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EMPLOYMENT, GROWTH, AND PRICE LEVELS
HEARINGS
BEFORE THU
JOINT ECONOMIC COMMITTEE
CONGRESS OF THE UNITED STATES
E IG H T Y -S IX T H CONGEESS
FIRST SESSION
PURSUANT TO
S. Con. Res. 13
MAY 25, 26, 27, AND 28, 1959
PART 4— THE INFLUENCE ON PRICES OF CHANGES
IN THE EFFECTIVE SUPPLY OF MONEY
Printed for the use o f the Joint Economic Committee
UNITED STATES
GOVERNMENT PRINTING
38663
OFFICE
WASHINGTON : 1959
For sale by the Superintendent of Documents, U.S. Government Printing Office
Washington 25, D.C. - Price 75 cents
JOIN T ECONOMIC C O M M ITTEE
( Created pursuant to see. 5(A) of Public Law 304, 79th Cong.)
PAUL H. DOUGLAS, Illinois, Chairman
WRIGHT PATMAN, Texas, Vice Chairman
SENATE
HOUSE OF REPRESENTATIVES
RICHARD BOLLING, Missouri
JOHN SPARKMAN, Alabama
HALE BOGGS, Louisiana
J. WILLIAM FU LB RIGHT, Arkansas
HENRY S. REUSS, Wisconsin
JOSEPH C. O’MAHONEY, Wyoming
FRANK M. COFFIN, Maine
JOHN F. KENNEDY, Massachusetts
THOMAS B. CURTIS, Missouri
PRESCOTT BUSH, Connecticut
CLARENCE E. KILBURN, New York
JOHN MARSHALL BUTLER, Maryland
WILLIAM B. WIDNALL, New Jersey
JACOB K. JAVITS, New York
R o d e r ic k H. R i l e y , Executive Director
J o h n W . L e h m a n , Clerk
S t u d y o f E m p lo y m e n t , G r o w t h , a n d P r i c e L e v e l s
(Pursuant to S. Con. Res. 13,86th Cong., 1st sess.)
O t t o E c k s t e in , Technical Director
W. L e h m a n , Administrative Officer
W. K n o w l e s , Special Economic Counsel
John
Jam es
n
CONTENTS
WITNESSES IN O R D E R OF APPEARANCE
Milton Friedman, Universtiy of Chicago and National Bureau of Economic Research______________________________________________________
Richard T. Selden, research associate, National Bureau of Economic
Research, and associate professor of banking, Columbia University____
Robert Eisner, professor, Northwestern University______________________
John G. Gurley, senior staff member, Brookings Institution_____________
Pag«
605
671
767
847
STATEM ENTS AND E XH IB ITS
Eisner, Robert, professor, Northwestern University_____________________
Exhibits:
Article reprinted from the Economic Journal, the quarterly
journal of the Royal Economic Society_______________________
Employment and price levels______ ___________________________
Hypothetical aggregate supply and demand functions__________
Hypothetical aggregate supply and demand functions after reduc
tion in cost of capital and increase in assets stemming from
increase in quantity of money_______________________________
Hypothetical aggregate supply and demand functions after reduc
tion in cost of capital stemming from increase in quantity of
money____________________________________________ _________
Unemployment equilibrium rates of growth____________________
Friedman, Milton, University of Chicago and National Bureau of Eco
nomic Research______________________________________________________
Exhibits:
Demand deposit turnover rates, 1943-58_______________________
Deposits and currency, all banks in the United States— June and
December through 1942, end of month 1943-46, last Wednesday
of month 1947__________________________________ ____________
Elements of the equation of exchange, quarterly, 1947-58______
Flow of funds sector velocities, 1939-56________________________
Four measures of aggregate monetary velocity_________________
Money Stock, income, and income Velocity, 1869-1957_________
Monthly rate of change in money stock, 1907-58_______________
Sector Velocity components, statistics of income, 1931-56______
Selected asset size velocities, nonfinancial corporations, statistics
of income, 1946-55__________________________________________
Selected sector velocities by major industry groups, statistics of
income, 1946-56_____________________________________________
The Quantity Theory of Money— A Restatement_______________
Gurley, John G., senior staff member, Brookings Institution___________
Exhibits:
Average,annual net issues of primary securities and GNP by short
cycles, 1897-1958____________________________________________
Average annual net issues of primary securities and their pur
chasers by short cycles, 1897-1958___________________________
Market for loanable funds_____________________________________
Money supply, time deposits, and other nonmonetary indirect
assets, 1948-58______________________________________________
Net issues of primary securities by short cycles, 1897-1958_____
Percentage composition of primary security issues by selected
periods. 1897-1958__________________________________________
Percentage of primary security issues purchased by ultimate
lenders, monetary system, and nonmonetary intermediaries,
by short cycles, 1897-1958___________________________________
Ratio of primary security issues to GNP by short cycles, 18971958_____4__________________________________________________
Selected indirect securities, 1947-58____________________________
Yields on U.S. Government securities_______ ___________________
nr
767
829
803
796
799
798
811
605
643
641
642
644
640
638
639
645
648
646
649
847
872
873
857
870
872
861
868
860
873
874
IV
CONTENTS
Selden, Richard T., research associate, National Bureau of Economic Research, and associate professor of banking, Columbia University_______
Exhibits (see also chart presentation in Mr. Friedman’s statement,
p. 638):
Cost-push versus demand-pull inflation, 1955-57________________
Cyclical movements in income, money stock, income velocity, and
prices: difference in monthly rates of change between reference
expansion and contraction, annual analysis, 1870-1954, ex
cluding war cycles___________________________________________
Pag©
671
700
693
A D D ITIO N A L IN FO RM ATION
Correspondence between the Chairman and the Federal Reserve Board__
Debt management, 1959________________________________________________
Inflationary pressures, 1955-57__________________________________________
Insured commercial banks, 1936-58, profits on (securities sold____________
Monetary Systems and Accelerator Models, article in the American Eco
nomic Review___________________________________________ ____________
Money rates________________________________________________ ___________
Selected data on interbank demand deposits and total demand deposits,
1939-58_____ _____ ____________________________ _________________ _
755
761
760
678
730
759
758
EMPLOYMENT, GROWTH, AND PRICE LEVELS
MONDAY, M A Y 25, 1959
C on gress of t h e U n it e d S t a t e s ,
J o in t E c o n o m ic C o m m it t e e ,
Washington, D.C.
The Joint Economic Committee met at 10 a.m., pursuant to call, in
room 457, Old Senate Office Building, Senator Paul H. Douglas
presiding.
Present: Senators Douglas and Bush; Representatives Curtis and
Widnall.
The C h a i r m a n . Gentlemen, the committee will come to order.
The fourth set of hearings which begins this morning are designed to
review the so-called classical inflation and deflation caused by increases
and decreases in the effective supply of money and credit with relation
ship to the quantity of transactions.
The committee is interested in determining the circumstances un
der which changes in the money supply necessarily lead to changes in
prices and those under which no price change follows:
For example, if substantial recourses of labor and capital are un
employed, will an increase in the money supply necessarily lead to
an increase in prices ?
In addition, the committee will study the effect of the changes in
the effective supply of money on growth, employment, and economic
stability.
We are very glad to welcome as the initial witness an old colleague
of mine, one of the most brilliant American economists, Mr. Milton.
Friedman, professor of economics, University of Chicago.
STATEMENT OF MILTON FRIEDMAN, UNIVERSITY OF CHICAGO AND
NATIONAL BUREAU OF ECONOMIC RESEARCH
Mr. F r i e d m a n . Thank you. I almost said Professor Douglas.
I am honored to appear before this committee. The issues that you
are examining are among the most crucial facing the Nation. Un
less we can achieve both a reasonably stable economy in the short
run and a reasonably stable price level in the long run, our free enter
prise economy is unlikely to be permitted to survive. And without a
predominantly free enterprise economy, we shall neither preserve
political freedom nor attain healthy economic growth, which in a free
society means the possibility for individuals to use their resources ef
fectively to promote their own aspirations.
With respect to the technical issues covered in the two papers I
have submitted, it will probably be most fruitful if in the main I
answer questions rather than try to cover the ground in full again.
605
606
EMPLOYMENT, GROWTH, AND PRICE LEVELS
As a background for such a discussion, I shall in this introductory
statement sketch the course of recent academic thinking about mone
tary matters and summarize a few central ideas, covered more fully
in the submitted papers, bearing on the relation between the stock of
money and other economic magnitudes.
The past three decades have seen first a sweeping revolution against
previously accepted economic thought about the role of monetary
factors in economic change and then a counterrevolution that is still
incomplete but promises to be no less sweeping. As with any suc
cessful counterrevolution, the result has not been simply to restore
the status quo ante. In the process, views initially held rather un
critically have been reexamined and improved, and some elements
of the revolutionary interlude absorbed.
Before the great depression of the early 1930’s, accepted economic
doctrine attached great importance to the stock of money as a deter
minant of the level of money income and of the price level. This
view rested on experience covering centuries in time and spanning the
globe in space. On numerous occasions, substantial increases in the
stock of money relative to output had been associated with sub
stantial increases in prices, and substantial decreases in the stock of
money relative to output with substantial decreases in prices. And
there were no known cases in which substantial changes in either
money or prices had occurred without a similar change in the other
magnitude.
The theoretical relation suggested by this experience was generally
termed “ the quantity theory of money.55 Like most established ortho
doxies, it became unduly rigid in form and structure and thereby
gave rise to expectations that were bound to be disappointed. In par
ticular, in the 19205s, it was a major element in the widespread belief
that the Federal Reserve System could and, what is even more ex
treme, would succeed in producing for an indefinitely prolonged
period a high degree of economic stability, itself a major ingredient
in the belief in a new era.
The great depression spawned a revolution in views. Though on a
restrospective examination the depression is a tragic testimonial to
the potency of monetary factors—the stock of money fell by a third
from 1929 to 1933—the failure of the monetary authorities to stem
the depression was taken as evidence that they could not have done
so. And in any event, the obvious disorders in the economy and the
urgent need for a remedy made the world in general and the economic
profession in particular receptive to new ideas.
John Maynard Keynes was the chief architect of the subsequent
intellectual revolution. He shifted emphasis from the relation be
tween the stock of money and the flow of income which was at the heart
of the quantity theory to the relation between different flows, in par
ticular between the flow of capital expenditures and the flow of in
come. He regarded changes in the stock of money as of minor im
portance in times of unemployment, and as exercising a significant in
fluence only in times of full employment. His disciples, as disciples
will, went much farther than the master. The view became wide
spread that “money does not matter55, that the stock of money was a
purely passive concomitant of economic change and played no inde
pendent part except as it might affect interest rates, and that hence
EMPLOYMENT, GROWTH, ANI> PRICE LEVELS-
607
the only role for monetary policy was the minor one of keeping in
terest rates low so as to avoid interfering with the investment re
garded as needed to offset the secular stagnation that was confidently
expected to be the major problem for the future.
Two forces combined to produce a counterrevolution in ideas. One
was strictly academic. Scholarly criticism and analysis of Keynes5
ideas demonstrated a logical fallacy in one of his central propositions;
namely, the proposition that, for a given stock of money, there might,
even in principle, exist no price and wage level consistent with full
employment; or, to put the proposition differently, that even in the
economist’s never-never land of the long run, and even if all prices
and wages were perfectly flexible, a free market system might have no
inherent tendency to full employment.
It has turned out on analysis that Keynes’ proposition involved an
error of omission. He neglected to take account of the effect of dif
ferent levels of prices on the real value attached by the community to
its wealth relative to its income, and of the effect of changes in this
ratio, in its turn, on consumption expenditures. When this effect is
taken into account, there is always in principle a price and wage level
consistent with full employment, though of course frictions or other
disturbances may prevent the economy from attaining such a position
at any point in time. Unemployment, that is, cannot be attributed
to an inherent “flaw in the price system;” it requires explanation in
terms of such other forces as rigidities in adjustments, external dis
turbances, and the like.
The second, and more obvious, though perhaps not more important,
factor that produced a counterrevolution was the brute force of events.
Many countries in the postwar period, including the United States,
pursued cheap-money policies, partly under the influence of the ideas
derived from Keynes that I have so briefly sketched. Every such
country experienced either open inflation or a network of partly ef
fective, partly ineffective, controls designed to suppress the inflation
ary pressure. In every case, the stock of money rose as a result of the
cheap-money policies and so did prices, either openly or in whatever
disguise was most effective in circumventing the controls. No country
succeeded in stemming inflation without adopting measures that made
it possible to restrain the growth in the stock of money. And every
country that did hold down the growth in the stock of money suc
ceeded in checking the price rise.
Western Germany’s “ economic miracle” after the monetary reform
of 1948 was the most dramatic episode, but the experiences of Italy,
of Great Britain, and of the United States differed only in detail.
And French experience, prior to the monetary reforms at the turn of
this year, is equally striking testimony by its contrast in both policy
and outcome.
These developments in the world of scholarship and of affairs have
produced a rebirth of interest in monetary changes. It is by now
clear, and widely accepted, that money does matter and matters very
much. There has been an increasing amount of research by econ
omists during recent years on just how monetary forces operate, on
what the relation is between monetary changes and other economic
changes, and on the structure and operation of our financial system.
I venture to predict that this trend will continue.
608
EMPLOYMENT, GROWTH, AND PRICE LEVELS
The modern version of the quantity theory that has been developed
as a result of this work is more sopisticated and subtle than the earlier
version. Like that earlier version, however, it attaches great impor
tance to the quantity of money as a determinant of prices and like it,
also, it is consistent with centuries of experience.
An examination of the role of money must distinguish sharply be
tween the arithmetic and the economics of the relation between money
and other magnitudes.
As a matter of arithmetic, we can always express national income in
two different ways:
First, as the product of the amount of money and its velocity of
circulation.
Second, as the product of an index of the quantity of goods and
services produced and an index of the average price of these goods and
services.
The two products are always equal, which gives the famous quan
tity equation: M V =P y, in its income form, where M is the stock of
money at any time; V, the income velocity of circulation of money;
P, the price level, and y, the rate of flow of real income.
As it stands, this equation is simply a definition of velocity; for any
values of the price level, real income, and the stock of money, all of
which can be observed directly, we can compute the value of V that
will make it true. It says nothing about the factors that might pro
duce a change in the stock of money or about the effect of such a
change. Conceivably, such a change might be absorbed entirely in
V, without affecting prices or output at all—this is the result im
plicit in the views of the extreme and rigid disciples of Keynes. Or
the change in M, the stock of money, might be entirely absorbed by
prices, without affecting velocity or output at all—this is the result
predicted by the extreme and rigid quantity theorists. Or the change
in money might be partly offset by a change in velocity, and the
remainder reflected partly in prices, partly in output—this is the result
experienced in the United States in the longer period movements of
the past century. Or the change in money might be reinforced by a
change in velocity in the same direction, the combined effect being
reflected in both prices and output, but in widely varying proportions,
depending on circumstances—this is the result experienced in the
United States during the shorter period movements, the so-called busi
ness cycles, of the past centuries. And still other combinations are
possible.
The economic issue concerns the circumstances under which one or
another of these outcomes is likely to occur and the process whereby it
does occur. This in turn depends on the factors that determine the
quantity of money, the problem of the supply of money; the factors
that determine the amount of money people want to hold, the demand
for money; and the factors that determine the process whereby the
amount or money people want to hold is adapted to the amount avail
able, the adjustment between demand and supply.
Under present conditions in the United States, the Federal Reserve
System essentially determines the total quantity of money; that is to
say, the number of dollars of currency and deposits available for
the public to hold. Within very wide limits, it can make this total
anything it wants it to be. Of course, it cannot do so instantaneously
EMPLOYMENT, GROWTH, AND PRICE LEVELS
609
or to the precise dollar, and it frequently expresses its proximate
objectives in terms of other magnitudes, letting the quantity of money
be whatever is consistent with these other objectives. But there is no
doubt that, if it wanted to, it has both the formal power and the actual
technical capacity to control the total stock of money with a timelag
measured in weeks and to a degree of precision measured in tenths of
1 percent.
Broadly speaking, therefore, the public cannot by itself affect the
total number of dollars available to be held. For any one individual
separately, it both appears to be true and is true that he can control
the amount of cash that he holds. He can increase his cash balances
by selling some assets for cash or spending less than he receives from
other sources. He can reduce his cash balances by spending on assets
or for other purposes more than he receives. For all individuals
combined, however, the appearance that they can control their cash
balances is an optical illusion. One individual can reduce or increase
his cash balance only because another individual or several others are
induced to increase or reduce theirs; that is, to do the opposite of what
he does. I f individuals as a whole were to try to reduce the number
of dollars they held, they could not all do so, they would simply be
playing a game of musical chairs. In trying to do so, however, they
would raise the flow of expenditures and of money income since each
would be trying to spend more than he receives; in the process adding
to someone else’s receipts, and, reciprocally, finding his own higher
than anticipated because of the attempt by still others to spend more
than they receive. In the process, prices would tend to rise, which
would reduce the real value of cash balances; that is, the quantity of
goods and services that the cash balances will buy.
While individuals are thus frustrated in their attempt to reduce
the number of dollars they hold, they succeed in achieving an equiva
lent change in their position, for the rise in money income and in
prices reduces the ratio of these balances to their income and also
the real value of these balances. The process will continue until this
ratio and this real value are in accord with their desires.
Conversely, if individuals were to try to increase the number of
dollars they held, they could not do so if the Federal Reserve System
did not increase the number available to be held. But in their attempt
to do so, individuals would try to spend less than they received,
which would lower the flow of spending and reduce the level of money
income and of prices. This would raise the ratio of cash balances
to income and the real value of cash balances.
This essential difference between the situation as it appears to the
individual, who can determine his own cash balances but must take
prices and money income as beyond his control, and the situation as
it is to all individuals together, whose total cash balances are outside
their control but who can determine prices and money income, is per
haps the most important proposition in monetary theory and cer
tainly the source of greatest confusion to the layman.
It follows from this analysis that if the nominal stock of money
changes, but the public at large wants to hold the same real stock
of money^ the monetary change will be reflected fully and propor
tionately in prices after adjustment has been made to the change.
In the interim, the effect on prices might be less or more and real income
610
EMPLOYMENT, GROWTH, AND PRICE LEVELS,
might also be affected. However, systematic discrepancies over any
period between movements in prices and in the stock of money must
reflect changes in the real stock of money that the public at large
wishes to hold.
It is pointed out in greater detail in the technical papers that have
been submitted that the main factors affecting the real stock of money
the public wishes to hold are:
(1) The level of income.
(2) The cost of holding money.
The level of real income affects desired real cash balances in two
ways:
In the first place, a change in real income affects the total volume
of transactions to be effected; that is, the amount of work, as it were,
for money to do. This effect would lead to a change in the desired
real stock of money in roughly the same proportion as in output.
In the second place, if there is a change not only in total real in
come but also in per capita income, it means that people are at a
higher or a lower level of living. With such a change in the level of
living, they may want to increase their stock of money more or less
than proportionately, just as an increase in level of living means a
less than proportionate increase in expenditures on bread but a more
than proportionate increase in the stock of durable consumer goods.
It turns out empirically that in this respect money is like durable
consumer goods rather than like bread, so that an increase in real
level of living is on the average associated with a more than propor
tionate increase in the real stock of money.
A very recent and rather novel finding is that the income to which
cash balances are adjusted is the longer term level of income that can
be expected, rather than the income currently being received. This
finding goes far to explain much that has hitherto been puzzling in
the cyclical behavior of the stock of money relative to income.
The cost of holding cash balances depends mainly on two factors:
The rate of interest that can be earned on alternative assets, and the
expected rate of change of prices.
I f a Government bond, for example, yields 4 percent, it costs an
individual $4 a year to hold $100 in cash instead of in the form of a
bond. I f prices are rising at the rate of 4 percent per year, for ex
ample, it will take $104 in cash to buy at the end of the year as much
as $100 at the beginning, so that it costs an individual $4 a year to
hold $100 in cash instead of in goods initially worth $100. In con
sequence, the higher are interest rates and the higher is the expected
rate of change in prices, the greater is the incentive for individuals
to economize on cash balances, and conversely.
Empirical evidence suggests that interest rates have a systematic
effect in the expected direction but that the effect is not large in mag
nitude. The experienced rate of change in prices has no discernible
effect in ordinary times, when prices are not expected to change by
much. On the other hand, the rate of change in prices has a clearly
discernible and major effect when price change is rapid and long
continued, as during extreme inflations and deflations.
In recent years, both interest rates and the expected rate of change
in prices have been working in the same direction in the United
States. Expectations of inflation have become more and more wide
EMPLOYMENT, GROWTH, AND PRICE LEVELS
611
spread and, partly for that reason, interest rates have risen. These
changes doubtless help to explain the recent tendency for the ratio
of the stock of money to income to decline despite a rise in real in
come per capita.
Of course, even after allowance is made for changes in real in
come per capita and in the cost of holding money, the ratio of cash
balances to income is not perfectly steady. But the remaining fluc
tuations are minor, certainly far smaller than those that occur in the
stock of money itself.
In concluding this introductory statement, I should like to empha
size two points that seem to me of central importance in fashioning
a wise national monetary policy.
The first is the closeness, regularity, and predictability of the rela
tion among the stock of money, the level of price, and the level of
output over any considerable period of years.
The second is our present inability to predict at all accurately
this same relation over very short periods, from month to month,
quarter to quarter, even year to year.
The first proposition means that in order to attain a reasonably
stable price level over the long pull, we must adopt measures that
will lead to a growth in the stock of money at a fairly steady rate
roughly equal to or slightly higher than the average rate of growth
of output.
The second proposition means that in the present state of our
knowledge we cannot hope to use monetary policy as a precision in
strument to offset other short-run forces making for instability. The
attempt to do so is likely merely to introduce additional instability
into the economy, to make the economy less rather than more stable.
It should be emphasized that this conclusion about short-run
changes is valid not only monetary policy but also for fiscal or other
policies. All these policies operate with a long lag and with a lag
that varies widely from time to time. We know too little about either
these lags or about what the economic situation will be months or
years hence when the chickens we release come home to roost, to be
able to be effective in offsetting the myriad of factors making for
minor fluctuations in economic activity. This is one of those cases
in which the best can be the enemy of the good.
As I examine the past record of stability in the United States,
I am impressed by the number of occasions on which major fluctua
tions have been a consequence of changing and at times erratic gov
ernmental policies with respect to money. This record offers much
support for the view that, if the monetary framework were stable,
our private enterprise economy is sufficiently adaptable to the other
changes that occur to yield a high degree of economic stability in the
short run as well as the long run.
For this reason, the urgent need, I believe—and here I am ven
turing farthest from any academic ivory tower—is to keep monetary
changes from being a destabilizing force, as they have been through
much of our history. In my view, this can best be done by assign
ing the monetary authorities the task of keeping the stock of money
growing at a regular and steady rate, month in and month out. This
would at one and the same time provide a stable monetary back
ground for short-run adjustments and assure long-run stability in the
purchasing power of the dollar.
612
EMPLOYMENT, GROWTH, AND PRICE LEVELS
The elimination of monetary uncertainty would promote healthy
economic growth by providing a stabler environment for both individ
ual planning and social action. But it would be no panacea. The
springs of economic progress are to be found elsewhere; in the quali
ties of the people, their inventiveness, thrift, and responsibility, in
public policies that give a free field for private initiative and promote
competition and free trade at home and abroad. Mistakes in mone
tary policy can render these forces impotent. A stable monetary
environment can give them an opportunity to be effective; it cannot
create them.
Thank you.
The C h a i r m a n . Thank you very much, Mr. Friedman.
I have a few questions.
I wonder if you have checked the theoretical development with the
actual movements of the supply of money, production, or price levels
in recent years; that is, have you tested your equations inductively ?
Mr. F r i e d m a n . Yes, Senator Douglas.
We have conducted a number of empirical studies comparing the
behavior of these various magnitudes and have computed empirical
equations of the kind that are suggested in the chapter submitted to
the committee.
As I said in my general statement, for most of the period for which
we have studied this relation, rates of changes of prices don’t have
much effect except during the wartime periods, because over most of
the period, the rates of changes of prices were rather small.
For the postwar period, and particularly for recent years, the com
puted equations work very well except for one discrepancy, which is
that over the past 4 or 5 years the velocity of circulation of money,
that is to say, the ratio of income to the stock of money, has been at a
higher level than would have been anticipated from these equations
alone.
The C h a i r m a n . That brings me to this point. In the years 1954-57,
the increase in the total of demand deposits was only from $134.4
billion to $138.6 billion, or about $4.2 billion— approximately 3
percent.
On the other hand, the increase in the total gross national product
reduced to constant purchasing power, 1958 dollars, was $403.2 bil
lion to $451.1 billion, or an increase of roughly $48 billion of constant
purchasing power, or of 12 percent.
I f these were the only factors you would expect, therefore, a de
crease in the price level of some 8 percent. Instead of that, the price
level rose by 4 to 5 percent.
Do you have any explanation for that ?
Mr. F r i e d m a n . Yes.
May I say first that with respect to the stock of money, the defini
tion we have used for most of our work is rather broader than the one
you suggest. In addition to currency and demand deposits, we have
included time deposits in commercial banks—not all time deposits, but
time deposits in commercial banks. There is one compelling statistical
reason for this procedure.
Before 1914 when the Federal Reserve System was established, it
was impossible statistically to separate time deposits in commercial
banks from demand deposits. Under the National Banking Act, re
EMPLOYMENT, GROWTH, AND PRICE) LEVELS'
613
serve requirements for both were the same on demand and time de
posits and there was no necessity for the banks to distinguish them.
Since our studies go back to 1867 and cover, therefore, a very long
period indeed, this statistical reason itself would be decisive.
The C h a i r m a n . If I may interject, it would be desirable for the
purposes of your study, but what about the current situation when
you have both sets of figures—namely, demand deposits and time
deposits ?
Mr. F r i e d m a n . I was coming to that. Senator Douglas.
In addition, we have examined which of these concepts seems to
give the closer relation with other magnitudes and there is a slight
margin, not an overwhelming margin, but a slight margin, in favor
of the broader concept which includes commercial bank time deposits,
but not other time deposits.
One important reason, if I may say so, is that since commercial bank
time deposits carry smaller reserve requirements than demand deposits
and since both are in the same banks, commercial banks have a strong
incentive to try to produce some shift of deposits from one category
to the other when they are under reserve pressure. In consequence, it
turns out for the period when figures on both time and demand de
posits are available, you get somewhat better results by looking at the
broader category.
Over the period from 1954 to 1957 that you mentioned in particular,
commercial bank time deposits expanded very substantially. This
was partly because of a change in the interest rates which they were
permitted by the Federal Reserve System to pay on time deposits.
Thus, in the 3 years from June 1954 to June 1957, currency plus ad
justed demand deposits rose from $126.7 billion to $135.2 billion or by
less than 7 percent; currency plus adjusted demand deposits plus time
deposits in commercial banks from $172.2 billion to $188.9 billion, or
by nearly 10 percent.
The second thing is that the particular dates you chose were from
the trough of the business cycle to the peak of the business cycle.
Over such a period it has always been true historically that velocity
tends to rise as ordinarily measured, and that was the case in this
period, so that in point of fact when this experience is put in the con
text of earlier experiences, the discrepancy between what you would
expect from the earlier experiences and this one is not very great.
Nonetheless, there is an appreciable discrepancy in the direction you
suggest.
The C h a i r m a n . I was going to say, because the Federal Reserve
Board publishes the figures on the velocity of bank deposits in New
York and outside, when you use those values for the cycles in your
equations do you get a correspondence or is there a discrepancy ?
Mr. F r i e d m a n . I have not been able to use those values in my equa
tions because my equations are computed for another concept. The
Federal Reserve Board figures are for a deposit turnover concept, and
most of our work has been done with an income velocity concept.
With the income velocity concept, velocity rose more from 1954 to
1957 than one would have expected from earlier experience, though
the bulk of the movement is consistent with earlier experience.
The C h a i r m a n . How do you account for this rise in velocity ?
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EMPLOYMENT, GROWTH, AND PRICE LEVELS
Mr. F r i e d m a n . Let me separate the two things: One, the rise in
velocity that generally occurs during a business cycle. Second, the
still greater rise which occurred in this episode.
The C h a i r m a n . H o w do you account for that ?
Mr. F r i e d m a n . W h i c h o n e ?
The C h a i r m a n . The second.
Mr. F r i e d m a n . I think myself it is largely accounted for by a
spreading notion that prices are going to be rising, by a widening
anticipation of rising prices in the future.
The C h a i r m a n . Could it have been caused by an increase in the
interest rate, making the cost of holding inventory more costly ?
Mr. F r i e d m a n . Yes, indeed, but such a relation is already included
in our estimate of the rise that would have been expected from earlier
experience. In our work we have allowed for the effect of interest
rates, and hence interest rates do not explain the rise over and above
that which we could account for on the basis of historical relations.
I have no doubt that in general the rise in interest rates is one of
the factors that accounts for a tendency for velocity to rise during the
cycle.
The C h a i r m a n . That presents a problem, that if the Federal Re
serve Board would attempt to slow down the rate of increase in
money supply versus the interest rate, thus preventing inflation from
coming in through the front door by speeding up velocity, may it not
permit inflation to come in through the back door ?
Mr. F r i e d m a n . No.
The C h a i r m a n . Why not?
Mr. F r i e d m a n . Because not the whole of the effect is dissipated.
For the reason you mention the effect of holding down the rise in the
stock of money is not as far-reaching as one might expect if he did not
take account of the effect on velocity through the interest rate. How
ever, it isn’t all dissipated. Indeed, the fact that the interest rate
rises is in a sense a sign that there is a pressure of demand for loans
on the market.
May I make one more statement in this connection, because I be
lieve that it is very misleading to look at the effect of Federal Reserve
policies in terms of an interest rate ?
Very often when the interest rate rises, it would be appropriate to
say that the Federal Reserve is following an easy money policy, and
when the interest rate falls it would be appropriate to say it is fol
lowing a tight-money policy.
I f one adopts the view often adopted that any rise in interest rate
betokens tight money and any fall in interest rate betokens easy
money, that implies that a constant interest rate would be a neutral
policy, and we all know from our own experience with the bond
support program that a monetary policy which pegs interest rates is
anything but a neutral policy.
I f one looks instead, as I think one should, at the behavior of the
stock of money, not of interest rates, then you will find that the Fed
eral Reserve System has been typically and traditionally easy during
periods of boom and tight during periods of contraction, and, conse
quently, it has tended, not intentionally, of course, to contribute to the
instability in our system rather than the reverse.
The C h a i r m a n . Mr. Friedman, I gathered from your final
comments that you believe that the Federal Reserve policy should have
EMPLOYMENT, GROWTH, AND PRICE* LEVELS
615
a total money stock increase and approximately a constant rate roughly
equal to, or perhaps somewhat higher than, the gross national product.
Mr. F r i e d m a n . Net national product, I would say, in real terms,
of course.
The C h a i r m a n . Deducting depreciation ?
Mr. F r i e d m a n . Yes.
The C h a i r m a n . And you don’t think Reserve policy should be used
as a short-run stabilizing factor ?
Therefore, you think Federal Reserve policy should be used par
ticularly for long-run stability, but not for short-run stability ?
Mr. F r i e d m a n . Yes.
The C h a i r m a n . What are you going to do about the business cycle?
The Federal Reserve Board thinks that it is trying to stabilize and
prevent the cycle. You are saying it should not try to do so and, simi
larly, you say the Government should not try to do so. Who is going
to do it?
Mr. F r i e d m a n . Senator Douglas, the question is what one thinks
the major problem is and what one thinks has in fact been the effect
of governmental policies in these areas in the past.
The statement I made is based upon the conclusion that, despite in
tentions, the policy measures actually taken have historically been a
destabilizing factor.
In light of experience, the most urgent need is not to have some ever
present back-seat driver who is going to be continually correcting the
driver’s steering, but to get off the road the man who has been giving
the car a shove from one side to the other all the time and making it
difficult for the actual driver to keep it on the straight and narrow
path. To leave the analogy, in point of fact, despite the intention of
monetary and fiscal policy, the effect has been to destabilize the
economy.
It is often said about the kind of statement I have made that it is
all right in theory, but it wouldn’t work in practice. I think the situa
tion in this case is exactly the opposite. I can see nothing to be said
in theory for the proposal I am making.
As a matter of theory, obviously the sensible thing to do if you
can is to try to be relatively tight in money and fiscal policy during
a period of expansion and to be relatively easy during a period of con
traction.
In theory, that would be the sensible thing to do, but if one looks at
the practice and asks what in fact has occurred as a result of the at
tempt of people to follow such a policy, he will find that the effect has
been just the opposite, that in fact it is so difficult to do the job, that
the effects have been destabilizing. Why is this?
I f monetary and fiscal policy were like a water tap so that as soon
as you turned it on it ran and as soon as you turned it off it stopped,
it is hard to believe that it could have the adverse effects I have
suggested. But that isn’t the case. Monetary and fiscal policy is
rather like a water tap that you turn on now and that then only starts
to run 6, 9, 12, 16 months from now. It is because of this long lag
in the reaction to policy that you have this tendency for policy in
fact to have an effect opposite to that intended.
The C h a i r m a n . That is said to be one of the difficulties in fiscal
policy in periods of recession or prosperity, but is it a defect of mone
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EMPLOYMENT, GROWTH, AND PRICE LEVELS
tary policy which is supposed to work more immediately and not have
such a time lag ?
Mr. F r i e d m a n . I think we have to distinguish between two differ
ent problems: How fast you can change the money supply, and
how fast the money supply changes economic activity.
With respect to the first, the changes in the money supply, that
can be brought about very rapidly.
The C h a i r m a n . Y o u mean by open market operations ?
Mr. F r i e d m a n . Yes, sir. That can be brought about very rapidly
by open market operations, discount rates, and so on. But the sec
ond, the time lag between the changes in the money supply and the
changes in economic activity, is a different matter.
I f one studies the chart 2 that is over there, which shows for the
period from 1907 to date the monthly rate of change in the money
stock, not the absolute money stock but the percentage by which it is
changing month to month, you find that peaks in the rate of change of
the money stock preceded the peaks in general business by something
like 16 months on the average, and the troughs preceded the troughs
in general business by something like 13 to 14 months on the average.
And what is true for this period is true also for the earlier period.
What is even worse, the lag is not always the same. Thus you have
a situation such that, when the Federal Reserve System takes action
today, the effect of that action may on some occasions be felt 5 months
from now and on other occasions 10 months from now, on other occa
sions 2 years from now. That is the major reason why it is so
difficult as a technical matter in the present state of our knowledge
to know what measures one ought to take at any given time.
The C h a i r m a n . Therefore, do not do anything except keep the
supply of money expanding at the general rate ?
Mr. F r i e d m a n . Senator Douglas, that would be quite a lot. I rea
lize that it is hard to describe this alternative policy as anything other
than just a foolishly simply policy. It seems as if any fool could do
better, but in fact very wise men have been unable to. I f one goes
back and examines the difference month by month between the actual
behavior of the stock of money and the behavior under the alternative
I suggest of a constant rate of increase, you will find that the actual
behavior has been less consistent with what in retrospect you would
have regarded as desirable than the alternative.
Let me illustrate from the immediate period we are in now.
From July 1957, which was the peak of the business cycle, to April
1958, which was the trough of the business cycle, the stock of money,
using the narrower definition of currency plus demand deposits ad
justed, fell at the rate of 1 percent per annum during that period. I f
you take my broader definition of currency plus adjusted demand
deposits, plus commercial bank time deposits, it rose at the rate of 3
percent per year.
Let’s look at the subsequent period, the period of recovery, from
April 1958 to April 1959, the latest date for which we have figures on
the stock of money.
Over that year, currency plus demand deposits rose by 4 percent, and
the broader concept by 5% percent. Thus, if you look at what actually
happened over this period, the alternative policy of increasing the stock
of money at a steady rate would have been more expansionary during
EM PLOYMENT, GROWTH, AND PRICE LEVELS
617
the recession and less expansionary during the recovery from the
recession.
Senator B u s h . Will the Senator yield ?
The C h a i r m a n . Yes, certainly.
Senator B u s h . According to your calculations of the money supply
under the broader concept, there really was no contraction in the money
supply during the recession that you mentioned, was there ?
There was an increase ?
Mr. F r ie d m a n . Yes.
This is the usual experience, Senator Bush. If you look back over
the whole period from 1867 to date, the money supply has had a very
strong upward trend and it has usually risen during contractions as
well as expansions in business, but at a slower rate.
The C h a i r m a n .
that true of 1929-33 ?
Mr. F r ie d m a n . Let me give the exceptions, because they are a very
interesting series of dates and you will see it is not an accidental se
quence of dates.
The only occasions on which the stock of money fell absolutely dur
ing the business cycle are 1873 to 1879,1893 to 1894,1907 to 1908,1920
to 1921,1929 to 1933, and 1937 to 1938.
The C h a i r m a n . Those are periods of depression ?
Mr. F r ie d m a n . Those are the periods of great depression.
The C h a i r m a n . Yet you say that the money supply increases during
the period.
Mr. F r ie d m a n . No, I beg your pardon. I said on the average during
the usual kind of a mild contraction, the money supply increases, but
at a slower rate than during expansion.
On the other hand, the only occasion on which the money supply falls
is in the great depressions. In every great depression, it has fallen.
My main point is really that an essential precondition for avoiding
great depressions is that we keep the money supply growing at a steady
and regular rate. To have kept prices stable during past periods,
would have required a rate of increase of the money supply of about 4
percent per year.
Senator B u s h . The question that arises from what you say, and
going back to the 1957-59 period which you point out, is whether
the money supply has had any effect on that recession at all, whether
it caused it, or whether it helped us out of it, and I would like you to
observe specifically on that. Will you ?
Mr. F r ie d m a n . Yes, surely.
Senator B u s h . I would judge from what you say, and your own
estimate of the action of the money supply in that time, that it had
little to do with the cause of either the recession or the recovery there
from, as far as the money supply, not the cost of money.
What is your observation ?
Mr. F r ie d m a n . I would not want to say that, Senator Bush.
I think the crucial problem in answering your question is what
you take as the norm. There is no such thing as no monetary policy.
There is some necessity of doing something about the stock of money.
Let me express my views here in a very tentative way, because I
think it is extremely difficult ever to say anything about a particular
episode. But my own impression is that monetary policy contributed
to some extent to the date of the onset of the recession.
Is
38563— 59— pt. 4------- 2
618
EM PLOYMENT, GROWTH, AND PRICE LEVELS
The record of the money supply during this past period was that
it was relatively tight for a relatively long period prior to 1957. I
think this had something to do with the onset.
Senator B u s h . I am talking about the cost of money rather than
the supply.
Mr. F r ie d m a n . No, I am talking about the supply, and these are
the figures that Senator Douglas was referring to. If one looks at
this chart (chart 2), which gives the rate of change in the money
supply, the percent change from month to month, the numbers are all
relatively low through this period of 1956-57. Then they fell rather
sharply during the recession, and this probably contributed to the
severity of the recession, though again I am not sure how much
weight you can give to it in the particular instance, because this effect
might have been felt later on.
More recently, the rapid expansion in the money supply was un
doubtedly a factor that has contributed to the rate of expansion,
though again most of its effects will probably be felt this coming year
or next year.
Representative C u r t is . Mr. Chairman, for the sake of the record,
that chart No. 2 is in the record, is it, or will be?
The C h a i r m a n . It will be in the record.
Representative C u r t is . And Professor Friedman was referring to
the third graph, which is the bottom graph of chart 2 ?
The C h a i r m a n . That is correct.
Mr. F r ie d m a n . Thank you very much.
The C h a i r m a n . I will ask just one more question, Mr. Friedman,
and that is this:
You have been advocating, I think, that the supply of money should
increase approximately at the rate of growth of the net national
product, or perhaps a little more.
I take it you feel it should increase at a rate somewhere between
3 and 5 percent a year, possibly 4 percent a year.
I would like to ask your view of that principle. Do you think the
money supply was allowed to increase adequately during the period
from 1954 to 1957; and the increase over the period as a whole, so
far as demand deposits and currency are concerned, was only 4 per
cent for 3 years, whereas on a 4-percent-a-year basis it would have been
12 percent ?
Mr. F r ie d m a n . The number that one wants to use for the desirable
rate of growth of the money supply depends very critically on the
concepts of money supply that is used.
I would not recommend the same number for currency plus de
mand deposits as for currency plus demand deposits plus commercial
bank time deposits because, historically, time deposits have been a
growing fraction of the total money supply and therefore one must
be very careful not to carry over a number like 4 percent from one
concept to another. One must adjust the number to each concept.
The C h a i r m a n . H o w much weight did you give to time deposits in
commercial banks as compared to demand deposits ?
Did you give dollar for dollar?
Mr. F r ie d m a n . Yes, dollar for dollar.
The C h a i r m a n . Obviously time deposits are much more passive
than demand deposits. I mean they are not drawn upon from ex
penditures and not checked out as much.
EM PLOYMENT, GROWTH, AND PRICE, LEVELS
619
I wonder if you would not reconsider that.
Mr. F r ie d m a n . There is, of course, no simple answer to that. Any
treatment has its defects. What is necessary, I think, is that one
should try to adjust his analysis to the concept he uses. The danger
ous thing is to shift from one concept to another without notice.
We have, I should say, some studies underway in an attempt to see
whether it would be better to use a fractional part of savings deposits.
In particular, these have to do with mutual savings bank deposits, and
some of the preliminary results suggest that a fractional value would
be an improvement, and I quite recognize that it might well be a
decided improvement. As of the moment, what we have done is take
it dollar for dollar.
Another problem is that one has to be careful what date he starts
from. If one starts at a particular date like the bottom of a depres
sion, 1954, or another date like the top of a boom, it is not clear that
one would want to attach a stable rate of change of the money supply
to any such particular date. I would say that taking the period as a
whole, if you had started from somewhere at the average level around
1952 or 1953, somewhere when you were not either at a trough or at
a peak, and from then on had expanded the total of currency plus
demand deposits, plus commercial bank time deposits, by something
like 4 percent per year, you would have had a monetary policy better
adapted to the fluctuations we have had than the policy actually
followed.
Such a constant rate of rise in the money supply would have meant
a slower rate of rise than we actually had during 1955 and a faster
rate of rise during 1956 and 1957. It would have meant a faster rate
of rise during the period of the recession and a slower rate of rise since
April 1958.
The C h a i r m a n . Mr. Curtis.
Representative C u r t is . Professor, I was very interested in your
recital of those periods before World War II of monetary contrac
tion and then the fact that you did not list 1949, 1950, and 1954,1955,
and 1957 and 1958, when we have had what people have called reces
sions, and others use different titles.
May I conclude from that that you regard those three postwar
recessions as of a different nature than the ones that you recounted?
Mr. F r ie d m a n . Yes. The difference in nature is partly one of de
grees, but I think it is more than that.
I think that one can in fact distinguish historically among two
different classes of depressions or of recessions, relatively mild depres
sions and relatively deep depressions. The kinds of depressions or
recessions we have had since the end of World War II have been rela
tively mild depressions. The kinds I was citing as occurring in
1920-21,1929-33, and 1937 to 1938 were deep depressions.
I think that our studies establish an enormously strong case that
in every deep depression monetary factors play a critical role. Mone
tary collapse has been a major source of deep depressions, and if I
were being a bit more unguarded, I would say the primary source.
On the other hand, if one takes the minor recessions, such as 1948-49,
1953-54, 1957-58, then monetary factors may have contributed to
them, but it is not possible on the basis of evidence to say that they
were dominated by monetary factors, and it may well be, and I am in
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EMPLOYMENT, GROWTH, AND PRICE LEVELS
clined myself to believe that it is true, that other factors played the
main role.
Eepresentative C u r t is . Could we turn it around, though, and say
that possibly wise monetary policies helped to prevent the post-World
War II recession from becoming deeper ?
Mr. F r ie d m a n . If by wise monetary policy you mean avoiding the
kind of catastrophic mistakes in monetary policy that were made in
1929 to 1933 and again in 1920-21, yes. The behavior of the stock
of money since World War II, and particularly since about 1950,
has been very much more conducive to economic stability than it
was in the earlier period, and it has been conducive to economic sta
bility because it has come very much closer to the kind of straight
line policy that I have been suggesting.
It is a fascinating thing to examine chart 2, if I may call your
attention to it. Disregard the very rapid short-run movements in it
because that is a question of mistakes in the figures, the fact that the
figures are very inaccurate and you have statistical errors.
What I would like to call your attention to, if I may, are the longer
swings. You will note that whenever you have a period when the
swings are very sharp, we have had a period of great economic insta
bility, and whenever the curve is relatively stable and the swing is
rather small we have had economic stability. There is a stable period
just before World War I and again in the 1920’s—I am sorry the chart
breaks here because if it didn’t, you could see that the stable period
extends all the way from 1922 to 1929—and again in the postwar
period, and those are the three periods which by common consent
would be regarded as the most stable periods in economic activity.
Senator B u s h . While you are there, may I just ask one question?
Eepresentative C u r t is . Certainly.
Senator B u s h . In 1933 you have the sharpest break in the money
supply.
Mr. F r ie d m a n . That is a question of statistics. It is not a real one.
The explanation of this particular movement in the series has to do
with the closing of the banks during the bank holiday. Before the
bank holiday, many banks had restrictions on the withdrawal of
deposits, but all of those deposits were counted as part of the money
supply. After the closing of the banks, only some banks were allowed
to open. The deposits in the banks that were not allowed to open are
excluded from the recorded figures and that is really the explanation
of this particular drop.
Senator B u s h . While you are there, how about the similar drop in
1929?
Mr. F r ie d m a n . That was a very real one. It was a reflection of the
stock market break that occurred in the fall of 1929. The withdrawal
of out-of-town funds from the New York stock market caused bank
pressure, caused an immediate very sharp contraction; then as funds
were thrown into the market, particularly the reserve funds, there was
a reaction. That is why I say these very short-term movements are in
many cases statistical figments.
For example, these movements through here (1943-45) are a reflec
tion of the Government’s war bond campaigns. These figures exclude
Government cost balances. On the occasion of a war bond campaign,
deposits were transferred from private accounts to Government ac
EM PLOYMENT,
GROWTH, AND PRICEi LEVELS
621
counts. Then, as Government paid them out again, they came back
into private accounts, and that is what accounts for these sharp fluc
tuations and also for these during the First World War.
Representative C u r t is . Professor, in your statement you state that:
Under present conditions in the United States, the Federal Reserve System
essentially determines the total quantity of money,
and then you go on to develop that. And in the concluding sentence
of the same paragraph, you say:
There is no doubt that, if it wanted to, it has both the formal power and the
actual technical capacity to control the total stock of money with a timelag
measured in weeks,
and so forth.
Really that surprised me a bit. You stated it that way and it led
me to thinking that maybe my basic concepts of what you regard as
money need correction.
Am I correct in the assumption that the measurement which you
use for quantity of money is on the theory that that will best reflect
the amount of credit that will be extended as well, or how do you
relate credit and money ? That is where my difficulty comes.
Mr. F r ie d m a n . I am very glad you asked that question, because I
think it is a very important question and one that is the center of
much confusion. It is important to distinguish between what one
might call monetary policy and what one might call credit policy.
By the stock of money, I mean literally the number of dollars people
are carrying around in their pockets, the number of dollars they have
to their credit at banks in the form of demand deposits, and also
■commercial bank time deposits. That is the stock of money at any
moment of time.
The amount of credit, on the other hand, is something that flows,
loans outstanding for 3 months, or for 6 months, or for 9 months, and
with any given stock of money you can have widely different amounts
of credit. You can have the same stock of money and a large amount
of credit or small amount of credit. The two are, of course, very
closely connected. They are connected by what from one point of
view is a historical accident, that creation of money has been combined
in commercial banks with the lending and investing of funds. That
isn’t a technical necessity. You could have the stock of money com
pletely separated from credit.
For example, if, let’s say, gold coins were the only money being
used, there would be no connection between them in any direct way.
Under our present system, they are very closely connected. Be
cause of this close connection, there is a tendency to confuse two dif
ferent kinds of effects of monetary policy.
One effect of monetary policy is on the number of these pieces of
paper around to be used.
Another effect is on interest rates through changes in the amount of
credit or availability of credit, and these two effects need to be
distinguished.
The doctrine that was proposed and carried out largely under the
influence of Keynes’ writings and that has now come, and from this
point of view unfortunately, to dominate the thinking even of the
central bankers, is that the stock of money has its influence only
through credit. I think that view is wrong.
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EMPLOYMENT, GROWTH, AND PRICE LEVELS
That is one of the ways in which changes in the stock of money have
an influence, but they also influence economic activity more directly
because of the desires of the people to make the stock of money they
hold conform to their other items of wealth, to their income, and to
their situation in general. Thus a change in the stock of money, inde
pendently of its effects on credit, will have effects on the rate at which
people seek to spend or the rate at which they seek to accumulate
cash.
Representative C u r t is . I am glad I exposed my ignorance by asking
that question because I am among those who are confused on this sub
ject. Yet it seems to me that one of the big problems that faces us at
the legislative level centers more around the question of credit than
it does of money.
From an economic standpoint I guess it doesn’t make, except from
the standpoint of measuring an understanding, too much difference
whether it is money or credit, as far as considering the amount of
purchasing power, for example, that is available.
Mr. F r ie d m a n . I think it does, Mr. Curtis. I think it makes a
great deal of difference.
I think from your point of view in particular, if I may say so, for
this reason: The Constitution gives Congress control over what money
shall mean and what shall be used as money and as legal tender. Con
gress has the direct responsibility to specify what our monetary sys
tem shall be, so I think control over the amount of money, either
directly, or indirectly through specifying the kind of monetary stand
ard we shall have or the rules under which the stock of money shall
be changed, is an inescapable part of the legislative responsibilities
of Congress.
Control over credit, I think, is in a very different area. Indeed,
I personally regard one of the undesirable effects of our present kind
of banking system the fact that credit and money are so closely con
nected that the Congress is led to control credit when what it really
should be controlling is money. That is to say, I see no reason why
we should necessarily have any stringent control over the borrowing
and lending activities of people.
Credit is of many kinds. Most credit in this country does not de
rive from banks. It derives from personal loans to others in the
form of mortgages, or holdings of bonds, or holdings of stocks. It
derives from transactions by financial intermediaries such as life in
surance companies, investment trusts, and the like.
There is no reason in principle, it seems to me, why these trans
actions should be controlled by legislation.
Representative C u r t is . I see my time right now has run out, but
you have well answered the question.
The C h a i r m a n . Senator Bush.
Senator B u s h . Professor Friedman, I want to go back to something
you said a little while ago regarding the Federal Reserve Board and
the possibility that it might contribute to instability by its monetary
policy.
We have frequently heard the Federal Reserve express their policy
as one of leaning against the wind, so to speak, and I would like you
to coment on that policy if you understand what is meant by it. 1
am sure you do.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
623
Mr. F r ie d m a n . Yes.
Senator B u s h . What should the Federal Reserve Board do with
demands for credit increasing ?
Prior to the most recent recession, we had tremendous increases in
the use of installment credit. In fact, there are some pretty reliable
opinions that it was overuse of credit by consumers, particularly in
stallment credit, that brought about this recession in business, because
it stimulated the purchase of goods beyond the year in which they
should be buying them, so to speak, particularly noticeable in the
automobile industry, I believe.
What is your general observation about that ?
Mr. F r ie d m a n . May I first call your attention, if I may, to a fea
ture of this chart, which I think is fascinating and important.
The Federal Reserve System was introduced in the year 1914.
Representative C u r t is . That is chart 1.
Mr. F r ie d m a n . Thank you.
This is on a ratio scale so that equal distances mean equal percent
age changes.
I think you will agree that the striking thing about this chart is
that this (the money stock) is a much more stable thing before the
Federal Reserve System than it is afterward. It behaves much less
irregularly.
If you take the whole period from 1869 to 1914, there is nothing
like the instability that prevailed in the period after 1914, and that
is true even if you take out the two wars.
Therefore, the Federal Reserve System, established partly with
the object of promoting greater stability in the stock of money, has
had the result of promoting less.
This isn’t because bad people were doing it or because of any bad
motives or anything like that.
Senator B u s h . N o , I am not assuming that.
Mr. F r ie d m a n . S o far as the more recent period is concerned, the
policy of leaning against the wind, if you could do it, would be an
admirable policy. In theory it is fine.
The problem is to know which way the wind is blowing, not when
you act but when your action is effective.
If what I do today has effects maybe 5 months from now, or 10
months from now, or maybe 15 months from now, then I have to
know which way the wind is going to blow 5, 10, or 15 months from
now. That we do not know, so in practice it is very difficult indeed
to lean against a wind when one doesn’t know which way it is
blowing.
Senator B u s h . Are you saying, then, that because of the difficulty
involved there should be no attempt to do it ?
Mr. F r ie d m a n . Yes, sir. I am saying that it would be preferable,
in my judgment, for the Federal Reserve System to say to itself,
or indeed for Congress to instruct it to act in this way, that instead
of trying to vary its policy behavior from day to day, instead of look
ing at credit conditions and the like, it would limit itself to seeing to
it that the stock of money grew at a perfectly steady rate month in
and month out, year in and year out. This would provide a stable
background for the other fluctuations.
Senator B u s h . This assumes, I presume, that the economy would
also grow at a stable rate. Is that not so ?
624
EM PLOYMENT, GROW TH, AND PRICE LEVELS
Mr. F r ie d m a n . It would not grow at a perfectly stable rate.
Senator B u s h . Would you want the stock of money to increase at
a stable rate, 3 or 4 percent a year, regardless of which way the econ
omy was going?
Mr. F r ie d m a n . Yes, sir; because in point of fact, if the economy
was tending to go down, this would tend to pull it back up. If it was
tending to go too far up, this would tend to pull it back down. It
would have the effect of a thermostatic reaction rather than of some
one stepping in and opening and closing the window all the time.
Senator B u s h . I thought you said a little while ago that the stock
of money really didn’t affect the upward or downward movement
very much.
Mr. F r ie d m a n . N o , sir. If I said it, I misspoke; I didn’t intend
to say that.
I think the stock of money is extraordinarily important in its
effect-^ but what is important about it is the instability in its behavior.
Take the 1929-33 depression, which is certainly the greatest depres
sion—I shouldn’t say that; the 1929-33 or 1838-43 are the two greatest
depressions in our history.
Senator B u s h . Let’s talk about the last one. We know a little more
about that.
Mr. F r ie d m a n . I think there is no doubt whatsoever that the depres
sion would have come to a close at the latest in 1931 if the Federal Re
serve System at that time had not allowed the money stock to decline
catastrophically. If I may go back to chart 1 and refer to the money
stock again, the policy I am suggesting would have had the money
stock grow steadily from 1929 on instead of declining sharply. If it
had done so, we would never have had the depression of 1929-33.
We might have had a recession. It might have been something like
the 1957-58 recession. My own guess is that it would have been over
either in late 1930 or the spring of 1931.
Senator B u s h . Would you say that the money stock was inadequate
all during the thirties, from 1931 through to 1939 ?
Mr. F r ie d m a n . That is a very difficult question because the inade
quacy or adequacy of the money stock depends on its preceding level.
In the abstract, there is no such thing as an adequate or inadequate
money supply, but I would say, and I am perhaps quibbling and being
overacademic, that by comparison with 1928-29, the money supply was
inadequate throughout the thirties, yes.
Senator B u s h . I would like to turn to another line of questioning
for a moment.
How do you feel about the question of giving the Federal Reserve
Board a little more control over credit, and particularly I have in mind
consumer installment credit?
Mr. F r ie d m a n . I think it would be a very bad thing to do. I think
the Federal Reserve System now has too many powers, not too few. It
is doing things that it ought not to be doing.
It seems to me, as I was saying, that Congress and its agencies have
a definite responsibility about money. So far as credit is concerned,
free enterprise is just as good for credit as it is for shoes, hats, and
anything else. The objective of our policy ought to be to allow credit
to adjust itself in a free market, provided we maintain a stable mone
tary background, Consequently I think it is inappropriate for the
Federal Reserve System to have powers over consumer credit.
EM PLOYM ENT, GROWTH, AND PRICE) LEVELS
625
I think its present powers over margin requirements are equally
inappropriate and ought to be eliminated, and I could make some fur
ther suggestions along these lines.
Senator B u s h . We would be glad to have them. This is a very
important matter.
Mr. F r ie d m a n . I agree.
I think again that emphasis on particular credit controls derives
from the confusion we were mentioning earlier between monetary
policy and credit policy.
For the purposes of monetary policy, that is to say, of controlling
the stock of money, it is unnecessary for the Federal Reserve to have
any powers over consumer installment credit, over stock market credit,
or over any other type of credit directly.
Senator B u s h . In your opinion, does our current adverse balance
of payments call for corrective monetary policy measures?
Mr. F r ie d m a n . No, sir.
Our adverse balance of payments, which involves a gold outflow,
is fundamentally a consequence of a whole pattern of policies, includ
ing as a very major policy our foreign aid policy. Given our foreign
aid policy, it seems to me eminently desirable for the United States
that a large part of it should take the form of the outflow of gold
rather than of goods, which are more useful in current consumption
and current production.
Senator B . You are not particularly concerned at the moment
about the trend in our balance of payments ?
Mr. F
. No, sir. The crucial question relates to gold.
u sh
r ie d m a n
Senator B u s h . Yes.
Mr. F r ie d m a n . The question of gold is of course very difficult and
complicated, but one of great importance.
Personally, if we could have a real honest-to-goodness gold standard,
I think there would be much to be said for it. I don’t see any prospect
whatsoever that we are going to have one.
It seems to me our present gold policy is comparable to our present
wheat policy. We have a price support program for gold, with the
one exception that we offer the support price to foreigners as well as
to domestic producers.
It seems to me that from this point of view it is highly desirable
that we get rid of a large part of our gold surplus. We now hold an
amount of gold that, in relation to the world’s gold, is very much in
excess of our fractional importance in any other way. We tried to
prevent that gold from influencing our monetary policy when it
came in.
It would be a serious mistake to let it influence our monetary policy
when it goes out.
Senator B u s h . On that matter of gold at the beginning, it will be
discussed again, so I want to ask you one more question there.
We have in the order of $20 billion worth in our gold supply, but
my recollection is about 12-billion-odd dollars of that, nearly $13
billion, is subject to recall by other governments, by other peoples,
which would leave our supply at $7 to $8 billion.
Does that seem adequate to you in view of conditions in the world
today?
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EM PLOYM ENT, GROW TH, AND PRICE LEVELS
Mr. F r ie d m a n . Yes, Senator Bush, because the calculation you refer
to is very questionable since it applies all of these foreign claims
against the gold reserve. That is like saying that our commercial
banking system is going to fall tomorrow because the reserves in the
form of balances with the Federal Reserve System amount to only
about 20 percent of the outstanding liabilities.
In point of fact, foreigners are inevitably going to hold dollar bal
ances here for a variety of purposes, and there is no immediate chance
that the claim against gold will be exercised, but if it were, I would
personally think it a serious mistake for us to promote a major de
flationary movement within this country to prevent the gold from
flowing out.
I think the better course of policy would be to let it flow out. In
deed, and this is more extreme, I think it would be the better course
of policy to permit the price of gold to become a free market price
instead of a controlled price.
Representative W id n a l l . Will you yield, Senator Bush?
Senator B u s h . Yes.
Representative W id n a l l . Professor Friedman, do you have any
opinion at all as to how it would affect the U.S. economy if Russia
should suddenly go on the gold standard?
Mr. F r ie d m a n . I am not sure what it would mean for Russia to
go on the gold standard. If Russia were to take some part of our
gold and provide us with goods and services, that would be a good
thing so far as I can see for us in two ways: It would reduce the
amount of goods and services that Russia had, and it would increase
the amount that we have.
On the other hand, if by Russia going on the gold standard—well,
I am not quite sure what that means. Very many people have been
concerned that Russia might dump her gold on foreign markets.
That would be a very serious thing for us so long as we maintain our
present support price for gold. With that support price for gold,
Russia’s dumping of gold means we provide Russia with foreign
exchange.
Indeed it seems to me a most curious matter. There is much pres
sure on the part of many people for a rise in the price of gold. The
two nations in the world that would benefit most from a rise in the
price of gold are two for whom American sympathies are hardly the
highest, Russia and South Africa.
Senator B u s h . I certainly commend you for that point of view.
I think it is a lot of commonsense.
The thought that we should talk about raising the price of gold
at this time or any time in the past has been discussed. One of the
principal objectives of this committee’s work this year is to try to
find out the relationship between the maintenance of employment and
price stability.
I would like you to comment on that.
Do you think those are mutually conflicting or not?
How do you feel about that ?
Mr. F r ie d m a n . I do not believe they are mutually conflicting. I
summarized some of the historical record on this question in one of
the papers that was submitted to you and that was published in the
compendium last year.
EMPLOYMENT, GROWTH, AND PRICE LEVELS
627
Let’s take just the American experience, if I may.
In chart 1 real income shows a period of very rapid growth
throughout the period from 1880 to the First World War, except
for the sharp depression in the early nineties. The earlier period
(before 1890’s) was a period during which prices were falling at
the rate of 2 percent a year. This later period was a period during
which prices were rising at the rate of 2 percent a year.
The period of the twenties, which was also a period of rapid
growth, about 1923 to 1929, was a period in which prices were almost
exactly stable.
My own conclusion is that what is important for economic growth
and economic stability is that prices behave in a regular way, that
they not display large fluctuations. The important thing is reason
ably stable behavior of prices.
As between various kinds of reasonably stable behavior of prices,
my personal conviction is that a reasonably stable price level is the
best. If you launch on an explicit policy of having prices rise, you
are engaged in a process in which it is very difficult to keep from
going farther. If 2 percent is right now, 4 percent will be right a
while from now, 10 percent later.
On the other hand, if you were to embark on a policy of trying to
pull down wages and prices, you would run into rigidities in wages
and great difficulties in adjustment, so that I think that the best
kind of a policy would be one which had as its objective a reasonably
stable price level.
Senator B u s h . Would you think then, in view of that, that it
would be wise for us to amend the Employment Act of 1946 so as
to state in the law that price stability is a condition, or requirement,
or assist to full employment ?
Mr. F r ie d m a n . I think it would be desirable to amend the act
to state that a reasonably stable price level is one of the objectives
to be sought. I am not sure I would want to say that it is an assist
to full employment, because that becomes a technical proposition.
Senator B u s h . However, to just state that it would be a desirable
objective?
Mr. F r ie d m a n . Yes, I think it would be desirable to do so.
I should also say in utter frankness that I find it hard to believe
that this would be of major practical importance, by comparison with
the adoption of measures such as a reasonably stable rate of growth
in the monetary supply, that would have the effect of giving us price
stability.
Senator B u s h . Thank you very much.
Chairman D ou glas . Mr. Widnall.
Representative W id n a l l . It is not clear to me how you arrived at
that figure of 3 percent.
What is that based on ? Past history, or is it based on population
growth ?
Mr. F r ie d m a n . Yes.
Representative W id n a l l . What do you relate it to?
Mr. F r ie d m a n . It is based on past history.
Suppose we take the experience in the United States over an 85year period from 1871 to 1955. That is the long period change.
That is the period covered roughly by these charts.
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EM PLOYM ENT, GROW TH, AND PRICE LEVELS
Over that period, just taking it all as an average for a moment and
not looking at the fluctuations within it, the stock of money has on
the average risen by about 5% percent a year. That is the average.
One and three-quarter percentage points has represented popula
tion increase. About 2 percentage points has represented an increase
each year in average per capita real income. About 1 percentage
point has been absorbed by decline in velocity: That is, by a growth
m the amount of money people want to hold in real terms, and, finally,,
on the average of this 85-year period, about 1 percentage point has
been absorbed by price rises.
If we take the 85-year period as a whole, it would seem that over
that period it would have taken something like a 4 or 4 ^ percent per
year rise in the stock of money as I have defined it to have kept prices
stable.
I must emphasize that this is for the particular definition of money
I have used. You would get a different answer if you used a dif
ferent definition.
Under present circumstances, the rate of growth of population is
on the average perhaps a bit less than it was over this period because
these were the periods of great immigration. I f one allows for what
seems a reasonable expectation of what is likely to happen, about
3 percent would be required on the average to offset growth in total
output, allowing for growth in both per capita output and popula
tion. The question then becomes, what to do about the secular
trend in velocity. On the average it has been about 1 percent. I f
we take this figure for the past 85 years and assume that it will apply
to the future, we get about 4 percent as the annual rate of growth
in the money stock required for price stability.
My own feeling is that what is really important is to pick a num
ber and stick to it and that it isn’t nearly so important whether
that number is 3 percent, 3% percent, 4 percent, 4% percent, so long
as it is somewhere within that range. Suppose you picked a slightly
wrong number. The result would simply be to have a slight tendency
for prices either to decline very slightly or rise very slightly, and
on the average you would come out about right.
The important thing is to provide a background of certainty in
terms of which people can make their plans and in terms of which the
system can operate, so you know what policy is going to be and not
have it an erratic thing that is subject to change from time to time.
Senator B u s h . If Mr. Widnall will permit me just to ask a ques
tion, the thing that troubles me about your plan is the practicality
of it.
You thought, of course, a lot about this and you believe it is per
fectly practical for the Federal Eeserve to step up that stock of money
each year at an even rate?
Mr. F r e e d m a n . Oh, y e s.
Senator B u s h . Regardless of what the economic conditions may be,
or the demand of the Treasury may be, or fiscal policy influences may
be. That can still be done practically, in your judgment?
Mr. F r i e d m a n . It is perfectly practical.
This doesn’t mean of course, that there won’t be some consequences.
I f you otherwise have strong inflationary pressure or strong up
ward pressure in a boom, following this policy would mean that the
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
629
interest rates will rise sharply and the Government will have to pay
a higher price for its money the same way everybody else does.
Senator B u s h . It is based on a confidence of a gradually rising
gross national product?
Mr. F r ie d m a n . Yes, sir.
Senator B u s h . Based on that?
Mr. F r ie d m a n . Yes, sir.
S e n a t o r B u s h . Y o u w o u ld n o t a d v o c a te t h a t i f y o u lo o k e d f o r a
r a th e r sta b le a c tio n o f th e g r o s s n a t io n a l p r o d u c t?
Mr. F r ie d m a n . It is very hard for me to say because I find it hard
to conceive of the circumstances that would produce a stable gross na
tional product.
I think our economy is one which has a strong tendency to grow,
that it has grown for 150 years. The basic springs of economic growth
are in the abilities and capacities of the people, in their willingness
to save some part of their annual income to add to capital, so that I
would confidently expect that unless we make serious mistakes in our
national policy, we can look forward with great confidence to a grow
ing economy.
Senator B u s h . That is the point I wanted to make, though, that
the steady increase in the stock of money is geared to this other
specification.
Mr. F r ie d m a n . And that they are related one to the other, that un
less you have a steady growth, this may impose obstacles in the way
of a growth in the economy, and of course, unless you have the growth
in the economy, the steady growth in the stock of money would mean
price rises.
As to the practicality of it, Senator Bush, I think that it unques
tionably is practicable. I think myself that one ought to specify ob
jectives for an agency that are within its competence. For this reason,
I am not myself in favor of instructing the Federal Reserve Board to
stabilize the price level, because it may not be able to do so. That is
not something over which it has direct control. It has only an in
direct effect on the price level insofar as it affects the stock of money.
On the other hand, the stock of money is exactly what it does control.
Representative W id n a l l . Did I understand you to say that sav
ings reduce the velocity of money ?
Mr. F r ie d m a n . N o , no. I am sorry.
Representative W i d n a l l . Cash savings ?
Mr. F r ie d m a n . Increase in real cash balances, yes.
Insofar as people save, they are adding to their wealth. Insofar
as they are adding to their wealth, they keep some part in the form
of money. If they kept in the form of money only the same percent
age compared to their income that they did before, velocity would
be unchanged. Historically, they have done more than that; that is
to say, historically, as people’s income has gone up by 1 percent in
real terms, that is, in terms of goods and services—they have tended
to increase the amount of money they held by something like 1%
percent, and this has meant a decline in velocity.
Do I get at your point ? I am not sure I do.
Velocity is a confusing notion. In many ways I think it would
be better if we turned it upside down and used its reciprocal. Let me
see if I can put it this way:
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EM PLOYM ENT, GROWTH, AND PRICE LEVELS
Under current circumstances, people are holding in the form of
money an amount equal to about 7 months’ income. If you go back a
hundred years, they were holding in the form of money an amount
equal to about 2 months’ income. That is what has happened over
100 years. That is what 1 percent a year amounts to over 100 years.
It has gone from about 2 months to something like about 7 months.
Of course, the money is not all held by individuals. About half
of this 7 months’ income held in the form of money is held by busi
ness firms and about half by individuals.
As people have gotten richer in terms of their income and their
wealth, they have increased the number of months’ income which they
hold in the form of cash or deposits. That is what a decline in veloc
ity means, when translated into terms that I think are perhaps more
meaningful.
Does this answer your question?
Representative W id n a l l . Yes, sir. Thank y ou .
Mr. F r ie d m a n . S o that an accumulation of savings insofar as it
increases wealth and insofar as it is held in cash, does lower velocity.
Representative W id n a l l . That is all.
Representative C u r t is . Mr. Chairman, could I ask a question there?
The C h a i r m a n . Representative Curtis.
Representative C u r t is . You mentioned the money. How about the
credit expansion?
That has grown tremendously, too, has it not, the amount of out
standing credit ?
When you mention assets of 7 months, is that a net balance ?
Mr. F r ie d m a n . We want to offset what some people owe against
what some people own, and we must distinguish between credit and
total wealth, because, for example, if one thinks of credit, A may
make a loan to B, and B may make a loan to C, and C may make a
loan to D, and if you added the amount of loans outstanding, the total
might be very many times as much as the amount of wealth.
Representative C u r t is . I was interested in the way you brought
down the average per person of 7 months’ earnings and I was just
curious to know, inasmuch as I think we have seen a very rapid
expansion of consumer credit, about what the figure for per capita
there might be.
Mr. F r ie d m a n . Consumer credit?
I am not sure what is the volume of outstanding consumer credit.
Representative C u r t is . I w as thinking of the historical trend you
gave, and also with respect to consumer credit. It seems to me that
it has been in the 20th century that we have seen the tremendous
growth there.
Mr. F r ie d m a n . I am not sure what the facts would show. What
we have seen is largely a change in the form of credit.
You now have explicit and formalized consumer credit. If we
look, not at the credit for the moment, but at the total amount of
wealth in the country in the forms of property and so on, this has
not changed drastically when you express it in terms of the number
of months’ income.
Total wealth of the country amounts to something like 3 or 4 years’
income. I am speaking just off the top of my nead and I can’t
guarantee the figure. It is something like 3 to 4 years, and apparently
it has been something like that for a hundred or more years.
EM PLOYMENT, GROWTH, AND PRICE LEVELS
631
Now, the wealth has taken different forms. It is clear that as the
economy has become broader and more complex, an increasing fraction
of wealth has been held indirectly through financial intermediaries,
through investment trusts and the like, and a decreasing fraction
appears to have been held directly. This is particularly true because
of the decline of agriculture.
In a farming community, much of the wealth is held directly by
the people who are using it and owning it in the form of the agricul
tural land and equipment. As you go to an industrial society, a much
larger fraction is held indirectly. Thus, much emphasis has been
placed, for example, on the growth of the whole complex of financial
intermediaries. This growth appears to have been a change in the
form of wealth and not really at the expense of holding of money
balances over the long pull.
If we take the long pull, the ratio of money to income, the number
of months5income which takes the form of money balances has grown.
What has happened is that the amount that has taken the form of
liabilities of financial intermediaries such as life insurance com
panies, of time deposits in mutual savings banks, and the like, has
grown even faster. The interpretation that seems to me valid is that
this has been at the expense of other kinds of wealth-—that is to say
it has reflected a shift in the form in which people hold their wealth
from direct holding to indirect holding.
Does this get at your question ?
Representative C u r t is . It is certainly right on it.
Thank you.
Senator B u s h . Mr. Chairman, I just want to go back to one
recommendation that you made. Professor Friedman, respecting the
powers of the Federal Reserve Board when we were on the subject of
credit control.
You observed that you thought, far from extending their powers,
they might be restricted further. I was wondering whether that is a
recommendation that is part of a package deal, so to speak, including
your stable increase of 3 percent, or would you favor, without that
steady increase, having their wings clipped, so to speak?
Mr. F r ie d m a n . I would favor having their wings clipped under
present circumstances.
What has happened is, of course, that whenever policy leads to re
sults that are undesirable, there is a perennial tendency to say that
it has done so because we don’t have enough power and we ought to
have more power, rather than to say that it has done so because we
were unwilling to take the consequences of a correct policy, or made
mistakes in policy.
Senator B u s h . I am not conscious of the fact that they have asked
for more power. In fact, they rather resisted that.
Mr. F r ie d m a n . If one looks historically at how they got the powers
they have, they almost all arose out of the kind of process I have
been describing.
In 1929 they felt, erroneously I think, that the stock market boom
was a major problem that should affect their current monetary policy,
and this was a source of their later powers over margin requirements.
It was because they were really unwilling to use their own powers.
The powers over consumer installment credit and the like are in
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EM PLOYMENT, GROWTH, AND PRICE LEVELS
directly a reflection of the bond support program during and after
the war. If you tie one hand behind your back by a program like
that, then it is natural to ask for something to have in the other hand.
I think it is inappropriate for the Federal Reserve System to exer
cise direct control over particular uses of credit, that the sole objec
tive of the Federal Reserve System should be to control the total stock
of money, and that this is true regardless of the particular criterion
that is adopted about the appropriate changes in the stock of money,
so that my suggestions are not part of a package deal.
Senator B u s h . Thank you.
The C h a i r m a n . Mr. Friedman, if I may make one comment, it
seems to me that a large part of your conclusions depend upon treat
ing time deposits as equivalent to demand deposits, and it seems to
me that these are much more in the nature of investments by the
individual and reinvestments in most cases by the commercial banks,
and that therefore you should not include these demand deposits in the
total supply. And similarly, the alleged increase in the velocity of the
circulation of money may be attributable to the growth of true time
deposits which were formerly held by people as cash prior to the
banking period, so I merely suggest that you give that careful con
sideration, which I am sure you will.
Mr. F r ie d m a n . Senator Douglas, the particular numbers I have
been citing would be affected by excluding time deposits from money,
but the major results and conclusions for policy or for analysis would
not be.
I have examined this question and I have found that similar con
clusions are justified if you use currency plus demand deposits alone.
The major difference is that you have to use a different number.
Instead of speaking, for example, of something in the neighbor
hood of 3 to 4 or 5 percent as the appropriate growth of the money
stock, you would have to speak of a smaller number, of something,
perhaps of the order of 2 to 3 percent because of the secular rise in
time deposits. However, the conclusions about the relative sta
bility of the relation between money and prices or money and money
income all hold if you substitute demand deposits plus time deposits
for the broader concept I have used.
So far as the scientific aspects of it is concerned, I of course agree
with you completely that a full analysis ought to recognize the dif
ference between, first, currency and demand deposits, then between
demand deposits and commercial bank time deposits, mutual sav
ings time deposits, and so on. In some of the more extensive work
we have done, we have tried to examine the relation among these
different parts.
In that respect, I agree with you completely, but so far as the
major conclusions stated here, I have tried to state conclusions which
have the property that they would be valid whichever particular
definition of money supply you used, except for the numbers that
you put into them.
Senator B u s h . Would the Senator yield on that point ?
The C h a i r m a n . Yes.
Senator B u s h . I am interested in what you say about this time
deposit of the commercial bank.
I am inclined to agree with you from any knowledge of what kinds
of deposits those are. A lot of them I believe are corporate accounts
EM PLOYMENT,
GROWTH, AND PRICE! LEVELS
633
which are idle balances, and they go up and down in the time de
posits account, do they not, depending on whether they need the
money in the business or not and, rather than leave it there idle with
out interest, they switch it over on the time, so I think that argues very
strongly for the validity of your position.
The rest of them, though, are the thrift accounts, are they not?
Mr. F r ie d m a n . Yes.
Senator B u s h . H o w do you measure the relative size of those two
limits in time deposits on commercial banks?
I have no idea what that is.
Mr. F r ie d m a n . I don’t have any figures available.
Senator B u s h . I would say the so-called thrift account might be
relatively stable, while the other might be up and down.
Mr. F r ie d m a n . It might well be.
May I make one comment that relates back to the question about
specific credit control, consumer credit control, and margin account?
There is one particular credit control that is generally not called
that; namely, the power of the Federal Reserve System to fix the rates
of interest which member banks may pay on demand and time de
posits. This is a species of price fixing and I think it has no place
in our System, and that this power of the Federal Reserve ought to
be abolished along with the powers to control specific uses of credit.
The rate of interest which member banks may pay on time deposits
is fixed, the maximum rate, by the Federal Reserve Board, and actual
rates have been up against that limit for quite a long time now.
The C h a i r m a n . One final point I should like to mention. In
preparation for your testimony, I read the book which you edited,
including an introductory essay which contained a rather bewilder
ing type of equations, and I realize things have moved a long way
since the days of Irving Fisher, but the equation which I studied
was very similar.
I see over here to the right a mysterious chart. I wonder if you
at least would not exhibit these charts so that the passing bystander
can realize that economics is becoming as complicated as atomic
physics (seep. 638).
Mr. F r ie d m a n . Thank you.
Let me suggest what these things are about as we go along, because
I am delighted to do so.
These are various equations that were used in the attempt to state
a formal structure of the factors that influence the amount of money
people want to hold, just as we talk about the factors that influence
the amount of shoes they want to buy or the stocks of durable goods.
This (equation (1)) is just the relation between their wealth and their
income.
This (W) is wealth, and that depends on what the interest rate
(r) is, which is on the bottom, and what their income (Y) is, if we
include in wealth the value of human capacity.
These expressions (equations (2), (3), (4), and (5)) are attempts
to show the relation among different kinds of rates of interest: You
take the rate of return which you get on a bond, that depends on the
coupon on the bond, plus the rate of change in the price of the bond;
that is to say, whether the price of the bond is rising or falling.
38563 O — 59— pt. 4-------3
634
EMPLOYMENT, GROWTH, AND PRICE LEVELS
The C h a i r m a n . The equations are in the article, copies of which
we have in the hands of the committee and are reproduced at the con
clusion of Mr. Friedman’s testimony.
Mr. F r i e d m a n . These are all attempts to show how the different
rates of interest which affect the cost of holding money are related.
Equations (2) and (3) were for bond interest, and these equations
(4) and (5) are for yields on equities, that is, common stocks. Equa
tion (6) is the rate in change of prices, and you can see that this en
ters into these other equations, because if you are going to compare
the interest rate on bonds with the interest rate on equities, you have
to take account of what is happening in prices.
Equation (7) is supposed to be an expression for what determines
the quantity of money demanded. The amount of money that peo
ple want to hold depends on what the price level is; depends on what
the rate of interest on bonds is, corrected for the changing price of
bonds; what the yield is on equities, corrected for the changes in the
prices of goods and services; what is happening to the price level,
whether the price level is rising or falling; what fraction of their
wealth they have in the form of the thing we ordinarily call wealth.
Let me put this last item another way:
Suppose 20 percent of people’s income is being received from prop
erty, on the one hand, or 5 percent on the other. Then in the latter
case they will have less wealth in the form of property and they will
tend to hold less money.
Equation (13) is the final one. This is a more sophisticated version
of the quantity equation that is in a very much simplified form in my
introductory statement. This (Y) is simply money income. This
(M) is the stock of money, and this (v) is velocity, but written so as
to show what the factors are which influence velocity, which make it
what it is.
What velocity is depends on what the rate of interest is on bonds in
general, what the rate of return is on stocks, that is, equity yield, what
is happening to the rate of change of prices, what fraction of people’s
wealth is in the form of property, what is their real income, and this
“u” is a symbol to remind you that there are some other things asso
ciated with the utility which the people attach to the holding of cash
balances, such as about how readily available banks might be, how
fast the mail is, and things like that, which need to be taken into ac
count in a full analysis.
The C h a i r m a n . Mr. Friedman, the Federal Reserve Board loves to
brief Senators and Congressmen on economic affairs in order to
diminish our economic ignorance, and so does the Council of Eco
nomic Advisers.
I wonder if we could arrange a seminar in which you could brief
these gentlemen on these equations. I will be glad to invite them and
have you brief them on these equations, if you would be willing to
come, and of course we will pay you an honorarium for it.
I think an advanced course for the Federal Reserve and possibly
even the Council of Economic Advisors would be very good.
Could you do that possibly ?
Mr. F r i e d m a n . A professor is always ready to profess.
The C h a i r m a n . Are there any other further questions?
Senator B u s h . One more.
EMPLOYMENT, GROWTH, AND PRICE LEVELS
635
Going back to the Feedral Reserve powers again, I want to ask just
this question, Professor Friedman. You are for curtailing that power
as far as credit control is concerned ?
Mr. F r i e d m a n . Yes, sir.
Senator B u s h . Would you also favor curtailing their powers af
fecting the money supply, as, for instance, their open market policy
powers, their power to control the discount rate, and their setting of
reserve requirements ?
Do you favor restriction of those powers also ?
Mr. F r i e d m a n . Yes, sir; I do, Senator Bush.
Senator B u s h . T o what extent, or would you abolish them ?
Mr. F r i e d m a n . There are two different levels on which I can answer
the question. One is in terms of what you might call minor alterations
in the present structure of powers. The other is in terms of a much
more fundamental reform in our whole monetary and banking
structure.
Let me talk about the first.
Senator B u s h . All right.
Mr. F r i e d m a n . With respect to minor alterations, I believe the
present structure of powers is an accumulation of powers which have
grown over time without any clear logic and in which the basic reason
for many of them have disappeared, and I would be in favor of a sharp
streamlining of their powers over the quantity of money.
Taking the present structure, I would do the following things, and
I am being dogmatic because of the limited amount of time. I would:
One, abolish rediscounting. It is an anachronistic survival of an
earlier day.
The C h a i r m a n . If I may interject, I am so glad you say that, be
cause I have been urging this for several years, finding almost no one
to support me, and I have urged that control be exercised directly over
the money supply through open market operations and not operating
on the interest rate, and I am delighted to have you say that. I feel
as though I have had great reinforcement on this point.
Mr. F r i e d m a n . Thank y o u .
Senator B u s h . I think you have a great audience here this morning.
Mr. F r i e d m a n . I would abolish discretionary control over Reserve
requirements. Both of these are very poor instruments of policies
from a technical point of view. I would require the system to operate
exclusively through open market operations. This is essentially what
Senator Douglas has said and I think it is a technical matter of stream
lining it.
Whatever criterion of policy you are going to adopt, this would be
a technically more effective set of policies, the reason being as follows,
if I may indicate briefly:
So far as discounting is concerned, its original purpose was to pro
vide a lender of last resort to commercial banks in difficulty. The
establishment of the Federal Deposit Insurance Corporation in 1934
eliminated that purpose. It no longer has that role.
The situation is now one such that in order to stay in one place,
the Federal Reserve System has to change the discount rate. Suppose
it holds it the same and that market pressures are making for rise in
interest rates. Then the same discount rate becomes more expansion
ary, so in order to stay in step, it has to keep with the market.
