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Robert L. Hetzel

The money supply is a widely watched statistic
today. Its weekly and monthly behavior is watched
by financial analysts interested in the cost of credit
in the money market. Its semiannual and annual behavior is watched by business analysts concerned
about the aggregate flow of goods and services from
the nation’s economy.
Its annual and quinquennial
behavior is watched by bond holders forecasting
future rates of inflation.
This article contains a
monetarist explanation of why the behavior of the
money supply is considered to be important.
The
first section reviews the post-World 1Var II behavior
of the money supply. Subsequent sections discuss the
relation between money and the business cycle, money
and inflation, and money and interest rates.
Behavior of Money Since World War II
The
behavior of the nominal quantity of moneyt that is,
the amount of money held by the pubIic expressed in
doilars, is shown in Charts 1 and 2. Chart 1 plots
for successive quarters from 1946 to the present the
rate of growth of X1 over the preceding eight quarter

FEDERAL RESERVE BANK

The rate of growth of IU1 decelerated
intervaIl
sharply after World War II, but accelerated during
the Korean War. From I954 to 1964 &I1 exhibited
a trend rate of growth of approximately
2 percent.
For this period, the cyclical behavior of M1 superimposed on the trend rate of growth is clearly visible.
The trend rate of growth of Ml rose beginning in
1964. From 1964 to 1976 the annualized rate of
growth of M1 was 5.3 percent.
Again, the cyclical
behavior of the money supply is clearly evident.
Recent data do not indicate any change in the trend
rate of growth of ill,. As of the first quarter of 1973,
the rate of growth of h;il over the preceding eight
quarters was 7.1 percent.
By the first quarter of
1976 this figure had been reduced to 4.3 percent. It
has risen since then, however, and was 5.1 percent
as of the second quarter of 1977.
1 Using data bexinnins
in 1944 I. a regression was run for each
consecutive quarter employing the M: figure for that auarter and
the eixht following
qxrters.
The re,wessions were of the form
Ion (MI) = a + bT -j-u, where T is a time trend.
T is the set
of numbers 0, 114, 2/4, . f . S!S. The average peyytase
chanpe .of
fy! ;;v$ an eight quarter nertod is .tben the co.effmzent b multxplmd
. AI! rates of channe in this article wtll emplou continuous
compoundinn.
Data for this and al other cberts were obtained from
a database mzintzined by the Xational Bureau of Economic Research.

OF RICHMOND

3

Chart 2 shows year to year growth rates for Mr
and Mz beginning in 1948. Like Chart 1, it is useful
for identifying trend rates of growth in money. Mr
and Mz possessed the same trend rate of growth
until the beginning of the 1960’s. The trend rate of
growth of Ma increased in 1961, about three years
earlier than for Ml. Since then, the average annual
rate of growth of Mz has exceeded that for Ml by
2.9 percentage points.

‘_
*‘,<
,‘ 10.0 i.

-

MI

What is of concern to individuals is not the nominal quantity of money they hold, but rather the real
quantity. Real, as opposed to nominal cash balances,
are measured in terms of command over resources.
One way of expressing this figure for the public is
the fraction of GNP which its money holdings equal.
Chart 3 shows the ratio of M1 to GNP and MZ to
GNP using annual averages for the years 1948 to
1976.2 Both ratios declined rapidly in the decade
after World War II. The ratio for Mz, however,
appears trendless since the end of the 1950’s. In
1976, the public held M1 balances amounting to 18
percent of GNP (about 9 weeks income) ; the comparable figure for M2 was 42 percent (about 22
weeks income).
Discrepancies Between Actual and Desired Real
Cash Balances Discrepancies
between the actual
and desired real cash balances of the public are
important because they cause changes in the spending behavior of the public. What causes such discrepancies to arise?
Monetarists employ the empirical
generalization that the real quantity of money individuals desire to hold depends in a predictable fashion
on a small number of variables. These variables include such things as interest rates, the amount of
uncertainty that characterizes economic relationships.
it is hypothesized that
and wealth. Furthermore,
changes in desired holdings of real cash balances
occur slowly. Relative to the amount of variability
that generally characterizes macroeconomic variables.
the ratio of Mz to GNP shown in Chart 3 is stable.
The corresponding
ratio for M1 is also stable after
allowance is made for trend. From 1960 to 1976, the
Mz ratio and the trend adjusted Mi ratio varied only

2111 Chart 3. the real quantity of money is expressed as the ratio
of money to GNP (nominal income).
GNP is the value for the
MI and Mz are average figures for the first six
particular yea*.
months of the particular year and the last six months of the preThe ratio of money lagged six months to GNP is
ceding year.
stabler than the ratio employing con6mporaneou.s figures.
The
reason, which is discussed in the text. is that in adjusting the ratio
of rn~ney to nominal income the public can only affect the denominator (nominal income).
When something causes the numerator
(money) to change. however. the public’s spending behavior only
affects the denominator after some time has passed, generally about
six months.

4

ECONOMIC

REVIEW,

about one percent from year to year.3 The stability of
the data on real cash balances supports the monetarist contention that the demand for real cash balances is stable.
The supply of money, on the other hand, is considered by monetarists historically to have been less
stable than the demand for money. Discrepancies
between the public’s actual and desired holdings of
real cash balances are viewed as arising from changes
More
in the supply, not the demand for money.
specifically, it is decreases in the rate of growth of
the money supply relative to trend rates of growth
that cause the public’s actual real cash balances to be
less than its desired real cash balances.4
As ex-

3Expressing these ratios as percentage changes removes the twnd
contained in them. From 1960 to 1976, the standard deviations of
the percentage changes in real Ml and real Mz balances, calcul.ated
as described in footnote 2, were 1.4 and 1.1 percent, respectively.
1 Real cash balances are the ratio of money to nominal income.
Nominal income may be expressed as the product of the price level
times real output. When the public has adjusted to a given rate
of growth of the money supply, the growth in the price level will
For a given level of wealth, real
match the growth in money.
cash balances. the ratio of money to nominal income. will remain
constant. A reduction in the rate of growth of the money SUIPP~Y
causes real cash balances of the public to decline because. initially.
money (in the numerator), but not prices (in the denominator),
are affected.

SEPTEMBER/OCTOBER

1977

plained below, this discrepancy causes the public to
reduce the rate at which it spends and produces a
recession.
Adjustment
of Actual
to Desired
Real Cash
Balances
The public alters its spending in response to discrepancies between its actual and desired
real cash balances. For esample, if the real quantity
of money people actually hold is less than what they
desire to hold, they reduce the rate at which they
spend in an attempt to increase their money holdings.
As a result, the typic2 producer
(employer) faces a
reduction in the demand for his product, which, if
He also
sustained, causes him to reduce output.
perceives a decline in the price at which he will be
able to sell his product in the fumre.5 This anticipated decline in the future price of his product causes
52~
the
like
rate

starting point of price stabi.lty is essumed in this section.
If
phrases
s t ar t‘IP~ pot‘n t ?ad been a ‘bos It+? rate of inflation,
1
“a fail ir. prices (1 should be repleced by *‘a reduction in the
of growth of prices.”

-

MI/GNP

--

M2/GNP

the producer to expect less revenue from the future
At the then
sale of a given amount of product.
existing nominal (dollar-denominated)
wage rate,
the total wages paid to employees for the production
of this given amount of product wil! remain unchanged. Consequently, real wages as perceived by
the employer rise in the sense that at the current
nominal wage rate, he will in the future have to turn
over a greater share of the proceeds to employees
from the sale of a given amount of product.
Employers will be willing to employ the same number
of employees as before only if nominal wage rates
are lowered.
Employees will resist any reduction in nominal
wage rates, even though what matters to them is real
wage rates and relative wage rates. Real wages are a
measure of wages in terms of their purchasing power.
This measure depends on the prices of the large
number of goods and services purchased by employees. Relative wages measure a wage in one job
reIarive to wages in other jobs. Again, this measure
depends on a large number of observations.
For the
individual employee, real and relative wages are
imperfectly calculable by using general price indices,
which only partially reflect his patterns of consumption and the occupational opportunities available to
him. The employee is only able to gather the information .necessary to evaluate his real and relative
wage rate over a period of time. Even if prices and
wage rates are falling elsev;here in the economy as a
result of the reduction in the rate at which the public
is spending, the individual empioyee will only gradHe will
ually become aware Jf this information.
initially interpret any decline in his nominal wage
rate as a deciine in his real and relative wage rate.
Kate the contrast with the employer. The profitability of his production and, therefore, the real
wage relevant to him can be determined by comparing the nominal wage to a single price, that of his
own product. The real wage relevant to the employee
is determined by comparing his nominal wage to
many prices, and time is required to gather the
information on prices. Both the employer and employee are guided by the real wage, but their perception of the real wage will differ at the onset of a
recession. At the nominal wage rate existing prior
to the reduction in the aggregate spending by the
public, employers will want to reduce employment.
If employers do cut nominal wage rates, employees
are more likely to quit in order to look for a job
ofiering the pre\-iously existing higher nominal wage
rate. Job seekers, hoping to find a job paying the
old nominal wage rate, are more likely to refuse a

FEDERAL RESERVE BANK

OF RICWW’4D

5

job offer at a reduced nominal wage rate. As a result,
unemployment rises.

purchases iri an attempt to rebuild their cash balances,
the inventories of producers accumulate.
Inventories are in general volatile, and it requires time for
producers to realize that their inventories are above
the desired average level more than just temporari’ly.
.. .
-_
_ . .
The declslon by producers to reduce output will
come only after the realization that inventories will
not return to the desired average level except through
a reduction in output.

