Full text of Review (Federal Reserve Bank of St. Louis) : January 1972

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FEDERAL RESERVE BANK
OF ST. L O U IS
JANUARY 1972

C O N TEN TS
ST. LOUIS

•

LOUISVILLE

: •

EIGHTH DISTRICT
,
• M E M P H IS
LITTLE ROCK

Vol. 5 4 , No. 1




Government Debt, Money, and Economic
Activity............................................................

2

Two Critiques of Monetarism
A Critical Look at Monetarist Economics

10

Comments on a Monetarist Approach to
Demand Management ........................... 26

Government Debt, Money, and Economic Activity1
by KENNETH STEWART

I HE AMERICAN economy in the last six years
has experienced a high rate of inflation. The recent
recession, which led to an increase in the rate of
unemployment, was not accompanied by a rapid re­
duction in the rate of inflation. As a result, the effec­
tiveness of traditional stabilization measures was ques­
tioned, and the New Economic Program, which
includes administrative controls on prices and wages,
was initiated as a solution to these problems.
An examination of economic evidence over the past
twenty years suggests that the course of monetary
expansion can explain both the emergence of inflation
in the mid-1960s and the occurrence of a high un­
employment rate at the turn of this decade. The pat­
tern of monetary growth has been, in turn, greatly
influenced by growth in Federal Government debt.
This article relates trend rates of growth of money
and changes in rates of monetary growth during the
past two decades to changes in output, employment,
and prices. It further analyzes the growth of Govern­
ment debt and its relationship to the expansion of the
money stock.

Money and Economic Activity
According to the view presented in this article,
the economy is considered to be basically stable and
in the long run to move along a trend path of output
determined by growth in its productive potential.
Some variation in output and employment around
'This article expands some of the views initially presented in
a speech by Darryl R. Francis at the Annual Intermountain
Banking Seminar, Utah State University, Logan, Utah, No­
vember 18, 1971, as well as in papers presented by Leonall
C. Andersen at the Nineteenth Annual Conference on the
Economic Outlook, The University of Michigan, Ann Arbor,
Michigan, November 18, 1971, and by Jerry L. Jordan at the
National Bureau of Economic Research Conference on Secu­
lar Inflation, Chicago, Illinois, November 5 and 6, 1971.

Page 2


the trend path occurs due to disturbances from labor
strikes, crop failures, changes in tax rates and other
factors, but these disturbances have seldom been the
dominant force in causing recessions or inflations.
Evidence indicates that marked and sustained
changes in the rate of monetary expansion have been
a major factor underlying virtually all cyclical fluctua­
tions and inflations. Changes in the rate of growth of
the money stock have been shown to have predictable
effects on total spending in the same direction.2
Changes in total spending have been associated first
with changes in output and later with changes in
prices.3 Consequently, the trend rate of growth of the
money stock, defined in this article as demand deposits
and currency held by the nonbank public, is viewed
as having a major influence in determining the trend
rate of growth of prices, whereas accelerations and
decelerations in the growth rate of money lead mainly
to short-run fluctuations in output and employment.4
These short- and long-run effects of money stock
growth on prices, output, and employment are demon­
2In the equation formulated by Leonall C. Andersen and
Jerry L. Jordan, a marked and sustained change in monetary
growth has its major effect on nominal GNP within five
quarters. See Leonall C. Andersen and Jerry L. Jordan,
“Monetary and Fiscal Actions: A Test of their Relative Im­
portance in Economic Stabilization,” this Review (November
1968), pp. 11-24.
3Equations formulated by Leonall C. Andersen and Keith M.
Carlson indicate that monetary actions generally affect total
spending with a two-to-three quarter lag. A change in the
rate of growth of total spending was accompanied by a
simultaneous change in the rate of growth of output. Prices
changed more slowly following a change in total spending. See
Leonall C. Andersen and Keith M. Carlson, “A Monetarist
Model for Economic Stabilization,” this Review (April 1970),
pp. 7-25.
4In “Money Supply and Time Deposits, 1914-69,” this Review
(March 1970), pp. 6-10, changes in money growth rates and
cyclical movements in economic activity were compared.