636
EMPLOYMENT, GROWTH, AND PRICE LEVELS
There are two ways of solving this problem. One is the w^y that
the Canadian Central Bank has attempted, of saying that the discount
rate will be one-quarter of 1 percent or something like that above
the market rate the week before on a particular kind of bill, and in
this way tying the discount rate explicitly to the market rate.
The other way of doing it would be to abolish discounting. Dis
counting serves only one function now. That is the function of fining
member banks for not meeting reserve requirements.
You need to have some device for that purpose, because if the mem
ber bank accidentally does not meet the reserve requirements, there
has to be some fine. I would substitute for the discount rate an
explicit set of fines at rates which would be punitive from the point
of view of the interest rate. They wouldn’t be very serious for the
banks since the fines would be only to correct for minor differences. So
I would abolish discount rates and discounting.
With respect to reserve requirement changes, they are a very poor
tool because, in the first place, they are discontinuous. You don’t
change reserve requirements by one one-hundredth of 1 percent. You
invariably tend to change them by 1 percent or a half of 1 percent,
and a half of 1 percent is a lot of money.
In the second place it is very hard to know what their effect is
because that depends not only on legal reserves, but also on the amount
of reserves that banks themselves want to hold. Under some circum
stances, an increase in reserve requirements may have no effect. In
other circumstances, it may have a very drastic effect, so I think this
is a technically very poor tool of policy. If you eliminated discount
ing and charges in reserve requirements, you would leave the Federal
Reserve System with the one tool which is effective and is important;
namely, their ability to buy and sell on the open market.
With respect to their ability to buy and sell on the open market,
I would leave them free with respect to the kind of securities they
deal in.
With respect to their “bills only’" doctrine, which is a recent doctrine,
I see nothing particularly wrong about it, but- I see no reason why it
should be a legislative mandate.
Does this answer your question ?
Senator B u s h . Thank you very much. It is very interesting.
Representative C u r t i s . I have a question.
The C h a i r m a n . Representative Curtis.
Representative C u r t i s . I have one question I wanted to ask.
I wonder if you would comment on this theory sometimes advanced,
that the demand for credit is inelastic. Therefore, credit restrictions
of a general rate result in discrimination against a particular type
of borrower.
Mr. F r i e d m a n . Again, one must distinguish clearly between credit
policy and the monetary policy, and this question has to do with credit
policy. It really has much less to do with Federal Reserve policy than
with the general structure of money markets.
No doubt certain categories of borrowers have an inelastic demand
for credit. That means that in a free market they will be the ones
who will get the credit. They will be willing to pay the price for it.
But if one takes the credit market as a whole, or the capital market
as a whole, it seems to me very hard to reconcile the view that the
EMPLOYMENT, GROWTH, AND PRICE) LEVELS
637
demand for credit is inelastic, taken as a whole, with the fact that
interest rates have fluctuated over relatively moderate ranges over
the last hundred years.
If for any commodity, whether it be credit or wheat, the demand
is highly inelastic, one consequence is very wide fluctuations in the
price of that commodity.
If people are urgently insistent on buying a particular commodity,
then small changes in its supply will lead to large changes in its
price, and consequently, if it were true that demand for credit as a
whole is very inelastic, that would have shown up historically in very
wide fluctuations in interest rates.
There are certain cases in which you have had such fluctuations,
for example, in call money rates on the stock market. In times of stock
market crises, the daily rate of call money has of course risen enor
mously, and that is a symptom, of a case in which the demand for credit
of that particular kind was very inelastic under those circumstances.
However, if you look at credit markets in general, it is very hard to
find many cases of that kind.
Consequently, my own judgment is that the demand for credit is
probably elastic, although particular segments within it may of course
be inelastic.
Representative C u r t i s . Would that not be particularly true of
consumer credit ?
It would seem to me that would be even more elastic than some of
the others you have described, what a person wants to buy.
Mr. F r i e d m a n . That is a very complicated issue you are raising be
cause the demand for consumer credit is connected with the price of
goods and services which are being bought on credit, and it is some
times hard to differentiate between the effect of a change in the prices
of the goods and in the terms of credit.
I haven’t made any detailed study of the consumer credit market
myself and can’t express any kind of really informed opinion on it. I
would be very much surprised if the demand for consumer credit were
notably inelastic. I think it is probably the other way, but I really
don’t have any empirical evidence that I can offer, only a vague
judgment.
Representative C u r t i s . Thank you.
Chairman D o u g l a s . Thank you, Mr. Friedman.
(The charts referred to follow:)
638
EMPLOYMENT, GROWTH, AND PRICE LEVELS
Chart 1
MONEY STOCK. INCOME, AND INCOME VELOCITY, 1869-1957
Shaded areas represent business cycle contractions.
a
EMPLOYMENT, GROWTH, AND PRICE LEVELS
639
MONTHLY RATE OF CHABCE INMONEY STOCK, 1907-58
t'
1
V*
j
x
M
- M
♦
---------- 1-----------~L...........-
1907
1906
1909
l... i....I
1
1
1 • *
1---- L. — J
1910 1911
IS12 1913 1911* 1915 1916 1917
1918 1919
1920
1921
.—
IS>23
1922
i.........;...........
1921*
•
r
4 i i n A i
1
J
l
,.
An.
1 * •
•
W iM
#
192U
1925
1926
.............. 1
»... i ....t.__ Li... 1
1
1
1
1l...............................................1 .................
1926 is129 193a 1931
1932 1933 1931* 1935 1936 1937 1938 1939
1927
f
c
**
v\s > / "
*- ^ V A M r /V\^/V A ^ V
1
s d r j^ r J ^ .A T ^
•
ill
..
19!*0
1 ...................
ft
191*1
V
*
r
____________1_____
191*1
_ 1 ___________ 1
19^2
1943
.___ L..J,1-...- |
1944 1945 is>1*6 191*7
1
191*8
4 .V..V.
191*9
99
1950
1951
1952
1953
i---- 1---- 1--
1951*
1955
Shaded a m i repres ent business cycle c o n tra c tio n *. Dots show s p e c lflc -c y c le peaks and troughs In r a te o f change o f money stoc k.
lin e s show e s tla a te d le v e ls o f steps and t h e ir dates (no steps shown a f t e r I U ) .
1956
Broken
1—
Xi?57
1958
640
EMPLOYMENT, GROWTH, AND PRICE LEVELS
Chart 3
FOUR MEASURES OF
AGGREGATE MONETARY VELOCITY
1919
25
30
35
40
45
50
55
58
Ratio scale
Chart 4
DEPOSITS AND CURRENCY
ALL B A N K S
IN THE UNITED STA TES
EMPLOYMENT,
GROWTH,
AND
PRICEi LEVELS
1926
1928
1930
1932
1934
1936
1938
1940
1942
1944
1946
1948
1950
1952
1954
1956
1958
I960,
642
EM PLOYMENT,
GROW TH, AND PRICE LEVELS
Chart 5
EJM VTS OP TO SgJATKB QT OCHA**, <glARHFLY, 19*7-58
EMPLOYMENT,
GROWTH, AND PRICEi LEVELS
643
Chart 6
DEMAND DEPOSIT TURNOVER RATES, 19^3-58
50
to
30
Ratio scale
J____I____I____I____ I____I____L
J____I____I____ I____I____L
19l*3 Mt 1*5 I16 47 W U9 50 51 52 53 5*t
55
56
57
58
644
EM PLOYM ENT,
GROW TH, AND PRICE LEVELS
Chart 7
FLOW OF FUNDS SECTOR VELOCITIES, 1939-56
V
EMPLOYMENT,
GROWTH, AND PRICEi LEVELS
Chart 8
SECTOR VELOCITY COMPONENTS, STATISTICS OF INCOME, 1931-56
V
645
646
EMPLOYMENT, GROWTH, AND PRICE LEVELS
Chart 9
SELECTED SECTOR VELOCITIES BY MAJOR INDUSTRY GROUPS, STATISTICS OF INCOME, 19^-56
V
EMPLOYMENT, GROWTH, AND PRICE LEVELS
Chart 10
SELECTED SECTOR VELOCITIES BY MAJOR INDUSTRY GROUPS, STATISTICS OF INCOME, I9I+6-56
V
647
648
EMPLOYMENT, GROWTH, AND PRICE LEVELS
Chart 11
SELECTED ASSET SIZE VELOCITIES, NONFINANCIAL CORPORATIONS,
STATISTICS OF INCOME, 19^6-55
V
(The statement of Mr. Friedman—“The Supply of Money and
Changes in Prices and Output”—is contained in the compendium of
papers submitted by panelists appearing before the Joint Economic
Committee on the “Relationship of Price to Economic Stability and
Growth,” pp. 241-256. It is for sale by the Superintendant of Docu
ments, Government Printing Office at $2 per copy, and is also avail
able at depository and university libraries.
The statement on the quantity theory of money— a restatement by
Mr. Friedman, follows:)
The Quantity Theory of Money—A Restatement
MILTON FRIEDMAN
REPRINTED PROM
STUDIES IN THE QUANTITY THE
ORY OF MONEY.
ED. BY MILTON
FRIEDMAN.
UNIVERSITY OF CHI
CAGO PRESS.
COPYRIGHT 1956
BY THE- UNIVERSITY OF CHICAGO*
38563 O— 59— pt. 4------ 4
649
650
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS.
The Quantity Theory of Money— A Restatement
T he quantity theory of money is a term evocative of a general approach
rather than a label for a well-defined theory. The exact content of the
approach varies from a truism defining the term “ velocity” to an allegedly
rigid and unchanging ratio between the quantity of money— defined in
one way or another— and the price level— also defined in one way or
another. Whatever its precise meaning, it is clear that the general ap
proach fell into disrepute after the crash of 1929 and the subsequent
Great Depression and only recently has been slowly re-emerging into
professional respectability.
The present volume is partly a symptom of this re-emergence and
partly a continuance of an aberrant tradition. Chicago was one of the few
academic centers at which the quantity theory continued to be a central
and vigorous part of the oral tradition throughout the 1930’s and 1940’s,
where students continued to study monetary theory and to write theses
on monetary problems. The quantity theory that retained this role dif
fered sharply from the atrophied and rigid caricature that is so frequently
described by the proponents of the new income-expenditure approach—
and with some justice, to judge by much of the literature on policy that
was spawned by quantity theorists. At Chicago, Henry Simons and Lloyd
Mints directly, Frank Knight and Jacob Viner at one remove, taught and
developed a more subtle and relevant version, one in which the quantity
theory was connected and integrated with general price theory and be
came a flexible and sensitive tool for interpreting movements in aggregate
economic activity and for developing relevant policy prescriptions.
To the best of my knowledge, no systematic statement of this theory as
developed at Chicago exists, though much can be read between the lines
of Simons' and Mints’s writings. And this is as it should be, for the
Chicago tradition was not a rigid system, an unchangeable orthodoxy, but
a wav of looking at things. It was a theoretical approach that insisted that
money does mat ter— that any interpretation of short-term movements in
economic activity is likely to be seriously at fault if it neglects monetary
changes and repercussions and if it leaves unexplained why people are
willing to hold the particular nominal quantity of money in existence.
The purpose of this introduction is not to enshrine— or, should T say,
inter— a definitive version of the Chicago tradition. To suppose that one
EMPLOYMENT,
GROWTH, AND PRICEi LEVELS
651
could do so would be inconsistent with that tradition itself. The purpose
is rather to set down a particular 4*model*1 of a quantity theory in an
attempt, to convey the flavor of the oral tradition which nurtured the
remaining essays in this volume. In consonance with this purpose, I shall
not attempt to be exhaustive or to give a full justification for every
assertion.
1. The quantity theory is in the first instance a theory of the demand
for money. It is not a theory of output, or of money income, or of the price
level. Any statement about these variables requires combining the
quantity theory with some specifications about the conditions of supply
of money and perhaps about other variables as well.
2. To the ultimate wealth-owning units in the economy, money is one
kind of asset, one way of holding wealth. To the productive enterprise,
money is a capital good, a source of productive services that are combined
with other productive services to yield the products that the enterprise
sells. Thus the theory of the demand for money is a special topic in the
theory of capital; as such, it has the rather unusual feature of combining
a piece from each side of the capital market, the supply of capital (points 3
through 8 that follow), and the demand for capital (points 9 through 12).
3. The analysis of the demand for money on the part of the ultimate
wealth-owning units in the society can be made formally identical with
that of the demand for a consumption service. As in the usual theory of
consumer choice, the demand for money (or any other particular asset)
depends on three major sets of factors: (a) the total wealth to be held in
various forms— the analogue of the budget restraint ; (b) the price of and
return on this form of wealth and alternative forms; and (c) the tastes and
preferences of the wealth-owning units. The substantive differences from
the analysis of the demand for a consumption service are the necessity
of taking account of intertemporal rates of substitution in (b) and (c) and
of casting the budget restraint in terms of wealth.
4. From the broadest and most general point of view, total wealth in
cludes all sources of “ income” or consumable services. One such source is
the productive capac ity of human beings, and accordingly this is one form
in which wealth can be held. From this point of view, “ the” rate of interest
expresses the relation between the stock which is wealth and the flow
which is income, so if Y be the total flow of income, and r, “ the” interest
rate, total wealth is
W=
Y
(1)
Income in this broadest sense should not be identified with income as it is
ordinarily measured. The latter is generally a “ gross” stream with respect
652
EMPLOYMENT, GROWTH, AND PRICE LEVELS
to human beings, since no deduction is made for the expense of maintain
ing human productive capacity intact; in addition, it is affected by
transitory elements that make it depart more or less widely from the
theoretical concept of the stable level of consumption of services that
could be maintained indefinitely.
5.
Wealth can be held in numerous forms, and the ultimate wealthowning unit is to be regarded as dividing his wealth among them (point
[a] of 3), so as to maximize “ utility” (point [c] of 3), subject to whatever
restrictions affect the possibility of converting one form of wealth into
another (point [Z>] of 3). As usual, this implies that he will seek an appor
tionment of his wealth such that the rate at which he can substitute one
form of wealth for another is equal to the rate at which he is just willing
to do so. But this general proposition has some special features in the
present instance because of the necessity of considering flows as well as
stocks. W e can suppose all wealth (except wealth in the form of the
productive capacity of human beings) to be expressed in terms of mone
tary units at the prices of the point of time in question. The rate at which
one form can be substituted for another is then simply $1.00 worth for
SI.00 worth, regardless of the forms involved. But this is clearly not a
complete description, because the holding of one form of wealth instead
of another involves a difference in the composition of the income stream,
and it is essentially these differences that are fundamental to the “ utility”
of a particular structure of wealth. In consequence, to describe fully the
alternative combinations of forms of wealth that are available to an
individual, we must take account not only of their market prices— which
except for human wealth can be done simply by expressing them in units
worth $1.00— but also of the form and size of the income streams they
yield.
It will suffice to bring out the major issues that these considerations
raise to consider five different forms in which wealth can be held; (i) money
(M ), interpreted as claims or commodity units that are generally accepted
in payment of debts at a fixed nominal value; (ii) bonds (/>), interpreted as
claims to time streams of payments that are fixed in nominal units; ( iii)
equities (£ ), interpreted as claims to stated pro-rata shares of the returns
of enterprises; (iv) physical non-human goods (G) ; and (v) human capital
(H). Consider now the yield of each.
(i)
Money may yield a return in the form of money, for example,
interest on demand deposits. It will simplify matters, however, and entail
no essential loss of generality, to suppose that money yields its return
solely in kind, in the usual form of convenience, security, etc. The magnn
tude of this return in “ real” terms per nominal unit of money clearly
EMPLOYMENT, GROWTH, AND PRICE LEVELS
653
depends on the volume of goods that unit corresponds to, or on the general
price level, which we may designate by P. Since we have decided to take
$1.00 worth as the unit for each form of wealth, this will be equally true
for other forms of wealth as well, so P is a variable affecting the “ real”
yield of each.
(ii)
If we take the “ standard” bond to be a claim to a perpetual income
stream of constant nominal amount, then the return to a holder of the
bond can take two forms: one, the annual sum he receives— the “ coupon” ;
the other, any change in the price of the bond over time, a return which
may of course be positive or negative. If the price is expected to remain
constant, then $1.00 worth of a bond yields r&per year, where rb is simply
the “ coupon” sum divided by the market price of the bond, so 1/rb is
the price of a bond promising to pay $1.00 per year. We shall call rh the
market bond interest rate. If the price is expected to change, then the
yield cannot be calculated so simply, since it must take account
the
return in the form of expected appreciation or depreciation of the bond,
and it cannot, like r 6, be calculated directly from market prices (so long,
at least, as the “ standard” bond is the only one traded in).
The nominal income stream purchased for $1.00 at time zero then
consists of
fb (0) + rb (0) d
rb (0) d rb (t)
r%(i) ' dt ’
where t stands for time. For simplicity, we can approximate this functional
by its value at time zero, which is
This sum, together with P already introduced, defines the real return
from holding $1.00 of wealth in the form of bonds.
(iii)
Analogously to our treatment of bonds, we may take the “ stand
ard” unit of equity to be a claim to a perpetual income stream of constant
“ real” amount; that is, to be a standard bond with a purchasing-power
escalator clause, so that it promises a perpetual income stream equal in
nominal units to a constant number times a price index, which we may,
for convenience, take to be the same price index P introduced in (i).1 The
nominal return to the holder of the equity can then be regarded as taking
three forms: the constant nominal amount he would receive per year in
1.
This is an oversimplification, because it neglects “ leverage” and therefore
supposes that any monetary liabilities of an enterprise are balanced by monetary
assets.
654
EMPLOYMENT, GROWTH, AND PRICE LEVELS
the absence of any change in P; the increment or decrement to this
nominal amount to adjust for changes in P ; and any change in the nominal
price of the equity over time, which may of course arise from changes
either in interest rates or in price levels. Let r€be the market interest rate
on equities defined analogously to rb, namely, as the ratio of the “ coupon”
sum at any time (the first two items above) to the price of the equity, so
l/r« is the price of an equity promising to pay $1,00 per year if the price
level does not change, or to pay
P it)
-
p (o T
if the pricQ level varies according to P(t). If re(/) is defined analogously,
the price of the bond selling for l/r«(0) at time 0 will be
P it)
. P ( 0 ) r f <0 *
at time /, where the ratio of prices is required to adjust for any change in
the price level. The nominal stream purchased for $1.00 at time zero then
consists of
-
\ m .i
*(« , '.<0) J Lr. (/) J_/A,
dt
} * P ( 0 ) + 'P (0 )
r . ( 0)
rA t)
1
P i 0)
P(0
‘ { ) ' P ( 0)
dPit)
dt
P {t)
P ( 0)
r9 (0)
r\it)
...
(4)
d r9iO
dt, *
Once again we can approximate this functional by its value at time zero,
which is
This sum, together with P already introduced, defines the “ real” return
from holding $1.00 of wealth in the form of equities.
(iv)
Physical goods held by ultimate wealth-owning units are similar to
equities except that the annual stream they yield is in kind rather than in
money. In terms of nominal units, this return, like that from equities,
depends on the behavior of prices. In addition, like equities, physical
goods must be regarded as yielding a nominal return in the form of ap
preciation or depreciation in money value. If we suppose the price level P,
introduced earlier, to apply equally to the value of these physical goods,
then, at time zero,
EMPLOYMENT, GROWTH, AND PRICE LEVELS
655
is the size of this nominal return per $1,00 of physical g o o d s.2 Together
with P, it defines the “ real” return from holding $1.00 in the form of
physical goods.
(v)
Since there is only a limited market in human capital, at least in
modern non-slave societies, we cannot very well define.in market prices
the terms of substitution of human capital for other forms of capital and
so cannot define at any time the physical unit of capital corresponding
to $1.00 of human capital. There are some possibilities of substituting
non-human capital for human capital in an individual’s wealth holdings,
as, for example, when he enters into a contract to render personal services
for a specified period in return for a definitely specified number of periodic
payments, the number not depending on his being physically capable of
rendering the services. But, in the main, shifts between human capital
and other forms must take place through direct investment and disin
vestment in the human agent, and we may as well treat this as if itVere
the only way. With respect to this form of capital, therefore, the restric
tion or obstacles affecting the alternative compositions of wealth available
to the individual cannot be expressed in terms of market prices or rates
of return. At any one point in time there is some division between human
and non-human wealth in his portfolio of assets; he may be able to change
this over time, but we shall treat it as given at a point in time. Let w be
the ratio of non-human to human wealth or, equivalently, of income from
non-human wealth to income from human wealth, which means that it is
closely allied to what is usually defined as the ratio of wealth to income.
This is, then, the variable that needs to be taken into account so far as
human wealth is concerned.
6.
The tastes and preferences of wealth-owning units for the service
streams arising from different forms of wealth must in general simply be
taken for granted as determining the form of the demand function. In
order to give the theory empirical content, it will generally have to be
supposed that tastes are constant over significant stretches of space and
time. However, explicit allowance can be made for some changes in tastes
in so far as such changes are linked with objective circumstances. For ex
ample, it seems reasonable that, other things the same, individuals want
2,
In principle, it might be better to let P refer solely to the value of the services
of physical goods, which is essentially what it refers to in the preceding cases, and to
allow for the fact that the prices of the capital goods themselves must vary also with
the rate of capitalization, so that the prices of services and their sources vary at the
same rate only if the relevant interest rate is constant. I have neglccted this refinement
for simplicity; the neglect can perhaps be justified by the rapid depreciation of many
of the physical goods held by final wTealth-owning units.
656
EMPLOYMENT, GROWTH, AND PRICE LEVELS
to hold a larger fraction of their wealth in the form of money when they
are moving around geographically or are subject to unusual uncertainty
than otherwise. This is probably one of the major factors explaining a fre
quent tendency for money holdings to rise relative to income during war
time. But the extent of geographic movement, and perhaps of other kinds
of uncertainty, can be represented by objective indexes, such as indexes of
migration, miles of railroad travel, and the like. Let u stand for any such
variables that can be expected to affect tastes and preferences (for “ util
ity” determining variables).
7.
Combining 4, 5, and 6 along the lines suggested by 3 yields the
following demand function for money:
1 d r '>
ldP
1 dr'
ld P
Y
\
A number of observations are in order about this function.
(i) Even if we suppose prices and rates of interest unchanged, the
function contains three rates of interest: two for specific types of assets,
tb and rt, and one intended to apply to all types of assets, r. This general
rate, r, is to be interpreted as something of a weighted average of the two
special rates plus the rates applicable to human wealth and to physical
goods. Since the latter two cannot be observed directly, it is perhaps best
to regard them as varying in some systematic way with r b and r€. On this
assumption, we can drop r as an additional explicit variable, treating its
' influence as fully taken into account by the inclusion of r& and r*.
(ii) If there were no differences of opinion about price movements and
interest-rate movements, and bonds and equities were equivalent except
that the former are expressed in nominal units, arbitrage would of course
make
r
1 d r > - r A. 1 d P
1 d f'
H ~ T b- d r - r t + p - d i - 7 t - d f •
(Ki
(8)
or, if we suppose rates of interest either stable or changing at the same
percentage rate,
, 1 dP
fb
T*
•
P dt'
that is, the “ money” interest rate equal to the “ real” rate plus the per
centage rate of change of prices. In application the rate of change of prices
must be interpreted as an “ expected” rate of change and differences of
opinion cannot be neglected, so we cannot suppose (9) to hold; indeed,
EMPLOYMENT, GROWTH, AND PRICE LEVELS
657
one of the most consistent features of inflation seems to be that it does
not.3
(iii) If the range of assets were to be widened to include promises to
pay specified sums for a finite number of time units— ‘'short-term”
securities as well as “ consols”— the rates of change of r& and r€ would be
reflected in the difference between long and short rates of interest. Since
at some stage it will doubtless be desirable to introduce securities of
different time duration (see point 23 below), we may simplify the present
exposition by restricting it to the case in which ft and rt are taken to be
stable over time. Since the rate of change in prices is required separately
in any event, this means that we can replace the cumbrous variables
introduced to designate the nominal return on bonds and equities simply
by fb and re.
(iv) Y can be interpreted as including the return to all forms of wealth,
including money and physical capital goods owrned and held direcfly by
ultimate wealth-owning units, and so Y/r can be interpreted as an esti
mate of total wealth, only if Y is regarded as including some imputed
income from the stock of money and directly owned physical capital
goods. For monetary analysis the simplest procedure is perhaps to regard
Y as referring to the return to all forms of wealth other than the money
held directly by ultimate wealth-owning units, and so Y/r as referring to
total remaining wealth.
8.
A more fundamental point is that, as in all demand analyses resting
on maximization of a utility function defined in terms of “ real” magni
tudes, this demand equation must be considered independent in any
essential way of the nominal units used to measure money variables. If
the unit in which prices and money income are expressed is changed, the
amount of money demanded should change proportionately. More tech
nically, equation (7) must be regarded as homogeneous of the first degree
in P and F, so that
( 10)
where the variables within the parentheses have been rewritten in simpler
form in accordance with comments 7 (i) and 7 (iii).
3.
See Reuben Kesscl, “ Inflation: Theory of Wealth Distribution and Application
in Private Investment Policy** (unpublished doctoral dissertation, Univer^iiv of
Chicago).
658
EMPLOYMENT, GROWTH, AND PRICE LEVELS
This characteristic of the function enables us to rewrite it in two
alternative and more familiar ways.
(i) Let X = 1 /P . Equation (7) can then be written
M
P
rei p1 dp
d t ; t o : pY
,(
;
u \j .
( 11 )
In this form ihe equation expresses the demand for real balances as a
function of “ real” variables independent of nominal monetary values.
(ii) Let X = 1 /F . Equation (7) can then be written
M
y
/
1 dP
P
,
W, y
\
,
UJ
1
/
v ^ rb,
1 dP
(12)
F “
p ,
or
V * V ({ r b, re , p1 dP
Y u^
J
j j , w f -p,
J-M
,1
(13)
In this form the equation is in the usual quantity theory form, where v is
income velocity.
9. These equations are, to this point, solely for money held directly
by ultimate wealth-owning units. As noted, money is also held by busi
ness enterprises as a productive resource. The counterpart to this business
asset in the balance sheet of an ultimate wealth-owning unit is a claim
other than money. For example, an individual may buy bonds from a
corporation, and the corporation use the proceeds to finance the money
holdings which it needs for its operations. Of course, the usual difficulties
of separating the accounts of the business and its owner arise with unin
corporated enterprises.
10. The amount of money that it pays business enterprises to hold
depends, as for any other source of productive services, on the cost of the
productive services, the cost of substitute productive services, and the
value product yielded by the productive service. Per dollar of money held,
the cost depends on how the corresponding capital is raised— whether by
raising additional capital in the form of bonds or equities, by substituting
cash for real capital goods, etc. These ways of financing money holdings
are much the same as the alternative forms in which the ultimate wealthowning unit can hold its non-human wealth, so that the variables r6, r t,
P, and (1 /P){dP/dt) introduced into (7) can be taken to represent the
cost to the business enterprise of holding money. For some purposes,
however, it may be desirable to distinguish between the rate of return re
EMPLOYMENT, GROWTH, AND PRICE LEVELS
659
ceived by the lender and the rate paid by the borrower; in which case it
would be necessary to introduce an additional set of variables.
Substitutes for money as a productive service are numerous and
varied, including all ways of economizing on money holdings by using
other resources to synchronize more closely payments and receipts, reduce
payment periods, extend use of book credit, establish clearing arrange
ments, and so on in infinite variety. There seem no particularly close sub
stitutes whose prices deserve to be singled out for inclusion in the business
demand for money.
The value product yielded by the productive services of money per unit
of output depends on production conditions: the production function. It is
likely to be especially dependent on features of production conditions af
fecting the smoothness and regularity of operations as well as on those
determining the size and scope of enterprises, degree of vertical integra
tion, etc. Again there seem no variables that deserve to be singled out on
the present level of abstraction for special attention; these factors can be
taken into account by interpreting u as including variables affecting not
only the tastes of wealth-owners but also the relevant technological condi
tions of production. Given the amount of money demanded per unit of
output, the total amount demanded is proportional to total output, which
can be represented by Y.
11.
One variable that has traditionally been singled out in considering
the demand for money on the part of business enterprises is the volume of
transactions, or of transactions per dollar of final products; and, of course,
emphasis on transactions has been carried over to the ultimate wealthowning unit as well as to the business enterprise. The idea that renders
this approach attractive is that there is a mechanical link between a dollar
of payments per unit time and the average stock of money required to
effect it— a fixed technical coefficient of production, as it were. It is clear
that this mechanical approach is very different in spirit from the one we
have been following. On our approach, the average amount of money
held per dollar of transactions is itself to be regarded as a resultant of an
economic equilibrating process, not as a physical datum. If, for whatever
reason, it becomes more expensive to hold money, then it is worth
devoting resources to effecting money transactions in less expensive ways
or to reducing the volume of transactions per dollar of final output. In
consequence, our ultimate demand function for money in its most general
form does not contain as a variable the volume of transactions or of
transactions per dollar of final output ; it contains rather those more basic
technical and cost conditions that affect the costs of conserving money,
be it by changing the average amount of money held per dollar of transac
660
EMPLOYMENT, GROWTH, AND PRICE LEVELS
tions per unit time or by changing the number of dollars of transactions
per dollar of final output. This does not, of course, exclude the possibility
that, for a particular problem, it may be useful to regard the transactions
variables as given and not to dig beneath them and so to include the
volume of transactions per dollar of final output as an explicit variable in
a special variant of the demand function.
Similar remarks are relevant to various features of payment conditions,
frequently described as “ institutional conditions,” affecting the velocity
of circulation of money and taken as somehow mechanically determined—
such items as whether workers are paid by the day, or week, or month;
the use of book credit; and so on. On our approach these, too, are to be
regarded as resultants of an economic equilibrating process, not as
physical data. Lengthening the pay period, for example, may save book
keeping and other costs to the employer, who is therefore willing to pay
somewhat more than in proportion for a longer than a shorter pay period;
on the other hand, it imposes bn employees the cost of holding larger
cash balances or providing substitutes for cash, and they therefore want
to be paid more than in proportion for a longer pay period. Where these
will balance depends on how costs vary with length of pay period. The
cost to the employee depends in considerable part on the factors entering
into his demand curve for money for a fixed pay period. If he would in
any event be holding relatively large average balances, the additional
costs imposed by a lengthened pay period tend to be less than if he would
be holding relatively small average balances, and so it will take less of an
inducement to get him to accept a longer pay period. For given cost
savings to the employer, therefore, the pay period can be expected to be
longer in the first case than in the second. Surely, the increase in the
average cash balance over the past century in this country that has oc
curred for other reasons has been a factor producing a lengthening of pay
periods and not the other way around. Or, again, experience in hyperin
flations showrs how rapidly payment practices change under the impact of
drastic changes in the cost of holding money.
12.
The upshot of these considerations is that the demand for money
on the part of business enterprises can be regarded as expressed by a
function of the same kind as equation (7), with the same variables on the
right-hand side. And, like (7), since the analysis is based on informed
maximization of returns by enterprises, only “ real” quantities matter, so
it must be homogeneous of the first degree in Y and P . In consequence, we
can interpret (7) and its variants (11) and (13) as describing the demand
for money on the part of a business enterprise as well as on the part of an
EMPLOYMENT, GROWTH, AND PRICE) LEVELS
661
ultimate wealth-owning unit, provided only that we broaden our inter
pretation of n.
13. Strictly speaking, the equations (7), (11), and (13) are for an indi
vidual wealth-owning unit or business enterprise. If we aggregate (7) for
all wealth-ow ning units and business enterprises in the society, the result,
in principle, depends on the distribution of the units by the several vari
ables. This raises no serious problem about P, rt, and re, for these can be
taken as the same for all, or about tt, for this is an unspecified portmanteau
variable to be filled in as the occasion demands. We have been interpret
ing (1 /P){dP/dt) as the expected rate of price rise, so there is no reason
why this variable should be the same for all, and w and Y clearly differ
substantially among units. An approximation is to neglect these diffi
culties and take (7) and the associated (11) and (13) as applying to the
aggregate demand for money, with (1 /P ) (dP/dt) interpreted as some kind
of an average expected rate of change of prices, w as the ratio 4of total
income from non-human wealth to income from human wealth, and Y as
aggregate income. This is the procedure that has generally been followed,
and it seems the right one until serious departures between this linear
approximation and experience make it necessary to introduce measures of
dispersion writh respect to one or more of the variables.
14. It is perhaps wrorth noting explicitly that the model does not use
the distinction between “ active balances” and “ idle balances” or the
closely allied distinction between “ transaction balances” and “ speculative
balances” that is so widely used in the literature. The distinction between
money holdings of ultimate wealth-owners and of business enterprises is
related to this distinction but only distantly so. Each of these categories
of money-holders can be said to demand money partly from “ transaction”
motives, partly from “ speculative” or “ asset” motives, but dollars of
money are not distinguished according as they are said to be held for one
or the other purpose. Rather, each dollar is, as it were, regarded as
rendering a variety of services, and the holder of money as altering his
money holdings until the value to him of the addition to the total flow' of
services produced by adding a dollar to his money stock is equal to the
reduction in the flow of services produced by subtracting a dollar from
each of the other forms in which he holds assets.
15. Nothing has been said above about “ banks” or producers of
money. This is because their main role is in connection with the supply of
money rather than the demand for it. Their introduction does, however,
blur some of the points in the above analysis: the existence of banks en
ables productive enterprises to acquire money balances without raising
capital from ultimate w^ealth-owners. Instead of selling claims (bonds or
662
EMPLOYMENT, GROWTH, AND PRICE LEVELS*
equities) to them, it can sell its claims to banks, getting “ money” in ex
change: in the phrase that was once so common in textbooks on money,
the bank coins specific liabilities into generally acceptable liabilities. Rut
this possibility does not alter the preceding analysis in any essential way.
16. Suppose the supply of money in nominal units is regarded as fixed
or more generally autonomously determined. Equation (13) then defines
the conditions under which this nominal stock of money will be the
amount demanded. Even under these conditions, equation (13) alone is
not sufficient to determine money income. In order to have a complete
model for the determination of money income, it would l>e necessary to
specify the determinants of the structure of interest rates, of real income,
and of the path of adjustment in the price level. Even if we suppose interest
rates determined independently— by productivity, thrift, and the like—
and real income as also given by other forces, equat ion (13) only determines
a unique equilibrium level of money income if we mean by this the level
at which prices are stable. More generally, it determines a time path of
money income for given initial values of money income.
In order to convert equation (13) into a “ complete” model of income
determination, therefore, it is necessary to suppose either that the demand
for money is highly inelastic with respect to the variables in v or that all
these variables are to be taken as rigid and fixed.
17. Even under the most favorable conditions, for example, that the
demand for money is quite inelastic with respect to the variables in v,
equation (13) gives at most a theory of money income: it then says that
changes in money income mirror changes in the nominal quantity of
money. But it tells nothing about how much of any change in Y is re
flected in real output and how much in prices. To infer this requires bring
ing in outside information, as, for example, that real output is at its
feasible maximum, in w'hich case any increase in money would produce
the same or a largfer percentage increase in prices; and so on.
18. In light of the preceding cx(x)sition, the question arises what it
means to say that someone is or is not a “ quantity theorist.” Almost
every economist will accept the general lines of the preceding analysis on
a purely formal and abstract level, although each would doubtless choose
to express it differently in detail. Yet there clearly are deep and funda
mental differences about the importance of this analysis for the under
standing of short- and long-term movements in general economic activity.
This difference of opinion arises with respect to three different issues:
(i) the stability and importance of the demand function for money; (ii)
the independence of the factors affecting demand and supply; and (iii)
the form of the demand function or related functions.
EMPLOYMENT, GROWTH, AND PRICE- LEVELS
663
(i) The quantity theorist accepts the empirical hypothesis that the
demand for money is highly stable more stable than functions such as
the consumption function that are offered as alternative key relations.
This hypothesis needs to be hedged on both sides. On the one side, the
quantity theorist need not, and generally does not, mean that the real
quantity of money demanded |>er unit of output, or the velocity of
circulation of money, is to be regarded as numerically constant over time;
he does not, for example, regard it as a contradiction to the stability of
the demand for money that the velocity of circulation of money rises
drastically during hyperinflations. For the stability he expects is in the
functional relation between the quantity of money demanded and the vari
ables that determine it, and the sharp rise in the velocity of circulation of
money during hyperinflations is entirely consistent with a stable func
tional relation, as Cagan so clearly demonstrates in his essay. On the other
side, the quantity theorist must sharply limit, and be prepared to specify
explicitly, the variables that it is empirically important to include in the
function. For to expand the number of variables regarded as significant
is to empty the hypothesis of its empirical content; there is indeed little
if any difference between asserting that the demand for money is highly
unstable and asserting that it is a perfectly stable function of an indefinite
ly large number of variables.
The quantity theorist not only regards the demand function 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 analysis of the economy as
a whole, such as the level of money income or of prices. It is this that leads
him to put greater emphasis on the demand for money than on, let us say,
the demand for pins, even though the latter might be as stable as the
former. It is not easy to state this point precisely, and I cannot pretend
to have done so. (See item [iii] below for an example of an argument
against the quantity theorist along these lines.)
The reaction against the quantity theory in the 1930’s came largely,
I believe, under this head. The demand for money, it was asserted, is a
will-o’-the-wisp, shifting erratically and unpredictably with every rumor
and expectation; one cannot, it was asserted, reliably specify a limited
number of variables on which it depends. However, although the reaction
came under this head, it was largely rationalized under the two succeeding
heads.
(ii)
The quantity theorist also holds that there are important factors
affecting the supply of money that do not affect the demand for money.
Under some circumstances these are technical conditions affecting the sup
ply of specie; under others, political or psychological conditions determin
ing the policies of monetary authorities and the banking system. A stable
664
EMPLOYMENT, GROWTH, AND PRICE LEVELS
demand function is useful precisely in order t o t r a c e o u t t h e e f f e c t s o f
changes in supply, which means that it is useful o n l y if supply is a f f e c t e d
by at least some factors other than those regarded a s a f f e c t i n g demand.
The classical version of the objection under this head to the quantity
theory is the so-called real-bills doctrine: that changes in the demand for
money call forth corresponding changes in supply and that supply cannot
change otherwise, or at least cannot do so under specified institutional
arrangements. The forms which this argument takes are legion and are
still widespread. Another version is the argument that the “ quantity
theory” cannot “ explain” large price rises, because the price rise produced
both the increase in demand for nominal money holdings and the increase
in supply of money to meet it; that is, implicitly that the same forces
affect both the demand for and the supply of money, and in the same way.
(iii)
The attack on the quantity theory associated with the Keynesian
underemployment analysis is based primarily on an assertion about the
form of (7) or (11). The demand for money, it is said, is infinitely elastic at
a “ small” positive interest rate. At this interest rate, which can be ex
pected to prevail under underemployment conditions, changes in the real
supply of money, whether produced by changes in prices or in the nominal
stock of money, have no effect on anything. This is the famous “ liquidity
trap.” A rather more complex version involves the shape of other func
tions as well: the magnitudes in (7) other than “ the” interest rate, it is
argued, enter into other relations in the economic system and can be re
garded as determined there; the interest rate does not enter into these other
functions; it can therefore be regarded as determined by this equation. So
the only role of the stock of money and the demand for money is to de
termine the interest rate.
19.
The proof of this pudding is in the eating; and the essays in this
book contain much relevant food, of which I may perhaps mention three
particularly juicy items.
On cannot read'Lerner’s description of the effects of monetary reform
in the Confederacy in 1864 without recognizing that at least on occasion
the supply of money can be a largely autonomous factor and the demand
for money highly stable even under extraordinarily unstable circum
stances. After three years of war, after widespread destruction and
military reverses, in the face of impending defeat, a monetary reform
that succeeded in reducing the stock of money halted and reversed for
some months a rise in prices that had been going on at the rate of 10
per cent a month most of the war! It would be hard to construct a better
controlled experiment to demonstrate the critical importance of the
supply of money.
On the other hand, Klein’s examination of German experience in World
EMPLOYMENT, GROWTH, AND PRICE LEVELS
665
War II is much less favorable to the stability and importance of the de
mand for money. Though he shows that defects in the figures account for
a sizable part of the crude discrepancy between changes in the recorded
stock of money and in recorded prices, correction of these defects still
leaves a puzzlingly large discrepancy that it does not seem possible to
account for in terms of the variables introduced into the above exposition
of the theory. Klein examined German experience precisely because it
seemed the most deviant on a casual examination. Both it and other war
time experience will clearly repay further examination.
Cagan’s examination of hyperinflations is another important piece of
evidence on the stability of the demand for money under highly unstable
conditions. It is also an interesting example of the difference between a
numerically stable velocity and a stable functional relation: the numerical
value of the velocity varied enormously during the hyperinflations, but
this was a predictable response to the changes in the expected rate of
changes of prices.
20. Though the essays in this book contain evidence relevant to the
issues discussed in point lS> this is a by-product rather than their main
purpose, which is rather tAtadd to our tested knowledge about the char
acteristics of the demand function for money. In the process of doing so,
they also raise some questions about the theoretical formulation and sug
gest some modifications it might be desirable to introduce. I shall com
ment on a few of those without attempting to summarize at all fully the
essays themselves.
21. Selden’s material covers the longest period of time and the most
“ normal” conditions. This is at once a virtue and a vice- a virtue, because
it means that his results may be applicable most directly to ordinary
peacetime experience; a vice, because “ normality” is likely to spell little
variation in the fundamental variables and hence a small base from which
to judge their effect. The one variable that covers a rather broad range is
real income, thanks to the length of the period. The secular rise in real
income has been accompanied by a rise in real cash balances per unit of
output— a decline in velocity— from which Selden concludes that the in
come elasticity of the demand for real balances is greater than unitycash balances are a “ luxury” in the terminology generally adopted. This
entirely plausible result seems to be confirmed by evidence for other
countries as well.
22. Selden finds that for cyclical periods velocity rises during expan
sions and falls during contractions, a result that at first glance seems
to contradict thaseeular result just cited. However, there is an alternative
explanation entirely consistent with the secular result. It will be recalled
38563 O— 59— pt. 4------ 5
666
EMPLOYMENT, GROWTH, AND PRICE LEVELS
that Y was introduced into equation (7) as an index of wealth. This has
important implications for the measure or concept of income that is
relevant. What is required by the theoretical analysis is not usual meas
ured income— which in the main corresponds to current receipts corrected
for double counting— but a longer term concept, “ expected income,” or
what I have elsewhere called “ permanent income.” 4 Now suppose that the
variables in the v function of (13) are unchanged for a period. The ratio
of Y to M would then be unchanged, provided Y is permanent income.
Velocity as Selden computes it is the ratio of measured income to the stock
of money and would not be unchanged. When measured income was above
permanent income, measured velocity would be relatively high, and con
versely. Now measured income is presumably above permanent income at
cyclical peaks and below permanent income at cyclical troughs. The ob
served positive conformity of measured velocity to cyclical changes of
income may therefore reflect simply the difference between measured
income and the concept relevant to equation (13).
23. Another point that is*raised by Selden *s work is the appropriate
division of wealth into forms of assets. The division suggested above is,
of course, only suggestive. Selden finds more useful the distinction be
tween “ short-term” and “ long-term” bonds; he treats the former as
“ substitutes for money” and calls the return on the latter “ the cost of
holding money,” He finds both to be significantly related to the quantity
of money demanded. It was suggested above that this is also a way to
take into account expectations about changes in interest rates.
Similarly, there is no hard-and-fast line between “ money” and other
assets, and for some purposes it may be desirable to distinguish between
different forms of “ money” (e.g., between currency and deposits). Some
of these forms of money may pay interest or may involve service charges,
in which case the positive or negative return will be a relevant variable in
determining the division of money holdings among various forms.
24, By concentrating on hyperinflations, Cagan was able to bring into
sharp relief a variable whose effect is generally hard to evaluate, namely,
the rate of change of prices. The other side of this coin is the necessity of
neglecting practically all the remaining variables. His device for estimating
expected rates of change of prices from actual rates of change, which
works so well for his data, can be carried over to other variables as well
and so is likely to be important in fields other than money. I have already
used it to estimate “ expected income” as a determinant of consumption,5
4. See Milton Friedman, A Theory of the Consumption Function, forthcoming publition of the Princeton University Press for the National Bureau of Economic Research.
5. See ibid.
EMPLOYMENT,
GROWTH, AND PRICEi LEVELS
667
and Gary Becker has experimented with using this “ expected income”
series in a demand function for money along the lines suggested above (in
point 22).
Cagan’s results make it clear that changes in the rate of change of
prices, or in the return to an alternative form of holding wealth, have the
expected effect on the quantity of money demanded: the higher the rate
of change of prices, and thus the more attractive the alternative, the less
the quantity of money demanded. This result is important not only
directly but also because it is indirectly relevant to the effect of changes
in the returns to other alternatives, such as rates of interest on various
kinds of bonds. Our evidence on these is in some way less satisfactory be
cause they have varied over so much smaller a range; tentative findings
that the effect of changes in them is in the expected direction are greatly
strengthened by Cagan’s results.
One point which is suggested by the inapplicability of Cagan’s rela
tions to the final stages of the hyperinflations he studies is that ft may at
times be undesirable to replace the whole expected pattern of price move
ments by the rate of change expected at the moment, as Cagan does and
as is done in point 5 above. For example, a given rate of price rise, ex
pected to continue, say, for only a day, and to be followed by price stabil
ity, will clearly mean a higher (real) demand for money than the same
rate of price rise expected to continue indefinitely; it will be worth in
curring greater costs to avoid paying the latter than the former price.
This is the same complication as occurs in demand analysis for a consumer
good when it is necessary to include not only the present price but also
past prices or future expected prices. This point may help explain not
only Cagan’s findings for the terminal stages but also Selden’s findings
that the inclusion of the rate of change of prices as part of the cost of
holding money worsened rather than improved his estimated relations,
though it may be that this result arises from a different source, namely,
that it takes substantial actual rates of price change to produce firm
enough and uniform enough expectations about price behavior for this
variable to play a crucial role.
Similar comments are dearly relevant for expected changes in interest
rates.
25.
One of the chief reproaches directed at economics as an allegedly
empirical science is that it can offer so few numerical “ constants/’ that it
has isolated so few fundamental regularities. The field of money is the
chief example one can offer in rebuttal: there is perhaps no other empirical
relation in economics that has been observed to recur so uniformly under
so wide a variety of circumstances as the relation between substantial
668
EMPLOYMENT, GROWTH, AND PRICE LEVELS
changes over short periods in the stock of money and in prices ; the one is
invariably linked with the other and is in the same direction; this uni
formity is, I suspect, of the same order as many of the uniformities that
form the basis of the physical sciences. And the uniformity is in more than
direction. There is an extraordinary empirical stability and regularity to
such magnitudes as income velocity that cannot but impress anyone who
works extensively with monetary data. This very stability and regularity
contributed to the downfall of the quantity theory, for it was overstated
and expressed in unduly simple form; the numerical value of the velocity
itself, whether income or transactions, was treated as a natural “ con
stant.” Now this it is not; and its failure to be so, first during and after
World War I and then, to a lesser extent, after the crash of 1929, helped
greatly ta foster the reaction against the quantity theory. The studies in
this volume are premised on a stability and regularity in monetary rela
tions of a more sophisticated form than a numerically constant velocity.
And they make, I believe, an important contribution toward extracting
this stability and regularity, toward isolating the numerical “ constants”
of monetary behavior. It is by this criterion at any rate that I, and I be
lieve also their authors, would wish them to be judged.
I began this Introduction by referring to the tradition in the field of
money at Chicago and to the role of faculty members in promoting it. I
think it is fitting to end the Introduction by emphasizing the part which
students have played in keeping that tradition alive and vigorous. The
essays that follow are one manifestation. Unpublished doctoral disser
tations on money are another. In addition, I wish especially to express my
own personal appreciation to the students who have participated with me
in the Workshop in Money and Banking, of which this volume is the first
published fruit. I owe a special debt to David I. Fand, Phillip Cagan,
Gary Becker, David Meiselman, and Raymond Zelder, who have at
various times helped me to conduct it.
W e all of us are indebted also to the Rockefeller Foundation for
financial assistance to the Workshop in Money and Banking. This assist
ance helped to finance some of the research reported in this book and has
made possible its publication.
EMPLOYMENT, GROWTH, AND PRICE' LEVELS
669
The C h a ir m a n . The meeting tomorrow will be in the auditorium
on the ground floor of the New Senate Office Building.
Richard T. Selden, professor of economics, Columbia University,
will be the witness.
I would suggest that the clerk of the committee, when he sends
an invitation to the members of the Federal Reserve Board, send
a copy of Mr. Friedman’s paper and advise them that we are expect
ing an examination on this subject.
(Thereupon, at 12:15 p.m., the committee recessed, to reconvene
at 10 a.m., Tuesday, May 26,1959.)
EMPLOYMENT, GROWTH, AND PRICE LEVELS
TUESDAY, MAY 26, 1959
C ongress of t h e U n it e d S t a t e s ,
J o in t E c o n o m ic C o m m it t e e ,
Washington, D.C.
The joint committe met at 10:05 a.m., pursuant to recess, in the
auditorium, New Senate Office Building, Senator Paul H. Douglas
presiding.
Present: Senators Douglas, Bush, and Javits; Representatives Pat
man, Curtis, and Widnall.
Representative P a t m a n (presiding). The committee will come to
order.
Senator Douglas is delayed. He will be here in a few minutes.
We have as our witness this morning Prof. Richard T. Selden, as
sociate professor of banking, Columbia University.
We are delighted to have you, Mr. Selden, and you may proceed in
your own way.
STATEMENT OF RICHARD T. SELDEN, RESEARCH ASSOCIATE, NA
TIONAL BUREAU OF ECONOMIC RESEARCH, AND ASSOCIATE
PROFESSOR OF BANKING, COLUMBIA UNIVERSITY
Mr. S e l d e n . Mr. Chairman and members of the Joint Economic
Committee, I greatly appreciate the opportunity you have given me
to take part in your important study of employment, growth, and
price levels. My topic today is the behavior of money.
There are two aspects of money behavior; changes in quantity
and changes in velocity of circulation. I shall devote most of my
formal presentation to the latter, for two reasons : the general pub
lic is much less familiar wTith velocity as an important economic
variable, and it is the aspect of money behavior on which I am most
qualified to speak.
Although I shall attempt to summarize the historical record over
the past 90 years, the major portion of my remarks will deal with
the period since 1945.
As all of us are painfully aware, the postwar years have been
years of inflation, by and large. We are now in the midst of a
great debate on the nature of this inflation. Many of the partici
pants in this debate regard the recent episodes of rising prices as
fundamentally different from those of the past. Some talk of “cost
push” inflation, while others point to the behavior of “administered”
prices; but these groups unite in concluding that what we have been
experiencing recently is a new inflation, in sharp contrast to the
classic demand inflations of earlier periods.
671
672
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS
The material I will present has a direct bearing on this debate, al
though it will not settle the basic issues.
Whatever the causes of postwar inflation, they are susceptible of
analysis by means of the equation of exchange. This equation, which
can never be false, states that any flow of payments can be regarded
on the one hand as the quantity of money multiplied by its velocity,
and on the other as the average price per transaction multiplied by
the number of transactions. In symbols, MV equals PT.
The equation of exchange tells us that any rise in P, the price level,
must be accompanied by a proportionate rise in M or Y or a propor
tionate fall in T. When we apply this system of analysis to the post
war period, we discover that rising velocity has been an important
characteristic of the recent inflation.
Later in this statement, I shall offer an explanation of the postwar
tendency for velocity to rise, but it may be appropriate to state a
major conclusion here. While undoubtedly it is true that no two
inflations are exactly alike, I do not find strong support for the
commonly held theory that recent inflations have been fundamentally
different from earlier ones.
(At this point the chairman entered the hearing room.)
Senator Douglas, my formal statement is rather lengthy and my
plan is to read portions and simply digest other portions.
The C h a ir m a n . We will print the whole paper.
Mr. S e l d e n . The topics I plan to take up are, first, a discussion of
the meaning of such terms as “inflation,” “money,” and “velocity”—
particularly the latter, together with a consideration of the available
statistical measures of these; secondly, a review of the historical rec
ord on money behavior up until the end of World War I I ; third, a
similar review of the postwar period; and fourth, an analysis of the
causal factors underlying postwar changes in the behavior of money.
Accordingly, I will begin with a discussion of the meaning of some
of these concepts, particularly of the velocity of money.
By “inflation,” m this discussion, I will mean simply a rise, whether
large or small, in any broad index of prices such as the Wholesale
Price Index or the implicit price deflators of the gross national
product.
By “money” I shall mean the sum of currency plus demand de
posits in commercial banks.
On some occasions I wrill follow Professor Friedman’s example
of including time deposits in commercial banks also. I will indicate
whenever I shift usage.
The “velocity of money” is simply the average number of times
each dollar is spent during a year, or whatever other time unit one
chooses. Economists have confused matters somewhat by coining a
variety of synonyms, including rapidity, frequency of use, turnover
rate, and so forth.
By a simple transformation of the equation of exchange, we can
see that the velocity of money is simply the ratio of PT to M ; that is,
the ratio of total payments to money.
The C h a ir m a n . Y ou do not draw any distinction between the
velocity of cash on one hand and bank credit on the other?
Mr. S e l d e n . I will discuss the velocity of demand deposits, the
deposit turnover ratios developed by the Federal Reserve System,
but aside from that I don’t discuss the velocity of currency for the
EMPLOYMENT,
GROWTH, AND PRICE) LEVELS
673
very obvious reason that it’s extremely difficult to get reliable esti
mates of currency payments.
The C h a i r m a n . D o you think that in practice there is any difference
between the velocity of cash or currency and velocity of checking
accounts?
Mr. S e l d e n . It’s very hard to answer the question since we have so
little information. However, when I pass to a discussion of chart 3,
I think I can present some evidence that will support the theory that
we can measure velocity adequately by taking these deposit turnover
rates or by following Professor Friedman’s usage of taking the
income velocity of money.
I don’t think it makes much difference whether one distinguishes
between currency and demand deposits. I feel it makes very little
difference.
I have said that the velocity of money is the ratio of payments
made during the year to the average stock of money during the year,
but I haven’t said wThat the payments are. What payments, then, are
described by the equation of exchange ?
Depending on the purpose at hand, they may consist of all pur
chases made during the year except barter transactions, or they may
include only certain types of purchases such as purchases made by
check, purchases of currently produced goods and services, purchases
by consumers, and so forth.
There is an associated velocity concept, of course, for every con
ceivable payments flow. It is therefore misleading to talk of “the”
velocity of money. There are many velocities.
Three velocity concepts are frequently mentioned in economic
literature and I will define these; we will pass in a few moments to
some statistical measures of these.
The first is the aggregate transactions velocity of money for the
entire economy. The second is income velocity. That is Professor
Friedman’s concept from yesterday. Third, we have deposit turn
over. I will explain each of these three very briefly.
The first, aggregate transactions velocity, is the ratio of all mone
tary purchases made during the year to average money existing
during the year.
The second, income velocity, is the ratio of national income or
gross national product to average money during the year.
The third measure, deposit turnover, is simply the ratio of pur
chases made by check to average demand deposits during the year.
To confuse matters a little more, I am going to mention two other
concepts which I will utilize in my analysis. One of these is called
the aggregate nonfinancial velocity and consists of the ratio of all
purchases of goods and services to the average money outstanding.
The final velocity concept that I will mention is sector velocities,
which are payments—money rations for particular groups within our
economy, such as manufacturing corporations, holders of demand
deposits in New York banks, and so forth. In other words, the con
cept of velocity may apply to the entire economy or it may be applied
with equal validity to groups within the economy. The latter is what
the sector velocity concept is trying to get at.
If we push the sector velocity concept to its logical limit, we may
visualize every individual who holds cash as maintaining some ratio
674
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
of purchases to the cash he holds. Averaging these countless millions
of individual velocities, we obtain the aggregate transactions or nonfinancial velocity for the entire economy.
There are good measures for each of these velocity concepts that I
have mentioned, with one exception: There is no statistical measure
of the aggregate transactions velocity. That corresponds to Prof.
Irving Fisher’s concept. There is no good measure of that particular
concept.
Now let’s turn to the second part of my remarks, the historical
record up to the end of World War II. I am going to talk about
trends and cyclical changes in the velocity of money.
Even a casual glance at chart 1, which is reproduced in this small
set and which is also on the easel, reveals that the trend of total de
posits plus currency wTas upward and that the trend of velocity was
downward w7ith only brief interruptions in both cases, over the period
1869-1945. There have been occasional downturns in the stock of
money, as Professor Friedman pointed out yesterday, but all of these
downturns have been associated with major depressions.
So far as velocity is concerned, w^e see that the trend has been al
most uniformly downward up to the end of World War II. So much
for the trends.
Cycles can also be studied from chart 1, although of course one can’t
study cycles very w^ell using annual data. One really ought to have
monthly or quarterly data for this purpose. However, we can see
cycles even in these annual data. We see that particularly after the
turn of the century the income velocity of money declines during the
shaded areas on the chart, which represent periods of business contrac
tion ; and velocity typically rises during the succeeding prosperity or
expansion phases of business cycles. There are one or two exceptions,
but on the w^hole, w^e find this a very faithful kind of cyclical behavior.
The C h a ir m a n . Mr. Selden, is that not because expansion is com
monly associated with the rise in prices and contraction with the fall
in prices, so that in a period of contraction money is wrorth more as
times goes on and therefore there is discouragement to spend and a
premium upon hoarding ?
Mr. S e l d e n . The facts, as you state them, are certainly correct.
What interpretation one places upon those facts, I am not entirely
sure.
In other words, wThy w^e have this observed pattern is a complicated
question. I can talk about that later, but the facts are perfectly
correct as you stated them.
The C h a ir m a n . If you w^ill forgive me, I w’ill call your attention
to a typing mistake in your manuscript.
It says “rises during business expansions and falls during business
expansions.” That is obviously a typing error and should be “con
tractions.”
Mr. S e l d e n . That is correct. Thank you for calling it to my
attention.
So much for the annual income velocity series that goes back to
1869.
When we pass to chart 3, winch is also on the easel, w^e find four
different measures of the velocity of money. The one w^hich is plotted
also on chart 1 is the low^er curve. This is the income velocity of not
EMPLOYMENT, GROWTH, AND PRICE LEVELS
675
only currency and demand deposits, but also of commercial bank
time deposits.
The curve just above that is the income velocity of demand deposits
plus currency. In other words, it embodies a narrower definition
money. The short curve above that is the aggregate nonfinancial
velocity and the top one is the demand deposit turnover rate at all
reporting centers throughout the country.
What do w^e see from chart 3 ?
Of course, w^e find that the general movement of income velocity,
whether one includes or excludes time deposits, has been downward.
Also, nonfinancial velocity went downward sharply during the very
short timespan that w^e had before 1945. From 1939 to 1945 it fell
very abruptly. The demand deposit turnover rate rose very sharply
until 1929 and fell even more sharply from 1929 to approximately
1943 or 1944.
We find in general a downward trend, although in the case of the
demand deposit turnover rate a trend wThich w7as interrupted during
the twenties by a very sharp countermovement. We have declining
velocity then throughout this timespan from 1919 to 1945.
So far as the cycles are concerned, I do not have the periods of
expansion and contraction indicated on this chart as on chart 1,
but one can see approximately the periods of business downturn
pnnctuating all of these series.
We find the cyclical movements quite evident in chart 3 as well as
in chart 1.
Senator B u s h . Since 1945, the trend is just as clearly up as it was
down before that ?
Mr. S e l d e n . Yes, Senator Bush, that is a point I am going to dwell
on at some length. You are entirely correct in thinking that an
explanation of that is needed. I will pass to that in a few moments.
Let?s turn to the third part of my comments, the behavior of the
velocity of money since 1945.
First of all, let’s see what has been happening to the aggregate
measures of velocity. In sharp contrast to the period 1869-1945, the
velocity of money has moved steadily upward, except for cyclical
downturns since the end of World War II. This is true whether one
measures velocity by deposit turnover, aggregate nonfinancial veloc
ity, or income velocity, and whether or not one includes time deposits
in money. By 1957 the ratio of annual gross national product to
demand deposits plus currency reached a level it had not experienced
since 1931, and the same was true of demand deposit turnover. These
relationships can be seen quite clearly on chart 3.
As Senator Bush has just pointed out, there was a turn in each of
these velocities approximately at the end of the war or during the
war, and we have had a rather unrelenting upward movement in each
of them since that time.
It is interesting to note that the three aggregate velocity measures
have displayed highly similar growth rates since the end of the war:
1.8 percent per year for income velocity and 2 percent for the other
two. This is a greatly different situation from the 1920’s when de
posit turnover rose sharply but income velocity did not.
Income velocity and aggregate nonfinancial velocity appear to be
tapering off in their rates of growth; deposit turnover, on the other
676
EMPLOYMENT, GROWTH, AND PRICE LEVELS
hand, has continued straight up. So much for the aggregate measures
of velocity.
Let’s look inside the economy at various sectors and see what has
been happening to the velocity of money within particular groups.
As I indicated earlier, there are several ways of analyzing velocity
by economic sectors: deposit turnovers by geographical groupings;
nonfinancial velocities by flow of funds sectors, and nonfinancial veloci
ties of corporations by industry and asset size groups. Charts 6 to 11
present selected sector velocities from these sources.
In chart 6 we see that deposit turnover has been rising persistently
since 1943 in New York City and since 1946 in six other centers and
other leading centers. However, New York City velocity has grown
about twice as fast—3 percent per year— as velocity elsewhere.
Since 1954, New York City velocity has been about twice as high
as velocity in the other centers and about two-thirds again as high
as six other centers velocity.
Senator B u s h . I s that due primarily to financial transcations with
in New York such as the stock exchange and bond market?
Mr. S e l d e n . I think that is a relevant consideration. I think there
is another important consideration which will come out when we look
at chart 11, and I am referring specifically to the fact that the large
corporate accounts tend to be centered in New York City and there
has been a decided difference between larger and smaller firms with
respect to the behavior of their cash holdings.
I think you have the double effect of large corporations and their
efforts to economize on cash balances and the effect of stock market
transactions and so forth.
The C h a ir m a n . Mr. Selden, have you gone into the relative rates
of turnover of the dealers in Government securities and the dealers
in stock market securities ?
Mr. S e l d e n . I am familiar with the testimony of the New York
Clearinghouse president recently before the Congress.
The C h a ir m a n . That testimony before the Senate Banking and
Currency Committee was startling to me.
They segregated the accounts for the month of February. They
found that the dealers in Government securities have balances averag
ing only $34 million, but that the bank balances have grown over
$18.8 billion in 1 month. This was a monthly velocity of 557 and an
annual rate of 6,683.
Since there are only about 22 trading days in a month, this means
an average daily velocity of 25. The average velocity of commercial
transactions in New York is approximately 32 for the year as con
trasted with the 6,683.
These are the most astonishing figures I have ever seen. Do you
have any explanation of them ?
Mr. S e l d e n . In lesser degree one can also find some very great
velocity differences between wholesale traders and public utilities
industries, for example. The wholesale velocity indexes are likely
to run 50 or 60 per year, depending on the line of wholesale trade
that you are talking about, whereas the public utilities velocity is
more likely to be in the 8 to 10 range.
The C h a ir m a n . The 6,683 would seem to me to indicate hyper
blood tension.
EMPLOYMENT,
GROWTH, AND PRICEl LEVELS
677
Senator B u s h . In the type of operation that the chairman is talk
ing about, that is the dealer in these bonds.
Representative P a t m a n . Y ou mean Government bonds ?
Senator B u s h . Yes; principally.
That is where the big volume is. He has a relatively small ac
count in the bank. He may have a capital of a very few million
dollars.
The C h a i r m a n . Thirty-four million total value.
Senator B u s h . That is all of them together; is it not ?
Mr. S el d e n . That is right.
Senator B u s h . But their borrowing is enormous.
The question I wanted to ask is whether the fact that they are bor
rowing many times their capital almost constantly does not result in
this tremendous turnover ?
Mr. S el d e n . I think it is related to it.
This particular type of business enterprise certainly would not be
able to transact this tremendous volume of business with such small
cash unless it had ready access to bank credit and other sources of
funds. These businesses are in such an exposed position that it seems
to me their position would be extremely hazardous operating on such
small cash balances unless they had behind them assurances of credit
and other resources on which they could rely.
Senator B u s h . Of course, their collateral in the case of these Gov
ernment-bond dealers is triple A. There is not really any risk in
volved in them.
Mr. S e ld e n . That is correct, Mr. Chairman. However, there is
always the danger of price fluctuations.
Senator B u s h . But it is a constant daily turnover of their portfolio.
They are not investors. They are traders for the most part.
Representative P a t m a n . Mr. Chairman, was that 1958 ?
The C h a i r m a n . 1959.
Representative P a t m a n . I assume the same rate of turnover prob
ably prevailed in 1958.
The C h a i r m a n . They did not segregate the accounts.
Representative P a t m a n . And they involved Government bonds; is
that right, Professor, that 1959 was comparable?
Mr. S e l d e n . I have no information, but I am glad you raised the
point because the important question related to my discussion here is
the trend of velocity and I am quite sure, if you looked at it in earlier
years, you would find similar relationships between the velocity of
traders on the one hand, and ordinary accounts in New York City on
the other.
Whether this is true or not, one can only conjecture.
The C h a i r m a n . Mr. Selden, I have had some correspondence with
the Under Secretary of the Treasury about these figures because they
disconcerted me very much. I wrote Mr. Baird, Under Secretary of
Treasury, that it seemed they must be dealing in Government bonds
without margins.
Representative P a t m a n . Senator Douglas, that is probably related
to the fact that last year, in 1958, the commercial banks made a profit
of $681 million on the sale or disposition of Government bonds.
Senator B u s h . H ow do you measure that profit ?
Representative P a t m a n . It is measured by Federal Deposit Insur
ance Corporation figures.
EMPLOYMENT, GROWTH, AND PRICE LEVELS
678
(Information referred to follows:)
Insured commercial banks, 1936-58, profits on securities sold
[In millions of dollars]'
1958
1957
1956
1955
1954
1953
1952
1951
1950
1949
1948
1947
1946
_
__
_
_
_
-
__
681
64
31
57
417
39
34
57
91
73
60
100
209
267
1945
__
- —
_ _ _ _ _ _
130
1944
_ _
___ 103
1943
_____
66
1942 _
__
145
1941 _
_______178
1940 _
_____
_ .
____
215
1939
______
173
1938— __
- - ____
117
1937 _____—
___
268
1936 _
Senator B u s h . I s it profit on the sale of Government bonds or the
interest ?
Representative P a t m a n . Profit on the sale of Government bonds, on
the sale of securities.
I do not say that they are all Government securities, possibly onehalf of 1 percent might be some other type, but generally they are
Government securities. That is the highest amount that the com
mercial banks had ever made in any one year.
That is comparable to 1954 when we had the dip of the depression
in 1953 and bonds went dow^n low and the banks bought lots of bonds.
Then in 1954, when they went up, they sold them. That was the high
est trading profit they had ever made, up to that time—$417 million.
In 1957 when they went down and the banks evidently purchased
them, in the early part of 1958 they must have sold them and they made
50 percent more than they made in 1954. They made $681 million.
In order that you may have a comparison there, in the preceding
year it wras $64 million and the year before that, 1956, it wTas $31 mil
lion; in 1955, $57 million. In 1954, which was after the low period
of 1953, it went up $417 million; 1953, $39 million; 1952, $34 million;
1951, $57 million.
In other wTords, in the years 1954 and 1958, immediately after dips
in 1953 and 1957, the banks made enormous profits. I looked into this
1954 deal and I discovered that a fewrbanks profited enormously more
than others. I hope we can look into this 1958 situation and see where
those profits went.
It is possible that these transactions that Senator Douglas speaks of
had something to do with it and are doubtless related to it in some
way.
The C h a ir m a n . Does it not seem to you as though most of these
transactions in Government bonds must be without margin in view
of this high turnover? If an appreciable margin were required, the
rate of turnover w^ould be less than this, would it not ?
Mr. S e ld e n . Senator Douglas, I really can’t claim any familiarity
with the operations of the Government securities dealers that would
enable me to enlighten you on this. It is something I am sure would
be relatively easy to ascertain, but I don’t have the answer at my
fingertips.
EMPLOYMENT,
GROWTH, AND PRICE) LEVELS
679
My emphasis has been on the trends of velocity since the end of the
war and I should imagine if we were to go back 10 years we would
find a quite similar relationship between velocities of the securities
dealers and velocities elsewhere.
I see no particular presumption in these high figures that we have
quoted that it is a particularly recent development. However, it is
a very worthwhile topic for investigation.
The C h a i r m a n . At the same time that the clearinghouse testified
on the rate of turnover of dealers in Government securities, they
testified on the turnover in dealers of stocks. That was something at
the rate of over 200 to the year.
Mr. S e l d e n . That is right.
The C h a ir m a n . A s compared to a commercial rate of about 32 ?
Mr. S e l d e n . There you are getting almost into the wholesaling
range. Some wholesalers may go up as high as 90 or a hundred a year,
so that is not completely outside the realm of credulity, but these
other figures, I grant you, are quite phenomenal.
Senator B u s h . The answer to Mr. Patman’s query on page 29 o f
the Economic Indicator is the enormous rise in Treasury hills re
flected in the dip in yields from the middle of 1957 dow7n to the middle
of 1958, which is almost an unprecedented swing in such a short time.
Bankers who had bought Treasury bills during the 1957 period
could not help but have made an enormous profit on them by the
middle of 1958. The same would apply to most any other type of
paper because of the very sudden drop in interest yields.
Representative P a t m a n . I am talking about profits on securities
sold.
Senator B u s h . I am, too.
Representative P a t m a n . That $681 million seems out of line. In
insured banks they have between $5 and $6 billion of capital stock;
I am not including the surplus or the undivided profits.
This amount of profit on securities sold, in the 1 year would thus
come to between 10 and 15 percent on their capital stock. It just
seems to be a pretty high rate of profit.
Senator B u s h . Capital stock or capital stock and surplus?
Representative P a t m a n . I am talking about voting capital stock.
Senator B u s h . That is relatively a small amount to their total
capital funds.
Representative P a t m a n . It is, of course, smaller, but that is the
part that controls the banks. Security profits of between 10 and 15
percent on their paid-in voting capital stock in 1 year. It just seems
to me as though there must be some inside information or they could
hardly profit so much.
They are speculating in Government bonds in a market that is not
supervised, nor regulated. We control the onion market and the aspar
agus market and the w^heat market and things like that, but we don’t
have any control over the Government-bond market of any type or
character.
I think it is a challenge to this committee to go into that further.
Senator B u s h . It is all right with me, Mr. Chairman.
Mr. S e l d e n . Shall I continue with the reading of my statement?
The C h a i r m a n . Yes.
Mr. S e l d e n . Let’s turn to chart 7, which I have in wall chart form
as well as in the small set.
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EM PLOYM ENT, GROW TH, AND PRICE LEVELS
Chart 7 shows annual velocities for 1939-56 by five flow of funds
sectors: Consumer, corporate business, farm and noncorporate busi
ness, Federal Government, and State and local government.
On inspection of the chart, one is struck immediately writh the con
trast between wartime and postwar velocity movements.
From 1939 to 1949, velocity rose in some sectors and fell in others,
but after 1941, declining velocity became the order of the day. The
declines were much sharper for the Federal, consumer, and farm and
noncorporate sectors than for the corporate sector. State and local
velocity also fell substantially, though not as much as consumer
velocity.
The postwar period, on the other hand, has been characterized by a
pronounced upsurge of velocity in every sector. For all sectors, the
1939-45 peak value had been exceeded by 1955, by as early as 1947
in the case of the corporate sector.
Except for the Federal Government, whose velocity has moved
somewhat erratically, the rises have been remarkable steady through
out 1946-56. Even Federal velocity has not been far out of line since
1947, and its extremely low value in 1946 is largely the result of the
huge sums obtained through the eighth war loan in December 1945.
In addition to the broad pattern of similarity since the end of the
war, several differences among sectors are evident in chart 7.
Senator B u s h . H o w do you get these figures, Mr. Selden ?
Mr. S e l d e n . Senator Bush, these are ratios of spending by the
particular sectors involved to the average cash holdings at the end
of the year for these sectors. The source is the flow of funds ac
counts prepared by the Board of Governors of the Federal Reserve
System, and there are annual estimates.
I might say, incidentally, that I am able to compute these ve
locities only for the period 1939-56 because the Federal Reserve Sys
tem has discontinued its relevant statistical series here. Unless that
particular gap is remedied, we will not be able to extend data of this
kind beyond the year 1956.
The most obvious differences, perhaps, are the great differences in
velocity levels. We have State and local velocity in the lower tier,
consumer velocity above that somewhat, and then we have nonfarm
and noncorporate velocity, Federal Government velocity, and at the
top of the heap we have corporate velocity. So there are some strik
ing differences in level.
Another difference is in the degree of cyclical variability. It is
interesting to see that the decline m aggregate nonfinancial velocity
during the 1949 and 1954 recessions resulted solely from falling ve
locity in the corporate sector. Cycles showTup only in the corporate
sector, using the annual data I am using here.
Still another difference is the fact that corporate velocity has been
lagging since 1946. These are all plotted on ratio scale and if we
notice the slopes of these particular curves, we see that corporate ve
locity rises somewhat more slowly than the others, meaning that it
has been lagging somewhat since 1946.
Let’s turn to charts 8, 9, 10, and 11. These are business velocities
by various groups of business. They are computed from the annual
Statistics of Income volumes of the Internal Revenue Service.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
681
In chart 8 I have major groups such as trade, manufacturing,
public utilities, and mining. These are all annual velocities from
193L
Throughout the period 1931 to 1956 as well as for the period since
the end of World War II, w^e find broadly similar velocity movements
among these centers. Manufacturing velocity has been very close
to that of all nonfinancial corporations in level, trend, and year-toyear movements. That is the broad curve on the chart.
Trade velocity, though much higher, moves in similar fashion;
the same is true of mining veliocity, which is considerably lower than
the others.
Public utilities velocity, in contrast, has risen somewhat faster than
velocity in the other industry divisions. However, we get the same
impression from this chart as from charts 3, 6, and 7 of a general
and pronounced postwar rise in velocity.
Passing to charts 9 and 10, we find velocities for 13 of the 54 major
industry groups available in “Statistics of Income.”
We have here retail food, food and kindred products, retail trade,
and so forth. As one would expect when passing from the general
to the more detailed, charts 9 and 10 reveal some striking dissimilari
ties, both in velocity levels and in trends.
The differences in level are what one would expect on the basis of
the relationships shown in chart 8; hence they need not detain us.
With respect to trends, however, the range of annual growth rates
runs from a minus two-tenths of I percent for retail food trade to
4.7 percent for motor vehicles and equipment. Other rapidly growing
sector velocities wTere those of electrical machinery and equipment
(2.7 percent per year), textile-mill products (1.7 percent), and retail
trade (1.6 percent). Other laggards were food and kindred products
(0.2 percent), general merchandise retail trade (0.2 percent), and
paper and allied products (0.7 percent).
The velocities in chart 11 are by size sectors, rather than industry
sectors, as measured by total assets. Although I have computed veloci
ties for all 10 of the size classes available back to 1946, the chart shows
them only for under $50,000, $10 million under $50 million, and $100
million and over.
Two important facts emerge from analysis of chart 11 and the un
plotted size data. The first is that there is a definite tendency for
small firms to maintain higher velocity ratios than large firms. The
second fact, which I shall argue below and which is important for
an understanding of the postwar behavior of money, is the much
sharper rise in velocity for the largest firms than for any other size
class; a growth rate of 2.5 percent per year compared with 1.3 percent
for the smallest class and only 0.9 percent for firms of intermediate
size.
Now I will turn to the final phase of my remarks, which is an in
terpretation of the postwar behavior of money.
The annual GNP price index has risen in each of the last 20 years
(chart 1). Even on a quarterly basis there have been only a few in
stances of price declines since 1947, the earliest year for which the
quarterly GNP price index is available; these occurred in the first
three quarters of 1949, the first quarter of 1953, and the second quarter
of 1954 (chart 5). The rate of inflation has been highly uneven, of
38563 O— 59— pt. 4—
6
682
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS*
course, with periods of approximate stability in 1949 and early 1950
and in 1952-54 punctuating periods of more rapidly rising prices.
Between the first quarter of 1947 and the third quarter of 1958, the
GNP price index rose by almost 37 percent.
As we have already seen, we may analyze the postwar inflation by
means of the equation of exchange. The variables contained in this
equation are plotted in chart 5, quarterly, 1947-58. Each of them
rose substantially over this period; money by 23.7 percent, velocity
by 56.8 percent, and real GNP by 41.9 percent.
The rise in real GNP, of course, was a deflationary factor in the
sense that the strong aggregate demand for goods and services was
met in part by expanded supplies rather than by higher prices.
Since the volume of money has grown at less than its prewar long
term rate since 1947, and has fallen substantially relative to real
GNP, it is clear that monetary expansion during the postwar period
was not a major factor in inflation.
Velocity, on the other hand, not only expanded twice as fast as
the stock of money; it has been moving counter to its long-established
downward drift. For these reasons, it appears that an analysis of
postwar inflation must center on velocity.
The C h a i r m a n . Mr. Selden, I do not have before me the arith
metic; but, in the simplest form of this equation, would it not be
that 1.37 was equivalent to 1.237 times 1.568 divided by 1.409 ?
Mr. S e l d e n . One would have to take the absolute levels at the base
year.
The C h a i r m a n . I am speaking o f relative levels.
Have you performed that ?
Mr. S e l d e n . I haven’t performed that.
The C h a i r m a n . Y ou can draw the conclusion that monetary expan
sion has not been the major factor in inflation, but, rather, the
velocity ?
Mr. S e l d e n . Yes, sir.
The C h a i r m a n . Government deficits, therefore, have not been a
major factor in inflation ?
Mr. S e l d e n . Except insofar as Government deficits have a relation
ship to the velocity of money, which quite clearly might be possible.
The C h a i r m a n . But not to the quantity of money ?
Mr. S e l d e n . Not in the quantity of money in any important degree;
no, over the period as a whole.
Representative P a t m a n . Can you suggest any way to control the
velocity of money ?
Mr. S e l d e n . There are undoubtedly ways of controlling it, but
I think most of them are antithetical to our free enterprise system
and would be repugnant to all of us. If we look at what happened
during the war, on chart 7, we see the great dip in velocity during
the wartime years, and I think in some measure at least that was the
result of the controls—or regimentation, if you wish to call it that—
that we experienced ‘during the war. I don’t think any of us want
to put up with that during times of peace.
Representative P a t m a n . And that is the only way you know of to
control velocity ?
Mr. S e l d e n . There are other ways of influencing velocity, I am
sure, but from a policy point of view it has always seemed to me
EMPLOYMENT,
GROWTH, AND PRICE) LEVELS
683
that there are alternative policies at hand which would be superior
to any attempt to work on the velocity of money.
I think one could accomplish the same aims in other ways, and
therefore I have not spent a whole lot of time thinking about that
particular problem.
In all probability, most of the postwar velocity rise is simply a
readjustment from wartime abnormalities. Not until 1953 did the
income velocity of demand deposits plus currency regain its 1941 peak
and the income velocity of total deposits plus currency was still well
below its 1942 and 1943 values in 1957—see chart 3.
Our study of sector velocities offers further evidence that the
readjustment continued at least until 1951 and perhaps even until
1955. Although both corporate and Federal velocities snapped back
quickly to their early wartime or immediate prewar peaks, there
were prolonged lags in the other major sectors (chart 7). Farm
and noncorporate velocity reattained its 1939 value only in 1953,
State and local velocity did not do so until 1954, and consumer velocity
achieved this feat as late as 1955.
Furthermore, in 1939-41 the velocity of demand deposits plus
currency probably was still below its normal prosperity level because
of the unusual severity of the 1929-33 and 1937-38 contractions. If
this is true, then velocity in the postwar period has been influenced
by two distinct readjustment processes rather than one, and there is
no assurance that these processes have been completed even now.
The return to equilibrium levels is not the whole story, however.
Superimposed on this fundamental factor were other forces of a
velocity-increasing nature. Evidence of this can be seen in the fact
that corporate velocity, after having resumed its immediate prewar
level in 1947, continued to push upward during the next 10 years,
and by 1956 had established a high for the entire period since 1931
(chart 8).
Among these other velocity-increasing forces, I would list the gen
erally higher level of interest rates and particularly the increased
availability and yields of money substitutes. Perhaps these were
supplemented to a minor extent by a growing belief in the inevitability
of inflation.
The rising trend of long-term interest rates and rates on bank loans
is common knowledge and needs no documentation. Like velocity,
these rates have moved up and down with succeeding phases of post
war business cycles, but rises have exceeded declines and an upward
trend has resulted. However, since long-term rates were of limited
significance before the war as velocity determinants, there is no rea
son to think they have been particularly important since 1946.
In my judgment, the principal reason why velocity has been rising,
other than the simple readjustment from wartime restrictions and
prewar depressions, is the increased importance of money substitutes
in the economy.
I have already mentioned the fact that liquid assets have been
growing persistently relative to money. Households have relied in
creasingly on time deposits and savings and loan shares as sources
of liquidity, no doubt in response to greatly improved yields. State
and local governments, as well as businesses, have learned that short
term Treasury securities are an attractive alternative to cash, and the
684
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
Treasury has obliged them by converting more and more of the public
debt to short-term obligations.
But there have been other developments in the realm of money sub
stitutes. Although it cannot be easily documented, there appears to
have been a substantial growth of charge accounts, trade credit, credit
lines at banks, and credit cards, along with a general improvement in
credit ratings. All of these developments have facilitated purchases
without cash and thus have tended to increase overall expendituremojiey ratios; that is, velocity.
Another highly significant change has been the increasing im
portance of large nonfinancial corporations as lenders. I am referring
here to the growth of repurchase agreements between such corpora
tions and Government securities dealers whereby firms may lend to
dealers essentially on a call basis, thus gaining interest income without
sacrificing an appreciable amount of liquidity.
The importance of these arrangements, together with outright pur
chases of governments, can be seen clearly in the fact that velocity has
risen much more rapidly for large corporations than for any other size
class (see chart 11); in general, only large corporations participate
in such transactions. It also explains part of the higher growth rate
of velocity in New York City, where large corporate accounts are
concentrated, than elsewhere (chart 6).
In summary, as I see it the 1946-57 velocity rise was primarily a
readjustment from wartime dislocations and prewar abnormalities.
However, these readjustments have been magnified by the growth of
money substitutes of various sorts, together with a trend toward higher
interest rates.
The C h a i r m a n . May I interrupt you now to raise two questions?
Mr. S e l d e n . Yes, sir.
The C h a i r m a n . The first refers to your statement that State and
local governments, as well as businesses, have learned that short
term Treasury securities are an attractive alternative to cash, and
the Treasury has obliged them by converting more and more of
the public debt to short-term obligations.
Would you say that in the creation of longer public debt durations
that that practice has been carried out ?
Mr. S e l d e n . I think that can be ascertained by looking at the
maturity structures of the Federal debt. I don’t have them at hand,
but we could develop them very quickly.
I think we could show without any doubt that there has been no
lengthening of the debt.
The C h a i r m a n . There has been a shortening of the debt ?
Mr. S e l d e n . I believe that is correct.
Perhaps someone can do some research on that quickly.