It is an observable fact that a decrease in the aggregate spending of the public initially affects quantities, output and unemployment, to a greater extent
than prices. Individual producers view the reduction in the demand- for their product as in part
particular to them. As a result, they will anticipate
having to continue paying current wage rates and
current prices for other factors of production since
these are determined for them elsewhere in the economy. Also, as explained above, employees will resist
reductions in their nominal wage rates even if producers are lowering the prices of the goods the
employees buy. With per unit costs of production
fixed, producers will reduce output and use less
labor and material inputs in response to a generalized reduction in demand.
(In economic jargon,
producers move down their marginal cost curves. j
The relative speeds of adjustment of quantities and
prices are discussed further in the Appendix.

The lag is not only long, but also variable. There
are many reasons.
The rate of growth of money
may deviate from trend in many ways, for example,
the deviation may be abrupt or gradual. The partic:ular pattern will affect the amount of time that must
elapse after a change in the rate of growth of money
in order for the public to become aware of a discrepancy between its actual and desired real cash
balances. Also, the public evaluates the desirability
of its money holdings not only with respect to the
current price level, but also with respect to the anticipated future intertemporal movement in the pr:ice
level. (Th e p rice level affects the denominator of
the definition of real cash balances used above, i..e.,
the ratio of money to nominal income, because nomiF’or
nal income is the price level times real output.)
example, the speed with which a change in the rate
of growth of money produces discrepancies betwe:en
actual and desired real cash balances may depend on
the extent to which the change is in the same or
opposite direction as any change in the rate of inflation that the public expects to occur. When such a
discrepancy appears, the public may try to eliminate
a variable fraction of it over a given time period

The effects of a sustained change in the rate of
growth of the money supply are felt on the economy
only with a long lag. Consider a decrease in the
rate of growth of money relative to its trend rate of
growth. People hold cash balances in order to buffer
discrepancies between receipts and expenditures.
As
a result their individual cash balances always exhibit
volatility.
It thus requires some time for them to
realize that their cash balances are more than just
temporarily below the desired average level.
The
same situation exists for producers with regard to
inventories.
When people do begin to slow their
..,

,:I,

,.

.’
.,,

‘.

.,

:

MtONiHLY
:

‘BEHAVIOR

PEpCENliGE

Chcti 4

i’

OF THE MONEY

;-

‘SUPPLY

CHANGfS IN :M, AND 3HIGH AND LOW STEPS IN THESE tHANGfS”
:
iANUARY .I950 TO APRIL 1964

‘,

.

,,: 1
I

t

0

-4.0

I

1

-

. O:,:.,-,
-5.0

,
1950
PBu&ess

6

,:

”

.

1952

ty@e peaks.
,
:

1954
,.
i

..

)
_’

‘*

,
1956

,

,

:1958

,
‘1

;

:

ECONOMIC

,
‘1960
.

SEPTEMBER/OCTOBER

1977

,,

,-

,
1962
,,’

”

REVIEW,

(

7.”

,:
;

!96-$;,,
..,

depending on other conditions in the economy. Furthermore, the public may assign different importance
at different times to the many alternative ways of
eliminating the discrepancy.
It may change its indebtedness, its holdings of financial assets, its stock
of consumer
durables, or its rate of consumption.
Finally, the effect on spenclillg due to monetary
forces can initially be either offset or reinforced by
real forces in the economy.
Chart 1 illustrates the statements made in the
preceding sections. The points labeled P date peaks
in the business cycle. The peaks are preceded by
declines in the rate of growth of the money supply.
The length of time betweerl the peak in the rate of
growth of the money supply ancl the pea?c in business activity is, however, quite variable.
Cl1art
3
depicts the lagged relationship between money and
output in :I different way.
It pIots the monthly
rates of growth of 32,. These growth rates occur
at either relatively high or relatively low levels for
extended periods. These periods were isolated visnally and a step function was plotted with the height
of the step equal to the annua!ized rate of growth
from the last month of the preceding step to the last
month of the particular step. As can be seen. in
general, a drop in the step function is iollowed by 2
peak in business cycle activity.G
It is interesting to note the dramatic decline in the

“The last business cycle peak mar’kcd on
19i4.
It is assumed that an earlier xnk
occurred in October 15:; as a result o- the
f
prxe rises
The sharp decline in busiaess
September 19i4 is assumed to have resulted
in the trend rate of growth of the money
on Chart 4.

the chart is September
in the business cycle
oil embarrro and energy
activity which beaan in
from the prior reduction
supply, which is shown

trend rate of growth of M1 after World War II
shown on Chart 1. The associated recession was of
very modest proportions considering the size of this
decline. The public expected prices to fall after the
war. Prices had fallen after every major war and
many anticipated a return to depression conditions.
In Chart 3 the real quantity of money is expressed
as a ratio of the quantity of money to nominal GNP.
If money and prices decline simultaneously,
this
ratio is unaffected as the numerator and denominator
both decline. In this case, if the demand for money
is stable, a decrease in the rate of growth of the
money supply does not produce a discrepancy between actual and desired real cash balances. If the
government is going to effect a reduction in the rate
of growth of the money supply, it can reduce the cost
to the economy by fostering a belief that the price
level wiil fall. thereby avoiding the emergence of a
discrepancy between the actual and desired real cash
halances of the public.’
It should be noted that the evidence summarized
in Charts 1 and 4 on the effect of money on the
economy refers to significant deviations from trend in
the rate of growth of money. There is little evidence
on the question of how short-run movements in the
rate of growth of the money supply affect the real
sector. Chart 5 plots variability in real GSP and in
7 The best way to affect price expectations
will depend on the
uarticular circumstances.
For exemple,
France in January 1960
required the public to turn in “old” francs for “new” francs in the
ratio of 100 to 1. It was an accounting change 0x11~~
but it affected
expectations about prices.
A monetary authority mght also induce
deflationary
price expectations
by announcing
the time path over
which it intends to reduce the rate of growth of the money supply
and then provinx its credibility by sticking to the announced time
path. At least the financially sophisticated public might then alter
their price expectations
and price setting behavior.

FEDERAL RESERVE BANK OF RICHMOND

7

:,:
:
., ,.

“:
,:
,:;; Ch,,,+‘j ,:

iARlABi\lli
MOVING

FOUR-TERM, STANDARD

4

----

,195O .c .I952

1954
,‘.

I,! MONEY

DEVlAT,ONs.OF~aUARTERLY
.,
:
,1949 - 1976

AND

OirTPlh

PERCENTAGE

_I;

‘.

:

CHANGES

” j

^

Iti’.REAL

., ;: .9,
:: \i;
:j

‘.‘,I

;;

GNP’-iQt;lD
._
.’

..
.^
.,

).
I’
.?,

:
4,

:;

,:

:’

,’

‘keel GNP

Real GNP

‘: 1956

“’ i958

‘!+O
,i ;_

,,: !962

Price Behavior The spending the public undertakes in order to eliminate a discrepancy between its
actual and desired real cash balances does not *in
itself eliminate the discrepancy.
Consider a closed
economy that is not growing and that has adapted to
a constant money supply. The public’s demand for
real cash balances and the price level will be constant. The money supply is now increased once and
s Chart 5 plots moving four-term standard deviations of quarterly
annualized percentage changes in MI and in real GNP.
BOver most of the period shown on Chart 5. the Fed followed a
policy of trying to stabilize conditions in the money market as
opposed to a p&cy of trying to control the rate of growth of the
monetary aggregates. Changes in the demand for bank credit were.
therefore, able to influence changes in the money supply.
If the
former changes were in the main unrelated to changes in the
demand for money. such changes would cause discrepancies between
the public’s actua1 and desired holdings of real cash balances. If
arrangements for eliminating short-run discrepancies are costly, the
effects of short-run variability in money are transmitted to the
real sector. On the other hand. if changes in the demand for bank
credit were in the main caused by changes in the demand for money.
the variability in the money series reflects variability in the demand
for money. If shifts in the demand for money had not been accommodated, discrepancies between the public’s actual and desired
holdings of real cash balances would have developed. If the growth
of the money supply had been kept stable over short time periods,
the result might have been to produce a more variable output series.

ECONOMIC

‘1964
,(

.1966

lji68

.:

the rate of growth oi M1.8 If the M1 series had
exhibited no variability over the period shown in the
chart, it is impossible to say, apart from recessions,
whether the variability in the real GNP series would
have decreased, remained the same, or increased.”

8

,I:. ~”

REVIEW,

1970
‘_

i972

1976’.