JANUARY 1972

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

strated on Chart I.5 The trend rate of growth of the
money stock, as shown in the top tier, increased from
a 1.7 percent annual rate through most of the 1950s
and early 1960s, to 3.7 percent in the first half of the
1960s, and to 5.8 percent in the second half of the
1960s and early 1970s. The trend rate of growth of
prices, as shown by the General Price Index panel,
rose in a similar pattern from the 1950s through the
1960s, reflecting, after about a three year lag, changes
in the trend growth of the money stock.
Relationships between output and employment and
the growth of the money stock relative to its under­
lying trend rates can be observed in the top and bot­
tom tiers of Chart I. During the two decades covered,
six periods of money stock growth occurred at rates
significantly greater than the underlying trend.6 Each
of these periods was accompanied (with a lag of one
or two quarters) by an upward movement in real
output toward or above potential real output as esti­
mated by the President’s Council of Economic
Advisers.
During this same twenty year interval the economy
experienced four recessions (as defined by the Naional Bureau of Economic Research) and two periods
of brief economic slowdown. Each of the four reces­
sions (shaded areas in Charts I and II) was preceded
by a marked slowdown or an absolute decline in the
rate of growth of the money stock. The recessions
occurred in the periods 1953-54, 1957-58, 1960-61, and
1969-70. When the rate of growth of the money stock
slowed in 1962 and 1966, the growth rate of real out­
put slowed, and a rise in the rate of unemployment
followed. The 1962-63 and 1966-67 periods of slow­
down were not of significant magnitude and duration
to be labeled recessions.
Chart I does not offer conclusive evidence that
monetary growth affects economic activity. However,
the relationships shown on the chart are consistent
with the view that the trend growth of money is a
major influence on long-run price movements, and that
accelerations and decelerations of monetary growth
about the trend have predictable effects on output and
employment in the short run.7 Price movements, on
5For econometric evidence supporting the interpretation of
these charts, see Andersen and Carlson, “A Monetarist
Model.”
6As used in this context, a period is a time interval of at least
six months duration. These periods of accelerating money
growth began in late 1951, 1954, 1958, 1961, 1965, and
1968.
7For an elaboration of a theoretical foundation underlying
these relationships, see Karl Brunner, “A Survey of Selected
Issues in Monetary Theory,” Schweizerische Zeitschrift fiir
Volkswirtschaft und Statistik (No. 1, 1971), pp. 1-146.



the other hand, have been little affected by short-run
variations in monetary growth.
The experience of the last two decades also sug­
gests that monetary growth has little lasting influence
on the rate of unemployment and the growth rate of
real output.8 Despite variations in the rate of mone­
tary growth about its trend as well as changes in the
trend in the 1950s and 1960s, growth of real out­
put tended to move towards or along its potential
growth path.9 The unemployment rate averaged 4.9
percent from 1952 to 1962 and averaged 4.6 percent
since then. The lasting effect of monetary actions is
on the trend of prices, whereas output and employ­
ment growth depend on real factors —labor force
trends and productivity.

Determinants of the Money Stock
In view of these observed relationships between
money and economic activity, it is important to con­
sider the factors which affect movements in the money
stock. The money stock ( M) , defined in this article
as demand deposits and currency held by the nonbank
public, can be expressed as a function of the monetary
base (B ) and a money multiplier (m ) such that:
M = mB.
Using this relationship, factors which cause the money
stock to change can be summarized by changes in
the monetary base and the multiplier.
The multiplier over the past twenty years has been
fairly stable.10 It has fluctuated over a narrow range
and has been shown to be predictable.11 Conse­
quently, the trend rate of growth of the money stock
has been dominated by the trend rate of growth of
the monetary base. The close association between
sFor an explanation of this observation see Milton Friedman,
“The Role of Monetary Policy,” The American Economic
Review (March 1968), pp. 1-17, and in The Optimum
Quantity of Money and Other Essays (Chicago: Aldine
Publishing Company, 1969), pp. 95-110.
9After the 1960-61 recession, the movement back toward po­
tential real output was relatively slow. This period followed
two recessions only two years apart which provided a basis
for the growing belief in the early 1960s that the economy
was becoming subject to relatively short business cycles. Such
a belief was probably a contributing factor to the slow recov­
ery to full employment in the early 1960s. In addition, the
economy received a minor additional shock shortly after the
1960-61 recession when money declined relative to the trend
in 1962.
10The money multiplier summarizes the decisions of commercial
banks to hold excess reserves, of the Government to hold
demand deposits, and of the public to hold currency, demand
deposits, and time deposits. A discussion of factors affecting
the money multiplier is presented by Jerry L. Jordan, “Ele­
ments of Money Stock Determination,” this Review (October
1969), pp. 10-19.
n See Albert E. Burger, Lionel Kalish III, and Christopher
T. Babb, “Money Stock Control and Its Implications for
Monetary Policy,” this Review (October 1971), pp. 6-22.
Page 3

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

JANUARY 1972

C hart I

Influ en ce of M o n e y on Prices, O u tp u t a n d U n e m p lo y m e n t

Latest d a ta p lo tte d : u n e m p lo y m e n t ra te -IV /1 9 7 1 ; a ll o th e r d o ta - lil/1 971


Page 4


F E D E R A L R E S E R V E B A N K O F ST. L O U I S

JANUARY 1972

Chart I

Influence of Federal G overnm ent Debt on M o n etary Expansion
195?