The C h a i r m a n . What periods are you taking as a basis for com
parison?
Mr. S e l d e n . The postwar period in general is what I am talking
about.
The C h a i r m a n . Has this continued in the last 6 years?
Mr. S e l d e n . Oh, yes; despite frequent avowals to the contrary.
It has been a very difficult thing to achieve any lengthening of the
debt. Perhaps it has been done momentarily, but within a matter of
months any lengthening that has been achieved has been more than
offset.
EMPLOYMENT,
So
GROWTH, AND PRICE LEVELS
685
The C h a i r m a n .
that more and more of the debt has been put
in short-time obligations ?
Mr. S e l d e n . Yes, and I am arguing that this has a very definite
impact on the economy through the velocity of circulation of money.
The C h a i r m a n . That is, it increases the velocity of circulation of
money and therefore raises the price level ?
Mr. S e l d e n . Perhaps, yes.
Senator B u s h . On that point, you do not suppose that the Treasury
would not prefer to lengthen its debt if it were feasible, do you ?
Mr. S e l d e n . Y o u say feasible, Senator Bush. I firmly believe that
this is feasible at some price. The price is the heart of the contract,
and particularly in this case.
We get into the whole question of the limitation on interest on
long-term debt which Congress has imposed, and other related
problems.
Senator B u s h . I think that is right. I think there undoubtedly
have been political pressures on the Treasury not to raise the interest
rate and to keep the interest rate down. The Treasury has been
under attack from time to time, almost constantly in recent years,
about high-interest rates and tight money and so forth.
If they were going to offer bonds long enough to make any average
extension of maturity of debts, undoubtedly they would have to get
a new law passed which would raise the ceiling on the interest rate,
and I doubt very much that up to the present time the Congress would
have given them that. There has been no indication whatever from
the Congress that they would so extend the ceiling on interest rates.
I am mentioning this apropos of what the chairman said.
The Treasury has been caught in a sort of vice and has not had very
much choice.
Mr. S e l d e n . That is true. It is like the leaky roof that we don’t
do anything about until it’s raining and then it’s too late.
In my judgment, this legislative change should have been made
perhaps 2 or 3 years ago when the whole thing was more or less an
academic issue. To have public hearings and deliberations on this
question at this time w7hen yields on Government securities are push
ing up close to the limit creates a very real problem.
It is unfortunate that something was not done before.
The C h a i r m a n . I have here the hearings on the January 1959
Economic Report of the President. On page 4 is a chart showing
the average length of the marketable debt to date.
In December of 1951 it was 6.1 years. In December of 1958 it was
4.9 years. I think this is very eloquent testimony to the fact that the
Eisenhower administration has not in practice carried out its pro
gram of lengthening the Government debt.
I can remember Mr. Randolph Burgess before he became Under
Secretary of the Treasury attacking the Truman administration and
the Democratic Party for not lengthening out the debt. Yet here we
find the debt, far from being lengthened, has been shortened.
Representative C u r t is . Mr. Chairman, are we going to have a
political debate up here?
The C h a i r m a n . These matters cannot be entirely disassociated from
policy.
686
EM PLOYMENT,
GROWTH, AND PRICE LEVELS1
Representative C u r t is . I might agree with that, but I think this is
an inquiry. I would like to answer, because this has gotten into
politics.
The C h a i r m a n . Politics is the discussion on public policy.
Representative C u r t is . I am one who is perfectly willing to engage
in a political debate at anytime. I have many times tried to make the
point that I thought the place for that was in the well of the Senate
and the well of the House rather than in this committee. But I must
say that I think the reason we have this problem is because we have
had excessive expenditures under our Democratic controlled Con
gresses.
That is a political issue, and I do not think it is a question to be
discussed here.
Representative P a t m a n . May I comment on what Mr. Curtis said
and Senator Bush ?
Senator Bush said that the Secretary of the Treasury is caught in
a vise. I do not agree to that at all.
The Federal Reserve could handle this situation. The Federal
Reserve System is operating under a law. Under the Constitution of
the United States, the President of the United States is obligated to
take care that the laws are properly executed.
Faithful execution of the law governing the Federal Reserve—in
reality owned 100 percent by the Government, lock, stock, and bar
rel—should be used in the Government’s interest. The Treasury,
with cooperation from the Federal Reserve, could fix the long-term
interest rate at any rate it desired to fix it, whether at 4 percent or
2y2 percent. They need only to decide bonds in the future, and keep
them up at par. They would remain at par. There is no reason why
they should not.
Now in connection with what Mr. Curtis, my distinguished friend
and Member of the House, said about excessive expenditures, the ex
cessive expenditures have been in large part due to high interest rates.
High interest rates have been the most inflationary thing that we have
had.
Representative C u r t is . Let me make a suggestion.
Why do we not take an hour on the floor of the House this week
and we will engage in that debate. I have some questions I would
like to ask the witness.
Representative P a t m a n . I have, too, but I would just like to say—
I am not expecting to take too much time on this, Mr. Curtis—that I
wanted to comment on what you said. Excessive interest rates, to
the point of being extortionate interest rates, have caused the excessive
expenditures that threw all budgets out of balance from the Federal
Government down to the housewives.
Representative C u r t is . Mr. Chairman, may I ask that the witness
be permitted, if he wants to, to respond to the debate and maybe we can
get some information from him.
Mr. S e l d e n . I would rather complete my nearly completed state
ment. I would perhaps make one comment. That is that long-term
debt, which is subject to price supports by the Federal Reserve System
or any other agency, becomes, economically speaking, very similar to
short-term debt. In other words, it becomes a money substitute and
has precisely the same effects on velocity that I have been arguing
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
687
short-term debt has had. I can’t help feeling that we could get into
a self-defeating situation through any return to price supports of
long-term Government debt.
Having said that, may I simply read the last two pages of my testi
mony and then we can proceed with the questions ?
What I have done so far is offer an interpretation of why the velocity
of money has gone up. I now wTish to consider a counterinterpretation
of this phenomenon which I do not find satisfying intellectually. This
is the “cost push” or administered pricing kind of explanation of
velocity rises.
Despite the preponderance of contrary opinion, I cannot agree that
cost pushes and pricing practices have been significant factors in the
recent inflation. My reasons are developed at length in the study that
is appended to this statement, and therefore I shall only summarize
my basic points here.
1. Inflation must operate through increases in the volume of money
or its velocity or through decreases in the volume of transactions. In
most cases, those who stress the importance of cost pressures and pric
ing practices fail to indicate how these factors influence the variables
of the equation of exchange. Instead they commonly assume, im
plicitly or explicitly, that the money supply is elastic or that velocity is
passive.
There is no basis in fact for such assumptions in the contemporary
American economy; the Federal Reserve Board maintains tight con
trol of the volume of money, and velocity studies suggest a high degree
of regularity in that variable.
2. As we have just seen, the recent inflation is mainly attributable
to higher velocity. The reasons for these velocity increases seem to be
quite unrelated to cost pressures or pricing practices.
3. Since inflation means a rise in a general price index, one cannot
usefully discuss it in terms of what has happened to the price of X
or of Y ; there may very well be offsetting movements among other
prices. How ever, when one analyzes the pattern of price change dur
ing 1955-57, one discovers that most of the important price rises
occurred in industries that were characterized by high levels of pro
duction and employment, long work weeks, sizable unfilled orders,
and other indicators of strong demand.
4. Comparisons of money wage rates and output per man-hour—
productivity— are not useful in determining the sources of inflation
since the finding that the former has outrun the latter is equally con
sistent wyith demand and cost theories of inflation.
5. The foregoing should not be interpreted to mean that cost pres
sures and price policies are unimportant to our economy. On the
contrary, tltey may produce serious misallocations of resources, fric
tional unemployment, or other undesirable consequenges. My only
point is that they have been greatly exaggerated as causes of inflation.
There is an additional question of major importance on which I
wish to comment in closing: Will inflation continue in the years
ahead ?
I do not see much likelihood of deflation in the future. Since 1896
the only significant price-level declines have occurred during the
severe depressions of 1920-21 and 1929-33. Yet prices have risen in
nearly every business cycle expansion.
688
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
This suggests that there is a long-established inflationary bias in
our economy, certainly nothing that can be called a new inflation, as
long as serious business declines are avoided.
Such a conclusion may be unduly pessimistic, however.
Inflations of the past have been characterized predominantly by
rapid expansion of money but stable or declining velocity, apart from
the usual cyclical variations. Obviously much wTill depend on the
success of our monetary authorities in keeping the rate of growth of
money within reasonable bounds.
In my judgment, the present pow7ers of the Federal Reserve Board
are entirely adequate for the achievement of sound monetary policy.
The chief danjjpr is not lack of appropriate tools, but, rather, lack of
determination and political support in the use of existing tools.
However, experience since 1951 provides a basis for optimism in this
respect.
Assuming that this optimism turns out to be justified, the trend of
prices will depend on the behavior of velocity. If velocity levels off
and maintains a more or less horizontal trend, then the outlook for
price-level stability will be good. On the oher hand, if velocity con
tinues to rise at its recent rate, inflation will probably continue.
The future trend of velocity will depend on the relative strength
of the various velocity determinants discussed earlier. We can con
fidently anticipate continued growth of real income per capita and
this should exert downward pressure on velocity.
On the other hand, we have little scientific basis for predicting the
future of interest rates, money substitutes, and other velocity deter
minants, and a prediction of the trend of velocity is therefore not
worth much.
My guess is that the upward drift in velocity will come to a halt
within the next few years. Whether this turns out to be the case,
only time will tell.
(Complete prepared statement of Mr. Selden follows:)
S t a t e m e n t o n t h e B e h a v i o r of M o n e y b y R ic h a r d
c i a t e , N a t i o n a l B u r e a u of E c o n o m ic R e s e a r c h
of B a n k i n g , C o l u m b i a U n i v e r s i t y
T.
Seld en , R ese a r ch A sso
A s s o c ia t e P ro f esso r
and
I. INTRODU CTORY R E M A R K S
Mr. Chairman and members of the Joint Economic Committee, I greatly appre
ciate the opportunity you have given me to take part in your important study
of employment, growth, and price levels. My topic today is the behavior of
money. There are two aspects of money behavior: Changes in quantity and
changes in velocity of circulation. I shall devote most of my formal presenta
tion to the latter, for two reasons: The general public is much less familiar with
velocity as an important economic variable, and it is the aspect of money be
havior on which I am most qualified to speak.
Although I shall attempt to summarize the historical record over the past 90
years, the major portion of my remarks will deal with the period since 1945.
As all of us are painfully aware, the postwar years have been years of inflation,
by and large. We are now in the midst of a great debate on the nature of this
inflation. Many of the participants in this debate regard the recent episodes
of rising prices as fundamentally different from those of the past. Some talk
of “cost push” inflation, while others point to the behavior of “administered”
prices; but these groups unite in concluding that what we have been experiencing
recently is a “new” inflation, in sharp contrast to the “classic” demand inflations
of earlier periods. The material I will present has a direct bearing on this
debate, although it will not settle the basic issues.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
689
Whatever the causes of postwar inflation, they are susceptible of analysis by
means of the equation of exchange. This equation, which can never be false,
states that any flow of payments can be regarded on the one hand as the
quantity of money multiplied by its velocity, and on the other as the average
price per transaction multiplied by the number of transactions. In symbols,
MV=PT. The equation of exchange tells us that any rise in P, the price level,
must be accompanied by a proportionate rise in M or V or a proportionate fall
in T. When we apply this system of analysis to the postwar period we discover
that rising velocity has been an important characteristic of the recent inflation.
Later in this statement I shall offer some explanations of the postwar
tendency for velocity to rise, but it may be appropriate to state a major con
clusion here. While undoubtedly it is true that no two inflations are exactly
alike, I do not find strong support for the commonly held theory that recent
inflations have been fundamentally different from earlier ones.
ii .
som e
e s s e n t ia l
concepts
and
t h e ir
s t a t is t ic a l
counterparts
It will be well worth our while to spend a few moments establishing some
terminological ground rules at the outset. In addition it may be useful to
consider the adequacy of statistical measures for the variables under discussion.
Inflation
Most economists use this term to denote a rise, whether large or small, in the
price level as measured by a broad price index. It is important to recognize
that a rise in any particular price, in and of itself, is not inflation, there may be
compensating declines in other prices included in the index. Indeed, with a
given total demand for goods and services one would normally expect such
offsetting price movements.
In the United States there are three principal measures of the price level:
the BLS Wholesale Price Index, the BLS Consumer Price Index, and the Com
merce Department’s implicit price deflators for gross national product. The
first is available annually from 1801 and monthly from 1890; the second is avail
able annually from 1913 and monthly from 1941; and the third is available an
nually from 1929 and quarterly from 1947. In addition, Dr. Simon Kuznets
has estimated GNP price deflators back to 1869 (chart 1). None of these price
indexes is entirely adequate for the study of inflation, but the Consumer Price
Index is the least satisfactory of the three because of its narrow scope and its
relative sluggishness. The Wholesale Price Index has two major shortcomings:
its omission of the prices of services and its failure to pick up all departures from
list prices. Where annual or (since 1947) quarterly data will suffice the implicit
price deflators are probably our best measure of the price level because of their
relatively broad scope.
Money and money substitutes
Money is anything that is generally accepted, and at par value, in the settle
ment of debts. In the United States only currency and demand deposits fit this
definition exactly. However, there are many other assets which, though not used
as exchange media, are very close substitutes for currency and demand deposits
in the sense that they can be converted into the latter quickly and without risk
of price fluctuation. What we have, essentially, is a continuum of assets with re
spect to their moneyness or liquidity. At one extreme there is money, the per
fectly liquid asset, and at the other there are highly illiquid assets such as art
objects. Most assets are between these extremes, some approximating money
in their liquidity, others falling toward the less liquid end of the scale.
Prominent among the close money substitutes are commercial bank time de
posits, savings accounts at mutual savings banks, series E bonds, and savings
and loan shares. Because of their high liquidity it is likely that these assets
influence the price level in much the same way as money proper. For this
reason some economists have defined money broadly to include other highly
liquid assets in addition to currency and demand deposits. Whatever the
theoretical merits of this procedure may be, we have no choice but to do this
in historical studies of the pre-1914 period. This is because bankers had little
incentive to distinguish between time and demand deposits before passage of the
Federal Reserve Act introduced much lower reserve requirements for the former
than for the latter. For this early period, therefore, money must be regarded
as currency plus total bank deposits.
690
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS:
Until recently the best money estimates have been those of the Federal Re
serve System, covering the period since 1892. Up to 1922 these estimates con
sist of the amount outstanding at the close of business on a single date in June
of each year; even as late as 1942 total money is given only for midyear and
yearend dates. A major extension of monetary statistics is now nearing com
pletion at the National Bureau of Economic Research. Under the direction of
Prof. Milton Friedman and Mrs. Anna J. Schwartz monthly estimates of money
have been prepared back to 1907, and annual and semiannual estimates to 1867.
Chart 1 shows this series on an annual basis; its month-to-month rate of change
is plotted in chart 2.
Velocity
As a broad historical generalization it is undoubtedly true that most of the
world’s significant inflations have resulted from excessive growth of money.
Realization of this fact explains the continuing appeal of the “quantity theory
of money.” But it is also true that velocity sometimes influences the price level,
even in the absence of changes in the quantity of money, and that is why velocity
is worth discussing. Despite the long history of the concept and the large body
of data relating to it, velocity remains a controversial topic. The plain truth
is that we have only begun to understand why money circulates rapidly in
some periods and slowly in others.
The velocity of money is simply the average number of times each dollar is
spent during a year (or other time unit). Economists have confused matters
somewhat by coining a variety of synonyms, including rapidity, frequency of
use, turnover rate, and so forth. By a simple transformation of the equation
of exchange it is obvious that velocity is the volume of payments per unit of
money: V=PT/M .
So far I have not indicated what payments are described by the equation of
exchange. Depending on the purpose at hand they may consist of all purchases
made during the year, less barter transactions, or they may include only cer
tain types of purchases (e.g., purchases made by check, purchases of currently
produced goods and services, purchases by consumers, and so forth). There
is an associated velocity concept, of course, for every conceivable payments
flow. It is therefore misleading to talk of “the” velocity of money.
The three velocities most frequently mentioned in economic literature are
aggregate transactions velocity, income velocity, and deposit turnover. The
first is the ratio of all monetary purchases to average money during the year;
the second is the ratio of national income or product to average money; and
the third is the ratio of purchases by check to average demand deposits during
the year. In addition to these three one also encounters aggregate nonfinancial
velocity, which is the ratio of all purchases of goods and services to average
money, and sector velocities, which are payments-money ratios for particular
groups of spenders (e.g., manufacturing corporations, holders of demand de
posits in New York City banks, etc.). If we push the sector velocity concept to
its logical limit we may visualize every holder of cash as maintaining some ratio
of purchases to cash balances. Averaging these countless millions of individual
velocities we obtain aggregate transactions (or nonfinancial) velocity.
Because of the lack of information about currency payments there is no sta
tistical measure of aggregate transactions velocity, but there are fairly good
measures of each of the other velocities described above.
1.
Income velocity. We have annual estimates of income velocity from 1869
using the National Bureau’s money series (total deposits plus currency) as de
nominator and Dr. Kuznets’ net national product series as numerator (chart
1). If money is defined as demand deposits plus currency we have annual in
come velocity estimates from 1914 (chart 3). Beginning in 1929 monthly and
quarterly estimates are available embodying the Commerce Department per
sonal income series and the National Bureau’s money^series. Another lessthan-annual income velocity series, in my judgment superior to the series just
mentioned, covers the period since 1939. This is the ratio of quarterly GNP to
outstanding money. This series is particularly useful for the postwar period
because we now have quarterly implicit price deflators and estimates of real
output back to 1947 (chart 5).
In general we may be confident that these income velocity series are reliable.
So far as the money component is concerned there can be no question of this,
particularly since 1907, the initial date of the National Bureau’s monthly series.
Even for earlier years it is doubtful that use of 1 day’s figures to represent an
entire year introduces any significant error; the volume of money is a relatively
EMPLOYMENT, GROWTH, AND PRICE/ LEVELS
691
stable magnitude in the short run, as reference to chart 2 will indicate. While
we cannot rely equally on the income estimates, we may nevertheless be sure
that the range of error is insufficient to invalidate their use for broad historical
analysis.
2. Deposit turnover. Annual deposit turnover estimates, published by the
Federal Reserve System, go back to 1919 (chart 3). As noted below, deposit
turnovers for New York City and other groups of reporting centers also date
from that year. The Federal Reserve has published monthly deposit turnovers
for a broad group of centers since 1943. In each case these series consist of
the ratio of debits against checking accounts to the average amount of such
accounts during the period.
These deposit turnover series have numerous statistical defects. Every time
a check is drawn its amount is added to total debits, even if it is payable to
cash or represents a transfer from one account to another or arises out of
lending or debt repayment. None of these debits is a payment in the sense that
is relevant to the equation of exchange. Furthermore, another large class of
debits, checks drawn for the purchase of stocks and real estate, is of limited
value in the analysis of inflation and the level of output. During the late
1920’s rapid growth of these purely financial debits caused a marked disparity in
the behavior of deposit turnover and income velocity (chart 3).
Because of the predominance of check payments in the American economy it
is likely that these deposit turnover series are fairly good indexes of aggregate
transactions velocity, statistical flaws notwithstanding.
3. Aggregate nonflnancial velocity. A statistical measure of this velocity has
become available annually for the period 1939-56 as a byproduct of the Federal
Reserve’s flow of funds system of social accounts (chart 3). The numerator is
total nonflnancial uses of funds. Stock purchases, debt transactions, and purely
technical operations involving money are excluded; payments by currency are
meant to be included as well as those by check. The denominator is essentially
the standard Federal Reserve money series. The version of nonflnancial veloc
ity shown in chart 3 excludes time deposits from money. The quality of this
series is hard to assess. My own judgment is that it is about as reliable
statistically as deposit turnover and much sounder in concept. Unfortunately,
the Federal Reserve has no plans at present for extending the required data
beyond 1956.
4. Sector velocities. Until recently very little attention has been paid to
velocity behavior by economic sectors, except for the Federal Reserve break
downs of deposit turnover by New York City, other leading centers, and smaller
centers (chart 6). By themselves these geographical deposit turnovers have
little value except to isolate the effect of financial operations, which mainly
affect New York City banks.
The Federal Reserve flow of funds accounts provide data for more meaning
ful sector velocities since they include both nonflnancial uses of funds and
year-end money holdings for consumers, the Federal Government, State, and
local governments, and several broad categories of business (chart 7). These
are annual estimates over the period 1939-56.
Finally there are several ways of computing velocities for various parts of
the business sector of our economy. Since 1931 the annual statistic® of income
volumes have tabulated financial statements of corporations filing tax returns
in such a manner that reliable sector velocities can readily be computed for
industry and size groups (charts 8 to 11). Similarly, since 1947 quarterly
velocities for major manufacturing industries can be derived from the Federal
Trade Commission-Securities and Exchange Commission Quarterly Financial
Reports for Manufacturing Corporations. One might also compute velocities
directly from published financial reports. All of these business sector velocities
have flaws, but they do not seem sufficiently serious to impair their usefulness.
III. T H E
H IS T O R IC A L
RECORD
OF
1945
Trends
Even a casual glance at chart 1 reveals that the trend of total deposits plus
currency was upward and that of velocity downward, with only brief interrup
tions in both cases, over the period 1869-1945. As far as money is concerned
this is what one would expect in a growing economy; the equation of exchange
makes it clear that failure of M to expand as rapidly as T would exert down
ward pressure on P, unless V were to rise. But V has fallen historically, as
we have just seen, and therefore M has had to expand even faster than T to
692
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
avoid long run deflation. The downward drift of prices in the last quarter of
the 19th century indicates that M grew insufficiently during that period (chart
1) ; likewise, the predominance of inflation since then indicates that on the
whole monetary expansion has been excessive in this century.
It will be recalled that the income velocity series shown in chart 1 utilizes
a broad definition of money. Chart 3 permits us to study trends in the velocity
of demand deposits plus currency for the much shorter period since 1919. Again
the general movement of income velocity was downward to 1945. However,
nearly all of the decline occurred during the severe business contraction of
1930-33 and the wartime restrictions of 1942-45. Except for these more or less
catastrophic events it is not at all clear that the income velocity of demand
deposits plus currency would have declined after 1919. This also raises the
unanswerable question of whether this velocity fell during 1869-1919, as its
more broadly defined counterpart did.
Demand deposit turnover had no simple trend during 1919-45 (chart 3). It
rose initially and then fell sharply and almost continuously from its 1929 peak
to a trough in 1944. The net effect, of course, was a substantial downward
movement of velocity. Again we have no way of knowing how this velocity
behaved before 1919.
Cycles
The existence of cycles in the behavior of money is well established. In gen
eral velocity rises during business expansions and falls during business expan
sions ; this pattern has been highly regular since the turn of the century. The
volume of money varies less than velocity cyclically. It usually rises during
contractions as well as expansions, but its rate of increase is less during the
former than the latter. Only during severe contractions does the volume of
money actually decline. These behavior patterns are readily apparent in charts
1, 3, and 5 for velocity and in charts 1, 2, and 5 for money. They are also shown
somewhat more rigorously in table 1, which I have taken from a forthcoming
publication by Professor Friedman. Needless to say, the interpretations placed
on these data are my own.
Table 1 summarizes the result of standard (though somewhat abbreviated)
National Bureau business cycle analyses as applied to annual data for money,
velocity, and related variables. It would prolong this discussion unduly to
describe the method of analysis fully but in brief the procedure involves the
following steps:
1. The dating of business cycle peaks and troughs. The National Bureau has
assigned monthly and quarterly as well as annual dates, but only the latter
concern us here.
2. For each trough-to-trough business cycle, computation of a cycle average
for the series under analysis.
3. Computation of cycle relatives by taking trough and peak year values as a
percent of the cycle average.
4. Computation of change per month in cycle relatives during expansions
and contractions. This is done for expansions, for example, by subtracting the
initial trough relative from the peak relative and dividing the difference by the
expansion’s duration in months.
5. Averaging these changes per month for a large number of cycles to obtain
average business cycle patterns during expansion and contraction phases. It
is these numbers that appear in table 1.
The data in table 1 cover the 18 complete peacetime business cycles between
1870 and 1954. They are arranged in two groups according to severity of the
cycle. We see that on the average money grew substantially during the expan
sions and moderately during the contractions of the 12 mild cycles. During
the six deep depression cycles, on the other hand, money increased at about the
same rate in expansions but fell during contractions. The velocity of total
deposits plus currency rose only slightly during expansions, whether in mild or
severe cycles, but fell markedly in both types of contractions.
The other variables in table 1 also deserve our attention. Income, both real
and money, rose and fell with business cycles much as one would expect. The
price level also has demonstrated cyclical conformity, but the contrast between
mild and deep depression cycles is notable. We see that moderate inflation has
been characteristic of both types of expansions, but that deflation has been
much greater during severe than mild contractions. Indeed, as reference to
chart 1 indicates, prices actually continued to rise during several business
contractions.
EM PLOYMENT,
GROWTH, AND PRICEl LEVELS
693
Table 1.— Cyclical movements in income, money stock, income velocity, and
prices: Difference in monthly rate of change between reference expansion and
contraction, annual analysis, 1810-1954, excluding war cycles
Change per month in reference-cycle relatives
during reference
12 mild depression cycles:
Money income. ____________ _______________________
Money stock____ _____ _______________________ ____ .
Income velocity _______ _ _ _ _ _ __ __ __ ____
Implicit price deflator.____ _______________ _. _______
Real income..
. ____________________________ ____
___________________ ..
Real stock of money________
6 deep depression cycles:
Money income____ _______________ ___________________
Money stock_______________ ________________________
Income velocity___ __________________________________
Implicit price deflator____________________ ____ ________
Real income ._ _ _ _ _ ....... ... ............ .......... .... ........
Real stock of money____ ______________________________
Expansion
Contraction
(1)
(2)
Excess of
expansion
over con
traction
(3)
0.64
.55
.08
. 12
.52
.43
—0.07
.28
—.32
-.0 2
-.0 5
.30
0.71
.27
.40
.14
.57
.13
.64
.60
.02
.16
.46
.42
-.9 7
-.2 8
-.6 9
-.4 4
-.5 3
.18
1.61
.88
.71
.60
.99
.24
N ote —All series have expansion period I-V.
Source: The series were analyzed as described in A. F. Burns and W. C. Mitchell, Measuring Business
Cycles (NBER, 1947), pp. 197-202. Because of rounding, col. 3 sometimes disagrees with the difference
between cols. 1 and 2. Deep depression cycles are 1870-78, 1891-94, 1904-8, 191&-21, 1927-32, and 1932-38.
All others are mild depression cycles except for war cycles 1914-19 and 1938-46, which are excluded. The
basis of classification is described in the NBER monograph on the money supply now in preparation.
Money income is net national product; current prices, preliminary estimates by Simon Kuznets, NBER,
prepared for use in the study of long-term trends in capital formation and financing in the United States:
Variant III (from 1929 based on estimates of commodity flow and services prepared by the Department
of Commerce). Money stock is averaged to center on June 30 from data in the monograph just mentioned.
Income velocity is money income divided annually by money stock. Implicit price deflator is money
income divided by real income. Real income is net national product, 1929 prices, Variant III from same
source as money income. Real stock of money is money stock divided by implicit price deflator.
Informative though it is, table 1 tells us nothing of the relation between
cyclical turning points in money and velocity and the peaks and troughs of
business cycles. In other words, I have said nothing so far to indicate whether
these are leading or lagging series. For velocity it is difficult to answer this
question because of the relatively short time spans of our monthly or quarterly
series; annual series do not convery much information of the type we seek. My
investigations lead me to believe that velocity is more or less coincident with
business cycles, and in any case does not usually lead general business down
turns.
We are somewhat better off with respect to money, although here we must
work with cyclical variations in the rate of change rather than in money itself.
Chart 2 shows month to month rates of change in seasonally adjusted money,
1907-55. The shaded areas of this chart represent business cycle contractions
and the dots indicate turning points in the series. Professor Friedman, in the
paper he prepared for this committee last year, concluded that “on the average
the rate of change of the money supply has reached its peak nearly 10 months
before the peak in general business and has reached its trough over twelve
months before the trough in general business.” Thus the rate of change in
money is a leading series.
Determinants of observed behavior
It would be presumptions of me to give the impression that we fully under
stand the various aspects of money behavior just described. This is particularly
true with regard to velocity. Nevertheless, I shall summarize what appear to
me to have the main determinants of velocity during 1869-1945 before turning
to the postwar behavior of money. A further discussion of these matters may
be found in my study of the recent inflation (pp. 7-8), which I have appended
to this testimony.
We have already seen that velocity is the ratio of a flow of payments to a
stock of money. All of this money must be held by someone at all times. If
an individual decides that he is holding too much money he may get rid of it
694
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
by spending it. All spending units taken together, on the other hand, cannot do
this, for the money disposed of by A will be acquired by B, with the total re
maining unchanged. Thus it is broadly true that the public cannot affect the
quantity of money, M. But in trying to get rid of superfluous cash the public
can influence the real volume of money, M/P, by bidding up the price level. It
can also thereby affect velocity, PT/M . The question of what determines ve
locity can therefore be rephrased to “ why does the public wish to hold varying
quantities of money from time to time in relation to the payments it makes?”
One determinant of the public’s demand for money to hold, and therefore of
velocity, is probably the level of interest rates. Holders of cash are keeping
a portion of their wealth in a barren form (except insofar as interest is paid
on deposits). When interest rates are low this involves no great sacrifice and
the public is content to maintain large balances relative to payments ; accord
ingly, velocity is low. High interest rates cause people to consider ways of
economizing on cash so that advantage may be taken of attractive opportunities
to len d; the result is high velocity.
Another important factor influencing velocity is the level of yields on money
substitutes, together with the availability of credit cards, trade credit, and
other devices that take the place of cash. Higher yields or increased avail
ability will cause the public to satisfy its liquidity needs by holding items other
than cash. Here again the result will be a rise in velocity as the public expands
the volume of payments in a futile attempt to unload money.
A third velocity determinant is the general level of well-being, as measured
by real income per capita. It is common knowledge that as income expands
consumption of some articles rises even faster than income while consumption
of others lags (or may even decline). We may apply the same idea to money.
It seems reasonable to suppose that the public will seek additional cash, rela
tive to the payments it makes, as real income per capita rises. This, of course,
implies falling velocity as an attribute of economic growth.
A fourth determinant, in a sense the fundamental one, is the extent to which
the holding of money is useful. This varies from one spending unit to another
and for the entire economy over time, depending on the economic environment.
The pattern of receipts and payments is one element of this environment; an
other is the risk of unforeseen reductions in receipts or additions to payments.
These factors are difficult to measure, and the degree to which variations in the
utility of money cause velocity fluctuations is therefore hard to assess.
The final velocity determinant I shall mention here is the public’s expectations
about the future value of money. I f the notion becomes widespread that prices
will rise, there is likely to be an attempt to move out of cash and into other assets
that are more inflationproof. As we have already seen, the public at large
cannot do th is; it can only augment the flow of payments, thus increasing veloc
ity. Perhaps I should add that this is a case of a self-confirming prediction: if
the public expects price rises it may behave in such a manner that prices will
indeed rise.
We can now frame some tentative answers to the following questions: Why
did velocity decline so persistently over the period 1869-1945? Why does veloc
ity rise during business expansions and fall during contractions?
The most likely answer to the first question is that velocity has declined since
1869 because per capita income has risen. Apparently the public wishes to
“ consume” more of the services of money as income grows, and this means keep
ing a larger stock of cash in relation to expected payments. There is a very real
question, however, whether this reasoning applies to all components of money or
only to time deposits; the behavior of the velocity of demand deposits plus cur
rency since 1919 does not conform well to this income hypothesis. Rather, the
extremely severe depression of the 1930’s and the period of wartime restrictions
before full recovery had been reached probably account for most of the velocity
decline observed between J919 and 1945.
One might have expected a rising rather than a falling trend of velocity since
1869 on the ground that improved techniques of managing cash, particularly by
businesses, have diminished the utility of money. No doubt such improvements
did occur, but during 1869-1945 they were more than offset by the income factor,
aided to a minor extent perhaps by a trend toward lower interest rates. The
same is true of the much discussed growth of financial intermediaries and their
spawning of money substitutes. Up to 1945 at least this trend was not strong
enough to produce rising velocity.
Let us turn briefly to the cyclical behavior of velocity. There can be little
doubt that variations in interest rates, particularly short-term rates, are respon
EMPLOYMENT,
GROWTH, AND PRICE) LEVELS
695
sible for some of the cyclical pattern in velocity. Other relevant factors may
include cyclical oscillations in price expectations and in the degree of optimism.
However, perhaps the most promising clue is revealed by the sector studies de
scribed below : the fact that cycles are virtually nonexistent except in the cor
porate business sector. This suggests that the main factor responsible for
cyclical variations in aggregate velocity may be business expectations concerning
the profitability of new plant and equipment and inventories compared with the
utility derived from keeping cash on hand. Probably a complete answer here
will be forthcoming only when the business cycle itself is fully understood.
IV .
T H E P O ST W A R BE H AVIO R OF M O N E Y : T H E H IS T O R IC A L RECORD
In some respects money has behaved much the same since 1945 as earlier in
our history, and in other respects not. I shall review these aspects of behavior in
the following paragraphs, taking up first the volume of money and other liquid
assets, next changes in the aggregate velocity of money, and finally velocity
change within particular sectors of the economy.
The volume of money and money substitutes
Chart 1 contains the salient facts about the postwar volume o f money, includ
ing commercial bank time deposits. The wartime period of rapid growth ended
abruptly in 1945. For 3 years, during 1947-49, the stock o f money was at a
complete standstill. Growth resumed in 1950 and has continued since then, but
at a noticeably slower rate than in earlier peacetime years.
Chart 4 permits us to analyze the components of money in some detail. (Note
that this chart, which I have taken from the Federal Reserve chart book, is
plotted on an arithmetic scale in contrast to the logarithmic vertical scale of
the other charts I have presented ; furthermore, deposits in mutual savings banks
and the postal savings system are included in chart 4 but excluded from chart 1.)
Demand deposits were nearly stable during 1947-4:9, rose moderately during
1950-54, rose only slightly during 1955-56, fell in 1957, and rose sharply in 1958.
Since currency has remained virtually unchanged since 1946, the behavior of
demand deposits plus currency is nearly identical to that of demand deposits
alone. Time deposits, on the other hand, have grown throughout the postwar
period and with great rapidity during 1952-54 and 1957-58.
An important characteristic of the postwar period has been the sharp expansion
of money substitutes. This is evident from the data in table 6 o f the appended
study of recent inflation. As this table shows, the ratio of money substitutes to
money rose steadily during 1952-57; and the rise would have been even more
striking had time deposits been counted as money substitutes rather than as
money. The only major money substitute not participating in this remarkable
growth has been U.S. savings .bonds. The expansion of savings and loan shares
has been especially dramatic.
Aggregate measures of velocity
In sharp contrast to the period 1869-1945, the velocity of money has moved
steadily upward, except for cyclical downturns, since the end o f World War II.
This is true whether one measures velocity by deposit turnover, aggregate nonfinancial velocity, or income velocity, and whether or not one includes time
deposits in money. By 1957 the ratio of annual gross national product to
demand depoists plus currency reached a level it had not experienced since 1931,
and the same was true of demand deposit turnover (chart 3).
It is interesting to note that the three aggregate velocity measures have dis
played highly similar growth rates since the end of the war—1.8 percent per year
for income velocity and 2 percent for the other two. This is a greatly different
situation from the 1920’s when deposit turnover rose sharply but income velocity
did not. Income velocity and aggregate nonfinancial velocity appear to be taper
ing off in their rates of grow th; deposit turnover, on the other hand, has con
tinued straight up.
Sector velocities
As I indicated earlier, there are several ways o f analyzing velocity by economic
sectors: deposit turnovers by geographical groupings; nonfinancial velocities by
flow of funds sectors; and nonfinancial velocities o f corporations by industry and
asset size groups. Charts 6 to 11 present selected sector velocities from these
sources.
696
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS
In chart 6 we see that deposit turnover has been rising persistently since 1943
in New York City and since 1946 in six other centers and other leading centers.
However, New York City velocity has grown about twice as fast (3 percent per
year) as velocity elsewhere. Since 1954 New York City velocity has been about
twice as high as velocity in the other centers and about two-thirds again as high
as six other centers’ velocity. One other point is worth mentioning: New York
City velocity, on an annual basis, fails to exhibit cyclical declines, while the
other two sector velocities do.
Chart 7 shows annual velocities for 1939-56 by five flow of funds sectors:
consumer, corporate business, farm and noncorporate business, Federal Govern
ment, and State and local government. On inspection of the chart one is struck
immediately with the contrast between wartime and postwar velocity movements.
From 1939 to 1941 velocity rose in some sectors and fell in others, but after 1941
declining velocity became the order of the day. The declines were much sharper
for the Federal, consumer, and farm and noncorporate sectors than for the
corporate sector. State and local velocity also fell substantially, though not as
much as consumer velocity.
The postwar period, on the other hand, has been characterized by a pro
nounced upsurge of velocity in every sector. For all sectors the 1939-45 peak
value had been exceeded by 1955— by as early as 1947 in the case of the cor
porate sector. Except for the Federal Government, whose velocity has moved
somewhat erratically, the rises have been remarkably steady throughout 1946-56.
Even Federal velocity has not been far out of line since 1947, and its extremely
low value in 1946 is largely the result of the huge sums obtained through the
eighth war loan in December 1945.
In addition to the broad pattern of similarity since the end of the war several
differences among sectors are evident in chart 9. Most obvious, of course, are
the great differences in velocity levels, with corporate business at the upper
end of the scale and State and local governments at the bottom. Another dif
ference is in the degree of cyclical variability. It is interesting to see that
the decline in aggregate nonfinancial velocity during the 1949 and 1954 reces
sions resulted solely from falling velocity in the corporate sector. Still another
difference is the fact that corporate velocity has been lagging since 1946, its
rate of increase being only about half those of the consumer and farm and
noncorporate sectors.
The business velocities shown in charts 8 to 11 were computed from statistics
of income. They are ratios of annual expenditures (except capital outlays) to
year-end holdings of currency and deposits (time as well as demand), as
reported by corporations filing tax returns. Those in chart 8, covering the
period 1931-56, are for selected major industry divisions: manufacturing,
mining, public utilities, and trade. Throughout this period, as well as since
the end of World War II, we find broadly similar velocity movements among
these sectors. Manufacturing velocity has been very close to that of all non
financial corporations in level, trend, and year-to-year movements. Trade
velocity, though much higher, moves in similar fashion; the same is true of
mining velocity, which is considerably lower than the others. Public utilities
velocity, in contrast, has risen somewhat faster than velocity in the other indus
try divisions. However, we get the same impression from this chart as from
charts 3, 6, and 7 of a general and pronounced postwar rise in velocity.
Charts 9 and 10 show velocities for 13 of the 54 major industry groups
available in statistics of income. As one would expect when passing from the
general to the more detailed, charts 9 and 10 reveal some striking dissimilarities,
both in velocity levels and in trends. The differences in levels are what one
would expect on the basis of the relationships shown in chart 8; hence they
need not detain us. With respect to trends, however, the range of annual
growth rates runs from a minus two-tenths of 1 percent for retail food trade
to 4.7 percent for motor vehicles and equipment. Other rapidly growing sector
velocities were those of electrical machinery and equipment (2.7 percent per
year), textile-mill products (1.7 percent), and retail trade (1.6 percent).
Other laggards were food and kindred products (0.2 pecrent), general mer
chandise retail trade (0.2 percent), and paper and allied products (0.7 percent).
The velocities in chart 11 are by size sectors, rather than industry sectors,
as measured by total assets. Although I have computed velocities for all 10
of the size classes available back to 1946, the chart shows them only for under
$50,000, $10 million under $50 million, and $100 million and over. This sacri
fices little information since the five smallest classes are clustered closely
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
697
together throughout the period, and the intermediate classes behaved much
like the $10 million under $50 million class.
Two important facts emerge from analysis of chart 11 and the unplotted size
data. The first is that there is a definite tendency for small firms to maintain
higher velocity ratios than large firms. The second fact, which I shall argue
below is important for an understanding of the postwar behavior of money, is
the much sharper rise in velocity for the largest firms than for any other size
class—a growth rate of 2.5 percent per year compared with 1.3 percent for the
smallest class and only 0.9 percent for firms of intermediate size.
V. T H E P O S T W A R BE H AVIO R OF M O N E Y AN D PRICES : A N
IN TER PRE TA TIO N
The extent of inflation and proximate causes
The annual GNP price index has risen in each of the last 20 years (chart 1).
Even on a quarterly basis there have been only a few instances o f price declines
since 1947, the earliest year for which the quarterly GNP price index is available;
these occurred in the first three quarters of 1949, the first quarter of 1953, and
the second quarter of 1954 (chart 5). The rate of inflation has been highly
uneven, of course, with periods o f approximate stability in 1949 and early 1950
and in 1952-54 puuctuating periods of more rapidly rising prices. Between the
first quarter of 1947 and the third quarter of 1958 the GNP price index rose by
almost 37 percent.
As we have already seen, we may analyze the postwar inflation by means of
the equation of exchange. The variables contained in this equation are plotted
in chart 5, quarterly, 1947-58. Each of them rose substantially over this period :
money by 23.7 percent, velocity by 56.8 percent, and real GNP by 41.9 percent.
The rise in real GNP, o f course, was a deflationary factor in the sense that the
strong aggregate demand for goods and services was met in part by expanded
supplies rather than by higher prices. Since the volume of money has grown at
less than its prewar long-term rate since 1947, and has fallen substantially rela
tive to real GNP, it is clear that monetary expansion during the postwar period
was not a major factor in inflation. Velocity, on the other hand, not only
expanded twice as fast as the stock of money; it has been moving counter to its
long-established downward drift. For these reasons it appears that an analysis
of postwar inflation must center on velocity.
Why velocity has risen since the end of the war
It may be useful to begin an explanation o f the postwar velocity rise by con
sidering some hypotheses that seem clearly inapplicable.
1. We may reject at once one promising and simple explanation. Since velocity
varies greatly among economic sectors, shifts in the relative importance of sectors
can affect aggregate velocity. I have studied such realinements in considerable
detail for the postwar period and have concluded that their effects on velocity
have been slight. Furthermore, they have tended to reduce rather than raise
velocity.
2. The fact that velocity has risen in virtually every sector suggests that the
forces responsible for rising velocity are general in nature. While most of the
velocity determinants discussed above (section III) do appear to be general in
their effects, one of them, the level of real income per capita, does not. Although
it is readily understandable that consumer velocity may depend on this variable,
it is not clear why corporate, Federal, and State and local velocities should be
similarly affected. This difference between consumers and other spending units
may account in large part for the fact that the income velocity o f total deposits
plus currency has shown more of a tendency to fall over time than has the income
velocity of demand deposits plus currency; consumers hold far and away the
largest portion of time deposits. In any case the income effect apparently was
velocity reducing in nature up to World War II. These considerations tend to
cast doubt on changes in per capita real income as a significant determinant of
velocity since the end of the war.
3. Finally, if the postwar velocity rise had been confined to income velocity
alone or to deposit turnover or aggregate nonfinancial velocity alone it could
have been attributed to the widespread mergers or to other factors that affect
the alternative velocity measures differently. The fact that these measures
have behaved with remarkable similarity since 1946 permits us to reject all such
hypotheses with confidence.
Having considered some inadequate explanations of the poswar velocity rise,
let us now turn to a positive approach to the problem. In all probability most
38563 0 — 59— pt. 4-------7
698
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
of the postwar velocity rise is simply a readjustment from wartime abnormal
ities. Not until 1953 did the income velocity of demand deposits plus currency
regain its 1941 peak, and the income velocity of total deposits plus currency
was still well below its 1942 and 1943 values in 1957. (See chart 3.) Our
study of sector velocities offers further evidence that the readjustment con
tinued at least until 1951 and perhaps even until 1955. Although both cor
porate and Federal velocities snapped back quickly to their early wartime or
immediate prewar peaks, there were prolonged lags in the other major sectors
(chart 7). Farm and noncorporate velocity reattained its *939 value only in
1953, State and local velocity did not do so until 1954, and consumer velocity
consumer velocity achieved this feat as late as 1955. Furthermore, in 1939-41
the velocity of demand deposits plus currency probably was still below its
normal prosperity level because of the unusual severity o f the 1929-33 and 193738 contractions. If this is true then velocity in the postwar period has been in
fluenced by two distinct readjustment processes rather than one, and there is no
assurance that these processes have been completed even now.
The return to equilibrium levels is not the whole story, however. Superim
posed on this fundamental factor were other forces of a velocity-increasing na
ture. Evidence of this can be seen in the fact that corporate velocity, after
having resumed its immediate prewar level in 1947, continued to push upward
during the next 10 years and by 1956 had established a high for the entire
period since 1931 (chart 8). Among these other velocity-increasing forces
I would list the generally higher level of interest rates and particularly the
increased availability and yields of money substitutes. Perhaps these were
supplemented to a minor extent by a growing belief in the inevitability of in
flation.
The rising trend o f long term interest rates and rates on bank loans is com
mon knowledge and needs no documentation. Like velocity, these rates have
moved up and down with succeeding phases of postwar business cycles, but
rises have exceeded declines and an upward trend has resulted. However,
since long term rates were of limited significance before the war as velocity
determinants there is no reason to think they have been particularly important
since 1946.
In my judgment the principal reason why velocity has been rising, other than
the simple readjustment from wartime restrictions and prewar depressions, is
the increased importance of money substitutes in the economy. I have already
mentioned the fact that liquid assets have been growing persistently relative to
money. Households have relied increasingly on time deposits and savings and
loans shares as sources o f liquidity, no doubt in response to greatly improved
yields. State and local governments as well as businesses have learned that
short-term Treasury securities are an attractive alternative to cash, and the
Treasury has obliged them by converting more and more o f the public debt
to short-term obligations.
But there have been other developments in the realm o f money substitutes.
Although it cannot be easily documented there appears to have been a substan
tial growth of charge accounts, trade credit, credit lines at banks, and credit
cards, along with a general improvement in credit ratings. All of these de
velopments have facilitated purchases without cash and thus have tended to
increase overall expenditure-money ratios (i.e., velocity).
Another highly significant Change has been the increasing importance of large
“ nonflnancial” corporations as lenders. I am referring here to the growth of
repurchase agreements between such corporations and Government securities
dealers whereby firms may lend to dealers essentially an a call basis, thus
gaining interest income without sacrificing an appreciable amount of liquidity.
The importance of these arrangements, together with outright purchases of
Governments, can be seen clearly in the fact that velocity has risen much more
rapidly for large corporations than for any other size class (chart 11) ; in gen
eral only large corporations participate in such transactions. It also explains
part of the higher growth rate of velocity in New York City, where large
corporate accounts are concentrated, than elsewhere (chart 6).
In summary, as I see it the 1946-57 velocity rise was primarily a readjustment
from wartime dislocations and prewar abnormalities. However, these readjust
ments have been magnified by the growth of money substitutes of various sorts,
together with a trend toward higher interest rates.
EMPLOYMENT,
H ave “cost pushes”
inflation?
or
GROWTH, AND PRICEi LEVELS
business pricing
practices
contributed
699
to postwar
Despite the preponderance of contrary opinion, I cannot agree that cost
pushes and pricing practices have been significant factors in the recent infla
tion. My reasons are developed at length in the study that is appended to this
statement, and therefore I shall only summarize my basic points here.
1. Inflation must operate through increases in the volume of money or its
velocity or through decreases in the volume of transactions. In most cases
those who stress the importance of cost pressures and pricing practices fail to
indicate how these factors influence the variables of the equation of exchange.
Instead they commonly assume, implicity or explicity, that the money supply
is “elastic” or that velocity is “passive.” There is no basis in fact for such
assumptions in the contemporary American economy : the Federal Reserve Board
maintains tight control of the volume of money, and velocity studies suggests a
high degree of regularity in that variable.
2. As we have just seen, the recent inflation is mainly attributable to higher
velocity. The reasons for these velocity increases seem to be quite unrelated to
cost pressures or pricing practices.
3. Since inflation means a rise in a general price index, one cannot usefully
discuss it in terms of what has happened to the price of X or of Y ; there may
very well be offsetting movements among other prices. However, when one
analyzes the pattern of price change during 1955-57 one discovers that most of
the important price rises occurred in industries that were characterized by
high levels of production and employment, long work weeks, sizable unfilled
orders, and other indicators of strong demand.
4. Comparisons of money wage rates and output per manhour (productivity)
are not useful in determining the sources of inflation since the finding that the
former has outrun the latter is equally consistent with demand and cost theories
of inflation.
5. The foregoing should not be interpreted to mean that cost pressures and
prices policies are unimportant to our economy. On the contrary, they may
produce serious misallocations of reson es, frictional unemployment, or other
undesirable consequences. My only point is that they have been greatly exag
gerated as causes of inflation.
Implications for the future
There is an additional question of major importance on which I wish to com
ment in closing: will inflation continue in the years ahead ?
I
do not see much likelihood of deflation in the future. Since 1896 the only
significant price-level declines have occurred during the severe depressions of
1920-21 and 1929-33. Yet prices have risen in nearly every business cycle ex
pansion. This suggests that there is a long established inflationary bias in
our economy— certainly nothing that can be called a new inflation—as long
as serious business declines are avoided.
Such a conclusion may be unduly pessimistic, however. Inflations of the
past have been characterized predominantly by rapid expansion of money but
stable or declining velocity (apart from the usual cyclical variations). Ob
viously much will depend on the success of our monetary authorities in keeping
the rate of growth of money within reasonable bounds. In my judgment the
present powers of the Federal Reserve Board are entirely adequate for the
achievement of sound monetary policy. The chief danger is not lack of appro
priate tools but rather lack of determination and political support in the use
of existing tools. However, experience since 1951 provides a basis for optimism
in this respect.
Assuming that this optimism turns out to be justified, the trend of prices will
depend on the behavior of velocity. If velocity levels off and maintains a more
or less horizontal trend then the outlook for price-level stability will be good.
On the other hand, if velocity continues to rise at its recent rate inflation will
probably continue.
The future trend of velocity will depend on the relative strength of the various
velocity determinants discussed earlier. We can confidently anticipate con
tinued growth of real income per capita and this should exert downward pres
sure on velocity. On the other hand, we have little scientific basis for predicting
the future of interest rates, money substitutes, and other velocity determinants,
and a prediction of the trend of velocity is therefore not worth much. My guess
is that the upward drift in velocity will come to a halt within the next few
years. Whether this turns out to be the case only time will tell.
Reprinted for private circulation from
THE JOURNAL OF POLITICAL ECONOMY
Vol. LXVII, No. 1, February 1959
Copyright 1959 by the University of Chicago
COST-PUSH VERSUS DEMAND-PULL INFLATION, 1955-571
RICHARD T. SELDEN
Vanderbilt University
I. INTRODUCTION
recently, monetary theorists
have approached the topic of in
flation with an air of assurance.
Whether employing the homely but
durable equation of exchange or the
newer Keynesian models, they have ex
plained price-level changes primarily in
terms of variations in aggregate demand.
True enough, there have always been dis
sidents,2 though mainly among those
without thorough grounding in macro
economics. Particularly since 1955, how
ever, we have been told with increasing
frequency, and by men of recognized
competence, that there is a new kind of
inflation in our land.* In fact, judging by
recent discussions there are several new
kinds of inflation, including wage infla
tion, profit inflation, sellers’ inflation,
and even “ tight-money” inflation.4 Each
n til
U
of these supposedly new phenomena is
said to operate through a cost push,
rather than through the traditional de
mand pull, and in this respect they con
front the monetary theorist with a diffi
cult choice. Unless he can show that re
cent price rises do not differ importantly
from those of earlier periods, he must
either rationalize cost-inflation theories
in terms of orthodox models or fashion
new models that encompass cost as well
as demand inflation.
I
shall argue that the 1955-57 inflation
was in fact basically similar to inflations
of the past and that the role of costs in
*
The literature reflecting this point of view has
become voluminous. I shall cite only a few examples:
John Kenneth Galbraith, “ Are Living Costs Out of
Control?” Atlantic Monthly, February, 1957; Na
tional Association of Manufacturers, A New Force
for Inflation (May, 1956); Abba P. Lerner, “Infla
tionary Depression and the Regulation of Adminis
tered Prices,” in U.S. Congress, Joint Economic
Committee, The Relationship of Prices to Economic
11 wish to express my gratitude to Gary S. Stability and Growth (Compendium of Papers Sub
Becker and Milton Friedman for their many helpful mitted by Panelists, March 31, 1958). I shall refer
suggestions.
to the latter volume as Compendium.
*
In 1911 Irving Fisher noted that “one of the 4 See Compendiumt p. 259, for Lemer’s defense of
supposed causes of high prices today, much under the term “sellers’ inflation.” On the allegedly infla
discussion at the present time, is that of industrial tionary effects of interest-rate rises see the state
and labor combinations” {The Purchasing Power of ments of Senators Humphrey and Sparkman, re
ported in the New York Timest January 27,1957. •
Money [1st ed.; New York, 1911], p. 179).
700
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
this inflationary episode has been greatly
exaggerated.6 1 shall proceed by first re
viewing in Section II some general as
pects of the American economy during
this period. It is clear that most costpush theories of inflation implicitly as
sume that higher costs can increase the
velocity of money; therefore as a pre
liminary to the core of this study, which
is contained in Section IV, I have pro
vided in Section III a resum6 of velocity
theory as it has been developed in the
“ Chicago” monetary tradition. In Sec
tion IV, I evaluate what appear to be the
more important variants of cost-push
thinking. These are reformulated in
terms of, and organized around, the
velocity theory presented in the preced
ing section. Section V summarizes the
argument and offers an alternative inter
pretation of recent price-level changes.
II. RECENT INFLATION: DIMENSIONS
AND PROXIMATE CAUSES
A. GENERAL CONSIDERATIONS
One fact about 1955-57 is beyond dis
pute: the price level did rise, however
measured. The Bureau of Labor Statis
tics’ Wholesale Price Index (WPI)
turned upward in mid-1955; the Consum
er Price Index (CPI) early in 1956. Both
indexes had been approximately stable
during the two preceding years. From
December, 1954, to December, 1957, the
W PI rose by 8.2 per cent, the CPI by
6.4 per cent. Another measure of the
price level, the implicit deflators of gross
national product (GNP), also increased
by 8.2 per cent over the same period.
These movements were more or less con
tinuous throughout the period, with a
definite tapering-off in evidence by the
middle of 1957. Unquestionably it is
true, as some critics have charged, that
701
these indexes overstate the degree of
price rise.6 But it is equally clear that a
large portion of the rises would remain
even if the upward biases could somehow
be removed.
Another fact merits mention at the
outset. The 1955-57 inflation began
about one year after the beginning of the
business-cycle expansion of July, 1954—
August, 1957. By the time the WPI
turned upward, the economy was vir
tually at full employment. The historical
record indicates that inflation has almost
always accompanied American business
expansions.7 The remarkable aspect of
the 1955-57 inflation is not that the price
level rose but rather that it did not begin
to rise earlier than it did.
B. THE PATTERN OF PRICE CHANGE
The broad price movements just noted
were the net result of widely varying
changes among component prices. The
WPI, with which the remainder of this
study deals, covers about 2,000 prices,
arranged in 15 major groups and 92 sub
groups.8 Figure 1 shows the indexes for
•Neil H. Jacoby, “ The Threat of Inflation,”
Harvard Business Renew, May-June, 1957, p. 30.
H. E. Riley describes the CPI and WPI, and indi
cates several of their limitations, in Compendium, pp.
107-16. On the logic of price indexes see Kenneth
Arrow, “The Measurement of Price Changes,”
Compendium, pp. 77-87.
7 Clarence H. Danhof, “The Behavior of Prices,
1890-1940,” Compendium, p. 136. See also Wesley
C. Mitchell, What Happens during Business Cycles
(New York: National Bureau of Economic Re
search, 1951), p. 37, for the average peacetime refer
ence-cycle pattern of wholesale prices, 1891-1938.
For the eleven reference expansions falling within
this time span, the average rise in wholesale prices
from initial troughs to peaks was 9 per cent.
1
Prices and indexes for each item and for product
classes, subgroups, and major groups are presented
monthly in the BLS publication Wholesale Prices
and Price Indexes. BLS Bulletin No. 1214, Wholesale
Prices and Price Indexes, 1954-56, provides a highly
useful summary of recent price data, together with
• In this study “inflation” meant simply a rise,a detailed description of the WPI and the relative
however small, in a broad index of prices.
importance of items in the index.
702
EM PLOYMENT, GROWTH, AND PRICE LEVELS
Total
Farm products
Processed foods
T extiles
L eathe r
Fuel and power
Chem icals
Rubber
Lumber and wood
Pulp and paper
M etals
M achinery
Household durables
Nonmetallic minerals
Tobacco and beverages
Miscellaneous
-10
-5
0
+5
+10
+15
Percentage change from December 1954
+20
F ig . 1.—Wholesale prices for major groups and all commodities, percentage change from December,,
1954, to December, 1955, 1956, and 1957.
EM PLOYMENT,
each major group and for all commodities
as of December of 1955, 1956, and 1957,
using December, 1954, as base. Average
prices increased sharply in machinery
and motive products; metals and metal
products; and pulp, paper, and allied
products. In nine other major groups
they rose moderately to substantially.
TABLE 1
P r ic e C h a n g e s , D e c e m b e r , 1954, t o D e c e m
b e r , 1957, WPI Subgroups w i t h G r e a t e s t
R ise s a n d D e c l i n e s
Subgroups with Greatest Rises
Eggs..................................................................
Metalworking machinery and equipment..
General-purpose machinery and equipment
Construction machinery and equipment. .
Iron and steel.................................................
Coke..................................................................
Coal................... ..............................................
Commercial furniture....................................
Electrical machinery and equipment.........
Other tobacco manufactures.......................
Subgroups with Greatest Declines
Manufactured animal feeds.......................
Hay, hayseeds, and oilseeds......................
Packaged beverage materials.....................
Grains..........................................................
Other farm products...................................
Animal fats and oils....................................
Plywood.................... ....................................
Man-made fiber textile products..............
Fertilizer materials.......................................
Electricity.......... ...........................................
Per Cent
Change
45.9
27.2
25.4
24.7
23.3
22.3
20.0
19.8
19.2
18.9
Per Cent
Change
— 28.5
—16.2
—14.8
—13.0
— 9 .6
— 8 .9
— 8 .4
— 5 .8
— 4 .9
— 4 .6
Source: Computed from data in Bureau of Labor Statistics
Bulletin No. 1214, Wholesale Prices and Price Indexes, 1954-56,
and the monthly BLS publication, Wholesale Prices and Price
Indexes (December 1957 Final).
However, prices declined over the period
in three groups—miscellaneous products,
lumber and wood products, and textile
products and apparel. Furthermore, 11
of the 45 yearly price changes shown in
Figure 1, involving 8 of the 15 major
groups, were negative.
The same picture of price dispersion
emerges from examination of the WPI
subgroups; prices for 23 of the 92 sub
groups declined over the same three-year
period. Table 1 shows the 10 subgroups
with the greatest increases and decreases.
703
GROWTH, AND PRICE LEVELS
Eggs, with a 45.9 per cent rise, heads the
list of subgroups whose indexes in
creased; various subgroups of machinery
and industrial raw materials dominate
the rest of the list. At the other extreme,
various subgroups of farm products and
processed foods declined the most.
Since they do not indicate the relative
importance of subgroups in the WPI, the
data in Table 1 are not especially mean
ingful. However, one can roughly deter
mine the relative contribution of each
subgroup to the over-all change in the
index by multiplying the relative price
change of the subgroup by its weight and
expressing the product as a percentage of
the sum of all such products. Table 2 preTABLE 2
P e r c e n t a g e C o n t r i b u t i o n , Su bgrou ps T h a t
C o n tr ib u te d M o s t t o t h e
W h o le s a le
P r ic e
In d ex ,
R is e in t h e
D ecem ber,
1954-57
Contribution
to WPI Change
(Per Cent)
Iron and steel..............................................
Electrical machinery and equipment........
Motor vehicles............................................
Petroleum and oil products. ......................
General-purpose machinery and equipment
Metalworking machinery and equipment..
Meats, poultry, and fish.............................
Livestock and live poultry.........................
Fabricated iron-structural metal products.
Converted paper and paperboard products
Sum of the above....................................
16.4
10.9
9.9
6.9
6.7
5.6
5.2
4.4
3.7
3.2
72.9
Source: Same as Table 1. Computed (1) by multiplying per
centage price change, December, 1954, to December, 1957, for
each subgroup by its relative importance in December, 1954,
and (2) by taking each product as a percentage of the sum of
products.
sents such data for the ten leading sub
groups for the entire period 1955-57.
This table has two important features.
First, these ten subgroups taken to
gether accounted for nearly three-fourths
of the total change in the index. Thus a
relatively small number of subgroups
dominated the WPI during the period
under consideration. Second, except for
the two categories of farm products and
704
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
processed foods, these subgroups have
certain common characteristics. In gen
eral, they comprise sectors of our econo
my that are strongly unionized and oli
gopolistic. It is not surprising that there
has been talk of wage inflation and ad
ministered pricing. As I shall argue later,
however, the prominence of capitalgoods industries in this list of subgroups
provides a better clue to the inflation
since 1954.
Before turning to other matters, let us
examine one further aspect of the pat-
60 per cent of the rise in the WPI.
Furthermore, price increases in 1957
were concentrated even more heavily
than in 1955-56 in the ten leading sub
groups.
C. THE PROXIMATE CAUSES OF INFLATION
Economists have evolved two macroeconomic frameworks, and each has its
uses in the analysis of inflation. For an
ex post study such as this, however, the
equation of exchange is much the more
valuable of the two.9 Accordingly, I shall
TABLE 3
P e r c e n t a g e C o n t r i b u t i o n , Su bgrou ps T h a t C o n t r i b u t e d M o s t t o t h e R is e in t h e
W h o l e s a l e P r ic e I n d e x , D e c e m b e r , 1954-56, a n d D e c e m b e r , 1956-57
D ecem beb,
1954— D e c e m b e b , 1956
Subgroup
Iron and steel....................................................
Electrical machinery and equipment............
Motor vehicles..................................................
Petroleum and oil products............................
General-purpose machinery and equipment.
Non-ferrous metals.........................................
Metalworking machinery and equipment...
Fabricated structural metal products..........
Converted paper and paperboard products.
Fabricated non-structural metal products..
Sum of the above.........................................
D ecekbek,
Per Cent
of WPI
Change
1956— D e c e m b e b , 1957
Subgroup
19.7
Meats, poultry, and fish...............................
11.1
Livestock and live poultry............................
Metalworking machinery and equipment..
9 .6
Motor vehicles................................................
7.4
Electrical machinery and equipment.........
7.3
6 .6
Eggs...................................................................
5 .8
Iron and steel..................................................
3 .7 ‘ Petroleum and oil products..........................
General-purpose machinery and equipment
3 .6
Cereal and bakery products.........................
3 .5
78.3
Sum of the above.
Per Cent
of WPI
Change
29.2
22.6
12.5
9 .8
8 .3
5.8
5 .6
5 .0
4 .2
3 .9
105.9
Source: Same as Tables 1 and 2. See note to Table 2 for method of computation.
tern of price change. The year 1957 dif
fered significantly from the two preced
ing years. Table 3 repeats for the sub
periods December, 1954r-56, and Decem
ber, 1956-57, the operation performed in
Table 2. The first subperiod had the
same patterns noted for the entire period,
but in exaggerated form. The main dif
ferences are that non-ferrous metals and
fabricated structural metal products re
place the livestock and meat subgroups
and that there is a somewhat greater con
centration of the over-all rise in the index
among the top ten subgroups. In 1957,
however, four subgroups of farm prod
ucts and processed foods accounted for
carry forward the discussion primarily in
terms of this equation.
In a proximate sense the 1955-57 in
flation was caused by one or more of the
* Since, in the Keynesian system, the division of
GNP among consumption, investment, government
and net foreign purchases usually is not considered
a function of the price level, the system provides no
way of determining the source of an inflation. At a
time of full employment an attempt by any sector
to increase its expenditures would leave the compo
sition of real income unchanged, as long as other
sectors resolutely resisted any reduction in their
shares of total output. The only result would be a
rise in money income, because of higher prices, equal
to the attempted addition to expenditures times the
reciprocal of the average propensity to save. Broadly
speaking, the events of 1955-57 were in harmony
with this view.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
following: an increase in the stock of
money, an increase in monetary velocity,
or a decrease in real income. Table 4 pre
sents indexes of these variables for 195557, using 1954 as base. In each of the
three years the stock of money rose by
more than 2 per cent, and the rise for the
entire period was 7.2 per cent.10 Evident
ly, monetary expansion played an active
role in the recent inflation. However, the
rate of growth of the money stock was
705
more than 3.5 per cent. Thus the price
level would have fallen had velocity been
stable.
Velocity, however, increased 10.4 per
cent over the three-year period, and at
its peak in the third quarter of 1957 it
was 13.2 per cent above the level of the
fourth quarter of 1954.11 It is clear that
in a proximate sense velocity was even
more important than the quantity of
money as a source of inflation during
TABLE 4
I n d e x e s of E l e m e n t s of t h e E q u a t i o n of E x c h a n g e , 1955—57
(Fourth Quarter, 1954*100)
Year
(and Quarter)
1955 (1)...........
1955 (2)...........
1955 (3)...........
1955 (4)...........
1956 (1)...........
1956 (2)...........
1956 (3)...........
1956(4)...........
1957 (1)...........
1957 (2)...........
1957 (3)...........
1957 (4)...........
Money
Income
Velocity
of Money
Deposit
Turnover,
Six Large
Cities*
100.3
100.2
101.1
102.5
102.5
102.6
103.1
104.9
105.5
106.1
107.2
107.2
103.3
105.7
107.6
107.6
108.0
109.0
110.0
110.8
112.2
112.8
113.2
110.4
100.4
108.0
98.5
110.3
104.6
109.1
104.2
117.9
114.8
116.0
108.4
116.0
Non
financial
Turnover f
Real
GNPf
105.2
108.2
109.8
110.8
N.a i
112.1
Sources: “ Money,” computed from monthly data, Federal Reserve Bulletin; "Income Velocity of
Money,” computed By dividing Commerce Department seasonally adjusted estimates of GNP by money;
"Deposit Turnover, Six Large Cities,” unadjusted estimates, Federal Reserve Bulletin; “ Non-financial
Turnover," computed from Federal Reserve flow-of-funds tables by dividing total non-financial uses for all
sectors by money; ' ‘Real GNP,” Survey of Current Business, July, 1958.
* Monthly figures, second month in each quarter,
t Annual figures.
t Not available.
well below its long-term average. Fur
thermore, the stock of money failed to
keep pace with the rising tempo of busi
ness activity: for the period as a whole
real GNP rose by 12.1 per cent, and the
stock of money per unit of output fell by
1955-57. This conclusion rests not only
on comparison of the percentage changes
in the two variables but on the further
fact that the expansion in the money
stock was less than normal, while the in-
11
The use of different measures of velocity gives
10
Money is defined throughout this study as the
slightly different percentage changes. I do not wish
sum of currency outside banks and all deposits (in
to defend my choice of velocity measures except to
cluding United States government deposits at com
mercial and Federal Reserve banks, deposits of for say that it shows as well as any other the general
eigners in United States banks, and time deposits at magnitude of the increase since 1954. Note that the
commercial and mutual savings banks). I have numerator is seasonally adjusted, while the denomi
chosen this concept of money for statistical con nator is not. The distortions thus introduced are less
venience; for the period since 1954 this does not in than those resulting from the use of an unadjusted
numerator.
volve a significant analytical sacrifice.
706
EM PLOYMENT, GROWTH, AND PRICE LEVELS
crease in velocity was greater than
normal.12
For 1955 and 1956 at least, one could
scarcely argue that prices rose because of
the failure of output to expand sufficiently.
Real GNP rose sharply by 8.2 per cent
in 1955 and rose by 2.4 per cent in 1956.
For the two years taken together the
growth rate of GNP was well above nor
mal; to offset the recorded price rises in
these years, almost unheard-of growth
rates would have been needed.
Thus cost-push theorists are saying, in
effect, that excessive wage or other cost
rises can somehow increase the stock of
money and its velocity. How this comes
about they do not indicate. I shall con
sider, in Section IV, several of the more
plausible links between costs and money
and costs and velocity. First, however,
a review of the fundamentals of velocity
theory may be of use.
III. A DIGRESSION ON
VELOCITY THEORY
The key to velocity analysis lies in the
application of orthodox demand theory
to money.18 The reciprocal of velocity,
real balances per unit of output ( M /P y ),
may be regarded as a commodity whose
services are in demand. A decrease (in18 “ Normally,” velocity rises during cyclical ex
pansion and falls during contractions. But the trend
of velocity has been downward, which means that
on the average the falls during contractions have
exceeded the rises during expansions. However, by
the third quarter of 1956 velocity exceeded the peak
it had attained in the second quarter of 1953, and it
continued to rise steadily for another year.
On the tread of velocity see Clark Warburton,
“ The Secular Trend in Monetary Velocity/’ Quar
terly Journal bf Economics, February, 1949, and my
“ Monetary Velocity in the United States,” Section
III, in Milton Friedman (ed.), Studies in the Quanti
ty Theory of Money (Chicago, 1956). It is possible
that the trend turned upward during or soon after
World War II. Warburton recognizes this possibili
ty, contrary to the impression left in my earlier
treatment of his views on velocity.
crease) in quantity demanded, of course,
means a rise (fall) in velocity. Quantity
demanded, in this as in all other cases,
can be analyzed in terms of the usual
categories: the commodity’s price, prices
of related commodities, incomes, tastes,
and expectations.
The “ price” of M /P y consists of the
opportunity costs sustained by moneyholders. The cost of holding money may
be measured in various ways, but for our
purposes it is the difference between
yields on illiquid assets and on money.
Since the yield on money is negligible and
does not change quickly, corporate bond
yields serve as a rough measure of the
cost of holding money. Higher bond
yields will lead to an increase in
velocity.14
Money substitutes can be handled in
the same fashion. Their attractiveness as
sources of liquidity depends on their
yields. A rise in the yields of money sub
stitutes will reduce the demand for
13 For a more complete treatment of the topics
discussed in this section see Selden, op. cit., and
Milton Friedman, “ The Quantity Theory of Money:
A Restatement,” in Studies in the Quantity Theory of
Money, and “ The Supply of Money and Changes in
Prices and Output,” Compendium, pp. 241-56.
14 Strictly speaking, this argument should be
stated in terms of equilibrium interest rates. This is
because lending is not the only alternative to holding
cash. Real investment is an important additional
alternative; hence the expected return on investment
also measures the cost of holding money. It is the
essence of cyclical disturbances that the relation be
tween returns on loans and returns on investment is
out of equilibrium— a fact that complicates the cycli
cal relation between interest rates and velocity.
Under such conditions a rise in the real rate will lead
to higher velocity even though the loan rate is con
stant. This may be visualized as a shift to the right
of the investment demand curve, accompanied by a
simultaneous and causally related leftward shift in
the demand curve for M/Py. The latter shift implies
an increase in velocity. This is probably a major
reason why studies of earlier periods have found a
relatively weak relation between velocity and inter
est rates (Selden, op. cit., pp. 195-205).
EMPLOYMENT,
M /P y ,
GROWTH, AND PRICE LEVELS
since households and firms will
tend to satisfy their liquidity needs by
holding near-moneys rather than money.
The income elasticity of demand for
M /P y appears to be well above zero in
the long run; that is, a permanent rise in
real income per capita leads to greater
quantity demanded and thus to a lower
velocity. Exactly the opposite relation
ship exists during cyclical income rises,
probably because households adjust their
holdings of cash primarily with reference
to permanent rather than current in
come.16 As current income falls during
recessions, the demand for nominal bal
ances (M ) does not fall correspondingly,
since permanent income falls more
slowly. The result is a reduction in veloci
ty, as computed with current income.
During business upswings the reverse
effect probably occurs.
Tastes may change in the aggregate
either as the result of income redistribu
tion or because of alterations in individu
al desires. One of the more significant re
distributional effects occurs when gov
ernment’s share of GNP fluctuates. Ob
viously, changes in tastes may be either
velocity-increasing or velocity-decreasing,
although cash-economizing innovations
may gradually reduce the basic desire
for liquidity.
The final category, expectations, is im
portant for short-run changes in velocity.
Most obvious, perhaps, are expectations
about the future value of money. If the
public expects the rate of inflation to in
crease (perhaps because of rapid mone
tary expansion), the demand for M /P y
will fall and velocity will rise. Probably
more significant for the general run of
cyclical inflations are businessmen’s ex-
707
pectations about the productivity of cap
ital and its relation to interest rates. A
rise in the expected marginal efficiency of
capital, with stable interest rates, will
reduce the quantity of M /P y demanded,
and velocity will rise. There are several
other expectational effects on velocity,
but there is no need to elaborate them
here.
IV . A N E V AL U A TIO N OF COST-PUSH THEO
R IES OF THE RECENT INFLATIO N
Hypothesis I: Cost Increases Have Caused
a Rise in the Stock of Money
There are at least two variants of the
hypothesis that rises in wages or other
costs may result in monetary expansion.
The first is based on the existence of a
public “ full-employment” policy. Cost
increases, according to this argument,
may lead to unemployment, which in
turn may trigger a government program
to restore full employment, with infla
tionary results. The second variant states
that firms whose costs have risen will
increase their demand for working capi
tal. Banks will expand their loans, and
the stock of money will increase.
Neither variant has much relevance
for the 1955-57 inflation. As I have
shown above, the role of money as a
source of inflation in this period was less
than that of velocity, at best this would
be a partial theory of price-level changes.
Moreover, the volume of money depends
not on the demand for loans, as the sec
ond variant implies, but on Federal Re
serve decisions about the size of bank
reserves. The monetary expansion during
1955-57 was mainly the result of two
factors: the failure of the Federal Re
serve to gauge the strength of inflation
15
See Milton Friedman’s research report in Na
ary forces correctly and Federal Reserve
tional Bureau of Economic Research, Thirty-eighth
preoccupation with Treasury refunding
Annual Report (May, 1958), pp. 39-41.
708
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
problems.16 Neithef of these seems to be
related to cost pushes.
Hypothesis I I: Velocity Is Passive
The commonest version of cost-push
thinking is the simple assumption, usual
ly implicit, that velocity passively ad
justs to whatever level will permit the
existing stock of money to finance an in
dependently determined volume of pay
ments. According to this view, the price
level is a mere agglomeration of loosely
related items. A rise in any price is re
garded as inflationary, since there is no
reason to expect compensating declines
among other prices.17
Pushed to the extreme, this hypothesis
amounts to a denial that there is a de
mand function for money such as that
described above. In this form we may
reject it on the basis of a growing body
of contrary evidence.18 Milder forms of
the hypothesis, on the other hand, are es
sentially a reiteration of J. M. Clark’s
remark about the irrational pursuit of ra
tionality:19 there may be a “ zone of in
determinacy” within whose limits cost
pushes can increase velocity and the
price level. Needless to say, one should
not expect administrators of cash bal
ances to adjust their holdings at once in
response to minute changes in the de
mand determinants. The problem lies in
the size of such velocity variations, and
here opinions may differ. Moreover, this
argument cuts both ways. If adminis
trators of cash balances have been get
ting along with less cash than desired,
cost increases may result in a reassess
ment of cash positions and a decision to
hold more money, relative to expendi
tures.
Testing the passive velocity hypothe
sis is not easy. An indirect approach
would be to see whether or not observed
variations in velocity are adequately ex
plained in terms of changes in the con
ventional determinants. I shall do this in
the following subsections and in Section
V. But there is a more direct way of get
ting at the problem. According to this
hypothesis, price rises occur mainly where
costs have been climbing rapidly.80 It
should be possible, through detailed
analysis of price changes, to determine
whether cost or demand factors have
predominated in the areas of greatest
price rise.
One must interpret such a test cau
tiously, however. As is always the case,
failure to disprove a hypothesis does not
establish its validity. The mere demon
stration that the price of X rose because
of an increase in unit labor cost of X is
equally consistent with inflation, defla
tion, or stability.21 On the other hand, if
MTo facilitate discussion, I assume that "produc
tivity” is unchanged.
11 See the testimony of Chairman Martin before 11 Wage increases resemble tax increases in many
the Senate Finance Committee (85th Congress), ways and should be analyzed in the same fashion.
Investigation of the Financial Condition of the United Ordinary incidence theory, of course, focuses on
States, pp. 1304-7 ff.
cost-price relationships within the taxed sector, but
17Examples are legion. For instance, see the con this does not mean that taxes have no general effects.
tributions of Paul A. S&muelson, E. S* Shaw, and If the proceeds of an excise are impounded, for ex
Henry C. Wallich in “ The Economics of Eisenhower: ample, prices in general will decline—even though
A Symposium/’ Review of Economics and Statistics, the taxed commodity’s price will rise in relation to
other prices. The degree of deflation depends largely
November, 1956.
on two factors: the tax yield and the extent to which
11 Friedman summarises the evidence in Cm - the reduction in the privately held money stock
pendium, pp. 241-56.
leads to a decline in private spending.
19Preface to Social Economics (New York, 1936),
A wage increase is analogous to a new payroll tax
p. 120.
or an excise on raw materials, except that the pro*
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
709
it can be demonstrated that no such
cost-price relationship exists, the passive
velocity hypothesis can be rejected at
once.
What kinds of evidence would permit
one to distinguish between cost-induced
and demand-induced price rises? In Fig
ure 2 the first is illustrated by the move
ment from po to Pit because of a leftward
shift in supply, the second is represented
by the rise from p Q to fc, in response to a
procedure. In practice demand and cost
factors are likely to operate simultane
ously. The rise from po to pz in Figure 2
illustrates this possibility. Obviously, an
increase in output does not mean that
costs have had no influence on price.
Nevertheless, an empirical investigation
of specific product markets should pro
vide worthwhile clues to the relative
strength of demand and cost influences
on prices.
shift of demand to the right. In the first
case output declines, the quantity of
labor demanded (or of other inputs
whose rates of remuneration have risen)
falls, and employment and hours de
crease. Opposite changes characterize the
second case.
Two complications, only one of which
is substantial, may impede this testing
The second complication— more ap
parent than real—grows out of “ admin
istered pricing.” Galbraith has argued
that most manufacturing firms typically
refrain from pricing at profit-maximizing
levels in the short run.22 Price p 0 in Fig
ure 2 illustrates this case under demand
I /D ' and supply SS. Under these circum
stances an increase in wage rates (or
other input prices) will probably be cov
ered fully by price rises (for example, to
p i ) , with no decline in employment un
less capital is substituted for relatively
ceeds are not impounded but constitute an increase
in workers’ incomes. Because of this fact deflation
need not occur. Indeed, depending on the demands
for cash, relative to expenditures, of those who lose
and gain income, inflation might well result. How
ever, for 1955-57 this does not seem to have been a
significant source of inflation. See Hypothesis V,
below.
“ John Kenneth Galbraith, “ Market Structure
and Stabilization Policy,” Review of Economics and
Statistics, May, 1957.1 do not pretend to give Gal
braith’s full argument here.
710
EM PLOYMENT, GROWTH, AND PRICE LEVELS
expensive labor. Indeed, higher wages
may be the pretext for an even greater
price rise, in which case output and em
ployment will rise without any change in
demand. Galbraith regards these price
rises as inflationary.
In my judgment Galbraith greatly
exaggerates the importance of adminis
tered pricing as a factor in inflation.23
Almost always price is below equilibrium
in these instances because demand has
increased and appropriate adjustments
have not yet been made. Galbraith as
sumes that these adjustments will not be
made at all unless cost justifications can
be shown. Even if this were true, such
price rises would still be demand-induced
initially; they reflect inflation rather than
cause it.24 But Galbraith’s assumptions
are doubtful for most industrial markets.
It takes time for businessmen to recog
nize the need for price changes and to
institute them. Public relations and col
lective-bargaining strategy may affect
the timing of demand-induced price rises,
but the evidence is clear that in most
cases rising demand leads to higher prices
fairly soon, whether costs go up or not.
It is time now for us to examine the
most important price rises since Decem
ber, 1954. Table 3 shows these for the
two subperiods, December, 1954r-56, and
December, 1956-57.1 shall take up these
subperiods in turn.
23 The whole topic of administered pricing is re
viewed by Martin J. Bailey, “ Administered Prices
in the American Economy,” in Compendium, pp.
89-106.
84 Furthermore, it is far from evident that the
raising of a price to its equilibrium level contributes
to inflation. Insofar as firms indulge in private price
control, they are redirecting upward pressure on
their own prices elsewhere in the economy. If the
administered price is subsequently raised, the de
mand for other goods will fall, and their prices will
tend to fall.
A. DECEMBER, 1954, TO DECEMBER, 1956
As I have already mentioned, the sub
groups included in Table 3 accounted for
more than three-fourths of the total rise
in the WPI during 1955-56. For all but
one of these ten subgroups—motor
vehicles—it is evident that strong de
mand was the decisive factor causing
higher prices. If we add to these nine the
numerous less important subgroups that
were characterized by strong demand (for
example, eggs, commercial furniture, and
“ other tobacco manufactures” ), it would
seem reasonable to conclude that at least
80-85 per cent of the rise in the WPI
occurred in sectors dominated by changes
in demand.
Several pieces of evidence support this
view. First, industrial production in
creased over the period for the sectors
corresponding to these nine subgroups, in
most cases more rapidly than aggregate
industrial production. In fact, the posi
tive relation between change in industrial
production and change in prices can be
generalized to the WPI as a whole. Fig
ure 3 presents the scatter for percentage
changes in these two variables, 1954-56;
the correlation coefficient is -f-0.40. Sec
ond, employment and average weekly
hours were high.25 Third, new orders and
unfilled orders approached their Korean
War peaks for primary metals and
machinery and attained record levels for
paper and paperboard products and fab
ricated metal products.26 Fourth, steel
operating rates neared capacity late in
1955 and remained high until early
1957.27
25 All references to employment, average weekly
hours, and average hourly earnings are based on
data contained in Monthly Labor Review, Tables
A-2, A-3, and C -l.
** United States Department of Commerce, Busi
ness Statistics (1957 ed.), pp. 20-22.
"Ibid., p.
157.
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
Of course, average and marginal costs
probably rose substantially in most of
these sectors during 1955-56. However,
one must be careful to distinguish be
tween cost rises that merely reflect shortrun supply inelasticity and those that re
sult from alterations in supply conditions
variable costs are dominated by employ
ment, scrap, and fuel costs.28 By early
1955 the labor market in steel was tight,
and labor’s bargaining position was
therefore strong. Demand for scrap grew,
and scrap prices soared as production ex
panded. Only in the case of rising fuel
i .................. i............— r ........