::

^:Y
I

for all; and, as a result, the public holds real cash
balances in excess of what it desires to hold. IndividuaIs wilI try to run down their cash balances by
spending more than they receive. Collectively, however, these individuals cannot reduce their nominal
money balances by spending at a higher rate because
one individual’s expenditure is another individual’s
receipt.
The increased spending does increase the demand
for the economy’s output.
As a result, output will
rise initially; and if the increased demand is sustained, producers will raise prices. The rise in the
price level eliminates the excess holdings of real cash
balances. In terms of Chart 3, the ratio of money to
GNP rises at first above its equilibrium value beAs the price level
cause of an increase in money.
rises, nominal income or GNP rises, and the ratio of
money to GKP falls. Prices rise and real cash balances fall until the latter are returned to their equilibrium value.
If the quantity of money had been decreased rather
than increased, equilibrium would have been restored
with a fall in the price level. The recession analyzed
above would come to an end after resources were
unemployed for a sufficient length of time to cause
prices to faII by enough to restore equality between
SEPTEMBER/OCTOBER

1977

the public’s actual and desired real cash balances.
The public’s spending then returns to its norma level
The above esample describing the consequences of
an increase in the money supply may be retold in
terms of an increase in the rate of growth of the
money supply. The resultant increase in the price
level is replaced by an increase in the rate of growth
of prices. &raking use of the monetarist assumption
that the demand for money is stable, the rate of inflation should be esplainabie by past rates of growth of
money. The relationship between the rate of growth
of money and prices need only hold as an average
Also, money will
taken over long time periods.
affect prices after a long lag because money affects
output with a lag and because many prices appear to
be set, implicitly or explicitly, in contracts of long
duration. Chart 6 plots the annualized rate of change
of the GSP price deflator between the current quarter and the quarter two years ago. The plot of the
two year average rate of growth of M1 is the same
one shown in Chart 1 escept that the observation on a
given date is for the quarter seven quarters ago
(money is lagged by seTen quarters).
The similarity
between the rate of change of prices and past money
Since money is plotted with a lag of
is striking.
seven quarters, its plot extends seven quarters into
the future.
Interest
Rates and the Quantity of Money
The
distinction between the nominal and the real quantity

----

of money and rhe relationship between the rate of
change of the money supply and inflation provides a
basis for at-&.-zing the popular belief that the Federal
Reserve System can control market interest rates.
The real rzte of interest measures the amount of
resources one must promise to deliver in the future
in order to obtain a given amount of resources in the
present. It induces savers to forego consumption of
currently available resources and constrains investors
in the use of currently available resources for production of commodities in the future.
The equilibrium
reai rate of interest equates the supply of resources
by the first group to the demand for resources by the
second group.
The interest paid to savers must
include this real return plus compensation for the
depreciation in the value of the dollars used to pay
The equilibrium
nominal interest rate is
interest.
then the equilibrium real rate of interest plus the
anticipated r.ze of inflation.
The Fed frmds rate is the rate of interest commercial banks charge on overnight loans of reserves
among themselves.
By buying and selling govemment securities. the Fed changes the amount of reserves banks hold, in the process pushing this rate
up or down. Such actions do not directly affect the
equilibrium rmminal interest rate. They do not affect
the real rate of interest because they do not affect
the determinF.nts of saving, such as the thriftiness of
the population, or the determinants of investment,

Pricer.

FEDERAL RESERVE BANK

OF RICHMOND

9

such as the availability of productive opportunities;
and in themselves they do not directly affect the
public’s inflationary anticipations.
Can the Federal Reserve System control market
interest rates by controlling the funds rate? To take
a particular case, can it lower market interest rates
by lowering the funds rate? An independent lowering of the funds rate means lowering it relative to
the equilibrium nominal rate of interest.
The cost
of funds to bunks is lowered, and it becomes profitable.for banks to extend additional credit. As banks
make additional loans, the derivative deposits of the
banking system increase.
The required reserves of
the banking system also increase, but the Federal
Reserve must supply these reserves in order to preserve the low level of the funds rate. Both the increase in credit and in the money supply act to lower
market interest rates.
At this point the public holds real cash balances in
excess of what it desires to hold. As just described,
this disequilibrium is resolved only by a rise in the
general price level. If the low value of the funds
rate is maintained, the increase in the money supply
will be maintained, and inflation will persist. As the
public comes to anticipate this inflation, lenders and
borrowers will incorporate a corresponding inflation
premium in interest rates, and the equilibrium nominal rate of interest will rise. The discrepancy between this rate and the funds rate, the cost of credit
to banks, therefore increases. As a result, banks have
even more incentive to extend loans, the money
supply increases even faster, and the rate of inflation
rises even further.
This process will cause the rate
of inflation to accelerate until either the monetary
system breaks down or until the funds rate is allowed
to rise to a level determined by the market, not the
Federal Reserve.
The Federal Reserve can lower market interest
rates in the short run by lowering the funds rate and
allowing the rate of growth of the money supply and
bank credit to increase because in the short run it
can control the real quantity -of money and bank
credit. The effect is temporary, however, because in
the long run the Federal Reserve can control only the
nominal quantity of money and bank credit. In the
long run, the public controls the real quantity of
money and bank credit.
The length of the short run referred to above depends on how rapidly the public revises its inflationary anticipations.
Chart 7 plots quarterly averages
of the rate on newly issued three-month
Treasury
bills and the annualized percentage change in the
GNP deflator over the previous two quarters.
The
public definitely did adjust interest rates over this
10

ECONOMIC

REVIEW,

period in response to the behavior of inflation. Chart
S plots quarterly averages for the rate on newly
issued three-month Treasury bills minus the annualized percentage change in the GNP deflator between
the current and the following quarter. This variable
measures the actual rate of return realized by investors in Treasury bills after allowance is made Bar
inflation. In only 3 out of the last 18 quarters have
investors earned a positive rate of return on these
securities. Since the last half of 1972, interest rates
have, in this sense, been at unsustainably low levels.
The evidence just cited suggests that although investors are slow in adjusting their anticipations of
future inflation, they do adjust these anticipations.
How does an independent decrease in the funds rate
affect market interest rates when investors are concerned about the stability of the purchasing power of
the dollar ? In the short run, short-term interest rates
will decrease. The funds rate, however, is the interest
rate on a loan of a maturity of one day. What is
relevant to the holder of, say, a ten year security is
the succession of one day funds rates over the next
The current funds rate offers little
3,650 days.
information on funds rates for more than a short
time in the future.
The welfare of the holder of a
long-term security is affected by the rate of inflation
over the life of the security.
If the decrease in the
funds rate is viewed as leading to an increase in the

j

.’

1~”

i
IblklATiON

.’

.:,I

Cfwt~7

AND $TERsT
I

RliTES

’ QUARTERLY. AVERAGES OF >THE THREE-MONTH
TREASURY FILL RAN AND *HE ANNUALIZED
PERCENTAGE CHANGE IN THE GNP DEFLATOR
,OVER THE PREVIOUS TWO QUARTERS

I

12.0

12.0
---

10.0 -

’

h
h

Bill Rate
Bill Rate
Inflation

::

8.0 -

- 2.6
<
l9kS

1970

1974,‘~.

1976

1
’ :

:”

SEPTEMBER/OCTOBER

1972

1977

,_‘:
2.

rate of growth of the money supply and, consequently, to a higher future rate of inflation, the decrease will lead to an immediate increase in interest
rates on long-term securities. In the long run, shortterm and long-term interest rates will increase.
Differing Behavior of the Monetary
Aggregates
The final section departs from the analysis of the
rest of the paper, that is, the analysis of the relation
of money to output, prices, and interest rates.
It
discusses briefly the question of which of the several
available money supply series one should watch.
If one is interested in predicting the behavior of
GSP, the answer depends on which money series is
most stably related to GSP.
Ml and Mz are generally the series watched most carefully currently, but
in the future it is possible that a more inclusive
aggregate will come to be more stably related to
GSP than either 311 or Mz. The discussion below
is confined to the differing behavior of M, and Ms.
As noted earlier, the trend rate of growth of &I2
exceeds the trend rate of growth of M, by about three
percentage points. One reason is that esplicit interest
payments are forbidden on demand deposits, but permitted on time deposits.
(Time deposits, excluding
certificates of deposits of $100.000 or more, are
included in JJ2, but not M,.)
Banks pay implicit
interest on demand deposits to business customers by
tying compensating balances to reduced rates on
loans. They pay implicit interest on clemand deposits
to individuals by reduced service charges for check
clearing.
Payment of interest in these forms, however, is costlier to the bank and of less w.lue to the
consumer than would be payment of the equivalent
esplicit
interest.
Furthermore,
indivicluals who
maintain large checking balances relative to the
number of checks thev write subsidize individuals in
the opposite position. For these reasons, banks and
their customers (and particularly
the group just
referred to) ha\:c an incentive to substitute time for
demand deposits. Banks. and customers of bnnks,
that belong to the Federal Reserve System have an
aclclitional incentive to make this substitution because
they must hold noninterest bearing reserves to a
greater extent against demand than against time
A continuing incentive esists for Ixmks
deposits.
and their customers to substitute time for demand
deposits.
Apart from differing trend rates of gromth, the
rate of growth of %I1 and $1, differ over shorter
periods because of the phenomena known as disinterDisintermediatio!
mediation and reintermediation.
occurs when market rates rise relative to ceiling
rates on time deposits.
The clifference between
FEDERAL RESERVE BANK

market and ceiling rates causes holders of time deposits to transfer funds to money market instruments.
The transferred time deposits return to the banking
system partly in the form of demand deposits and
partIy in the form of time deposits. The result is to
raise the rate of growth of M1 relative to Mr. The
reverse process. reintermediation, occurs when market rates fall relative to ceiling rates. The rate of
growth of X2 then rises relative to the rate of growth
of M,.
Chart 9 plots monthly the difference between the
go-day Treasury bill rate and the ceiling rate on
single ni;lt.urity tirtte deposits of less than $100,000
and the difference between the rate of growth of Ml
and I’v~,.‘~ In general, as the Treasury bill rate rises,
the rate of growth of 12, rises relative to ;LIzl and
conversely.
The period from January 1973 to Sep1974 is an exception ; the rise in interest
telIl?Xi
rates is not matched by a rise in the rate of growth
of 3i1 relxtive to &. Apparently, during this period
the effects of clisinterntediation were offset by the

‘“The data are smoothed csponentially
equals 3 times the nctunily observed
the previously plotted value.

