivation of the LM curve, it is necessary to consider the money market. The key to understanding the LM curve is the distinction between the transaction demand for money and the speculative demand for money: the former relates the demand for money to the level of income, and the speculative demand for money relates the demand for money to the rate of interest.

  1. The monetarists' case To illustrate the extreme monetarist case, assume the interest elasticity of demand for money to be zero. The LM curve will, correspondingly, be vertical, as in Figs 16.8(a) and (b). In Fig. 16.8(a), an expansionary fiscal policy has succeeded in moving the IS curve to the right (i.e., IS' to IS2); however, because of the existence of a vertical LM curve the only result is an increase in interest rates; income remains unchanged at y'. In Fig. 16.8(b), an expansionary monetary policy has shifted the LM curve to the right (LM¹ to LM2) and results in lower interest rates (r¹ to r²) and a higher income level (y¹ to y²).
  2. The Keynesian case Here the interest elasticity of demand for money is assumed to be infinite. Hence, the LM curve is horizontal. Figure 16.9(a) illustrates the 'liquidity trap' and in theory renders monetary policy ineffective. An expansionary monetary policy is instigated, which unfortunately does not alter the position of the perfectly elastic LM curve (i.e., LM¹ = LM2). The result is, therefore, an ineffective monetary policy with interest rates and income remaining unchanged (ie., r' = r²; y = 2). In Fig. 16.9(b) an expansionary fiscal policy. coupled with a perfectly elastic LM curve, shifts the IS curve from IS' to IS: income increases but interest rates remain unchanged. There is one other case in which an increase in the supply of money will be ineffective and that is when the 'interest elasticity of investment' equals zero. Hence the IS curve will be vertical as in Fig. 16.10. An expansionary monetary policy in this situation will only result in a lowering of interest rates (to 2). Income will remain unchanged at y', thus keeping both demand and prices constant.

The debate between the Keynesians and the monetarists turns upon the importance of monetary and fiscal policies. If the LM curve is elastic then, logically, fiscal policy must be superior. However, should the LM curve be highly inelastic then fiscal policy is rendered impotent? It may be questioned whether the dispute can be resolved by reference to the available empirical evidence. The extreme cases, frequently quoted, are not supported by the facts. An eclectic position, between the two extremes, is likely to be nearer to the truth.

Therefore, it is useful to examine the intermediate case, where the IS curve has a negative slope and the LM curve has a positive slope (see Fig. 16.11). Owing to Keynes' assumption of downwardly inflexible wages and prices, at all levels of output below full employment there will be a unique LM curve corresponding to a given supply of money. Once full capacity has been reached, however, prices begin to respond in an upward direction to increases in the pressure of demand. At or above y, a unique LM curve corresponds to a given level of real balances. The initial impact of an increase in the money supply will be to shift the LM curve to the right, intersecting with the IS curve, at a new, higher level of equilibrium income (y).

However, if y is immovable then an inflationary gap will be opened up (y-ye)s which deflates the value of real money balances and shifts the LM curve back to its original position, intersecting at y, but at a higher price level. This is just a more elaborate way of presenting the cash balance transmission mechanism. It must, therefore, be concluded that 'money does not matter in an income-expenditure model:

  1. If there is a liquidity trap in operation;
  2. If the investment function is completely interesting and inelastic.

Only when one or both of these two conditions is fulfilled will an increase in the supply of money not affect the price level. Monetarists have given the crude quantity theory a more rigorous theoretical basis. Their basic contribution to modern economics is that they stress that it is vitally important to allow for the monetary consequences of fiscal policy. In some cases, monetary and fiscal policy actions are the same actions, in that both will involve changes in the supply of money. The influence of changes in the supply of money on the level of economic activity is said to involve time lags and expectations effects. This means that the IS-IM curve model is often unsuited to analyze monetarist arguments, since the model is a static one, and assumes that the price level and the level of expectations are given. However, when properly used, the model can throw some light on the issues in question.

The effectiveness of monetary policy issues hinges largely on the magnitude of the interest elasticity of the demand for money. Both monetary and fiscal policies are potentially important. It is no longer possible to claim that 'money does not matter, nor that 'money alone matters'. It is surprising to think that either of these views was seriously advocated, yet they represented the polarization of views in the early stages of the Keynesian-monetarist controversy. Other aspects of the controversy are still being debated, such as whether or not the Government can effectively control the money supply and the wider political questions which follow.

interest velocity of money

Figure 16.7 The interest velocity of money.

The monetarist case

Figure 16.8 The monetarist case (the LM curve is vertical).

The Keynesian case

Figure 16.9 The Keynesian case (the LM curve is horizontal).

supply of money

Figure 16.10 An increase in the supply of money will be ineffective when the interest elasticity of investment is zero (the /S curve is vertical).

intermediate case

Figure 16.11 The intermediate case where the IS curve has a negative slope and the LM curve has a positive slope.

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