1953

1954

1955

1956

1957

1958

1959

I960

1961

196? 1963

1964

1965 1966

1967

1968 1969 1970

1971

197?

>NS OF DOLLARS

Federal Governm ent Debt
300

T ed eral Governm ent Debt is th e sum of de bt held by Federal Reserve Banks
- and d e b t held by private investors. The origin al da ta may be found in the
ta ble entitled "O w n ersh ip of Public D eb t" in th e Federal Reserve Bulletin.
:
.■
Seasonally A d juste d________________________

4th q tr 70 '

RATIO SCALE
^
S IlllO N S OF DOLLARS

Federal Government Debt
Held by the Federal Reserve System
Seasonally Ad juste d
! _ |___ *217,

S§3rd qtr 6)

1 11
.
.
i

i

i

i «

i

r

Percent of Federal Governm ent Debt
Held by the Federal Reserve System
Seasonally Ad juste d

RATIO SCALE
BILLIONS OF DOLLARS

4 t h qtr

M o n e ta ry Base
S e aso na lly A djusted

rd qtr 61

I. . .t_L
RATIO SCALE
>NS OF DOLLARS

M o n e y Stock
S easonally A djusted

3rd qtr 62

I 11
Latest d a ta plo tte d: F ed erol G o vernm en t d e b t, m oney sto ck-lll/19 71 ; m on eta ry base-IV/1971




Page 5

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

JANUARY 1972

T a b le I

Sources o f the

B ase

M o n th ly A ve ra g e s o f D a ily Figures
(D o lla r A m o u n ts in M illio n s , N o t S e a s o n a lly A d ju s te d )
Percent o f Base
Dec.
1971

Sept.
1949

Dec.
1971

$ 1 7 ,4 4 1

$ 6 9 ,2 6 2

4 0 .9 %

7 6 .4 %

164

108

.4

.1

352

3 ,9 1 5

.8

4 .3

2 4 ,6 3 7

1 0 ,1 3 2

5 7 .8

1 1.2

1 0.8

8 .4

Sept.
1949
H o ld in g s o f G o ve rn m e n t
Securities
D iscounts a n d A dvances
F loat

F ederal Reserve C re d it

G o ld

Stock

S p e cia l
Tre a sury

D ra w in g

Rights

C urre n cy

7 ,6 1 2

4 ,5 9 2

O u ts ta n d in g

T re a sury Cash H o ld in g s

.4

400

-

1 ,3 1 0

—

454

649

—

1 ,9 2 6

-

3.1

—

.5

—

1.5

—

2.1

the monetary base (Table I ) . Since
1949, the amount of gold held has
declined almost continuously. The de­
cline in gold stock has contributed a
negative influence to growth of the
base, while increases in Federal Re­
serve holdings of U.S. Government se­
curities, the dominant component of
Federal Reserve credit, has contributed
a positive influence. Other sources,
though their net influence has been
positive, have contributed relatively
little to movements in the base during
the past twenty years.