OF RICHMOND

as follows: the plotted vaIue
monthly value plus .7 times

11

.* ““.li“’
,I )’ ‘_;:
,i :$ 4.0

,:

M2

-

MI minus

----

:i:

Rate Differential

historically high level of interest I.ates. The high
level of interest rates reinforced those factors that
depress the trend rate of growth of M1 relative to MZ,
offsetting the usual effect of disintermediation.
After allowance is made for differing trend rates
of growth and for disintermediation and reintermediation, over periods as long as six months, the rates
of growth of Ml and MZ are similar. Taking account
of these factors permits one to use either M1 or hlas an indicator of the thrust of monetary policy.
Conclusion
The theory and empirical
assumptions discussed above constitute a monetarist explanation of the importance of the money supply.
A
variety of policy implications follow from these ideas.
If the demand for the quantity of money is stable,
stable growth rates of money will eliminate or reduce
business cycle fluctuations.
If money affects output
with a long and variable lag, a countercyclical monetary policy can destabilize the economy.
The only
way to. reduce the rate of inflation is to reduce the

12

I:,
” i..,\

‘$0

ECONOMIC

REVIEW,

.I^

*I

rate of growth of the money supply. Low growth
rates of the money supply produce low nominal rates
of interest, and vice versa.

References
Friedman,
Milton.
“Money:
Quantity
Theory.”
inte;f.national Encyclopedia of the Social Sciences. l9e.w

York: Macmillan and Free Press, 1968.
.
ment.”

“Nobel Lecture:
Inflation
and
Journal of Political Economy,

Unemploy85, (June

1977)) 451-71.
. “The Quantity
Theory of Money-A
RestateStudies in the Qualztity Theory of Money.
Edited
by Milton Friedman.
Chicago:
University
of Chicago Press, 1956.

ment.”

Friedman,
Milton and Anna Schwartz.
“From
Gibson
Explo,-ations i?l Economic Research,
to Fisher.”
Occasional
Papers
of the National
Bureau of Economic Research, 3, (Spring 19’76), 288-91.
. “Money
and Business
Cycles.”
Review of
Economics and Statistics, 45, Supplement (Febru.-

ary 1963), 32-78.

SEPTEMBER/OCTOBER

1977

APPENDIX

In the text, employees
are described
as unwilling
to accept reductions
in their real wage rates at the
onset of a recession.
Because they obtain information on prices in the rest of the economy
only
slowly, they are also unwilling to accept reductions
in their nominal wage rates.
In effect, employees
and employers
enter into contracts
that set the
nominal
wage rate, but not the amount
of employment.
The total earnings of an employee equal the wage
rate times the number of hours worked.
The employer, because of uncertain
demand for his product, cannot guarantee
in advance to the employee
what the total earnings
of the employee
will be.
This much seems obvious, but it is not obvious why
employees
enter into implicit
or explicit
employment
contracts
that
allow
quantities
(hours
worked)
more flexibility
than prices (wage rates).

The fact that changes
in aggregate
spending
by
the public affect output before prices indicates
that
the first kind of contract
is more prevalent
than
the second.
\\‘hy individuals
deal with uncertainty
in the first, rather than the second war, :lowever,
Perhaps
the unemployment
associated
is unknown.
with the first kind of contract,
which is produced
by unforeseendeclines
in product
demand,
gives
employees
time to engage in job search for alterFor a particular
native sources
of employment.
firm the variability
in the demand for its product
caused by forces other than recessions
may be the
dominant
form of variability.
Laid off workers
will then generally
not expect to have to engage in
the relatively
expensive
job search associated
with
recessions.

A contract may guarantee
the wage rate, but not
the total number
of hours to be worked.
If an
unanticipated
reduction
in the demand for the employer’s product
occurs, he can reduce output by
laying off workers.
Because
his wage costs per
unit of output are fixed, he reacts to a decline in
the demand for his product by reducing output, not
prices.
With this kind of contract,
the employee’s
total wages are uncertain
in advance.
He knows
the wage rate with certainty,
but not the number
of hours he will work.
The automobile
industry
furnishes
an example of this kind of contract.

The behavior
of labor unions may also furnish
a clue to the reason
for the prevalence
of the
first kind of contract.
When confronted
with the
dilemma
of either reducing
wage rates and preserving
jobs and union members
or maintaining
wage rates and losing jobs and union members,
unions have generally
chosen the latter alternative.
The reasoning
imputed
to union leaders
is that
with a general wage reduction
all union members
are unhappy.
With a maintenance
of wage rates
and a reduction
in jobs, only those workers
who
lose their jobs are unhappy, but they are no longer
members
of the union, so their dissatisfaction
does
not count.

Alternatively,
a contract may guarantee
the number of hours to be worked, but leave the wage rate
dependent
on the demand for the employer’s
product.
If an unanticipated
reduction
in the demand
for the employer’s
product occurs, he can stabilize
output by reducing
the price of his product,
and
the wage rate paid employees.
Because
the employer’s wage costs per unit of output are variable,
he can react to a decline in the demand
for his
product
by reducing prices, not output.
With this
‘kind of contract,
the employee’s
total wages are
uncertain
in advance.
He knows the number of
hours he will work with certainty,
but not the
wage rate.
Salesmen
and others who work on a
commission
basis furnish an example of this kind
of contract.

The same logic may perhaps be applied to nonunionized work forces.
With the first kind of contract, a reduction
in the demand for an employer’s
However,
those
product
leads to a Ioss of jobs.
workers who are retained are still paid the previous
wage rate and their morale
and productivity
is
maintained.
U7th the second kind of contract,
a
reduction
in demand
for an employer’s
product
leads to a reduction
in wages, not jobs.
Although
this possibility
was foreseen by workers when they
entered into their employment
contracts
they will
still feel disappointed
by a “bad roll of the dice.”
Worker morale will suffer and so will productivity.
The differing efiect on workers’ productivity
under
the two forms of contracts
may make the former
kind of contract
preferable.

FEDERAL RESERVE BANK OF RICHMOND

13

Thomas M. Humphrey

are again in full en~plojwenf

THOW%

at ample mages.

ATTWOOD

(1819)

Mr. Attwood opines, that the multiplication of
the circulating p>zedEClizlm, the consequent diand
n&&ion of its value, do not wzerely ditninislz the
pressure of taxes and debts, and other fixed
charges, but give en@oy+newt to labor, and fhaf
to an indefinite extent . . . . Mr. Attwood’s
error is that of supposing that a depreciation of
the currency really increases the demand for all
articles, and conseqztently their prodlrction, because, zcnder sogme circumstances, it nzay create
a false opinion of an increase of depnand; which
false opinion leads, as tlze reality would do, to an
increase oj production, followed, however, by a
fatal revulsion as soon as the delusion ceases.

JOHK

STUART

MILL

(1833)

Accompanying the current recovery, now well into
its third year, is a heated debate over the role of
monetary policy in restoring and maintaining economic stability. Two groups of participants dominate
the debate, namely advocates of activist expansionary
policies at one extreme and proponents of steady
monetary growth at the other. The policy views of
these competing groups have been conveniently summarized by Professor Karl Brunner [ 131. himself a
member of the stable money group.
According to Brunner, the activist group (1 j assigns top priority to the speedy return to full employment, (2) urges rapid mone! growth to help
achieve that objective, (3) prescribes monetary finetuning to maintain full employment once it is reached,
and (4) recommends acceptance of inherited inflntion on the grounds that the cost of accepting it is
far less than the cost of eradicating it. The stable
money group, by contrast, (1) attaches top priority
to the elimination of inflation on the grounds that
14

ECONOMIC

REVIEW,

price stability is an essential prerequisite for an efficiently functioning economy and a sustained high
average level of employment, (2) recommends that
the monetary authority gracluaily approach and thereafter permanently adhere to a target path of money
growth consistent with a zero rate of inflation, (3)
prescribes that discretionary fine-tuning be replaced
by fixed monetary rules, in particular the noninflationary constant money growth rate rule, and (4j
warns that the social cost of accepting inherited
inflation far exceeds the cost of eradicating it.
The debate between policy activists and stable
money proponents is not new. The essentials of the
debate can be traced back more than 140 years to a
celebrated controversy between Thomas Attwood and
John Stuart Mill over gold versus paper monetary
standards in post-Napoleonic
war Britain.
This
debate occurred during a long deflationary period
that abruptly succeeded a wartime inflationary boom.
The postwar deflation brought severe unemployment.
industrial stagnation, and economic distress.
.Qtwood, a Birmingham banker and political reformer,
sought to relieve rhe distress by replacing the esisting gold-based currency with an inconvertible paper
currency geared to the level of employment.
He was
opposed by Mill, the famous philosopher-economist
who, as a leading member of the orthodox British
Classical school, defended the gold standard and
dismissed all paper currency schemes as purely inflationary.
The debate centered on such modern
policy issues as unemployment versus inflation, rules
versus discretion, and the benefits and costs of accepting and eliminating inflation.
This article esamines the Attwood-Mill controversy and shows how
similar it is in essentials to the current policy debate.’
Attwood’s
Views
Thomas
Attwood
was the
policy activist of his day. He advocateci full employment and gently rising prices, both to be achieved by
monetary fine-tuning. He stated these views in more
i The literature on the Attwood-Mill
debate includes the references
listed at the end of the article.
Reaardinr
Attwood’s
views. see
Checkland r141. Cony
115. pp. ~1-957. Fetter 112, pp. vii-xxviii]
Link IIS, PP. 6-351, O’Brien
119, PP. 164-53. and Viner 122. pp:
173. 1S6-r. 195, 199, 212-14, 2S91. On Mill. see Link 116, pp. 14~~61
168-72,
177-91.The present article draws heaviiy from these sources:

SEPTEMBER/OCTOBER

1977

than a dozen pamphlets, in numerous letters to the
press as well as in private correspondence, in testimony before three Parliamentary committees, and in
several speeches before the House of Commons
where he served as representative for the district of
Birmingham from 1832 to 1839. His views can be
organized under five headings corresponding to the
central themes of his analysis. These include ( 1) full
employment as the policy goal, (2) primacy of monetary policy, (3) feasibility of monetary fine-tuning,
(4) benefits of price inflation, and (5) costs of price
deflation.
Full Employment
as Policy -Goal To Attwood,
full employment was the overriding
policy goal.
“Employment,”
he said, “is a right which a good
citizen may claim of his country without any kind of
degradation or obligation” [4, pp. 4.5-6, cited in 16,
p. 201. He reiterated this view in 1832 in his testimony before the Parliamentary
Bank Charter Cow
wzittee. When asked the question:
Do you consider that as long as there exists a
labourer in the country not fully employed, an in-

creased issue of currency
vantage, whatever it be?

Attwood

may be made with ad-

replied :

As a general principle, I think, unquestionably,
that so long as any number of industrious honest
workmen in the Kingdom are out of employment,
supposing such deficiency of employment not to be
local but general, I should think it the duty, and
certainly the interest, of Government, to continue
the deureciation of the currencv until full emolovment & obtained and general p;osperity
[9, p. 467,
cited in 15, p. 861.

Elsewhere he stated that “the first and most important duty for the Legislature to attend to, is to take
care that an ample demand for labor is restored and
maintained throughout the country” [ 11, p. 171.
Attwood defined full employment as an excess of
vacant jobs over unemployed people, or, as he put it,
“a greater demand for labor, than labor can possibly
supply” 14, p. 39, cited in 16, p. 341. This excess
vacancy measure also provided tlzc criterion of an
appropriate quantity of money, as can be seen from
Attwood’s statement that money creation “cannot be
said to be carried to too great an extent, until the
general demand for labor, in all the great departments
of industry, becomes permanently greater than its
supply. There is no other correct measure of a redundant, or deficient, circulating medium” [ 10, cited
in 14, p. lo]. Thus if labor is in excess supply, the
money stock is too small and should be expanded.
Its expansion should he continued until excess demand just begins to develop in the labor market. At
this point the correct amount of money is in existence
and expansion should therefore cease. Note that he

explicitly puts an upper as well as a lower bound on
the appropriate quantity of money. Thus he states
that “Whenever . , . the money of a country is sufficient to call every laborer into action, upon the system
and trade best suited to his habits and his powers,
the benefits of an increased circulation can go r>
farther. . . .” Beyond that point, further &crease is
“nugatory or injurious” [2, p., 68, cited in 22, p.
‘;“--d
213n.l. In short, hq_spec.,lc a .unique ideal money
stock target consistent with full employment.
In specifying his full employment target, Attwood
was confronted with a measurement problem created
by the lack of employment or unemployment
statistics.
He tried to solve this problem by suggesting
These
three proxy measures of full employment.
included the price of wheat (a crude index of the
cost of living), the wages of agricultural labor (Attwood’s “par of labor”) and the rate of interest, respectively.
He assumed that full employment existed
Spewhen these variables reached certain levels.
cifically, wheat prices at 15 shillings a bushel, weekly
wages at 18 shillings, and interest rates at 5 percent
spelled the existence of full employment. Departures
from these norms indicated corresponding departures
from full employment and the need for monetary
Thus lower prices and wages and higher
action.
interest

rates

signaled

unemployment

and

the need

for monetary expansion. Deviations in the opposite
direction meant overfull employment and the need
for monetary contraction.
Attwood assumed that
these proxies were mutually consistent and would
not produce conflicting signals for the authorities.
He also assumed, in effect, that employment could
be maintained at the desired level by pegging nominal
wage, price, and interest rate variables.
Attwood’s association of given wage and price
levels with a given level of employment corresponds
to present-day use of Phillips curve relationships beLikewise, as
tween inflation and unemployment.
will be shown later, John Stuart Mill’s criticism of
Attwood

on

this point

is similar

to modern

criti-

cisms

of the Phillips curve. Like modern critics of
the Phillips curve, Mill argued that one could not
peg real economic variables by pegging nominal
variables (whether wages, prices, interest rates, or
the money stock) since there exists no permanent
relation between the two kinds of variables, i.e., they
are independent of each other in the long run. Note
also that Attwood’s version of the Phillips curve
referred to wage and price levels rather than to the
rate of inflation.

In his time it was natural

in terms of a stable long-run

high prices corresponding
inflation today.

FEDERAL RESERVE BANK

OF RICHMOND

to think

price level, with low or

to low or high rates of

15

The preceding has documented Attwood’s concern
with full employment.
Further proof that full employment was for him the desideratum of monetary
policy is contained in his discussion of conflicts between the goals of internal and external equilibrium
,. ypder the gold standard.
Regarding the objectives
of fu;! anployment and convertibility of the currency
into gold a; 2 ,@ed price, Attwood’s view was that
the former should .prez;ail. i -In fact, if .full employment proved to be incompa?ible .\+th convertibility
and the maintenance of fixed exchange rates, then
Attwood was prepared to sacrifice the latter even if it
meant the complete cessation of foreign trade. That
is, Attwood was quite willing to replace the existing
gold standard monetary system of convertible paper
currency and fixed exchange rates with an alternative
system of nonconvertible paper and flexible exchange
rates if full ernploymenr so required.
Attwood was
one of the first to argue that floating eschange rates
could provide a nation with the autonomy necessary
to control its own money stock and achieve its domestic objectives independent of the rest of the world.
By abandoning fixed exchange rates for floating ones,
the authorities could pursue domestic. employment
targets free of an external constraint.
As he put it:
under floating exchange rates the nation would he
“Self-existent,

self-dependent,

liable

to

no

foreign

actions, entirely under our own control; contracting,
expanding, or remaining fixed, according as the
wants and exigencies of the community may require”
[7, p. 341.
Primacy of Money
Attwood constantly
stressed
the importance of money in the achievement of full
employment.
His analysis invariably linked changes
in the level of economic activity to changes in the
money supply, implying that the latter variable is the
dominant determinant of the former.
Prosperity, he
said, “is indeed to be attributed to one cause only.
and that cause is the general increase of the Circulating Medium” [ 7: p. 121. Similarly, a ‘%ontraction
of the Currency” is “the sole cause of the distress of
Agriculture, and of all other distress” [T, p. 911. It
follows, therefore, that “it is the deficiency of money,
and not its excess, which ought most to be guarded
against, which produces want of employment, poverty, misery, and discontent in nations!’ Ill, p. lS] .
In line with the foregoing precept, he prescribed
monetary injection via government loans and open
market operations or, as he put it, “a forced creation
of additional currency” as the sole remedy for unemployment [ 1, p. 91. He specifically rejected two nonmonetary remedies, namely David Ricardo’s capital
16

ECONOMIC REVIEW,

levy plan and William Cobbett’s “equitable adjustment of contracts,” both designed to stimulate ecouomic activity by reducing the burden of fixed costs.
To Attwood, nothing but monetary expansion would
restore prosperity.
Wothing,” he wrote, “can feed
the labourers, nothing can serve the country, unless
it has the effect of cre&zg, or bringing into action,
an additional quantity of the currency” [I, p. 383.
He also viewed money growth as the key to maintaining prosperity once it was restored.
He argued
that sustained full employment required a money
growth rate sufficiently rapid to accommodate the
Gold, he:
trend growth rate of capacity output.
thought, could not grow at the required pace, which
is one reason he advocated paper over gold. With.
paper, there would be no shortage of money to limit.
economic growth. To summarize, Attwood stressed
monetary growth as the solution to two problems:
that of moving onto the full employment path (i.e.,
the short-run problem of eliminating cyclical unemployment) , and that of staying on the path (the longrun problem of maintaining adequate growth).
Monetary Fine-Tuning
Like his mode’rn activist
counterparts,
Attwood believed in the efficacy of
monetary fine-tuning.
He advocated the assignment
of monetary management to a legislative commission.
This body would regulate the quantity of money not
by adhering to rigid “laws of maximum and minimum but by judicious legislative operations upon the
issue of bank notes, or other national paper” [3, p.
!63, cited in 22, p. 2131. The economy needed to be
stabilized and effective stabilization called for disFor example, wise and skillful
cretion, not rules.
monetary management could nulIify shocks to full
employment arising from sudden shifts in the demand for money.
In case of any sudden panic occurring, so as to
occasion an unusual demand for money . . . the
~~ozcowertible
&per
instantly expands itself to
meet the demand, and the demand is satisfied and
the mischief stayed [7, p. 341.