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Percentage change in ind u strial production
F ig . 3.— Relationship between percentage change in wholesale prices and percentage changes in indus
trial production, December, 1954, to December, 1956, by WPI subgroups. (It was not possible to find
suitable production counterparts for the following price subgroups: 1.1-1.8, 3.4, 3.6, 4.1, 6.3, 6.7,j7.1,
9.2, 9.6, 10.5, 10.8, 13.5, 13.6, 14.3, and 15.1-15.5. Several of the remaining price catagories were com
bined to achieve comparability with production groupings; as a result, only 54 points are plotted in the
figure. For both prices and production the percentage changes are in there-month averages centered at
December.)
themselves. Only the latter are relevant
to cost-push hypotheses. It seems likely
that a large part of the cost increases
since 1954 are attributable to near-capac
ity production levels. This appears to be
the case with steel, for instance, where
28 United States Senate, Committee on the Ju
diciary, Subcommittee on Antitrust and Monopoly,
Administered Prices—Steel (Senate Report No. 1387
[85th Cong.]), p. 42.
prices do we find a significant cost in
crease for the steel industry that did not
result directly from the increased de
mand for steel.
Thus nearly every case of significant
relative price rise in 1955-56 can be ex
plained largely in terms of heavy de
mand. The glaring exception is motor
vehicles. They, too, were in great de
mand during 1955, and it is entirely un
712
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
derstandable that their prices rose in that
year. But prices of motor vehicles also
rose in 1956, a poor year for the auto in
dustry. Employment in 1956 was below
1955 levels except in January and Febru
ary, and average weekly hours were
down. Profits fell by nearly $700,000,000.29 Average hourly earnings of produc
tion workers, on the other hand, rose ten
cents in September, 1956, on top of
smaller rises in June, July, and August;
they continued to rise during the rest of
the year. Undoubtedly, the 1956 price
increases in motor vehicles, insofar as
they were real, are the clearest example
of a cost-induced price change one could
hope to find. Indeed, for the period 195556, they are virtually the only such ex
ample, and we must conclude that the
passive velocity hypothesis finds little
support in this period.
B. DECEMBER, 1956, TO DECEMBER, 1957
The striking thing about price rises in
1957 is the extent to which they occurred
in farm and processed food subgroups
(see Table 3). These subgroups, which
are usually not regarded as hotbeds of
administered pricing or wage-induced in
flation, accounted for more than 60 per
cent of the rise in the W PI in 1957. How
ever, these sectors are peculiarly subject
to autonomous cost changes of the same
general sort that form the basis of costpush theories of inflation. Analytically,
it makes little difference whether supply
curves shift because of higher wage de
mands or because of a drought. Appar
ently, these important price increases
during 1958 were supply-dominated rath
er than demand-dominated. For in
stance, the price rises in meats, poultry,
and fish occurred almost entirely in
meats. The major cost in meat packing is
livestock. Livestock prices rose in 1957,
with volume declining, as farmers experi*• United States Department of Commerce, Busi
ness Statistics (1957 ed.), p. 93.
enced favorable feeding conditions and
withheld animals from the market.30
Aside from these farm-product and
food subgroups, the most important
price rises in 1957 took place in sub
groups where prices had risen significant
ly during 1955-56: metalworking ma
chinery and equipment, motor vehicles,
electrical machinery and equipment, iron
and steel, petroleum and oil products,
and general-purpose machinery and
equipment. Since conditions differed
among these sectors, I shall comment
briefly on each of them.
1. Metalworking machinery and equip
ment.— Through. the first six months of
1957 this sector continued to be in a state
of boom. Employment was approximate
ly stable at a high level, and the work
week was longer than in 1955. During
this period prices rose only moderately.
A definite slackness appeared in July and
persisted through the year end, as em
ployment and hours both fell. Prices rose
steadily from July to December, presum
ably in response to higher costs of ma
terials and labor.
2. Motor vehicles .— Prices of motor
vehicles, according to the Bureau of
Labor Statistics, were stable until the in
troduction of 1958 models in October.
Production and employment improved
somewhat over 1956 but were still well
below 1955 levels. On the whole, it ap
pears that higher employment and mate
rials costs were the major reasons for the
higher prices.
3. Electrical machinery and equipment.
— Prices in this subgroup rose moderate
ly until September and then leveled off.
Employment held up well, though a
shorter work week was evident early in
the year. Production tended to slip
throughout 1957 but was higher than in
1956 for the first seven months. There
were probably cost pressures on prices in
80
The volume of livestock marketing is given in
Survey of Current Business, February, 1958, p. S-2.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
this subgroup during 1957; however, it
is equally clear that the state of demand
exerted a definite influence on prices.
4. Iron and steel.—After small de
clines in February, March, and April,
iron and steel prices again rose and
reached a peak in August; they then de
clined for the rest of the year and in
creased less than 2 per cent over the year
as a whole. Demand was slack after Feb
ruary, and it seems clear that the sum
mertime price increases were related to
the rise in employment costs which oc
curred at that time.
5. Petroleum and oil products.— Al
though there was a small net price rise in
this subgroup during 1957, the rise took
place entirely in January and February,
in the wake of the Suez crisis. Prices then
moved downward during the remainder
of the year. This is clearly an instance of
a demand-induced price rise.
6. General-purpose
machinery and
equipment.— This sector also experienced
strong demand during the first half of
1957 but suffered a slump in the last half
of the year. Prices rose steadily through
out the year. It does not seem reasonable
to explain the price rises after midyear in
terms of changes in demand.
In summary, price increases during
1957 differed substantially from those of
1955-56. While strong demand was dom
inant in the earlier period, it was not
during 1957. However, even in 1957 there
was strong demand in several important
sectors early in the year; for petroleum
changes in demand appear to tell nearly
the whole story. Furthermore, the really
important cost changes occurred in farm
products and processed foods more than
in the strongly unionized and oligopolized sectors that have become the favor
ite whipping boys.
In evaluating these findings, it is well
to keep the following facts in mind. In
38563 O— 59— pt. 4------ &
713
general, 1957 was a year of relatively
stable prices. The WPI rose by less than
2 per cent, and the increases for most of
the subgroups in Table 3 were small. A c
tually, even these moderate increases al
most surely are exaggerations, since they
fail to take account of secret price cut
ting, which must have been much more
widespread at the end of the year than at
the beginning. Where authentic price
rises did occur, they probably were based
on mistaken forecasts of expanding de
mand. It takes time to recognize such
mistakes and to determine the appropri
ate adjustments.
Finally, as I pointed out at the begin
ning of this subsection, the existence of
cases of cost-induced price rises estab
lishes no presumption whatever in favor
of the passive velocity hypothesis, even
though their non-existence effectively
refutes the hypothesis. It will become
clear in the remainder of this section and
in Section V that there are other suffi
cient reasons for the behavior of velocity
in 1957.
All in all, it seems surprising that so
much attention has been devoted recent
ly to the hypothesis that monetary ve
locity passively adjusts to whatever level
cost pressures may require of it. At most
this hypothesis is a secondary explana
tion of doubtful validity for the inflation
of 1955-57.
Hypothesis I I I : Cost Increases Have
Raised Velocity via Higher Interest
Rates
Of course, the passive velocity hy
pothesis is not the only method of linking
cost changes to velocity. It is entirely
possible that cost increases affect veloci
ty by altering the basic velocity deter
minants outlined above in Section III. I
shall examine these possibilities in this
and the following three subsections.
714
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
As everyone knows, interest rates rose
sharply between late 1954 and late 1957.
During 1955 the rise occurred primarily
in short-term rates; in 1956 and 1957 all
rates tended to move up uniformly (see
Table 5). Velocity undoubtedly rose as a
result of these interest-rate changes.
However, it seems most unlikely that
cost pressures were responsible for the
higher interest rates.
steadily in 1955 and 1956, as they have
since 1951; this trend accelerated dra
matically in 1957. Demand deposits grew
only modestly in 1955, on the other hand,
and were at a standstill during 1956-57.
Simultaneously with the growth of time
deposits, the banks unloaded a large vol
ume of government securities. To induce
holders of cash to exchange their money
for governments, yields on the latter had
TABLE 5
S e le c t e d I n t e r e s t R a te s, M a r c h , June,
S e p t e m b e r , a n d D e c e m b e r , 1954-57
Year and
Month
1954:
March..........
June.............
September. .
December...
1955:
March..........
June.............
September. .
December...
1956:
March..........
June.............
1957:
March.
June.........
September.
December.
United States
Government
Long-Term
Bond Yields
Corporate
Bond Yields
(Aaa)
Commercial
Paper Rates
(4-6 Mo.)
Treasury
Bill Yields
(3 Mo.)
2.51
2.54
2.51
2.57
2.86
2.90
2.89
2.90
2.00
1.56
1.31
1.31
1.03
0.64
1.01
1.14
2.71
2.76
2.88
2.88
3.02
3.05
3.13
3.15
1.69
2.00
2.54
2.99
1.28
1.41
2.07
2.54
2.90
2.89
3.19
3.43
3.10
3.27
3.56
3.75
3.00
3.38
3.50
3.63
2.25
2.49
2.84
3.21
3.26
3.58
3 .66
3.30
3.66
3.91
4.12
3.81
3.63
3.79
4.00
3.81
3.08
3.29
3.53
3.04
■ve Bulletin.
Basically, interest rates rose during
1955-57 because businessmen expected
high returns on additions to plant and
equipment. This in turn gave rise to a
strong demand for bank loans. Since the
banks faced a generally stern central
bank, there were only three ways of
meeting the strong demand for loans:
they could draw down excess reserves
and vault cash, they could entice time
deposits, or they could dispose of invest
ments. Quantitatively, only the latter
two were important, and the banks used
them both. Time deposits expanded
to rise considerably. On the reasonable
assumption that these former cashholders did not reduce expenditures pro
portionately with the reduction of their
cash, velocity thereby rose.
One might maintain that this process
was set in motion by increases in wages
or other costs. The argument might run
along any of several lines: cost increases
caused an increased demand for working
capital; wage increases stimulated laborsaving investments; or businesses ex
panded in anticipation of improved mar
kets because of higher wages. It is prob-
EMPLOYMENT,
715
GROWTH, AND PRICE LEVELS
ably too much to hope that we will ever
know exactly why the 1955-57 investment boom took place. However, until
someone can produce convincing evidence to the contrary, it seems reasonable to regard the recent boom as essentially the same sort of phenomenon that
has characterized business expansions of
the past.
rise in the volume of money substitutes
has proceeded year after year, regardless
of the intensity of cost pressures,
During 1955-57 yields on money substitutes climbed significantly, while
yields on demand deposits and currency
did not; it is reasonable to conclude that
this was an important factor in the
growth of money substitutes.31 This con-
table
6
V o lu m e o f M o n e y S u b s t i t u t e s a n d R a t i o o f M o n e y S u b s t i t u t e s t o M o n e y
E n d o f Y e a r , 1952-57
(In Billions)
Y ear
1952
M oney Su b s t it u t e s
1954
1955
1956
1957
Credit-union total assets*.. .
Life insurance policy reservesf
Savings and loan shares J—
United States government
short-term debt (publicly
held marketable debt ma
turing within one year) § . .
Tax and savings notest. . .
Savings bonds*...................
$
25.1
5.8
57.9
3 1.0
6 .0
57.7
27.6
4.5
57.7
"S7.9
56^3
52! 5
Total money substitutes. . . .
$172.1
$186.1
$190.2
$200.0
$210.6
$221.3
.84
.89
.87
.89
.91
.94
Ratio: money substitutes to
money.......... ........................
* Credit Union Yearbook.
f Life Insurance Fact Book.
{ Federal Reserve Bulletin.
1.5
62.6
19.2
1953
$
1.9
66.7
22.8
$
2.2
70.9
27.3
$
2 .8
75.4
32.2
31.7
$
3 .4
79.7
37.1
33.9
$
4.1
84.1
42.0
38.6
( Computed from Federal Reserve Bulletin by subtracting United States government, Federal Reserve, and commercial bank hold
ings from total marketable federal debt maturing within one year.
Hypothesis IV : Cost Increases Have Raised
Velocity by Expanding the Volume of
M oney Substitutes
It is true that the volume of money
substitutes grew rapidly during 1955-57
(see Table 6), both absolutely and rela
tive to the stock of money, and that this
is an important reason for the rise in
velocity. But there is no basis for at
tributing these changes to cost pressures.
One might argue that wage or other cost
increases have redistributed income in
favor of groups that prefer to hold their
liquid assets with non-bank intermedi
aries. This is tenuous at best. Income dis
tribution seems to have been stable dur
ing the last few years, and in any case the
elusion finds support in the fact that sav
ings bonds have not participated in this
growth; the volume of such bonds actu
ally declined sharply in 1957. Although
yields on savings bonds have gone up,
they remain low during the first few
years after issue. For the person who
wants to maintain his liquidity, the ris
ing yields on other money substitutes
and on time deposits have made these
assets much more attractive.
The higher yields on money substi
tutes, in turn, can be traced to two fac
tors.82The first, of course, was the invest81 See the following subsection.
** Various yields are compared in the Savings and
Loan Fact Book, 1958, p. 58.
716
EM PLOYMENT, GROWTH, AND PRICE LEVELS
ment boom and the associated heavy de
mand for lendable funds and high inter
est rates. The second is the regulatory
framework that permits non-bank inter
mediaries to pay higher returns on their
short-term claims. T o repeat, none of this
has any obvious connection with costs.
Hypothesis V: Cost Increases Have Raised
Velocity by Changing Tastes
There are two rather different lines of
argument under this heading. One holds
that cost changes may have redistributed
income in favor of groups that hold little
money, thus reducing the weighted aver
age desire to hold money. The other
stresses the effects of high interest rates
on the evolution of credit institutions
and techniques of financial management.
It is true that compensation of em
ployees has been a rising portion of na
tional income in recent years. It is not
true, however, that the prewar trend to
ward reduction of inequality has con
tinued during 1955-57. In 1955 the high
est quintile of consumer units received a
larger share of personal income than in
1952 and 1953.33 The share of this group
was constant in 1956 and actually rose in
1957. The share of the lowest quintile fell
slightly during the recession year 1954
and was the same in 1955 and 1956 as in
1952 and 1953. In any case, I am not
aware of any evidence supporting the
view that wage-earners typically hold
smaller balances relative to expenditures
than other groups. Furthermore, analysis
of sector velocities reveals that the rate
of increase from 1955 to 1956 was less for
consumers than for all sectors taken to
gether.34 If the hypothesis under discus” See Selma F. Goldsmith, “Size Distribution of
Personal Income,” Survey of Current Business, April,
1958.
94 Sector velocities may be computed from Fed
eral Reserve flow-of-funds data (see Table 4).
sion were valid, one would expect pre
cisely the opposite result.
One might argue that a different and
more significant redistribution has taken
place— between the public and private
sectors. Since the federal governments
velocity ratio is several times that for the
rest of the economy, a growth of the fed
eral sector at the expense of the private
sector would lead to higher velocity. Un
fortunately for this line of argument, fed
eral government expenditures declined
relative to GNP during 1954r-57.35 It is
clear, nevertheless, that the growth in
federal spending, even though accom
panied by surpluses in the cash account,
has contributed to the rise in velocity.
Even if every tax dollar had been fully
spent by tax-paying households, govern
ment accomplished the same volume of
spending with much smaller cash bal
ances. The released cash then was avail
able to facilitate additional private ex
penditures. The total stock of money, as
I have defined it, was unaffected by this
process; the result was therefore an in
crease in velocity and, of course, the
price level. There is no evidence, how
ever, that public budgetary policy was
influenced by cost pressures during this
period.
The second hypothesis states that high
interest rates stimulate financial innova
tions that reduce the need for cash.36 By
' * Of course, government expenditures declined
relative to GNP only because private expenditures
grew at an even faster pace. The growth in private
spending, in turn, resulted partly from an increase
in the quantity of privately held money, partly from
an increase in private velocity. These conclusions
are based on computations with the standard GNP
and money series, with transfer and interest pay
ments included in government spending.
“ Warren L. Smith, “On the Effectiveness of
Monetary Policy,” American Economic Review,
September, 1956, p. 601; Hyman P. Minsky, “ Cen
tral Banking and Money Market Changes,” Quar
terly Journal of Economics, May, 1957.
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
itself this hypothesis provides no link be
tween costs and velocity, except insofar
as costs are to blame for tight money. I
have already rejected the latter notion in
discussing Hypothesis III. While there is
some plausibility to the idea that neces
sity is the mother of invention, this hy
pothesis should be tested against the
broad sweep of history and not simply
for a two- or three-year period. The trend
of velocity has been downward, until re
cently, for more than a century. Appar
ently, the influence of improved financial
techniques, whatever the cause, has been
dwarfed by such velocity-reducing fac
tors as rising real income, the falling cost
of holding money, and, in the case of in
come velocity, vertical disintegration of
the economic process. One is left with the
feeling that changes in tastes have not
had a major influence on velocity.
Hypothesis V I: Cost Increases Raised
Velocity by Changing Expectations
As suggested in Section III, there are
several dimensions to expectations as
velocity determinants. One of these is the
expected rate of inflation as a cost of
holding money. If the public believes the
editorial writers, it will interpret a gen
eral cost increase as a harbinger of infla
tion. In these circumstances it will be
rational for households and firms to
draw down their cash, relative to ex
penditures. This can be accomplished
only through an increase in expendi
tures, since there is no way in which the
public at large can reduce its balances.
A general increase in spending will be
inflationary, thus validating the editorial
writers’ predictions.
Undoubtedly, most people believe that
cost pushes are inflationary. However,
the continued rapid growth of fixed
claims during 1955-57 argues against the
chain of events just described. Whether
717
this was because the public is not highly
sensitive to rising prices as a cost of hold
ing money or because the amount of in
flation was so small is unimportant for
the present discussion.
Another and closely related aspect of
expectations and velocity concerns the
timing of expenditures. If prices are ex
pected to rise, because of cost increases
or for any other reason, consumers and
businessmen may decide to buy now in
stead of next month. Such bunching of
expenditures is likely to cause price in
creases. It is difficult to test this hy
pothesis for 1955—57 or any other period.
As far as households are concerned it
seems most unlikely that anticipatory
buying has been a factor of any impor
tance in recent years. In the case of busi
nesses it appears that most investment
programs are thought out well in ad
vance of actual expenditures and that
they lack the flexibility envisaged by this
hypothesis. It is interesting that, of 867
firms responding to a Commerce Depart
ment survey, only 32 mentioned prices of
capital goods as a reason for changes in
investment plans during 1956.*7And pre
sumably most of these were cases in
which plans were carried out despite (not
in anticipation of) higher prices.
According to still another argument
linking costs, expectations, and velocity,
businessmen believe that cost pressures
are inflationary and that inflation means
continued prosperity. In these circum
stances they may undertake investment
programs in anticipation of rising sales.
The consequences will be inflationary.
That this hypothesis is valid is certainly
within the realm of possibility, although
I am unaware of any evidence in its sup
port. Until such evidence is forthcoming,
” Murray F. Foss, and Vito Natrella, “Invest
ment Plans and Realization/1 Survey of Current
Business, June, 1957, Table 1.
718
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
it seems reasonable to interpret the 195557 investment boom as an ordinary cycli
cal phenomenon, lacking any special
connection with costs.
Finally, it is possible that the pattern
of expectations created by cost changes
lacks symmetry. Specifically, as wage
negotiations take place, wage-earners’
expectations of higher incomes may not
be offset entirely by stockholders’ expec
tations of diminished incomes. The re
sult might well be increased expenditures
and upward pressure on prices. Again, it
is not easy to test this hypothesis. How
ever, the fact that prices of consumer
goods have risen so much less than those
of capital goods does not suggest a strong
influence of this kind on velocity and the
price level.
V. CONCLUDING REMARKS
The preceding discussion has been
largely negative. My main concern so far
has been to analyze critically a common
ly held interpretation of the 1955-57 in
flation rather than to offer a coherent al
ternative view. The position I have taken
on the cost push is summarized in the fol
lowing points.
1. Anything that affects the price
level must do so through changes in the
stock of money, its velocity, or the vol
ume of transactions.
2. The recent inflation has resulted
from a strong upsurge in velocity, to
gether with moderate monetary expan
sion.
3. Cost-push theorists are therefore
arguing (usually implicitly) that the
stock of money and its velocity have
risen because of cost increases.
4. Usually velocity is assumed by
these theorists to be an arbitrary ratio
between unrelated magnitudes, which
passively adjusts to cost pressures. This
type of cost-push hypothesis can be re
jected for 1955-56 on the basis of specific
industry analyses; for 1957, on the other
hand, it is not possible to refute the hy
pothesis in this way.
5.
It does not seem possible to estab
lish convincing links between costs and
velocity via the conventional velocity de
terminants or between costs and the
stock of money.
Two tasks remain: to examine further
evidence bearing on the passive velocity
hypothesis for 1957 and to outline an al
ternative account of why prices have
risen since 1954. Actually, the latter in
cludes the former,-since the status of the
passive velocity hypothesis for 1957 will
depend on whether or not velocity
changes in that year can be explained
adequately along conventional lines.
In the course of the preceding discus
sion I have mentioned five factors that
were responsible for the 1955-57 infla
tion: an increase in the stock of money, a
higher cost of holding money, expansion
of substitute sources of liquidity, the
growth of government expenditures, and
a general rise in confidence, particularly
on the part of businessmen. Several of
these factors were closely interrelated,
and I shall not pretend to give a full
account of all the complications in
volved.
For one reason or another— perhaps
partly because of the large expansion in
the stock of money during the preceding
year— households and firms faced 1955
with a feeling of optimism. This in itself
goes far in explaining why velocity began
to rise. However, this optimism had sev
eral further effects on velocity and on the
stock of money which intensified infla
tionary forces. The increased consumer
expenditures were debt financed to a
great extent, as were business investment
outlays. One result was an expanded
money stock, although the board of gov
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
ernors of the Federal Reserve System
prevented any sizable enlargement of
bank reserves. In this general climate of
monetary restraint the strong demand
for loans resulted in higher interest rates,
at first mainly on short-term debt but
eventually throughout the debt struc
ture. The banks sold government bonds
in great volume throughout 1955 and the
first half of 1956. Of course, this could be
accomplished only with progressively
higher bond yields. The result was an in
crease in velocity, since the bond pur
chasers almost certainly did not reduce
their expenditures proportionately with
the reduction in their cash holdings.
Furthermore, the strong demand for
loans was an important factor leading to
growth in the volume of money substi
tutes during recent years. Savings and
loan associations and credit unions of
fered higher returns in order to lure de
posits. The flow of funds to these and
other providers of liquid fixed claims had
a direct impact on velocity: the funds
soon returned to the banking system, so
that bank reserves were not impaired;
but those who borrowed from non-bank
intermediaries were enabled to augment
the total flow of expenditures.
Simultaneously with these develop
ments, all levels of government increased
their expenditures on goods and services.
The inflationary potential of expanded
public spending was not entirely nullified
by an even greater expansion in tax re
ceipts. The transfer of expenditures from
private to public hands released a portion
of the money stock for the financing of
additional expenditures.
It is possible that wage and other cost
increases aggravated these inflationary
developments somewhat, though it is
719
clear that their role was not major. The
only plausible link between costs and in
flation is the possibility that, when wages
rose, wage-earners may have increased
their expenditures more than stockhold
ers reduced theirs, not because of differ
ent marginal propensities to hoard for
the two classes of income recipients, but
because of an asymmetry in the degree of
awareness of income changes. However,
even this could not have been an impor
tant factor in the recent inflation, since
the most intense pressure on prices was
experienced in capital goods rather than
consumer goods.
The developments just outlined con
tinued through the first half of 1957. De
spite the growing evidence of cost pres
sures on relative prices, there is no reason
to regard the velocity changes in that
year as being fundamentally different
from those of 1955 and 1956. It is true
that the optimism of the earlier years had
dampened greatly by 1957. On the other
hand, interest rates, the volume of
money substitutes, and government ex
penditures continued to increase. Veloci
ty turned downward sharply in the final
quarter of 1957, presumably because of a
crisis in confidence. It does not seem rea
sonable to ascribe more than a minor
part of these velocity changes to cost
pressures.
In conclusion, cost-push theories of in
flation have been greatly overworked in
explaining the course of the American
economy during 1955-57. Their impact
on the price level was of minor impor
tance during this period. Furthermore,
insofar as costs have had any such im
pact, the traditional tools of monetary
theory seem entirely adequate for their
analysis.
(See chart presentation in Mr. Friedmanns statement, pp. 638-648.)
the profits on securities sold. (The material appears at page 678.)
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
720
The C h a i r m a n . I think the Chair has taken more than his share of
the time in questions, so I will refer to Congressman Patman.
Representative P a t m a n . I ask consent, Mr. Chairman, to place in
the record at the point where I mentioned about the earnings and dis
tribution of profits of insured commercial banks, and particularly the
profits on securities sold, this statement showing by years back to 1936
the profits on securities sold. (The material appears at p. 678.)
The C h a i r m a n . And the source for this is what ?
Representative P a t m a n . Federal Deposit Insurance Corporation.
The C h a i r m a n . Without objection.
Representative P a t m a n . Mr. Selden, you are talking about volume
of money and velocity. I want to ask you about how some of this
money gets into circulation.
I was impressed by your statement that our inflation in the past few
years has been as a result of velocity of money and not by additional
vo1
#
en the Open Market Committee of the
Federal Reserve System buys a billion dollars worth of bonds in the
open market and issues a billion dollars worth of credit, whether it
actually delivers the Federal Reserve notes or not, that money is
placed in the bloodstream of business and our economy from here on
out, is it not ?
Mr. S e l d e n . That is correct.
Representative P a t m a n . It is in somebody’s pocket in the form of
Federal Reserve notes or, more realistically, it is in somebody’s ac
count at some bank. In any case, it is in circulation and outstanding.
Mr. S e l d e n . That is correct.
Representative P a t m a n . The Federal Reserve System is now hold
ing a portfolio of about $25 billion of interest-bearing obligations of
the United States purchased in a similar manner. It has reported to
the Committees on Banking and Currency that this amount is a great
deal more than the System needs to hold for either income purposes
or possible future needs of monetary controls.
Now the Federal Reserve authorities, in legislation now pending to
reduce and adjust member bank reserve requirements (S. 1120), pro
poses a scheme which would make available additional reserves to
member banks so that they could purchase very large amounts of these
Government bonds from the Fed’s portfolio. My own estimate, based
on the bill and what the Fed has said as to the amount of securities it
feels it should keep, is that about $15 billion of these bonds could or
would be transferred to the commercial banks substantially improv
ing, as the Federal Reserve authorities themselves point out, the earn
ing position of the private commercial banks.
Mr. S e l d e n . From the standpoint of administration of monetary
policy, it seems to me this would be essentially a neutral kind of
operation.
On the one hand you are wiping out some reserves of the banks and
1 11
J‘
1
Jl
11
' 1 J’ l saying that the banks
It seems to me the quantity of money outstanding would be essen
tially unchanged.
EM PLOYMENT, GROWTH, AND PRICE LEVELS
721
Representative P a t m a n . From the standpoint of the quantity of
money in circulation there may be a great deal in what you say, but
the point is that the Government, through its own instrumentality,
the Federal Reserve System, has bought and paid for these securities
once. It has bought them in the open market and by holding in one
hand the pieces of paper which the other hand must pay has in effect
canceled them. Of course, they have not been canceled or “retired”
in fact, since the Treasury goes on owning and paying interest into
the Federal Reserve. Meanwhile the Federal Reserve, as another
branch of the Government, holds the bonds, collects interest, and then
in effect turns the interest back into the Treasury after, of course,
taking out its “cut” for operating expenses which have sometimes, it is
true, included some very “plush” items.
Instead of reducing member bank reserve requirements so that they
can expand their earning assets by taking over some $15 billion of
these bonds, I propose that the Federal Reserve System instead trans
fer $15 billion of these obligations to the Treasury Department for
immediate cancellation.
Mr. S e l d e n . When the bonds were initially purchased by the Fed
eral Reserve System, this created reserves which permitted the banks
to expand the quantity of money. The second phase of this transac
tion is that they—the Federal Reserve—sell them. This, it seems to
me, is simply reversing, negating, and washing out completely the
first transaction. If they buy the same securities back again, as the
third step of the transaction, then we are back where we were initially.
We have created new reserves.
Representative P a t m a n . The point I want to make is, in respect
to this $25 billion of Government securities that the Federal Reserve
has, and they admit they do not need that much portfolio. It has now
been suggested that we ought to reduce reserve requirements so that
the private commercial banks can buy about $15 billion.
My point is, and I am going to argue at least as long as I get any
attention or consideration of it, that these $15 billion m bonds, now
owed on the one hand and now owned on the other by the Govern
ment itself through two different agencies, should be canceled and
not given away. In other words, we should have a bond burning and
burn $15 billion more or less, in bonds and thereby reduce the national
debt that much because those bonds have actually been paid for with
U.S. Government money.
Senator B u s h . At that rate, if the gentleman would yield, it would
not take long to get rid of the whole national debt.
Representative P a t m a n . Yes, it would take a long time, Senator,
because you would have terrific opposition from certain people and I
do not think we would get far on getting rid of the national debt.
But we can get rid of $15 billion because we already have that in
hand.
Senator B u s h . If you could do it as easily as you say in 1 year, it
would not take very long to get rid of the whole thing.
Representative P a t m a n . We are not creating a new situation to do
it, Senator. We are merely having to take cognizance of a situation
that has already been created because the pending legislation now
contemplates a wholly new situation— a situation in which these bonds
become earning assets of private banks instead of a branch of Govern
ment.
722
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
If you had a mortgage on your home and you gave someone the
money to pay for that mortgage and the person making the payment
had the mortgage transferred to himself instead and then demanded
payment of interest from you, you would think that would be out
rageous and naturally you would be right.
That is what the Government is doing. An instrumentality of
the Government is buying these bonds, and instead of canceling
them, letting the instrumentality get interest on the bonds and now
they seek a way of putting them back into circulation and making
the people pay for them twice.
Senator B u s h . I may be wrong, but it seems to me you are treat
ing the Federal Reserve System and the Treasury as though they
were just one. The obligation is the obligation of the Treasury.
Those bonds are not the obligation of the Federal Reserve Board.
Representative P a t m a n . I know, but Federal Reserve Board has
paid for them with another form of Government obligation of Fed
eral Reserve notes that is just as much a mortgage on the incomes and
the property of the people as an interest-bearing obligation.
So the Federal Reserve has taken our Bureau of Engraving and
Printing money and paid for these bonds. Therefore, the bonds
should be canceled except where they can be used in the necessary
functions of the Federal Reserve System. They say they are not
needed in their functions, that they do not need those bonds. They
want to turn them back over to the commercial banks, thereby mak
ing the people pay for the bonds twice.
Mr. S e l d e n . I don’t see that there is any great issue involved, sir,
if I may say so.
The interest income paid to the Federal Reserve System reverts
to the Treasury.
Representative P a t m a n . Ninety percent of it flows back to the
Treasury and the other 10 percent belongs to the Treasury, but is
temporarily withheld. The difference is, if you let that 15 billion
go back to the private commercial banks, and they will get them for
nothing, instead of their interest flowing back into the Treasury, it will
flow into the profits of the private commercial banks.
Mr. S e l d e n . The whole thing has me somewhat mystified because
if the commercial banks wished to increase their portfolios of Gov
ernment securities, this can be done at a moment’s notice on the open
market. Securities can be purchased from private holders other
than the Federal Reserve System.
I am not aware of the existence of a large volume of excess re
serves in the banking system now which needs to be employed.
Representative P a t m a n . That is precisely the catch. It is pro
posed to reduce the reserve requirements so that they do have added
reserves. Of course the giveaway is clouded by some horsetrading
because they cannot afford to just turn $15 billion over to the private
commercial banks. They just would not try it without some hocuspocus.
The C h a i r m a n . Mr. Curtis?
Representative C u r t is . Dr. Selden, I was very much interested in
your breakdown of the factors that affected velocity.
As I gathered from your paper, you list five. One is the level of in
terest rates. The second listed here is credit. Three is ratio to real
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
723
income. Four is the extent that holding is useful. Five is the expec
tations of future values.
There seems to have been a sixth that you list on page 18, which
you say is improved techniques of managing cash.
Would you regard that as one that should be added ?
Mr. S e l d e n . N o ; I would include that under the extent to which
the holding of cash is useful.
Representative C u r t is . Rather than improved techniques?
Mr. S e l d e n . That will depend on the technical proficiency of
people and of businesses in their management of their cash accounts.
As experience is accumulated, we begin to be more sophisticated in
the management of cash. I think this is certainly true at the business
level, in any case. It may be that we can make a given amount of
cash go further.
Representative C u r t is . And the same would apply to some degree
to the personal holdings, too ?
Mr. S e l d e n . Yes, sir; I believe it does.
Representative C u r t is . Y ou list the level of interest rates as a sort
of plus factor that increases velocity. I was a little curious about
that.
Mr. S e l d e n . This is what Professor Friedman was speaking of
yesterday under the terminology of the cost of holding money. He
mentioned two factors there, the level of interest rates and rate of
price level change.
For simplification here, I left out that second factor. The in
fluence of interest rates on velocity can be described in this way:
Cash is a barren sort of wealth holding. There is no income from
cash except where interest is paid on deposits. The extent to which
people want to hold cash will depend upon the extent to which they
are sacrificing monetary income by holding cash instead of something
that is income-earning.
Representative C u r t is . Then turning around to the point of de
mand for money, you do not feel that the amount of the interest rate
that is determined would slow down in the amount of debt creation,
or not sufficiently so ?
Mr. S e l d e n . No; I agree with what Dr. Friedman said yesterday,
that there is probably a fairly elastic demand for credit. I also think
we have to distinguish between credit matters and monetary matters,
as he did yesterday.
R epresentative C u r t is . Y
ou
agree w ith his statem ent?
Mr. S e l d e n . Yes; I subscribe to it completely.
It seems to me the level of interest rates probably has some effect on
the amount of cash that people are willing to hold and therefore
velocity, but I don’t think it is a major or dominant factor.
Representative C u r t is . The second item, which I have listed as
credit, although you described it as increased use of substitutes, is
very definitely a plus item in increasing velocity, is it not ?
Mr. S e l d e n . Yes, sir.
Representative C u r t is . I was a little disappointed to find from
your paper that you do not think we can measure that very well.
Mr. S e l d e n . We can measure some aspects of it exceedingly well,
but there are a great many ramifications to it.
I was referring there to the volume of lines of credit in existence.
I don’t know any place where I can put my hand on a figure which
724
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
would tell me what the total volume of negotiated lines of credit would
be at all banks in this country, for instance. Perhaps such a figure
exists, but I am not familiar with it. I am not familiar with any
figure which would tell me the extent to which individuals use credit
cards for the purchase of gasoline. I could perhaps find this out by
doing a little research.
Representative C u r t is . It seems to me, as your paper has pointed
out, that since World War II there has been a tremendous increase
in the use of the substitutes for money. I think in that category the
factor of consumer credit has been probably very predominant.
I am looking for whatever statistics we might have that might
measure that.
Mr. S e l d e n . It is certainly not impossible to measure. It would
be quite a chore and one which I have not found time to get around to.
Representative C u r t is . In your conclusion, you state that for
future predicting, we cannot very well predict the future of money
substitutes. I wonder if we can find the underlying factors that have
brought about the use of money substitutes.
Insofar as consumer credit is concerned, I think it is a very healthy
thing which is enabling our people to spread their purchasing power
for a lifetime more evenly over their years. In their earlier years,
there is probably a need for more expenditures than they would have
the cash and reserves for. If we have gotten to the point where we
have met that human desire, I think we could look forward to a de
clining of any future expansion of money substitutes in that area.
Do you think that is an area worthy of investigation ?
Mr. S e l d e n . I do, and I tend to agree with you, although it is
rather intuitive on my part, that the rate of increase of money sub
stitutes will begin tapering off. No doubt we will continue to develop
substitutes for cash in the future; technology is not going to stand
still here. But I don’t think it is going to be as important in the next
decade or two as it has been.
Representative C u r t is . I think it is a result of our income tax laws.
There are tremendous pressures to defer income to later years. There
is this same human desire to spread their income more equally over
a lifetime.
Number three, ratio to real income, you have listed as a minus
factor. In other words, that would tend to slow the velocity.
Mr. S e l d e n . That is right. When we look at chart 1 we see that
persistent downtrend since 1869 in the income velocity of money.
How do we explain that? That is a question I have spent quite a
bit of time thinking about. My conclusion has been that the rise in
living standards, in other words, rising income per capita, has been
the major factor.
Representative C u r t is . That led me to this question.
Do we have any figures of the per capita ratio of debt to per capita
assets?
I think that is as important a f actor as real income. You must also
consider the net assets.
Mr. S e l d e n . It is an area in which I have no immediate informa
tion. I simply haven’t looked at it from this point of view.
Representative C u r t is . D o you agree that that may not be as impor
tant as real income but it is a relevant consideration ?
EM PLOYMENT, GROWTH, AND PRICE LEVELS
725
Mr. S e l d e n . Yes, sir.
Representative C u r t is . Then you list the extent of the holding
being useful. I put that down as a plus or a minus. That could go
either way, could it not ?
Mr. S el d e n . Yes, sir.
Representative C u r t is . Then the last one, expectations of future
value, again could be a plus or minus, going either way ?
Mr. S e l d e n . That is right.
Representative C u r t is . So we come back to Nos. 1 and 2, level of
interest rates and money substitutes, as the place where we have expe
rienced that expansion in the 20th century, this increase in velocity ?
Mr. S e l d e n . We must remember that the velocity increase has been
primarily since 1945. It is mainly a postwar phenomena.
Representative C u r t is . That would make me believe it is almost
exclusively in this area of money substitutes. I have long felt that it
was, and I have long felt that the phenomena has not been a bad one
because it is reflecting this attempt to spread income.
If thait is so, we are dealing with a different problem than many
people have presented to us.
Representative P a t m a n (presiding). Senator Bush.
Senator B u s h . Do you feel that the Federal Reserve Board powers
are sufficient, inadequate, or too great ?
Mr. S el d e n . They are certainly not inadequate.
I think I would say, if anything, they are too great.
Senator B u s h . You would what ?
Mr. S el d e n . I would say that if anything, they are too great. They
certainly are sufficient for sound monetary policy, it seems to me.
Senator B u s h . If you were going to suggest how they should be
changed, what would you suggest?
Mr. S e l d e n . I think I would follow the recommendations of the
previous witness, Professor Friedman, in that regard.
As I recall, he stressed two things: One was the elimination of the
power to vary reserve requirements. Second is the elimination of
rediscounting.
I believe I would strike at both of those.
Senator B u s h . Do you have any legislative recommendations to
make to this committee respecting the Federal Reserve System or the
banking system ?
Mr. S el d e n . The recommendations I would make, other than the
ones I have just made, would be that we permit the Treasury to sell
securities at a competitive open-market rate of interest so that some
appreciable lengthening of the Federal debt can be achieved.
Aside from that, I would like to see, either by legislative mandate
or as a result of discussion within the Federal Reserve System, the
announcement of a monetary policy which they intend to imple
ment. As it stands now, we are all somewhat in the dark as to what
are the objectives of our central bank. They change from time to
time.
I think it would be salutary if they had an announced policy of
some kind which they would stick to so that all of us would live in a
stable monetary environment. And we could make plans accordingly.
Senator B u s h . They have frequently referred to their monetary
policy as one of leaning against the wind. That does not seem to
be adequate indication of what their policy is?
726
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS
Mr. S e l d e n . Again, to steal Professor Friedman’s words on this, it
depends on which way the wind is blowing.
Senator B u s h . On the question of price stability and its relation
ship to maximum employment, how do you feel about that?
Legislation has been offered to make price stability an objective
in the Employment Act of 1946. Do you care to comment on that ?
Mr. S e ld e n . When you asked me for recommendations, I neglected
to mention that.
Yes, I would agree with an amendment of that sort making price
level stability a coordinate goal with the maintenance of full em
ployment.
Senator B u s h . Do you feel they are compatible and not conflict
ing in their interests ?
Mr. S e l d e n . Yes, providing one adopts a sensible definition of
full employment.
Quite often in economic literature, one encounters what seems to
me a rather restrictive definition of full employment. The Beveridge
report, which was published by Sir William Beveridge in the early
postwar period, adopted a definition of full employment which liter
ally meant that everybody would be employed.
It seems to me that kind of situation is not compatible with price
level stability. We have normally frictional unemployment, mean
ing by that that from time to time people change jobs. Almost in
variably there is some duration of time, usually relatively short,
between the quitting of one job and reemployment on another. We
have found that this amounts to several hundreds of thousands of in
dividuals in the American economy at any moment in time. I think
it would be unfortunate if the idea ever became implanted in the
policymakers minds that this kind of unemployment could be elim
inated entirely.
Senator B u s h . I think that is right. The law does not speak of
full employment anyway. It refers to maximum employment and
the factor you have mentioned is taken into account in that.
I have no other questions, Mr. Chairman.
Representative P a t m a n . Mr. Widnall.
Mr. W id n a l l . Professor Selden, on page 3 you said the wholesale
price index has two major shortcomings, its omission of the price of
services and the failures to pick up the departures from list prices.
Do you have any facts and figures indicating what would happen
to the price index if you included those two items ?
Mr. S e l d e n . They have been working in opposite directions re
cently. The prices of services have been going up. We see that from
the Consumer Price Index, so there is no question as to what is hap
pening with the price of services.
On the other hand, when we come to the question of a fictitious
price, it is very hard to amass any body of data which would be con
vincing on this. At* the same time, I believe anyone who reads trade
journals and keeps his ear to the ground, so to speak, has been aware
during the last year or so of instances of departures from list prices.
The Bureau of Labor Statistics makes every effort to find out about
these and when they do know of them, they give the actual prices
rather than the listed prices, which is appropriate.
What I am saying is that they fail to pick up a lot of these in
stances. I know of one case in particular.
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
727
During 1957 and 1958, the wholesale price index of this particular
group of commodities was rising continuously through a period of
obviously slack demand. I spoke to the person in charge of market
ing of these commodities for a major producer, and asked him what
the explanation was. He said, “Haven’t you heard of our great white
sale ?” It turned out that actually these items were not being sold at
this price even though the Bureau of Labor Statistics was unaware
of it.
How important this is, I cannot say. All I know is that I have
personally become aware of a number of instances of this and I think
the failure of the wholesale price index to decline during the 1957-58
recession is in part attributable to errors of this kind. I think on a
realistic basis we did have some deflation which did not show up in
the index.
Representative C u r t is . Would the gentleman yield ?
Is that not somewhat true in the retail field.
Mr. S e l d e n . Yes, sir. You have allowances of one sort or another,
trading stamps and other kinds of offers which are payments made
for soap and so forth. I think there are factors of this kind working
in the Consumer Price Index, too. However, I think it is probably
more important in the wholesale index.
Representative W id n a l l . It has interested me very much in going
to retail stores recently to see at how much of a discount you can
get so many items and in the food line how cheap are certain items
of food compared to several years ago. Yet we hear constantly about
rising prices.
I don’t think food prices seem to be weighted as much as they should
be in connection with the price index today. Meat is up, but many
other items are way down.
Eggs are down, for instance. They are a basic commodity and
used to a great extent in the average family fare.
Mr. S e l d e n . I think the Consumer Price Index is a relatively in
ferior criterion of what is happening to the value of money in any
case. I feel that it is a narrow and sluggist index.
If you want to find out what is happening to the price level, I
think you would do better looking either at the wholesale index, which
I like to use despite its flaws, or we now have this quarterly price de
flator series that the Department of Commerce is putting out, and I
think that is probably a pretty good index.
Representative W id n a l l . Do you have any recommendations as to
how the Consumer Price Index could be improved ?
Mr. S e l d e n . It could be broadened greatly by extending the cover
age of it. As it stands now, it is limited to moderate income fami
lies in the larger centers of population. I think it can be broadened
in terms of the types of things that are priced, the types of markets
that are surveyed geographically, and so on. However, even a greatly
broadened Consumer Price Index is still just a Consumer Price
Index.
Despite the fact that consumption is so important in our economy,
it leaves out of account the very important area of capital equip
ment and many other kinds of items which households don’t purchase.
I think when we measure the value of money, we should measure it
broadly against the prices of all kinds of goods and services.
728
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
Mr. W id n a l l . That is all. Thank you.
Representative P a t m a n . Senator Javits.
Senator J a v it s . Professor Selden, first let me welcome you as a
fellow New Yorker.
Mr. S e l d e n . Thank you, sir.
Senator J a v it s . I would like to call your attention specifically to
the analysis contained in your statement, which I find especially in
teresting to me.
In the first place, I would like to have you reaffirm your statement
in which you say:
I cannot agree that cost pushes and pricing changes have been significant fac
tors in the recent inflation.
Does that mean that you do not regard cost pushes and pricing
practices as having been great factors in the recent inflation, or does
it mean that under no circumstances could cost pushes or pricing prac
tices be significant factors in an inflation ?
Mr. S e l d e n . Taking the latter statement, of course that is a rather
extreme position.
Senator J a v it s . I am just trying to get your position.
Mr. S e l d e n . My position is simply based on my reading of history.
I can’t say what will happen in the future and I can’t say what has
happened in other countries. Furthermore, it is based on my reading
of history primarily during this 1955-57 period, which is commonly
assumed to be an example of cost push.
I will say that I don’t think they have been a major factor.
Senator J a v it s . Is it fair to say that you are testifying that the
cost push and pricing practices engaged in from 1953 to 1957 have not
been significant factors ?
Mr. S e l d e n . Yes, sir.
Senator J a v it s . I think that is very important because there is a
widespread feeling, as you know, that the contrary is the case.
Apparently it is your feeling that we have not, either by so-called
administered prices or by wage increases, in any major way out
stripped the productivity of the economy or the giving of real value,
let us say, for the receipt of money ?
Mr. S e l d e n . That is correct.
You see, when you look at the pattern of price change during 1955
to 1957, you find that investment goods were particularly important
in the rise of the wholesale price index. It is true, of course, that
these investment goods industries are characterized in some instances
by what is called administered pricing. It is also true that these
investment goods industries are characterized in some cases by strong
unions which have won large wage increases. We have three possible
interpretations coinciding. We have the strong demand for capital
goods and we have the pricing practices of the capital goods producers
and we have the labor situation within those areas of the economy.
Which of the three do you select ?
It simply seems to me that during 1955 and 1956 particularly the
price increases in those areas reflected strong demand. We know
that the 1955 to 1957 business expansion was a period of exceptionally
rapid capital goods expansion. I think that the long workweeks and
the high levels of employment in general and the high levels of in
dustrial production in those areas testifies to the strong demand for
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
729
those goods which existed in the economy and it is reasonable to
attribute the largest part of these price rises to that phenomena of
strong demand.
Senator J a v it s . Then, you say, if velocity levels off and attains
a more or less horizontal trend, then the outlook for price level stabil
ity will be good.
You add, we can confidently anticipate continued growth of real
income per capita. This should exert downward pressure on velocity.
Is it fair to say that you conclude that if we have continued growth
of real income— and I emphasize the word “real”—per capita, that
the outlook for price level stability is good ?
Mr. S e l d e n . One would have to continue reading the next sentence
too, because those are coupled together.
You see, as Representative Curtis brought out, you have some
factors moving velocity in a downward direction and you have other
factors tending for an upward movement of velocity. There is a tug
of war. It is a question of the relative strengths of these factors.
I think I would agree with the sense of your comment that rising
real income per capita will be an important factor influencing
velocity.
Quite apart from its influence on velocity, an increase in the flow
of goods and services will in itself be a deflationary factor.
Senator J a v its . S o your theory of the behavior of money, if it is
correct, would lead us to the conclusion that increased productivity
and increased markets, both foreign and domestic, will give us a satis
factory rate of advance, will help us avoid excesses of inflation with
the present machinery of government and present equipment that
controls ?
Mr. S e l d e n . Yes.
I think the present machinery is adequate. The question is how
it is going to be used or operated.
My own feeling is one of optimism in this respect. I think we
have had good leadership on the whole. If we can continue to get it
or perhaps improve it a little bit, I think the longrun prospect for
the next decade or two, barring unfavorable international develop
ments, is for only moderate inflation or perhaps even stability.
Senator J a v its . S o w^e are on the right track as you see it?
Mr. S e l d e n . I do believe so.
Senator J a v it s . And we just have to keep at it with the greatest
diligence ?
Mr. S e l d e n . That is right. We have to have determination and
not be deflected from our purpose. I think that would be the best
policy.
Senator J a v it s . Thank you, Mr. Chairman.
Representative P a t m a n . The chairman desires to insert in the
record (1) the American Economic Review article on “Monetary
Systems and Accelerator Models,” by Hyman P . Minsky, (2) certain
correspondence between Senator Douglas and the Federal Reserve
Board, and (3) two brief items by Prof. Alvin Hansen on inflation
ary pressures and debt management thereto.
Without objection, they will be placed in the record at this point.
(Information referred to follows:)
38563 O— 59— pt. 4------- 9
The American Economic Review
VOLUME XLVII
DECEMBER 1957
NUMBER SIX
MONETARY SYSTEMS AND ACCELERATOR MODELS
By H y m an P. M in s k y *
A significant part of recent literature on both growth and businesscycle theory has been based upon some form of an interaction be
tween a consumption (saving) relation and an induced investment
relation. The authors who have constructed these accelerator-multiplier models have paid little, if any, attention to the monetary pre
requisites and effects of the assumed processes.1 Obviously the accelerator-multiplier process takes place in the context of some monetary
system. In this paper the manner in which the time series generated
depends upon the interaction of an accelerator-multiplier process and
the monetary system will be investigated: the main emphasis will be
on the upper turning point and the possibility of generating steady
growth. In this paper the lower turning point is unexplained aside from
noticing how the various monetary systems can act as a brake on
disinvestment and also, by changing liquidity, set the stage for a re
covery.
The procedure will be to examine the result of combining a linear
accelerator-multiplier model with a number of alternative monetary
systems. The terms (interest rate) and the manner (type of liability)
of financing investment are affected by the behavior of the monetary
system. In turn, both money-market conditions and the balance-sheet
structure of firms affect the response of firms to a change in income.
This can be interpreted as making the accelerator coefficient an en
dogenous variable related to the monetary system. Hence the material
♦The author is associate professor of economics, Brown University. A large portion of
the work on this paper was done while he was a visiting associate professor at the Uni
versity of California, Berkeley. He wishes to acknowledge his debt to Julius Margolis,
Roger Miller and Merton P. Stoltz for their helpful comments and suggestions.
’ J. R. Hicks, A Contribution to the Theory of the Trade Cycle (Oxford, 19S0) and
S. C. Tsiang, “Accelerator, Theory of the Firm, and the Business Cycle,” Quart. Jour.
Econ., Aug. 1951, LXV, 325-41 briefly consider monetary factors.
730
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
731
in this paper could be formalized as a series of nonlinear acceleratormultiplier models.2
This paper is divided into four sections. The first is a brief review
of the attributes of both linear and nonlinear accelerator-multiplier
models, which is followed in the second section by an analysis of the
behavior of the accelerator model with the quantity of money con
stant. The third section is an investigation of how the system would
behave with the quantity of money varying in a number of different
ways. In the last section some implications of the analysis for mone
tary and fiscal policies are briefly explored.
I. Formal Attributes of Accelerator-Multiplier Models
The essential linear accelerator-multiplier model can be written:*
Yt = Ct + I t
(1)
= «FW
(2)
It =
- F«_2)
(3)
where F = income, C = consumption, I = investment, a = marginal
(= average) propensity to consume, & = accelerator coefficient and t
is the number of the “day.” By substitution, equations (l)-(3 ) yield:
Yt = (a + f i Y t . t - p Y ' - t
(4)
Equation (4) is a second-order difference equation; its solution in
general is of the form:
Yt =
+ A&S
(5)
where Ai and At depend upon the initial conditions and |*» and p* are
determined by the values of « and P.
Aside from the effects of the initial conditions, the time series gen
erated by a second-order difference equation can be any one of the
following: (1) monotonic equilibrating; (2) cyclical equilibrating;
(3) cyclical with constant amplitude; (4) cyclical explosive; (5)
monotonic explosive.4 By itself, no one of these five types of time
Ct
3 Obviously the interest rate and consumer debt affect consumption expenditures also;
therefore the consumption coefficient also depends upon the behavior of the monetary sys
tem. The “Pigou effect” can be interpreted as a particular relation between the consump
tion coefficient and the monetary system. Such effects are ignored in this paper.
* This stripped model exhibits the characteristics of a linear accelerator-multiplier model
which are important for the problems discussed in this paper. The incomes should be in
terpreted as deviations from a “zero” level of income given by F0= \/l—a where X could
be identified with autonomous investment or ‘‘zero income” consumption.
W. J. Baumol, Economic Dynamics, An Introduction (New York, 1951), Ch. 10, 11,
gives a very simple discussion of the solution to second-order difference equations.
4The type of time series generated is determined by the values of M* and y*, which in
turn depend upon the values of a and p. For a type-1 series, \h and H* are both less than
1, for a type-2, 3, or 4 series m* and m* are conjugated complex numbers, and for a type-5
series y* and \h. are both greater than 1.
732
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
series is satisfactory for business-cycle analysis. Types 1 and 5 are not
cyclical. If they are to be used, either floors or ceilings to income or
pushes (systematic or random) from outside have to be posited. A
time series of type 2 would in time result in the cycle dying away, so
that some systematic or random push is required to maintain the
cycle. A time series of type 4 would in time generate fluctuations
greater than any preassigned value. Hence floors and ceilings have to
be posited to constrain the fluctuations. A type-3 time series is a selfsustaining cycle, but its existence depends upon a particular value of
P and, in addition, the time series it generates is “too” regular.
A way out of this difficulty is to have the # and P coefficients vary
over the cycle, thus generating a time series which is a combination
of the different types of time series. Hicks and Goodwin do this by
assuming that the value of P is so great that, unless constrained, an
explosive time series is generated, but that constraints, in the form of
a maximum depreciation rate and full employment (or the capacity
of the capital-goods-producing industries), exist. These constraints
force realized investment to be different from induced investment, and,
formally, they can be interpreted as changing the value of £. As the
value of (5 is assumed to fall (rise) when income is very high (low) or
increasing (decreasing) very rapidly, an acceptably irregular cyclical
time series is generated. Obviously by linking explosive, cyclical and
damped movements together, any type of time series which is desired
can be generated.
A set of formal nonlinear models similar to those of Hicks and Good
win can be generated by positing that the value of P, the accelerator
coefficient, depends upon money-market conditions and the balance
sheets of firms. These factors in turn depend upon the relation between
the level and rate of change of income and the behavior of the mone
tary system. In this paper however the mathematical model of the
accelerator process will be a simple linear form. It is hoped that what
is lost in mathematical neatness may be offset by what is gained in the
identifiability of the economics.
So far we have not taken up the effects of the initial conditions. The
initial conditions are particularly important in determining the income
generated by a type-5 (monotonic explosive) time series for small
values of t. To generate a type-5 time series, Hi and |*2 are both greater
than 1 in the relation F# — ^4iiV + ^ 21*2*. To set off the recursive
process two levels of income F0 and Fi (the initial conditions) are
needed, which determine the values of At and A 2. U Fi is greater than
Yo and the ratio of Fi to Fo is less than 1x2, the smaller root, then At,
the coefficient of 1*1, the larger root (also called the dominant root),
will be negative. As the larger root will in time dominate, a negative
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
733
will in time result in a negative Yt. Hence if the rate of increase of
income given by the initial conditions is less than the smaller root,
there will be a turning point in the time series even though the values
of a and &are such as to generate a monotonic-explosive time series.*
This leads to an alternative way of interpreting the Goodwin-Hicks
type of nonlinear accelerator models. When the floors and ceilings be
come effective, a new set of initial conditions is, in effect, imposed on
the time series. If these new “initial conditions” result in the sign of
the coefficient of the dominant root changing, then in time the direction
of the movement of income will be changed. The effects of monetary
constraint can also be interpreted in this manner.
Following Goodwin and Hicks we will assume that the value of fi
is so large that, unless it is constrained, the accelerator-multiplier
process will generate an explosive time series. The solution of the
accelerator-multiplier model will be Yt — Aiy-i* +
where >
P*2 > 1 and the initial conditions are such ( Yi/Yo > 1*2) that At and
Ai are both positive. For the range of magnitudes of Y 1/ Y 0 which it
seems sensible to posit, A 2 will be much larger than Ai. This means
that at the early dates (t small) of the development the weight of (*2
is high while at the later dates Hi dominates. The rate of growth of in
come generated by the explosive process being considered increases in
time, approaching 1*1 as a limit.®
The increasing rate of increase of income that such an, explosive
accelerator process generates will in time be greater than the accepted
possible rate of growth of productive capacity. In order to be able to
maintain the continuity of the accelerator process, we assume that all
the relations are in money terms and that the accelerator process may
generate changes in the price level. We will, at a number of points, call
attention to some specific effects of price level changes.
II. The Accelerator Model with the Quantity of Money Constant
In this and the following section we will derive several time series
that result from the interaction of an accelerator-multiplier process
Ai
‘ If the two roots are equal, then the solution to the difference equation is Ft =
+ 4st\h‘ (see Baumol, op. cit., Ch. 10, 11). If Y1/Y0 — Hi, then 4 : = 0 and a constantrate-of-growth series is generated. If F i/F «< jij, then At < 0 and in time Yt < F»-»;
if Yt/Y, > Hi, then At > 0 and, at least in the early days, the rate of increase of income
is significantly greater than Hi. In terms of a second-order difference equation, a steady
rate of growth of income can be characterized as a knife edge: it requires not only that
o and (3 be such that Hi =|*» > 1 but also that- F1/F 0 = Hi (see S. S. Alexander, “The
Accelerator as a Generator of Steady Growth,” Quart. Jour. Econ., May 1949, LXIII,
174-97.
*In Sections II and III a number of tables will be exhibited to illustrate the results of
combining an explosive accelerator-multiplier process with a number of different monetary
systems. In each case it is assumed that a = .8, P = 4, F« = 100 and Yt — 110. For these
values jfa = 3.73, |x, = 1.07, At = 1.1 and A, = 98.9 so that F, = 1.1(3.73)’ + 98.9(1.07)'.
In time F »«/F i will approach 3.73.
734
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
and various types of monetary systems. The monetary systems to be
considered are classified in terms of the monetary changes which can
take place. Monetary changes are changes in either the velocity of
circulation or the quantity of money. Therefore we will consider the
following alternative monetary systems: (A) neither velocity nor
quantity changes; (B) only velocity changes; (C) only quantity
changes; (D) both velocity and quantity change.7 The first two mone
tary systems will be considered in this section, the last two in the next
section.
Except in the first monetary system, we assume that there exists a
fractional reserve banking system. The money supply is changed by
either the creation of deposits in exchange for business firms’ debts or
the destruction of deposits by business firms’ repayment of bank debt.
That is, the banking system is a commercial banking system rather
than one that deals in government and other securities.8 In all that
follows the central bank’s relations with the commercial banks are
integrated into the “monetary system.” For example, an infinitely
elastic money supply can be achieved by a central bank lending to
commercial banks, or by a central bank purchasing open market
paper. Also in a monetary system we include the specialized financial
intermediaries.
The income velocity of money and the liquidity preference relation
can be characterized as mirror images of each other.9 When income
velocity rises, the liquidity of the economy falls and vice versa. A
useful construction is to assume that for each level of money income
Y, there exists a minimum quantity of money Mr which is necessary
to sustain the volume of payments associated with F. If M t is the
total quantity of money in existence then there is no money available for
portfolio use; we have a maximum income velocity of money Vm for
1 Cases A and B, where the quantity of money is constant, may be thought of as worlds
of 100 per cent money. If at the “initial point” excess liquidity exists, so that velocity can
increase, it is Case B, otherwise it is Case A. Case C (l), where the money supply is in
finitely elastic, is a world of a paper-money authority which ignores price-level considera
tions (perhaps a world in which the central bank follows a “needs of business” rule).
Case C(2), where the quantity of money has an exogenously determined rate of growth,
is a gold-standard world where gold production is autonomous and determines the rate
of growth of the money supply. Case D of course is similar to the existing monetary system.
8Some of the differences between the classical quantity theory of money and the
Keynesian liquidity preference theory of money can be imputed to the way in which the
banking system is assumed to operate. The quantity theory approach is consistent with
bank lending to business (commercial banking) whereas the liquidity preference theory
follows from banks purchasing securities on the open market. In commercial banking an
increase in the quantity of money enables a business firm to effect a decision to purchase
goods and services. On the other hand, open-market operations substitute money for
another asset in the portfolios of the public, and whether or not purchases of goods and
services result depends upon the reaction of the public to this change in liquidity.
#A. C. Pigou, Keynes*s General Theory (London, 1951); H. S. Ellis, ‘‘Some Funda
mentals in the Theory of Velocity,” Quart. Jour. Econ., May 1938, LII, 431-72.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
735
each Y , so that Mr • Vm = Y. If M is greater than Mr then the actual
velocity, V, is less than Vm. The difference between M and M r is M l,
the amount of money which is held as a liquid asset. If the quantity of
money is constant, portfolio money M l must fall when V rises.
If V < Vm then M l > 0. Abstracting from changes in the quantity
of money, with M l > 0, the interest rate is determined by the demand
curve for investment, ex ante saving, and the terms upon which holders
of liquidity are willing to substitute earning assets for money. Sim
ilarly, if M l = 0, then the interest rate is determined by the demand
for investment, the supply of saving and the terms upon which
individuals are willing to hold cash as an asset. With a given money
supply in excess of Mr there exists a rate of interest at which house
holds and business firms as a whole are not willing either to increase
or to decrease their holdings of money. Any other market interest rate
involves either an increase in cash balances so that savings are utilized
to increase liquidity, or a decrease in cash balances so that investment
is financed from the reservoir of purchasing power. It is assumed that
changes in the market rate of interest will affect the amount of invest
ment induced by a given change in income.
Assume that all investment is made by business firms. On a consoli
dated balance sheet of all firms, investment is represented by an
increase in plant, equipment or work in progress, and it will be offset
by an increase in liabilities (equity or debt) or a decrease in other
assets (cash or liquid assets). Business investment can be equityfinanced as a result of either ex ante saving by households and firms
or a decrease in the cash balances of households. Business investment
can be debt-financed as a result of ex ante saving by households, a
decrease in households’ cash balances or by an increase in bank debt
of business firms. The financing of investment by a decrease in the
cash (liquid assets) balances of firms does not affect either the debt
or the equity liabilities of firms: it only makes firms less liquid.
Whereas ex ante saving and decreases in the liquidity of households
can be used for either debt or equity financing of investment, increases
in the quantity of money can be used only for the debt financing of
investment. Households, business firms, and banks are sensitive to
the composition of the balance sheets of firms; in particular an increase
in the ratio of debt to equity or a decrease in the ratio of cash to
other assets in firms’ balance sheets will make business firms less will
ing to borrow and households and banks less willing to lend. Hence
if investment is financed in such a way as either to increase the ratio
of debt to total liabilities or to decrease the liquidity of business firms,
the amount of investment induced by a given change in income will
fall. The value of the accelerator coefficient therefore depends upon
736
EM PLOYMENT, GROWTH, AND PRICE LEVELS
two variables, the market rate of interest and the structure of the
balance sheets of firms. Changes in these variables can dampen what
otherwise would be an explosive movement of income.
A. Neither Velocity nor Quantity Changes
Using the Swedish concepts,10 we define Yt — C t = (1 — a)F«-t
as ex ante saving. Assuming, as pure accelerator-multiplier models do,
that all of investment is induced, then It —,P(F*-i — Yt-i) is iden
tified as ex ante investment. From equations (l)-(3 ), it follows that
for Yt > Yt-1 it is necessary that It = P(Ft-i — Ft-2) > (1 — a)F*-i,
for Yt < Yt-i it is necessary that It = P(Ft-i — Yt-2) < (1 — «)Ft-i.
With a monetary system in which neither the velocity of circulation
nor the quantity of money changes, if ex ante investment is greater
than ex ante saving, the ex ante saving has to be rationed among
investors, and the market in which this rationing takes place is the
money market. The excess of demand over supply results in a rise in
interest rates, which will continue until realized investment is equal
to ex ante saving. In Figure 1, ex ante investment is based upon the
-1
SAVING, INVESTMENT
F i g u r e 1. R e c o n c i l i a t i o n of E x A n t e S a v i n g a n d I n v e s t m e n t
rate Ri so that P(F»-i — Yt-t) = It'. The inability to finance more
than It ( = St) of investment results in a rise in the interest rate to R 2.
Such a monetary system leaves no room for an accelerator-multiplier
cycle. A necessary condition for the functioning of an accelerator
10B. Ohlin, “ Some Notes on the Stockholm Theory of Savings and Investment,” Econ.
Jour., Mar. and June 1937, XLVII, 53-69 and 221-40. Reprinted in American Economic
Association, Readings in Business Cycle Theory (Philadelphia, 1951), pp. 87-130.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
737
process during an expansion is that a source of financing of investment
in addition to ex ante saving should exist.11
Symmetrically, if ex ante saving is greater than ex ante investment
then an increase in investment is forced so that all of the available
financing is absorbed by real investment. If there exists no way in
which savings can be utilized other than in investment, then the terms
upon which firms can finance investment must change so that realized
investment is greater than ex ante investment. This equality of ex ante
saving and realized investment stabilizes income, thereby halting the
“inducement to disinvest.”
B. Only Velocity Changes
With a constant money supply, realized investment can differ from
ex ante saving only if the velocity of circulation of money changes.
We will first take up the purely mechanical implications of the exist
ence of a floor and a ceiling to velocity. We will then consider the
effects on the value of the accelerator coefficient of changes in velocity
when no excess liquidity exists and when excess liquidity exists (the
Keynesian liquidity trap). To the extent that a fixed money supply
and a ceiling to velocity set an upper limit to the money value of
income, secular growth requires a falling price level, and this has
implications for the accelerator process.
We have assumed that the interest rate and the balance-sheet struc
ture of firms (liquidity and the debt-equity ratio) affect the value of
the accelerator coefficient. The financing of investment by absorbing
idle cash balances does not necessarily change the debt-equity ratio of
business firms, for we can assume that the debt-equity preferences of
households are not strikingly different when ex ante saving and when
idle cash balances are used to finance investment.12 Therefore the
“ A fall in the price level of investment goods may result in St of monetary savings
being sufficient to finance /* of real investment. Conversely a rise in the price level of
investment goods will lower the amount of real investment that a given amount of money
savings can finance. In Figure 1 the savings curve can be read as a supply curve and the
investment curve as the demand curve (with respect to price) for investment goods at a
fixed interest rate. Then reading R% and Rx as price levels, the accelerator phenomenon
determines the price level of investment goods. This interpretation of Figure 1 must be
what a writer who uses a ceiling to investment-goods production in his models has in
mind (for example, Goodwin, op. cit.). In the original interpretation of Figure 1, even if
It oi investment is financed, the supply conditions of investment goods (with respect to
price) may be such that spending It on investment goods results in a rise in the price of
investment goods; as indicated earlier the accelerator process can lead to a rising price level.
“ J. G. Gurley and E. S. Shaw, “Financial Aspects of Economic Development,” Am.
Econ. Rev., Sept. 1955, XLV, 515-38, discuss the effect of available assets on saving be
havior. It may be true that the asset preferences of households when using cash balances
are different from their preferences when using ex ante saving to finance firms. In this
connection, the legal and traditional limitations on the portfolios of financial inter
mediaries no doubt tend/to affect business investment.
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
738
balance sheets of investing firms do not deteriorate during an expansion
financed by increasing velocity. Of course the liquidity of households
and firms is reduced but, unless the liquidity trap is operative, this is
reflected in the interest rate. Therefore in this section only the interest
rate and, in the liquidity-trap situation, the changes in liquidity at a
constant interest rate can affect the accelerator coefficient.
Assume that a cumulative rise in income is set off. This increases the
quantity of money needed for transaction purposes and, therefore, as
the process continues there are progressively smaller asset holdings
of money which can be used to finance investment in excess of ex ante
saving. The highest attainable level of money income is that level at
which all of the available money supply is required for transactions
(see Table I). At that income realized investment cannot exceed ex
T able
I.—O n l y
V e l o c it y C h a n g e s
(Constant Money Supply—No Interest-Rate Effects)
Monetary System
Money Supply =*100
Maximum Velocity=2
Accelerator Process
a=» .8, 0 = 4.0
F o=100, I W 1 0
Time
Y
0
1
2
3
4
5
6’
100
110
128
* 174
2 00
200
160
C
Savings
Ex Ante
_
—
80
88
20
22
102
26
35
40
40
139
160
160
Investment
Financed
by AV°
Realized
Investment
Ex Ante
_
—
40
72
184
104
0
_
—
30
40
72
61
40
0
10
18
46
26
0
-4 0
Realized
Velocity
1 .0 0
1 .1 0
1.28
1.74
2 .0 0
2 .0 0
1.60
• Investment in excess of ex ante saving. Obviously negative investment financed by AF
means that ex antt saving is greater than investment.
saving. Realized investment equal to ex ante saving results in a
constant income which, given the accelerator assumption, induces
zero investment. Ignoring any effects that the interest-rate and balancesheet changes accompanying velocity increases have upon the accelera
tor coefficient, a monetary system with a constant quantity of money
may impose a ceiling to money income. This ceiling is not determined
by full employment or by the capacity of the investment goods indus
tries; it is determined by the limited ability of changes in velocity to
finance investment.
Symmetrically if a minimum velocity exists, a floor to money income
exists. However the floor is not entirely symmetrical with the ceiling,
and in this paper the lower turning point is essentially unexplained.
Let us examine what would be happening in the money market
ante
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
739
during a process such as is detailed in Table I. Ignoring the liquidity
trap, a rise in transaction money as income rises means that with a
constant money supply portfolio money becomes scarcer. The interest
rate at which cash can be withdrawn from portfolios into the income
stream rises as asset money is used to finance investment in excess of
saving. With a fixed quantity of money and a rise in income, the
balance sheets of households and firms show a smaller ratio of asset
cash to total assets, liquidity decreases. The decrease in liquidity and
the rise in the interest rate both tend to decrease the accelerator
coefficient.
Alternatively, on the downswing ex ante investment is smaller than
ex ante saving. With a constant money supply, this excess saving is
CHANGE IN
CASH BALANCE
M3 0
INCREASE
M2
DECREASE
X 3 l "3 S
0
F igure 2. Sa v in g , I n v e s t m e n t ,
and
1*2
1*2
SAVING , INVESTMENT
C a s h B alances
absorbed by a reduction in velocity. Money available for asset pur
poses increases as it is withdrawn from the income stream. The interest
rate falls and the liquidity of the community rises so that the amount
of disinvestment induced by the given downward shift in demand
decreases. Both on the upswing and the downswing, the monetary
system which is based solely upon changes in velocity acts as a stabil
izer of realized induced investment unless the fall in income is so great
that the money released from transaction purposes lowers the interest
rate to the floor interest rate of the liquidity trap. At this interest rate
the stabilizing effect upon aggregate disinvestment of the fall in
financing terms will cease, although increasing liquidity can continue
to act as a stabilizer.13
Figure 2 illustrates the use of cash balances to finance investment
u Increasing liquidity raising the consumption coefficient is of course the “Pigou effect.”
740
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
and to offset ex ante saving. At the interest rate Ri, and income Fo,
the velocity of circulation of money remains constant. This is illus
trated by the Li curve intersecting the zero change in cash balances
line at Ri. At higher interest rates cash assets would be freed to finance
investment; at lower interest rates saving would be absorbed by cash
balances. The amount of investment which can be financed at any
interest rate is equal to the sum of ex ante saving and the change in
cash balances. Assume that income rises so that at the interest rate
Ri, It of investment is induced. The h curve illustrates how the
value of the accelerator would be changed by a change in interest
rates. The excess of demand over the supply of finance results in a
rise of the interest rate to Ri. As I " is greater than ex ante saving,
income will rise and the transaction demand for cash will increase.
This will raise the schedule relating the change in cash balances to the
interest rate to Li, so that the interest rate at which investment will
be financed by a fall in liquidity will be higher.
If a fall in income shifts the investment demand curve to h , ex ante
investment is h'. With a constant money supply the excess of ex ante
saving over induced investment will depress the interest rate, and
realized investment will be 1 " > 1%, O M 3 being added to cash bal
ances. As S > I " income will fall, and this will shift the liquidity
curve downward so that cash balances can be used to finance invest
ment at an interest rate lower than Ri.
If the cash balance-interest rate relation is as the Y 3, Y 2 and Y 1 set
of curves indicate, then excess liquidity exists; this is the Keynesian
liquidity trap situation. With an investment curve h , h ' — S of invest
ment will be financed by a decrease in cash balances; and if the
investment curve is h , S — 1% will be added to cash balances. In
both cases no change in interest rates will occur. In the Keynesian
liquidity trap situation the money market damps down neither the
“boom” nor the “bust.” On the boom side, the liquidity trap will
exist until the need of cash for transactions absorbs a sufficiently
large portion of the money supply so that the Keynesian liquidity
trap comes to an end. There is no endogenous limiting factor to the
liquidity trap on the downswing aside from the effect that improved
liquidity has upon firms’ balance sheets. Therefore the Keynesian
liquidity trap situation allows full scope to an explosive accelerator
coefficient. And in the upswing, an explosive accelerator process will
generate greater increases in money demand than the increases in
productive capacity, so that a strong accelerator in combination with
excess liquidity will generate large price increases.
Either the ceiling to velocity or the effect of rising interest rates
and decline in liquidity upon the accelerator coefficient will break the
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
741
cumulative expansion. A fall in money income will occur. The quantity
of money needed for transactions falls, and ex ante saving which is
not realized in investment will result in the addition of money to port
folios. If the price level does not fall during a depression the ceiling
real income remains fixed, while if the price level falls, even though
the ceiling money income remains fixed, the ceiling real income rises.
Net investment implies an increase in productive capacity. With a
constant money supply and in effect a ceiling to velocity, larger real
incomes can be realized only if the price level falls. To the extent that
the accelerator inducement to invest is large only when income is
approximately equal to productive capacity, strong expansions can
only occur if the price level falls secularly.
The effect of the expectation that in the long run the price level
will fall is to increase the expected pay-off period of an investment.
This is equivalent, in its effect upon investment by firms, to a rise in
interest rates with a constant price level, so that a falling price level
will tend to lower the value of the accelerator coefficient. Therefore
the business cycle will be characterized by weaker booms than would
occur with a permissive monetary system. Such a monetary system will
be associated with a tendency toward relatively stable income for,
unless liquidity is greatly increased during a downswing, long periods
in which realized investment exceeds ex ante saving cannot occur.
III. The' Accelerator Model with Quantity of Money Variable
In this section we will consider two monetary systems, those in
which only the quantity of money can change and those in which both
the quantity of money and its velocity can change.
We assume that commercial banks create money by lending to
business firms. The maximum realized increase in the money supply is
equal to the difference between ex ante investment and ex ante saving:
A M = ex ante I — ex ante S — A Y
Assume that V = = - j y j - = 1 . The increase in the money supply in
the hands of households is the asset which makes the change in net
worth equal to ex ante investment.14 As income velocity is 1, there will
14Assume that ex ante I > ex ante S, realized I — ex ante I ; also that (ex ante I — ex
ante S ) is financed by an increase in bank debt. The changes in the consolidated balance
sheets of households, business firms and banks will be:
Households
Debt and Equity of
Firms
-\-(ex ante S)
Demand Deposits
+ (ex ante I —ex ante S)
Net Worth
-f(e* ante I)
742
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS
be no net change in the quantity of money that individuals hold as
assets. This is equivalent to assuming that the interest rate at which
banks lend to business is the interest rate at which money and earning
assets are substituted in household portfolios.15 The only relevant
monetary change in these models is in the quantity of money.
When the money supply increases at an independently given rate,
the autonomous increase in the money supply is not necessarily equal
to the difference between ex ante investment and ex ante saving. If the
increase in the money supply is greater than the difference between
ex ante investment and ex ante saving we assume that this difference
accumulates in the banking system (as excess reserves) and can be
used to finance future investment. If the increase in the money supply
is less than the difference between ex ante investment and ex ante
saving, realized investment will be less than ex ante investment and the
increase in income will be equal to the increase in the money supply.
For each monetary system we will first investigate the mechanical
properties of these relations, assuming that the accelerator coefficient
does not change, and then investigate the possible effects of the
associated money market and financing developments upon the value
of the accelerator coefficient.
A. Quantity Changes but Not Velocity
Two monetary systems in which only the quantity of money can
change will be taken up. In the first, the money supply will be assumed
to be infinitely elastic, and in the second the money supply will be
assumed to increase at a fixed arithmetic or geometric rate.
1. Infinitely elastic money supply. If the quantity of money can
increase without limit then no matter what the difference between ex
ante investment and ex ante saving, the difference can be financed.
Also we can assume that the terms upon which the banking system
Firms
Productive Assets
+ (ex ante I)
Demand Deposits
(no change)
Debt and Equity
to Households
Debts to Banks
-\-(ex ante S)
+ (ex ante I —ex ante S)
Banks
Debts of Firms
(ex ante I —ex anteS)
Demand Deposits
+ (ex ante I —ex ante S)
“ Alternatively if the liquidity-trap rate of interest rules, even if V > 1, the rise in the
quantity of money in excess of transaction needs can all be absorbed by households’ port
folios without lowering the interest rate. However, in this case any rise (virtual) in the
interest rate would imply a substitution of earning assets for money in the portfolios of
households. This then becomes a case of financing investment from cash balances. If
V > 1 the money supply and firms’ debts to banks do not increase as rapidly as income.
EM PLOYMENT,
743
GROWTH, AND PRICE LEVELS
lends do not change. Such a monetary system is consistent with the
existence of an explosive accelerator process since it permits a cumula
tive rise in money income. Is there anything inherent in the operations
of such a monetary system which will lead to a dampening of the
accelerator process? (We will ignore the political repercussions of the
cumulative rise in prices which is implicit in a full-employment situa
tion in which the rate of growth of money income is greater than
that of productive capacity.)
T able
II.—I n f in it e l y
E la st ic M
oney
Su p p l y
(Constant Velocity—No Interest-Rate Effects)
Monetary System
All ex ante S used for equity
financing. All increases in
money used for debt financing.
Accelerator Process
:.8
0= 4
F0=100
Time
Investment
Savings
Ex
Ante
100.
110.
128.
174.
323.
80.
88.
102.
139.
Ex Ante
P(Yt-i-Yt-2)
20.
22 .
40.
72.
184.
26.
35.
Realized
A
Money
Supply
30.
40.
72.
184.
18.
46.
149.
10 .
AEquity Financing
ATotal Investment
.67
.55
.36
.19
During an expansion, the increase in money supply occurs as invest
ing firms add bank debt to their liabilities (see Table II). Assuming
that the percentage distribution of ex ante saving between debt and
equities of business firms is constant, a cumulative explosive expan
sion on the basis of the creation of money will (ceteris paribus) result
in a fall in the ratio of equity to debt in the balance sheet of firms.16
Even if the terms upon which firms can borrow are unchanged by the
19Total induced investment is P(F* — Y t-i). Ex ante saving is equal to (1 — a) Ft.
Assuming that a constant proportion of ex ante saving is used for equity financing, the
latter is X(1 — a)F*. The ratio of the change in equity to total investment, therefore is:
X(1 — a) Yt
X(1 - a)
The general solution to the second-order explosive accelerator process is of the form
Ft =
+ A t where fii > m* > 1* Therefore, we can write:
F*_i ^ A im
Yt
*-1 +
i + d !( « y l
A i Vm /
A 2^2^ _
Anil* + A^tt
^
744
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
deterioration of their balance sheets, borrowers’ risk will rise.17 This
will lower the amount of investment induced by a given rise in income.
Hence, even with a monetary system that permits all of ex ante invest
ment to be realized, the financing of investment by bank debt can
result in lowering the accelerator coefficient which in turn lowers the
rate of increase of income. This continues until the accelerator coeffi
cient falls sufficiently to replace the explosive by a cyclical time series,
in which there eventually occurs a fall in income. With a fall in income,
the excess of ex ante saving over induced investment will be utilized
to reduce bank debt. Also, the failure of some firms which have relied
heavily upon debt financing will result in the substitution of equity
for debt in balance sheets. Both changes during the downswing raise
the ratio of equity to debt in firms’ balance sheets18 which acts as a
The limit of ( — ^
= 0 , therefore the limit of (
\ Yt
\ M l / <-«•
X(1 — a)Yt
Hence
p(Yt— Yt~0
^
is — •
/
Ml
X(1 — a)
------------------
aPProaches ^ a limit
In the early stages of an explosive accelerator process the ratio of
Yt
> — • Therefore,
Ml
the ratio of equity financing to total investment decreases as the accelerator process continues.
17M. Kalecki, “The Principle of Increasing Risk,” Economica, N. S., Nov. 1937, IV,
440-47.
“ On the downswing (ex ante S > ex ante /) , the balance sheets of the three sectors
change as follows:
Banks
Business Debt
—(ex ante S
Demand Deposits
—ex anteT) —- A M
—(ex ante S
—ex ante I) = —AM
Firms
Capital Equipment
Debt and Equities to
Households
Debt to Banks
+ e x ante I
+ e x ante S
—(ex ante S
—ex ante I ) = —AM
Households
Demand Deposits
Business Assets
— (ex ante S
—ex ante I) — - A M
-\-ex ante S
Net Worth
+ e x ante I
If failures occur in the account of households labeled Business Assets, equities will be
substituted for debt and in the account of business firms labeled Debt and Equities to
Households, equity will be substituted for debt. Also as business firms fail banks acquire
titles and debts which are considered unsuitable for bank portfolios. The sale of such
assets to the public results in the substitution of business assets for demand deposits in
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
745
stabilizer. The endogenous limits to an explosive accelerator process,
in the absence of restrictions on the money supply, are the deteriora
tion of firms’ balance sheets due to debt-financing of investment on
the upswing; and the reverse circumstances during the liquidation
process on the downswing.
Two possible offsetting factors to the increasing debt-equity ratio
in the financing of investment during an explosive expansion are an
increase in the ratio of ex ante saving flowing to equities and the capi
tal gains that accompany an increase in the price level of capital goods.
As ex ante saving finances a decreasing proportion of total investment
during an explosive expansion, a possible increase in the proportion of
ex ante saving flowing to equities cannot for long prevent a deteriora
tion of the balance sheets of firms. If, however, cumulative price-level
inflation is politically permissible a deterioration of firms’ balance
sheets need not occur. Business firms are borrowers and the real
burden of a debt decreases with a rise in the price level. If the assets
of business firms are valued at their current replacement costs, then
the rising price level raises the equity account. Such capital gains
improve the balance sheets of firms and they occur generally in an
inflation. The price-level rise plus the flow of ex ante saving to equity
investment may be sufficient to keep the debt-equity ratio constant,
thereby preventing any deterioration in the balance sheets of firms.
However, this requires an increasing rate of change in the price level of
capital goods.19 Nevertheless, if an explosive inflation is politically
the public portfolios, and in a net reduction of demand deposits. These changes obviously
do not affect the net worth of households and the capital equipment accounts. However,
as the value of productive capacity may be reduced during a downturn, the value of the
capital equipment account of firms and the net worth account of households may be re
duced; the equity liabilities of firm and equity assets of households lose a part or all of
their value. This in turn can affect the “subjective” preferences of households and firms
so that liquidity preference rises.
