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January 14, 1977
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N o Tears for Keynes
During the Great Depression, the
central public-policy debate concerned the role that government
should play in reviving a faltering
economy, with some economists
advocating an expanded government role and "classical" economists arguing against it. Today, in
the wake of the worst recession
since the Depression, we seem to
have come full circle, with the revival of many of those earlier classical arguments.
In that Depression-era debate, classical economists argued that the
role of government was very limited. Money, they claimed, was simply a ({veil" over the real economic
world, and thus could do little to
stimulate real economic activity. An
increase in the money supply
would simply increase the price
level. Indeed, they argued that
workers could not be fooled into
accepting lower real wages even
when they were disguised as higher
money wages, so that there was
nothing that stimulative public policy could do in the long run to
eliminate unemployment. On these
grounds, public policy could alter
real economic activity only if it
could in some sense fool the public.
Enter Keynes
John Maynard Keynes, a highly
skilled economist and statistician
from Cambridge, was well-trained
in this classical notion of the limitations of public economic policy.
Throughout his early career, he had
expressed the Cambridge view of
the world-the classical quantity
theory, which stressed money's limited role as a policy tool. According
to this theory, the money supply
was the sole determinant of the
absolute price level, but of little
else.
Yet Keynes ultimately rejected his
intellectual heritage when he published " The General Theory of Interest, Employment, and Money."
The (General Theory' emphasized
that individuals desire money for
other than transactions (spending)
reasons; for example, they may
desire to hold money because the
risk of doing so is less than the risk
of holding bonds if interest rates
are expected to rise (and bond
prices to fall). In modern Keynesian
thinking, monetary policy was
downgraded and fiscal policy instead was accepted as the primary
tool of economic stabiliz-ation, with
the Federal budget being used to
manage aggregate demand. Another persistent thread running
through the (General Theory' was
the argument that prices were
"wage determined." This continual
reliance on wages as the primary
factor determining prices gave rise
to the cost-push theory of inflation.
Enter econometrics
Twentieth-century aggregate economic theory-Keynesian and nonKeynesian-did not submit to hard
scientific testing until economists
discovered how to handle the
mountains of available statistics
through econometric model building. This new methodology involved the statistical estimation of
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interrelated equations describing
private market behavior-for example, the response of consumption
to a rise in income, or the sensitivity
of savings to changes in interest
rates. Most large-scale econometric
models were built along Keynesian
lines, emphasizing the interrelationship between income and
expenditures. Also, most of these
early models yielded large fiscalpolicy impacts and rather modest
monetary-policy impacts, reflecting
the model builders' preconceptions
concerning policy's proper role.
In the late 1960's, however, economists at the Federal Reserve Bank of
St. Louis reacted to this strong
Keynesian bias by developing a
model which emphasized the dominant role of the money supply in
determining nominal and real output, especially in the short-run. In
this model, fiscal variables displayed
very little long-run ability to
affect real output. Models of this
type were scorned by textbook
Keynesians, but still showed good
results in interpreting reality.
Enter Friedman
The guiding spirit behind this antiKeynesian sentiment was the University of Chicago's Milton Friedman, the 1976 Nobel laureate in
economics. Friedman was not personally involved with the testing of
"monetarist" econometric models
of aggregate economic activity, but
he had a great deal to do with them
intellectually. In a seminal essay
published in 1956, he said, "The
quantity theorist not only regards
2
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the demand fu nction for money as
stable; he also regards it as playing a
vital role in determining variables
that he regards as of great importance for the analysisof the economy as a whole, such as the level of
money income or of prices."
Friedman threw down the gauntlet
to Keynesians with his thesis regarding the "stability" of the demand for money. Over the years,
students of Friedman have spent
countless numbers of computer
hours showing that the demand for
money is dependent on only a few
variables, and that this relationship
shows a good deal of statistical
stability over time. Indeed, the
stable money-demand hypothesis
was the rock upon which the St.
Louis Fed economists built their
model of the U.S. economy.
Yet, Keynesiansdisputed these
money-demand stl:Jdies.They often
found an unstable demand for
money over short-run periods, on
the basisof quarterly or even
monthly data. This difference was
not merely a point of esoteric intellectual dispute, for if they could
prove that the demand for money
was actually unstable, Keynesians
would win much of the debate over
fiscal vs. monetary policy.
The stable money-demand debate
still rages in the pages of economic
journals, but the monetarists appear to have won some major battles in the twenty years since Friedman edited " Studies in the Quantity Theory of Money." Central banks
around the world now pay a good
deal of attention to the impact of
money on nominal output and
prices. Money is no longer regarded simply as a veil over real
economic activity. Indeed, Congress itself has been influenced to
the extent that it passeda resolution in 1975 requiring the Federal
Reserve to report periodically on its
annual monetary targets.