Similarly, discretionary fine-tuning would prevent
the overissue of money and the acceleration of inflation at full employment.
When public confidence runs high and the instruments of credit have a tendency to expand themse!.ves into excess, the slightest touch upon the ROYLco?zvert&ilit~ basis of the Circulation instantly reduces the whole [7, p. 341.
In sum.

discretion
should prevail and the economy
would be kept on an even keel by “a judicious issuing
and withdrawing of the banknote circulation” around
the full employment level 13, p. 150, cited in 14.
p. 101.
SEPTEMBER/OCTOBER

1977

Benefits of Inflation
A central theme in Attwood’s writings is the necessity of price inflation.
Price increases were an essential ingredient in his
full employment program. “The great object of currency legislation,” he said, “should therefore be to
secure and promote this gradual depreciation” of the
currency [3, p. lOln., cited in 14, p. 81. To this end
he extolled the benefits of gently rising prices.
Restore the depreciated state of the currency and
you restore the reward of industry, you restore
confidence, you restore production, you restore consumption, you restore everything that constitutes
the commercial prosperity of the nation [l, p. 661.
This passage shows that, for Attwood, inflation is
desirable precisely because it stimulates economic
activity. The rise in the level of income, output, and
employment constitutes the benefits of inflation. But
what is the mechanism or linkage involved, i.e., ho=!
does the stimulus work? According to Attwood, it
does so by reducing the burden of real fixed costs
thereby raising profits and profit expectations that
provide the means and the inducement for business
expansion. Specifically, a money-induced increase in
aggregate spending bids up product prices while fixed
costs remain constant in nominal terms. The resulting spread between prices and costs increases current
profits and leads to the formation of optimistic expectations of future profits. These profits, actual and
expected, spur production and employment.
Profits
are clearly the key to increased economic activity and
inflation raises profits by generating a gap between
prices and fixed costs. In brief, “there is no difficulty
in employing and maintaining labourers, so long as
the prices of the products . . . are kept above the
range of the fixed

charges and nzonied expenses,”

i.e., so long as business is profitable [7, p. 42. Italics
in original.].
This point is further emphasized in
Attwood’s summary of the money-price-profit-employment nexus. “Prosperity,” he says, has occurred
whenever the government has
filled the Country with what is called Money; and
this plenty of Money has necessarily produced a

general
elevation
of prices ; and this general
elevation of prices has necessarily
produced a
general increase of profit in all occupations;
and
this xreneral increase of nrofit has. as a matter of
course, given activity to* every trade in the kingdom: and whilst the workmen, in one branch of
trade, are producing one set 03 articles, they are
inevitably consuming an equal amount of all other
articles.
This is the prosperity
of the Country,
and there is no other prosperity which has ever
been enjoyed, or ever can be enjoyed [7, pp. 11-121.

Costs of Price Deflation
Finally, Attwood continually warned against the evils of falling prices. In
doing so, he used much the same arguments as
modern policy activists. The only difference is that

modern analysts have gone one derivative beyond
Attwood. He worried about the harm done by falling
prices. They worry about the costs of a falling rate
of inflation.

Like his current activist counterparts,
Attwood
saw the harmful effects of deflation as stemming from
institutional, contractual, and expectational -rigidities
built into the structure of product and factor prices.
These rigidities, he thought, worked in two ways.
First, they prevent prices from adjusting swiftly
in response to deflationary pressures. It took a long
time, he believed, for deflation to work its way
through the price structure.
During this time, quantities (output and employment),
not prices, had to
bear the main burden of adjustment.
As he put it, to
engage in deflationary
contractions
of the money
supply in an economy in which “the whole machinery
of society is worked through the medium of monetary debts and contracts, is to arrest the movement
of that vast and complicated machinery [and] to
destroy the beneficial employment of labor” [ 11,
P*

21.

Second, rigidities produce distortions in cost-price
relationships.
These occur because rigidities are not
uniform across the price structure, i.e., different
prices have different speeds of adjustment.
Specifically, wages and other contractually fixed costs
(“all the monied incumbrances”)
adjust sluggishly
relative to product prices. Thus, when general prices
fall, product prices fall relatively to wages and fixed
This reduces profits which constitute the
costs.
As a result
means and the incentive to produce.
economic activity slackens and unemployment rises.
These effects are clearly outlined by Attwood in the
following passage.
If prices were to fall suddenly, and generally, and.
equally, in al! things, and if it was well understood,
that the amount of debts and obligations were to
fall in the same proportion, at the same time? it is
possible that such a fall might take -place v&hout
arresting consumption and production, and in that
case it would neither be injurious or beneficial in
any great degree, but when a fall of this kind takes
place in an obscure and unknown way, first upon
one article and then upon another, without any
correspondent fall taking place upon debts and obligations, it has the effect of destroying all confidence in property, and all inducements to its
production, or to the employment of laborers in
any way [3, pp, 78-9, cited in 22, p. 186. Italics in
original.].

Elsewhere
modities
the fixed

he states that when “the prices of comare suffered

to fall . . . within

charges and expenses

the country

dies” [7, p. 42.

the level of

. . . the industry
Italics

of

in original.].

In short, owing to rigid cost elements, deflation
leads to recession. And once started, a recession in-

FEDERAL RESERVE BANK OF RICHMOND

17

evitably worsens, or so -4ttwood thought.
He beIieved the economy to be unstable in a downward
direction.
Falling prices depress profits and profit
expectations and cause an unloading of stocks. This
puts further downward pressure on prices, profits,
and expectations causing another unloading of stocks,
etc. A downward multiplier effect takes hoid and the
cyciical trough is not reached until stocks are exhausted and prices start to rise because of shortages.
This sequence brings great suffering to unemployed
For these
workers and hardship to businessmen.
reasons, price deflation shock? be avoided at all costs.
Policy Views of the Classical School
Attwood
Hi s
was not a member of the Classical school.
policy views were unorthodox in his time. But his
analytical tools were largely the same as those of his
CIassical school contemporaries.
From them he
obtained the quantity theory of money, which he used
in expounding the relationship between money and
prices. And his treatment of the economic effects of
inflation derived straight from David Hume, whose
analysis likewise formed the central core of the
Classical doctrine of forced saving according to which
inflation temporarily
stimulates activity by transferring wealth from unproductive fixed-income recipients to productive capitalist entrepreneurs.
The
clash between Attwood and the CIassical school was
not over economic analysis or theory, Instead it was
over immediate objectives of policy, Attwood iocusing on instant full employment and the Classical
economists focusing on external and internal stability
of the value of money, which they associated with
the gold standard.”
The Classicists attached great importance to stability in the value of money, regarding it as an essential prerequisite for justice in contracts and for economic growth and efficiency. Without this stability,
parties to contracts would be exposed to arbitrary
and capricious transfers of income and wealth arising
from unforeseen changes in the value of money.
Such transfers constituted unjust vioIations of contracts.
Likewise, without the monetary stability
provided by the gold standard, producers, who are
already heir to numerous real business risks, would
face additional
risks arising from unanticipated
changes in the value of money. These additional risks
discourage production
and inhibit reaI economic
2 The Classicists thought that gold, for all its vicissitudes,
was a
more stable standard of value than the alternatives. especially paper.
Ox this point, see Robbins I21, pp: 69-731.
They maintained that,
given the world gold stock, re~sosonaole national price stability wwld
be assured under the gold standard by the operation of the priccspecie-f&m mechanism.
That is. a temporarv
rise in domestic
prices relative to for&n
prices would induce a balance of payments
deficit snd a corresponding
gold outflow that aouid reverse the price
increase and restore prices to their initial level.

18

ECONOMK

growth. Moreover, they cause real resources-effort,
time, knowledge-to
be diverted from productive
pursuits into forecasting and risk-bearing activities
that would be totally unnecessary if money’s value
were stable and predictable. This represents a wasteful and inefficient use of resources that results in a
lower Ievel of output than the economy is capable of
producing.
As the preceding suggests, the CIassical economists were not obiivious to the desirability or’ full
empioyment.
On the contrary, they were very much
concerned that economic resources, including labor,
he utilized as fuily and efficientIy as possible. But
they believed that efficient resource utilization (full
employment) could best be achieved not by making
it the main target of monetary policy but by establishing a framework of preconditions within which it
could flourish.
One of these essentiaI preconditions
was stability (i.e., predictability and reliability) of
the value of monev . If monetary stability prevailed,
they thought, then fu!I employment would tend to
take care of itself.”
This attitude helps espfain their opposition to
Attwood. In a nutshell, they feared that his schemes.
by making fuII employment the desideratum of monetary policy, would in the end lead to conditions
They foresaw the
opposite to those he intended.
following gloomy sequence as the natural consequence
of his proposals: internal inflation, esternal disequilibrium ancl gold drains, exhaustion of the nation’s
gold reserves, abandonment of the gold standard and
of convertibility of the currency (the sole check to
overissue), hyperinflation.
and eventually economic
breakdown and stagnation.
In short, they felt that
his infIationist schemes constituted a formula for
disaster.
Mill’s Critique of Attwood
Sowhere is the Classical school’s opposition to Attwood more strongly
espressed than in the writings of John Stuart Mill.
NiIl, of course. was a leading Classical economist
ancl an uncompromising
defender of, the gold standard. His comments on r1ttwood appeared first in
an 1533 article entitled “The Currency Juggle” and
later in Chapter 13 of his famous treatise Principlrs
of Politico!

Econow~

(1848).