19In the arithmetic example of Table II, in time-period 3, only .36 of the total new
investment was financed by savings. If, in period 3, the price level of capital goods rose
so that the value of existing capital goods rose by 2.0, then the ratio of the increase in
equity to the increase in assets would be .5. In period 4 only .19 of a larger total invest
ment was financed by savings. For the ratio of the increase in equity to the increase in
the value of the assets to be .5, the value of existing capital must rise by 11.4. As total
assets in period 4 are presumably only slightly larger than in period 3, this implies that
the rate of increase in the price level of capital goods must rise if a constant ratio of equity
to total assets is to be maintained. For example:
4
3
Period
35.0
26.0
Saving, ex ante
184.0
72.0
I realized
149.0
46.0
A money
114.0
20.0
Required A value of existing capital
149.0
46.0
A equity =*S-f A value
298.0
92.0
A assets * / realized + A value
.5
.5
Ratio of A equity to A assets
38563 O— 59— pt. 4------ 10
746
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
tolerable, there is no endogenous reason why an accelerator process
with an infinitely elastic money supply need come to a halt.
Therefore, at least two monetary situations allow full scope to an
explosive accelerator process: the Keynesian liquidity trap and an
infinitely elastic money supply. It is perhaps no accident that the
emphasis upon “real” floors and ceilings as causes of the nonlinearity
of the accelerator coefficient occurred at a time when the high volume
of government bonds outstanding and their support by central banks
made the money supply in fact infinitely elastic. An era of tight money
on the other hand naturally leads to an examination of the monetary
prerequisites for the operation of the accelerator phenomena.
2. Money supply increases at a fixed rate. A monetary system in
which the rate of growth of the money supply is exogenously given,
for example a fractional reserve banking system based upon a gold
standard, is equivalent to an infinitely elastic money supply if the
difference between ex ante investment and ex ante saving does not
exceed the per-period growth of the money supply. The only endoge
nous limitation to expansion in this case comes from the deteriorating
balance sheets and liquidity of business firms, as is true with an
infinitely elastic money supply. The interesting alternative exists when
the difference between induced investment and ex ante saving is greater
than the rate of growth of the lending ability of banks.
Throughout this section we will assume that at the initial period
the banking system does not possess excess liquidity. Hence the avail
able financing is equal to ex ante saving plus the possible increase in
the money supply. If induced investment is equal to or greater than
this, realized investment will be constrained to the available financing.
In this case income will grow at the same rate as the money supply.20
(a) Arithmetic rate of increase in the money supply. If the money
supply increases by a fixed amount per period (constant arithmetic
rate of increase), income will grow at this rate until ex ante saving
increases sufficiently so that induced investment per period becomes
less than the available financing. When this happens, the per-period
increase in income will fall below what it had been, and therefore
induced investment will decrease. The downturn occurs when ex ante
saving catches up with the expansion process so that all of the invest
ment induced by the constant arithmetic rate of growth of income can
be realized without using all of the newly available credit.21 (This case
is illustrated in Table III.)
« 0(Y , - Ki_i) > (1 - a ) Y, + A M and Y, - M,\ so that Ki+i = aY, + (1 —a) Y, + AM-,
Khi-F .+ A M .
* In an accelerator-multiplier model a necessary condition for F( > F»_iisthat/?(F(_i — F*-*)
> (1 —a) K#_i. We post an arithmetical increase in the money supply per period of AM so
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
T a b l e I I I .— A r it h m e t ic a l l y I n c r e a s in g M
oney
747
Su p p l y
(Constant Velocity—No Interest-Rate Effects)
Monetary
System
+10 per
time period
Accelerator Process
a =* .8
/3=4
Time
Investment
F
0
1
2
3
4
5
6
7
8
100.0
110.0
120.0
130.0
140.0
150.0
160.0
168.0
166.4
C
__
80.0
88.0
96.0
104.0
112.0
120.0
128.0
134.4
Savings
Ex Ante
__
20.0
22.0
24.0
26.0
28.0
30.0
' 32.0
33.6
Induced
0( F w -F w )
__
—
40
40
40
40
40
40
32
Realized
__
30.
32.
34.
36.
38.
40.
40.
32.
Investment
Financed
by Increased
Money
Supply
—
+10.0
+10.0
+10.0
+10.0
+10.0
+10.0
+ 8.0
- 1.6*
* In time period 7, ex ante S + A M > e x ante / ; therefore F7 —Fe< A if. As a result, in time
period 8 the accelerator expansion is broken.
During the expansion, the demand for financing is always greater
than the available supply; the money market constrains investment.
When the arithmetic increase in income becomes less than the increase
in the money supply financing conditions ease. The resulting decline
in the rate of interest may act to increase the inducement to invest
(decrease the inducement to disinvest); this possibility is ignored in
Table III. Since the banking system finances a decreasing proportion
of realized investment during the expansion, the deterioration of the
balance sheets of investing firms will be limited during such an expan
sion.
When income declines, the autonomous increases in the money
supply result in an accumulation of excess reserves in the banking
system, and ex ante saving in excess of induced investment results in
a repayment of bank debt by firms. These changes should brake the
decline in income.
The accumulation of excess reserves by banks and the improved
balance sheets of firms during the downswing implies that if an expan
that the available financing is (1 —a) Ft_i+AM: hence if j3(Ft_i—F*-2) ^ (1 —a) F*_i+AM then
realized investment is (1—a)Yt-\+AM. Hence Y t= F(_i+AM so that P(Yt—Y t+\)=pAM
which we once again assume > (1 —a)(F*_i+AM) so that Ff+i= F*_i+2Alf. Eventually
j8(F«+»—Ft+n_i)= < (1 —a) (F*_i+»AM)+AM; so that Ft+rt+i<F*+»+AM; therefore
0(Fi+n+i—Yt+n)<P{Yt+n— Y
and the accelerator process turns down.
748
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
sion begins it will not at once be constrained by the money-market
and balance-sheet effects. If the arithmetic rate of growth of the
money supply is small compared to the accumulation of financing
ability during the decline in income, a sharp fall in investment will
occur at the date that the accumulated financing ability is absorbed,
thereby decreasing the per-period increase in income. The smaller
increase in income will lead to a fall in induced investment, and a
sharp fall in income may occur. A constant arithmetic rate of increase
of the money supply in conjunction with an explosive accelerator
process will tend to generate a cyclical time series.
(b) Geometric rate of increase in the money supply. Consider a
money supply that increases at a constant geometric rate, pt*. As was
noted earlier the solution of an explosive accelerator process can be
written as Ft = A&i + A&J with > {x2 > 1 with A 1 and A 2 depend
ing upon the initial conditions. That is, the rate of growth of income is a
weighted average of the two rates of growth i^i and i*2. If f*s, the rate
of growth of the money supply, is greater than (or equal to) (jli, the
greatest rate of growth that income can achieve, the system behaves as
if the money supply were infinitely elastic. Hence the cases that have
to be examined are when 1*1 > 1*2 > n* > 1 and when ^ > |x3 > |x2 > 1.
Take first the case in which pti > \l2 > iJt.3 > 1. With no excess liquid
ity, the maximum attainable rate of growth of income is the rate of
growth of the money supply. To sustain this rate of growth, it is neces
sary that induced investment be equal to or greater than the available
financing. When the rate of growth of the money supply, and therefore
the rate of growth of income, is less than i*2 induced investment will
not be large enough to absorb the available financing.22 The rate of
growth of income will be smaller than the rate of growth of the money
supply, and this new smaller rate of growth of income also will not
be sustained. These progressively smaller rates of growth of income
** Assume M «_i= F*_1 and
Y t=*mMt-i—mYt-i.
— 1) F«_i — [(1 — cfin zY t-i 4- (jus — i ) n z M t - i ] ^ 0
is necessary for Yt+i-mYt- Therefore 00*8—1) —(1—
—(a+/3)pi-HH-e=0. It follows that
(/**—1)^3—«=0, so that p f
a + 0 + %/(« + « ’ - 4 (0 + €)
Mi -
2
The relevant root is
- a + ft — V(<x -j- ft)2 — 4Q3 -f e)
2
and if €*0 (induced investment is equal to ex ante saving plus the increase in the money
supply), fxi—ni)\i€>0 (induced investment greater than ex ante saving plus the increase in the
money supply) m3>M2- Therefore a rate of growth of the money supply equal to or greater than
the smaller root of the accelerator process is a necessary condition for self-sustained growth.
to
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
749
will in time result in insufficient induced investment to offset ex ante
saving and at this date income will fall. Therefore, if the rate of
growth of the money supply is smaller than the smallest rate of growth
that the accelerator process, if unconstrained, would generate, an upper
turning point in income will be produced.23
The argument as to what happens once income turns down for a
geometric rate of increase in the money supply is essentially the same
as for an arithmetic increase in the money supply. Excess reserves
accumulate in the banking system and firms’ balance sheets improve
during the downward movement. Once a sufficient upward movement
again begins, an unconstrained expansion can take place until the
excess liquidity is absorbed, at which time the rate of growth of the
money supply will again constrain the rate of growth of income. A
money supply growing at “too small” a rate will lead to a cyclical
rather than a steady-growth time series.
If the rate of growth of the money supply is equal to the smaller
root of the accelerator process (i.e., t*3 = [*2), both income and the
money supply will grow at this rate. Throughout this process the ratio
of ex ante saving to bank financing of investment will be constant. If
this ratio is consistent with the balance-sheet goals, there is nothing in
this process which would lead to a downturn in income. Also this rate
of growth of income may be consistent with a fairly stable price level.
Steady growth may result from combining an explosive accelerator
process and an appropriately increasing money supply.*4
Consider now the second case, in which pti > n* > 1*2 > 1. In this case
the rate of growth of income during any time period will depend upon
the weight of the two roots. If the weight of (x2 is high, then the accel
erator process will generate a rate of growth of income less than the
rate of growth of the money supply. However, since Hi > 1*2, in time Pi
will dominate the rate of growth of income so that income will be
increasing faster than the money supply. The money supply does not
constrain the growth of income until the total growth of income equals
* This can be demonstrated by noting that Y o ^ A i+ A * and Y i^ A u x i+ A ^ and given
that Mi>M*>M3>0 and Fi=*/isFo then A\*= Y^—A%\
{Yo-“At)m-\-Atii2 so that
Yo(j*i — Mi)
.
----------------- At.
Ms — Mi
As Fo>0, ms~ mi< 0 and mj^Mi^O? ;4j>0.
Also At=* Y 0—A 1, miFo^^imi-MPo—Ai)fjL%so that
Fo(mi — M*)
A
-------------- — A1.
Mi — M2
As Fo>0, mi—*m*<9 aud Mi“ MJ>0> j4 i<0.
A \the coefficient of the dominant root mi is negative. As A\pi+Attn>Ai-{-A 2 and mi>m* It
follows that |A i| > \ A 1|. However in time A imi'-Mimi* will be <0, so income must turn down.
“ That is, the Harrod-Domar case of steady growth can be the result of appropriate
monetary conditions.
750
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
the total growth of the money supply. Whether this case results in
steady growth or in a downturn of income depends upon what hap
pens to the accelerator coefficient once the monetary constraint be
comes effective.
At the beginning of such an explosive expansion the rate of growth
of income is less than the rate of growth of the money supply. At the
date when the total growth of income becomes equal to the total growth
of the money supply the rate of growth of income will be greater than
the rate of growth of the money supply. Therefore at some intermedi
ate date, the rate of growth of income will be the same as the rate of
growth of the money supply. This rate of growth of income will induce
sufficient investment, at the financing terms and balance sheets ruling,
for the rate of growth of income to increase. Therefore if the rate of
growth of income is constrained to the rate of growth of the money
supply, and the accelerator coefficient does not change, a sufficient
amount of investment will be induced to generate a rate of growth of
income greater than the rate of growth of the money supply.
However until the increase in income and in the money supply
becomes equal, this system operates with excess liquidity. At the date
that the excess liquidity is absorbed, the rate of growth of income will
be greater than the rate of growth of the money supply so that when
the monetary constraint becomes effective two things will occur: the
rate of growth of income will fall and financing terms will rise. When
financing terms were relatively easy because of excess liquidity a rate
of growth of income equal to the rate of growth of the money supply
induced sufficient investment to increase the rate of growth of income.
However in a suddenly tight money market financing terms may so
change that the accelerator coefficient will fall, and this can lead to a
fall in income.
Nevertheless, if the money supply is growing at a geometric rate
greater than the smaller root of the accelerator process, a constant
rate of growth of income may be generated. In this case money income
will grow at a faster rate than if the money supply grew at the rate
given by the smaller root. Hence such a steady rate of growth of
income can be associated with a substantial rate of increase in the
price level. In addition, the ratio of bank financing to ex ante saving
increases as the rate of growth of the money supply increases.
If the accelerator falls as a result of the tightening of the money
market, income can turn down. The behavior of the economy with
this monetary system on the downturn and on subsequent expansions
would be essentially the same as in the previous case where the rate
of growth of the money supply was smaller than the smaller root of
the accelerator process.
EMPLOYMENT,
751
GROWTH, AND PRICE LEVELS
B. Both Velocity and Quantity Change
The earlier consideration of the interaction of an otherwise explosive
accelerator-multiplier process with monetary systems in which only
changes in velocity and changes in the quantity of money can occur
enables us to consider monetary systems in which both quantity and
velocity of money can change. We first assume that the quantity of
money is changing but that velocity is greater than 1, we then consider
the effects of changing velocity. Finally we take up changes in liquid
ity preference.
1. In the cases where investment in excess of ex ante saving is
financed by an increase in the quantity of money, we assumed that the
income velocity of money was 1. We can now drop this assumption. If
income velocity is greater than 1, and if an excess of ex ante invest
ment over ex ante saving is financed by an increase in the quantity of
money, then excess liquidity results. This excess liquidity can be util
ized to finance investment.
Assume that the excess liquidity resulting from an investment
initially financed by the banks is used to substitute business debt or
equities to the public for business debt to banks. If AM = Yt ~ Yt-i
and V > 1, then new transaction cash is
AM
AM
(
1\
------ > and asset cash is A M -----------= { 1 --------) AM.
V
V
\
V)
After the public purchases business debts or equities, the net increase
in debt to banks is
j ( Y t - Ft-O
and investment is Ft — aYt-i, therefore:
Y, - Yi-i
ABank Debt
ATotal Assets
_
V
Yt — aYt-\
1 Yt -
F t_ x
V Yt — aYt-i
As an explosive accelerator process takes hold, the ratio — ----
Yt — a Yt-1
rises and the ratio of the change in bank debt to the change in total
assets approaches If the public’s distribution of ex ante saving and
excess liquidity between debt and equity assets is constant during an
expansion, the balance sheets of business firms deteriorate. As the
weight of bank financing is smaller than in the case of unit velocity,
752
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
the deterioration will not be so rapid as in the case in which bank
creation of money is the sole technique by which investment in excess
of ex ante saving can be financed. Therefore, the possibility that the
deterioration of firms’ balance sheets will lower the accelerator coeffi
cient is smaller.
j
Yt_ y t i
2. Note that in---------------— a rise in velocity decreases the ratio
V Yt - a Y ^
of bank financing to the total change in assets and that a rise in the
propensity to consume increases the dependence upon bank financing
of investment. Therefore, autonomous or cyclically induced changes
in these parameters can change the ratio of debt to equity financing,
which can change the accelerator coefficient. In particular a rise in
velocity tends to counteract the deterioration of firms’ balance sheets
in a business-cycle expansion financed by bank creation of money.
3. Autonomous or cyclically induced changes in the liquidity pref
erence relation can change the dependence of an expansion upon
changes in the money supply and therefore affect the ratio of bank
debt to total assets of firms. If liquidity preference decreases, the
excess of investment over ex ante saving can be financed by with
drawals from cash balances at lower interest rates than were previously
ruling. Such an “autonomous” decrease in liquidity preference can,
both by improving financing terms and by decreasing the dependence
of business firms upon bank financing, raise the accelerator coefficient.
A great stock-market boom, such as in the late 1920’s, may be inter
preted as reflecting a lowering of liquidity preferences; as a result
business expansion could be financed with less reliance upon the
banking system than otherwise.
Alternatively, an autonomous rise in liquidity preference may lead
to the result that business borrowing from banks will increase the
liquidity of households rather than finance investment. That is, a por
tion of business borrowing from banks ends up as “liquid hoards” of
households. Such borrowing by business firms in excess of the differ
ence between ex ante saving and realized investment will increase the
rapidity with which firms’ balance sheets deteriorate. An explosive
accelerator process may be broken by such changes in liquidity pref
erence.
Such changes in liquidity preference have been labeled autonomous.
There exist plausible mechanisms by which the upward movement of
an explosive accelerator process would lead to a fall in liquidity
preference. However, there do not exist equally plausible mechanisms
by which a rise in liquidity preference can be considered as endoge
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
753
nous during an expansion. During a downswing there exists a plausible
mechanism which can raise the liquidity preference of households.
This can force a deterioration of firms’ balance sheets, and thereby,
through its effect upon the accelerator coefficient, a further fall in
investment. There does not seem to be any endogenous factor which
would lead to a fall in liquidity preference on a downswing. Changes in
liquidity preference seem to be destabilizing.
IV. Policy Implications
Let us asume that the policy goal is steady growth at a stable price
level. The policy measures to be used are monetary policy, which in
the language of this paper means to choose a monetary system, and
fiscal policy. It has been shown that steady growth requires a money
supply that increases at a geometric rate: but that a too rapidly grow
ing money supply results in rapid price inflation and that a too slowly
growing money supply results in a downturn of income.
The smallest self-sustaining rate of growth of income is equal to
the smaller root of the accelerator process, |i2. If productive capacity
can also grow at this rate, then the policy goal of growth without
inflation is attainable. If the rate of growth of income is greater than
the maximum possible rate of growth of productive capacity, the pol
icy goal is not attainable. In the latter case, we assume that steady
growth accompanied by secular inflation will be chosen in preference to
a constant price level and intermittent growth. The policy goal there
fore becomes steady growth with a minimum rate of secular inflation.
If the policy-makers prize steady growth and abhor falling income,
and if secular inflation is accepted as the price that has to be paid for
growth, then the policy-makers would be able to “play it safe” by
allowing the actual rate of growth of the money supply to be greater
than the minimum self-sustainable rate of growth of income. That is,
the policy-makers would accept some unnecessary inflation in order
to be on the safe side in maintaining full employment.
For a given consumption coefficient, the greater the rate of growth
of the money supply, the greater the ratio of bank debt to debt and
equities to households in the balance sheets of firms. Therefore the
greater the rate of increase in the money supply, the greater the
chance that induced investment will decrease because of the unsatis
factory nature of firms’ balance sheets. Two policy measures which
can counteract this effect are: (1) an interest rate policy designed to
keep velocity greater than one; (2) a fiscal policy designed to increase
the money supply without increasing business debt to banks.
It was shown that if income velocity is greater than one and if the
money supply is being increased by business borrowing from banks,
754
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
the net increase in business borrowing from banks will be smaller than
the difference between realized investment and ex ante saving. In
order to achieve this result bank financing of business must be at a
high enough interest rate to keep income velocity greater than one.
But the accelerator coefficient also depends upon the interest rate. Thus
if the monetary policy designed to keep income velocity greater than
qne is carried too far the accelerator coefficient will fall and the self
sustained growth will be interrupted.
To keep interest rates at a given level, the central bank must be
willing to supply reserves to commercial banks, in response to com
mercial banks’ demands, without limit at a fixed rediscount rate.
Therefore the rediscount rate seems the appropriate tool of central
bank policy.
Nevertheless if the money supply can increase only by business
borrowing from banks, a ratio of debt to equities in business balance
sheets can result which will lead to a decline in induced investment.
Government deficits financed by borrowing from banks result in an
increase in the money supply without any corresponding increase in
business debt. If interest rates are such that velocity is greater than
one, debts and equities to households .will be substituted for debts to
banks in the business firms’ balance sheets. This is more conducive to
steady growth than the situation in which all of the increase in the
money supply required for steady growth is created in exchange for
business debt. Therefore government deficit financing, even during a
period of sustained growth and secularly rising prices, may be desir
able in order to maintain the conditions for further growth.
EMPLOYMENT,
755
GROWTH, AND PRICE LEVELS
of t h e
B oard op G ov e r n o r s
F ederal R eserve S y s t e m ,
Washington, D.C., March 20,1959.
Hon.
Pau l H . D
ouglas,
Chairman, Joint Economic Committee, Congress of the United States,
Washington,
D e a r Mr. C h a i r m a n : Attached is a memorandum of reply to questions asked
of Chairman Martin by you and by Congressman Patman at the hearings before
your committee on February 6,1959.
I trust you will find these replies responsive and of interest to the committee.
Sincerely yours,
C. C a n b y B a l d e r s t o n ,
R e p l ie s
to
Vice Chairman.
Q u e s t io n s b y Senator D ouglas a n d C o n g r e ssm a n P a t m a n
E c o n o m ic C o m m i t t e e H e a r i n g s F e b r u a r y 6, 1959
at
J o in t
Question by Senator Douglas: Would it not be preferable, in implementing
monetary and credit policy, for the Federal Reserve to rely on open-market
operations to achieve restraint or ease, but refrain from changing discount
rates? In these circumstances interest rates generally would not rise, or not
rise as much, in periods of credit restraint. When there is considerable unem
ployment and excess capacity, would you agree that this result would be
desirable, since higher interest rates would tend to “ hold back full recovery?”
Answer: As an instrument of credit policy the discount rate is one aspect
of the discount operation as a whole, which functions as a complement to the
open market instrument. In a period of rising business activity, demands for
bank credit may rise to such an extent that banks are unable to meet these
demands on the basis of their existing reserves. There are essentially two
ways in which banks can obtain additional reserves; the Federal Reserve
System can, on its own initiative, supply reserves by purchase of Government
securities in the open market; alternatively, banks can on their own initiative
increase their reserves by borrowing at Federal Reserve banks.
When credit demands are in such strength as would promote growth in
credit and money in excess of the expansion of goods and services available for
purchase, the Federal Reserve, in the interest of economic stability, tempers
the amount of reserves available to meet such demands. When the Federal
Reserve does not furnish on its initiative all of the reserves sought by banks
in circumstances of very active credit demands from private sources credit
conditions in the economy as a whole tend to tighten. Individual banks, finding
that their available reserve funds are not adequate to permit them to meet
all credit demands, may react to the situation either by selling or running off
liquid assets, or by borrowing from their Federal Reserve bank. In either event,
one effect is likely to be a rise in market interest rates.
Which method a particular bank uses to adjust its position will depend on
a number of factors, including the kinds and amounts of securities or other
openmarket paper in its portfolio, its earning rate on these securities, and the
rate it must pay on borrowings at the discount window. Banks are generally
reluctant to become indebted to the Federal Reserve except for very short
periods, and when in debt feel constrained to liquidate assets. The deterrents
to borrowing are greatly weakened if market yields on securities owned become
and remain substantially higher than the discount rate. In these conditions,
banks may even be induced to borrow for profit, a development which renders
difficult effective administration of the discount window.
Federal Reserve banks, in acting on member bank requests for credit, must
therefore weigh each request in the light of the needs of the individual bank,
the uses to which reserves are being put, and the general character and rate
of credit expansion in the economy. While banks may expect that requests
based on temporary needs resulting from reserve shifts beyond their individual
control will be met, it is recognized that borrowing at the Federal Reserve is
a privilege, not a right. Continued borrowing under circumstances pointing to
unhealthy or unsound expansion of credit will be discouraged.
Federal Reserve Regulation A, revised in February 1955, sets forth the follow
ing guiding principles applicable to member bank borrowing:
“ Federal Reserve credit is generally extended on a short-term basis to a
member bank in order to enable it to adjust its asset position when necessary
because of developments such as a sudden withdrawal of deposits or seasonal
requirements for credit beyond those which can reasonably be met by use of the
756
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
bank’s own resources. Federal Reserve credit is also available for longer
periods when necessary in order to assist member banks in meeting unusual
situations, such as may result from national, regional, or local difficulties or from
exceptional circumstances involving only particular member banks. Under ordi
nary conditions the continuous use of Federal Reserve credit by a member bank
over a considerable period of time is not regarded as appropriate.”
In applying these principles it is of prime importance that the general re
luctance of banks to borrow at the Federal Reserve be reinforced by a discount
rate with real deterrent power at times when a tempering of bank credit growth
is in the public interest. In other words, in order to make the discount mechan
ism an effective supplement to open market operations the Federal Reserve is
obliged to maintain discount rates not markedly lower than market yields on
the most readily available alternative source of bank reserves, Treasury bills.
If the Federal Reserve in these circumstances did not adjust its discount rates
to keep them “ in touch” with market rates, the task of administering the discount
window to prevent excessive credit expansion would become very difficult. In
the absence of a rate deterrent to borrowing. Federal Reserve bank officers
would be without workable guidelines in acting on a great number of borrowing
requests from banks, many of whom would be in the position of profiting directly
from the relatively low rate on borrowings.
The need for frequent reappraisal of the discount rate in order to maintain the
effectiveness of the discount operation as a credit instrument is recognized in
the Federal Reserve Act itself. Section 14(d) of the act empowers each Federal
Reserve bank
“ To establish from time to time, subject to review and determination of the
Board of Governors of the Federal Reserve System, rates of discount to be
charged by the Federal Reserve bank for each class of paper, which shall be
fixed with a view of accommodating commerce and business; but each such bank
shall establish such rates every
Board” [Italic added.]
14
days, or oftener if deemed necessary by the
At times conditions are such that market rates and discount rates vary from
each other for extended periods. When credit demands are relatively light
and banks have abundant reserves with negligible borrowings, short-term market
rates are likely to fall well below the discount rate.
This occurred in 1954
and also in 1958.
There have been other times when market rates have remained above the
discount rate for a considerable period and have been little affected by changes
in the discount rate. For example, last year the market yield on 90-day
Treasury bills rose sharply from below 1 percent in July to around 2 % percent
by early October, while discount rates were raised from 1% percent to 2 per
cent in August and September, as shown on the attached chart. Since early
October the yield on 90-day Treasury bills has fluctuated generally within a
narrow range—between 2% and 3 percent, while discount rates were raised in
late October to 2 y2 percent and in early March to 3 percent—a total increase of
1 percentage point. Rates on longer term securities likewise rose sharply in
the summer and early fall and have shown little further change since early
October. In this period member bank borrowings have averaged close to $500
million, a much smaller amount than prevailed in other recent years when
market interest rates were around present levels. The recent period provides
an excellent illustration of the fact that market rates are strongly influenced
by other factors than Federal Reserve policies.
Rising market rates of interest almost inevitably follow along with rising
business activity because expansion of credit demands are an essential accom
paniment of such a rise. The discount rate is essentially a technical rate, relat
ing to the availability of borrowed reserve funds for banks. It is not a rate at
which public and private borrowers in the market can avail themselves of funds.
In periods of active credit demands, market rates will generally array them
selves in closer relationship to the discount rate, because banks are always in a
position to supplement their lending capacity by borrowing at the Federal Re
serve. It is to keep this source of supplementary lending power under con
tinuous and effective regulation that the Federal Reserve must rely on flexible
adjustment of the discount rate to changing market and economic conditions.
In any case, if the discount rate were not used for this purpose but access to
the discount window were limited by instruction, a similar impact on market
EM PLOYMENT,
GROW TH, AND PRICE LEVELS
757
rates of interest would occur, as individual banks sold Treasury bills or other
securities to acquire the reserves denied through the discount window. Con
ceivably, the shortrun impact on market rates would be greater.
Question by Mr. Patman: What is the effect of the Federal funds market on
the Federal Reserve discount operation? Are not banks using this market
really bypassing the Federal Reserve?
Answer: The existence of the Federal funds market, a loosely organized
market in which banks having excess reserves lend these balances to other
banks, usually for 1 day, enables many banks to manage their reserve positions
to a closer degree of tolerance than would otherwise be possible. The net result
may be that the banking system has fewer pockets of excess reserves, and per
haps also a smaller total volume of reserves. Another way of saying the same
thing is that shortrun reserve shifts through the Federal funds market result
in more nearly optimum use by the banking system of the existing reserve base,
with less use of Reserve Bank credit.
From the standpoint of the individual bank, borrowing reserves in the Fed
eral funds market as a way to adjust to a reserve deficiency adds a liability
to its balance sheet. In this respect Federal funds borrowing is similar to bor
rowing from the Federal Reserve. In either case, adjustment by borrowing is
a temporary expedient; if the need for reserves continues, the bank will be
obliged to reduce its holdings of securities or curtail its lending activities to
bring its reserve position into balance.
While an individual bank which borrows Federal funds may thus avoid bor
rowing at a Federal Reserve bank, it does not necessarily follow that the exist
ence of the Federal funds market materially impedes Federal Reserve discount
policy. In the first place, participation in the Federal funds market is con
fined to a relatively small number of banks, most of them the larger banks in
financial centers. In the second place, transactions through the Federal funds
market do not alter the total supply of reserves available to the banking system,
which can be influenced by Federal Reserve policy actions. The supply of
funds in the market is closely related to the general state of reserve availability
for the banking system. When reserve availability is tight, interest rates in the
Federal funds markets will tend to rise to, or close to, the discount rate. With
the supply of reserve funds limited at such times, the discount mechanism, in
cluding the discount rate, can perform effectively its function of supplementing
the open market instrument in regulating the volume of money and credit so
that it is kept in alinement with the needs of the economy at a stable level of
prices.
Question by Mr. Patman: Have not interbank deposits increased rapidly,
approaching the same level that existed prior to the passage of the Federal
Reserve Act when too much money was concentrated in too few banks?
Answer: Prior to the establishment of the Federal Reserve System, banks
kept substantial portions of their cash liquidity reserves in the form of deposits
at other banks. Under today’s conditions, however, the first line of reserves of
member banks is maintained in the form of legal reserves on deposit at Federal
Reserve banks. Under these circumstances, banks now maintain balances at
other banks primarily as a part of correspondent relationships— for liquidity
purposes, to facilitate check clearance, and to obtain a variety of services and
advice.
The total of interbank balances increased substantially between 1939 and
1945, as the table shows. There has again been some growth in the last year or
so, but total interbank balances held at member banks were only $600 million
higher in 1958 than in 1945. New York banks actually held fewer deposits due
to domestic banks in 1958 than in 1945, although they continued to hold sub
stantial deposits for foreign banks. Moreover, as would be expected, a substan
tial portion of total interbank balances held by member banks represented the
approximately $4 billion which nonmember banks keep on deposit—an amount
which in large part represents the legal and working reserves of nonmember
banks.
The growth of member bank interbank deposits for the period shown is of
diminished significance when compared to the large growth in the total of
demand deposits of all banks. Interbank deposits at member banks, which
represented 27 percent of total demand deposits of all banks in 1939, declined
by 1945 to 16 percent, and in recent years have remained at about 11 percent.
758
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
Selected d a ta on in te rb a n k d em and deposits a n d to ta l dem and deposits, 1989-58
[Millions of dollars]
Percent of
Nonmem
All com
member
ber banks— mercial
bank
banks—
interbank
balances
due from
demand
deposits
All mem
deposits
to total
domestic
ber banks
banks
adjusted 1 demand
deposits
Demand deposits of domestic banks held by
member banks
Year (June
call date)
1939________
1 9 4 5 ..-.......
1946..............
1947________
1948........
1949........... .
1950......... ...
1951......... .
1952________
1953..............
1954........... .
1955________
1956..............
1957...........
1958..............
New
York
2,992
3,271
3,127
2,898
2,830
2,680
2,692
2,744
3,193
2,979
3,237
3,129
3,080
2,775
3,084
Chicago
Reserve
city
Country
746
1,174
1,047
1,056
1,055
962
977
1,006
1,136
1,175
1,287
1,125
1,149
1,133
1,211
2,920
5,510
5,220
4,773
4, 751
4, 460
4,848
4,996
5,624
5,744
6,220
5,979
6,078
5,648
6,115
439
1,108
997
885
798
762
850
913
1,060
1,049
1,212
1,249
1,321
1,243
1,267
7,097
11,064
10,391
9,612
9,433
8,864
9,368
9, 659
11,013
10,947
11,956
11,482
11,627
10,799
11, 676
(J)
(2)
(2)
(2)
3,163
3,037
3,214
3,394
3,833
3,843
3,958
3,811
4,000
3,816
3,964
27,355
69,053
79,476
82,186
82,697
81,877
85,040
88,960
94,754
96,898
98,132
103,234
104,744
105, 706
106,169
25.9
16.0
13.1
11.7
11.4
10.8
11.0
10.9
11.6
11.3
12.2
11.1
11.1
10.2
11.0
1Excludes interbank and U.S. Government deposits and collection items; data are partly estimated
prior to 1947.
2 Beginning with Dec. 31, 1947, the all-bank series was revised; previous data not strictly comparable.
MONEY
RATES
EMPLOYMENT,
GROWTH,
AND
PRICE
LEVELS
1952
1954
1956
1958
I960
Oi
o
760
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
H
GRADUATE
arvard
SCHOOL
U n iv e r s it y
OF PUBLIC
AD M INISTRATION
Cambridge, Mass.
I n f l a t io n a r y P r e ssu r e s,
1955-57;
a
N eg l e c t e d F acto r
What was the primary cause of the fairly sharp rise in prices from 1954
to 1957?
As always, there were of course many interrelated factors, but the primary
cause has, I feel, been overlooked by almost everybody, and especially by the
administration and the officials of the Federal Reserve.
The evidence seems to me overwhelmingly clear that the inflationary pres
sures were caused mainly by an excessive splurge o f investment in plant and
equipment. This indeed has been the main cause of inflationary pressures in
boom periods throughout our history. Yet there is no case in history, I believe,
in which the increase from an already high base was so large as from 1954
to 1957. The increase was 39.3 percent (p. 149, President’s report, January
1959). And the outlays in plant and equipment were already in 1954 at the
near record high of $29.5 billion, which was $1.4 billion above 1952 and only
$0.7 billion below 1953, the two previous peak years.
Now what was the result? As shown in the charts on pages 11 and 19 in
the President’s January 1959 report, the prices o f producers’ finished goods
(p. 11) rose 22 percent, and the prices of producers’ equipment (p. 19) by
a similar amount. In the same period the prices o f metals and metal products
(p. 181) rose 18.1 percent, the prices of machinery and motive products (p. 181)
17.3 percent, while construction and factory building costs (p. 11) rose 15
percent. In the meantime general wholesale prices rose only 7 percent. It
appears to be quite clear that the heavy inflationary pressures struck in the
area of plant and equipment in consequence of the extraordinary increase in
investment.
For further evidence note the table on page 97 of the President’s 1959 report,
where a comparison is made between price increases from 1953 to 1957 in the
United States and selected European countries. In the United States prices
rose less than in Western Europe except in the case of producers’ durable
equipment. In this country the price increase for producers’ equipment was
17 percent; in the European countries the average figure was only 8 percent.
On the other hand, the Consumer Price Index increased only 5 percent in the
United States, while the average increase for the European countries was 12
percent.
The effect of this burst of investment in the United States was a rapidly
developing excess o f manufacturing capacity. This is strikingly disclosed in
the President’s 1959 Economic Report (p. 11). Yet all through this period
Secretary Humphrey was calling for more and more investment and urging
tax measures to stimulate it. That we in fact borrowed from the future is
now clear. Secretary Humphrey had never learned the lesson that investment
in excess of the requirements of growth and technological progress will drive
the marginal productivity of capital down to a point where investment outlays
dry up, as indeed was the case in 1958.
The recovery of 1955-57 was far too narrowly based, and this spelled its
own doom. A more balanced recovery would have given us a sustainable rela
tion of manufacturing capacity to the demand for consumers goods and services.
We do indeed urgently need to accelerate the growth of our economy. But
this cannot be achieved simply by piling up excess capacity. What is needed
is to step up technological research, thereby opening up new investment oppor
tunities. Excess capacity spells stagnation (such as we are just now wit
nessing) ; new investment opportunities, on the other hand, open the doors to
growth and expansion.
To be sure, if an authoritarian government had held wages rigidly constant
in the face of the excessive burst of investment, the inflationary pressure would
rapidly have evaporated. Wage increases in 1955-57 reenforced the rising
price trend. Yet it is to be noted that hourly earnings in durable manufacturing
increased only 15 percent while hourly earnings in building construction in
creased 14 percent (p. 167, President’s 1959 report). This is less than the
increase in prices in the capital goods industries disclosed above.
It should also be noted that in the entire calendar years 1955-57, the Federal
budget had a surplus averaging $4.5 billion per year (p. 220, President’s January
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS
761
1959 report). It was the spurt in outlays on plant and equipment, not the
Federal budget, that was feeding the inflationary pressures.
With respect to consumer prices, which rose only 5 percent from 1954 to
1957, it is quite obvious (as indeed is correctly noted in p. 18 in the President’s
1959 report) that this increase was “ not closely related to the immediate busi
ness situation.” The prices of services including rent were making a “ delayed
adjustment to earlier increases in prices and costs.” Note especially the chart
on page 17 in the President’s 1959 report.
These I think are matters of the greatest importance. So long as we con
tinue incorrectly to appraise the forces causing the price increases o f 1955-57
we shall continue to pursue erroneous policies. This applies, of course, par
ticularly to the current debate on the budget.
A l v in H . H a n s e n .
D ebt M a n a g e m e n t ,
1959
Last week the Treasury undertook a major financing operation involving
$14,900 million of maturing certificates and notes. Holders of the maturing
securities refused to accept the new securities offered to the tune of over $2
billion.
It is, I believe, generally agreed that this unfortunate result was mainly due
to the failure of the Treasury to tailor its issues to the needs of the market.
Holders of the maturing issues, notably corporations, wanted shorter-term se
curities than those offered by the Treasury. Yet this event was seized upon by
both Treasury officials and Mr. Martin as further evidence supporting the al
leged urgency of a balanced budget.
This raises a very fundamental issue with respect to Treasury and Federal
Reserve policy.
In the first instance, the Treasury should pay much closer attention to the
requirements of the market. Instead, the Treasury is inclined to push long-term
issues regardless of market needs. Still at best it is likely to make mistakes.
What then?
The Federal Reserve should stand ready to underwrite Treasury offerings,
taking up whatever the market refuses to absorb. This ought to be accepted
without argument as one of the primary functions o f a central bank. Yet our
Federal Reserve System, under Mr. Martin’s leadership, has backed away from
this obligation.
During the peculiarly difficult period through which we are passing, it might
indeed prove to be a very good thing for the Federal Reserve to take over a
much larger proportion of the public debt than it now holds. Any undue
expansionist effect from such purchases of U.S. Government securities could
easily be offset by raising reserve requirements. Larger holdings by the
Federal Reserve would: { a ) reduce the net interest charges (since excess
profits of the Reserve banks flow back to the Treasury), (&) strengthen the
position of the Treasury and greatly ease the task of debt management.
These are times when conventional methods are quite inadequate. It is shock
ing to hear high administration officials declare that we cannot afford adequate
defense, education, housing, urban renewal, etc. And now we have the added
argument that retrenchment is necessary because the Treasury is unable to man
age the public debt. It is unable to manage only because the Treasury and the
Federal Reserve, under present leadership, have reverted to obsolete thinking and
policies. Instead of giving us a vigorous, positive leadership, they are spreading
a fear psychology throughout the country by alarmist talk about inflation. We
need a Marriner Eccles back on the job.
Ax v i n H . H a n s e n .
Representative P a tm a n . I would like to ask you, Professor, about
your statement advocating the elimination of reserve requirements?
Mr. S e ld e n . N o , variations in reserve requirements.
R epresentative P a t m a n . Y ou m ean to m ake it a ll the sam e, ju st like
rim e deposits, a 5 percent reserve, and m ake it across the board ?
Mr. S e ld e n . I am referring to existing legislation.
The Federal Reserve Act permits the Board of Governors to set the
level of reserve requirements, depending upon the class of bank.
38563— 59— pt. 4-------11
762
EM PLOYMENT, GROWTH, AND PRICE LEVELS
In the case of the larger size, the central reserve city banks of New
York and Chicago, the Federal Reserve Board can set it between 13
and 26 percent. I advocate elimination of that discretionary power
to vary reserve requirements.
Representative P a tm a n . D o you consider inflation a threat now?
Mr. S e ld e n . Yes. I have not studied it in great detail, but I think
the statistics which have been becoming available in the last month or
two are a little bit disquieting with respect to the rate of increase of
the stock of money. It seems to me it has been unusually rapid. I
think this is a worry.
However, I must add that I do not think we are under threat of any
rapid or sudden increase in prices.
Representative P a tm a n . H o w do you reconcile the position of the
Federal Reserve current recommendation that their powers to deal
with inflation be, in effect, weakened ?
They are recommending that the central reserve city banks that
now have a minimum reserve requirement of 13 and a maximum of
26 have a reduction from 26 to 20. How can anyone who believes
that inflation is a threat believe also that we should weaken the power
of the Federal Reserve to cope with inflation in that manner?
Mr. S e ld e n . I would simply state that I feel that the Board of
Governors has very strong powers through its Federal Open Market
Committee, via open market purchases of Government securities. It
seems to me that is the most sensible method.
Representative P a tm a n . That would make more inflation.
I am talking about dealing with inflation, fighting the inflation.
Mr. S e ld e n . Representative Patman, I am talking about sales of
such securities as well as purchases. These work in either direction.
Representative P a tm a n . I am talking a;bout fighting inflation.
You cannot fight inflation by buying Government bonds.
Mr. S e ld e n . N o , but by selling them you can.
Representative P a tm a n . They claim that inflation is a great
threat. I f it is a great threat, why should they seek to weaken their
powers to fight it, by reducing the maximum reserve requirement
from 26 to 20 ?
It has been higher than 20 percent, I believe, most of the time since
1937 when the Federal Reserve Board doubled the reserve require
ments of the banks. It was raised to 26 percent in 1937; again in
1941; and again in 1948. It was aibove 20 percent from 1936 until
1954. Only in the past 2 years has it been below 20 percent, now pro
posed as a maximum.
Over that long period of time, they needed the power to have more
reserve requirements than 20 percent. Yet they come in now and
ask that their weapon be weakened to fight inflation to where they
cannot possibly impose reserves exceeding 20 percent.
Mr. S e ld e n . I believe at the moment there is no difference in the
required reserve ratio between central reserve and reserve of city
banks.
Representative P a t m a n . Yes; there is.
Mr. S e ld e n . There is in the law, but is there in fact? Could some
one check that ?
Representative P a tm a n . I can check it for you. It is 18 percent
in the central Reserve cities and 16^ in the Reserve city banks.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
763
Mr. S e ld e n . The reduction of the statutory power to vary reserve
requirements from a maximum of 26 percent to a maximum of only
20 percent would leave unaffected the actual reserve position of the
central reserve city banks as they now stand since they are below the
20 percent maximum they are requesting.
Representative P a t m a n . The reserve requirement is now 16% per
cent, and central reserve city banks 18 percent, and the country banka
are 11 percent, and all commercial banks 5 percent on time deposits*
Mr. S e ld e n . Yes, sir.
Representative P a tm a n . Y o u made a statement awhile ago about
liquidity, indicating that you were not concerned about that.
Do you believe that if Federal Deposit Insurance Corporation were
to fail to have sufficient assets to meet the demands upon it, that it
would be a moral obligation of Government to support it?
Mr. S e ld e n . I think the first line of defense that the Government
could take in any future crisis which might lead to the circumstances
you are suggesting is to pursue central banking policy, Federal Re
serve policies, of a sort which would obviate need for that.
Representative P a tm a n . That is off on a somewhat different subject.
I say that respectfully. I am just asking you a simple question:
Do you consider it a moral obligation ?
Mr. S e ld e n . Yes, sir.
Representative P a tm a n . I f you want to qualify that, will you do it
in the record ? Time is of the essence now and I want to get through
here.
Mr. S e ld e n . Yes, sir.
Representative P a tm a n . On the value of our dollar going down,
I want to invite your attention to the fact, Professor, that the dollar
that bought interest at short-term on Government securities in 1945,
1946, and 1947, we will say, is worth 10 cents today because the rate
of interest for that purpose has gone up 10 times. So we have a 10cent dollar for the purpose of paying interest on short-term obliga
tions compared to 1945.
Do you see any evils occurring in our economy by reason of the
continuing increase in interest rates over the years ?
Mr. S e ld e n . It is hard to say yes or no. In general, I am not
greatly concerned about it.
Representative P a t m a n . It enters into the cost of production and
everything else, though.
Mr. S e ld e n . When we look at the present level of interest rates com
pared to the levels that prevailed in the 1920?s, we still have some
distance to go. I feel that the low rates that we experienced earlier
in the postwar years and during the war were essentially abnormal in
the sense that they were depression-bred.
Representative P a t m a n . I am sorry but we just have word of a
quorum call in the House and we will have to leave, and I want Mr.
Curtis to ask any questions he desires to ask.
Representative C u r t is . In order to save time, I will give the ques
tions and Mr. Selden may supply the answers.
One was the question raised in answer to your question on the in
flationary threat, I pose the question:
What would happen, in your judgment, if we have to market an
other $3 or $4 billion of Federal debt, for deficit financing, on top
of the $13 billion deficit financing in the fiscal year just ending?
764
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS
I would like to get your judgment as to what impact you think
that would have.
The other question reverts back to the line of questioning I pursued
previously.
(The following was subsequently received for the record:)
Responses
by
Prof. Richard T. Selden to Questions b y Representative Curtis
Asked During Hearing, May 26, 1959
1. The marketing o f another $3 or $4 billion of Federal debt at this time
in my judgment would have no major effects on the economy. In this regard
one must distinguish between the effects of additional Government expendi
tures, which at the time o f expanding business activity such as the present
would clearly be inflationary, and the effects of the related bond sales. I f as
a result of the additional debt the Federal Reserve System permits the volume
o f bank reserves to expand, this will mean an expansion in the stock of money
with further inflationary implications. However, I see no reason why the
Treasury would not be able to sell another 3 or 4 billions of debt without mone
tary expansion, provided it were willing and legally able to compete for long
term funds against private borrowers. The difficulty here is the statutory
limitation on interest rates which the Treasury may offer on new debt. In my
opinion this limitation should be abolished by Congress.
2. With respect to the effect on velocity of the increasing reliance on debt
financing in preference to equity financing, one would have to consider two pos
sible effects. On the one hand there is the effect on the velocities of the firms
that engage in debt financing, and on the other there is the effect on the pur
chasers of securities. The influence of debt on business velocity has probably
been to depress it somewhat. As compared with equity financing debt creates a
contractual obligation by the firm to make certain payments at particular points
in time, and these payments will lead to periodic cash accumulations in the
firm. How important this effect on business velocity is I cannot say.
The influence of debt on lenders is just the reverse, however. Debt instru
ments, particularly those with short maturities, are closer substitutes for money
than equities are. It seems likely, therefore, that creditors maintain higher
velocity ratios than shareholders, other things being equal.
Taking both effects into account, in my judgment the increased reliance
on debt financing has contributed, on net, to the postwar velocity rise.
Representative C u r t is . Y o u mentioned the fact that the velocity
has risen much more rapidly for large corporations than any other
size class. I was wondering what you thought the effect of the
amount of corporate financing that has been done through debt as
opposed to equity financing might have on increased velocity. I am
premising that on the assumption that the ratio of equity financing to
debt financing of corporations has declined, particularly since World
War II.
I f it has, in my judgment it is largely as a result of our tax struc
ture. I f that premise is true, I would like to know whether you
think that has had an increase on velocity.
I noted also your remarks in reply to Senator Javits’ question.
You may give a yes or no answer to this. You do feel, do you not,
that there is relatively greater upward flexibility of wages and prices
as compared with downward flexibility ?
Mr. S e ld e n . Yes, sir.
Representative C u r t is . But you do not feel that has been a major
factor, as I understand it.
Mr. S e ld e n . That is right.
Representative C u r t is . D o you feel that evidence seems to be now
available indicating unions have added much to the downward price
rigidities, or is that out of your field ?
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
765
Mr. S e l d e n . It is somewhat out of m) field, but in talking to others
I gather that the increase in unionization has not had any great effect
in this regard. Wage rates are typically rigid in a downward direc
tion in all economies that we know anything about, whether unionized
or not.
Representative C u r t i s . Thank you very much.
Representative P a t m a n . Tomorrow, May 27, in the old Court
Chamber of the Senate wing of the Capitol, we will have our hearing
at 10 o’clock. Prof. Robert Eisener will be our witness. He is from
Northwestern University.
We want to thank you very kindly, Professor, for your appearance.
I know you have been very helpful to us. We will carefully con
sider everything you have said and everything you have written which
we have inserted in the record.
The committee will stand in recess until tomorrow morning at 10
o’clock.
(Thereupon, at 12:15 p.m., the committee recessed, to reconvene at
10 a.m., Wednesday, May 27,1959.)
EMPLOYMENT, GROWTH, AND PRICE LEVELS
WEDNESDAY, MAY 27, 1959
C ongress of t h e U n it e d S t a t e s ,
J o in t E c o n o m ic C o m m it t e e ,
Washington, D.C.
The Joint Economic Committee met at 10 a.m., pursuant to recess,
in the Old Supreme Court Eoom, the Capitol, Senator Paul H. Doug
las, chairman, presiding.
Present: Senators Douglas, Bush, and Javits; Representatives Pat
man and Curtis.
The C h a ir m a n . The committee will come to order.
We are very happy indeed to welcome Professor Eisner of North
western University, who is going to read a paper on the IncomeExpenditure Approach to the Analysis of Money Relationships.
Mr. Eisner.
STATEMENT OF ROBERT EISNER, PROFESSOR, NORTHWESTERN
UNIVERSITY
Mr. E is n e r . I am very happy to be here, Mr. Chairman.
I have a lengthy paper, and some associated documents for the rec
ord. I do not think it would be appropriate to try to read all of that
here this morning. I should like, therefore, to read parts and sum
marize parts and make use of some material I have put on the black
board, which perhaps we can find a way eventually to get into the
record.
The C h a ir m a n . I will have this copied and put in the record.
767
C harts
Chart A
k%
3%
Demand
($ Billion)
Money
($ Billion)
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
769
Ch a b t 0
Y
(output)
Year
0_________ _______ ____ ____ ___ ___ ________________ __________
1...................................
.................... ................
0___ _________________________ _______________________________
1_________ ____________________________________ _______________
0_____ ____ ______ _________________ ______ ____ ______ __________
1___ ______ ______ _____ ________________ ____________ __________
Chabt
400
420
400
406^
460
475^
K
(capital)
1,200
1,260
1,200
1,220
1,380
1,426
Id
(investment
demand)
60
20
40
D
Full em
ployment
Productive capacity (P)___________________________________________________
Output (Y)_______________________________________ _____ ______ ______ _____
Saving-r-output ( y ) ' “...............................................................................................
Investments (equals saving) (I, which equals S) ___________________________
Change in productive capacity (0.4X1)______________________________________
100
100
.10
10
4
90 percent
employ
ment
100
90
.OS
4.5
1.8
Mr. E i s n e r . In some economies production is undertaken accord
ing to plan or governmental directive. In a profit oriented, market
economy, production is for sales. I f businessmen or other producers
expect to be able to sell what they produce at a price which warrants
production, they produce; otherwise they do not.
Thus in our economic system there are two relations which can be
said to determine jointly the rate and prices of output. One of these
relations we call the supply function. This in turn is based upon
the production function and the terms under which the owners of
productive factors are willing to sell the services of these factors. The
other we call the demand function, what businessmen may expect to
be spent on what they might produce. The income expenditure ap
proach suggests nothing more nor less than that, once we specify the
technological conditions of production and the terms under which
people wish to work, the amount that is actually produced, the num
ber of people employed in production, and the prices at which goods
are sold depend upon what people are willing to spend.
This simple, intuitively plausible notion, that production and prices
are determined in the short run (when technological conditions are
fixed) by demand, by what people spend, is the framework of the
economic analysis that has oriented leading economists for the past
quarter century. Within this framework economists have by and
large challenged older views and have developed policy implications
suggesting the advisability, if not the necessity, of an increased role
for government in an otherwise free economy. I shall attempt, in the
pages which follow, both to present this framework in some detail and
to indicate certain implications of its use.
1. The historical setting and the clash of ideas.
We should observe that throughout history man has known vary
ing degrees of economic misery.
In the past, this misery has been associated with how much people
could produce. When nature did evil work, when there were droughts
or pestilences, production was down. The rather unique characteristic
770
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS
of the modem world is that, with tremendous industrial progress, we
have developed a situation where, no matter what we can produce,
we frequently find ourselves lacking, because we do not use all of our
capacity to produce.
Now, classical economists in large part ignored this problem. They
argued that in general supply creates its own demand, and there is
nothing to concern oneself about demand. The only reason for de
pressions or unemployment is some kind of a temporary disequilib
rium, perhaps some mistake of governmental monetary policy, which
presumably could be cured in time.
With chronic unemployment in England after World War I and
with the long, deep, almost worldwide depression of the 1930’s, tra
ditional economics fairly cried for revision. This revision, while
ultimately the work of many minds, was inspired and laid out in its
essential form by the late John Maynard Keynes in The General
Theory of Employment, Interest and Money.
The essential classical proposition challenged by Keynes was the
tenet that full employment was necessarily the natural state of a
competitive economy. Unemployment, Keynes argued, might for
long periods of time be endemic to the system and there would then
be nothing that any individuals, whether workers or businessmen,
could do by themselves to eliminate it. Further, Keynes declared,
the mass unemployment of his time could in no reasonable sense be
considered voluntary, as some economists argued on the alleged ground
that workers could not get work only because they demanded wages
higher than employers could afford to pay. While not denying that
workers tended to resist money wage cuts in time of unemployment
(although indeed such resistance was only partially successful),
Keynes insisted that a fall in money wages was entirely unlikely to
increase employment. The error in the classical reasoning might in
deed be explained as an illustration of the logical fallacy of composi
tion : the invalid inference that something true of the individual or
the part is necessarily true of the aggregate or the whole. It might
well be true that an individual employer would find himself able to
hire more workers if he could pay lower wages. For then he might
be able to charge lower prices for his product and sell more. However,
if all wages were to be lower, throughout the economy, all prices
would be lower and each individual businessman would lose the com
petitive advantage he expects to have when he thinks of cutting his
prices with everything else, the income of his buyers as well as the
prices of other sellers, remaining the same.
To analyze the effects of a wage change, or any other aspect of the
problems of employment and income, a new set of analytical tools was
necessary, a set appropriate for explaining the economy as a whole.
This set of tools, fashioned in large part by Keynes but explained
and sharpened by a whole generation of economists since, I shall now
attempt to present in fairly elementary form. I shall supplement
this presentation with a somewhat more technical note bearing par
ticularly on the role of money, and with two previously published
professional papers relating these tools to economic growth.
We might now turn in the paper to table 1 (see p. 796). And we
have here in schematic form the essential elements or outline of the
income-expenditure approach. What we indicate is that any hypo
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
771
thetical or possible level of employment, in order for the producers
or businessmen of the economy to undertake it, must involve an ex
pectation of proceeds, of receipts, if you wish, which would be such
as to justify this employment.
By looking at the first two columns, we can quickly get a notion of
what they mean. I f 70 million people were to be employed—I might
add that these figures are hypothetical, but, as you can see, they are
reasonably close to the figures that would apply to the economy as we
know it in the country today—if employment were to be 70 million,
it might be argued that the supply of goods forthcoming in a year
would be about $460 billion. That means that in order for producers
to employ 70 million people, they would have to expect receipts or
proceeds of $460 billion. I f they did not, there would be no point to
their hiring 70 million people, because they would find that they could
not sell all of the goods that they could produce.
On the other hand, if they were to employ 65 million people, they
would have to expect receipts of $430 billion. O f course, the more
people that are employed, the more that is produced, the more busi
nessmen would have to expect and demand in expenditures for their
goods to warrant the employment, and hence the production.
Now, the paradox and irony of this is that unlike what classical
economists might have suggested, there is no guarantee that, what
ever the production, there will be a demand. The notion that we have
is that demand, aggregate demand or total demand, can best be viewed
as made up of some four components, one of them the demand of con
sumers, which we call consumption; second, the demand of business
men for inventories and producers’ goods, capital goods, which we
call investment; third, the demand of foreigners, which we like to
treat as a net demand, the difference between what foreigners demand
from us and what we demand from them; and fourth, Government
demand. The total supply or production of goods has to be demanded
by some one of these four groups indicated by these four headings.
I f the total demand of these four groups is less than the total sup
ply, then businessmen will find that they are supplying goods for
which there is no demand, and in a free economy, when nobody is
forcing them to produce, if they find there is no demand for their
goods, the only reasonable thing to do is to cut back production.
Now, what we have assumed here as a first simple approximation
is that, regardless of the level of output, we have certain amounts of
investment demand, foreign demand, and Government demand. In
table 1, this is assumed to be $60 billion for investment demand, $5
billion for net foreign demand, $85 billion for Government demand.
The curiosity of this is that while it is not entirely unreasonable to
suggest these figures for those three components, it is very clearly
unreasonable to say that consumption demand would remain the same,
regardless of the level of output or employment, because clearly the
amount that we as individuals consume must depend pretty much upon
our income. In the short run we can use up past savings or borrow,
but sooner or later we are caught up by the fact that if we are not
earning income we do not have the wherewithal to consume.
But the second element in this consumption function or relation
which is particularly important is the fact that as income increases,
our consumption tends to increase by less than our income. Because
772
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
all of us have a propensity to save, we have the notion that consump
tion is generally less than income, and particularly that as income
changes consumption changes by less, or what economists call the
margin of propensity to consume, the proportion of additional in
come that would be consumed, is less than one. This we have em
bodied in table 1, where we note that as income or output—because
whatever the supply or output would be, the income would have to
correspond to that—goes up, from 340 to 370, consumption goes up
from 220 to 235, a ratio of 15 to 30, or one-half.
Looking at table 1, if these relations were to obtain, we can con
clude that there is only one level that the economy could sustain.
That would be a level of employment of 60 million, because at that
level of employment, $400 billion worth of goods would be supplied,
and the total demand for goods would be $400 billion. I f business
men were for some reason to increase their production to $430 billion,
for that purpose hiring 65 million, they would find that the total de
mand would go up by only $15 billion. Because businessmen produce
for profit, if they cannot sell their goods, they will not produce.
Therefore, if we find that this level of employment is not satis
factory—and with the illustrative figures I have it is clear that it is
not—and that an employment of 60 million would represent a sub
stantial amount of unemployment in our present economy, the ques
tion arises: is there anything that would change these relations auto
matically, or is there anything that we can do to bring about an in
crease in either the consumption column, the investment column, the
foreign column, or the government column? I f we cannot, we are
stuck. To analyze this, we have to go a bit behind the scenes and
consider further now what influences the amount, for example, the
businessmen invest.
The notion we have here is that businessmen invest, that is, accum
ulate inventories willingly or buy capital goods, plant, and equip
ment, because they think that the profit that they will earn on these
goods that they are acquiring is more than the cost of money. I f it is
not, it is a foolish thing to do. I f money is worth 5 percent to you,
there is no point to acquiring a new plant or new equipment that will
only pay you 4 percent. And of course a fortiori, as the economists like
to say, if the expected profit on investment is negative, then there is
really no conceivable cost of money which would induce businessmen
to acquire more capital goods.
Now, the cost of money is a rather peculiar animal, and it is this
peculiar characteristic of the cost of money, together with the kind
of profits that people might reasonably expect on investment, which
accounts for the particular results that economists usually get when
they use the income-expenditure approach. And I might add that
an approach does not change the nature of the real world, but of
course it can facilitate bringing out certain relationships which are
sometimes abscured in other approaches, and that I believe most econmists feel have been obscured in the old quantity theory approaches.
I can now perhaps turn to the blackboard, where I have a number
of diagrams and charts, I have labeled them A, B, C, and D. And
we might first look at A, in which we relate the investment demand
and the rate of interest or the cost of money, or what people might
earn on money.
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
773
We have on the vertical axis “ i” for interest, on the horizontal axis
investment demand, and what we say is that the lower the rate of
interest, the lower down we go on the vertical axis, the higher the
investment demand, that is, the greater the abscissa, the more to the
right that investment-demand line appears. In other words, if the
rate of interest were 4 percent, the businessmen of the economy all
put together might find that there was $60 billion worth of capital
goods and inventories that they could acquire that would give them a
profit of 4 percent or more. Therefore, they would do so.
On the other hand, if the rate of interest were as low as 3 percent,
there would be an additional $10 billion of goods, which they would
find it profitable to acquire. This $10 billion would be addtional
plant and equipment and perhaps inventories, on which their esti
mated rate of profit is somewhere between 3 and 4 percent, not suffi
cient to acquire if the alternative profit we did not buy were at 4
percent, but sufficient to warrant acquisition if the alternative profit
were 3 percent.
Looking at that, one is to remember that in this analysis the
only way we can effect anything is to affect some one of these four
components of demand—this with the parenthetical remark; except
to the extent we can affect supply, which, in the short run, we presume
we are not able to do.
One way to increase investment demand, in looking at this, is to get
that rate of interest, the opportunity cost of money, the amount the
businessmen would have to pay to get the money to buy capital goods,
down below, let us say, 4 percent. We might presume that table 1,
where investment demand is $60 billion, corresponds to a rate of in
terest of 4 percent.
Well, to figure out how we might do that, we should look at chart
B, in which we relate the supply and demand for money to the rate
of interest, and we note initially that if we have a money supply
of $130 billion, which we might say is the amount of money that
the monetary authorities have put in existence for us, then our situ
ation of equilibrium, which would indicate that the money supply
is equal to the money demand, would be one of the 4 percent. At
4 percent, people would be content to hold just the amount of money
which is supplied, $130 billion.
Now, it should be remembered that when people hold money, they
are sacrificing the return they could receive on interest, they are sac
rificing the use of consumer goods that they might buy. The lower
the rate of interest, the less the sacrifice, and therefore the more money
they might want to hold.
One way, then, to get the rate of interest down is to increase the
supply of money. And in this analysis, it becomes clear that a
prime way in which the amount of money can affect demand or ex
penditures is by affecting the rate of interest, particularly if we re
strict ourselves to the notion that the effect upon the quantity of
money is gotten only by conventional monetary policy, not by budget
deficits. Therefore, we have a situation where the Federal Reserve,
for example, simply goes out and buys bonds from the public. I f it
does this, it increases the quantity of money. But it has no particular
effect upon the quantity of assets that people hold, because people
are giving up bonds and getting in return money.
774
EM PLOYMENT, GROWTH, AND PRICE LEVELS
The effect of this operation, then, is to lower the rate of interest.
Now, here comes the real sticker. As we have drawn this moneydemand curve, we see that even if you double the quantity of money
from $130 billion to $260 billion, you lower the rate of interest only
from about 4 to 3 percent. For that matter, if you were to increase
the quantity of money still further, you would get even a more negli
gible lowering of the rate of interest.
The reason for this is that whenever people decide to hold money or
give up money, they have to consider what they are losing. As the
rate of interest gets down, people have to recognize that if they were
to buy bonds they face a very substantial risk of loss if the rate of
interest were to go up.
I might perhaps try to squeeze on the board a numerical explana
tion of that. I f the rate of interest were, for example, 3 percent, we
would have a situation where a bond paying $3 a year, maturing in
20 years, would sell for let us say $100. That is what a rate of
interest of 3 percent would mean.
Now, if the rate of interest were, however, to rise to 4 percent, what
would happen to the price of this bond ? Clearly, anybody familiar
with the money markets would realize that the price of a 20-year
bond paying $3 a year with a rate of interest in the market of 4 per
cent would have to drop from $100 to about $85, just roughly.
What this means is that when the rate of interest is 3 percent, peo
ple may think that, “ You know, that rate of interest is perhaps not
very certain to remain there. That is unusually low. It is likely to
go up again the next time the administration decides we had better
tighten up on money. I had better not buy a bond paying 3 percent.
I had better not pay $100 for a $3 bond, because if I do, I may take
quite a loss.”
Now, it is this essential notion, which Keynes called “ the specula
tive motive,” which results in the situation where it is very difficult
to get the rate of interest down below a certain point because as it
goes down, people begin to hold on to money rather than buy bonds,
with the fear that if they do buy bonds they will lose.
This has some rather interesting implications for monetary policy.
I f our objective is to get the rate of interest down, to raise investment
demand, then we are going to find that every time the monetary
authority operates in such a way as to raise interest rates, it implants
in people the notion that any low rate of interest would sometime or
other rise again in the future, which will make it all the more difficult
to get the rate of interest down if in a period of depression or un
employment you want to do that.
But now, back to the main track of our analysis, we can see that we
can increase investment demand by increasing the money supply, and
for example, we might double the money supply from $130 billion to
$260 billion. In so doing, we would lower the rate of interest from 4
percent to 3 percent, but the effect on investment demand would not
be major. It would be an increase of investment demand from $60
billion to $70 billion.
The C h a ir m a n . Y o u have assumed a rather inelastic investment
curve?
Mr. E is n e r . That is correct.
The C h a ir m a n . D o you think that is true ?
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
775
Mr. E is n e r . I am not quite sure it is true, but of course this is an
empirical question to argue about. I might add that all of us have
some notion of what the real world is like. If we see unemployment
about, we look for explanations of it. Our economy has known un
employment periodically. I f the investment-demand curve were very
elastic, not drawn nearly as vertical as I would have it, then you would
have a situation where this analysis would suggest that we would
never really have any danger of unemployment. But in fact we do
have the unemployment. That would be one basis for inferring this.
However, there have been a lot of empirical investigations. I cannot
say that we always have things entirely conclusive. The analysis
is tricky. But I think on the short run that curve should not be drawn
in too elastic a f ashion.
We can now use this approach to analyze very directly the role
of money, and we can see for example that if the monetary authority
or the Federal Reserve were, for example, to double the quantity of
money, we would have some effect. But the effect has to be analyzed
through the effect on demand. It is not the quantity of money per
se that has anything to do with the economy. It is how people use
this money. I f they put it under the mattress, it has no effect. I f
they take the money to buy goods, this increases demand, and this will
tend to increase output, and this will tend, I must suggest, very likely
to increase prices as well.
So this analysis indicates, then, that one way to raise output would
be to increase the quantity of money. But this effect would be shown
through a reduction in the rate of interest, a consequent increase in
investment demand. I might add perhaps an increase in the demand
of State and local governments for public capital projects, because
they, too, are considerably influenced by the cost of capital and the
rate of interest.
I think it might be best to move on rather quickly, leaving a number
of things perhaps for closer examination in the text of the paper that
I am presenting for the record, and consider now the role of prices
in this. Suppose we were to increase the quantity of money in a
period of considerable unemployment. The argument there would be
that in the first place we would get likely a small reduction in the
rate of interest, because in a period of unemployment, when there is
little demand for money on the part of businessmen, who do not want
to expand and do not want much investment goods, the rate of interest
is already low.
It would be argued that where the level of employment is low and
there is much excess capacity, while increases in demand are likely to
bring about some increase in price, the increase in price should be
relatively little.
It seems clear that whenever businessmen experience an increase in
demand, this is signaled in part by increased prices, as income firms
up and markets seem surer, but that where there is a lot of excess
capacity, the forces of competition, imperfect as they may be, are
likely to prevent any substantial increase in prices,
I have illustrated the general relation that I think economists
might agree upon in figure 1. (See p. 803.) And there you can see
that if we find some way in increasing effective demand, the demand
for goods in money terms, by perhaps increasing the quantity of
776
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
money or by increasing Government expenditures or by cutting
taxes—any of these things might conceivably affect some one of the
four components of demand—as we do this the effect upon employ
ment, if we start from a very low level of employment, for example,
20 million employment, at the left hand side of the diagram, is quite
substantial. Employment initially rises almost proportionately to
the increase in demand. And at this point there is very little in
crease in prices.
As, however, we get closer and closer to full employment, the in
creases in demand—and I must emphasize from whatever source,
from an increase in the quantity of money, from increased Govemexpenditures, from increased consumer expenditures, from increased
consumer expenditures having nothing to do with Government—from
whatever sources of increase in demand as you approach full employ
ment, you find that the increases in employment are proportionately
small and the increases in prices tend to be somewhat larger.
The C h a ir m a n . Dr. Eisner, have you any idea as to where this
critical point is ?
Mr. E is n e r . I am afraid I do not have any very precise idea. But
I have some general observations on the subject, in terms of implica
tions for policy, implications as to which I think neither I nor any
body else has a very precise idea. Perhaps I could come back to that,
if you would like.
So much for our quick sketch of the role of prices. I would like
to emphasize at this point, however, that economists insist that, after
all, the wealth of nations, going back to Adam Smith, the welfare of
the economy, in the last analysis, has nothing to do with prices in
itself. Our welfare is determined by what we have in the way of
goods, factories, schools, of defense, whatever we feel we need. Our
welfare is measured in these real terms. I f prices are high, but we
have more of all of these things in real terms, we are better off than
if prices are low, and we have less of these things.
Figure 1 suggests that you may run into the difficulty that as you
try to keep the price level low you find that you tend to keep employ
ment low, and if you keep employment low in real terms, we are
clearly worse off, because we have less in the way of goods.
Now, finally, I would like to tie this in to what has become very
much the center of public discussion, the question of economic growth.
But here I would like to emphasize something of a paradox. It is
usually suggested that growth is desirable for its own sake, and growth
certainly is desirable. But the income-expenditure approach enables
us to see that the growth is not merely desirable for its own sake. It
becomes something of an essential in order to preserve prosperity and
any reasonably high level of employment.
The reason for that is that an essential component of this aggregate
demand, we have noticed, is investment demand, the demand on the
part of businessmen for additional inventories, for additional capital
equipment. And this demand of businessmen we find is intimately
related with growth.
Suppose you have an economy which is fixed in its rate of output.
Suppose, taking a look at chart C on the lower left hand corner of the
board, we find that in the year zero we have an economy with an
output of $400 billion worth of goods and services.
EMPLOYMENT, GROWTH, AND PRICE LEVELS
777
Well, for that output, there is just a certain amount of capital
goods that businessmen find it desirable to have. Perhaps to pro
duce $400 billion worth of goods in a year, they need $1,200 billion
worth of plant, equipment, and inventories. As long as they are pro
ducing only at $400 billion, that is all the plant and equipment and in
ventories they need. True, they have to replace things as they wear
out. What is more, they may want to acquire a certain amount o f
new inventories or new plant and equipment, to make use of techno
logical advance. But in large part, their demand for additional capi
tal goods is limited.
As a matter of fact, if we presume that the technological advances
are all embodied in the replacement, there is no net investment de
mand as long as the output remains at $400 billion. The only way
in which businessmen would require to invest, to buy more plant and
equipment, is if they find that what they have is not enough. And
they will not find that what they have is not enough until output is
increased.
We can illustrate that in just very simple figures by noting what
might happen if in the year 1 output had increased from $400 to
$420 billion. Then we might find fairly reasonably that business
men would figure that they need $1,260 billion of capital, thus
maintaining the same 3 to 1 ratio.
But if in the year zero they had $1,200 billion, in order to get to
$1,260 billion they would have to acquire, order, have produced, $60
billion more of plant and equipment. So you see the amount of in
vestment demand is intimately related with how much the economy
is growing.
Now we have a few more reasonably illustrative figures below.
Suppose the economy were growing at a—well, look at the very bot
tom. Suppose the economy were growing at a 5 percent rate. I f the
economy were growing at a 5 percent rate, you would find that an
economy that started initially with $460 billion worth of goods and
services being produced, which we had noted back in table 1, corre
sponds to 70 million employment, which would be roughly full em
ployment, such an economy would need $1,380 billion of capital. I f
it were to grow at 5 percent, it would increase to $475% billion in the
year 1, and the amount of capital required for that would be $1,426
billion, an increase of $46 billion, about 10 percent of the $460 billion
of output being produced in the year zero.
Now, suppose we assumed that the 10 percent of output goes to
simply investment for purposes of replacement or for purposes of
embodying technological change, and therefore we had $46 billion
roughly being demanded there. Or maybe we should say about $40
billion. I f we add on the $46 billion being required because of an
increase in output of 5 percent, we find that we get a total investment
demand which would be in the area of $92 billion, actually. Ajid I
do not know if this is entirely clear on table 1 or on table 3, but the
illustration can easily be developed to indicate that this would be
sufficient investment demand so that the total aggregate demand would
equal the aggregate supply.
On the other hand, if employment were growing at only a 1%
percent rate, as indicated in the middle two lines on chart C, we would
find that the amount of capital needed initially, $1,200 billion, would
38563— 59— pt. 4------ 12
778
EM PLOYMENT,
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increase to $1,220 billion, and there would be an investment demand
of $20 billion, for purposes of expansion.
Senator B u s h . May I ask a question, Mr. Chairman?
The C h a ir m a n . Certainly.
Senator B u s h . It is not quite clear to me how these figures develop.
The basic figure, I take it, there, is the left hand column. That is
output. And if that goes up 20 billion, the assumption then is that
the capital investment would have to be increased to take care of
that?
Mr. E is n e r . The assumption is that the capital stock, the total
amount dollar value of factories, equipment, inventories, would have
to go up.
The paradox is that investment, the acquisition of capital goods,
involves a change in the capital stock.
Senator B u s h . And the assumption is that it would have to go up
at the same percentage of growth as the output. Is that right?
Mr. E is n e r . Well, this is a simplifying assumption. But it is
quite unessential for the analysis. That is, we could assume that the
capital stock would have to go up less than in proportion. Or you
could make an extreme assumption and assume it goes up more than
proportionately. But aside from technological change, which does
account for a good amount of investment but far from all of it, unless
there is a need for more capacity, because output is going up, the
demand for output is going up, there is no need for additional
factories.
I f General Motors is going to produce a million cars, then it needs
a certain size plant, and it is not going to need more plant until it
decides that the demand justifies a capacity of a million and a half
cars, for example. And this applies right through the economy.
The major element in investment demand, a major element, prob
ably the largest single one, is the demand for additional plant and
equipment in order to produce additional goods. I f the economy is
stationary, if production is remaining at the same rate, the factories
we have are enough.
This indicates, you see, that at a low rate of growth investment de
mand would be less. But if investment demand is less, we are going
to find that aggregate demand, which is the sum of the four compo
nents of consumption, investment, foreign demand, and Government
demand, would be less. And, indeed, in terms of the illustration I
have here, which is really not unreasonable, although clearly I am not
going to want to stand on the exact figures involved—in terms of this
illustration, it can quickly be shown that a 1%-percent rate of growth
would leave us with such an investment demand that our aggregate
demand would equal aggregate supply only at an employment of 60
million.
Well, finally turning to the other side of the coin, this is intended to
indicate that a rapid rate of growth may be necessary to give us
enough investment demand so that total demand is equal to what we
can produce at full employment. But you may ask yourself: Suppose
we are not at full employment. What might the growth be ? Now, that
is indicated in table 4. I illustrate it in this fashion. We have two
columns there, one called full employment, one 90 percent employ
ment. And I try to keep the figures very simple for illustrative pur
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
779
poses. Let us assume that under full employment we have a produc
tive capacity of 100 and under full employment that means, using all
of that capacity, our output is 100.
Now, let us assume that saving as a ratio of output, S over Y —Y is
the symbol economists frequently use for output—saving as a ratio of
the output is 10 percent. And investment we find must be equal to
saving. Saving in real terms will equal investment. So investment,
we can say, 10 percent of output, is 10.
Now, let us assume that each dollar of capital goods additional en
ables us to produce about 40 cents more per year. It increases our
capacity by 40 cents. That is not an unreasonable assumption. It is
pretty close to the 3 to 1 ratio. It actually implies a 2y2 to 1 ratio.
Well, that would mean that if we did invest $10 or $10 billion, what
ever the magnitudes we are talking about, the change in capacity of
the year would be four-tenths for every dollar of four-tenths of a
billion for every billion. So the change in capacity would be $4 bil
lion. Now, we had an output of 100, a capacity of 100, the change in
capacity is four, and with full employment, then, we have a 4-percent
increase in capacity.
Suppose, however, we did not have full employment, but had 90
percent of full employment. Output, therefore, would be not 100,
but 90.
Now, we might at this point ask ourselves: When output goes down,
what do all of the empirical data suggest happens to the amount that
we save and invest? It is very clear that as output goes down, the
amount that we save and invest goes down more proportionately,
certainly more in the short run. That is, people, as we witnessed
recently, try to maintain their consumption as well as they can, and
the drop in output is largely a drop in the output of capital goods.
It would be quite reasonable to assume that at 90 percent of employ
ment saving would drop to 5 percent of output instead of 10 percent
of output, and this saving would be 5 percent of a reduced output.
This saving then, 5 percent of 90, would be 4.5.
Now, if we still maintain that each dollar of additional capital pro
vides an increase in capacity of four-tenths of a dollar, then we find,
multiplying 4.5 by four-tenths, that the increase in capacity is only 1.8.
But if capacity was initially 100, an increase in capacity of 1.8 repre
sents only a 1.8 percent increase in capacity.
Now, these, of course, are crude numerical illustrations. I have in
several professional articles tried to indicate this in more rigorous
forms. I think the broad outlines really should be unchallangeable to
all those who think through them. The notion simply is that our
capacity increases in large part because of the addition to our plant
and equipment. When we have unemployment, we add to our plant
and equipment less. We save and invest less. And as we save and
invest less, there are fewer additional factories, less additional equip
ment, and then capacity will be growing at a lesser rate.
Well, I have taken really much more time than I had meant to.
Let me conclude perhaps by reading from my conclusion in the paper,
as I have presented it.
I might just before that read perhaps a paragraph from my manu
script, in which I say:
In the last analysis we find ourselves in an Alice-in-Wonderland world in
which we have to run to keep in the same place and in which to get anywhere
780
EMPLOYMENT, GROWTH, AND PRICE LEVELS
we have to run twice as fast. The reason for this is that aggregate demand
depends in significant part on its own rate of growth. I f the growth in aggre
gate demand slows or ceases, investment demand (which is largely induced by
the need for new capital to provide for growth) shows an absolute decline.
For investment demand to remain merely a constant percent o f total output,
effective demand must be growing at an increasing absolute rate—a constant
compound interest rate if the saving ratio and other relations remain unchanged.
The implications o f this for Government policy are such that while rising
prices may or may not be an aid in maintaining demand— I rather believe that
they are an aid, for reasons suggested in part above—the measures necessary to
keep demand growing at a constant compound interest rate and to keep demand
and output always at or close to the full employment level are such as to make
rising prices a likely byproduct. Growing demand, particularly where it is
pushed unrelentingly by Government monetary and fiscal policy, is likely to
raise prices. Recall that in our economy higher prices are precisely the signal
and lure which induce producers to increase output. What is more, unemploy
ment and excess capacity are the chief downward pressures upon prices. I f the
economy is kept at or close to full employment (as I believe it should be) we are
denied these downward pressures and we may well find the increasing rate o f
demand, however much desired and necessary, tending to pull up prices as well
as output.
6. Conclusion:
The income-expenditure approach requires that any presumed effects o f
economic variables and actions upon the levels of employment, output and prices
be shown to operate through aggregate supply and demand functions o f the sort
here presented. This approach proves particularly useful in analyzing the role
of present or proposed governmental policies. Will a cut in personal income
taxes raises the consumption function? What kind of a tax cut will have the
greatest or most rapid impact? W ill permitting faster depreciation for tax
purposes raise investment demand? What will the effect of tariff cuts be upon
consumption and upon foreign demand? Will a general wage increase in a
large industry influence any of the aggregate demand functions? For each of
these questions economists employing the income expenditure approach have at
least been shown where to look for answers. Indeed the questions themselves
have frequently only been perceived within the framework here presented. And
in many cases we are able to give clear and useful answers.
In evaluating the role of money, we apply the same test as we would with
any other variable. If the quantity of money influences the levels o f employ
ment, output and prices this influence must be demonstrable in its effects upon
the aggregate supply and aggregate demand functions. When the role of money
is analyzed in this fashion we find that its likely effect on supply in real
terms is virtually nil. Its effects upon demand can be significant, but these effects
are likely to be much more limited than has been suggested by application o f
older, crude “ quantity theories of money” , a matter which I shall discuss in
more technical terms in “A Note on Money and Prices,” which follows this paper.
In this note, I might add, I explore the likely eventuality or likely
results of a situation where the Government and the Federal Re
serve keep the quantity of money rigidly constant, but go ahead and
increase Government expenditures.
Starting from a situation of full employment, it is inevitable that
prices will rise. And this I do not take as any revolutionary dis
covery, but simply as something of an answer to those who would
argue that the all-important determinant of prices is the quantity
of money. One can hold the quantity of money constant, increase
Government expenditures, and clearly increase prices.
The C h a ir m a n . Thank you very much, Mr. Eisner, for your very
suggestive paper.
I f you will turn back to your hypothetical table which shows a
disparity between the sum total of price tags on goods and the sum
total of purchasing power in the pockets of the people, with the ex
ception of one condition, what would you say to what I suppose would
be the reply of the modern classicist, namely, that every item which;
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
781
goes into the cost of pricing a commodity is also income for some
body, and that therefore you cannot have a disparity between the
two ? Do I make myself clear ?
Mr. E is n e r . Yes, surely, Mr. Chairman. The answer to that is
that it certainly is true that the items that go into the price of the
commodity are income. But that does not mean that the people that
receive the income will necessarily want to spend it in the period under
consideration.
The essential fact of our economy is that whan we produce goods
we want income. But that does not mean, as the earlier classicists
suggested, that therefore we immediately want to buy. And we need
only go around the room and ask ourselves how many of us make
it a practice of spending all of our income to buy goods. Almost all
of us, until we get to the point of retirement—I hear some laughs, and
I should quickly concede that many of us are constrained to spend
all of our income, because we do not find it enough; but as a rule,
most of us try to reserve some of our income. The Government
forces us to do so in large part, by contribution to social security
funds, and employees have pension funds, in whihc part of the value
is not even given to us but goes into an insurance fund. We add to
savings accounts. In all of these cases we are not spending all of
our income.
The C h a ir m a n . What happens to the income which is not spent ?
Mr. E is n e r . What happens to the income that is not spent by con
sumers is that either it is spent by others or it represents goods which
pile up in stores, in business inventories, which are not sold. That is,
in the given period, of course, the income must equal the output.
But if people do not want to buy the output, businessmen quickly
learn the lesson.
And, being stuck with it, they therefore reduce their orders in the
subsequent period, which means that output goes down. And it
goes down until it gets to such a point that everyone is willing to
buy it willingly.
Of course, the output does go somewhere. That is to be recognized.
But if it goes to businessmen in the form of undesired inventories,
that is not going to be a desirable situation that we would expect to
continue.
Representative P a t m a n . I have enjoyed your statement very much,
Mr. Eisner.
Do you not think that the demand for money and credit is being
restricted now because local people less frequently operate local busi
nesses, like the grocery store, drugstore, picture show, and things like
that. In other words, do you not think that, as absentee ownership
enters into the picture in the local community, that necessarily re
stricts the demand for money and credit?
Mr. E is n e r . This may be a partial answer to your question. It
is my impression that the effect of monetary policy is to restrict the
availability of money in a rather uneven fashion. That is, if the
Federal Reserve follows the policy of selling Government securities,
keeping rediscount rates high, or making reserve requirements high,
this tends to make it difficult to borrow from banks, raises the rate
of interest, and those people that have to rely upon borrowing from
banks are very seriously handicapped, and I would think this would
782
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
be in larger part smaller businessmen, people who are interested in
borrowing for purposes of purchasing houses. And the general effect
is not an even one through the economy. In large part, with the de
velopment of the corporate sector of the economy, my impression is
that the kind of monetary controls that we have have relatively little
impact upon business expenditures.