From 1952 to the middle of 1961,
increases in securities held by the Fed­
O th e r D eposits a n d O th e r
eral Reserve System almost offset de­
—
2.6
2 ,3 2 4
4 .0
1 ,6 9 3
F ederal Reserve Accounts
creases in the gold stock. The mone­
1 0 2 .2 %
9 5 .7 %
$ 4 3 ,5 3 4
$ 8 6 ,7 2 5
Source Base
tary base grew slowly in this period.
2.2
4 .3
3 ,9 3 0
—
938
Reserve A d ju s tm e n t M a g n itu d e
Beginning in the 1960s, increases in
1 0 0 .0 %
1 0 0 .0 %
$ 9 0 ,6 5 5
$ 4 2 ,5 9 6
M o n e ta ry Base
Federal Reserve holdings of Govern­
ment securities more than offset reduc­
Totals may not add due to rounding.
tions in the gold stock, and the
monetary base grew more rapidly. A two-tiered gold
these two rates is indicated by the trend lines in the
system, established in March 1968, separated the gold
bottom two panels of Chart II.
market into private and official sectors, each with its
The monetary base represents the net monetary
own price. Since April 1968, the gold stock has re­
liabilities of the Government (U.S. Treasury and Fed­
mained roughly constant and has contributed little to
eral Reserve System) held by the public (commercial
growth of the monetary base. Gold now represents
banks and nonbank public). The monetary base has
only 11.2 percent of the base.
been referred to as “high powered” money because it
Holdings of Government securities by the Federal
can be used as reserves of commercial banks to ex­
Reserve represent the System’s acquisitions of Federal
pand demand deposits by more than the amount of
Government debt through its open market operations.
reserves.12
These security holdings presently comprise 76.4 per­
cent of the monetary base, and since the early 1960s
Given that changes in the monetary base are the
changes in security holdings have been the dominant
major determinant of changes in the rate of monetary
influence on growth of the base. Through purchases
expansion, it is important to ascertain the factors
and sales of securities, called open market operations,
which have led to changes in the base. Table I
presents the sources of the monetary base. Growth of
the Federal Reserve can control the growth of the
monetary base by offsetting or complementing any
the monetary base during the past twenty years has
movements in other sources.
been determined primarily by two sources — Federal
Reserve Credit and the gold stock. An increase in the
dollar amount of either of these sources, other things
Influence of the Federal Government Debt
equal, increases the monetary base by an equal
on Monetary Expansion
amount.
Growth of Government securities held by the Fed­
In September 1949, when the gold stock source of
eral Reserve System depends on the growth of Gov­
the base was at its peak, it comprised 57.8 percent of
ernment debt and the percent of this debt the System
decides to purchase. This section traces the growth of
12A discussion of the monetary base is presented by Leonall
Government debt over the last twenty years, the ac­
C. Andersen and Jerry L. Jordan, “The Monetary Base —
quisition of debt by the Federal Reserve System and
Explanation and Analytical Use,” this Review (August
the reasons for debt acquisition by the System.
1968), pp. 7-11.
Tre a sury D eposits a t Federal Reserve —

Page 6



F E D E R A L R E S E R V E B A N K O F ST. L O U I S

Growth in Federal Government
Debt Outstanding
Growth of Government debt is shown in the top
tier of Chart II.13 Government debt outstanding oscil­
lated around a one percent annual trend rate of
growth from the first quarter of 1952 to the third
quarter of 1961. Unified budget deficits of $3.4 billion
and $7.1 in fiscal years 1961 and 1962, respectively,
initiated an increase in the trend rate in the early
1960s. From the third quarter of 1961 to the fourth
quarter of 1966, Government debt rose by $20.2
billion, or at an annual trend rate of 1.6 percent.
Large unified budget deficits of $8.7 billion and
$25.2 billion were incurred in fiscal years 1967 and
1968, respectively. These deficits further increased the
trend growth rate of Government debt. From the
fourth quarter of 1966 to the fourth quarter of 1970
Government debt grew by $27.8 billion, or at a 2.6
percent annual rate.
Government debt grew in the early 1960s mainly
because of deficits incurred in fiscal years 1961 through
1965. During this period outlays for domestic civilian
programs increased at about an 8 percent annual rate
and tax receipts rose at a 5 percent rate. The slower
growth in tax receipts reflected tax cuts in 1962,
1964, and 1965. In the second half of the 1960s, de­
fense expenditures rose sharply, while at the same
time nondefense expenditures accelerated further.
These rapid expenditure increases were not accom­
panied by increased tax rates, except in fiscal 1969,
and as a result, large deficits were incurred in fiscal
years 1967, 1968, 1970, and 1971.

Federal Reserve Acquisition of Debt and
Growth of the Monetary Base
Federal Government debt held by the Federal Re­
serve System changed little in the 1950s, but then
grew rapidly in the 1960s. Changes in the monetary
base during the 1960s roughly paralleled that of the
System’s holding of debt. Debt acquisition by the
Federal Reserve System and the percent of debt held
by the System are shown on Chart II (second and
third panels from the top).
Between the first quarter of 1952 and the third
quarter of 1961, the proportion of Government debt
held by the Federal Reserve System remained roughly
constant at around 11 percent. As Government debt
increased, securities held by the Federal Reserve Sys­
tem increased proportionally, and as the debt de­
13Federal Government debt is defined in this article as the sum
of debt held by Federal Reserve Banks and debt held by
private investors. The original data may be found in the
table entitled “Ownership of Public Debt” in the Federal
Reserve Bulletin.