In these writings he attacked Attlvood’s full employment proposals on at least three grounds. First,
he questioned the feasibility of attempts io peg emhigh levels yin inflation.
pIoyment at nrbitraril!
Second. he argued that even if inflation could stimu3This point is stressed most forcefully
Robbins [ZO, p. 13: and 21, p. ‘il.

REVIEW. SEPTEMBER/OCTOBER 1977

by O’Brien

119. p. 165J and

late the economy such stimulus was undesirable in
terms of its effects on efficiency and equity. Third,
he asserted that monetary policy should be conducted
on the basis of rules, not discretion.
Mill’s analysis
of these issues is remarkably modern and is described
in some detail in the following paragraphs.

nominal wages. The labor is willingly supplied by
workers who mistake the rise in nominal wages for
real wage increases.
In Mill’s words, “the inducement which . . . excited this unusual ardor in all
persons engaged in production, must have been the
expectation of getting more commodities generally,
more real wealth, in exchange for the produce of their
labor, and not merely more pieces of paper” [ 18;
p. 5501. Owing to inflation, howe:Fer; these expectations, Mill noted, will be disappointed and subsequently revised downward. In this way expectations
will adjust to reality, i.e., the inflation eventually
will be accurately perceived and fully anticipated.
The third point in Mill’s argument is that the
inflationary stimulus vanishes when perceptions adjust to reality, i.e., when producers correctly perceive
demand increases as nominal rather than real and
workers realize that real wages have not risen. When
this happens, economic activity reverts to its original
(preinflation)
level, but only after undergoing a
temporary recession to correct for the excesses of
the inflationary period. In other words, the return
to equilibrium involves some overshooting
and a
period of below-normal activity.
Here is Mill’s
conclusion that, when people are fooled by inflation,
economic activity is affected both at the time of the
misperception and also when the misperception is
As Mill expressed it, the “increase of
corrected.
production” is “followed . . . by a fatal revulsion as
soon as the delusion ceases” [ 17, p. 791.
Finally, Mill argued that Attwood’s proposal to
peg employment via inflationary money growth assumed the existence of permanent money illusion, an
Attassumption patently at odds with the facts.
wood’s scheme, he says, “calculates on finding the
whole world persistin, u for ever in the belief that
more pieces of paper are more riches and never discovering that, with all their paper, they cannot buy
more of anything than they could before. No such
mistake was made during any of the periods of high
prices, on the experience of which [Attwood] lays
In sum, inflation
so much stress” [ 18, p. 5501.
stimulates activity only if people are fooled into
believing that nominal gains are real. But you cannot fool all the people all the time. Money illusion is
not permanent.
Therefore attempts to peg output
and employment at above-average levels are bound
to be futile. Inflation cannot permanently stimulate
economic activity.

Pegging Output and Employment
Regarding the
feasibility of stimulating activity via inflationary
money growth, Mill argued as follows. First, such
stimulus is at best temporary.
Second, it occurs only
when inflation is unanticipated and catches people by
surprise.
Being unexpected, the inflation fools or
deludes people into increased activity under the mistaken belief that real profits and wages have risen.
As Mill put it, inflation
could only succeed in winning people on to these
unwonted exertions by a prolongation of what
would in fact be a delusion; contriving matters so,
that by a progressive rise of money prices, every
producer shall always seem to be in the very act
of obtaining an increased remuneration which he
never, in reality, does obtain [18, p. 5501.
For example, suppose there occurs an unanticipated
increase in nominal aggregate demand that drives up
general prices. To each producer, the inflation appears as an unexpected rise in the demand for his
In an environment in which changes are
product.
always occurring in the relative demand for different
goods, he will not know whether this change is special
to him or pervasive. But if inflation has not occurred
for some time, he will likely interpret the demand
shift as special to himself and so expand output.
Surprised by inflation, he will misinterpret the general price increase as a rise in the relative price of
his own product. In this way each producer will be
led to think that the demand for his product has increased relative to the demand for other products.
Consequently, each will tend to expand production
and aggregate output will rise.
That this was Mill’s interpretation is clear from his
statement that a general rise in nominal demand
“produced a rise of prices, which, not being supposed
to be connected with a depreciation of the currency
[i.e., not perceived as being connected with general
inflation], each merchant or manufacturer considered
to arise from an increase of the effectual demand for
his article, and fancied there was a ready and permanent market for almost any quantity of the article
which he could produce.”
In short, an unexpected
inflation, “may create a false opinion of an increase
of demand; which false opinion leads, as the reality
would do, to an increase of production” [ 17, p. 791.

Contrary
to
Costs and Benefits
of Inflation
Attwood, Mill contended that the costs of inflation
far exceed the benefits. He based his contention on
three arguments.

The increase in ouput of course requires extra
labor which employers obtain by offering higher
FEDERAL

RESERVE

BANK

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19

First, inflation-induced
rises in economic activity
are harmful because they put undue strain on scarce
resources and productive capacity. Attwood’s concept of absolute full employment is actually overfull
and unsustainabie employment.
It implies a forced
draft economy in which resources are used inefficiently and workers are tricked into overexerting
themselves under the mistaken belief that their real
wages wili be higher than they actually prove to be. A
reasonable definition of full employment would allow
for some normal slack capacity and unemployment
consistent with the inevitable frictions and resource
realIocations that continually occur in a dynamic
economy. As Xill put it, “the healthy working of the
social economy requires, that, in some channels, capital should be in full, while in others it should be in
slack, employment”
[ 17, p. 79 J . In other words.
some slack is necessary for peak efficiency.
Here
Mill was obviously identifying full employment with
what analysts now call the natural rate of unemployment, i.e., the rate that, given the frictions and structural characteristics of the economy, is just consistent
with demand-supply equilibrium in labor and product markets.
Moreover, he was also specifying the
costs in terms of exertion and reduced efficiency of
forcing activity to exceed its natural or equilibrium
level.
Second, inflation produces costly downward as well
as upward deviations from the natural or equilibrium
level of activity. Inflationary booms breed corrective
periods of recession-or
“revulsion” in Mill’s words
--involving painful losses of output and employment.
These losses must be taken into account in any reckoning of the costs of inflation.
Third, unanticipated
inflation has noneconomic
social costs. People are deceived into increased activity. Contracts are unjustly violated. Income and
wealth are arbitrarily and unfairly transferred from
creditors to debtors and from money holders to
money issuers.
True, for every loser there is a
corresponding
winner so thai one might conclude
that the net redistribution effects are zero. But this
argument would be valid only “if integrity and good
faith were of no importance to the world” [ 18: p.
5521. fn a word, inflation is “a form of robbery” or
“a gigantic plan of confiscation” [ 17, p. 691.
Rules Versus Discretion
On the issue of rules
versus discretion, Mill was diametrically opposed to
Attwood.
Mill argued that a money stock regulated
by fixed rules has the virtues of reasonable predictability, stability of value, and freedom from alteration
by design. Discretionary
monetary control, on the
other hand, has certain inherent disadvantages.
The
20

ECONOMK

REVIEW,

most basic is that men simply cannot be trusted with
This is particularly true of
discretionary powers.
“issuers . . . of a government paper” who “always
have a direct interest in lowering the value of the
currency, because it is the medium in which their
own debts are computed” [ 18, p. 5441. Even whe:n
the monetary authorities have the best of intentions,
they are still susceptible to pressures to expand the
money stock excessively.
“The temptation to overissue, in certain financial emergencies, is so strong,
that nothing is admissible which can tend, in however
slight a degree, to weaken the barriers that restrain
it” [ lSt p. 5461. Being subject to alteration by design
or human error, a discretion-controlled
money stock
is bound to be unpredictable and extremely unstable
in value.
Among alternative monetary arrangements,
MiX
considered a discretionary-controlled
inconvertible
paper system to be the worst of the lot. There being
no automatic check to the overissue of such currency,
its purchasing power, he said, could be depreciated
“without limit” 118, p. 3%f. Much better would be
an inconvertible paper money stock subject “to strict
rules, one rule being that whenever bullion rose above
the &lint price, the issue should be contracted until
the market price of bullion and the Mint price were
again in accordance” [ 18, p. 5451. Regulated by thlc
price of gold, this currency “would not be subject to
any of the evils usually deemed inherent in an inconvertible paper” [ 18, p. 5451. The trouble with this
rule, however, was that it did not have the public support necessary to enforce its rigid adherence.
The
gold standard did not suffer from this defect and
therefore constituted the best monetary system. Under
the gold standard, currency was freely convertible
into gold at a fixed price. This convertibility rule \va:j
definite, simple, easily understood, and had the strong
public support required to enforce the authorities’
compliance [ 18, p. 5461.
Classical School’s View of Deflation
The preceding paragraphs have described J. S. Nil’s viem
on (1) full employment
versus convertibility
as
policy goals, (2) rules versus discretion in the conduct of monetary policy, and (3) the benefits and
costs of inflation. Mill did not address a fourth issue
raised by Attwood, namely the costs of price deflation.
But other Classical economists,
including
Thomas Malthus, John W’heatley, Robert Torrens.
and above all, John Ramsay McCulloch, did address
Their position has recently beer.
this very issue.
summarized by Professor Denis P. O’Brien, himself
a leading authority on the Classical school. Accord-,
ing to O’Brien, the Classical economists “took from
SEPTEMBER/OCTOBER

1977

Hume not only the analysis of [the stimulating
effects of] inflation but also a view that deflation had
the reverse effect” [ 19, p. 1631. Like Attwood, they
recognized and deplored the painful effects of deflation on output and employment.

economy’s ability to generate high average levels of
employment v,-hen undisturbed by monetary shocks.
Like Mill, they believe that attempts to peg unemployment at arbitrarily low levels through moneta?y *”
management are futile and counterproductive,.
Like
him they maintain that economic acti$y
liourishes
best in an environment of price stzlility.
For this
reason they assign top o&ri;y to moving to a zero
target rate of infIa:icnGven if it means slowing the
pace of the recovery during the transition.
Moreover, like &&ill,they advocate rules rather than discretion in the conduct of monetary policy. The rule
they prescribe calls for a constant rate of money
growth equal to the trend growth rate of output.
This rule is consistent with full capacity utilization
and the zero target rate of inflation.