Representative P a t m a n . D o you consider that the trend that I have
just mentioned, in the direction of absentee ownership of local busi
nesses, is a bad trend in our country ? Do you think it should be re
versed, that something should be done about it, or should we let it go ?
Mr. E is n e r . I have no considered opinion on that, and I think it
would be better if I refrained from answering it.
Representative P a t m a n . Y o u mentioned the rate of interest a while
ago as though you considered it something that the competitive free
market determined. You do not consider that we have a competitive
free market in this country in interest rates, do you, Professor ?
Mr. E is n e r . N o , it is certainly imperfectly competitive. But the
question that I think properly arises in issues of this kind is whether
the imperfections are sufficient to alter the conclusions of a particular
analysis. In the context in which I was speaking, I do not know that
this is critical. It may well suggest an amplification of what I indi
cated a moment ago, that because of the imperfections, the effect of
tight money can well be quite discriminatory. And thus tight money
does no m(ean that all find equal difficulty in getting money. Those
that are in the habit of going to capital markets and a booming stock
market may find it the easiest thing in the world to raise funds by
floating a new issue, while the small businessman, who wants to go to
the bank, just finds he is quite up against it.
Representative P a t m a n . In a recent period of tight money, there
was considerable talk about restricting consumer financing and things
like that. But there was no talk about restricting the money market in
a way that the big fellow would be unable to get money. I think that is
bad for our country. I f we are going to have restrictions, let it apply
slear across the board. In these efforts to have tight money to restrict
credit something should be done to make sure that every person and
corporation who is deserving, would have a fair opportunity of get
ting a part if they deserve it.
Mr. E is n e r . I might just add that in interviewing businessmen
quite intensively, a number of years ago, I gained the distinct impres
sion that the cost of money, the cost of capital, was a relatively minor
consideration. I f you would interview a financial vice president, he
would certainly tell you, “ Oh, the cost of capital is very important.5’
But on more than one occasion, when I was able to get the president
and chairman of the board in with the financial vice president, he
would say, “ Oh, sure. We want to get money as cheaply as possible.
But if there is any worthwhile investment project, we will find the
money one way or the other.”
And I think this can be made clear in theoretical terms by rec
ognizing that money is, after all, just one of a number of things that
people can use. It has substitutes. And what I become rather fond
of suggesting is that we ask ourselves what would happen to the
economy if the monetary authority began reducing the quantity of
nickels; suppose the monetary authority said, “We are going to
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
783
make nickels really tight, so that you can’t get nickels,” and they
would keep selling bonds for nickels and keep withdrawing nickels
from circulation. What would that do to the economy, to the rate
of interest? I would suggest it would do very little, because no
body would pay a premium for nickels when he could get pennies
and dimes. This seems rather obvious and perhaps ludicrous.
I f money is made tighter, businessmen can make the existing money
go around more rapidly. They can begin to use more and more fully
charge accounts. Individuals can use charge accounts; business can
use credit. There is really no reason ultimately why business need be
hamstrung by a lack of money. Money is a debt of banks.
We might ask ourselves : What would happen to the economy if
the Government said, “ We are sick and tired of this money. We are
tired of furnishing a medium of exchange for the public. Let them
furnish their own.” We withdraw all money from circulation; as
in 1945 the old German marks became illegal. Would the economy
really have to bum down? Or could not General Motors say, “Well,
we have no money to pay United States Steel for the steel we need
for our cars. Here is a note on our cars. And for so many tons of
steel, here is a note for so many cars. You can use this note to pay
your suppliers and your workers, and this note can then be used to
buy General Motors cars.”
And ultimately, you see, even at that extreme, you would find new
debt instruments, new forms of money, replacing the old.
Because there are all of these substitutes, the monetary author
ity’s control over the state of the economy, I would insist, is very
imperfect and very loose. And I frankly am one of those who while
well aware of the increasing attention being given to monetary policy,
considers that increasing attention quite unwarranted. I think the
lessons of the 1930’s remain uncontradicted, that the quantity of
money does not, certainly in the short run, have any very intimate
relation with the level of economic activity. And there are good theo
retical reasons which can justify and explain this empirical observa
tion tht we have.
The C h a i r m a n . Mr. Curtis ?
Representative C u r t i s . Thank y o u , Mr. Chairman.
I would like to comment that this note on money and prices is a
rather technical and complicated thing and very interesting.
Now you say:
To some extent the choice of stable prices over high employment and output is
one that should be made or rejected by the people, regardless of the views of
economists.
Dr. Eisner, I have been of the impression that this is not a choice;
that we actually need stable prices if we are going to attain high em
ployment. Do you regard those as conflicting values ?
Mr. E i s n e r . Yes. I think in considerable part they may be con
flicting values. And I welcome the question, because I recall a ques
tion of the chairman which I can at this point answer along with
yours.
At this point I think economists should be modest and recognize
that we cannot indicate exactly that level of employment at which
demand tends to be so great that prices tend to go up. We cannot
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EM PLOYM ENT, GROWTH, AND PRICE LEVELS
pinpoint that. Nor can we pinpoint precisely what the effects of any
of our actions are. We do know that clearly when the money demand
becomes greater than the supply, that can be produced at full employ
ment, prices must go up. When the money demand gets less than the
output that can be produced at full employment, output goes down.
Now, suppose we are faced with the kind of problem that is simply
this: We have, let us say, 4 million unemployed, or 3 million unem
ployed now. We say to ourselves, “ I f we were to increase the quantity
of money or cut taxes, and everything else remained the same, if we
were to cut taxes by X amount, we could eliminate this unemploy
ment in 6 months, if everything else remained the same.” And then
you would say, “ Fine. Let’s do it.”
But then the economist has to say—he is not sure that everything
will remain the same. Maybe in this 6 months business will begin
to boom all the more, and we will find that this cut in taxes or in
crease in the quantity of money, sufficient to raise employment by 3
million to full employment, would in fact, with the other increase
that might occur, give us too much demand and send prices up.
Now, no economist can guarantee to you that that may not happen.
The safe thing to do if you want to be sure that prices do not go up
is not to give any impetus to demand. On the other hand, you cannot
be sure that perhaps demand aside from Government action will not
go down.
We never can predict exactly where we will be 6 months from now,
and we have to make a decision of political policy as to which way we
want to take our chances on erring. I f demand is too high, we will
tend to have price inflation. I f demand is too low, we will have
unemployment.
Eepresentative C u r t is . But you hinge everything on consumer
demand. And yet on the next page you do pay attention to invest
ment demand, and you recognize that high employment comes from
economic growth. Economic growth, in turn, depends very materially
upon investment demand, and also the supply of investment funds.
Now, do you not believe that stability of prices has a great effect upon
this investment side of the problem ?
Mr. E is n e r . Well, on this point, if anything, sir, I think I would
go in the other direction, though I do not want to emphasize this too
strongly. My impression is that rising prices tend, if anything, to
stimulate investment demand.
Eepresentative C u r t is . But how about the supply of investment
capital to take care of that ?
Mr. E is n e r . I think this also stimulates the supply of investment
capital.
I might add, just by way of example: this was perhaps not a good
time to do it—I do not know—but I found myself with a few thou
sand dollars, and I put it into the stock market just a week or two
ago. And my notion is that if prices are tending to go up, I do not
think they are going to be going up drastically, but if they continue to
go up, I am much better putting my money in a share of a corporation
which will benefit from the increase in prices, than holding my money
under the mattress, so to speak.
Eepresentative C u r t is . Yes, but the problem there is that you get
into a very basic situation—and I might say the reason I believe that
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
785
the stock market is acting the way it is is a traditional type of infla
tion, where there is too much demand going after too small an amount
of commodity, which is the stock, because of the deemphasis on equity
financing and the encouragement of debt investment.
Now, you get to this situation, where I think to a large degree the
recent recession, in my judgment at any rate, came from a lack of
capital in the areas where we were going to experience the economic
growth. In other words, the companies cut back on their capital
expansion.
Now, the effect of previous inflation upon the investment plan—
you pay attention in your paper to the replacement problem of equip
ment, and yet our tax laws are such that replacement is based on
original cost, not replacement cost; and when we devalued the dollar
from $1 to 50 cents, we in effect had a capital levy on all plant in
vestment of about 50 percent.
In other words, in order to just replace, in order to take care of
obsolescence and these other things but just to replace, we had to have
twice the amount of investment capital that was originally put in
there.
Now, where is that capital going to come from ? In your paper,
you talk about taking care of the victims of inflation. But nowhere
do you mention what effect it has on creditors and what effect it has
on savings, not only from the standpoint of the psychological effect on
savers, but also the actual effect on the amount that is being saved,
which has been cut by the very increase in prices.
It seems to me those are all economic factors that make stable prices
important if we are going to get economic growth. Would you care
to comment on those observations?
Mr. E i s n e r . Yes. Thank y o u .
On the question of the replacement cost of capital as a result of
price inflation, I think that this argument is only partially valid, in
that if we look at the aggregate amount of depreciation charges we find
that these depreciation charges, being based in large part on assets
originally acquired at higher prices by an expanded economy, turn
out in fact, in the aggregate, to be at least equal to the replacement
cost of the assets that have to be replaced.
Representative C u r t i s . Where did you get the premise that they
were acquired at high cost? The general turnover on plant and
machinery in this country, for example—the acquisitions were around
1940.
Mr. E i s n e r . Yes. Well, I actually, it so happens, have done a good
bit of work on depreciation, and have a number of articles I would
be happy to suggest on the subject. But the essential relation is
simply this: Capital tends to last a long time. In 1959, on the aver
age, businesses are replacing plant and equipment that was acquired
perhaps in the 1930’s. They did not require much plant and equip
ment m the 1930’s. In the first place, the economy was smaller, to
begin with, and in the second place, of course, the 1930’s were a time
when we were not acquiring a lot. So that even if you doubled or
tripled the prices which would have to be paid to replace that equip
ment, there is not very much.
On the other hand, depreciation charges, which the firms write up,
that the accountants write, are based only in very small part upon the
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EM PLOYM ENT, GROWTH, AND PRICE LEVELS
assets acquired in the 1930’s. Even on a straight-line basis, they are
a fixed proportion—if assets were to last 25 years, for example, it
would be one twenty-fifth of the dollar value at original cost of all
of the assets acquired from 1934 to 1958. And in a growing economy,
and certainly in an economy where prices are rising, it can be shown
in algebra, and it can also be observed by simply looking at the de
preciation accounts, that the amount actually charged as a whole is
more than the replacement requirements, or at least equal thereto.
And I know that looks strange to many people, because what they
tend to think of is simply one individual item of equipment. They
say, “ Well, look at this $100 piece of machinery that I acquired in
1933. I have to pay $300 to replace that.”
But in fact, one cannot look properly at one item of equipment.
One has to look at the total depreciation charges of the firm.
In my interview studies some years ago, since I was interested in
depreciation, I questioned a good number of comptrollers and top
company executives about this, and while initially they gave me ex
actly the argument you have—“ You know, this is terrible. Replace
ment costs are very high”—then I questioned them closely whether,
with their depreciation allowances, reckoning the increased service
ability and advance in new methods, new equipment, depreciation
charges would not be sufficient to at least maintain existing capacity.
And I certainly got no clear answer that it would not. I think when
I got through to them it became clear in many cases and some of them
would volunteer the information, that actually their depreciation
charges were sufficient to replace expiring capacity.
Representative C u r t is . I can see we are in rather fundamental
disagreement on this subject. I have been interested in it, too, as a
member of the Ways and Means Committee, trying to figure out
depreciation charges. But I will certainly be very happy to read
some of your papers on this and see if I can determine where we
might be in error or where we might actually be in agreement.
But the point essentially I was trying to get across—and that was
only one of the illustrations that I used in that rather lengthy state
ment I made—was my concern that you felt that it was a question
of choice between stable prices and high employment; that the two
were not two goals that we have to seek, and each was dependent
upon the other.
Senator B u s h . Dr. Eisner, I have been very interested, too, in your
statement this morning, one of the most interesting ones we have had.
^We have serious problems that confront us down here from time to
time, and last year and the year before, 1957, we experienced a rather
sharp recession in business, which you know all about, as to the fig
ures on it, anyway. And it was a matter of great concern politically
as to what should be done about that situation, if anything, by the
Government.
I am trying to relate your philosophy here, as you have expressed
it, to practical considerations, and I am not asking this question to
embarrass you, but in an earnest effort to try to appraise your think
ing as an economist, as against a practical situation which we faced.
And therefore I would like to ask you two questions.
In that period from the autumn of 1957, the late autumn, through,
let us say, April or May of 1958, a year ago, did you favor the U.S.
Government making a cut in taxes ?
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
787
Mr. E i s n e r . Yes, I did.
Senator B u s h . Did you favor a step-up in Government spending at
that time ? Did you support mentally or otherwise the recommenda
tions that were made on many hands to step up the possibility of
Government spending very substantially ?
Mr. E i s n e r . Yes, I did support that mentally. I think I was on
record only for a cut in taxes.
The C h a i r m a n . May I say I want to congratulate the witness in
having the good sense to favor tax reduction at that time.
Senator B u s h . I will say he had a lot of excellent company. I am
not sure I want to congratulate him on the decision, but I must say
he was in awfully good company.
The C h a i r m a n . Thank y o u .
Senator B u s h . N o w , have you any recommendations respecting
the Federal Reserve Act and the powers of the Federal Reserve
Board? Do you think that the Congress should change the powers
that they have, or restrict them or enlarge them ?
Mr. E i s n e r . N o . I have no considered recommendation on that.
Senator B u s h . Y o u are familiar with the statement that is fre
quently made that their policy, insofar as monetary policy is con
cerned, is to lean against the wind? When the demand is very
high, they are supposed to use somewhat restrictive measures, and
vice versa. Do you think that is a sound policy, or not?
Mr. E i s n e r . I have reservations with regard to that policy, which
are implicit really in the paper I presented, or reasonably explicit in
the paper I presented this morning.
I think in the interests of longrun growth the policy of the Federal
Reserve should be directed to keeping money as plentiful as possible,
keeping the rate of interest as low as possible. I think that every
time it leans against the wind in a period of inflation, it, of course, in
that period raises the rate of interest and makes money tighter, and it
makes it more difficult to get the rate of interest down to a reasonable
minimum in periods when there are not inflationary pressures.
So I would rather have the Federal Reserve iollow generally a
policy of keeping money plentiful, getting the rate of interest as low
as possible, and if we do find a very clear and compelling need for
action to stop an increase in prices, I would much rather see this done
by fiscal power, that is, by raising taxes or cutting expenditures or
cutting payments to people.
Senator B u s h . D o you think that is very practical, though? You
know how hard it is to get a tax bill through the Congress. That is
a serious question. Theoretically, that might be right, but my chair
man will support me, I think, in stating that it is a very difficult
thing to raise taxes. You go back to 1956-57, if you want to take the
same period that I raised earlier, there. And I doubt very much that
the Congress would have entertained a recommendation for a tax
increase at that time, despite the fact that we were at the peak of a
boom, the biggest that we had ever seen in history up to that time,
with full employment. Many people referred to it as overemploy
ment, and so forth. Do you think it would have been practical, politi
cally, to suggest a tax cut at that time, a? a restrictive measure?
Mr. E i s n e r . Y o u mean a tax increase ?
Senator B u s h . A tax increase. I beg your pardon.
788
EM PLOYMENT,
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Mr. E is n e r . Well, I claim no expert knowledge of the political
process.
Senator B u s h . Well, you are a political economist, I think.
The C h a ir m a n . I would like to support what he says, namely, that
even at the height of a business boom it is almost impossible to in
crease taxes. In fact, the tendency then is for decreased taxes, on
the ground that receipts are plentiful and this is the time to aid
business.
Senator B u s h . And my conclusion from that, very respectfully,
is that your suggestion that you use fiscal practice is not really a very
good answer. It is not a practical answer to the problem o f : What
are you going to do about a boom ?
Mr. E is n e r . I might just point, though, to the qualification that I
indicated. I said that I would use fiscal policy to fight an inflation
where there was a clear and compelling need. My impression is that
there has not been any clear and compelling need for action against
inflation for at least the past 10 years. As a matter of fact, I am
quite mystified, except as a political scientist, at the great concern
and hullabaloo about price increases.
Since the first 6 months of the Korean war, certainly our price in
creases have been very modest, probably less on the average than they
have been through most of our history. And I certainly see nothing
in the past 8 ^ years, since the Korean war inflation—and that was
just in the initial period of the Korean war—that would justify action
against prices.
I think that generally the action that would be called for would be
tax cuts against recession, and while again I disclaim expertese as a
political scientist, my impression is that the Congress would have
much less trouble getting through tax cuts than tax increases.
Senator B u s h . Well, you have got a good point there, I think, about
the relative price stability over that period.
The purpose of Federal Reserve action in 1957,1 believe, was not
wholly anti-inflationary, but it was an attempt, I believe, to avoid the
possibilities of a big bust due to the overaccumulation of goods and
services, particularly goods, through a very large overextension of
credit.
In other words, the classic illustration that is used there is the auto
mobile industry. They got up to 7 million cars, which was way
above the average growth trend or any other figure, and what they
were doing there was borrowing against another year’s production.
It turned out that that is what happened, I think.
Now, Federal Reserve used some of its powers at that time to
temper this exaggerated buying spree, so to speak, by restricting credit
to some extent.
So it was not wholly anti-inflationary, you see. At least, that is
my observation.
Now, do you disapprove of the Federal Reserve using those powers
in that way at such times ?
Mr. E is n e r . I think that I do. I can go back at this point to the
general theory of John Maynard Keynes back in the 1930’s, when he
argued that there is much talk about the necessity of trying to stab
ilize things, reduce the booms, and raise the troughs, and it seems
to me, as he argued then, that this is rather pointless. We do not
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
789
want to cut off the booms. We like the booms. We want to fill in
the troughs. And I am not convinced that action to cut off the booms
does any particular good in eliminating the next recession. It may
just bring it on somewhat more rapidly. I think in real terms, wel
fare is measured by the amount that we produce. We should try to
keep that production as close as we can to a maximum at all times.
I think the cost of doing this is likely to be a more rapid increase
in prices than we would have otherwise, but I think that in spite of
all the concern expressed for this, the increase in prices does not hurt
the economy as a whole. It hurts, perhaps, some individuals, and I
think far fewer individuals than we generally admit, and to the ex
tent it does hurt these individuals it certainly is within the power of
the Congress to take measures to help them out.
It is, you know, generally argued, ‘‘Look how badly off we are. A
dollar now is equivalent in value to 46 cents 25 years ago,” or some
such figure. But people sort of want to have their cake and eat it,
too. They want to go on having the much larger number of dollars
that they have now, and would also like to have dollars of the same
value.
It is argued, for example, that people on pensions are much worse
off, because the pensions are not worth as much. But I might raise
the question as to what these pensions might likely be or have been if
over the past 25 years the Government had not followed an expan
sionary policy, if we had continued with the large amount of un
employment of the 1930’s. I would then suggest that these pensions
would be far less in dollar amount, and people would really be worse
off.
My notion is that this has been a very prosperous economy on the
whole in the past decade, and the price increases have not prevented
probably 95 percent of us from being much better off than we were
ourselves 25 years ago, or than our fathers or the people who were
comparable to us in the social scale were 25 years ago.
Senator B u s h . Well, I think that makes a pretty good case for
that broad statement. In regard to the last 10 years, I think they
have been on the whole very prosperous years. But on this boom
business, you say Mr. Keynes does not want to cut off booms, and you
do not either. I do not either, provided they will last. But the his
tory of these things is that they bust somewhere along the line. I
have lived through one of these, myself, much to my regret and ex
pense. And I wonder whether you think—I know you have studied
the history of this 1929-30 period there; I am sure you have—that the
Federal Eeserve at that time was unwise to attempt to restrict the
use of credit, which had already expanded to such an extent that, as
I remember, brokers’ loans were 9 billions of 1929 dollars, which is
more than twice as much as they are today, despite the devaluation
of the dollar. I mean: Was the Federal wrong in trying to restrain
that use of credit at that time, in 1929 ?
Mr. E is n e r . I would probably want to avoid a judgment on 1929,
but I do have the impression that the Federal Reserve was overly
restrictive in its policy in subsequent years, and that a freer and
easier monetary policy in the several years following 1929 might
have mitigated some of the disaster.
Senator B u s h . Y o u mean in the 1930’s ?
790
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
Mr. E is n e r . In the 1930’s. In the early 1930’s.
Senator B u s h . Well, I do not recall those figures. I believe it was
1932 or after that, that long term rates got down below 4 percent. Is
that what you have in mind?
Mr. E is n e r . I am not fresh on the details, but I believe it has been
charged, probably correctly, that the Federal Reserve was all too tight
in several occasions on money. I believe as early as 1930 and 1931.
But it might be better to check the record and not use my recollection.
Senator B u s h . The year 1930 was a big year, in business and in
dustrially, too.
Mr. E is n e r . But it was the beginning of a downturn. One of the
difficulties is that these things tend to gain momentum. And unless
you are prompt in easing up as you swing into a downturn, it be
comes all the harder to do very much about it, so that 1930 probably
should have been a time when the Federal Reserve should have been
easing up very substantially, certainly in hindsight.
Senator B u s h . But you do not have any comment to make about
their behavior or activities in 1929 ?
Mr. E is n e r . No ; not of my personal knowledge, so I should avoid
it.
The C h a ir m a n . Mr. Eisner, I think you have presented a very
able paper. We have heard two papers on the quantity theory of
money in the preceding days, and your paper seems to be concerned
with a different world, almost, from those that were discussed.
I know you have not had the advantage of reading the precise
papers, though you may have seen their articles.
Would you give any place, and if so how much, to the quantity of
bank credit and the velocity of bank credit and their effect on prices?
Mr. E is n e r . The difficulty is that the way the chairman, has
phrased the question, I expect intentionally, the answer has to be yes,,
that the velocity and the quantity certainly affect the level of prices
and output, because as we usually define velocity, the velocity times
the quantity is exactly the amount that is spent. So all that we are
saying is that the amount spent affects prices and output.
I think the fatal defect in the quantity approach is that it is
usually presumed that there is something reasonably stable about
velocity, so that as we alter the quantity of money, which is certainly
what the monetary authority has the power to do, we will not have
compensating changes in the velocity. And my impression of the
empirical evidence—and I believe a good bit of that advanced by Mr.
Selden himself—is that velocity does vary all over the map; that
when you get into a depression velocity goes way down. And I think
there is little evidence that an increase in the quantity of money or
credit or potential credit would do anything other than involve a cor
responding drop in velocity.
I might point out that velocity is simply defined, usually, as some
thing like the total expenditures divided by the quantity of money.
And if one therefore increases the quantity of money, unless we can
say that that will increase the quantity of expenditures, then increas
ing the quantity of money by raising the denominator of the fraction,
must decrease the velocity.
It is interesting to me to note that Professor Friedman, certainly a
very able economist indeed, in now modifying and modernizing the *
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
791
quantity theory of money, is in effect taking into account in part the
kind of factors that we traditionally discuss in the income-expenditure approach. And the question then becomes one of whether chang
ing the money quantity by influencing the costs of money will in
fluence expenditures and in that way prevent a corresponding drop
in velocity. For my part, I continue to find it much more convenient
to look at things in the way I have indicated here, so that we can then
see very clearly that there is no necessary reason why changing the
quantity of money will change expenditures. It may simply lead to
a change in the other direction in velocity.
The C h a ir m a n . I s this what lies behind the statement you made
in your paper, that there can be a disparity between the total income
distributed and the total demand for products expressed in money
terms ? That the velocity may change ?
Mr. E is n e r . Yes; I believe that could be translatable in this fashion.
That is, one could argue, for example, that with a given quantity of
money, if employment were 65 million rather than 60 million, and
$430 billion of goods were produced, rather than $400 billion, the
velocity would be more than if $400 billion were produced.
The way we would usually indicate this is simply the identity, which
I can put on the board, MV equals PT, or sometimes MV equals PY,
with T for total transactions, or you can alternatively use Y as total
income. The difficulty with that is that it is unquestionably true as
a matter of definition. But if we were to change M, there is utterly
no reason, just looking at that, to presume the V will not go down.
The question whether V goes down correspondingly or not is precisely
the question of what changing the cost of money does to demand, to
expenditures. And unless one goes behind the scenes and examines
this, that kind of an equation strikes most of us as rather useless
tautology.
I should not say useless tautology. It is a tautology which may or
may not be useful, depending on how we marshal our knowledge
within it.
Senator J a v it s . I would like to say that you could say as well that
Y equals C plus I plus G is a useless tautology, as something that is
mechanically correct. The question is whether the behavior rela
tions subsumed under these terms are predictable to a greater or lesser
extent, and whether they are reliable, and to what extent they are
reliable.
In other words, this is not quantity theory, nor is Y equal to C
plus I Keynesian theory. The question, for instance, is: How pre
dictable is velocity of circulation under various circumstances ? Can
we really depend on the consumption function ?
I think all of us on all sides have a lot to learn yet. I do not think
economics has even begun to answer the substantive questions. But
you would grant, would you not, that logically one or the other
formulations of the problem might turn out to be the better? And
it might well be that for certain kinds of problems one approach
is preferable to the other? Would you agree with that statement?
Mr. E is n e r . Well, I would agree that one can formulate the prob
lem in either terms in logically consistent fashion. My concern is
that formulating the problem in the terms of the quantity theory,
even though made more sophisticated and subtle, tends to obscure some
of the particular problems into which we have run.
792
EM PLOYMENT, GROWTH, AND PRICE LEVELS
For one thing, it obscures the fact—it can be brought out, but it
has tended to obscure the fact—it seems to me that it tends to be some
what obscured in the presentations of the best of the modern quantity
theorists—it tends to obscure the fact that the direct cost of holding
money is nil, except for price changes, and that if we are trying to
analyze what happens in an economy where prices do not change, we
can never get the cost of holding money, or the opportunity cost of
holding money, below a certain point. And not being able to get
it below that certain point, we find that the chances of increasing
expenditures by this means are quite limited.
Now, this can be spelled out in the quantity theory. You can say
that the demand for money depends upon income, the rate of interest,
the rate of change of prices, the amount of wealth we have, and none
of us, no economist, should have any objection in getting over some
of the work done by the people that contributed to the Friedman
edited volume on the quantity theory. I know there was some ten
dency to argue, there, that the amount of money that people wanted
to hold did not seem to be very clearly related to the cost of holding
money.
Now, that, it seems to me, is not reasonable. I think I could indi
cate places where the empirical data have been misinterpreted. But
I have the feeling that that is just the kind of pitfall, perhaps, that
the quantity theory encourages. I f one were willing to openly recog
nize the effect of the cost of money upon the amouint that people
would want to hold, one would ultimately get the same results as
one does with the income-expenditure approach.
But perhaps it is a matter of historical tradition. There seems to
be a reluctance to make that move, even when it is explicitly recog
nized in the theoretical function or relations, as Professor Friedman
has explicitly related.
I recall quite distinctly a passage, I think in one of his essays, in
which he argues that, in fact, the evidence does not seem clear that the
quantity of money has fluctuated substantially with the cost of money,
of holding money.
One of the difficulties there, I think, is that they measure the cost of
holding money in terms of the rate of interest and past changes in
prices; when, after all, one is concerned with the expected future
change in prices. This is perhaps a narrow technical point, and I will
concede that if the two theoretical formulations are handled carefully
and adequately, and the empirical data are properly fed into them,
there is no reason why one should get different results with one frame
work than with another.
The C h a ir m a n . Thank you very much, Dr. Eisner. We are greatly
indebted to you.
Mr. E is n e r . Thank you, sir.
The C h a ir m a n . Your full statement will appear in the record.
(The statement referred to is as follows:)
T he
I n c o m e -E x p e n d it u r e
A pproach
to
the
A n a l y s is
of
M oney
R e l a t io n s
(By Robert Eisner)
In some economies production is undertaken according to plan or governmental
directive. In a profit oriented, market economy production is for sales. I f busi
nessmen or other producers expect to be able to sell what they produce at a
price which warrants production, they produce; otherwise they do not.
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
793
Thus in our economic system there are two relations which can be said to
determine jointly the rate and prices of output. One of these relations we call
the supply function. This in turn is based upon the production function and the
terms under which the owners of productive factors are willing to sell the serv
ices of these factors. The other we call the demand function, what businessmen
may expect to be spent on what they might produce. The income expenditure
approach suggests nothing more nor less than that, once we specify the techno
logical conditions of production and the terms under which people wish to work,
the amount that is actually produced, the number of people employed in produc
tion, and the prices at which goods are sold depend upon what people are willing
to spend.
This simple, intuitively plausible notion, that production and prices are deter
mined in the short run (when technological conditions are fixed) by demand,
by what people spend, is the framework of the economic analysis that has
oriented leading economists for the past quarter century. Within this framework
economists have by and large challenged older views and have developed policy
implications suggesting the advisability, if not the necessity, of an increased role
for government in an otherwise free economy. I shall attempt, in the pages
which follow, both to present this framework in some detail and to indicate
certain implications of its use.
1. The historical setting and the clash of ideas
Throughout history man has known varying degrees of economic misery. Until
the development of modern capitalism, however, this misery seemed related
directly to vicissitudes in the struggle with nature. When there were floods or
droughts, fire, or pestilence, production dropped, and frequently men starved. In
these periods men, with the meager tools at their command, were simply not
able to produce enough.
With modern capitalism came enormous material progress. Man became in
creasingly able to provide for himself first the necessities of life and then more
and more “ luxuries,” including the luxury of voluntary leisure in which he
could enjoy the growing fruits of his labor. But still there remained variations
in the levels of relative prosperity. Man continued to enjoy good times and bad
times, but with one essential difference. Bad times were no longer periods when
man was physically unable to produce. Rather they were times when produc
tive capacity was as great or greater than ever, but factories with all their new
technology were idle, workers were unemployed, and farmers could not sell their
bountiful harvests at prices which enabled them to pay their debts, let alone buy
the goods they needed for adequate living. How explain such poverty amidst
potential plenty ?
To most classical economic theorists such phenomena represented transient
“disequilibrium” or the results o f interference with the free workings of the
economic system or a combination of the two. Adam Smith’s “ invisible hand”
was expected to bring about an optimum allocation of resources and this implied
a full utilization of resources. What became known as “ Say’s law” stated that
there could be no general problems of overproduction or excess supply because
those that produced or supplied commodities did so only in order to obtain
other commodities in return. Since for every supply there was a corresponding
demand for some other good (or the same good), total quantities supplied must
equal total quantities demanded. There could, of course, be temporary over
supplies of some goods and corresponding excess demands for other goods at
existing prices. But then prices would adjust, in a free market, so that
(Tnairtities supplied and demanded of each commodity were made equal. This
might take some time but it was not usually considered that this time might
be very long unless monopolistic imperfections (or trade-union restrictions)
prevented the free adjustment of prices (or wages). I f such imperfections
were permitted to become important, or if governments were to act capriciously
to interfere with the free workings o f the system, difficulties might indeed
develop and persist. But for a freely competitive system full employment was
the normal or equilibrium order of things. Departures from this desired state
were to be ascribed to temporary phenomena incidental to not undesired change
or to interferences with that freely competitive system. Among the main body
of orthodox economic thinkers, as opposed to the “ heretics” and soapbox orators,
the problem of aggregate demand had no place.
With chronic unemployment in England after World War I and with the long,
deep, almost worldwide depression of the thirties, traditional economics fairly
38563 O— 59—pt. 4----- 13
794
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS
cried for revision. This revision, while ultimately the work of many minds,
was inspired and laid out in its essential form by the late John Maynard
Keynes in “ The General Theory of Employment, Interest, and Money.”
The essential classical proposition challenged by Keynes was the tenet that
full employment was necessarily the natural state of a competitive economy.
Unemployment, Keynes argued, might for long periods of time be endemic to the
system and there would then be nothing that any individuals, whether workers
or businessmen, could do by themselves to eliminate it. Further, Keynes de
clared, the mass unemployment of his time could in no reasonable sense be con
sidered “ voluntary,” as some economists argued on the alleged ground that
workers could not get work only because they demanded wages higher than em
ployers could afford to pay. While not denying that workers tended to resist
money-wage cuts in time of unemployment (although indeed such resistance was
only partially successful), Keynes insisted that a fall in money wages was
entirely unlikely to increase employment. The error in the classical reasoning
might indeed be explained as an illustration of the logical fallacy of composi
tion : the invalid inference that something true of the individual or the part is
necessarily true of the aggregate or the whole. It might well be true that an
individual employer would find himself able to hire more workers if he could
pay lower wages. For then he might be able to charge lower prices for his
product and sell more. However, if all wages were to be lower, throughout the
economy, all prices would be lower and each individual businessman would
lose the competitive advantage he expects to have when he thinks of cutting
his prices with everything else, the income of his buyers as well as the prices
of other sellers, remaining the same.
To analyze the effects of a wage change, or any other aspect of the problems
of employment and income, a new set of analytical tools was necessary, a set
appropriate for explaining the economy as a whole. This set of tools, fashioned
in large part by Keynes but expanded and sharpened by a whole generation of
economists since, I shall now attempt to present in fairly elementary form. I
shall supplement this presentation with a somewhat more technical note bear
ing particularly on the role of money, and with two previously published pro
fessional papers relating these tools to economic growth.
2. Aggregate supply and aggregate demand
The core of modern aggregative economics, the economics of the economy as
a whole, is that production is determined not merely by what we are able and
willing to produce but also by the demand for production, or what we are willing
to buy. Indeed what we are willing and able to produce is at any time merely
an upper limit to what we can produce. What we do produce may be less, and
frequently if not generally is less, than what we can produce. How much of
what we do produce is less than what we can produce depends upon how much
effective demand, what people pay, measured in real terms, is less than what
with the existing stock of capital and existing techniques and the labor of all
those wanting to work, we can produce.
In technical language we may say that production is a function of the capital
stock (and perhaps the intensity with which it is used) and the quantity of
labor employed. But the actual level of employment, and hence the actual level
of output, will depend upon the aggregate supply function and the aggregate de
mand function. The aggregate supply function relates each possible level of
employment to the expectation of proceeds or sales which producers would have
to have, in the light of the production function or costs, to justify it. The
aggregate demand function relates each possible level of employment to the de
mand that producers would actually expect (on the basis of the income that
they would find such employment would generate). The “ equilibrium” level
of employment is then the level of employment for which aggregate demand
equals aggregate supply. • The demand corresponding to this amount of employ
ment is known as the effective demand. The resulting output, which is what is
produced with this level of employment, not necessarily full employment, is
then equal in value to the effective demand.
A major task of classical economists was to analyze the determinants of
what we can produce, the conditions of supply. But once we reject the old
idea that supply creates its own demand, we see it much more immediately
relevant to explain what determines demand, which more often than not
will be sufficient to tell us what we actually produce. And since what we ac
tually produce now, in the way of plant and equipment and new skills and
techniques (the “ production” of schools and research laboratories), determines
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
795
what we can produce tomorrow, the conditions of demand are responsible for the
supply functions of the future. What then is the nature of the aggregate
demand function?
Aggregate demand may most usefully be broken into the following com
ponents: (a) consumption, (b) investment, (c) foreign, (d) government.
Let us examine each of these in turn.
(a) In a free economy consumption demand in any period of time may be
taken as the actual consumer expenditures for goods and services in that period,
what is frequently called consumption. The single factor most responsible for
determining the amount of our consumption is our income. In the short run
we may borrow or draw on past savings but sooner or later we are caught up
by limitation of our income and our need to provide for a period of retirement
in which we do not expect income. Because of this consideration of provision
for old age, plus perhaps a desire to grow richer and leave an estate, it is gener
ally argued that as income rises, consumption rises but not by as much. Thus,
the more we earn the more we consume, but also the more we save, that is, the
more we abstain from current consumption in order to provide for future con
sumption or merely in order to get richer.
This last hypothesis, that what economists call the marginal propensity to
consume, or the ratio of changes in consumption to changes in income, has a
value less than one, turns out to be of critical significance. For it means that as
output and, consequently, income grow, we cannot expect consumers to purchase
all of the increased goods and services available. But if they do not purchase
the additional products that stem from growth, others must be willing to pur
chase them. If not, in a free economy producers will not produce additional
products—recall that production is for sales, or demand—and output cannot
grow. We find, in fact, that except at very low outputs, consumption is con
siderably less than total supply. Therefore, unless the consumption function as
we know it is drastically changed (perhaps by governmental action), there
remains a gap between consumption and the output of a prosperous economy, a
gap which must be filled by one or several of the other components of demand.
(b) Investment demand is simply the demand for current output by producers.
This takes the form of demand for additional inventories or demand for addi
tional or new plant and equipment. It may be best to consider these separately.
One key to understanding investment demand must be the realization that a
firm in a stationary situation needs only to replace the plant and equipment
wearing out. It is not a source of net investment demand. All net investment
demand, and a major part of gross capital expenditures, must stem from change.
One fo rm o f ch a n ge w h ich is perhaps b a sic is grow th . If a firm is p rod u cin g any
given output to meet any given demand, it may have no need to add to its capital
equipment. However, if demand for its products and, consequently, its output
grows, it needs additional plant and equipment in order to produce, at least to
produce efficiently, the additional output.
A second kind of change which may induce investment is a change in relative
prices of capital and other factors of production. Particularly, if the cost of
capital as measured by the cost of obtaining or using funds to buy capital goods
(generally and loosely speaking, the rate of interest) declines, producers may
find it economical to substitute capital for other factors of production.
Third, there may be changes in the production function, that is, in our tech
nology, which may induce investment in order to permit utilization of more ad
vanced and more efficient capital goods. Such new capital goods may be used,
of course, both to replace old capital goods and to replace other factors of
production.
Fourth, there may be changes in product demand which will necessitate invest
ment because the capital goods utilized for products previously demanded may
not be usable, or fully usable, for the new products. Changes in product demand
may stem from changes in tastes or from changes in product prices, which might
come from changing techniques of production, changing relative prices of factors
of production, and changing patterns of international trade.
Finally, it should be realized that these factors and others are likely to inter
act, in manners which will be discussed in part below, in their ultimate deter
mination of the amount and pattern of investment demand.
Investment in inventories is frequently the balancing item between output
and demand. As demand falls output is not usually cut promptly and business
finds itself more or less involuntarily investing in inventories. This generates
a negative investment demand as firms attempt to disinvest in inventories in
796
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
subsequent periods. On the other hand, if demand rises, after an initial “ un
demanded” disinvestment in inventories as stocks are depleted before producers
increase output, a positive demand for investment in inventories is generated in
future periods. While investment and investment demand in inventories may
be on the average fairly small, the large movements between negative and
positive figures are an important element of cyclical instability.
If investment demand for inventories is to be on the average positive there
must be growth in output. For again, whatever the various purposes of in
ventories, whether raw materials, goods in process, or finished products, a given
output will in general require a given stock of inventories. One will not require
more inventories and hence not wish, in the long run, to invest in inventories,
unless production is growing.
Since business acquires goods not for individual satisfaction but for profit,
it makes sense to view the investment decision as relating the expected profit
on each dollar of investment to the return for alternate uses of the funds.
This rate of profit, technically that rate of discount which would equate the
sum of expected future returns from a contemplated investment to its supply
price, is affected by the relation between current and expected prices of products
as well as the current price of investment goods themselves. Thus, if one can
buy new plant and equipment now at current prices but reckon that the addi
tional product provided by this new plant and equipment in the future will
sell at much higher prices, the profitability of investment, as compared, for
example, with keeping cash, is enhanced. It is in this sense that rising prices
are considered to be a spur to demand.
(c) Foreign demand for a nation’s production must ultimately be conveyed
in the currency of that nation. Thus foreign demand for American goods must
be expressed in dollars. It then becomes clear that foreign demand for American
goods must depend upon (be a function of) the dollars foreigners have, the
rate at which they are “ earning dollars” (by selling goods to those who use
dollars as a source of payment, chiefly Americans), the rate at which they are
being given dollars (in private or public “ charity” ), or the terms at which
they can borrow dollars, and the attractiveness (in terms of both prices and
other qualities) of American goods. It also becomes clear that in the long run
foreigners’ demand for American goods must depend upon the dollars they
receive from our purchases, our loans, and our gifts.
(d) Government demand for goods and services in the American economy
includes the demand o f State, local and Federal governments. State and local
governments are perforce influenced considerably in their expenditures by
receipts from taxes, which in turn depend upon the income of the community.
In part, however, they are concerned with the cost of borrowing. For many of
their expenditures are capital in nature and the current cost which must be
met out of tax receipts is largely the interest cost of the financing.
The Federal Government is not, and should not consider itself, in the opin
ion of most economists, bound to limit its demand to the amount o f its receipts
from taxes. For the Federal Government, with its control over the monetary
system, can actually create money or can determine the costs to itself of borrow
ing. The final determinants of Federal demand, however, are in large part
political in that the political authority is ultimately free to determine the
amount of goods and services that the Federal Government will seek to purchase.
The essential notion of the income expenditure approach is that with a fixed
supply function in real terms, which in the short run is a reasonable assump
tion, one can affect the level of expenditures, and hence the level of prices
and/or employment and output, only by affecting one of these components of
demand. We may illustrate this with the following table:
T a b le 1.— Hypothetical aggregate supply and demand functions
Demand (billions)
Employment
(millions)
Aggregate
supply
(billions)
70_______________
65_______________
60___ ___________
55_______________
50_______________
$460
430
400
370
340
Consump
tion
$280
265
250
235
220
Investment
$60
60
60
60
60
Foreign
(net)
Govern
ment
$5
5
5
5
5
$85
85
85
85
85
Aggregate
$430
415
400
385
370
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
797
It is to be noted that in table 1 we have assumed that the levels or rates of
investment demand, foreign demand, and government demand are constant and
do not differ for different possible levels of employment and supply. This is
not entirely consistent with the discussion above but is a useful simplification
to facilitate understanding the basic relations. Consumption is however made
to depend upon employment and output. Thus, if employment were to be 50
million, output or supply would be $340 billion and consumers would buy $220
billion of this output. But if employment were 55 million, output would be
$30 billion more, or $370 billion, and consumption would be only $15 billion
more, or $235 billion. In effect we have assumed the consumption function,
Consumption = $50b + 0.5 (Output).
The consequences of the assumptions of this illustration are that only at an em
ployment of 60 million and a consequent output of $400 billion would aggregate
demand be equal to aggregate supply (in this case at $400 billion). I f employ
ment were 70 million, supply would be $460 billion and the total of consumption
(280), investment (60), foreign (5 ), and government demand (85) would be
only $430 billion. This aggregate demand of $430 billion would be $30 billion
less than aggregate supply. Thus businessmen would find that they had pro
duced output for which there was no demand. Since goods acquired by busi
ness constitute investment we would have actual investment in excess of invest
ment demand. There would be excess inventories or an excess stock of plant
and equipment or both. Consequently producers would reduce their output,
business would generally reduce its orders, until excess inventories could be
worked off or excess plant and equipment could wear out or become obsolete.
But by this reasoning, it can be shown similarly that if employment were 65
million there would again be an excess of aggregate supply over aggregate
demand, and in a free economy producers would react by cutting output and
employment. On the other hand, if employment were below 60 million, aggre
gate demand would be in excess of supply and producers would increase output
in order to make up for depleted inventories and/or to make available wanted
capital goods. Only at a level of employment of 60 million and an output of
$400 billion would there be no tendency for output to rise or fall. This level
of employment might, to be sure, be much below “full” employment. There
might be many millions unemployed. There might be much idle capacity in
the economy. But given these assumed demand relations, 60 million would be
the level of employment that would be sustained and $400 billion would be the
output that would be produced.
It should be noted that we have been careful to base our results on certain
specific assumptions. It is now time to examine these assumed relations to
ascertain the extent to which they might respond, themselves, to forces in the
economy and to what extent they may be made to respond to certain outside
influences of government. Among these outside influences will be manipula
tions of the supply of money and credit. However, throughout it should be re
called that this approach requires that any effect upon the level of employment
and the rate of output or, as we shall see later, upon the level of prices, must be
shown to operate through one or several of these components of demand, or
through a change in the supply function.
3. The role of money
Money has an implicit role in the system of relations described above but it
becomes easy to see that its relation is not as simple and obvious as some
economists have believed in the past. To understand its role we must analyze
its effect on each of the components of demand. Before turning to this analysis
we should define money and indicate a few of its essential characteristics.
For our purposes a number of definitions of “ money” might serve. W e shall
use the one which is probably most common, although consistent use o f most
of the others which are also employed would not affect our analysis. We shall
define money as currency in circulation and demand deposits of commercial
banks. We thus do not count as money time deposits or other assets which can
readily be converted to money. An essential characteristic o f this money, it
should be noted, is that except for price changes, it can be held without cost
or gain. A second characteristic to be noted is that money is a stock, not a
rate or flow per unit of time. Thus it is not of the same dimension as the
supply and demand quantities discussed above. We may have, say, $130 billion
of money in the economy and a national income or output of $400 billion per
year (or $33 billion per month or $8 billion per w eek).
798
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
Further, it should be noted that while money has no cost or gain attached
directly to its holding, aside from price changes, it does have what is called
an opportunity cost, which is the value of the opportunity the holder of money
for any given unit of time foregoes, as a result of not using his money during
this period. Thus a person that holds $100 from January 1 to February 1 may
be thought of as foregoing the interest he would have received on a bond or
loan, the yield (or capital appreciation) on an equity (or the profit on a
capital good he might have owned directly), or the extra satisfaction from con
sumption that he might have enjoyed in January instead of in February. He
will not hold the money unless the value to him of having the money in January
(minus the inconvenience or cost, if any, of making a transaction) is greater
than the value of the foregone alternatives. On the other hand, if additional
money is worth more to him (again after considering the cost or inconvenience
o f transactions) than the alternatives indicated, the individual will borrow (or
lend less), sell stock (or buy less stock) or reduce consumption in order to obtain
more money.
Let us now suppose a situation of unemployment and less than full output,
say employment of 60 million and output of $400 billion when 70 million people
want to work and could produce $460 billion of goods and services if they were
working, as indicated in table 1. Our stock of money may be $130 billion and
the price level may be stable at an index which we will call 100. What will be
the effect of an increase in the quantity of money to say $260 billion, or twice
its former amount?
To answer this question properly we must first determine the manner in which
the quantity of money is increased. If this is done by the monetary authority
alone, that is by Federal Reserve open market purchases or other actions that
bring about or make possible an increase in the quantity of demand deposits,
we can expect some reduction in the rate of interest and general easing of the
terms at which money can be borrowed. The result of this lowering of the cost
of money is that the community will be ready to hold some of the additional
money because its opportunity cost will be lower. But more important, those
contemplating investment, particularly the acquisition of capital goods, will find
at least some investment that was not relatively profitable at the previous, higher
cost of money is relatively profitable now. Investment demand will thus in
crease. Suppose investment demand increases by as much as $10 billion. Sup
pose further that State and local governments, considering the cost of borrowing
in deciding upon school construction and other public capital expenditures, now
see fit to increase their demand for goods and services. It would then be appro
priate to reconstruct table 1, as follow s:
Table 2.— Hypothetical aggregate supply and demand functions after reduction
in cost of capital stemming from increase in quantity of money
Demand (billions)
Employment
(millions)
Aggregate
supply
(billions)
70_______________
65______ ____ _
60_______________
55_______________
50_______________
$460
430
400
370
340
Consump
tion
$280
•265
250
235
220
Investment
$70
70
70
70
70
Foreign
(net)
$5
5
5
5
5
Govern
ment
$90
90
90
90
90
Aggregate
$445
430
415
400
385
Inspection of table 2 reveals that at the old level of employment of 60 million,
aggregate demand will now be more than supply or output. Thus producers
will increase output to meet the demand. When output is at $430 billion, re
quiring an employment of 65 million, aggregate demand will be found equal to
supply and we will be at “ equilibrium” .1 Thus the effect of our increase in the
quantity of money by 100 percent was to raise income and output by some $30
billion, a substantial increase, but one of less than 10 percent.
1 This equilibrium would involve the “money market” as well, for the increased income
would have also generated exactly enough increase in the demand for money so that, at
the lower rate of interest or opportunity cost, the community will now be content to hold
the increased supply of money.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
799
While the exact magnitudes of effect are arbitrary at this level of analysis,
the chain of relations can be sketched in detail. The Federal Reserve action
increasing the quantity of money, and consequently easing the terms at which
money can be obtained, lowers the rate of interest or the “cost of capital” .
This in turn stimulates investment demand, both public and private. (T o the
extent consumers borrow to “ invest” in durable goods consumption may also be
raised. Or it may be preferable to subsume this in “ investment” as is gener
ally done with residential housing construction.) As the increase in invest
ment and Government demand eventuates in increased capital expeditures, those
producing the increased amounts of capital goods are earning additional in
come. As they spend part of this additional income, consumption rises. Thus
the increase in the quantity of money and easing of credit may be said to have
induced an increase in capital expenditures (public and private) of $15 billion,
and by the operation of the “multiplier” this in turn brought about a further
increase in consumption demand, and hence of output, of $15 billion.
Had the quantity of money been increased in such a fashion that there were a
net gain in the assets of the private sector of the economy one might have ex
pected some further increases in demand. It should be realized that by open
market operations the Federal Reserve is giving the community more money
but taking from it bonds or other securities of equal value. Thus, aside from
some possible increase in the value of bonds and other securities outstanding,
the community is no better off, having merely exchanged assets in the form of
bonds or notes for assets in the form of money. However, suppose the money
supply is increased by means of a Federal budget deficit. In this case it is
simple for appropriate Treasury and Federal Reserve policy to bring about an
increase in the quantity of money held by the public with no corresponding de
crease in other assets. The typical consumer might then find himself in a
position where with increased wealth in the form of cash balances in his pos
session he feels less need for additional savings. He would thus save less out of
his current income. This would imply that aggregate consumption for any level
of total output or income (aggregate supply) would be higher. It is conceivable
that this increase in assets would bring about the situation depicted in table 3.
T a b l e 3 . — Hypothetical aggregate supply and demand functions after reduction
in cost of capital and increase in assets stemming from increase in quantity of
money
Employment
(millions)
Aggregate
supply
(billions)
70.______________
65..........................
60___ _____ ____ _
55______________
50____ __________
$460
430
400
370
340
Demand (billions)
Consump
tion
$295
280
265
250
235
Investment
$70
70
70
70
70
Foreign
(net)
$5
5
5
5
5
Govern
ment
$90
90
90
90
90
Aggregate
$460
445
430
415
400
Table 3 reveals that as a result of increased consumption demand stemming
from increased assets held by the private sector of the economy, the equilibrium
level of output is raised by another $30 billion, to a total of $460 billion. By the
coincidence of our assumptions this happens to be the output which would be
produced if all 70 million wishing to work were in fact employed. However,
there is no necessary reason why the asset effect of a doubling of the money
supply should prove just sufficient in its additional contribution to demand to
bring us to the point of full employment. What our analysis should make clear
is that conventional monetary policy, as practiced by the Federal Reserve and
the banking system, will not have as great an effect on demand as manipulations
of the money supply which make use of fiscal policy and involve a change in the
net worth of the private sector of the economy.
It may be well at this point to make clear what is lurking within the system
to bring about various possible effects of changing quantities of money. Econ
omists usually write that consumption, while relatively uninfluenced by the rate
of interest may be somewhat affected by the real value of private assets in the
form of money and Government bonds— assets in other words, which do not have
corresponding private liabilities. Investment is considered to be affected par
800
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
ticularly by the rate of interest, but to a limited extent. It is frequently argued
that investment demand is not very interest “elastic.” What this means is that
producers are much concerned with expected profits on investment. I f this is
high they will invest; if it is low they will not invest. But the variations in the
rate of interest or cost of capital are relatively small compared to the variations
in the rate of expected profit on investment. Thus, in a time of recession no
possible reduction in the cost of capital may induce any major increase in in
vestment, in the face of very low, probably negative, expected profits on invest
ment. On the other hand in times of prosperity it may prove very difficult to
raise the relevant cost of capital sufficiently to choke off much investment, as
expected profits on investment will generally appear very high.
But the rate of interest itself must be equal to the amount necessary to in
duce holders of money to hold no more than the amount of money actually in
existence. If the amount of money in existence is small relative to the price
level, holders of money will find it relatively valuable and will require a high
rate of interest to induce them to refrain from accumulating more money rather
than lending it out. As the quantity of money is increased, the community finds
that the marginal value of holding money is decreased and money can be had at
a lower rate of interest.
The critical question in all this is how much the rate of interest will be re
duced by increasing the quantity of money. In answering this question we must
realize that the relevant rate of interest is something that measures the cost of
capital to the firm and this would be related essentially to the yield on long-term
securities. But one cannot expect an unlimited fall in this rate or yield in
response to increases in the real quantity of money. For one thing, the rate of
interest clearly cannot fall below zero. Since there is no cost to holding money
there can be no point to lending money which we know will be returned only in
lesser amount after a period of time. But even further, it is reasoned, as the
rate of interest becomes lower than it has usually been in the past and hence
lower than many people expect it to be in the future there is an increasing
demand for money for what has been called speculative purposes. This in
volves simply the tendency of people to hold money rather than long-term bonds
if they expect that the rate of interest may rise. For if the rate of interest
rises, existing bonds, paying a fixed amount, will fall in value and their holders
will suffer substantial loss, one likely to be much greater in amount than the
interest forgone by holding cash until the rate of interest does raise.
These two factors, the relatively high elasticity of the demand for money
with respect to the interest rate, which limits the amount that the rate of
interest on long-term bonds can vary, and the relatively low elasticity of invest
ment demand with respect to the rate of interest, which narrowly limits the
amount that investment demand can be expected to change with respect to any
given change in the rate of interest, combine to reduce the role of monetary
policy in affecting the level of demand. Thus use of the income-expenditure
approach, together with our estimates of how the interest rate responds with
respect to changes in the quantity of money and how investment demand re
sponds to changes in the interest rate, lead economists to the notion that mone
tary policy can be useful in influencing the level of demand, but that it is not
likely to be sufficient if major effects are required.
The problem is indeed compounded when we consider these relations in time
of depression. At this point the lack of investment demand and the general low
in economic activity may be expected to make available large amounts of “idle”
cash. But to the extent the rate of interest has consequently fallen it is clear
from our analysis above that increases in the quanitity of money are likely to
add more to “ idle” cash than anything else. For the already relatively low rate
of interest (as well, probably, as the scarcity of high quality investment oppor
tunities) would make the recipients of the increased cash reluctant to give it
up. There wouid be little or no further fall in the rate of interest or cost of
capital and hence little or no increase in investment or output. Any increase
in the quantity of money under these circumstances would be absorbed in
a further decline in the “ velocity” of circulation of money, a depression phe
nomenon recognized by economists of all schools and persuasions.
While these difficulties of conventional monetary policy in times of depres
sion are fairly well recognized, two corresponding problems in time of infla
tionary booms are not as generally perceived. In time of inflation one would
expect a monetary authority to attempt to reduce demand by reducing the
quanitity of money. It would be successful to the extent that it raised the
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
801
rate of interest and this rise in the rate of interest reduced investment demand.
But to the extent it raises the rate of interest does it not strengthen the gen
eral view that low rates of interest cannot be considered normal? And have
we not observed above that it is precisely this view on the part of the public
that limits the possibility of lowering the rate of interest in order to increase
demand during a depression? Hence action of the monetary authority to raise
interest rates during a period it judges “ inflationary” reduces its ability to raise
demand by reducing interest rates in a depression.
But a second difficulty which is only recently receiving substantial atten
tion is that the monetary authority controls essentially the quantity of money
that we have defined, currency, and demand deposits. In a time of boom, it
may well be argued that reductions in the quantity of money so defined can have
only a limited effect in raising the rate of interest or the cost of capital. For
modern business corporations are in a good position to accelerate the “ velocity”
of money by borrowing from insurance companies or other nonbanking financial
institutions. Further, they may simply create their own credit. Rather than
pay an exorbitant rate of interest for money most o f us may be happy to use
I O U’s of General Motors or A.T. & T. to pay our debts. After all, money is
only an I O U, usually of a bank. Large American corporations are as reliable
debtors as most banks.
This existence of money substitutes which reduce the monetary authority’s
ability to alter the effective cost of money may perhaps be seen in extreme form
by considering what might happen to economic activity in a period of inflation
if the monetary authority were to reduce indefinitely the supply of nickels.
Surely none of us would be willing to pay any premium in order to possess
nickels (except perhaps as a collector’s item). For, simply enough, dimes and
pennies would be available as substitutes at such trivial extra inconvenience
that it would be most uneconomical to pay any higher rate for nickels than the
cost of obtaining dimes and pennies. Now essentially the same thing applies
with respect to money generally. Money is certainly a convenience to have
around but rather than pay any great amount for the privilege of having money,
as we have defined it, we should certainly keep our wealth in the form of sav
ings deposits, government bonds, and other monetary and nonmonetary assets.
With money expensive to hold for transactions purposes it would pay all of us
to resort more and more to charge accounts. Trade credit would grow and
eventually, if the monetary authority continued to make money unavailable,
we might expect United States Steel to pay its workers and suppliers with claims
on automobiles which it had received from General Motors in payment for steel.
Ultimately therefore, the rate of interest could not be raised beyond the price at
which we were willing to make resources available for investment, plus the
modest added cost to firms of having to utilize money substitutes instead of
money.
4. The role of prices
Thus far our analysis has been conducted almost exclusively in real terms.
We must now recognize that while real effects are our ultimate concern, in a
monetary economy such as ours demand is expressed in money terms and how
much any money demand is in goods and services depends upon prices. Thus,
for example, a doubling of the quantity of money by the monetary authority
may increase aggregate demand in money terms by $30 billion but the important
question remains: How much of that $30 billion will result in an increase in
output and how much will be spent merely in an increase in prices ?
This depends on what happens to costs as demand and possibly output change.
In regard to decreases in money demand when we start from a position of
stable prices there is considerable evidence that many costs, and particularly
wage costs, are inflexible in a downward direction. This has been taken by
some to be in fact the explanation for the development of unemployment in
the face of a decline in money demand. The argument o f most of those using
the income-expenditure aproach, however, is that a fall in wages and money
costs in the face of a fall in money demand would not prevent the development
of unemployment. For as wages fell generally, and hence costs fell, all prices
would fall. Consequently incomes would fall, including both wage and profit
income and there would then be a further fall in money demand. The only
conceivable gains from this general fall in wages and prices would be: (1)
those that might develop from the change in the distribution of real income
802
EM PLOYMENT, GROWTH, AND PRICE LEVELS
and wealth in favor of those with income and wealth more or less fixed in
money terms; (2) the increase in demand occasioned by any drop in the rate
of interest resulting from an increase in the real quantity of money (nominal
quantity of money deflated by the price level) if the nominal quantity of
money were kept from declining as fast as prices; and (3) the increase in the
real value of net assets of the private sector (Treasury currency and Gov
ernment bonds) resulting from the failure of these net assets to decline in
money terms as fast as the price level. It seems reasonable to argue that the
first of these gains is entirely uncertain and might well be negative, in that
the gainers from any change in the real distribution o f income and wealth
may in fact have a lesser propensity to spend (demand) than the loser. The
second gain may be limited for reasons discussed above but to the extent it
does occur it may just as well be accomplished by an increase in the nominal
quantity of money as by a decrease in wages and the price level. A similar
argument applies to the third possible gain and here, even more so than with
the interest rate effect just discussed, it is doubted that the magnitude of
gain could amount to much for any reasonably conceivable drops in the price
level.
While it is felt that these possible gains are doubtful or small at best it
would appear that the losses from any free fall in wages and prices in response
to a fall in money demand might well prove disastrous. In the first place,
a substantial fall in prices would give debtors and others with obligations
fixed in money terms a greatly increased burden. This might bring about
bankruptcies and general, consequent dislocations of production. And second,
falling prices are likely to generate expectations of a continuing fall in prices.
Then there would be a tendency to postpone purchases (and speed up sales),
which would further reduce demand.
Thus it is fairly generally agreed among economists that although in fact
wages and prices are not flexible in a downward direction, if they did fall
freely in a depression matters would be likely to be worse rather than better.
What, however, about their tendency to move in an upward direction, a mat
ter which has received a great deal of publicity in recent times?
Let us at this stage consider again the situation depicted in table 1, above.
We have an equilibrium level of output and demand of $400 billion, which en
tails employment of only 60 million and unemployment of 10 million. Sup
pose we now increase the money supply as suggested earlier. To the extent that
this succeeds in increasing aggregate demand in money terms, and it should
be recalled that this effect may well be seriously limited, will prices rise?
The answer would be, “ Probably yes, but not by much.” The point here is
simply that any increase in demand, whether brought on by an increase in
the money supply or by any other means, public or private may cause some in
crease in prices. This is one proposition that is true for the individual firm,
the industry, and the economy as a whole. An increase in demand tends to in
crease prices. The increase in prices, along with a decline in inventories is
indeed what “ signals” producers to increase output. But it is also true for
the individual firm, the industry and the economy that when there is much ex
cess capacity it is likely that output will expand considerably with a relatively
small increase in prices. Only when capacity is pretty well utilized will fur
ther increases in demand generate substantial increases in prices.
Thus there may be no level of unemployment or excess capacity such that
economists can say that any increase in demand at this point will have no effect
on prices. Similarly, there may be no level of prosperity such that economists
can say that at this point an increase in demand will influence only prices
and will bring about no increase in output. Rather, there is a more or less
continuous function relating demand, the level of employment, and prices. Start
ing from a low level of employment, increases in demand are associated with
substantial increases in employment and relatively small increases in prices.
As the level of demand rises, further increases in demand bring about larger
increases in prices and smaller increases in employment (and consequently
output). This may be presented graphically in figure 1, below.
EMPLOYMENT,
GROWTH,
AND
PRICE
LEVELS,
803
F ig u r e 1
804
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS
In figure 1, I have suggested this possibility that increases in effective de
mand beyond the point of full employment may continue to increase the level
of employment (and probably consequently the rate of output). I base this
on the notion that there are many—particularly women, members of minority
groups, and those in the retirement ages— who are not generally in the labor
force and would not be working under conditions of full employment but
who would be working if effective demand were such as to continue to bid up
money wages after the full employment point had been passed. However,
aside from this particular issue which I personally would consider of some
importance, it would be argued by most economists that once full employment
is reached further increases in money demand can bring about only an increase
in prices and no further increase in output.
It is important to remember throughout that it is not the increase in the quan
tity of money per se that brings about an increase in prices. If all recipients
of additional money were to put it under their mattresses or in some other
manner prevent it from influencing their spending or demand it would have
no effect upon prices. It is rather the increase in demand that brings about a
varying degree of price increase. But this price increase would occur with an
increase in demand however induced, with or without an increase in the
quantity of money. Thus, if taxes were cut or Government expenditures in
creased or business got optimistic and decided to spend more, or consumers went
on a buying spree, even if money did not increase in quantity, prices would
rise because of the increase in demand. In any of these instances, prices would
rise more the less the excess capacity and unemployment.
There are here an anomaly and problem for policy that go well beyond the
matter of money. It is that in order to increase employment and output we
must have an increase in demand, but increases in demand tend, increasingly,
as we near full employment, to increase prices. On the other hand, in order to
reduce prices, or perhaps even to halt a rise in prices, we have to restrict or
check demand. But a restriction of demand will not only hold down prices;
it will also hold down output and employment.
While there are various measures, such as the removal of tariff barriers and
other impediments to international trade and efficient specialization, the elim
ination of agricultural price supports, excise taxes and sales taxes and the
refusal or reduction of legislative support of monopolistic restrictions and
price fixing, which tend to reduce prices or prevent their rise, it cannot be
blinked that the essential cause of high or rising prices is high or rising de
mand. And no economist can honestly guarantee that measures to choke off
demand will not affect adversely both employment and output. To some extent
the choice of stable prices over high employment and output is one that should
be made or rejected by the people, regardless of the views of economists. But
the choice should be made by the people with the benefit of the best informa
tion that economists can make available as to the nature of their choice. One
point in particular looms very large and must be borne in mind. That is that
general price changes are essentially problems of distribution, in which some
people may be better off and some people may be worse off but the economy as a
whole is substantially unaffected. Thus if 70 million people are working,
their total output will be pretty much the same regardless of whether prices
have been stable or have been rising at a rate of 2 percent or 5 percent per
year. But if employment is only 60 million, output will be very much less,
no matter what the trend in prices. Thus economists are constrained to remind
the people, while still leaving the choice to them, that rather than cut employ
ment to 60 million with its general loss in output, it should be possible to set
up appropriate institutional arrangements so that those (perhaps fewer than we
realize) who are really suffering from inflation can be reimbursed out of the
extra output of the 10 million extra people working when demand is high enough
to bring about rising prices. The particular form of these arrangements—for
example, government bonds and social security payments geared to the price
index, private insurance and pensions based upon investment in equities which
could rise in value with the stock market—need not be specified in detail here.
But it certainly is possible to have all of the people better off with the output
of 70 million than the output of 60 million, regardless of the movement of
prices.
5. The role of growth
In much recent discussion, economic growth has been held up as the end of
economic activity. Paradoxically, whether desirable or not in itself, growth
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
805
is inextricably interwoven with the problems of employment, output and prices
with which we have been concerned.
Indeed, our analysis thus far has, in its abstraction from growth, been
essentially inconsistent. Without the existence of economic growth much of our
demand, particularly investment demand, turns out to be without foundation.
Yet once growth is admitted into the analysis it becomes improper to assert,
for example, that a rate of output of $460 billion is produced under conditions
of full employment. If this is so for one moment of time it cannot, under
conditions of growth, be true for the next. For in the next moment, 70 million
people will be able to produce at a faster rate than $460 billion per year and,
what is more, more than 70 million people will be wanting to work.
The paradox of our economy is that growth is not only desirable, by most
standards; it is necessary if we are to prevent serious unemployment. The rea
son for this can be seen fairly readily within the framework of the income ex
penditure approach. Examining the issue in the context of table 1, we note
that under conditions of full employment we would require an aggregate demand
at the rate of $460 billion per year. If consumption, foreign, and government
demand were as indicated in table 1, we should then require an investment de
mand of $90 billion. But the investment that would be demanded to replace
plant and equipment wearing out would hardly be more than $40 billion. This
“ replacement” it should be remembered, would embody all of the latest tech
nological advances and it would not be proper to attribute any major additional
investment demand to technological change. But where then might the addi
tional $40 or $50 billion of investment demand, some 10 percent of output,
come from ? The answer is that if the demand is to be forthcoming it must come
from producers who need additional plants and equipment and goods in process
in order to increase capacity to meet an expanding demand for their products.
A major part of the investment demand necessary to sustain a high level of
output must be based on actual or anticipated increases in output.
We may even get some crude notion of the amount of growth necessary to
sustain full employment. It is probably not a bad estimate, for purposes of
illustration, that it takes about $3 of capital goods, on the average, to produce
$1 of output in a year. This would mean that an additional output of some
$15^ billion would require additional capital goods to the amount of $46 billion.
Additional output of $15^ would constitute an increase of some 3V3 percent.
Generalizing, if net saving at full employment constituted 10 percent of out
put— and this is probably a conservative figure— we would require a 3 % percent
annual rate of growth of output to sustain full employment.
What if output grew less rapidly? The results can be presented in rigorous
mathematical fashion but they may be seen readily with just a bit more of
arithmetic. Suppose output grew at only 1% percent per year. Then we find
that that investment demand to provide the required additional capital amounts
to only 5 percent of output ($3 of additional capital for every dollar o f addi
tional output). But now if we continue to assume that about 10 percent o f out
put is necessary for replacement of wornout and obsolete capital goods we find
that, at an output of $400 billion, investment demand would total some $40 bil
lion for replacement and $20 billion for expansion or the total o f $60 billion
which would just be sufficient to give an aggregate demand o f $400 billion.
Thus the lesser rate o f growth would be sufficient to sustain only a lesser in
vestment demand and hence a lesser level of employment. The relationship
between growth and employment, one can begin to see, runs two ways. More
rapid growth causes a higher level of employment at any moment o f time. But
it is certainly true, and this kind of analysis should make this all the more
clear, that higher levels of employment imply a higher rate of growth. For the
higher the level of employment the higher the level of output. And the higher
the level of output the more, other things being equal, will be saved, that is, will
go into additional capital goods. These capital goods will expand capacity.
The faster the rate of addition of capital goods the faster the rate of growth
of capacity.
Fcr example, if with full employment and full utilization of capacity an
economy devotes 10 percent of its output to capital accumulation or investment
in human skills and if each dollar of such output is accompanied by an in
crease in productive capacity of 40 cents per year it is a matter of simple
arithmetic to demonstrate that, as long as that economy maintains full employ
ment and full utilization of capacity, it will grow at a 4 percent rate. But now
suppose that this same economy, operating at only 90 percent o f full employ
ment and 90 percent of capacity, concentrates on using its diminished output
806
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS
largely to attempt to maintain its standard of living. Then it might devote
only, say, 5 percent of its reduced output to capital accumulation and invest
ment in human skills. If each dollar of such output is still accompanied by an
increase in annual capacity of 40 cents, our arithmetic reveals that the economy
will now limp along at a rate of growth of 1.8 percent, less than half the 4 per
cent full employment rate.
I explore some of the possible relations between the level of employment and
the rate of growth in more general, somewhat mathematical terms in “ Under
employment Equilibrium Rates of Growth,” American Economic Review, March
1952, pages 43-58, which I should like to make available for the record. Much
remains to be done to estimate in reasonably precise fashion the relation be
tween the rate of growth and employment. But there can be no question that
the two are positively related. I have every reason to reiterate my conclusion
in that article: “ The attainment and maintenance of full-employment equi
librium in growing economies is * * * the problem of raising the rate of growth
of income and/or reducing the rate of growth of productive capacity at levels of
full employment” (p. 57). If for reasons of public policy we reject the latter
possibility (which might be realized by increasing consumption at the expense of
capital accumulation, research, and education), then full employment becomes
all the more dependent upon adequate growth.
A critical issue that has exercised economists is whether we can be sure that
the economy can grow at a rate sufficient to generate an investment demand
equal to all the saving that will be forthcoming at full employment. I f it can
not, we will find full employment beyond our reach, except perhaps for sporadic
booms, unless the Government takes some measures to reduce saving or change
the growth-employment relation. I have discussed this issue in fairly rigorous
mathematical terms in On Growth Models and the Neoclassical Resurgence,
Economic Journal, pp. 707-721, and should like to offer this too for the record.
I may, however, indicate here some of the implications of that discussion.
First, it is possible that for a particular consumption function and rate of
growth of the labor force there is no attainable growth in output in a free
economy that would, with a stable price level, generate sufficient investment
demand to absorb full employment saving. However, the very nature of the
underlying relations suggests a number of measures, both of fiscal and mone
tary policy, that could ease or eliminate this problem where it exists. The
Government might, by appropriately redistributing income, reduce saving. It
might rather operate, however, to maintain saving, while raising public or pri
vate investment demand.
Public investment can be undertaken, whether in human skills (education)
or roads or other public projects without regard to the profit motive. Private
investment demand can be increased by bringing about more capital intensive
methods of production. This might be achieved either through research-induced
changes in the production function or by changing the tax structure or lowering
the cost of capital (rate of interest). If, as a consequence, longer lived capital
is employed in production we may find, for example, that an increase in annual
output or capacity of $1 requires an increase in capital, or investment, of say
$3 instead of $2.50, as was implied in our examples above. This would mean
that an economy with net saving equal to 10 percent of output might require a
rate of growth of 3 ^ percent instead o f 4 percent to maintain full utilization
of capacity and full employment.
Conversely, if the monetary authority keeps money relatively tight and the
rate of interest is consequently higher and the cost of capital more, one would
expect production to be carried on in less capital intensive fashion. One would
then require a higher rate of growth to maintain full employment, but this also
implies that, other things being equal, a more rapid rate of growth could be
obtained with a given rate of saving and given techniques, if measures were
also taken to keep demand sufficiently high in the face of the high interest costs.
Economic growth has a number of other implications for the issues of money
and prices with which w£ have been concerned. It is apparent, for example,
that if output is to grow from year to year and we are to recognize the insti
tutional factors that prevent and probably make undesirable a fall in prices,
the quantity of money should grow at at least the same rate as output. For if
the quantity of money grows less rapidly, we may expect a rise in the rate of
interest and a downward pressure on. demand which will inhibit growth.
In the last analysis we find ourselves in an Alice-in-Wonderland world in
which we have to run to keep in the same place and in which to get anywhere
we have to run twice as fast. The reason for this is that aggregate demand
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
807
depends in significant part on its own rate of growth. I f the growth in aggre
gate demand slows or ceases, investment demand (which is largely induced
by the need for new capital to provide for growth) shows an absolute decline.
For investment demand to remain merely a constant percent of total output,
effective demand must be growing at an increasing obsolete rate— a constant
compound interest rate if the saving ratio and other relations remain un
changed.
The implications of this for Government policy are such that while rising
prices may or may not be an aid in maintaining demand—I rather believe that
they are an aid, for reasons suggested in part above—the measures necessary
to keep demand growing at a constant compound interest rate and to keep de
mand and output always at or close to the full employment level are such as
to make rising prices a likely byproduct. Growing demand, particularly where
it is pushed unrelentingly by Government monetary and fiscal policy, is likely
to raise prices. Recall that in our economy higher prices are precisely the
signal and lure which induce producers to increase output. What is more,
unemployment and excess capacity are the chief downward pressures upon
prices. If the economy is kept at or close to full employment (as I believe it
should be) we are denied these downward pressures and we may well find the
increasing rate of demand, however much desired and necessary, tending to pull
up prices as well as output.
6*. Conclusion
The income-expenditure approach requires that any presumed effects of eco
nomic variables and actions upon the levels of employment, output and prices
be shown to operate through aggregate supply and demand functions of the sort
here presented. This approach proves particularly useful in analyzing the
role of present or proposed governmental policies. Will a cut in personal income
taxes raise the consumption function? What kind of a tax cut will have the
greatest or most rapid impact? Will permitting faster depreciation for tax
purposes raise investment demand? What will the effect of tariff cuts be upon
consumption and upon foreign demand? Will a general wage increase in a
large industry influence any of the aggregate demand functions? For each
of these questions economists employing the income expenditure approach have
at least been shown where to look for answers. Indeed, the questions them
selves have frequently only been perceived within the framework here pre
sented. And in many cases we are able to give clear and useful answers.
In evaluating the role of money we apply the same test as we would with
any other variable. I f the quantity of money influences the levels of employ
ment, output and prices this influence must be demonstrable in its effects upon
the aggregate supply and aggregate demand functions. When the role of money
is analyzed in this fashion we find that its likely effect on supply in real terms
is virtually nil. Its effects upon demand can be significant, but these effects
are likely to be much more limited than has been suggested by application of
older, crude “quantity theories of money,” a matter which I shall discuss in
more technical terms in “A Note on Money and Prices,” which follows this paper.
A NOTE ON MONEY AND PRICES
Old ideas die hard, perhaps, as has been written provocatively, because “ in the
field of economic and political philosophy there are not many who are influenced
by new theories after they are 25 or 30 years of age.” 2 But what is more, old
ideas not quite dead are sometimes revived to lead inappropriately influential
lives.
I have the impression that the notion is gaining ground that, after all, a fairly
simple quantity theory of money does explain or predict adequately the level of
prices. Allegedly impressive statistical data are presented indicating that in
various periods in various countries time series indicate high correlations be
tween the nominal quantity of money and prices or money income. ( Sometimes
correlations are noted between money and real output or consumption, as well,
but this is outside the scope of the current note.) I have no desire to question
the accuracy of such statistical calculations. Indeed these results are certainly
what one would expect from a general theory of money, prices, income, and em
ployment. But somehow these results seem to be interpreted, explicitly or im
* J. M. Keynes, “ The General Theory of Employment, Interest and Money” (New York,
Harcourt, Brace & Co., 1 9 3 6 ), pp. 3 8 3 -3 8 4 .
808
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
plicitly, in accordance with the boldness and degree of sophistication of the
author, as “evidence” that the “ income-expenditure” approach and its associated
fiscal policies are useless, misguided and bad while the “ quantity theory of
money” is an appropriate guide to explanation and policy. I should like to clear
the air by presenting a simple if extreme problem which gets to the heart of the
real controversy. I shall also present a solution to this problem which should
be unquestionable to any unprepared to make extreme (unreasonable) assump
tions about the world.
Let us assume an economy whose operations can be described in the following
familiar set of functional relations and identities.
Consumption function
C = C (Y , i, M)
( 1)
Investment demand function
I d= I d (Y , i)
(2)
Liquidity preference function
Md= M d (Y, i)
(3)
Saving-investment demand equilibrium
ID= I
U)
Money market equilibrium
MD=M
( 5)
Output identity
Y ssC + I + G
(6 )
Money-price identity
Q
(7)
We assume further that G, the level of real government expenditures on goods
and services, and Q, the nominal quantity of money, are exogenously determined.
This leaves us eight unknowns with only seven equations. But our neoclassi
cal heritage comes to the rescue; we assume that employment is determined by
the supply and demand functions for labor which are respectively related to the
real wage and the marginal product of labor. Output, Y, is then determined by
the production function, the given stock of capital and (full employment) equi
librium utilization of labor. We further assume that our seven equations are
consistent. Thus it is now possible for the price level, P, to adjust so that we
get a real quantity of money,3 M, equal to a demand for real cash balances, MD,
consistent with a rate of interest, i, which will generate a rate of consumption,
C, and investment demand, I D, which with the equilibrium condition that invest
ment demand equals investment, I which is identically equal to saving), will give
us a total output, Y, equal to the full employment level of output.
We have thus ruled out as nonexistent or irrelevant the Keynesian liquidity
trap, asserting in effect that if there is such a floor to the rate of interest, the
full-employment rate of interest, at the moment of time described by our func
tional equations, is above this floor. The only parametric assumptions we make
3
In order that we may consistently use the same “ M” in relation to liquidity preference
(3 ) and the cash balance effect ( 1 ), we can assume that all money is Treasury currency
and that there are no Government bonds held by the private sector of the economy.
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
809
are those indicated by the following signs of partial derivatives, assumptions
with which I believe few will wish to quarrel:
Cy> 0
(1 .1 )
C i^O
(1 .2 )
Cm^
(1 .3 )
o
/ rS O
(2 .1 )
li< 0
(2 .2 )
M >0
(3 .1 )
M ,< 0 .
(3 .2 )
We have thus assumed practically that the elasticities with respect to real income
of consumption, investment demand and the demand for money are positive, and
the corresponding elasticities with respect to the rate of interest are negative,
with the consumption-interest and investment-demand-income elasticities even
permitted to be zero. We might actually make somewhat less sweeping assump
tions, but those above should be generally acceptable and simplify the argument.
There is one crucial assumption, however, to which the rigid (but not the sophis
ticated) quantity theorist may object, that is, that M i< 0 . He would presum
ably insist that M. equals zero, that is that the demand for money is a unique
function of income (even a linear function, at that). But as we shall see, it is
only on the basis of such insistence ( or some arbitrary assumptions about move
ments of our functions) that he will be able to reject our results.
Armed with this system, let us ask what consequences may be expected from
an increase in the Government’s real expenditures on goods and services, with no
increase in taxes but open market operations which will keep the nominal quan
tity of money constant in the face of the resultant budget deficit. Imagine, if
you will, that the Government decides to arm, develop, or educate to the amount
of, say, $50 billion per year and that the Federal Reserve banks execute appro
priate open market operations or reserve requirement policies to keep the rele
vant quantity of money constant.4 What will happen to the price level, P? The
strict (or “crude” ) quantity theorist would argue that since the quantity of
money is unchanged, prices will no change. Let us see.
First we note that since Y cannot rise above its full employment value, an
increase in G must mean a decrease in C and/or I, which at equilibrium must
mean a decrease in C and/or JD. But if Y cannot rise, leaving aside the “ Pigou
effect” (1.3), C and/or / D can be decreased only by an increase in i. So far we
are really quite classical. Considering G as a form o f investment, we are merely
saying that an increase in one form of investment is balanced by a decrease in
other investment and increase in saving, both of which are induced by a rise in
the rate of interest.
However, now we note equations (3) and (3.2). A rise in the rate of interest
must reduce the demand for real cash balances. Without invoking any peculiar
Keynesian speculative motives, we may rest this aspect of the argument merely on
the idea that the opportunity cost of holding resources in the form, of cash is the
interest foregone. The higher this cost the less idle cash balances we shall wish
to hold. But the demand for real cash balances depends only upon income and
the rate of interest.4 Since income cannot go up, the change in the demand for
real cash balances can reflect only the rise in the rate of interest and must be
negative. Then equilibrium in the money market can be maintained only if the
real quantity of money in existence goes down. With the nominal quantity of
money held constant it is clear that the real quantity can be reduced only by a
rise in the price level.
4 Ignoring, in this context, the role of assets, including assets of cash balances.
38563 O— 59— pt. 4------ 1)4
810
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
Now if we consider (1.3) we find something of an inverse of the “ Pigou effect”
in that a rise in prices can be the means o f reducing real consumption directly,
without relying upon an indirect effect via the rate of interest. For with the
nominal quantity of money, Q, fixed, a rise in prices means a fall in M, the real
value of cash balances, and a consequent decline in real consumption, To the
extent this cash balance effect is operative the interest rate will not have to move
as much. Also, for any specified increase in O and given values of Ci, Jt, and
Mi, the greater is C m the less will P have to rise to preserve equilibrium. But P
will still have to rise.
If the reader is a quantity theorist and wonders where his theory has gone
astray, the answer is quite clear. He should have been stubborn and refused
to concede equation (3.2), making the demand for money vary inversely with
the rate of interest. And yet does this not indicate convincingly the weakness
of his position. Who can seriously argue that people will be totally impervious
to the rate of interest in deciding how much of their money to keep in noninterest-bearing cash? After all, holding cash in any form is a matter of con
venience (which of course in the limiting case becomes virtual necessity) and
should not the quantity demanded of this convenience, like all other conveniences,
vary inversely with its price? Or is money to be the one great exception to
that great classical contribution— the law of demand?
But once we concede that the demand for money varies inversely with its
cost— the rate of interest— we can reject the conclusion of this analysis only by
objecting to the stability of functions (1), (2 ), and (3 ). We could, for example,
argue that consumption, investment demand, and the demand for money are not
the given, specified functions of income and interest we indicate but depend
as well on some other factor, say expectations* which are affected by variations
of G. That in fact these variables are not unique functions of income and the
rate of interest and are rather affected by expectations—and many other fac
tors—nobody would deny. But can we assert that it is likely that an increase
in Government expenditures financed in such a way as to keep the quantity
of money constant would generate changes in expectations or other factors of
such a nature as to lower consumption and investment demand by as much as or
more than the increase in Government expenditures? Or can we assert that
the rise in the rate of interest would generate such a change in the liquidity
preference function that the same quantity of money or more is demanded at
the higher rate of interest as was previously demanded at the lower rate?
I suppose these possibilities cannot absolutely be ruled out. People did
argue that Government expenditures in the thirties were discouraging private
investment, perhaps in the view of some by more than the amount of the Gov
ernment expenditures. It is conceivable that a rise in the rate of interest would
generate expectations of a further rise in the rate of interest or might be
accompanied by expectations of price declines brought on by tight money
in some sectors; either of these factors could increase the demand for liquidity.