New palace coup
In emphasizing the relationship between money and prices-an argument still in dispute-monetarists
have raised the flag of the preKeynesian classical economists. To- .
day, more flags are in the offing. In
the most recent assaulton the conventional wisdom, Robert Lucas,Jr.,
of the University of Chicago and
Thomas Sargent and Neil Wallace of
the University of Minnesota argue
that public policy's impact on real
economic activity has been grossly
overstated.
Their basic point is that statistical
economic models of the economy
have misrepresented the way individuals and businessmen form their
price expectations. In their view,
economists have always assumed
that the public could never learn
the "policy rule"-that is, the manner in which policymakers respond
to economic information in determining future policy. Lucas,Sargent
and Wallace argue that this view is
mistaken and that the private sector
has "rational expectations"people actually can, over a period
of time, learn about the real structure of the economy and the policy
rule by which policymakers behave.
3
This knowledge is enough for the
private sector to offset whatever
impact policymakers exert on the
real economy.
This notion of rational expectations
leads to what might be called
"super-classical" economic results,
for in effect neither fiscal nor
monetary policy would have any
impact on real economic growth.
The only way policymakers could
affect real output would be to fool
the public as to their intended actions. All other policy effects on
real output would be negligible.
While this theory has received only
moderate statistical testing, it has'
led to the revival of the classical
argument that money is to some
extent a veil over the real economy.
" Rational expectations" might help
explain why some econometric
models have shown monetary policy to be more stimulative than fiscal
policy, because the public has had
greater knowledge of fiscal policy
(tax rates, government spending,
etc.) and less knowledge, until recently, of the actions of the Federal
Reserve. If this line of argument is
believed, monetary policy henceforth might lose some of its power
to affect real economic growth. This
remains an hypothesis for future
economists to test. In sum, however, it seems clear that a circle has
been closed in economic theory,
stretching from pre-Keynesian
classicism,to Keynesianism, to the
anti-Keynesian revolution of the
1960'sand, finally, back to strict
classicaleconomics.
Joseph Bisignano
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BANKING DATA-TWELfTH FEDERAL
RESERVE
DISTRICT
(Dollar amounts in millions)
Selected Assetsand liabmties
large CommerdallBanks
Amount
Outstanding
12122/76
Change from
year ago
Dollar
Percent
+ 1,171
+ 527
+ 236
- 123
+
49
+ 122
+- 760
- 116
+ 1,934
+ 755
41
+ 1,093
+ 162
+ 370
+ 468
+ 605
12129/76
Change
from
+ 4,839
+ 4,278
+ 335
- 833
+ 1,867
+ 1,609
+ 396
+ 165
+ 3,663
+ 1,743
1
+ 2,443
- 1,736
+ 8,503
- 3,112
- 4,853
Loans (gross, adjusted) and investments*
Loans (gross, adjusted)-total
Security loans
Commercial and industrial
Real estate
Consumer instalment
U.S. Treasury securities
Other securities
Deposits (less cash items)-total*
Demand deposits (adjusted)
U.S. Government deposits
Time deposits-total*
Statesand political subdivisions
Savingsdeposits
Other time deposits:j:
Large negotiable CD's
94,878
70,842
1,898
22,858
21,464
12,230
11,177
12,859
95,087
27,032
334
66,081
5,895
30,820
26,809
11,201
Weekly Averages
of Daily figures
Week ended
Week ended
12129/76
12122/76
Member Bank Reserve Position
ExcessReserves(+)/Deficiency (-)
Borrowings
Net free(+)/Net borrowed (-)
federal funds-Seven Large Banks
Interbank Federal fund transactions
Net purchases (+)/Net sales (-)
Transactions with U.S. security dealers
Net loans (+)/Net borrowings (-)
+
+
58
1
57
+ 5.37
+ 6.43
+ 21.43
- 3.52
+ 9.53
+ 15.15
+ 3.67
+ 1.30
+ 4.01
+ 6.89
- 0.30
+ 3.84
- 22.75
+ 38.10
- 10.40
- 30.23
Comparable
year-ago period
7
0
7
+
+
116
24
92
46
+
613
+ 1)39
124
+
165
+
620
*Includes items not shown separately. :j:lndividuals, partnerships and corporations.
Editorial comments may be addressed to the editor (William Burke) or to the author •. . .
Information on this and other publications can _be obtained by calling or writing the Public
Information Section, federal Reserve Bank of San francisco, P.O. Box 7702, San francisco 94120.
Phone (415) 544-2184.
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