They too were strongly opposed to deflation; they
saw the hardship that this could produce and they
saw too that increases in the money supply could
offset this hardship and raise the level of activity.
But they believed that Attwood’s

inflationism,

con-

taining within itself the dangers of hyperinflation

had the potentiality of producing, through the
‘d&truction of not only convertibility
but the currency itself, far more suffering even than was eng$htrin
bouts . of deflation under convertibility.
their approach was to try to make a
convertible ‘system work more gently [19, p. 1651.

In other words, the Classical economists thought that
the costs of accepting inflation exceeded the costs of
eliminating it.

Finally, just as the Classical school agreed with
Attwood on the adverse side effects of deflation, so
do stable money proponents concur with activists on
the costs of removing inflation.
In fact, the reason
they propose a gradual descent to a zero inflation
target is to minimize the unemployment costs during
What they dispute is the activists’
the transition.
estimate of the costs of accepting inherited inflation.
They believe the activists seriously underestimate
They contend that any publiclythese costs.
announced willingness to accommodate inherited inflation will lead to accelerating and highly erratic
(variabIe) inflation involving great social harm. Not
only will there be repeated falls in output and employment whenever the inflation rate drops, but the
very unpredictability of volatile inflation will increase
business uncertainty, will make capital investment
decisions riskier, will divert energies and skills from
industry to speculation, and will reduce the informa-

The Current Debate The Attwood-Mill
debate
ended with the mid-nineteenth
century Australian
and Californian gold discoveries that provided the
monetary expansion long sought by proponents of a
paper standard. But the issues and viewpoints of the
debate survive and flourish to this very day, as Karl
Brunner’s recent Congressional testimony confirms
[131According to Brunner, present-day policy activists
stress the persistent slack in resource utilization and
urge speedy recovery facilitated by rapid monetary
growth.
Moreover they argue that continuous finetuning is needed to maintain full employment in the
face of autonomous shocks. To this end they contend
that money growth should be rapidly adjusted to the
shifting state of the economy. Finally, they are willing to tolerate inherited inflation on at least three
grounds.
First, the unemployment costs of fighting
inflation are too high to make anti-inflationary policy
feasible.
Second, inflation, if unanticipated,
will
exert a beneficial stimulus to output and employment.
Third, if the inflation is fully anticipated it will have
no permanent effect on resource allocation or income
distribution and so will be virtually painless. Thus
at best inflation is beneficial, and at worst it is harmless. On the basis of this cost-benefit calculus, activists conclude that a policy of accepting inflation is
superior to one of combating it. All this is very
reminiscent of Thomas Attwood’s analysis.

tion

RESERVE

of

market

prices

thereby

making

the

price system a less efficient mechanism for coordinating economic activity.
The end result will be
slower economic growth, lower productivity,
and
Mill would have
higher average unemployment.
agreed comp’!e?ely with this diagnosis.
Conclusion
Ii the foregoing is at all an accurate
account of the current debate then it follows that the
roots of that debate lie in the earlier Attwood-Mill
controversy.
That the issues and arguments of an
ancient controversy would survive virtually intact to
form the core of a key policy debate almost 150 years
later is indeed a remarkable
fact.
At feast three
First,
conclusions can be drawn from this fact.
modern economists, for all their sophisticated econometric modds and high-speed computers, have advanced little beyond their nineteenth century prede-

On the other side of the debate, arguments similar
to those of John Stuart Mill and the Classical school
are still very much in force. Like Mill, current proponents of stable monetary growth argue that activists tend to overestimate the amount of slack capacity existing in the economy and underestimate the
FEDERAL

content

BANK

OF RICHMOND

21

cessors in understanding and knowledge of the costs
and control of inflation and unemployment.
Second,
neither side has yet convinced the other, otherwise
the debate would have long since been laid to rest.
In other words, neither side has been proven con-

elusively right or wrong, suggesting that neither has
a monopoly on the truth. Third, if this is indeed the
case, the debate is likely to continue as long as inflation and unemployment
remain major unresolved
problems.

References
1.

Attwood, Thomas.
The Remedy; or, Thoughts on
the Present Distresses.
Second edition. with additions.
London: 1816.

2.

A Letter to tite Right Honourable
Nicholas 17ansittart, on the Creation of Money, and
on its Action Upon National Prosperity.
Birmingham: 1817.

3.

. Observations on Currency, Population and Pauperism,
in Two Letters to A.rthttr
Young, Esq.
Birmingham:
1818.

5.

. A Letter to the Earl of Liverpool, ox
the Reports of the Committees of the TUJOHouses
of Parliament, on the Questions of the Bank Restriction Act.
Birmingham : 1819.

Selected Eeoltomic Writings of Thomas
Attwood.’
Edited with an Introduction by Frank
Whitson Fetter.
Xo. 18 in Series of Reprints of
Scarce Works on Political. Economy. .$ondon: The
k;onnqdon
School of Economics and Pohtlcal Science,,

13.

Brunner, Karl. Prepared Statement on Monetary
Policy in Conduct of Monetary Policy.
Hearin.gs
before the Committee on Banking, Finance and
Urban Affairs,
House of Representatives,
95th
Gong., 1st sess., February 2, 3, and 4, 1977, pp.
153-175.

14.

Checkland,
1815-1850.”
pp. l-19.

15.

Corry, B. A. Money, Saving and .Znvestment
English Economics
1800-1850.
Xew York:
Nartin’s Press, 1962.

16.

English
Link, Robert G.
Fiuctuations
1815-1848.
University Press, 1959.

17.

Tait’s
Mill, John Stuart. “The Currency Juggle.”
Edinburgh
Xagaxine
(1833).
As reprinted in
Vof. I of Dissertations
a;?d Discxssio??s.
Boston :
1865. pp. 68-81.

18.

--.
Principles of Political Economy (1848).
New edition, edited by W. J. -4shley.
London:
Lon,gmans, Green, and Co., 1909.

19.

O’Brien,
Denis
London : Oxford

20.

Robbins, Lord. The Th.eo,ry of Economic Development in. the History of Economic Thought.
New
York: St. Xartin’s Press, 1968.

. P,rosperity Restored;
or Reflections
on the Cause of the Present Distresses and on the
Only Means of Relieving Them. London: 1817.

4.

12.

6.

7.

8.

9.

10.
Il.

A Second Letter to the Earl of Liverpool, on the’ Bank Reports, as Occasioning the h7ational Dangers and Distresses. Birmingham:
1819.
The Late Prosperity,
and the
Present A&e&y
of the Country, Explained;
the
Proper Remedies Considered, and the Comparative
Merits of the English and Scottish Systems of
Banking .Discussed, in a Correspondence
Between
f3n J.lf;;cZa~r
and Mr. Thomas Attwood.
LonDistressed State of the Country.
The
Speech of Thomas Attwood, Esq. on this Important
Subject, at the Toun’s Meeting in Birmingham~,
held on the 8th of May 1829. Birmingham
and
London : 1829.
. Report
crecy in the Bank of
kfi~utes of Evidence.
mons, 1831-32, (772))

from the Committee on SeEngland Charter; with the
Parliamentary Papers, ComVI, pp. 452-468.

Letter to The Times, 4 December

21.

Letter to Sir Robert Peei on the Currency, published in Aris’s Birminghum Gazette of
January 30, 18&Y.

22.

1843.

’

New York:

Economists,
S. G. “The Birmingham
The Economic History Review (1948),

P.
The
University

Theories of Ecoaonzic
Xew York:
Columbia

Classical
Economists.
Press, 1975.

Political Economy:
Past and Present.
Columbia University Press, 1976.

Viner, Jacob.
Studies
national Trade (1937).
A. M. KeIley. 1965.

In The Theory of ZnterReprinted.
iXew York :

Fifth District farmers demand for credit was unusually strong in the second quarter of 1977.
Supplies of loanable funds at commercial banks were generally ample. however. although not as
much so as in other recent Jx-zriotls. Loan-to-deposit
ratios oi I)articipating
h:?nks were hi&q.
but
Ioan referral activity continued to be weak.
Some loan repaylxent problems were preva!ent in areas
hit hard by droughtt and loan renewals or extensions
i\:cre greater in some of these areas.
These

are some of the more significant findings of the Quarterly
conducted by the Federal Reserve Bank of Richmond for
report is available in mimeographed form. Copies ~;:a?;
Department, Federal Reserve Bank of Kichmond, P. 0.

22

ECONOMIC

REVIEW,

Survey of Agricuiturnl Credit Conditions
the second quarter of 1977. The complete
be ol)tninetl

by

writing

to

the

Box 27622. :Kichmond, Virginia

SEPTEMBER/OCTOBER

Zn
St.

7977

Research

23261.