But I should think that not many would consider these possibilities generally
likely. Hence we are left with the conclusion that a constant quantity of money
is not a sufficient condition for the maintenance of constant prices. And of
course, to the extent we depart from our full employment assumption, an increase
in output may be substituted for part or all of the increase in prices. In any
event, this brief note should help make clear or remind us of some of the special
assumptions or conditions necessary to validate statements that (1) the quantity
of money uniquely determines prices and money income or (2) changes in the
quantity of money are sufficient to explain changes in money income.
UNDEREMPLOYMENT EQUILIBRIUM RATES OF GROWTH
BY
ROBERT EISNER
Reprinted from
A m e r ic a n E c o n o m ic R e v ie w
Volume XLII, No. 1, March, 1952
811
812
EM PLOYMENT, GROWTH, AND PRICE LEVELS
UNDEREMPLOYMENT EQUILIBRIUM RATES OF GROWTH
By
R o b e r t E is n e r *
I.— Introduction: Aggregative Theory Tackles the Problem of Growth
There is evidence that the Keynesian revolution is moving into a
new phase. After over a decade of discussion, the aggregative concepts
of the determination of the levels of income and employment have
become well-intrenched in the core of economic theory. “ Saving and
investment curves” and the approach which they symbolize have be
come the common property of the professional economic theorist and
the college sophomore. But at this point an advance guard has plunged
on. Harrod, Domar, Hicks and others have left behind the stationary
equilibria of saving, investment and employment to lead us into a
turbulent new world of growing economies.1
In this new world a first casualty of the older Keynesian system is
the wage unit. Measurement is now undertaken in terms of real output.
Next, a new dimension is added to the aggregate supply function; pro
ductive capacity increases over time— that is, the zero elasticity portion
of the curve of aggregate supply moves to the right as the economy
grows. With these and other changes which will become apparent in the
course of this article, it is possible to make secure certain gains of the
first phase of the revolution and to afford new insights into the long-run
determinants of employment. In furtherance of this latter objective,
we shall offer new sets of schedules or curves of aggregate growth which
may in some measure expose and clarify fundamental relationships of
growing economies in the manner that our older schedules of aggregate
flows of investment and saving revealed essential relationships of econ* The author is assistant professor of economics at the University of Illinois. He is indebted
to Professors Evsey D. Domar and Fritz Machlup of The Johns Hopkins University for dis
cussion of some of the concepts of this article when it was still in a formative stage. He has
profited as well from helpful criticisms of a later draft by William M. Capron of the R an d
Corporation and Professor C. Addison Hickman of the University of Illinois.
1 Pertinent works by R. F. Harrod include: “ An Essay in Dynamic Theory,” Exon. Jour.,
Vol. X L IX (Mar., 1939), and Towards a Dynamic Economics (London, 1948). Evsey D.
Domar’s works on growth include: “ Capital Expansion, Rate of Growth, and Employment,”
Econometric^ Vol. 14, no. 2 (Apr., 1946), pp. 137-47; “ Expansion and Employment,” Am.
Econ. Rev., Vol. XXXVn, No. 1 (Mar., 1947), pp. 34-55; and “ The Problem of Capital Ac
cumulation,” Am. Econ. Rev., Vol. X X X V H I, no. 5 (Sept., 1948), pp. 777-94. J. R. Hicks has
made Harrod’s concepts an important foundation of his A Contribution to the Theory of the
Trade Cycle (Oxford, 1950). These names, of course, while they represent early or prominent
arrivals, far from exhaust the growing group of explorers in this field.
EM PLOYMENT,
813
GROWTH, AND PRICE LEVELS
omies in stationary equilibrium. Development of these new curves of
growth will, however, involve us in consideration (and perhaps some
reconsideration) of the traditional functions of saving and investment
upon which certain of the new curves will be found to depend.
We shall take as a starting point, and as a framework for much of
this analysis, the intriguing algebraic models of Professor Domar on the
relationship between rates of growth and levels of employment. Pro
fessor Domar has devoted much of his work to an examination of the
rate of growth necessary for the maintenance of full employment. I
shall, after presenting the Domar tools, essay to apply those tools and
some others to a further demonstration of the underemployment impli
cations of rates of growth less than the full-employment rate.
II .— Domar and the Full Employment Equilibrium Rate of Growth
Domar defines <r as the ratio of the change in productive capacity
which takes place in an economy in any period to the change in capital
stock (investment) which occurs during the same period.2 He uses the
symbol a for the proportion of income saved (invested). Thus, denoting
investment by / , income by F, and productive capacity by P,
c l = AP,
(i)
I = aY,
(2)
AP = «<rF.
(3)
and
Now if the maintenance of equilibrium requires either that excess
capacity remain at zero (full employment: F = P) or that the amount
of excess capacity does not change (F = P —constant), the equilibrium
growth in income must equal the growth in productive capacity.
Operating under the assumption, for purposes of simplification, that
equilibrium involves full employment (F = P), Domar finds that to
maintain equilibrium, income (F) must grow by the amount aoY in
every period. Quoting Domar directly:
a<r is the equilibrium rate of growth. So long as it remains constant,
the maintenance of full employment requires investment to grow at
a constant compound-interest rate.*
* “ Expansion and Employment,” op. cit., p. 40. The wording of this definition, it should be
noted, is such that *■may well be a function of other variables than investment. In particular,
increases in population which involved increases in the supply of labor would raise the value of am
* “ Capital Expansion, Rate of Growth, and Employment,” op. cit. p. 141. Cf. “ The Problem
of Capital Accumulation,” op. cit., p. 781. The constancy of our will depend, of course, on the con
stancy of a, the proportion of income saved, and of <r, the productivity of investment, or on
mutually counterbalancing changes in these variables. We shall abandon Domar’s assumption
that a is constant, in the course of our analysis. We shall, however, retain the assumption of a
814
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
If a remains constant as income changes, it must represent both the
average and marginal propensities to save. For since
(2)
I = aY
differentiation reveals that
to
,
-----= a.
,
(2a)
dY
However, according to the multiplier theorem, the change in income
equals the change in investment divided by the marginal propensity
to save. Thus,
AI
AY = -----
a
(4)
and, dividing by (2) above,
AF
A/
-------------aY
al
(5)
or
In words, the proportionate rate of growth of income equals the pro
portionate rate of growth of investment. In order to maintain an equi
librium rate of growth of income the economy must also, if a is constant,
maintain the same rate of growth of investment. Under the assumption
of Domar’s model that equilibrium involves full employment, therefore,
aa is the equilibrium rate of growth of investment.
III .— Underemployment Rates of Growth
We must at this point modify Domar’s formulation by declaring ex
plicitly that our can be considered the equilibrium rate of growth only as
long as full employment is considered a condition of equilibrium. In
this connection, it must be pointed out that a wide range of economists
have denied that full employment is an equilibrium condition. Marx
argued that capitalism could not exist without a “ reserve army of the
unemployed.” Keynes is perhaps most famed for his theory of under
constant value of It may be noted that among elements contributing to stability in the value
of 9 would be a constant rate of growth of the supply of labor. The maintenance of a constant
value of r in the face of irregular variations in the supply of labor would require counter
balancing changes in other determinants of a such as technology and the marginal productivity
of capital.
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
815
employment equilibrium. And most contemporary economists, one
would suspect, feel that relatively “full” employment can be ap
proximated in a private capitalistic economy only in exceedingly un
stable periods of boom which would not be thought of as conditions of
“equilibrium.”
Developing further the underemployment element of the Domar sys
tem, we may state that if equilibrium involves a constant proportion of
idle capacity, equilibrium demands that
(7)
where 6 is the “coefficient of utilization” or the per cent of productive
capacity which is utilized.
Then, if we start from a position of equilibrium such that
Y0 = 6Po,
(7a)
maintenance of equilibrium requires that
AY = 6AP
(*)
or
(8a)
(3)
AY
----= ao6.
Y
(9)
The equilibrium rate of growth, if equilibrium involves less than full
employment, is thus a<rO, where 6 is the proportion of productive ca
pacity utilized at equilibrium.
It is interesting to present these relationships in terms of Harrod’s
system of “dynamic economics” which considers expressly a concept of
underemployment equilibrium in economies with rising levels of output.
Harrod’s Gw or “ warranted rate of growth” is “ that over-all rate of
advance which, if executed, will leave entrepreneurs in a state of mind
in which they are prepared to carry on a similar advance.”4 Further,
Harrod adds, Gw “in Keynesian fashion contemplates the possibility of
growing ‘involuntary* unemployment.” Now, in Harrod’s system a con
dition of equilibrium obtains when the actual rate of growth (G ) equals
Gu>. Since to maintain full employment, on Domar’s terms, the rate of
growth must equal a<r, a requirement for full-employment equilibrium
4 Towards a Dynamic Economics, p. 82.
816
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
for Harrod must be that G = Gw=ao\ If a certain proportion of unem
ployment (slack resources) is the condition for putting “entrepreneurs
in a state of mind in which they are prepared to carry on a similar
advance,” then Gwmust equal curd, where 6 is again the utilized propor
tion of productive capacity, i.e.,
G = Gw = clgB.
(10)
This extension and application of Domar’s concepts to Harrod’s
system reveals, then, that where the equilibrium level of employment
is a constant proportion of full employment, the equilibrium or “war
ranted” rate of growth decreases as this ratio of the equilibrium level
of employment to the level of full employment decreases. The main
tenance of full employment equilibrium demands a higher rate of growth
than the maintenance of underemployment equilibrium.
While Domar’s mathematical demonstration of the outcome of any
constant rate of growth, r, should be convincing to those who prefer
such rigorous reasoning,6 arithmetic exploration may make the matter
clearer to the general reader. Assume, therefore, that a = 0.1, <r=0.4,
and r = 0.03. Then, 0 = 0.75; equilibrium will be approached with only
75 per cent of productive capacity utilized. Roughly speaking (assuming
that the proportion of existent human resources utilized is equal to the
proportion of capital resources utilized),6 we may say that 25 per cent
* See, particularly, “ Capital Expansion, Rate of Growth, and Employment,” op. cit.t pp.
140-44. The essence of this may be reproduced as follows:
“ Since
( 11)
/ capital [K\f being the sum of all net investment, equals
£ = £. + /« f V ‘<a= k ,+ — («"- i).
•'o
r
( 12 )
As t becomes large, K will approach the expression (I o/r)#*, so that capital will also grow at a
rate approaching r. As F « ( l / a ) / 0er*, the ratio of income to capital is
r
>
r
and
Y
r
lim — =* — ”
K
a
(14)
Then, substituting K = P / a into (14), above, we obtain
lim
Y
r
P
a<r
(15)
• The relative magnitudes of unemployment of capital and of labor resulting from redundant
capacity is, of course, actually, a function of price, wage and interest flexibilities, capital and
labor mobilities and various other institutional factors. However, it seems reasonable to assume
a fairly high correlation between the utilization of capital and labor.
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
817
of the labor force will be unemployed. The reader may demonstrate for
himself, with self-constructed period analysis based on the assumed
parameters, that this will be so whether the economy starts from a posi
tion of full employment, 25 per cent unemployment, or more than 25
per cent unemployment. However, it is important to keep in mind that
the actual rate of growth, r, is assumed to be constant.
When we allow r to vary and, further, to become largely a function
of the proportion of productive capacity which is utilized, we move from
Domar’s system to Harrod’s system, from Domar’s r to Harrod’s actual
rate of growth, G. We then get results frequently much different from
the convergence to a given coefficient of utilization suggested by Domar.
Domar, in effect, has shown the relationship between what Harrod
might designate as the maintenance of various possible “warranted” or
equilibrium rates of growth, the productivity of investment and the
employment ratio (the ratio of actual to “full” employment). He has not
considered the effects of departures of the actual rate of growth from
the equilibrium rate of growth. Domar’s system thus enables us to
present underemployment (or full employment) equilibrium. Harrod
emphasizes this equilibrium’s essential instability— an instability which
leads to the underemployment (/^equilibria which form a major element
of the system of Hicks.
IV.— Underemployment “ Equilibrium” or Disequilibrium
Many economists objected strenuously to Keynes’ concept of under
employment equilibrium. Would-be objectors to the theoretical concept
of underemployment equilibrium rates of growth considered in this
article may, however, find little tangible to attack. For our “equi
librium” is a formal mathematical condition defined merely as stability
over time of the variables which enter our system. In most of this
analysis we do not consider the requirements which such stability
must impose upon variables outside of our system such as wages, inter
est rates, price levels and expectations. Thus, when we indicate that a
certain constant rate of growth of income, if maintained, must involve a
certain constant proportion of unemployment, we are reasoning in a
quite formal manner and do not consider what factors would have to be
operative for such a constant rate of growth actually to be maintained.
In this respect we are, after all, conforming to the usual theoretical
exercises with saving and investment schedules, in which we assert
that if a certain investment schedule is operative, a certain equilibrium
level of income must follow. We abstract here from the underlying
determinants of the actual and “equilibrium” rates of growth of income
as we abstract, temporarily, in the saving and investment schedule
analysis, from the problem of the underlying determinants of the saving
and investment schedules.
818
EM PLOYMENT, GROWTH, AND PRICE LEVELS
As Harrod points out, however, the “equilibrium” of growing econ
omies is essentially unstable. If the actual rate of growth exceeds the
“warranted” or equilibrium rate of growth, a shortage of capital goods
(raw materials, finished products, machinery, etc.) develops; new orders
and increases in output to make up this shortage accelerate the growth
of income. Conversely, if the actual rate of growth falls short of the
warranted rate, a relative surplus of goods must manifest itself; en
trepreneurs, in an effort to work off this surplus, cut orders and output.
The rate of growth, already too low, declines and, indeed, becomes
negative.
Readers familiar with Harrod’s model may ask now what an equi
librium condition involving underemployment signifies for Cr, the
equilibrium value of C (which is the ratio of aggregate ex post investment
to changes in income, I /A Y ) . Before answering this question it is well
to point out that Cr does not actually have any particular subjective
meaning to the individual entrepreneur. Rather it is merely the selfconsistent value of C. Thus, Cr is that value of C for a given period which
will lead entrepreneurs to undertake actions which will, in the aggregate,
give rise to the same value of C in the ensuing period. Other things,
including s, the proportion of income saved, remaining equal, this con
stant value (Cr) of C will then involve a constant value (Gw) for G,
the rate of growth of income. A value of C in excess of CTmeans, how
ever, that entrepreneurs on balance find more investment has taken
place (more inventories have accumulated, more machinery has been
constructed, etc.) than the actual growth in aggregate demand (in
come) warrants. Hence orders and output are reduced.
Our concept of underemployment equilibrium includes, in effect, a
greater value for Cr than would be the case if the equilibrium condition
involved full employment. When we suggest that a rate of growth in
volving underemployment can be self-perpetuating, we are suggesting
as well, therefore, that the accumulation of capital at a rate which,
because of its relation to the rate of growth, involves the creation of a
constant proportion of excess capacity, will lead entrepreneurs to ac
tions which, in the aggregate, continue this rate of growth.
Understanding of these relationships may be enhanced by the re
flection that this increase in the value of Cr and decrease in the value of
Gwfrom the values which could be compatible with full employment are
not what present the system with underemployment. A high, fullemployment value for Gw would, as Harrod points out, merely make
more difficult the maintenance of full employment by setting a require
ment for G (which would have to equal or exceed Gw) which would be
more difficult to fulfill. The consequence, in Harrod’s model, would be
chronic periods of underemployment disequilibrium. During these
periods, because the actual rate of growth, G, would be less than the
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
819
warranted or equilibrium rate of growth, Gw, and consequently, C
would have to exceed Cr, unwanted or excess capital would accumulate
and cause the levels of production and income to drop precipitously. It
would then only be in periods of mass unemployment, with an abun
dance of slack resources, that it would be possible for the economy to
grow at such a rate that G would be in excess of Gw, with C consequently
less than Ct, and the downward pressures could be briefly dispelled.
The lowering of Gw and the raising of Cr from their full employment
values, in this system, reduce the danger of chronic underemployment
disequilibrium and substitute the possibility of an (unstable) equi
librium growth, involving underemployment. The admitted instability
of this equilibrium invites consideration of restraining mechanisms
which must be added to our model to prevent its “exploding” to infinite
heights or impossible depths at the first departure from the line of
stable growth. Restraining mechanisms, such as capacity “ ceilings” in
booms and real limits to the rate of disinvestment in periods of decline,
prove quite useful in developing “ Hicksian” models of the business
cycle within the framework of growing economies. The present writer
has worked extensively with those models and the failure to consider
them in this paper implies no unfavorable judgment as to their sig
nificance.
V.— Growth Curves: A Diagrammatic Presentation of
Underemployment Equilibrium
The Keynesian revolution may, perhaps, make secure its conquest
of the new world of growth by recourse to diagrammatic presentation of
the sort that was so significant in its earlier triumphs. For in a fashion
strikingly analogous to creation of the familiar “ saving-investment”
curves of. current textbooks it is possible to devise curves connecting
rates of growth and the relative level of employment.
In the following pages we shall demonstrate growth curves appropri
ate for various saving functions. The relationship between saving and
growth and employment thus revealed will suggest interesting hy
potheses as to the hitherto frequently baffling nature of the aggregate
saving function.
Figure 1 illustrates this relationship when all of Domar’s simplifying
assumptions, including the assumption that saving is a constant propor
tion of income, are accepted. On the horizontal axis, instead of income or
employment, as in the traditional Keynesian analysis, we plot (in
percentage figures) F /P , the ratio of output to productive capacity.
“ Full employment” is indicated by output equal to productive ca
pacity, or the abscissa, F /P , equal to 100%. We shall boldly refer to
the value Y /P as the “employment ratio,” thereby assuming that the
proportion of labor which is unemployed is always equal to the pro
EM PLOYMENT,
820
GROWTH, AND PRICE LEVELS
portions of other resources which are idle.7 On the vertical axis we plot,
instead of saving and investment, percentage rate of growth of pro
ductive capacity (which is a function of real saving and the productivity
of investment) and percentage rate of growth of income (which is a
function of the rate of growth of investment; in Figure 1 the percentage
rates of growth of income and investment are equal because investment
has been assumed to be a fixed proportion of income, that is, I = a F ).
We may refer to the percentage rate of growth of productive capacity
per unit of time as (<i P / d t ) / P or as («d P / P ) / d t . Similarly, we may refer
to the percentage rates of growth of income and investment, per unit of
time as, respectively, { d Y / Y ) / d t and ( d l / l ) / d t . But inasmuch as the time
dimension, implicitly thought of as a year, will in any event be the
same for the various magnitudes, and since time symbols are conven
tionally omitted in referring to “ stationary” variables such as income
and investment, we shall omit the “<#” from our rate of growth sym
bols. The percentage rates of growth of productive capacity, income
and investment per unit of time are thus denoted in Figure 1, and in
the rest of this paper, as respectively d P / P , d Y / Y y and d l / I .
Now, since <r is defined as the change in productive capacity accom
panying each unit of investment,8
dP
In
—
= —
P
P
(16)
where I is the volume of investment.
However,
S = I = aY.
(2b)
Hence,
dP
-----=
P
V
acr —
•
(17)
P
In common sense terms, the growth of productive capacity depends
(at least in part) upon investment, which equals saving. But saving, in
turn, is a positive function of income. Thus with any given level of
productive capacity, the rate of growth of productive capacity will vary
directly with income, that is, with the proportion of productive capacity
which is utilized.
7 See footnote 6.
9 In order for <r to have enough stability to be meaningful it must be associated with a unit
of intended or desired investment which entrepreneurs find useful in the productive process. It
cannot refer to the unwanted inventories or other excess investment which help confirm the
Keynesian saving-investment identity. Thus, though not necessarily rejecting this identity,
we must restrict the application of this analysis to “ equilibrium1’ conditions, in which invest
ment will be so constituted as to have a meaningful/and reasonably consistent relation to
productivity.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
821
% Rate o f Growth
Employment
%
R atio
9
F ig u r e 1. I n v e s t m e n t a C o n st a n t P r op or tio n of I n c o m e ;
I =* CtY
dP
Y
P
P
——
■= a<r— •
It is therefore possible to construct a family of d P /P curves (rate of
growth of productive capacity curves) which slope upward from left to
right. The magnitude of slope of these curves depends upon the values
of a and <r. In Figure 1, curves are shown for each of the values of aa
from —0.02 to 0.06. Then, on the same graph we may let a horizontal
line indicate the rate of growth of income (d Y / Y ). The equilibrium
ratio of income to productive capacity (or “employment ratio”) is now
indicated by the intersection of the growth of income curve with the
appropriate growth of productive capacity curve. For example, if
a = 0.2 and (r= 0.2, the appropriate d P /P curve is the one designated
‘W = 0 .0 4 .” Then, if income were to grow at a three per cent rate (an
EM PLOYMENT, GROWTH, AND PRICE LEVELS
822
nually—an assumption which would approximate historical data and
which consequently will be applied for illustrative purposes also in
Figures 2, 3, and 5), the equilibrium Y / P ratio would be 75%, the
abcissa of the intersection of the curves, d Y / Y = 3% and d P / P
= a a ( Y / P ) ywhere aa = 0.04.
In the traditional “saving-investment” analysis, either raising the in
vestment curve or lowering the saving curve would raise the equilibrium
level of employment. In our diagram, either raising the “growth of in
come curve” or lowering the “growth of productive capacity curve”
will raise the equilibrium ratio of employment. To extend the analogy
further, in our diagram, lowering a, the average propensity to save, will
lower the d P / P curve (rotating it clockwise, with the origin as a ful
crum) and thus raise the employment ratio. And increasing d l / / , the
rate of growth of investment, will raise the d Y / Y curve, via the mul
tiplier effect, thus raising the employment ratio.
In Figure 2 we drop the assumption that investment is a constant
proportion of income but we retain a constant m arginal propensity to
save. As a further modification, we replace the traditional saving func
tion,
S = aY -
(18)
b
by a function in which our second parameter makes saving depend, in
part, upon productive capacity, i.e.,
S = aY -
PP.
(19)
This new function, we may suggest, may solve some of the persistent
difficulties encountered in attempts to derive a long-run saving function
from time series data.9 It also points to a negative partial correlation
• It may be noted that if we accept the traditional saving function,
5 * aY - 6,
then
S
—
s
aY
■ ■
-b
P
P
dP = —
la
P P
dP_
and
(18)
,
(18a)
Since
—
p ’mcu> p
p'
I = S,
( 20)
Thus in a growing economy, with P rising, at any given employment ratio (Y/P) the value
of dP/P will be increasing. However, this is merely a corollary of the fact that in a growing
economy, with F rising while remains constant, saving would be a rising proportion of in
come, approaching the proportion a. The saving function actually used in Figure 2, on the
other hand, is based on the hypothesis that there is no long-run change in the proportion of
income saved.
b
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
823
% Rate o f Growth
F ig u r e 2. In v e s t m e n t a F u n c t io n o p In co m e a n d P r o d u c t i v e C a p a c it y ;
/»aF-/3P
dP
/
Y
\
between productive capacity and investment, which would appear to
conform to both statistical data (low levels of investment during periods
of unemployment), and economic theory.10
The “growth of productive capacity (<dP/P) curves” of Figure 2 may
be derived quickly. Since S = /,
I = aY
- 0P.
(19a)
10 Since investment is frequentfy designed to increase productive capacity, as productive
capacity increases, with income remaining constant, the demand for investment goods and
the amount of investment may be expected to drop.
824
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
But
dP _ la
(1 6 )
~P ~ ~P
and hence
dP
/
Y
\
T - ( “ 7 - ' h
(21)
Thus, as in Figure 1, the d P /P curves are positively sloped straight
lines. For any given values of a, 0 and <r, the rate of growth of pro
ductive capacity varies directly with the employment ratio. However,
in Figure 2 extremely high rates of unemployment (low employment
ratios) are associated with absolute declines in productive capacity. And
in Figure 2, the d P /P curves, in order to attain a moderate positive
value at a high (but not 100%) employment ratio, must be more sharp
ly sloped than the d P /P curves of Figure 1, which begin from the origin.
This last characteristic of our curves assumes considerable interest
when translated into ordinary language. So expressed, it states: our
saving and productivity of investment functions may be such that the
maintenance of full .employment demands a high rate of growth; a
stationary economy can exist, with d P /P curves such as those il
lustrated, but only with large proportions of unemployment.
Figure 3 introduces a savings function which adds realism and also
sharpens the suggestive relationships which we have just been consider
ing. Now saving (investment) is made a function of both income and
the employment ratio (F /P ). This may be explained, at least in part,
by the dis-saving necessary to care for the unemployed. As income in
creases, there is a rise in the volume of saving as well as in the living
standards of those who are earning. However, where productive ca
pacity (P) grows faster than income (F), thus reducing the value of
Y / P , unemployment rises and a. greater proportion of income is used
in providing for consumption of the unemployed. We may also point
out that this function, suggesting relatively high levels of investment in
periods of full employment, squares well with statistical data on cyclical
fluctuations of income and investment.
The specific function exhibited in Figure 3 (though not statistically
derived) expresses in a reasonably simple fashion the general relation
ships just cited. Thus:
( 22 )
(2 2 a )
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
825
dP
~p
% Rate of Grovth
( r ’ p>
Znployment
%
Ratio
4»
F ig u r e 3 , I n v e s t m e n t a F u n c t io n op I n c o m e , P r o d u c t iv e C a p a c it y a n d t h e
E m p l o y m e n t R a t io ;
T-niy-'h
Examination of Figure 3 reveals that as full employment is ap
proached, the employment ratio becomes less and less responsive to
increases in the rate of growth of income. Put another way, it appears
possible that the investment and productivity functions are such that
38563 O— 59— pt. 4------ 15
826
EM PLOYMENT, GROW TH, AND PRICE LEVELS
it is impossible to secure full-employment equilibrium without rates of
growth which, on the basis of past performance, our economy cannot be
expected to maintain.
The attainment and maintenance of full-employment equilibrium in
growing economies is then the problem of raising the rate of growth of
income and/or reducing the rate of growth of productive capacity at
% Rate of Growth
t dY
' y
dPx
F u ll employment
F i g u r e 4 . A t t a i n i n g F u l l E m p l o y m e n t b y R a is i n g R a t e o r G r o w t h o r I n c o m e C u r v e ;
f -[■©■-*
levels of full employment. These complementary approaches are ex
hibited diagrammatically in Figure 4 and in Figure 5. In Figure 4, raising
the income growth curve from 3 % to 6 % brings a movement of the
equilibrium employment ratio, as indicated by the intersection of the
curves for growth of productive capacity and of income, from just over
80% to 100%, or full employment. In Figure 5, a similar movement to
full employment is accomplished by lowering the value of a from 0.3
to 0.2, thus moving to the right and lowering the growth of productive
capacity curve sufficiently to make it intersect the income growth curve
at a 100% employment ratio.
EM PLOYMENT,
GROW TH, AND PRICE LEVELS
827
% Rate of Growth
fdV
dP\
\ Y ' P )
F ig u r e 5. A t t a i n i n g F u l l E m p l o y m e n t b y R e d u c in g S a v i n g , t h u s L o w e r i n g R a t e
o f G r o w t h o f P r o d u c t iv e C a p a c i t y C u r v e ;
The diagrams presented in this section, as well as the general con
cepts of this article which they portray, have weaknesses similar to
those of the aggregative, “ Keynesian” diagrams and concepts of sta
tionary economies. Specifically, these diagrams and concepts abstract
from the micro-economic functions and relations from which, ulti
mately, they must derive their content. In addition, it should be
pointed out that these diagrams and concepts, in their present develop
ment, have not been applied to the essential process of transition from
one equilibrium to another. However, they may be of some value both
in assisting the forward march of the advance guard of “ revolutioniz
ing” economic theorists and in helping to consolidate for the rest of the
profession some of the newly won ground. In substance, they may
facilitate analysis of the modem capitalistic economic system without
abstracting out the element of growth which has seemed to so many—
private profit enthusiasts as well as the system’s critics— to be of its
essence.
REPRINTED FROM
THE
ECONOMIC
JOURNAL
THE QUARTERLY JOURNAL OF THE ROYAL ECONOMIC SOCIETY
Edited by R. F. H A R R O D and E. A. G. R O B I N S O N
Assisted by R. C. O. MATTHEWS
DECEM BER
1958
V o l. L X V I I I
LO ND O N: M A C M I L L A N AND CO. L I M I T E D
N E W Y O R K .* T H E S T . M A R T I N ’ S PR ESS
829
830
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
O N G R O W T H M O D E LS A N D T H E N E O -C L A SSIC A L
R ESU R G EN CE 1
I. T h e
A ttack
o n
t h e
G r o w t h
M odels
T h e relatively prosperous decade o f the fifties has been replete with
retreats from the econom ics o f the thirties. It is good that economists are
ready to meet the social issues o f their ow n d ay; the problem o f under
em ploym ent in a developed capitalist econom y has hardly the urgency o f
yesteryear. But ills rooted deep in the structural relations o f an econ om ic
system have a way o f recurring, unless those structural relations are ade
quately and permanently changed. T here is hence purpose in clarifying
and preserving from distortion in later lights some o f the now older diagnoses .2
In recent journals several respected economists have join ed the attack on
grow th-cyclical models o f the H a rrod -D om a r-H ick s variety. I submit
that these models are such, in their inspiration and assumptions, that the
attacks can be successful only with the inclusion o f an apparently unintended
target— Keynes. I propose to make clear the Keynesian content o f the
growth models and to redress somewhat the current balance b y defending
and building upon the Keynesian heritage.
T h e banners o f the attackers are strikingly similar. James T o b in rebels
against the concept o f “ straight and narrow paths from w hich the slightest
deviation spells disaster.” 3 Kenneth Boulding ridicules the “ H - D - H ”
or “ H iccu p ” dynam ic with its “ dismal,” “ gloom y,” “ masochistic ”
prophecies .4 R obert Solow rejects “ the characteristic and powerful co n
clusion o f the H a rrod -D om a r line o f thought . . . that even for the long run
the econ om ic system is at best balanced on a knife-edge o f equilibrium
grow th.” 5 A ll three see the basic problem raised b y the H a rro d -D o m a rHicks growth m odel enthusiasts as the unique result o f (arbitrary and un
warranted) assumptions o f fixed proportions o f the factors o f production.
M ore com pletely, in the words o f T ob in , “ Contem porary theoretical models
o f the business cycle and o f econom ic growth typically possess two related
1 The writer is indebted to Norman F. Byers, Alfred H. Conrad, F. H. Hahn, Harry G. Johnson,
Alvin L. Marty, Tibor Scitovsky, Robert Solow, James Tobin and Fred M. Westfield for helpful
reactions and suggestions. He wishes to acknowledge, in particular, the valuable and detailed
comments of Robert H. Strotz. The paper was prepared in part during the tenure of a Social
Science Research Council Faculty Research Fellowship.
2 This paragraph was written, with perhaps pardonable truculence, in the pre-recession summer
of 1957.
8 “ A Dynamic Aggregative Model,’ * Journal o f Political Economy, Vol. L X III (April 1955),
103-15.
4 “ In Defense o f Statics,” Quarterly Journal o f Economics, Vol. L X IX (November 1955),
especially pp. 492-5.
6 “ A Contribution to the Theory o f Economic Growth,” Quarterly Journal o f Economics, Vol.
L X X (February 1956), 65-94.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
831
characteristics: ( 1 ) they assume production functions that allow for no
substitution between factors and ( 2) the variables are all real m agnitudes;
m onetary and price phenom ena have no significance 55 (p. 103) -1 Generally,
the attackers argue that with consideration o f variable-factor proportions
and flexible prices, unlike in the H a rrod -D om a r-H ick s models, not one but a
variety o f warranted rates o f growth becom e possible and the econ om y w ill
be free to adjust to whatever rate is appropriate for full em ploym ent.
II.
W h a t H a r r o d , D o m a r a n d H ic k s R e a l l y
S a id
It can be shown quickly that the growth models did encompass variable
factor proportions and reasonable operation o f the m on ey-p rice mechanism.
First, in H arrod’ s form ulation, Gw, the warranted or self-sustaining rate o f
growth, depends upon s , the proportion o f incom e saved (or that proportion
remaining after saving is utilised in “ autonomous 55 investment and export
balances), Cr, the “ required ” or equilibrium, current capital-ou tpu t ratio
which leaves entrepreneurs satisfied, and d* (for “ deepening ”),2 the p ro
portion o f output absorbed in lengthening the production process or
increasing the cap ital-ou tp u t ratio. Algebraically,
= S
or
r
G„Cr + d * = s
- ............................ (1)
................................. ( 1 . 1 )
In this latter form the above equation expressed directly the condition
o f equality between the proportion o f output for w hich there is investment
dem and ( GwCr + d) and the proportion o f output saved (s).z I f the actual
1 In “ Complementarity and Long-range Projections,” Econometrica, October 1956, pp. 429-50,
which came to the writer’s attention when this paper was in penultimate draft, P. J. Verdoom also
relates the Harrod-Domar models to an assumption of complete lack of substitutability of factors.
The implication of Verdoom’s work is that this complementarity assumption may prove not un
reasonable for purposes of prediction or as a description of the medium-long-run adjustment
powers o f the economy. But Verdoom’s thesis is also consistent with the argument we shall
develop, that there is substitutability but that economic constraints limit crucially the range of
admissible factor ratios.
* Harrod used the symbol d to denote deepening; we have changed this to d* in order to avoid
confusion with the differential and derivative symbol, d.
* I f we write capital as
K =r--r
.......
. . (i.2)
investment can be written
dK
K dr
l ~ d t ~ Tdi
+
d(K/r)
dt
•
and the ratio of investment to income is
/
d log T K
r~
dt
d(K/r)
d t ..........................................K m
v
For the equilibrium condition described by the warranted rate of growth it is presumed that KjY,
EM PLOYM ENT,
832
GROWTH, AND PRICE LEVELS
rate o f growth is less than the warranted rate, investment dem and must
then be less than saving, and the rate o f growth o f output and (eventually)
the rate o f output must turn dow n. But if Gn, the “ natural ” rate o f
growth or m axim um rate o f growth o f which the econom y is capable under
conditions o f full em ploym ent, is less than G w, then the actual rate at full
em ploym ent w ould have to be less than Gw. It follows that investment
dem and w ould have to be less than saving at full employm ent. Thus full
em ploym ent could at best represent a mom entary position o f disequilibrium.
A critical aspect o f the problem , then, can be form ulated as how to prevent
Gw from exceeding Gn. O n e way to d o this is to have deepening— a
positive value o f d*. H arrod states explicitly, “ d m ay have a positive value
because o f the nature o f the inventions occurring. It m ay also have a
positive value because the rate o f interest is falling. O u r aim should be to
get such a progressive reduction in the rate o f interest that
GwCr = s — d = GnCrr
Harrods adds, “ I f d is positive, Cr will increase through time, and may
eventually becom e so great as to enable us to dispense with d .” 1
N ow , increasing capital intensity stemming from lower interest rates
implies changing factor proportions and indeed, with linear, hom ogenous
production functions (as assumed by Solow and T o b in ), changes in the
cap ital-ou tp u t ratio must mean changes in factor proportions. Thus
H arrod is saying that factor proportions may change so m uch— the econom y
may get so capital intensive— that the rate o f growth necessary to absorb
saving (the “ warranted ” rate, Gw) will be reduced to an acceptable level.
But, H arrod continues, “ T h e question we now have to ask is whether there
will be any natural tendency for the rate o f interest to com e dow n sufficiently.
This is the crux o f the matter [emphasis added, R . E .], the crux, perhaps, o f
that m od em econom ic situation to which we shall revert, when the post
war shortages cease.”
I submit that there can be n o dou bt that in H arrod’s
m odel factor proportions are quite variable and the m on ey-p rice mechanism
is free to operate as it w ill; there is no uneconom ic, arbitrary, technological
the actual, current capital-output ratio, is the ratio currently demanded, and therefore equals Cr.
j( zrj
Then if ^
>or ** deepening,’* is taken as the time rate at which entrepreneurs demand [desire)
that the capital-output ratio change, y is the ratio of investment demand to output.
rate o f growth is that value of
The warranted
(Harrod’s G) for which
d\o%YK
dt
d(KIT)
I
S
dt ~ r ~ s ~ r > .............................. {
or that value which makes investment demand equal saving.
1 Towards a Dynamic Economics (London, 1948), p. 96. This corresponds precisely, as should
become clear below, to Solow’s positive value for the rate of change of the capital-labour ratio (r > 0),
leading eventually to an equilibrium ratio, r* [Loc. cit., p. 70).
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
833
constraint .1 H ow ever, as m ore capital is used, other things remaining
equal, the return on capital must fall. T h e difficulty is that this fall m ay
conflict with the Keynesian floor to the rate o f interest or, m ore generally,
with the rate o f return on capital which entrepreneurs will find acceptable.
D om ar, similarly, is clear in pointing out that the crucial issue is not
whether capital-ou tpu t ratios are fixed but rather whether they are free to
adjust in such a manner as to eliminate “ T h e Problem o f Capital A ccum ula
tion.” 2 Raising the question o f the Am erican econ om y’s ability to co n
tinue indefinitely absorbing new capital at its rapid post-war rate, D om ar
w rites:—
“ Im plicit in this worry is the b elief that the possibilities o f the socalled deepening o f capital (in the sense o f an increasing ratio o f capital
to output) are limited. Therefore the am ount o f capital that the
econom y can absorb, at a given incom e level and over a given period
o f time, is limited as well. . . . W e have thus assumed, at least for the
purpose o f this discussion, that there exists a fairly stable ratio between
annual output (or national incom e) and the capital stock needed for
its production, this ratio to be indicated b y the letter s. W hile,
strictly speaking, we shall treat s as a given constant, it need not be so.
It is certainly not the same am ong various firms and industries. T h e
national average (if such exists) can be made a function o f time, in
terest rate, or o f something else. B ut it must have some stability , because
i f s can be anything , our argument fa lls through and we are back at the K nightSimons Position ” [that “ investment opportunities are practically un
limited ”].3
Finally, Hicks w ould have cyclical fluctuations about a growth trend
develop with any o f a wide variety o f capital-ou tpu t ratios (as well as
saving ratios and lags ).4 Hicks argues that any values o f the accelerator
above the “ U pper Point ” will generate a “ strong ” cycle when equilibrium
is disturbed, values merely above the 44 M id d le Point ” will lead the system
into strong cycles, and even values merely above the “ L ow er Point ” will con
tribute to some (dam ped) cyclical fluctuations. A n d Hicks devotes m uch space
in his “ inspection o f the ceiling ” and his analysis o f “ the monetary factor ”
to a consideration o f whether the forces that transform the accelerator or the
desired capital-ou tpu t ratios are likely to eliminate the troublesom e in
stability and departures from full em ploym ent w hich the H - D - H models
all suggest. H icks’ answer, o f course, is not encouraging. But again, the
difficulty is due to incapacities o f adjustment o f the monetary fram ework and
o f the econ om ic system generally and not an arbitrary assumption o f
(technologically determined) com ers in the production isoquants.
1 Cf. Harrod’s amplification of this point in his “ Comment ” on Harold Pilvin’s “ Full Capacity
vs. Full Employment Growth,” The Quarterly Journal of Economics, Vol. LX V II (November
1953), pp. 553-9.
* American Economic Review, Vol. X X X V III (December 1948), pp. 777-94.
8 Ibid., pp. 777-9, emphasis added.
4 J. R. Hicks, A Contribution to the Theory o f the Trade Cycle (Oxford, 1950).
834
EM PLOYMENT, GROWTH, AND PRICE LEVELS
III. “ A D y n a m ic A g g r e g a t i v e M o d e l 55 w i t h S om e K e y n e s i a n
Param eters
The issues may be fairly joined by constructing a model which draws
heavily upon the elegant presentations of two of the critics, Solow and Tobin,
and utilises such a model to consider conditions or assumptions sufficient to
give the peculiar or particular Harrod-Domar-Hicks results. We shall
consider first the factor-proportion question, assuming initially that private
saving equals the change in physical capital and is some constant ratio of
output. Later we shall enlarge the area of debate by introducing a more
general saving function, complete with a “ Pigou effect55 and a new
“ dynamic Pigou theorem.55
The Production Function, Factor Proportions and the Rate of Profit
Let us assume, with Solow and Tobin, that net output is a linear, homo
geneous function of capital and labour:
T = F(K,L)
............................... (2)
and that output consists of only one good, which may be consumed or
retained as capital (invested). Writing r = K /L for the capital-labour
ratio, we may, on the basis of the homogeneity assumption, factor out L and
rewrite the production function:
r-Z.F(f,l)
........... (3)
We may further assume diminishing marginal returns to each factor of
production, throughout the economically relevant range of factor pro
portions, so that, in particular,
<PF
^ < ° ............ w
But since in equilibrium the rate of profit, t, is presumed to equal the net
marginal product of capital, we may write
i= F K =Fr
............................... (5)
and, consequently, substituting in (4),
7 r < ° ............................................<6)
In words, i must be a monotonic, decreasing function of r; an increase in the
capital-labour ratio must mean a decrease in the rate of profit.
Taking Harrod5s system as representative for our purposes, we may
express his symbols as
Cr -
and
K
L
r
r ~ r T ~ F ( r , l ) ......................... ^
EMPLOYMENT,
835
GROW TH, AND PRICE LEVELS
where r is the capital-labour ratio corresponding to the equilibrium ca p ita loutput ratio, Cr, and
dC, _ F(r, 1 ) - tF t
.
dr ~ [F (r,l )]2
................................. W
H ence, substituting in (1) and simplifying terms, and denoting F f o l ) b y
r _ ( d l o g T \ s p d lo g r d lo g F
G« - [ — d T - ) ~ r F - ~ d T + - ~ d T
F (r,l) is total output per unit o f labour and rFr is
F,
n fm
(10)
•
But since
the return to
capital per unit o f labour, for all econom ically relevant values o f r (where the
share o f capital is less than unity) we obtain from (9) the condition that
^ > 0
......................(11)
or that H arrod’s C r, the capital-output ratio, varies in the same direction as
the capital-labour ratio. From ( 8) and (11),
d* = 0 a sjt = 0
.................. (12)
or deepening depends upon an increase in the capital-labour ratio: m ore
over,
dd *
, rt\
7 ^
>
U)
d
° ..................................<13>
.e., deepening is a m onotonically increasing function o f the rate o f change
o f the capital-labour ratio. N ow , dismissing negative values o f Cr, as
1 Noting that
d lo g F
dlogTIL
dlog T
~~dt~ ~
dt
“
dt
dlog L
d t ..............................
we may write the actual rate of growth of output
d log T
d t~
d lo
logg K
dt
( d lo
(d
logg K
V
d\ogL\
d
log L\ , d lo
logg F
dt
dt
dt
/i n o ,
............................
Since saving is presumed to be realised (whether consistent with entrepreneurial equilibrium or not),
s „
sL-F
1
^ K
r
dK
d log K
/1AQN
^dt =
d t ~ .................................. (10*3)
so that, substituting in (10.2),
d logT
s
I d log K
~dr-r F-\~dt
dlogL\
--------------------
d lo g F
drj+ —dr
•
*
•
•
( 1 0 *4 )
But then, where
d lo g K
dt
d lo g L _d logr
~dt ~
dt
....................................1
nn ^
'
(10.4) becomes identical with (10): the actual rate of growth of output equals the warranted rate
when the capital-labour ratio is actually changing at the rate
neurial equilibrium.
consistent with entrepre
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
836
econom ically irrelevant, and negative values o f s — d* as unlikely and
uninteresting in the present context, we see from ( 1 ) that
S £ < ° ..................................<14)
and
5& < °
■ ( 15)
•
Then, combining (14) and (11),
dG„ dCr
W
- W
n
.
.
■ (16)
/ l f <0
and com bining (15) and (13),
J G ^ = dG_u . J £ _ < 0
Jd r\
Zd ,( d r\
id t)
d [ d t)
'
^
In words again, H arrod’s warranted rate o f growth may be reduced by an
increase in the capital-labour ratio (16) as well as by an increase in the rate
o f change o f the capital-labour ratio (17).
But now we shall introduce some reasonable parameters into our p ro
duction function. Critics o f the growth models deal with functions w hich
im plicitly or explicitly (like the C obb-D ou glas illustration Solow employs)
im ply the assumption that the marginal net product o f capital is always
positive, regardless o f how high the capital-labour ratio rises; barring dem and
problem s it must always pay to invest. This, indeed, is one o f the “ crucial ”
assumptions 2 on which the growth m odel critiques rest. It embodies again
1 These results may also be obtained directly in terms of r.
T
Again denoting ^ == F(r, 1) by F,
we may write
=
.........................
Then, substituting in (1),
G. = (j - d*) -r
............................................... (16.2)
The partial derivative of Gw with respect to r, assuming s and d* constant, is then
....................................(16.3)
As explained above in regard to (11), we may take F — rFr, the relative share of labour, as positive.
Hence, where
ort
s — d* — constant > 0,
<0
........................(16.4)
And the partial derivative of G„ with respect to d*, with s and r assumed unchanged, is
§
“ -F<°
• • : ......................<17-»>
1
Solow warns that: “ A * crucial * assumption is one on which the conclusions do depend
sensitively, and it is important that crucial assumptions be reasonably realistic. When the results
o f a theory seem to flow specifically from a special crucial assumption, then if the assumption is
dubious, the results are suspect ” (loc. cit., p. 65). But he charges this to the Harrod-Domar model.
N o.
272.— v o l . L x v ra .
3a
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
837
the optimistic notion of unlimited investment opportunities; it should not
be surprising that it yields optimistic conclusions. Let us, however, in
curiously more classical vein,1 recognise that in any given period, or with
a given production function, there is a limit to the extent to which greater
round-aboutness of production will pay for itself. All we are arguing is that
with a given quantity of labour there is some finite amount of capital at which
the diminishing net marginal return to capital will reach zero. With more
than that amount of capital the marginal net product of capital will be
negative; additional capital will not realise, and hence should not be
expected to realise, sufficient returns during its life-time to pay for itself.
We thus add the further description of our production function,
FE^ 0 as JTfJTo, L = L0
. . . .
(18)
K
or utilising the homogeneity assumption and defining r0 = -=-°,
i
= Fr§ 0 as rgr0 .......................(19)
Now the existence of r0, a limit to the profitable extensibility of the
capital-labour ratio, will prove sufficient to admit the possibility of the
“ H-D-H ” difficulties,2 but, if we wish to get more Keynesian, we can add
a liquidity trap at say iv where it > 0 and is the rate of return equal to the
floor to the rate of interest. To ix will correspond some capital-labor ratio,
say rl5 where rx < r0 and
i = Fk = Fr| ^ as r = r±
.
.
.
.
(20)
Hence there is an upper limit to the value of r, which may be denoted by
r0 or rv depending upon whether we wish to assume that the rate of (net)
profit can fall to zero or only to some value above zero. Since from (16)
it can be seen that Gwis a monotonically decreasing function of r, for any
given values of s and d* ^e.g., d* — 0 = ~
there is then a lower limit to
If this lower limit is still higher than the actual or maintainable rate
of growth the economy is in for the H-D-H maladies.
Gw.
dr
But what if there is deepening, that is, d* and ^ are positive? Here we
1 Consistently, for example, with the formulation by John M. Cassels, “ On the Law o f Variable
Proportions,” reprinted from Explorations in Economics in Readings in the Theory of Income Distribution,
pp. 103-18.
2 The simplifying assumption of linear homogeneity o f the production function enables us to
meet the Solow-Tobin type critiques on their own ground, but it is a stronger assumption than we
require. The Harrod-Domar-Hicks problem may be exhibited by any production function in
which, with the given (presumably exogenous) growth of labour supply and the rate of capital
accumulation consistent with the saving function, the marginal net product of capital is declining,
and has no non-negative lower bound.
838
EM PLOYMENT, GROWTH, AND PRICE LEVELS
are referring not to a higher but to an increasing capital-labour ratio. As we
noted in (17), the greater the rate of increase of the capital-labour ratio,
other things equal, the less the warranted rate of growth. Thus we may
concede that if the warranted rate of growth is too high there is always some
rate of change of factor proportions which will be sufficient to make the
warranted rate of growth any necessary lower figure. We are not, however,
out of the woods. For, in accordance with (6), an increasing value of r
must mean a decreasing rate of profit. But since i ^ 0 or i > iv eventually
(with j t > e>e > °)>
di
as r = r0 or as r ^ rl5 ^ = 0
.
.
.
.
(21)
Then, writing
dr _ dr_ dF,
d t ~ d F / d t ...............................
we can see that since, as stated in (5), in equilibrium, the rate of profit equals
the marginal product of capital or i = F „ as
-dt\
I =
unless^ r^ - ° °
• • (23)
and, substituting di = dFr in (22) and (22) in (8), we derive,
'* - § -
i - i
.......... <2*>
To paraphrase our equations once more, where the capital-labour ratio is
increasing ^
> 0^, deepening is taking place (d* > 0), and then, as
Harrod (among others) points out, the warranted rate of growth is reduced
and thereby relief is found. But deepening (d* > 0) requires a falling
marginal net product of capital, and hence a falling rate of profit
~ < 0^.
There is a limit to how far the rate of profit can fall, and
hence, unless the marginal net product of capital falls asymptotically to this
df
limit (so that ^
-> — oo , the unlimited investment opportunities argument
again), there is a limit to how long any given rate of deepening (any given
positive value of d*) can be maintained. Thus we should observe that the
rate of deepening is curbed not only by price and money rigidities and
direct institutional constraints on the rate of fall of the equilibrium rate of
return on investment
whatever the freedom from constraints, as long
as there is a lower limit to i (even if only at i = 0), i cannot fall fast for long
without hitting bottom.
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
839
The Saving Function, Asset Preferences and “ Pigou Effects”
We shall now abandon the assumption that saving equals the change in
physical capital and is a constant proportion of output. We shall instead
introduce the saving function,
dW
rn S = s ( r , i , K , y ' )
dt
.
.
.
.
(25)
where W stands for wealth or total accumulated savings and is defined as
W rn K + ^
............................... (26)
the total of physical capital and the real value of cash balances, so that
saving is defined as
dW
dt
We may therefore, substituting in (10), rewrite the formulation of the
warranted rate of growth as
M jP / d log M
K [
dt
d\ogP\
dt j
dlogr
d logF
dt
^
dt
'
}
We shall assume that saving is positive (at least initially) and linear,
homogeneous in income and wealth. Thus with a constant rate of profit
and a constant ratio of wealth to income the saving-income ratio will like
wise remain constant.2 To the extent that the converse is true and, in
particular, that the desire to save is dissipated with increasing income and
wealth, our whole problem would, of course, at least ultimately, disappear.
But that converse assumption has not to my knowledge been argued to be
1 Saving is thus identically equal not to investment but to the sum of investment and the change
in the Government’s real, net obligation to the private sector of the economy. The definition is
analogous to that used in national-income accounts, where saving is made equal to the sum of
investment and the government deficit. It should be realised that, consistent with this definition,
private saving equals income (after taxes) plus government transfer payments and capital gains,
including the increase in the real value of cash balances, minus consumption. This formulation,
in view of our concern with price flexibility, would seem superior to that usually offered (and accepted
by Tobin), where saving is identified only with the change in capital stock. That formulation is,
o f course, identical with ours if the real value of cash balances is assumed to be fixed. But in a
model including variable prices and ruling out money illusion, it seems preferable to identify the
behavioural saving function as that describing the aggregate of individual additions to net worth,
whatever the form in which these additions are embodied. We join Tobin in adopting the simplify
ing assumption that there are no bonds and that the only stores of value are physical capital and
government-issued money.
2 This would appear consistent with the statistical and theoretical work by Kuznets, Modigliani,
Duesenberry, Friedman and others. Tobin’s assumption that saving is zero for some positive income
(loc. cit., p. 104) is not appropriate for the long-run saving function which is relevant.
840
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
currently relevant, and will not be entertained. O u r saving function m ay
be further described b y the follow ing partial derivatives:
SY > 0
S ,| 0
but ^ 0 ................................. (25.2)
SK
S M /P<
and
........................................ (25.1)
<
0
0
........................................ (25.3)
........................................ (25.4)
W ith the possible exception o f (25.2), in which it is assumed that the interest
elasticity o f saving is not sufficient to make any difference, these would not
appear, in the present context at least, to be controversial. A nd in this
context (25.2) need be disturbing only to those w ho stand on the original
neo-classical position that the rate o f interest can be expected to vary
sufficiently to ensure the equality o f investment dem and and saving under
conditions o f full em ploym ent.
T h e form in which savings are held will be described by an asset pre
ference function,
y
=
M (K , i, Y )
..................................(28)
the satisfaction o f which defines a condition o f portfolio balance.
function has the general specifications,
This
M k > 0 ........................................ (28.1)
Mi < 0 .
...........................(28.2)
M
and
t > 0 ........................................ (28.3)
But we shall also endow it with the Keynesian characteristic that the dem and
for liquidity becom es absolute as the rate o f return on investment approaches
some lower limit. Thus we add,
M{
iv
— co as i
or merely, as f = 0 .
.
.
(28.4)
since m oney is presumed to be a non-depreciating store o f wealth, and hence
i ^ ix or i
0
..................................(28.5)
O u r system is now com plete, and the issue can be specified as follows.
Is an actual rate o f growth o f output equal to the solution for the warranted
rate in (27) necessarily consistent (or attainable) with the full-em ploym ent
conditions,
' L = Lg, the labor supply,
(29)
d log L _d log Lt
dt
~
dt
/oon
...............................
and the profit maximisation or “ economic ” relationship
Ft
=
i^
tx or ^ 0
......................... (30)
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
841
along with the related constraints upon rand -j expressed in (19), (20) and
(23)? Or we may pose the issue in perhaps more familiar guise: can we
be sure of equality between the rate of change in the capital-labour ratio
determined by saving and changes in labour supply and the rate of change in
this ratio acceptable to entrepreneurs under the constraints of the production
function and market-determined asset preferences, i.e., can
S
K
M\P fd logM
K \ dt
d\ogP\
dt J
dlogLs _ d\o gr 0
dt
dt "
.
* {* }
Within the framework of an analogous set of relationships,1 it has been
argued (by Tobin), “ In this model, unlike those of Harrod, Hicks and
others, failure of the labor supply to grow at the rate necessary for balanced
growth [constant capital-labor ratio] does not mean that growth at a slower
rate is impossible.55 2 The rate of profit must fall, it is conceded, as the
capital-labour ratio grows, and “ Portfolio balance requires, therefore, that
a given increment of capital be accompanied by a greater price decline than
in the case of balanced growth. But there is some rate of price decline that
will preserve portfolio balance, even1in the extreme case of completely
inelastic labor supply.”
This argument, however, is clearly invalid if the “ given increment of
capital55 would bring the marginal net product of capital below ix (or
below zero), thus violating condition (30). Portfolio balance can then
be preserved only if the price decline reduces the increment of capital
(saving) sufficiently so that Fr ^ ix (or 0).
But can the static “ Pigou effect55 rescue us? Must there always be
some level of prices (above zero) for which real cash balances will be so large
that the supply of saving will be reduced to whatever amount is consistent
with the exogenous growth of the labour force and an economic capital-labour
ratio? For this to be true it must be made clear that our assumption that
SMjP < 0 is not sufficient.3 As indicated by Patinkin,4 the reduced rate
1 In which, however, functional saving is defined as the change in capital stock (cf., footnote 1,
p. 716, above) and is dependent only upon income, thus excluding the Pigou effect, but is assumed
(“ crucially ” ) to be zero for some positive income producible under conditions of full employment
(cf., footnote 2, p. 716, above).
2 Tobin, loc. cit., p. 107. The word “ possible ” in the text seems clearly to have been a mis
print, and I have taken the liberty of changing it to “ impossible ” in my quotation.
3 It is interesting to note that the Pigou effect, which we are here admitting, implies a curious
type of money illusion to which illusion-hostile neo-classicists might wish to take exception. For
an increase in the real value of cash balances makes society no wealthier in “ real ” terms, that is in
goods. The illusion of greater wealth is accepted by private individuals in so far as they consider
the balance sheet o f only the private sector of the economy, and do not reckon that society is in
some sense the debtor as well as the creditor of each dollar of government obligation.
4 Don Patinkin, “ Price Flexibility and Full Employment,” as reprinted in American Economic
Association, Readings in Monetary Theory, especially pp. 267-9, and Money, Interest, and Prices (Evan
ston, Illinois, 1956) p. 236.
38563 O— 59— pt. 4—
16
842
EM PLOYMENT, GROWTH, AND PRICE LEVELS
o f saving resulting from increased cash balances m ay involve an asymptotic
relation in w hich the total possible effect is finite:
d2S
> 0 so that
S Mlp -> 0 as M /P ->
oo
.
(25.5)
T h e econ om ic plausibility o f this argument is suggested b y the observation
that the acquisitive motive, as well as the desire to better oneself, to pass
m ore on when one leaves this w orld than one had when one entered, are
fundamental parts o f the capitalist ethic. W h o really finds that he is rich
enough and ceases trying to get richer? But i f society, no matter h ow great
its wealth, will always strive to accum ulate m ore, we can have no assurance
that, even aside from expectational and other dynam ic considerations,1 the
saving ratio can be made sufficiently low .2
But there is still a w ay out for the growth m odel critics. U nder the
restrictive conditions we have assumed, there must be a consistent solution
for the warranted rate o f growth as defined in (27)— i f we d o not require
price stability. F or with a constant nom inal quantity o f m oney, Af, we
can, from (25) and (26.1), write the increm ent o f capital
.
W ith falling prices ^
.
.
(32)
^ is, o f course, negative and (at least m athe
m atically) there is nothing to prevent this negative value from being indefinitely great, reducing
dK
to any necessary level, regardless o f the supply
o f saving.
“ Equilibrium ” can thus b e m aintained b y a perpetual fall in prices, in
w hich the com m unity “ saves ” b y increasing the real value o f cash balances.
Paraphrasing somewhat Patinkin, we have a “ dynam ic Pigou theorem ,” 3
w hich suggests that there is some rate o f fa ll o f prices sufficient to satisfy the
excess o f the full em ploym ent desire to save over whatever investment
dem and m ay be forthcom ing. T h e reader m ay estimate for him self the
probability o f finding expectations functions, let alone institutional flexi
bilities, w hich w ould make such a solution econom ically plausible.
1 O f course, few to-day, in any event, would argue that the Pigou effect could be expected to
maintain generally full employment in a dynamic system with the substantial fluctuations in demand
which have characterised Western economies.
1 It has been argued that underlying the portfolio balance equation is the desire of individuals
(and the community) to split increments of wealth as between physical and monetary assets in
order to minimise risk (Tobin, pp. 106-7). This would suggest that increments o f wealth in the
form of cash balances would increase the demand for physical capital, although its expected return
were not thereby improved. But it can also be argued that as wealth increases, in line with the
saving motives discussed above, its marginal utility approaches a positive asymptote and the hedg
ing incentive would disappear as marginal utility became constant.
* Cf., Patinkin’8 static “ Pigou theorem ** in “ Price Flexibility and Full Employment,** p. 271.
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
843
Our system has been endowed explicitly with the neo-classical comple
ments of variable factor proportions, flexible prices, cash-balance effects
and a fixed linear, homogeneous production function (thus ruling out the
employment of capital-using innovations like a Deus ex machina to set the
plot straight). By way of summary, we shall describe the operation of this
system when confronted with a rate of growth in the labour supply (ulti
mately Harrod’s “ natural rate of growth ” ) less than the “ proper ” fullemployment rate warranted by the supply of saving. And by way of
simplification of exposition we shall consider the case (suggested by Tobin)
where the supply of labour is “ completely inelastic . . . with respect to the
real wage and with respect to time.”
Since the rate of saving is (by hypothesis) positive, the ratio of capital to
labour must increase continuously and the rate of profit must fall con
tinuously. As the rate of profit falls the community becomes disposed to
take larger and larger proportions of increments of wealth in the form of
money. With a fixed stock of money, successive increments of wealth will
then require successive declines in the level of prices. But as the rate of
profit approaches the value of i at which M { approaches minus infinity we
find the community approaching a situation where no further increase in
the stock of capital and decline in the rate of profit is consistent with port
folio balance, regardless of the decline in the price level (or alternately,
increase in the quantity of money). The rate of profit cannot (in equili
brium) fall below the point of infinite elasticity of the demand for money
because the community stops accepting further increases in capital (which
is what lowers the value of i) as i reaches that lower limit. But this means
that positive saving can take place only in the form of the increased cash
balances stemming from falling prices. And it is only thus that the rela
tively too large (positive)- warranted rate of growth is reducible to equality
with the natural rate.
There is no assurance that such a solution, of perpetually falling prices,
would prove dynamically stable when we admit the role of expectations.
For price declines generating expectations of further price declines would
increase the relative attractiveness of money as compared to physical capital,
and might leave no point of equilibrium as long as there were physical
capital of which individuals might dispose. I shall not attempt to explore
further the difficulties along these lines, but, in any event, it is on this
solution of perpetually falling prices—a “ dynamic Pigou theorem ”—that
a rejection of the possibility of the growth model problems would have to rest.
IV. C o n c l u s i o n
The implications of recent models of economic growth and fluctuation
of the Harrod-Domar-Hicks variety have been challenged as the consequence
of arbitrary assumptions of rigid technological relationships and/or rigid
price relationships. This challenge is unfounded.
844
EM PLOYMENT,
GROWTH. AND PRICE LEVELS
For the Harrod-Domar-Hicks models require no more in the way of a
production function than most of us would be willing to grant as reasonable.
Specifically, they do require a schedule of net marginal productivity of capital
declining in such a way that there is a limit to the capital-labour (or capitaloutput) ratio which is economically feasible. This limit may be reached
at the point where the marginal efficiency of investment equals the rate of
interest set by the Keynesian liquidity trap. It may even be reached only
at the point where the marginal net product of capital is zero (and the
marginal efficiency of investment also zero if expectations are founded on
reality). But limit there must be.
And if there must be an upper limit to the capital-output ratio, there
must, for any saving ratio, be a lower limit to the rate of growth of output
(or labour) which will be consistent with the saving forthcoming. This
minimum “ required 55 rate of growth can then be reduced only to the
extent the saving ratio can be reduced. If the saving ratio will not adjust
automatically, via interest-rate changes or “ Pigou effects,55 to whatever
value is consistent with whatever rate of growth of output obtains, then
there remains some minimum “ warranted,55 “ equilibrium55 or “ fullemployment 55 rate of growth. This rate of growth is thus determined
jointly by the upper limit to the automatic, free adjustment of the capitaloutput ratio and the lower limit to the automatic free adjustment of the
saving ratio. If we do not obtain this rate of growth we are in some kind of
trouble—an underemployment trouble which the models merely seek to
explain, not create.
We are not always in this kind of trouble. We may not always'face a
problem of capital-output ratios and saving ratios determined by free
economic forces being inconsistent with underlying determinants of economic
growth such as population and the development of additional natural
resources. The problem may become remote for substantial periods of
time because of various social or governmental pressures (intended or
unintended) upon these ratios. But whether or not the problem is at any
moment of time crying for solution, it does exist. And in view of the
historical record of cyclical instability, uneven growth and recurring periods
of unemployment in the (private-profit-motivated) capitalistic economies
we have known, the problem seems important. It is perhaps a mark of the
technological backwardness of economic theory that the “ H-D-H dy
namic 55 arrived so late. It will certainly (in the view of this observer) be
a mistake to hasten to discard it.
R
Northwestern University.
Evanston.
obert
E is n e r
EM PLOYM ENT,
G R O W T H , AND PRICE
LEV ELS
845
ROYAL ECONOMIC SOCIETY
PATRON:
HER MAJESTY TH E QUEEN
C O U N C IL :
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Vice-Presidents
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(Whereupon, the committee adjourned, to reconvene on Thursday,
May 28, 1959.)
EMPLOYMENT, GROWTH, AND PRICE LEVELS
TH U BSDA Y, M A Y 28, 1959
C ongress of t h e U n it e d S t a t e s ,
J o in t E c o n o m ic C o m m it t e e ,
Washington, D.C.
The Joint Economic Committee met at 10 a.m., pursuant to recess,
in room P-63, the Capitol, Senator Paul H. Douglas (chairman),
presiding.
Present: Senators Douglas, Bush, and Representatives Widnall,
Patman, and Reuss.
Representative P a tm a n . The committee will please come to order.
We have with us Professor Gurley this morning of the Brookings
Institution. W e are delighted to have you, Professor. You have a
very interesting subject: “ Institutional Frictions in Money and Credit
Markets.”
You may proceed in your own way, sir. Senator Douglas is delayed
temporarily, but he will be here shortly.
STATEMENT OF JOHN G. GURLEY, SENIOR STAFF MEMBER,
BROOKINGS INSTITUTION
Mr. G u r le y . Thank you , Mr. Patman.
I very much appreciate the opportunity that you have given me to
appear before this committee. I shall proceed by reading a few
parts o f my paper and talking about some of the other parts of it.
The monetary authorities attempt to regulate the market for loan
able funds in such a way as to bring about interest rates and other
terms o f lending that are compatible with full employment and
reasonably stable prices.
This market which I propose to examine may be described by a
demand function, a supply function, and equilibrium condition.
There are demand conditions, supply conditions, and equilibrium
conditions to this market.
The demand for loanable funds during any period is the planned
issues o f primary securities coming from consumers, from govern
ments, from business firms. These primary securities are composed
o f corporate bonds, mortgages, consumer debt, Federal Government
securities, State and local securities and claims of this sort; all claims
and equities emanating from the nonflnancial sectors of the economy.
Chart I illustrates that the three channels through which the
primary securities may be sold. First, they may be sold directly to
ultimate lenders.
Second, they may be sold to the monetary system. In this case, the
ultimate lenders acquire not the primary securities but additional
money balances.
847
848
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
Third, the primary securities may be sold to nonmonetary inter
mediaries. These intermediaries are mutual savings banks, savings
and loan associations, life insurance companies, credit unions, pen
sion funds, and similar institutions. I am also including the time de
posits of commercial banks in the category of nonmonetary inter
mediaries. That is, the monetary system is composed of the monetary
accounts o f the Treasury, the Federal Reserve banks, and the demand
deposit departments, so to speak, of the commercial banks.
So the ultimate lenders end up either with the primary securities
themselves, if they are sold directly, or they end up with more money
if they are sold through the monetary system, or they end up with
nonmonetary indirect assets of various types if they are sold through
nonmonetary intermediaries.
The nonmonetary indirect assets take the form of mutual savings
deposists, savings and loan shares, shares in credit unions, policy
holders’ equities in life insurance companies, and similar claims.
That is the demand side of the market for loanable funds. The
supply side is this: the supply of loanable funds during any period
is the demand for primary securities by the ultimate lenders them
selves, by the monetary system, and •by the nonmonetary inter
mediaries.
There is equilibrium in this market whenever the demand for
loanable funds is equal to the supply of loanable funds. But that is
the same thing as saying there is equilibrium when the issues of
primary securities are equal to the demand for these issues.
Whenever the demand for loanable funds exceeds the supply of
loanable funds, interest rates rise on these securities and other terms
of lending tighten. In the reverse case, interest rates fall and other
terms o f lending are eased.
That is a bird’s eye view of the loanable funds market. What I
would propose to do in the next few minutes is to look at each one of
these aspects of the market a bit more carefully than I have up to
this point.
Representative P a t m a n . D o you discuss Federal funds in connec
tion with your statement ?
Mr. G u r l e y . No, I do not. We will start with the demand for
loanable funds.
As I said, the ultimate borrowers’ demand loanable funds by is
suing primary securities. These securities are issued to finance ex
cesses of expenditures over income, that is, deficits? and to finance the
acquisition of financial assets and existing tangible assets such as
land.
Actual gross national expenditures for output by the economy as a
whole (including the foreign sector) are always equal to its gross
national income earned in producing the output. It follows, there
fore, that if some economic units have excess expenditures, or defi
cits, others will have an equivalent amount of excess incomes, or
surpluses. Deficits and surpluses are simply two sides of the same
coin ; like love and marriage in the popular song, you can’t have one
without the other.
There are several other factors that affect the growth of primary
securities; that is, the demand for loanable funds during any period
of time. But I can neglect these now and perhaps come Dack to them
later.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
849
I would now like to look at chart I I on page 9, which shows the
issues o f primary securities as a radio of gross national product by
short business cycles since 1897.
You can see from that chart that except for the two world wars and
the great depression, primary security issues were around 9 or 10 per
cent o f gross national product in each one o f these cycles. That is to
say, if gross national product in some period was on an average $200
billion a year we would find primary security issues of around 10 per
cent o f that, or $20 billion. That is, there would be $20 billion of new
corporate issues plus Government issues plus mortgages plus short
term debt and so forth.
The ratio of primary security issues to gross national product was
quite high in the two World Wars because deficits and surpluses were
quite high. Budget imbalances were high, that is, relative to gross
national product. Also, during those two periods, deficits and sur
pluses were permanently located in sectors. They did not rotate from
one sector to another.
When deficits and surpluses are permanently located in sectors, the
deficits lead to primary security issues in large volume and the sur
pluses lead to accumulations of financial assets in large volume.
In the depression, on the other hand, the ratio of primary security
issues to gross national product was quite low because deficits and
surpluses themselves were quite low relative to gross national product
and because deficits and surpluses rotated among sectors of the
economy.
Now, I will move to the supply side of the loanable funds market.
On the supply side we have the demand for primary securities by ulti
mate lenders, by the monetary system, and by nonmonetary inter
mediaries. I want to discuss each in turn.
During any year ultimate borrowers issue a certain mixture and
amount o f primary securities. In most circumstances, ultimate len
ders demand only a portion of these security issues, since they also
desire to accumulate money and nonmonetary indirect assets (claims
on nonmonetary intermediaries). Ultimate lenders ordinarily want
diversification of their financial assets—some corporate bonds, some
money, some time deposits, and so on.
The portion of primary security issues rejected by ultimate len
ders is sold to the monetary system and to nonmonetary intermedi
aries. When the issues are sold to these intermediaries, ultimate len
ders acquire money and nonmonetary indirect assets rather than pri
mary securities.
What determines the portion of primary security issues wanted by
ultimate lenders? This portion depends, for one thing, on the interest
rates on primary securities. Ultimate lenders will want a large por
tion of primary security issues at high interest rates, a small portion
at low interest rates.
Further, given these interest rates, they will want more or less
primary securities depending on the composition of these securities.
They will increase their purchases if the issues are mostly short-term
and riskless; they will reduce their purchases if the issues are domi
nantly long-term and risky. Moreover, the portion o f primary se
curity issues demanded by ultimate lenders depends on the types of
claims offered by financial intermediaries, and on the interest rates
paid by these intermediaries.
850
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
Ultimate lenders will reduce their demand for primary securities
if these other claims are especially attractive and if intermediaries
pay high deposit rates on them. They will also reduce their de
mand for primary securities as national income rises, for this increases
their need for money balances.
Finally, the portion of primary security issues wanted by ultimate
lenders depends on the stage o f development of techniques for dis
tributing these securities from borrowers to lenders, a subject which
deserves a few more words.
While distributive techniques get primary securities distributed
efficiency from borrower to lender, intermediatiye techniques take
primary securities off the market and substitute In their place in
direct securities—money and nonmonetary indirect assets. The prin
cipal function of financial intermediaries is to purchase primary se
curities from ultimate borrowers and to issue indirect securities for
the portfolios of ultimate lenders.
Part o f the total supply of loanable funds comes from commercial
banks. This section explains how the money-creating powers of
commercial banks change interest rates on primary securities, and
how these powers are controlled by the central bank.
During any year, as we have seen, ultimate borrowers demand
loanable funds by issuing primary securities. Ultimate lenders would
consent to purchase all of these security issues only at very high in
terest. rates. At somewhat lower interest rates, ultimate lenders
would reject a small portion of the security issues. A t very low in
terest rates, they would reject most of them.
Commercial banks, by purchasing primary securities and creating
money, affect the level of interest rates on primary securities. I f
commercial banks purchase a small portion of the primary security
issues, ultimate lenders must purchase the remaining large portion
(neglecting nonmonetary intermediaries for the moment), and they
will do so only at high interest rates.
I f commercial banks purchase a large portion o f the primary se
curity issues, only a small portion is left for ultimate lenders, which
they will consent to purchase at low interest rates. Thus, by varying
the proportion of primary security issues that they purchase, com
mercial banks can change interest rates on these securities.
The reserve mechanism that the central bank has, the Federal Re
serve has, over its member banks, is really a direct control imposed
by the central bank over the commercial banking industry. It is a
direct control in this sense: The commercial banks produce money
output by purchasing two main types of input: reserves and primary
securities. I f they could get all of both types of inputs that they de
sire, there would theoretically be no limit to the amount of money out
put that could be produced. But what the reserve mechanism does is
to control the supply of one o f the bank’s inputs, reserves, and tell the
commercial banks that they must use so much of that input to produce
a dollar o f money output.
O f course by varying the amount of rationed input going to com
mercial banks or by changing the reserve requirement itself, the
central bank can control the level of money output of commercial
banks and in this way control the portion of primary security issues
that commercial banks purchase during any period of time.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
851
The nonmonetary intermediaries too can increase the supply of^
loanable funds and lower rates on primary securities. I am going to
discuss this by first looking at nonmonetary intermediaries, aside
from the time deposits of commercial banks. Then I will look at the
time deposits of commercial banks separately.
Nonmonetary intermediaries increase the supply of loanable funds
by first selling claims on themselves (nonmonetary indirect assets)
for money and then selling the money for primary securities. These
transactions clearly increase the demand for primary securities by
nonmonetary intermediaries. And, just as clearly, the transmissions do
not change the monetary system’s demand for primary securities, for
demand deposits are simply transferred from one holder to another
without affecting total deposits. The question remains whether the
transactions affect ultimate lenders’ demand for primary securities.
The answer to this question depends on what it is that ultimate
lenders want to give up when they purchase nonmonetary indirect
assets. I f they want to give up primary securities, then the increase
in demand for these securities by nonmonetary intermediaries will be
met by an equivalent increase in the supply of them from ultimate
lenders, the result being no change in the total demand.
If, however, ultimate lenders want to give up money and not pri
mary securities, then the increase in demand for primary securities
by nonmonetary intermediaries is a net increase in total demand.
Consequently, the more that nonmonetary indirect assets compete with
money rather than with primary securities in the portfolios of ulti
mate lenders the greater will be the increase in total demand for pri
mary securities when nonmonetay intermediaries expand.
When the growth of nonmonetary intermediaries leads to an
increase in the supply of loanable funds, interest rates on primary
securities fall as the intermediaries increase their demand for these
securities. This can continue for as long as the intermediaries are
willing to sell claims on themselves for money and use the money to
purchase primary securities. The central bank does not attempt in
any direct way to regulate the amount of these transactions.
Now let us look at time deposits.
The time deposit departments of commercial banks are nonmone
tary intermediaries, and the time deposits themselves are nonmonetary
indirect assets. They are “ nonmonetary” because they are not part
o f the money supply: they are not generally accepted as means of
payment. They are “ indirect” because they are claims on a financial
intermediary. This is the one portion o f nonmonetary intermediation
over which the central bank has direct control.
An increase in ultimate lenders’ demand for time deposits increases
time deposits and reduces demand deposits. Because the reserve re
quirement on time deposits is lower than on demand deposits, com
mercial banks are able to increase their demand for primary secu
rities. This increases total demand for primary securities unless
ultimate lenders and other nonmonetary intermediaries reduce their
demands for primary securities by an equal or greater amount.
These demands will be reduced to the extent that ultimate lenders
choose to give up primary securities or other nonmonetary indirect
assets when they purchase time deposits. On the other hand, the more
that time deposits compete with money rather than with primary
securities and other nonmonetary indirect assets the greater will be
852
EM PLOYMENT, GROWTH, AND PRICE LEVELS
the increase in total demand for primary securities when time de
posits grow. Under these circumstances, the growth o f time deposits
is “ inflationary” in the sense that it lowers interest rates on primary
securities.
Representative P a t m a n . May I ask you a question there ?
Mr. G u r l e y . Certainly.
Representative P a t m a n . You state that time deposits are not part
o f the money supply ?
Mr. G u r l e y . That is right.
Representative P a t m a n . A s I understand it, commercial banks do
not keep separate books on time deposits and demand deposits to
the extent that they segregate the additional deposits created by
reason of their ability to do so.
Let us say that a bank has so much in time deposits against which
they have a reserve of 5 percent. But the reserves are intermingled
as I understand it, so that if the bank is loaned up, and a demand
deposit requiring a 20 percent reserve is switched to time deposit,
the bank would be enabled to make loans aggregating $3 million more
in order to be loaned up.
To the extent that deposits can be shifted in this way, I do not see
how your statement is in every way correct when you suggest that
time deposits are not part o f the money supply.
Mr. G u r l e y . Time deposits are not generally accepted as a means
o f payment.
Representative P a t m a n . I know they are not.
Mr. G u r l e y . The commercial bank can create all sorts of things,
Mr. Patman. It can create claims that have maturities of a hundred
years if it obtains permission to do so. But we would not count
everything that banks create as part o f the money supply.
Representative P a t m a n . That is all I care to ask you. You may
continue.
Mr. G u r l e y . An increase in time deposits is inflationary to the ex
tent that time deposits compete actively with money—to the extent,
that is, that an increase in demand for time deposits reduces the de
mand for money holdings.
Representative P a t m a n . Demand deposits are comparable to the
deposits made in other entities such as savings and loans and credit
unions, and institutions like that. How can commercial banks argue
that these institutions are competitors when the commercial banks
have such tremendous power to create money and these others do not
have power to create money at all ?
Mr. G u r l e y . The others do not have power to create money but
they have power to create such things as savings and loan shares.
Those come into the world created too. Credit unions also have
power to create shares or deposits, mutual savings banks have the
power to create mutual savings deposits. These creation powers
are different.
Representative P a t m a n . But they cannot expand on them like the
commercial banks can expand with the Federal Reserve System ?
Mr. G u r l e y . Well, the mutual savings bank does not have quanti
tative controls imposed on it, so it does not have multiple creation in
the legal reserve sense. But that is simply because it is not controlled
in the same way that commercial banks are.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
853
Representative P a t m a n . The mutual savings are only in about
16 States, up here in the northeast.
Mr. G u r l e y . I am using those only as an example.
Representative P a t m a n . But savings and loans cover the entire
country, as do the credit unions?
Mr. G u r l e y . That is right. There is a part of my paper which
covers the question that you have just raised about the creation
powders, although I had not planned to deal with it in this brief state
ment here.
Representative P a t m a n . Very well. Go ahead. I am sorry to
have interrupted you.
Mr. G u r l e y . Chart IV shows the percentage of primary security
issues that wrere purchased by ultimate lenders, the monetary system,
and nonmonetary intermediaries during each of 13 short cycles.
It may be seen that ultimate lenders supplied an increasing share
of loanable funds from 1897-1900 to 1915-21, while the monetary sys
tem supplied a declining share. Nonmonetary intermediates about
held their ow7n over this period, first gaining relatively and then los
ing. The monetary system continued to supply a declining share of
loanable funds during the 1920’s and 1930’s, while nonmonetary in
termediates, on balance, gained significantly.
During 1939-46, w^hen war finance took over, the monetary system
increased its share of loanable funds to 32 percent, but in the post
war period it has again supplied a relatively small part of the total—
about 12 percent since 1947. Nonmonetary intermediaries, on the
other hand, have supplied an increasing share of loanable funds dur
ing this period; since 1950 they have become the dominant force in
the loanable funds market.
In the past decade there have been three brief recessions, but on
the whole there has been excessive demand for current output of
goods and services at prevailing price levels and at relatively full
employment of labor services. This excess demand has led to rising
levels of money wrage rates and commodity prices, and at times these
price increases have anticipated the continuation of excess demands.
The result has been a rise in the consumer price index since 1948 of
20 percent.
Why have monetary policies failed to halt the price increases ? The
basic reason is that these policies have failed to slow down sufficiently
the growth of aggregrate demand for current output of goods and
services. They have failed to do this, I believe, largely because the
monetary system’s supply of loanable funds has not been limited
nearly enough in view' of the very large supply of these funds coming
from other sources, principally from nonmonetary intermediaries.
The monetary authorities have operated under the mistaken belief
that it is sufficient to restrain growTth in the money supply; they have
failed to appreciate the inflationary consequences o f the enormous
increase in the supply of loanable funds that has come from the
creation o f time deposits and claims on nonmonetary intermediaries.
By encouraging the growth of time deposits and by failing to com
pensate for the growth of other nonmonetary indirect assets, they
have permitted the supply of loanable funds to grow too rapidly to
bring aggregate demand dow^n to noninflationary levels.
854
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
During this period the money supply rose by approximately $32
billion, time deposits by $27 billion, and other nonmonetary indirect
assets by $120 billion. The combined growth of time deposits and
other indirect assets exceeded the growth of the money supply on
the order of 5 to 1. In the last 4 years this ratio has been around
10 to 1.
R e p r e s e n ta tiv e P a t m a n . I s i t y o u r u n d e r s ta n d in g th a t th e la w t h a t
p r o v id e s t h a t in te re st s h a ll n o t be p a id on d e m a n d d e p o sits is c o n
sid e re d u n e n fo r c ib le a n d th a t no e ffo r t is r e a lly m a d e to e n fo r c e i t ?
It is violated all over the country, generally by giving certain cus
tomers benefits and favors in different forms in order to compensate
them for their demand deposits.
Mr. G u r l e y . I imagine that that is true, though I do not know
whether it is a technical violation or not.
Representative P a t m a n . It is not a technical one the way I con
strue it.
Mr. Robertson of the Federal Reserve Board said the law is just
simply unenforcible, and Chairman Martin of the Federal Reserve
Board said it was unenforcible.
In a hearing conducted recently the testimony was brought out
that the banks have a lot of ways of violating this law. They pro
vide free parking space; they even give free tickets to Europe, and
tickets to shows.
Mr. G u r l e y . They will even cash checks for one.
Representative P a t m a n . They have many and different ways of
violating it without their actually paying interest in cash over the
counter. I think Congress should take another look at that, do you
not?
Mr. G u r l e y . I think Congress should take another look at the
interest rate, restrictions on both demand deposits and time deposits.
Representative P a t m a n . It is certainly unfair for you as a customer
o f a bank, if your deposit gets down low, to be charged for it when
other depositors are not. Some depositors receive pay indirectly for
a deposit when it reaches a certain stage and others do not receive
anything at all. Do you not think that there should be uniformity
enforced by the commercial bankers themselves in order to give each
persons an equal fair opportunity. Possibly a law should be passed
to require or compel equal treatment o f their customers.
’ Mr. G u r l e y . I have no informed opinion about that, Mr. Patman.
Representative P a t m a n . Very well.
Mr. G u r l e y . The growth of time deposits has been encouraged by
relatively low reserve requirements against these liabilities and, in
recent years, by an increase in the interest rate ceiling on the deposits.
The rapid growth of nonmonetary intermediaries has been due to the
favorable composition of primary security issues during the period
(weighted heavily toward mortgages and consumer debt), to the at
tractive indirect securities they have offered the public, and to the
relatively high deposit rates they have been able to pay.
As interest rates on primary securities have risen, these intermedi
aries have been able to increase the demand for their indirect securi
ties through increases in deposit rates.
The monetary authorities have restrained growth in the supply
o f loanable funds sufficiently over this period to raise interest rates
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
855
on primary securities and to tighten other terms of lending. But, in
view of the heavy demands for current output—and I realize by this
statement, Mr. Patman, I am walking into the lion’s den—interest
rate increases have been on the meager side; indeed, interest rates in
recent years have been low relative to levels attained in previous
periods of prosperity.
Moreover, any level of interest rates may be less effective today in
restraining spending than in the past. In recent years, the composi
tion of demand for loanable funds has swung toward government
and consumers and away from business, and this has probably made
the economy as a whole less sensitive to changes in interest rates. In
addition, high corporate income tax rates have probably made the
business sector itself less sensitive to monetary policy.
Representative P a t m a n . I would like to invite your attention to
one thing about the increases being low.
I f we compare the interest cost of short-term Federal obligations
now with, say, 1945 or 1946-47, the dollar is only worth 10 cents now
in comparison with then, because the rates are 10 times as high. So
when you said that the increases are low, you certainly did not refer
to the cost o f short-term obligation to the Treasury.
Mr. G u r l e y . I am referring to them, but I was not comparing the
interest rates now on those short-term obligations with those that pre
vailed in 1945-46. It is true they are much higher now than they were
then.
Representative P a t m a n . The preceding years too ?
Mr. G u r l e y . I am looking back to the period, say, 1880 on, and
looking at periods of prosperity, including the 1920’s.
Representative P a t m a n . D o you not think that instead o f shooting
for the higher interest rates of the past, we should shoot for the lower
rates that we once maintained over a long period o f time ?
Mr. G u r l e y . I think there is a lot to that argument. I am not
really addressing myself to it at this point. What I am asking is,
W hy did the monetary authorities not stop the rise in prices through
quantitative controls, assuming that they really wanted to do so?
Why didn’t they bring about sufficiently tight credit conditions to
achieve their goal of price stability ? I am not advocating that they
should have made credit a whole lot tighter during the postwar period
than they actually did.
Representative P a t m a n . D o you not agree that if they were to
tighten it to the extent that they would control it, it would cause a
lot more unemployment ?
Mr. G u r l e y . On the whole, we have had price increases during the
postwar period, we have had excess demands for current output, and
full employment.
Representative P a t m a n . Y o u may continue, if you will.
Mr. G u r l e y . The inflationary effect of growth in nonmonetary in
termediaries can be offset by the monetary authorities. All they
need do is to restrain, more than they otherwise would have to do,
the growth o f money and time deposits. This will force primary
securities into the hands of ultimate lenders and so raise interest
rates and tighten other terms of lending. It will compensate for the
rapid growth of financial intermediaries that lie outside o f the con
trolled area.
856
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
But they are not likely to do this if they continue to concentrate
almost exclusively on the money supply and fail to recognize the in
flationary impact of growth in time deposits, savings and loan shares,
mutual savings deposits, shares in credit unions, and so on.
To slow7 down inflation, the monetary authorities, as I have said,
would have had to restrain growth in the supply of loanable funds
more than they did during the past decade. That is, if you wanted
to do it by monetary policy. Given the fact, however, that they have
direct controls only over commercial banks, this would have greatly
curtailed the growth of these institutions. And if inflationary pres
sures continue for another decade, the monetary authorities, to stop
them, will have to crack down hard on commercial banks, especially
if there continues to be rapid growth in the uncontrolled institutions.
This prospect does raise a few questions about our present control
techniques.
The first has to do with the simple matter of equity. Is it equitable
to control one area of financial intermediation wThen, as I have shown,
the activities of all can add to inflationary pressures? The second
question is whether such control techniques can lead to balanced growth
in our economy. Some sectors of the economy are heavily dependent
on funds from commercial banks; other sectors rely more on other
financial institutions.
When commercial bank growth is slowed down to compensate for
rapid growth of other financial intermediaries, we are in effect deny
ing growth to some areas of the economy in order to compensate for
rapid growth in other areas. Is such unbalanced growth tolerable in
our economy ?
Third, what effect in the long run do direct controls over one area
o f financial intermediation have on that area, in view of the fact that
this area is subject to severe competition from other, uncontrolled
intermediaries ? Does the controlled area in the long run lose vitality,
fail to attract the best leaders, fail to attract sufficient capital, lower
the quality of its product, and fail to supply funds to borrowers on
the frontiers of economic growth ?
Finally, when a relatively diminishing area of financial intermedi
ation is subject to controls, does so much “ slippage” develop in the
mechanism as to make it impossible to formulate intelligent monetary
policies ? These are the questions that must be answered in deciding
whether to string along with our present control techniques for another
decade.
Thank you.
Representative P a t m a n . And you want to insert the tables, too?
Mr. G u r l e y . Yes.
Representative P a t m a n . Your statement will be inserted in the
record, and also the tables, at this point.
(The material referred to follow s:)
M o n e ta ry T h e o ry and F in a n c ia l I n s titu tio n s
(John G. Gurley, Brookings Institutionx)
The monetary authorities attempt to regulate the market for loanable funds
for the purpose of achieving interest rates and other terms of lending that are
1 The views expressed in this paper are those of the author. They do not necessarily
reflect the views of other members of the Brookings staff or of the administrative officers
of the institution.
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
857
compatible with policy goals of steady output growth at reasonably stable prices.
The market for loanable funds is the market the monetary authorities enter in
their efforts to influence prices and quantities on other markets. It is this
market, therefore, that must be studied first.
THE MARKET FOR LOAN FUNDS
This market can be described by a demand for loanable funds, a supply of
loanable funds, and an equilibrium condition. I proceed in that order.
The demand for loanable funds
The demand for loanable funds, during any period, is the planned issues of
primary securities by nonfinancial economic units—by consumers, business firms,
and Government units. Primary securities are the obligations of these economic
units, and they include corporate bonds and equities, short-term business debt,
trade debt, consumer debt, mortgages, Federal, State and local government securi
ties, and other claims.
As chart I illustrates, ultimate borrowers may sell primary securities through
any of three channels: (1) directly to ultimate lenders; (2) indirectly to them
through the monetary system; or (3) indirectly to them through nonmonetary
financial intermediaries.
CHART I
The Market for Loanable Funds
Monetary System
Ultimate
Borrowers
Primary security issues
Nonmonetary
Intermediaries
*
Ultimate
Lenders
Increase in
^nonmonetary
indirect assets
When primary securities are sold directly to ultimate lenders, the latter of
course acquire these securities. This is called direct finance.
When primary securities are sold to the monetary system, the ultimate
lenders acquire money balances instead of primary securities. This is called
indirect finance through the monetary system. Money is defined as currency
outside of banks, adjusted demand deposits, and U.S. Government demand de
posits. The monetary system includes the monetary accounts of the Treasury,
Federal Reserve banks, and commercial banks. This system excludes the time
deposit departments of commercial banks.
When primary securities are sold to nonmonetary financial intermediaries,
ultimate lenders acquire, instead of primary securities, claims on these inter
mediaries, or nonmonetary indirect assets. This is called indirect finance
through nonmonetary intermediaries. These intermediaries include time de
posits of commercial banks, mutual savings banks, savings and loan associations,
life insurance companies, credit unions, private pension funds, and similar
38563— 59— pt. 4------ 17
858
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
institutions. Nonmonetary indirect assets are time deposits, mutual savings
deposits, savings and loan shares, and so on.
The supply of loanable funds
The supply of loanable funds, during any period, is the demand for primary
securities by ultimate lenders, the monetary system, and nonmonetary inter
mediaries.2 These demands, as chart I shows, lead to accumulations by ultimate
lenders of primary securities, money, and nonmonetary indirect assets.
Market equilibrium
The market for loanable funds is in equilibrium when the total demand for
loanable funds is equal to the total supply of loanable funds. It is in equilibrium,
in other words, when issues of primary securities by ultimate borrowers are
equal to total demand for these securities by ultimate lenders, the monetary
system, and nonmonetary intermediaries. When there is excess demand for
loanable funds, interest rates on primary securities rise and other terms of
lending tighten. When there is excess supply of loanable funds, interest rates
on primary securities fall and other terms of lending are eased.
The scope of monetary controls
The monetary authorities ordinarily do not control directly the demand for
loanable funds. Further, they have no direct control over the supply of loanable
funds coming from ultimate lenders and from nonmonetary intermediaries. In
stead, monetary controls usually impinge on only one portion of the total supply
of loanable funds— that coming from the monetary system.
The monetary authorities seek to regulate the total supply of loanable funds
in relation to the total demand for these funds. They try to bring about an
excess demand for loanable funds when they want credit tightness. They en
deavor to achieve an excess supply of loanable funds when they want credit
ease. The purpose of credit tightness is to reduce spending for current output
and to lower commodity prices. Credit ease is meant to increase spending for
current output and raise commodity prices. Hence, by controlling one portion
of the total supply o f loanable funds, the monetary authorities attemp to in
fluence total economic activity.
The scope of this paper
The following pages examine more closely the various parts of the market for
loanable funds that we have just looked at briefly. The discussion is both
analytical and empirical.
THE DEMAND FOR LOANABLE FUNDS I ISSUES OF PRIMARY SECURITIES
Ultimate borrowers demand loanable funds by issuing primary securities.
These securities are issued to finance excesses of expenditures over income on
income and product account (deficits), and to finance the acquisition of financial
assets and existing tangible assets (e.g., land).
Determinants of primary security issues.
Actual gross national expenditures for output by the economy as a whole
(including the foreign sector) are always equal to its gross national income
3 This is what the orthodox definition boils down to.
Is defined a s :
Planned saving by economic units
The supply of loanable funds
Increase in stock o f money
Increase in economy’s demand for money (hoarding).
Assuming that saving and investment are done by different groups and that savers do
not repay debts, planned saving is equal to economic units’ increase in demand for primary
securities, money, and nonmonetary indirect assets. The increase in the economy’s demand
for money minus that of economic units is the increase in demand for money by non
monetary intermediaries. With these definitions, the supply of loanable funds is redefined
as:
Economic units’ increase in demand for primary securities
Economic units’ increase in demand for nonmonetary indirect assets
Increase in stock of money
Nonmonetary intermediaries’ increase in demand for money.
The second item is fequal to nonmonetary intermediaries’ increase in demand for primary
securities and money; the third item is equal to the monetary system’s increase in demand
for primary securities, neglecting gold. This yields my definition
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
859
earned in producing the output. It follows, therefore, that if some economic
units have excess expenditures, or deficits, others will have an equivalent amount
of excess incomes, or surpluses. Deficits and surpluses are simply two sides of
the same coin; like love and marriage in the popular song, you can’t have one
without the other.3
Economic units with deficits generally finance the deficits by issuing primary
securities, though they may use their previously accumulated financial assets.
Economic units with surpluses generally “ invest” the surpluses in financial assets,
though they may reduce previously incurred debt.4 Consequently, the growth o f
deficits and surpluses among economic units generally leads to larger issues o f
primary securities and accumulations of financial assets.
Given the size of deficits and surpluses, the growth of primary securities and
financial assets is larger when deficits and surpluses are located more or less
permanently among economic units, for chronic deficits are eventually financed
by issues of primary securities and chronic surpluses are eventually “ invested”
in financial assets. On the other hand, when deficits and surpluses “ rotate”
rapidly among economic units, primary security issues and financial-asset ac
cumulations are generally small. The reason is that deficit-surplus rotation
gives economic units greater opportunity to shuttle existing financial assets
back and forth to each other, without having to create new ones.
Primary security issues also tend to be relatively large when economic units
issue these securities for the purpose of acquiring financial assets. Security
issues for this purpose are more likely to occur as the structure o f financial
assets becomes more variegated—as there are more and more different types
of financial assets from which to choose. Then it becomes increasingly rational
for economic units to be in debt and to hold financial assets at the same time.
Primary security issues and GNP, 1897-1958
Over the long period from 1897 to 1958, net issues of primary securities
(valued at issue prices) averaged around 10 percent of the sum of gross na
tional product (valued in current prices).5 That is, it required about $10 of
primary debt and equity issues to finance each $100 of expenditures for current
output.
Primary security issues during 14 short business cycles since 1897 are com
pared to GNP in chart II. Each ratio is found by dividing primary security
issues during a cycle by the sum of GNP during that cycle. Each short cycle
begins with a recovery year and ends with a recession or depression year. It
is clear that the ratio of issues to GNP got out of line only during short cycles
characterized by war or deep depression; it was high in the former periods and
low in the latter. In the other 10 short cycles, the ratio moved within the
narrow range of 7.5 to 10.6 percent, shown by the shaded area in the chart.
There is no evidence of an upward or downward trend over this long period.
The ratio rose above its normal range only when GNP itself rose sharply
above its previous levels, as during the two World Wars. In these years deficits
were abnormally high relative to GNP and both deficits and surpluses were
chronically embedded among sectors of economic units. Both of these factors
led to relatively large security issues. The ratio fell below the normal range
only when GNP fell abruptly and moved along at levels well below those previ
ously attained, as during the 1930’s. In that decade, deficits were low relative
to GNP and defieit-surpluses rotation was prevalent. These factors produced
relatively low security issues.
8 Deficits and surpluses reflect the fact that the distribution of spending among economic
units is not the same as the distribution of income among them. I f these distributions
were exacly the same, each economic unit would have a balanced budget, and all expendi
tures for current output by each unit would be financed internally from that unit’ s current
income.
A financial system restrains output growth, however, if it ties the distribution of
spending too rigidly to the distribution of income among economic units. This is because
the economic units with the most productive spending opportunities are not necessarily
those with current income to cover such spending.
I f investment projects are to be
exploited in order of their expected profitability, it is generally necessary for some economic
units to spend in excess of their current incomes and others to spend less than their cur
rent incomes. That is, an efficient ordering of spending throughout the economy generally
requires deficits by some economic units and surpluses by others.
4 For simplicity I am ignoring trading in existing tangible assets.
6 Primary securities include Government securities, corporate bonds and equities, mort
gages, and a variety of short- and intedmediate-term debt.
860
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
CHART II
Ratio of Primary Security Issues to
GNP by Short Cycles, I897-I958
Based on data in Appendix Table I
Composition of primary security issues, 1897-1958
The composition of primary security issues depends on the rate and pattern
of real economic activity over periods that vary from the long sweep of a cen
tury to the seasons of a single year. For decades Government units may play
so large a role in economic activity that Federal, State, and local government
issues dominate the security markets. Over other long periods the corporate
business sector may be bidding for the lion’s share of loanable funds, so that
corporate bonds, equities, and short-term business debt take precedence. Mort
gages are issued in heavy volume during the rising phases of the building cycle,
and then dry to a trickle when construction activity is at low ebb.
Over the shorter periods of business cycles, the composition of primary secu
rity issues seems to vary systematically. During early recovery years, the flow
of issues tends to be most heavily weighted with short-term business borrowing,
and long-term flotations feature bonds rather than equities. In the later phases
of the upturn, corporate bond issues may decline as equities appear in heavier
volume. Recession and depression minimize private short-term issues ; bond
financing becomes more attractive; and the Federal Government often succeeds
State and local governments on the security markets. There is variation in
the composition of primary security issues, too, between intervals of war and
peace and between periods of net foreign investment and disinvestment.
Chart III shows the composition of primary security issues during five long
periods since 1897. Each period had its distinctive rate and pattern of real
growth and hence its own mixture o f primary security issues. The relatively
high levels of Government expenditures during 1933-46 led to Government issues
that almost completely dominated the security markets. The construction
booms of the 1920’s and the recent postwar period show up in relatively heavy
mortgage issues. The dominance of business spending in 1897-1914 is clearly
reflected, too, in these financial data. The real world and the financial world
are actually one world.
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
861
S u p p l y of L o an able F u n d s : U l t im a t e L en ders
I turn now to the other side o f the market. The supply o f loanable funds
comes from ultimate lenders, the monetary system, and nonmonetary inter
mediaries. Each is taken up in turn.
Ultimate lenders and portfolio diversification
During any year ultimate borrowers issue a certain mixture and amount o f
primary securities. In most circumstances, ultimate lenders demand only a
portion of these security issues, since they also desire to accumulate money and
nonmonetary indirect assets (claims on nonmonetary intermediaries). Ultimate
leaders ordinarily want diversification of their financial assets—some corporate
bonds, some money, some time deposits, and so on. The portion o f primary
862
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
security issues rejected by ultimate lenders is sold to the monetary system and
to nonmonetary intermediaries. When the issues are sold to these inter
mediaries, ultimate lenders acquire money and nonmonetary indirect assets
rather than primary securities.
What determines the portion of primary security issues wanted by ultimate
lenders? This portion depends, for one thing, on the interest rates on primary
securities. Ultimate lenders will want a large portion of primary security
issues at high interest rates, a small portion at low interest rates. Further,
given these interest rates, they will want more or less primary securities de
pending on the composition of these securities. They will increase their pur*
chases if the issues are mostly short-term and riskless; they will reduce their
purchases if the issues are dominantly long term and risky. Moreover, the
portion of primary security issues demanded by ultimate lenders depends on
the types of claims offered by financial intermediaries, and on the interest rates
paid by these intermediaries. Ultimate lenders will reduce their demand for
primary securities if these other claims are especially attractive and if inter
mediaries pay high deposit rates on them. They will also reduce their demand
for primary securities as national income rises, for this increases their need for
money balances. Finally, the portion of primary security issues wanted by
ultimate lenders depends on the stage of development of techniques for dis
tributing these securities from borrowers to lenders, a subject which deserves
a few more words.
Development of distributive techniques
Good distributive techniques get primary securities distributed efficiently from
borrower to lender. These techniques include the broadcast of information— to
borrowers regarding the asset preferences of lenders and to lenders regarding the
issues of borrowers. They include, too, a widespread network of communication
that tends to overcome regional market barriers. Facilities for rapid contract
and settlement of loan transactions— security exchanges—increase the resem
blance of security markets to competitive commodity exchanges. Facilities for
brokerage, for market support and seasoning of new issues, for dealer inven
tories, for future as well as spot deliveries are other familiar distributive tech
niques. The guarantee of private securities by Government and the issue of
Government securities themselves in place of private securities are still other
examples.
The development of these techniques increases ultimate lenders’ demand for
primary securities. They widen security markets and permit each borrower and
lender a higher degree of diversification in his debt and financial assets. In
vesting in primary securities alone, each lender can spread his budget o f financial
assets over a greater variety of claims than he could acquire on local markets.
He can increase the advantages associated with the last dollar’s worth o f pur
chases of primary securities. And each borrower can diversify the form of his
debts, reducing the disadvantages associated with the last dollar’s worth of
indebtedness.6
SUPPLY OF LOANABLE FUNDS
FINANCIAL INTERMEDIARIES
While distributive techniques get primary securities distributed efficiently
from borrower to lender, intermediative techniques take primary securities off
the market and substitute in their place indirect securities—money and non
monetary indirect assets. The principal function of financial intermediaries is
to purchase primary securities from ultimate borrowers and to issue indirect
securities for the portfolios o f ultimate lenders.7
Financial intermediaries may be divided into two main groups: the monetary
system and nonmonetary intermediaries, the latter including time deposits of
commercial banks. In its intermediary role, the monetary system purchases
8
The development of distributive techniques tends to raise the level of investment and
saving by increasing the marginal utility of the last dollar’ s worth of financial assets to the
lender and reducing the marginal disutility of the last dollar’s worth of debt to the bor
rower.
A t the same time, such development tends to increase the efficiency of resource
allocation by pitting more investment opportunities against one another for lenders to
look over.
7
Intermediative techniques give lenders a wide variety of financial assets particularly
suited to them and at the same time make it less necessary for borrowers to issue types
o f securities that are ill-adapted to their businesses. Like distributive techniques, then,
Intermediative techniques raise the marginal utility of the last dollar’ s worth of financial
assets to the ultimate lenders and reduce the marginal disutility of the last dollar’s worth
o f debt to borrowers.
In these ways, they tend to raise investment and saving and to
allocate scarce savings optimally among investment alternatives.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
863
primary securities and creates money. In its role as administrator of the pay
ments mechanism, the monetary system transfers deposit credits on its ledgers be
tween economic units. Nonmonetary intermediaries purchase primary securities
and create nonmonetary indirect assets.
There are various criteria for classifying nonmonetary intermediaries. Some
intermediaries are private, others governmental. Mutual savings banks, savings
and loan associations, private life insurance companies, and credit unions, among
others, are included in the former category. Federal land banks, the postal
savings system, and Government trust funds, among others, are in the latter.
Some of the private intermediaries are incorporated for stockholders’ profit, and
some are mutuals. Most purchase a narrow band of primary securities—mort
gages, or corporate equities, or government securities—while a few purchase a
wide assortment. Many intermediaries issue only a few varieties of indirect
securities, but others, such as life insurance companies, have a bewildering array
of issues. A few intermediaries, principally sales finance companies, rely heav
ily on other intermediaries as purchasers of their indirect securities.
The product of intermediation is the indirect financial asset coined from the
underlying primary security and bearing its own utilities. The reward of inter
mediation arises from the difference between the rate of return on primary
securities held by intermediaries and the interest or dividend rate they pay on
their indirect debt. There are notable differences among indirect financial as
sets,, in the utilities that command a market price and yield a profit to inter
mediation. Money is a means of payment, claims on life insurance companies
provide a defense against misfortune, shares in mutual funds offer opportunities
for capital gains, shares in credit unions and deposits in mutual savings bank
provide utilities of convenience and perhaps camaraderie, and shares in sav
ings and loan associations may give one future access to mortgage funds. Yet
there are also notable similarities among indirect financial assets. For most
of them there is a constant or determinable redemption value, and investment
costs are low. Contracts are divisible into convenient units from low to high
denomination. In these and other respects, indirect financial assets are a class
apart from the bulk of primary securities that are the raw material for the
process of intermediation.
SUPPLY OF LOANABLE FUNDS: MONETARY INTERMEDIATION
Part of the total supply of loanable funds comes from commercial banks.
This section explains how the money-creating powers of commercial banks change
interest rates on primary securities, and how these powers are controlled by
the central bank.
Monetary intermediation and interest rates
During any year, as we have seen, ultimate borrowers demand loanable funds
by issuing primary securities. Ultimate lenders would consent to purchase all
of these security issues only at very high interest rates. At somewhat lower
interest rates, ultimate lenders would reject a small portion of the security
issues. At very low interest rates, they would reject most o f them.
Commercial banks, by purchasing primary securities and creating money, affect
the level of interest rates on primary securities. I f commercial banks purchase
a small portion of the primary security issues, ultimate lenders must purchase
the remaining large portion (neglecting nonmonetary intermediaries for the
moment), and they will do so only at high interest rates. I f commercial banks
purchase a large portion of the primary security issues, only a small portion is
left for ultimate lenders, which they will consent to purchase at low interest
rates. Thus, by varying the proportion of primary security issues that they
purchase, commercial banks can change interest rates on these securities.
The nature of quantitative controls
The central bank imposes quantitative controls on (member) commercial
banks for the purpose o f regulating the total supply of loanable funds so as to
produce interest rates and other terms of lending that are compatible with steady
output growth at reasonably stable prices. These controls are administered
through changes in reserves and reserve requirements.
Reserves are claims on the central bank which must be held by commercial
banks in some (minimum) proportion to their own liabilities. These claims
are, of course, created by the central bank when it purchases assets. Com
mercial banks are required to hold them in an amount that is usually some mini
864
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
mum percentage o f their deposit liabilities. This minimum percentage is the
reserve requirement.
The reserve mechanism is a direct control imposed by the central bank over
the commercial banking industry. Commercial banks produce money output
by purchasing inputs of reserves and primary securities. In many circum
stances, given their deposit rate, as set by the central bank, commercial banks
would like to produce more money than economic units are willing to hold at
the income, price, and interest rate levels aimed at by the central bank. There
fore, the money output of commercial banks must be reduced below the level at
which the banks would like to operate. The central bank does this by rationing
one of the banks’ inputs and specifying how much of it is to be used per unit
o f their output. The rationed input is the reserves of commercial banks, and
the reserve requirement defines how much of this rationed input must be used
to produce a dollar of output.,
The rationed input is produced and allocated through purchases of primary
securities and other assets by the central bank. The more of these assets that
the central bank purchases the more of the rationed input becomes available
to commercial banks for use in money production. The central bank, then,
controls the supply of the rationed input and, through the reserve requirement,
places a ceiling over money output. A dollar of money output, for example,
may require 20 cents of the rationed input and 80 cents of other, unrationed,
Inputs.8
Quantitative controls and interest rates
The central bank and commercial banks both supply loanable funds by de
manding primary securities. The primary securities (and other assets) held
by the central bank determine the reserves of commercial banks. These re
serves, along with the reserve requirement, determine the amount of primary
securities that commercial banks can hold. The reserve requirement, therefore,
is a method of sharing primary securities between the central bank and com
mercial banks. In general, the higher the reserve requirement the larger is
the central bank’s share of the primary securities held by it and commercial
banks together—by the monetary system.
The central bank can increase the monetary system’s supply of loanable funds
by purchasing primary securities and creating reserves on which commercial
banks can purchase additional primary securities. The central bank can also
lower the reserve requirement, allowing commercial banks to purchase addi
tional primary securities. The resulting increase in the supply of loanable
funds lowers interest rates on primary securities. Opposite policies by the
central bank raise interest rates.
SUPPLY OF LOANABLE FUNDS: NONMONETARY INTERMEDIATION
Nonmonetary intermediaries, too, can increase the supply of loanable funds
and lower interest rates on primary securities. I discuss this by first looking
at nonmonetary intermediaries other than time deposits of commercial banks.
Time deposits are dealt with after that.
Nonmonetary intermediation and interest rates
Nonmonetary intermediaries increase the supply of loanable funds by first
selling claims on themselves (nonmonetary indirect assets) for money and then
selling the money for primary securities. These transactions clearly increase
the demand for primary securities by nonmonetary intermediaries. And, just
as clearly, the transactions do not change the monetary system’s demand for
primary securities, for demand deposits are simply transferred from one holder
to another without affecting total deposits. The question remains whether the
transactions affect ultimate lenders’ demand for primary securities.
The answer to this question depends on what it is that ultimate lenders want
to give up when they purchase nonmonetary indirect assets. I f they want to
give up primary securities, then the increase in demand for these securities by
8
Put this way, the method is quite familiar. To lim it the output of some industries in
Wartime, the Government rations certain scarce inputs (materials) to them. Given the
amount of these inputs that are needed to produce a unit of output, a ceiling is placed
on the total output of the industry. The difference here is that the Government does not
specify the “ reserve requirement” to these industries— the amount of the rationed input
that must be used per unit of output. But in most industrial processes this is fairly well
set by technological conditions.
EMPLOYMENT,
GROW TH, AND PRICE LEVELS
865
nonmonetary intermediaries will be met by an equivalent increase in the supply
of them from ultimate lenders, the result being no change in the total demand.
If, however, ultimate lenders want to give up money and not primary securities,
then the increase in demand for primary securities by nonmonetary intermedi
aries is a net increase in total demand. Consequently, the more that nonmone
tary indirect assets compete with money rather than with primary securities
in the portfolios of ultimate lenders the greater will be the increase in total
demand for primary securities when nonmonetary intermediaries expand.
More generally, the extent to which nonmonetary intermediaries increase the
total supply of loanable funds in any period depends on the absolute amount of
their expansion, the degree of substitutability between money and the various
claims on other intermediaries, and the incremental demand for money by inter
mediaries as they expand.
When the growth of nonmonetary intermediaries leads to an increase in the
supply of loanable funds, interest rates on primary securities fall as the inter
mediaries increase their demand for these securities. This can continue for as
long as the intermediaries are willing to sell claims on themselves for money
and use the money to purchase primary securities. The central bank does not
attempt in any direct way to regulate the amount of these transactions.
Time deposits and interest rates
The time deposit departments of commercial banks are nonmonetary
intermediaries, and the time deposits themselves are nonmonetary indirect
assets. They are “ nonmonetary” because they are not part of the money supply:
they are not generally accepted as means of payment. They are “ indirect” be
cause they are claims on a financial intermediary. This is the one portion of
nonmonetary intermediation over which the central bank has direct control.
An increase in ultimate lenders’ demand for time deposits increases time depos
its and reduces demand deposits. Because the reserve requirement on time
deposits is lower than that on demand deposits, commercial banks are able to
increase their demand for primary securities. This increases total demand for
primary securities unless ultimate lenders and other monetary intermediaries
reduce their demands for primary securities by an equal or greater amount.
These demands will be reduced to the extent that ultimate lenders choose to give
up primary securities or other nonmonetary indirect assets when they purchase
time deposits. On the other hand, the more that time deposits compete with
money rather than with primary securities and other nonmonetary indirect as
sets the greater will be the increase in total demand for primary securities when
time deposits grow. Under these circumstances, the growth of time deposits is
“inflationary” in the sense that it lowers interest rates on primary securities.
A DIGRESSION ON ALLEGED DIFFERENCES BETWEEN COMMERCIAL B A N K S AND
NONM ONETARY INTERMEDIARIES
I have attempted to show that there is no analytical difference o f any impor
tance between commercial banks and nonmonetary intermediaries. In particular,
both are capable of creating loanable funds, lowering interest rates on primary
securities, and adding to aggregate demand for goods and services. I have not
dealt, however, with all the alleged differences between these two types of
institution. In this section I wish to cover the more important of these.
Banks “ create” money
It is frequently said that commercial banks are a class apart from other finan
cial institutions because they create money. To begin with, put the emphasis on
“ create.” It is clear, though, that there is nothing strange in the fact that com
mercial banks create something. All financial assets in the economy are created.
Corporate bonds are created by corporations, mortgages by individuals and
others, mutual savings deposits by mutual savings banks, and so on.
Money is created when the monetary system purchases nonmonetary assets,
mainly primary securities. Other financial assets are created when their issuers
purchase money— yes, “ purchase” money, because money is also a claim, though
generally a non-interest-bearing one. The difference between, say, mutual sav
ings banks and commercial banks is that the former create savings
deposits by purchasing money, while the latter create money by purchas
ing, say, bonds. And the difference, in this regard, between nonfinancial
corporations and commercial banks is that the former create bonds by purchas
866
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
ing money, while the latter create money by purchasing bonds. These are, of
course, differences, but there is nothing in these processes of creation to suggest
that we should stand in awe of one at the expense of the others.
Banks create “money”
Now put the emphasis on “money” ; that is, banks are different because they
create money. The implication of this may be that money is inherently more
important than other financial assets. It is true that money, as the means of
payment, is a highly useful financial assets. But so are financial assets, such as
corporate equities, that give people the opportunity to participate in private en
terprise ; or financial assets, such as claims on insurance companies, that protect
one’s family against a myriad of catastrophes. And money, as a liquid asset
to hold, has many close competitors.
The implication, however, may be that only the creation o f money is “ infla
tionary.” But this is wrong. I have already shown that the creation of non
monetary indirect assets can lead to an increase in the total supply of loanable
funds, which lowers interest rates on primary securities. Lower interest rates,
along with easier terms of lending generally, can generate an excess demand for
current output at prevailing price levels. In this way the creation of non
monetary indirect assets may produce an excess of ex-ante investment over
ex-ante saving, which place upward pressure on output and prices. Thus, the
growth of both commercial banks and nonmonetary intermediaries may be
inflationary.
In quantity theory terms, commercial banks can add to inflationary pres
sure by creating money; nonmonetary intermediaries can do the same thing
by increasing the velocity of money through the creation of nonmonetary in
direct assets. The money-creating institutions are unique in being able to raise
M ; nonmonetary intermediaries are unique among financial institutions in being
able to raise V.
The process of multiple creation
Let’s now go back to “ creation” and take up the allegation that commercial
banks are different because they engage in multiple creation of deposits. In
analyzing this, I have to distinguish between multiple creation in the general
sense and multiple creation in the legal reserve sense.
In the general sense, multiple creation is found almost everywhere. Take
automobiles. Suppose that the production process calls for 10 cents’ worth of
rubber inputs and 90 cents’ worth of other inputs to produce a dollar of auto
mobiles. Then automobiles are produced or created in a ratio of 10 to 1 to
rubber inputs. This is multiple creation of automobiles. Housewives create
omelettes by some multiple of cream inputs. Laundries create laundry serv
ices by some multiple of their starch inputs. There is multiple creation in each
of these cases because the value of the output exceeds the value of any one of
the inputs with which the output is being compared.
In much the same way, there is multiple creation of financial assets by all
financial intermediaries. Commercial banks create money by purchasing a
variety of assets. If the money output is compared to any one of the banks'
asset inputs, it is clear that the output is a multiple of this input. Mutual
savings banks create savings deposits by purchasing money and with the money
purchasing primary securities of various types. I f the savings deposits are
compared with any one of the savings banks’ assets, we find that there has
been multiple creation of savings deposits. The same is true for all financial
intermediaries. This is simply a way of saying that it generally takes more
than one ingredient to make a cake, the value o f the cake being a multiple of
the value of any one of the ingredients.
EM PLOYM ENT,
GROWTH, AND PRICE LEVELS
867
In the legal reserve sense of the term, only commercial banks engage in
multiple creation, because only commercial banks are subject to quantitative
controls in the form of legal reserves. Multiple creation in this sense means
that commercial banks must purchase a dollar’s worth of a special input in
order to produce several dollar’s worth of output. It is obvious, then, that the
value of the output is a multiple of this special input. All nonmonetary inter
mediaries, however, would engage in multiple creation if they, too, were subject
to quantitative controls—if they had to purchase a dollar’s worth of a special
input to produce several dollar’s worth of output, In brief, if there is anything
different about commercial banks in this respect it is because they are controlled:
they are not controlled because they are different.
Volatility
It is felt that commercial banks are different from other financial institu
tions in that they are inherently more unstable or more volatile. This, I think,
is largely an illusion that arises from the fact that commercial banks are con
trolled by the central bank while other intermediaries are not.
Commercial bankers often have a profit incentive to produce more money
output than the central bank wants them to produce. To limit production, the
central bank imposes direct controls by rationing one of the banks’ inputs and
specifying how much of this input is to be used per unit of the banks’ output*
The imposition of these direct controls, along with restrictions on free entry,
creates a disequilibrium system in the banking industry— an excess o f the
money supply that banks would like to produce over the money supply that they
are forced to produce. As in any disequilibrium system, pressures are created
that make the industry look quite volatile.
In this situation of strain, an increase in total reserves or a reduction in
reserve requirements would naturally lead to a rapid and almost explosive
expansion of output to the new legal limit. And, of course, a tightening of con
trols would cause banks to contract output rapidly—for that is the law. Thus,
when controls are first eased and then tightened and then eased on an industry
in a disequilibrium position, an illusion is created from the responses o f the
industry that there is something inherently unstable about it.
There is not much doubt that nonmonetary intermediaries would exhibit
much the same tendencies if they were subject to similar quantitative controls.
TH E SUPPLY OF LOANABLE FUNDS ! TH E RECORD, 1 8 9 7 - 1 9 5 8
The supply of loanable funds comes, as I have shown, from ultimate lenders
and financial intermediaries, including the monetary system and nonmonetary
intermediaries. The record of this supply from 1897 to 1958 is now presented.
Chart IV shows the percentage of primary security issues that were purchased
by ultimate lenders, the monetary system, and nonmonetary intermediaries
during each 13 short cycles.9 Nonmonetary intermediaries, for this purpose,
include time deposits of commercial banks, mutual savings banks, savings and
loan associations, life insurance companies, credit unions, postal savings systems,
and private pension funds.
9 I have combined the two short cycles of 1928-33 and 1934-38 into one period, solely
for simplicity of chart presentation.
868
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
CHART IV
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
869
It may be seen that ultimate lenders supplied an increasing share of loanable
funds from 1897-1900 to 1915-21, while the monetary system supplied a declin
ing share. Nonmonetary intermediaries about held their own over this period,
first gaining relatively and then losing. The monetary system continued to
supply a declining share of loanable funds during the 1920’s and 1930’s,10 while
nonmonetary intermediaries, on balance, gained significantly. During 1939-46,
when war finance took over, the monetary system increased its share of loanable
funds to 32 percent, but in the postwar period it has again supplied a relatively
small part of the total—about 12 percent since 1947. Nonmonetary intermedi
aries, on the other hand, have supplied an increasing share of loanable funds
during this period; since 1950 they have become the dominant force in the
loanable funds market.
M ONETARY POLICY DURING TH E RECENT POSTWAR PERIOD
In the past decade there have been three brief recessions, but on the whole
there has been excessive demand for current output of goods and services at
prevailing price levels and at relatively full employment of labor services.
This excess demand has led to rising levels of money wage rates and commod*
ity prices, and at times these price increases have anticipated the continuation
of excess demands. The result has been a rise in the consumer price index
since 1948 of 20 percent.
Reasons for failure of monetary policies
Why have monetary policies failed to halt the price increases? The basic
reason is that these policies have failed to slow down sufficiently the growth
of aggregate demand for current output of goods and services. They have
failed to do this, I believe, largely because the monetary system’s supply of
loanable funds has not been limited nearly enough in view of the very large
supply of these funds coming from other sources, principally from nonmonetary
intermediaries. The monetary authorities have operated under the mistaken
belief that it is sufficient to restrain growth in the money supply; they have
failed to appreciate the inflationary consequences of the enormous increase in
the supply of loanable funds that has come from the creation of time deposits
and claims on nonmonetary intermediaries. By encouraging the growth of
time deposits and by failing to compensate for the growth of other nonmonetary
indirect assets, they have permitted the supply of loanable funds to grow too
rapidly to bring aggregate demand down to noninflationary levels.
Chart V records the growth over the last decade in the money supply, time
deposits, and other nonmonetary indirect assets.11 During this period, the
money supply rose by approximately $32 billion, time deposits by $27 billion, and
other nonmonetary indirect assets by $120 billion. The combined growth of time
deposits and other indirect assets exceeded the growth of the money supply
on the order of 5 to 1. In the last 4 years, this ratio has been around 10 to 1.
30 Primary security purchases by the monetary system do not include gold purchases.
Hence, this measure grossly understates the increase in asset purchases by the monetary
system during the 1930’s.
11 The latter include mutual savings deposits, savings and loan shares, policyholders*
equities in life insurance companies, shares in credit unions, claims on private pension
funds, and deposits in the postal savings system.
870
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
EM PLOYMENT, GROW TH, AND PRICE LEVELS
871
The growth of time deposits has been encouraged by relatively low reserve
requirements against these liabilities and, in recent years, by an increase in
the interest rate ceiling on the deposits. The rapid growth of nonmonetary
intermediaries has been due to the favorable composition of primary security
issues during the period (weighted heavily toward mortgages and consumer
debt), to the attractive indirect securities they have offered the public, and
to the relatively high “ deposit rates” they have been able to pay. As interest
rates on primary securities have risen, these intermediaries have been able to
increase the demand for their indirect securities through increases in deposit
rates.
The monetary authorities have restrained growth in the supply o f loanable
funds sufficiently over this period to raise interest rates on primary securities
and to tighten other terms of lending. But, in view of the heavy demands for
current output, interest rate increases have been on the meager side; indeed,
interest rates in recent years have been low relative to levels attained in pre
vious periods of prosperity. Moreover, any level of interest rates may be less
effective today in restraining spending than in the past. In recent years, the
composition of demand for loanable funds has swung toward Government and
consumers and away from business, and this has probably made the economy
as a whole less sensitive to changes in interest rates. In addition, high cor
porate income tax rates have probably made the business sector itself less sensi
tive to monetary policy.
Nonmonetary intermediaries have not only supplied large amounts of loanable
funds by creating claims on themselves and purchasing primary securities, but
they (and commercial banks) have also, over the past decade, sold Federal
Government securities in order to gain funds for purchases of private primary
securities. These “ switching” operations have made ultimate lenders more
liquid as they have gained liquid Government securities and given up less
liquid private ones. The operations have tended to increase ultimate lenders*
demand for primary securities generally, and so have contributed to an increase
in the supply of loanable funds. Nonmonetary intermediaries, therefore, have
taken relatively illiquid primary securities out of ultimate lenders’ portfolios
and replaced them with highly liquid nonmonetary indirect assets and Govern
ment securities. By creating (nonmonetary indirect assets) and switching
(from Government to private securities), the intermediaries have made the public
substantially more liquid.
This sort of thing is exactly what economists have long advised the Treas
ury not to do in managing the public debt. Traditional debt management
principles are that the maturity of the public debt should be lengthened dur
ing periods of inflationary pressure and shortened in recessions. Maturity
lengthening in boom periods makes economic units somewhat less liquid and
so tends to raise interest rates on primary securities generally. The activities
of nonmonetary intermediaries, on the other hand, shorten maturities of pri
vate debt held by economic units during such periods and so tend to add to in
flationary pressures. Thus, nonmonetary intermediaries engage in a kind of
perverse private debt management that operates outside the area o f financial
control.
Conclusions and questions
The inflationary effect of growth in nonmonetary intermediaries can be off
set by the monetary authorities. All they need do is to restrain, more than
they otherwise would have to do, the growth of money and time deposits.
This will force primary securities into the hands of ultimate lenders and so
raise interest rates and tighten other terms of lending. It will compensate
for the rapid growth of financial intermediaries that lie outside of the con
trolled area. But they are not likely to do this if they continue to concentrate
almost exclusively on the money supply and fail to recognize the inflationary
impact of growth in time deposits, savings and loan shares, mutual savings
deposits, shares in credit unions, and so on.
To slow down inflation, the monetary authorities, as I have said, would have
had to restrain growth in the supply o f loanable funds more than they did
during the past decade. Given the fact, however, that they have direct con
872
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
trols only over commercial banks, this would have greatly curtailed the growth
of these institutions. And if inflationary pressures continue for another decade,
the monetary authorities, to stop them, will have to crack down hard on com
mercial banks, especially if there continues to be rapid growth in the uncon
trolled institutions. This prospect does raise a few questions about our present
control techniques.
The first has to do with the simple matter of equity. Is it equitable to con
trol one area of financial intermediation when, as I have shown, the activi
ties of all can add to inflationary pressures? The second question is whether
such control techniques can lead to balanced growth in our economy? Some
sectors of the economy are heavily dependent on funds from commercial banks;
other sectors rely more on other financial institutions. When commercial bank
growth is slowed down to compensate for rapid growth of other financial inter
mediaries, we are in effect denying grwth to some areas of the economy in
order to compensate for rapid growth in other areas. Is such unbalanced
growth tolerable in our economy?
Third, what effect in the long run do direct controls over one area o f financial
intermediation have on that area, in view of the fact that this area is subject
to severe competition from other, uncontrolled intermediaries? Does the con
trolled area in the long run lose vitality, fail to attract the best leaders, fail
to attract sufficient capital, lower the quality of its product, and fail to sup
ply funds to borrowers on the frontiers of economic growth? Finally, when
a relatively diminishing area of financial intermediation is subject to con
trols, does so much “ slippage” develop in the mechanism as to make it im
possible to formulate intelligent monetary policies? These are the questions
that must be answered in deciding whether to string along with our present
control techniques for another decade.
A p p e n d ix
T a b l e I .—Average annual net issues of primary securities and GNP by short
cycles, 1897-1958
[D ollar am ounts in b illion s]
Average
annual
net issues
Average
annual
GNP
(Percent
age) Issiesincome
ratio
$1.4
2.2
2.5
3.0
3.2
9.7
6.2
$16.3
21.5
27.5
32.7
36.4
68.5
81.4
8.6
10.2
9.1
9.2
8.8
14.2
7.6
1897-1900
1901-04 _____
1905-08______
1909-11 ____
1912-14 ___
1915-21 ___
1922-24______
Average
annual
net issues
1925-27______
1928-33_____
1934-38______
1939-46_____
1947-49_____
1950-54______
1955-58______
$10.0
2.6
3.3
29.3
18. 7
30.9
36.7
Average
ann-al
G NP
(Percent
age) Issuesincome
ratio
$94. 2
80. 5
79. 2
162. 9
250.6
337. 8
423.4
10.6
3.2
4.2
18.0
7. 5
9.1
8.7
T a b l e II .—Net issues of primary securities by short cycles, 1897-1958
[In billions of dollars]
Govern Corporate Corporate
Short-term
Net issues ment secur bonds
stock
Mortgages
debt
ities
1897-1900____________________
1901-04______________________
1905-08______________________
1909-11______________________
1912-14______________________
1915-21______________________
1922-24______________________
1925-27______________________
1928-33______________________
1934-38______________________
1939-46______________________
i947-49______________________
1950-54______________________
1955-58______________________
5.6
8.6
10.1
9.1
9.6
67.9
18.5
30.1
15.9
16.7
234.1
56.1
154.3
146.9
0.6
.3
.9
.9
.9
26.4
.5
- .3
9.9
16.0
215. 5
4.2
39.5
23.5
1.5
2.5
3.1
2.4
2.2
8.3
5.8
9.0
4.0
-1 .5
-2 .9
11.5
19.1
22.0
1.0
2.0
2.4
1.8
1.9
7.9
4.2
6.2
11.5
1.3
4.2
5.2
12.0
13.4
0.5
1.0
1.4
1.9
2.6
11.8
6.1
9.9
3.9
.3
6.6
20.8
51.0
57.5
2.1
2.7
2.4
2.2
2.0
13.4
1.9
5.2
-13 .4
.6
10.7
14.5
32.7
30.5
873
EM PLOYMENT, GROW TH, AND PRICE LEVELS
T a b l e III. — Average annual net issues of primary securities and their purchasers
by short cycles, 1897-1958
[In billions of dollars]
Average
annual net
issues
1897-1900 _ ____ _____ _____________________
1901-04___________________________ ___________
1905-08___________________ __________ ____ ___
1909-11.-____ ________________________________
1912-14__________________ ____________________
1915-21______________________ ____ ___________
1922-24______________________________________
1925-27______________________________________
1928-33 ____________________________________—
1934-38 _______ ______________________________
1939-46____________________________ ____ _____
1947-49______________________________________
1950-54_____________________________________
1955-58______________ ______ _________________
1.4
2.2
2.5
3.0
3.2
9.7
6.2
10.0
2.6
3.3
29.3
18.7
30.9
36.7
Average annual purchases by
Ultimate
lenders
Monetary Nonmonetary
system
intermedi
aries
0.3
.5
.6
.9
.6
1.8
8.1
3.7
—. 4
2.2
7.0
7.1
12.7
19.1
0.5
.6
.4
.4
.7
1.4
.7
1.0
- .9
.8
9.5
-.2
6.2
3.5
0.6
1.1
1.5
1.7
1.9
6.5
2.4
5.3
3.9
.3
12.8
11.8
12.0
14.1
T a b l e IV.— Selected indirect securities, 1947-58
[In billions of dollars]
Money Time
supply deposits
1948_____________
1949______________
1950______________
1951______________
1952______________
1953______________
116. 5
116. 5
122.6
129.7
135.9
136.1
35.8
36.1
36.3
37.9
40.7
43.7
Money Time Others 1
supply deposits
Others 1
92.6
100.2
107.7
118.1
129.8
142.3
1954______________
1955______________
1956______________
1957______________
1958______________
140.3
143.4
145.0
144.0
148.7
46.8
48.4
50.6
56.1
62.9
156.6
171.6
186.7
201.4
218.8
i Includes mutual savings deposits, savings and loan shares, deposits in postal savings system, and assets
of life insurance companies, credit unions, and private pension funds.
Representative P a tm a n . Y o u indicated that something should be
done to require equity in the allocation of credit.
In 1958, as Mr. Martin testified before the Joint Economic Commit
tee, Federal Reserve made the position of the banks easier so that
they could expand greatly. I did not know at the time, but I dis
covered later that the Federal Reserve made the position for the banks
to expand loans and investments by $10,400 million. That money
was however used not for business loans as the Federal Reserve obvi
ously intended but was all used for purchase of U.S. Government
obligations—incidentally without cost to the banks, the way it was
handled. During that time, not only did they not make any busi
ness loans, but business loans were actually called to the extent of a
billion and a half dollars during that period.
It looks like the country last year, m 1958, came out of the depres
sion not because of the Federal Reserve but despite the Federal
Reserve.
Do you have any comments to make on that ?
Mr. G u r l e y . A s you know, 1958 was a depression year and I would
not be surprised if, as in all depression years, business loans dropped.
I would not be surprised if, as in all recession years, the Federal Re
serve supplied reserves to commercial banks for them to expand their
earning assets.
38563— 59— (pt. 4-------18
874
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
It is true I am sure, as you say, Mr. Patman, that the commercial
banks used these funds to purchase primarily Federal Government
obligations. This is not entirely without cost to them, however, be
cause they are creating liabilities at the same time and there are
interest and other costs connected with these liabilities.
The purchase of Government securities certainly eased interest
rates on these securities and this case undoubtedly spread to other
markets.
Representative P a t m a n . By “ ease” do you mean lower interest
rates?
Mr. G u r l e y . Yes, during the heavy purchases. There was one
phase.
Representative P a t m a n . When was that ? I do not recall it.
Mr. G u r l e y . Let me consult my data.
Representative P a t m a n . Suppose you indicate what interest rates
were at the beginning of the year, the middle of the year, and the
end of the year ?
Mr. G u r l e y . I cannot give you all those figures from this table.
Representative P a t m a n . Y o u may put them in the record if you
do not find them now and I would like Mr. Reuss to ask any questions
about it.
(The following was subsequently received for the record:)
Yields on U.S. Government securities
Long term
January 1958............................................................................................
June 1958 _________________________________
_____ __
December 1958_____________________________________________
3.24
3.19
3.80
3 to 5 years 3-month bills
2.77
2.25
3.65
2.44
.83
2.77
Representative R e u s s . Thank you, Mr. Chairman.
I want to congratulate Dr. Gurley for his very searching paper
and for raising the number of important questions that he does.
I gather your main conclusion from your study of the effect of the
so-called financial intermediaries is that the monetary authorities of
this country, in concentrating all their attention on credit creation
by the commercial banks while ignoring the substantially much larger
contribution to the total demand by the financial intermediaries, are
in effect swallowing camels and straining at gnats, that they are over
emphasizing one phase of it.
Is that right?
Mr. G u r l e y . Yes, that is one of the main conclusions.
Representative R e u s s . You have led me to think that, in your opin
ion, monetary policy is the vastly preferable way of controlling infla
tion. Is that a correct inference from what you have said?
I am referring particularly to what you said to the chairman a
moment ago when you said—and I think I quote you—“ by monetary
policy, if that is the way you want to do it.”
Mr. G u r l e y . That is right.
I think monetary policy can bring about a stable price level over
a long period of time. I am not necessarily of the opinion that this
is a preferable way at all times to do this.
Representative R e u s s . This raises two questions in my mind.
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
875
Do you not think or agree with me that fiscal policy, specifically a
quite courageous tax policy, is an awfully good way of dealing with
inflation too ? I am not saying that we should cast monetary policy
aside; but should we not use fiscal policy more than we do?
Mr. G u r l e y . I agree. A courageous fiscal policy is a good tiling.
Representative R e t j s s . By which I mean mainly increases in tax
revenues, because we have to spend a good deal on our Government,
no matter what.
Secondly, would you agree with me that something called adminis
tered prices, namely prices in concentrated industries where a few are
able to exercise some degree of market domination, have something
to do with price rises in recent economic history; that, by and large,
neither monetary nor fiscal policy is a sovereign remedy for adminis
tered price inflation; and that we have to look around for new insti
tutional arrangements to restarin wage-price movements in those
concentrated industries.
Mr. G u r l e y . I am not convinced of that at all, Mr. Reuss, but I
have not made a detailed study of it.
Representative R e u s s . N o w to ask a question in the field of po
litical science, which has also been in the purview of Brookings
Institution.
You have said that we are badly neglecting an important field of
economic activity here in the field of financial intermediaries.
Under our governmental system, whose job in the executive branch
is it to advise the Congress of what needs to be done in fields like this,
and what, in fact, has been done about it ? I think it is fine that you,
from one of our great private foundations, are up here opening our
eyes to this problem.
However, under our system of Government who is supposed to be
doing this in the executive branch ?
Mr. G u r l e y . I do not know. The Council of Economic Advisers
could certainly point to the deficiencies of monetary policy in this
respect if they thought there were such deficiencies, and I imagine
they could certainly bring it to the attention of Congress. I am
almost positive the Federal Reserve would not call this sort of thing
to the attention of Congress.
Representative R e u s s . In fact they have not, have they ?
Mr. G u r l e y . In fact they have not to my knowledge.
Representative R e u s s . In fact also the Council of Economic Ad
visers has not, has it ?
Mr. G u r l e y . T o m y k n o w l e d g e , n o .
Representative R e u s s . Nor has the Treasury, so far as you know,
nor any other agency of the executive branch ?
Mr. G u r l e y . I t h i n k t h a t is r i g h t , s o far a s I k n o w .
Representative R e u s s . Is it not important under a good system
of executive government that somebody somewhere in the executive
branch be assigned the task of studying this, worrying about it, and
coming up with recommendations to Congress on it ?
Mr. G u r l e y . I think it is important that the important things be
studied. It might well be that people in the executive branch do not
consider the factors I have mentioned to be important, and they might
turn out not to be important These things have to be thrashed out
for quite a while, I would think, among economists and others. My
876
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
own view, of course, is that these are very important factors in water
ing down the effectiveness of monetary policy and I would certainly
like to see them studied.
Representative R e u s s . N o w a word about your recommendations,
conclusions, and questions.
You point out that the monetary authorities need only restrain the
growth of money and time deposits more than they otherwise would
have to do, to offset the inflationary effect of growth in nonmonetary
intermediaries. By the monetary authorities you mean the Federal
Reserve System ?
Mr. G u r l e y . Yes, the Federal Reserve System.
Representative R e u s s . And how are they to restrain (a) the growth
of money, and ( i ) time deposits ? By what methods ?
Mr. G u r l e y . They restrain the growth of the sum of demand and
time deposits. Under our system now time deposits may grow freely;
there is a perfectly elastic supply of them.
Representative R e u s s . They have no statutory mechanism for re
straining the growth of time deposits now, do they ?
Mr. G u r l e y . There is a small reserve requirement against time
deposits, but the important thing is to control the sum of demand and
time deposits. If, for example, it is discovered that the growth of
$10 billion of time deposits was at the expense of demand for demand
deposits, then the proper policy is to reduce reserves or raise reserve
requirements in such a way as to get the supply of demand deposits
down to the lower demand for them.
Representative R e u s s . But is this not the very straining at gnats
and swallowing camels technique which you deplored a moment ago?
Are they not going to have to deal murderous blows to demand de
posits in order to keep the total down ?
Mr. G u r l e y . Yes, I think that if by monetary policies we want to
get rid of the excess demand for current output, and if inflationary
pressures do last for several more years, then it is going to take a very
vigorous restraint on commercial bank growth in order to achieve
this result through this policy mechanism.
Representative R e u s s . Would that not be subject to charges of in
equality? Would it not be necessary to have the same kind of
controls over time deposits that the monetary authorities now have
over demand deposits ?
Mr. G u r l e y . D o you mean by that, Mr. Reuss, I raise the reserve
requirements on time deposits to the level of demand deposits?
Representative R e u s s . I do not want to go into the techniques of
doing it, because, frankly, I am way beyond my depth there. I was
trying to relate this sentence of yours on page 32, which suggests that
all this is very easy, with the next page where you point out that, if
the Federal Reserve is going to be restricted in its control powers
to demand deposits, representing a small part of total deposits, and
if it tries to do the whole job by concentrating on the one area over
which they have power, this has two unfortunate consequences: First,
it does not do its job, because it cannot; second, it creates great
inequalities.
Aren’t these disadvantages, therefore, equally applicable to the
sentence I read ?
Mr. G u r l e y . Yes, sir; that is right.
EM PLOYMENT,
GROWTH, AND PRICE LEVELS
877
Representative R e u s s . Y o u have an interesting question in your
statement. Because our controls over the banking system are loose,
you ask whether the system may not lose vitality, fail to attract
the best leaders, capital, et cetera, vis-a-vis the savings and loan asso
ciations, the mutual savings banks, and the credit unions. Is that
a fair paraphrase of your question ?
Mr. G u r l e y . Yes, it is.
Representative R e u s s . Are you suggesting that there is a real so
ciological problem here, that bankers are becoming second rate and
less imaginative as compared to officers of these other institutions?
Mr. G u r l e y . I have an idea that it is so, and I have an idea that
we can put two and two together.
When an area is controlled, an area of this sort that is part of
a larger area, where there is pretty severe competition, and the con
trolled segment is held back in various ways over a longer period of
time, the result is conservatism within that industry among the lead
ers. In other words, I would tend to reverse the usual argument.
It is often said that conservative bankers are really the trouble with
banks. But I think that it is really that the conservative bankers
grow out of, they are the result of the controlled system that has
lasted for a long, long time over this area of financial intermediation.
So far as the capital is concerned, Mr. Reuss, commercial banks,
as you know, have lost capital relative to their assets or deposits
for a century. That is, the capital-asset ratio has been declining.
Why has management chosen to let the capital-asset ratio decline?
I am almost positive that the reason is that banks have earned less
net profits after taxes on assets for a century.
This ratio has been going down and down for a hundred years.
I f you are earning less net profits after taxes on assets, the thing
to do, if you are going to have a rate of return in this industry
comparable to the rates of return elsewhere, is to let your capital
fall relative to your assets. In this way, whatever net profits you
have left will earn a comparable rate of return on the relatively
lower amount of capital; that is, comparable to the rate of return
earned elsewhere.
In a free economy this will come about anyway.
Representative R e u s s . Y o u are talking about the ratio of a com
mercial bank’s capital to its deposits?
Mr. G u r l e y . Yes, or to its assets; either way.
Representative R e u s s . I should think-----Mr. G u r l e y . This ratio has fallen for a century.
Representative R e u s s . Yes, but I do not know whether that par
ticular bit of evidence shows that banking is a poor business into
which an enterprising young man ought not to venture.
Mr. G u r l e y . No.
Representative R e u s s . It shows that with a given hundred dol
lars I can rent a desk and office space and get a banking charter,
and I can do a great deal more business, particularly as the monetary
authorities pursue their present policy of lowering the reserve re
quirement. That gives me a bigger bang for a buck, as the man says.
I am questioning whether the decreasing ratio between bank de
posits or assets on the one hand and bank capital on the other hand,
m and of itself, shows that banking is less attractive than it once was.
878
EM PLOYM ENT, GROWTH, AND PRICE LEVELS
However, with that one reservation, I am sure there is much other
evidence bearing on your thesis.
Eepresentative P a t m a n . May I ask a question there ?
I f you will notice, Professor, in the country banks, the reserves are
just about the same amount as their capital accounts. In the reserve
city banks, reserves are more than capital accounts, and in the central
reserve city banks, they are considerably more than capital accounts.
Why would there be such a difference there between the classes of
banks ?
Mr. G u r l e y . I do not have the difference here but I think I
know-----Representative P a t m a n . Y o u agree that what I say is right?
Mr. G u r l e y . I think what you say is substantially correct, yes.
It is also true—and this almost follows from what you said—that
the ratio of capital to assets, not just to reserves but to total assets of
banks, is lower in the largest banks, which are mostly in the central
reserves city locations, than it is in the country banks. You will
find the country banks with a much higher amount of capital relative
to their assets than would be true in the larger banks. Since country
banks have smaller reserves relative to assets, it follows that their
reserves to capital are relatively small.
I think the reason for these differences—although once I give the
reason it raises another question—is that the amount of net profits
earned on assets is higher in the country banks than in the much larger
banks in the central reserve cities. The larger banks earn lower
amounts of net profits on their assets. Over the years their capital
has been worked down relative to their assets so that rates of return
throughout all banks—country, middle sized, big banks and so on—
are just about the same in most years.
Representative P a t m a n . May I invite your attention to the fact
that banks are making a lot of money now on sales of Government
securities. Last year in 1 9 5 8 , testimony has developed, they made
$ 6 1 8 million, which is 5 0 percent more than they made the banner
year of 1 9 5 4 just after the 1 9 5 3 freeze.
Mr. G u r l e y . Those years were recession years.
Representative P a t m a n . Yes. After the recession of 1 9 5 3 they
cleaned up.
Mr. G u r l e y . That is right.
Representative P a t m a n . About four times as much as they ever
made on an average before. And then after the depression year of
1 9 5 7 , they cleaned up again, much more, $ 6 1 8 million.
I think it puts the burden of proof on somebody to defend this
speculation in an unregulated, uncontrolled market for Government
securities.
Mr. G u r l e y . In all other years the commercial banks had larger
losses on securities than they had profits.
Representative P a t m a n . Well, they made some money each time.
O f course they have a very favorable setup taxwise. We can take on
their losses a hundred percent deduction.
I want to ask another question, Mr. Reuss, and then I will be
through.
I want to ask you about Federal funds. Is that not getting to be
quite a big thing, the use of Federal funds?
EM PLOYMENT, GROWTH, AND PRICE LEVELS
879
Mr. G u r l e y . I have not followed the data. The use of Federal
funds always gets to be a bigger thing whenever reserves are tight.
Representative P a t m a n . What I am talking about is disassociated
from the Federal Reserve. In the Federal Fund Market in New York
now, oftentimes the rate quoted is 2 and 2y2 percent, when the redis
count rate in the Federal Reserve bank is 3. Evidently they must
have a lot of funds in order to compete with the Federal Reserve it
self. Do you know the extent of the Federal Fund Market?
Mr. G u r l e y . The amount of transactions? No, I do not.
Representative P a t m a n . Go ahead, Mr. Reuss. Excuse me.
Representative R e u s s . I have just one question.
Dr. Gurley, do you think Congress ought to pass legislation extend
ing the power of the Federal Reserve System over lending by the socalled financial intermediaries? And if you do, what general tech
nique do you recommend ? This is a question among others that the
Joint Economic Committee will have to answer by next January.
I wondered if you have a technique in mind.
Mr. G u r l e y . That is a very difficult question to answer. I would
just like to see the Federal Reserve conduct its monetary policies with
the knowledge that the expansion of time deposits and claims on non
monetary intermediaries is inflationary and has to be offset; that one
cannot just increase the money supply by 2 percent or 3 percent per
year and think that somehow one is restraining things regardless of
financial growth elsewhere.
The present tools cannot be used properly if one has the wrong
theory of how to use them. It seems a shame, when the tools are not
really being used properly, from the standpoint of Federal Reserve
goals themselves, to change the tools at that time spreading them out
to other intermediaries.
Even so—even if the present tools were used intelligently—it may
well be that we would not consider them adequate. There are ques
tions of equity, of resource allocation, of their impact on the behavior
of the controlled sector, and others.
I f it turns out that the present tools are inadequate, we should
seriously consider the imposition of quantitative controls on some
nonmonetary intermediaries. These controls could take the same
form as those now imposed on commercial banks. My own feeling is
that it will be necessary—as well as wise—to move eventually in that
direction.
I should add that the growth of Government intermediaries, such
as FNMA, also contributes to inflationary pressures, and despite Con
gress’ control over these institutions there has been little attempt to
coordinate their activities with monetary policy. This should be one
of the first steps taken to broaden the base of financial control.
Representative R e u s s . The Federal Reserve in the last 5 years, by
use of the rediscount rate and open market operations, has allowed
the monetary supply to grow very slowly. Between 1954 and 1958,
the average annual rate of increase was only iy 2 percent, and some of
us on the Joint Economic Committee thought that that was an in
sufficient expansion of the money supply—cash and demand deposits.
Do I gather from what you are saying that it is your view that the
Federal Reserve should have expanded the money supply at an even
lower and smaller rate than 1y2percent a year ?
880
EM PLOYM ENT, GROW TH, AND PRICE LEVELS
Mr. G u r l e y . It is not just the existence of the intermediaries, but
it is the rapid growth of them, more rapid in the last 10 years than we
have ever seen before. I f one does not take this into account, then one
goes ahead increasing the money supply by 2 or 2y2 or 1y2 percent,
whatever it is, the same as one has done in the past under a different
financial environment.
It is my opinion that the money supply should have been increased
by less than it actually was if we wanted monetary policy to stop the
rise of prices during this period.
Representative R e u s s . D o you think that the rise in prices during
the last 5-year period has been due to excess overall demand ? Or, to
put it another way, that the Federal Reserve, despite all the chewingout they get from the Democrats on this committee and elsewhere for
its tight money policy, has been insufficiently tight? I gather you do.
Mr. G u r l e y . I d o , y e s .
Representative R e u s s . H o w do you account for the fact that during
more than half of this 5-year period we have had two major recessions
which saw, in the case of the last one at least, 7 percent of the working
force unemployed and more than one-quarter of the industrial re
sources of the country unused? How do you square that with your
thesis that the trouble has been that we have had too much demand ?
Mr. G u r l e y . I am talking about the average over the full postwar
period, Mr. Reuss. Sure, it is true that we have had three recessions
and certainly during those times I would not call for a tighter mone
tary policy. But I think that on the average over the full postwar
period, monetary policy has not been tight enough to stabilize prices.
Representative R e u s s . I can and do agree, let me say in conclusion,
with your central thesis that it is a rather vain thing to use a mone
tary policy which is incapable of doing the job assigned to it by its
adherents because it reaches only a small part of the total monetary
demand. I can agree with that thesis without necessarily agreeing—
and I guess I do not agree—with your historical hindsight that in
fact we have had insufficiently tight money in the last 5 years or so
and that that has been the cause of the inflation we have had.
I would phrase it slightly differently by saying, thank God that
the Federal Government’s controls were as inefficient as they were,
because at least the leakage has brought us somewhere closer to having
the amount of demand that the economy needs.
Mr. G u r l e y . Mr. Reuss, I would agree with just about everything
you said on that. I do not think we are really in disagreement. The
basic causes of the inflation are certainly not the lack of monetary re
straint during this period. For myself I am not overly concerned at
all about the small rise in prices that we have had during most of these
years in the postwar period. I would much rather take those with the
full employment output that we have had than a lesser amount of
output with stable prices.
All I am saying is that the people who are really concerned about
inflation, and the Federal Reserve apparently is, did not make money
tight enough during this period as a whole to do the job they were
really trying to do during the period. I f other people are interested
in doing this job, too, then I would say the same thing to them.
Representative R e u s s . So historically for the last 5 years one
might say that if the Fed has succeeded it is only because it has
failed?
EMPLOYMENT,
GROWTH, AND PRICE LEVELS
881
Mr. G u r l e y . From our point of view, right.
Representative S e u s s . Thank y o u .
Representative P a t m a n . Several members of our staff would like
to ask some questions, but before calling on them I would like to dis
cuss with you very briefly, Doctor, what you said about three reces
sions, postwar recesions. You referred to 1949, 1953, and 1957, I
assume ?
Mr. G u r l e y . Yes.
Representative P a t m a n . We used to have these recessions about
every 10 or 15 years. I hope this does not become a traditional pat
tern, every 4 years: 1949, 1953, 1957, 4 years between each. I hope
we have not accelerated.
Mr. Eckstein?
Mr. E c k s t e i n . I have a couple of questions.
First, evaluating the growth of financial intermediaries, do you
feel they serve some useful purpose ?
Mr. G u r l e y . I think probably over a long stretch of time they
not only raise levels of saving and investment in the economy, but
tend to allocate savings optimally among alternative investments.
Mr. E c k s t e i n . Another question. We have had this growth of
intermediaries, a growth which has continued even in recent years.
At the same time our Treasury has run into worse and worse prob
lems in managing its debt. Do you feel that the intermediaries could
play a more constructive role in helping the Treasury with its debt
problem ?
Mr. G u r l e y . By purchasing more Government securities ?
Mr. E c k s t e i n . I suppose that would be one way.
Mr. G u r l e y . I notice Secretary Anderson has appealed to the
mutual savings banks to do just this.
I see no reason why they should be forced to purchase any partic
ular type of asset.
Mr. E c k s t e i n . I f there were less financial intermediaries and if
more of the funds were invested by ultimate lenders would not more
of them buy Government securities than intermediaries do ?
Mr. G u r l e y . Yes, I think that might be so. What you are saying
is that financial intermediaries do compete with certain types of pri
mary securities, very liquid primary securities, and the Government
securities are among these. I would agree. It works the other way
too, of course. There is competition both ways.
Mr. E c k s t e i n . Y o u are concerned with the lack of control which
anybody has over the financial intermediaries. Do you think that
the present Federal Reserve open market policy of bills only cuts
them off even more than is necessary from any kind of controlled
intermediaries ?
Mr. G u r l e y . Yes, I think it cuts them off more. Purchases and
sales by the Federal Reserve of shorts or longs, Treasury issues of
shorts or longs—all these are techniques of debt management. It is
putting more long securities out into the market and taking shorts
off, or vice versa, and financial intermediation is really the same
thing. It is taking long-term private debt off the market and putting
short-term liquid debt into the market. The more control over pub
lic and private debt management you have the better the control you
have over the whole loanable funds market.
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So the Fed is cutting itself off from part of this area of control
by just sticking to “bills only.”
Representative P a t m a n . Senator Bush, I was going to call on Mr.
Frucht here next, but since you have come in and certainly want to
ask questions, you come first.
Senator B u s h . I am a little embarrassed at being late but it was
one of these conflicts, Mr. Chairman, with another committee.
Representative P a t m a n . Yes, we all have them.
Senator B u s h . I may be asking a question that has been asked be
fore. I f so, stop me.
Representative P a t m a n . That is all right. We recognize that the
members do that sometimes; but it is perfectly all right.
Senator B u s h . If it has been asked I will not press for an answer.
Let me ask you this:
Last year in the first few months of the year, the Congress was
faced with some very critical decisions. It was recommended by many
that taxes be cut at that time. In view of the fact that we had a sub
stantial degree of unemployment some recommended very large in
creases in Government spending, and many bills were introduced to
that end.
I would like to ask you this question: Was it your opinion in the
early part of 1958 or at any time in 1958 that we should cut taxes in
order to help come to grips with the unemployment situation that then
existed ?
Mr. G u r l e y . Yes, it was in the early part of 1958.
Senator B u s h . You favored that?
Mr. G u r l e y . I did.
Senator B u s h . T o what extent did you think we should have cut
taxes ? Did you have any particular idea ?
Mr. G u r l e y . I had no particular idea.
Senator B u s h . You just thought that a tax cut would be a helpful
move?
Mr. G u r l e y . Yes.
I might say I changed my mind by June or July.
Senator B u s h . You changed your mind?
Mr. G u r l e y . Later on, yes.
Senator B u s h . A s you saw that the recovery caught hold and ap
peared to be correcting itself.
What about the bills that were introduced to substantially increase
Government spending? Did you favor any of those particularly, do
you recall ?
Mr. G u r l e y . No, I do not think I had any opinion. I favored a
tax cut and I do not think I had any opinion at that time about in
creasing Government expenditures.
Senator B u s h . Y o u did not want to make any recommendations as
to increased Government spending bills?
Mr. G u r l e y . I did not even express my opinions on tax cuts. These
were my private nightmares; that is all.
Senator B u s h . I imagine before classes in the university you must
get questions at sometime on what your opinion is on various impor
tant pending matters, do you not ?
Mr. G u r l e y . Yes. It depends on the class. I f I have them well
under control, I do not.
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GROWTH, AND PRICE LEVELS
883
Senator B u s h . I had the privilege last autumn of serving on the
Chubb Fellowship at Yale University for a week, and I was a guest
in numerous classes in economics, international economics. I did not
find them at all reluctant to ask me questions of very pressing impor
tance, and they were somewhat difficult to answer at times.
At any rate, you simply stand on the statement that you did then
favor a tax cut.
Why did you favor a tax cut at that time ? What were the reasons
in your mind ?
Mr. G u r l e y . Because I thought capital expenditures were going to
decline more than it turned out that they actually did.
Senator B u s h . And you thought that a tax cut would cause in
creased capital expenditures ?
Mr. G u r l e y . Yes.
Senator B u s h . And you felt at the time you favored the tax cut
that it should be done regardless of the fact that it would likely in
crease an already certain deficit in the budget ?
Mr. G u r l e y . Yes; that is right.
Senator B u s h . I have no other questions, Mr. Chairman.
Representative P a t m a n . Mr. Frucht ?
M r . F r u c h t . I a m c o n c e r n e d w it h y o u r q u e s tio n s in y o u r s ta te
m e n t, a n d I w o u l d lik e t o a sk y o u s e v e r a l q u e s t io n s o n th o s e p o in ts .
The first, a question of the equity of controlling banks and not
controlling in any direct sense the financial intermediaries. What I
am wondering about here is, if we did not overcontrol—if you want
to use that term—banks in regard to interest payments on deposits
and portfolios on the time part of the bank operation, would this not
significantly change your position with regard to this matter of
equity ?
Mr. G u r l e y . With regard to what ?
Mr. F r u c h t . The equity of controlling the banks as opposed to not
controlling the nonfinancial intermediaries.
Mr. G u r l e y . N o .
Mr. F r u c h t . To go on, then, on that same point. On the question
of balanced growth, for instance, is it or is it not true that the claims
of borrowers from intermediaries get to the banks through the finan
cial intermediaries to a large extent ?
Mr. G u r l e y . N o . Consumer debt, mortgages, and so on can be
sold to financial intermediaries as these borrowers depend on financial
intermediaries to a very large extent other than the commercial
banking system. When the commercial banking system is held down,
it cuts out certain types of business loans, let us say. It does not
stop the growth of other intermediaries that cater more to consumers
through mortgage and consumer debt borrowing. This is a type of
unbalance that I have in mind.
Mr. F r u c h t . There are two questions here; are there not? The
sources of funds for the intermediaries: One would be just hoardings,
probably, and the other would be borrowings from the commercial
banks, either directly or indirectly through the sale of securities.
Would that be true ?
Mr. G u r l e y . Well, the source of funds is the purchase in the first
instance of money by the creation of a claim on these intermediaries.
As long as they can purchase money by creating mutual savings de
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EM PLOYM ENT, GROWTH, AND PRICE LEVELS
posits or a share or something of the sort, they have funds with which
to purchase securities. This m no way reduces the size of the commer
cial bank system.
It in no way depends on the intermediaries borrowing directly from
the commercial banking system.
Mr. F r u c h t . They do this to some extent; do they not ? And then
they float securities in the market and thus perhaps reduce hoardings ?
Mr. G u r l e y . They do what ? I think I missed out on this question.
Mr. F r u c h t . I am just trying to figure out from whence comes the
financial support for the intermediaries. One would assume that it
either must originate in changes in the money supply or in substitu
tions or changes in hoarding.
Mr. G u r l e y . The funds originate from the decision of some person
to purchase a claim on these intermediaries with money. This is all
that has to happen.
Mr. F r u c h t . This money is either created by new money, in a
sense created by the commercial banking system, or results from a
running down of idle balances ?
Mr. G u r l e y . That is right.
Mr. F r u c h t . I am in considerable agreement with you that present
control mechanisms discriminate seriously between banks and non
banking institutions. But if we removed some of these discrimina
tions, would we not then make the banking communities more re
sponsive to the needs of the economy and more able to compete ef
fectively ?
Mr. G u r l e y . Yes, I think there are certainly ways of making the
commercial banking system better able to compete effectively, but this
does not necessarily mean that the inequities of the control mechanism
have been removed.
Mr. F r u c h t . I am concerned for instance with the question of the
fact that in competing for hoardings or for idle balances, the com
mercial banks are quite powerless here, whereas the financial inter
mediaries are able to pay interest which the commercial banks are not.
I am wondering also what is your opinion as to the present justi
fication for the distinctions and in controls between the time deposits
and demand deposits.
Mr. G u r l e y . Ideally, the difference in the two reserve requirements
should reflect the degree of substitutability between time deposits and
demand deposits. For example, if time deposits were exactly like
demand deposits, if they were perfect substitutes, then clearly the re
serve requirement should be the same on both demand deposits and
time deposits.
If, on the other hand, every time time deposits grew by $1 this re
duced demand for money by 50 cents, then ideally the reserve re
quirement on time deposits should be one-half the reserve require
ment on demand deposits.
Mr. F r u c h t . Does not the legal distinction between these two kinds
of deposits have significant implications? For instance, does it not
influence the time structure of loans in a period of expansion ? For
instance, might it not result in loans of longer duration, as when the
banking system wants to expand ?
Mr. G u r l e y . Because its time deposits are growing very fast?
Mr. F r u c h t . Yes.
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885
Mr. G u r l e y . That is right.
Mr. F r u c h t . In other words, is this not an artificial factor in a
sense which affects the duration of loans and also affects in the same
way the position of the banks vis-a-vis the nonflnancial intermediaries ?
Because the nonflnancial intermediaries can pay significant interest
payments to depositors, in a sense, on accounts that are used for a
short-term purpose. Would you say that is true ?
Mr. G u r l e y . I am going to have to understand your question a
little bit better.
Mr. F r u c h t . I am sorry.
In other words, the very thing in such a period which the com
mercial banks are precluded from carrying out, namely, paying in
terest on deposits used for short-term loans, is available and open
to the nonflnancial intermediaries?
Mr. G u r l e y . That is right.
Mr. F r u c h t . And does this not constitute a really significant dis
crimination against the commercial banks ?
Mr. G u r l e y . Yes, I think it does.
Mr. F r u c h t . Going back to the question of sociology that Mr. Reuss
raised, if these particular discriminations were limited or reduced,
might it not have a very big effect on the virility, on the aggressive
ness of the commercial banker ?
Mr. G u r l e y . I think it would have an effect but I do not think a
significant effect. I think the control mechanism itself, the mecha
nism of quantitative controls is so overwhelming here that the point
you mention is not of great significance.
Mr. F r u c h t . Just to refer briefly to your point about the unintel
ligent use of controls by the Federal Reserve System, Professor
Friedman’s thesis, as you well know, is that these characteristics are
of long duration, that there is a great consistency in this pattern of
“ unintelligence.” I am wondering whether we ought to blame the
Federal Reserve authorities for unintelligence really or whether this
is built in to the control instruments themselves.
Mr. G u r l e y . I do not know how to answer that.
Mr. F r u c h t . Professor Friedman’s thesis is that as a general
rule, if I understand it correctly, the Federal Reserve Board leans
in one direction when it should lean in the other and vice versa, and
that there is a great consistency in this sort of perverse behavior.
Mr. G u r l e y . I disagree with that. I think that is much exag
gerated. The thing that is more true I believe is that by not taking
account over the long run of the inflationary impact of the growth
of time deposits and claims on other intermediaries, the money sup
ply has been allowed to grow too much to bring about stabilization
of the price level.
There are times in short periods when the economy has needed not
monetary restraints but the opposite, and we have reverse situations.
So far as those turning points are concerned I think the record of
the Federal Reserve is fairly good. I would not argue on Fried
man’s side on this.
Mr. F r u c h t . Y o u would not agree with Mr. Shaw, then?
Mr. G u r l e y . And I would not agree with Mr. Shaw on this point;
that is right. It is a much exaggerated position I believe.
Mr, F r u c h t . Thank you, Mr. Chairman.
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Representative P a t m a n . Mr. Knowles, would you like to ask some
questions ?
Mr. K n o w l e s . Yes, I have one or two I would like to bring up
here to clarify some points.
First of all, was your answer to a question of Dr. Eckstein con
cerning the purchase of Government securities by these financial in
termediaries rather than commercial banks, grounded in the notion
that these financial intermediaries can obtain a higher rate of interest
on other assets that they can purchase than they receive on Govern
ment’s, and therefore, why should they sacrifice the difference in
interest? Is that basically your point?
Mr. G u r l e y . Yes.
Mr. K n o w l e s . In other words, you would say that if the Treasury
put out securities carrying a higher rate of interest, then your posi
tion would shift. I f they were allowed to charge a higher rate of
interest your position would shift and you would say in this case
you would expect that the financial intermediaries ought to and would
buy a higher fraction of Government security offerings ?
Mr. G u r l e y . Yes. However, interest rates on existing Governments
will adjust anyway to make them competitive with other securities.
Mr. K n o w l e s . In your statement you use a phrase about some non
monetary financial intermediaries supplying large amounts of loan
able funds by creating claims on themselves.
The word “ creating” is used in the commercial banks in the sense
o f creating deposits on a fractional reserve basis. Are you using the
term “ creating” here in this sense—that these people create a supply
of funds in the same way that as a commercial bank, or is it that they
create a claim on themselves and thus tap the real savings of savers
and then act as an intermediary to pass these real savings on to the
ultimate borrower.
Mr. G u r l e y . I can put it in a slightly different way. The mone
tary system increases the money supply by creating money. The
other intermediaries increase income velocity of money by creating
other types of claims on themselves.
Does this restatement help ?
Mr. K n o w l e s . A little, but the point I am trying to get at is, are
these intermediaries tapping as an ultimate source of their funds,
saving by you and me and business and others; are they tapping a
final saving somebody has made out of hia income; he has saved this
and put it aside and invested it through the intermediary; or is it in
the form of a monetary creation in the same sense, to use an extreme
case, as if they had minted the money.
Mr. G u r l e y . Each person’s saving is in financial assets or real
assets of various types, and one type of financial asset is money, so
our money holdings represent part of our saving. Other financial
assets are claims on the nonmonetary intermediaries. So they too
represent part of our saving.
In that sense the monetary system and the nonmonetary interme
diaries stand on the same footing in creating a financial asset that
we can acquire instead of consuming our income, that is, saving our
income.
Suppose that you desire to buy savings and loan shares, a hundred
dollars worth. That may or may not represent any increase in your
EMPLOYMENT, GROWTH, AND PRICE LEVELS
887
saving. It might simply mean you would like to change one type
of financial asset that you now have, let us say a hundred dollars of
money, for a hundred dollars of savings and loan shares. So there
would be no new saving in the economy as a result of the growth of
savings and loan associations by $100.
Yet they then could go into the market with your hundred dollars
and buy primary securities, bidding up the prices of securities, mak
ing terms of lending easier in the market.
Mr. K n o w l e s . But unless someone saved, past or present, there
would be no power on their part to expand the amount of loanable
funds through the Federal Reserve System and the commercial bank
ing system. Any expansion of a monetary character which does not
represent real savings by consumers or business would have to come
from monetary systems directly, not through the financial interme
diaries.
Mr. G u r l e y . The growth of nonmonetary intermediaries can bring
about an excess amount of investment over saving in the planned
sense. This can be done by the growth of nonmonetary intermediaries
as well as by the growth of the commercial banking system. One
does it by creating money; the other does it by increasing the velocity
of money through the creation of special claims on themselves.
Mr. K n o w l e s . And in this latter sense o f increasing the velocity
you would assert that they are inflationary?
Mr. G u r l e y . Exactly.
Mr. K n o w l e s . Now, on this last point of equity that was raised,
I can recognize your equity argument but I wonder if you would
make the same argument or raise the same issue about the question
of the difference in control between the commercial banks and these
other intermediaries in regard to the problem of growth.
Would you say that the rate of growth of the economy is slowed
by the unequal pressure that is exerted in our monetary policy, versus
what it would be if the pressure as you put it were applied across
all, equally and equitably: that is, financial intermediaries and the
commercial banking system, both?
Mr. G u r l e y . That is a difficult question. I am not sure I am in a
position to answer that.
Representative P a t m a n . I s there any reason why we should not
recess subject to call of the Chair? Without objection, we will recess
subject to the call of the Chair.
(Whereupon, at 11:45 a.m., Thursday, May 28,1959, the committee
recessed, subject to the call of the Chair.)
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