JANUARY 1972

creased, securities held decreased proportionally.
Variations in Government debt outstanding in the
1950s, especially late in the decade, tended to ac­
celerate and decelerate growth in the monetary base.
Variations in the base, in turn, were a major cause
of fluctuations in the money stock.
When the trend rate of growth of Government debt
increased in the first half of the 1960s, the percent of
the debt held by the Federal Reserve also increased,
as the rate of acquisition of debt by the Federal Re­
serve was more rapid than the expansion of the Gov­
ernment debt itself. Increased purchases of Govern­
ment securities by the Federal Reserve directly in­
creased the monetary base, increasing its trend rate
of growth, which in turn increased growth of the
money stock and economic activity. As resource
utilization approached its upper limit, as defined by
potential output, the rate of inflation increased.
From the third quarter of 1961 to the fourth quar­
ter of 1966, the Federal Reserve purchased $15.9 bil­
lion of Government securities adding to its portfolio
at a 9.1 percent average annual rate. The effect of
debt acquisition on growth of the monetary base was
partially offset by a $4.3 billion decline in the gold
stock, and the monetary base grew by $13.7 billion.
This increase accelerated growth of the base to a 4.4
percent annual rate, and growth of the money stock
began to accelerate in the third quarter of 1962. Real
output grew with little effect on prices until 1965
when a high level of resource utilization was reached
and price increases began to accelerate.
The Federal Reserve continued to rapidly increase
its security holdings in the second half of the 1960s,
when growth of the debt accelerated further. As a
result, growth of the monetary base, money stock, and
prices accelerated. From the fourth quarter of 1966 to
the fourth quarter of 1970, Government debt held by
the Federal Reserve grew by $17.2 billion, or at an 8.7
percent annual rate. As a consequence, the portion of
debt held by the Federal Reserve increased from
16.8 percent in late 1966 to 21.1 percent in late 1970.
The base increased by $16 billion, accelerating to a
5.4 percent annual rate of growth. Money stock
growth accelerated to a 5.8 percent annual rate during
this period and the rate of increase in prices climbed
to a 5.1 percent rate beginning in the second quarter
of 1969.

Major Factors Influencing Acquisition of
Debt by the Federal Reserve
The Federal Reserve System purchases Govern­
ment securities for several purposes. However, conPage 7

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

JANUARY 1972

Interest Rates

1950

1951 1952 1953 1954 1955 1956 1957

1958 1959 1960

1961

1962 1963 1964 1965 1966 1967 1968 1969 1970

1971

1972 1973 1974 1975

Shaded are as represent pe rio ds of business recessions as d e fin e d b y (he N o tio n a l Bureau o f Economic Research
la te s t d a ta p lo tte d : D ecember

cem over market interest rate movements has been
a major factor influencing Federal Reserve acquisition
of Government debt over the last two decades.14
Debt issues by the Federal Government put up­
ward pressure on interest rates. When the Federal
Reserve System buys Federal Government debt in the
open market, both the supply of credit and the money
stock are increased. Greater availability of funds in
the credit markets initially puts downward pressure
on interest rates. System actions are thereby capable
of preventing interest rates from rising during times
of Treasury borrowing.
Purchases of securities also increase the monetary
base which produces an expansion in the money
stock. If growth of the money stock is greater than
increases in the demand for money balances, then the
difference will tend to be reflected in an increase in
aggregate demand. An increase in aggregate demand
stimulates economic activity and tends to increase the
demand for credit placing upward pressure on market
14Michael W. Keran and Christopher T. Babb, using regres­
sion analysis, found that changes in Federal Reserve hold­
ings of Government securities and changes in the monetary
base were influenced, in descending order of importance, by
market interest rates, changes in the amount of United
States Government debt outstanding, and economic stabili­
zation objectives. See Michael W. Keran and Christopher
T. Babb, “An Explanation of Federal Reserve Actions
(19 33 -68),” this Review (July 1969), pp. 7-20.

Page 8


interest rates. If prolonged price increases accompany
an acceleration in total spending, expectations of
future price increases develop. Borrowers are then
willing to pay and lenders demand an inflation pre­
mium which raises market interest rates. Thus, sus­
tained increases in the money stock usually exert
upward pressure on interest rates.
The initial, short-run impact of its security pur­
chases on interest rates generally has received the
greatest attention in the day-to-day operations of
the Federal Reserve System. Large debt acquisition
by the System has resulted from attempts to maintain
existing money market conditions during times of
Treasury borrowing. The positive longer-run impact
of monetary expansion on interest rates has been a
factor leading to an accelerating trend rate of growth
of the money stock in the 1960s.
Variability around trend movements of the mone­
tary base may be attributed in considerable measure
to alternating concern between reducing inflation and
facilitating a relatively rapid economic expansion to
lower the rate of unemployment. When the rate of
inflation intensified monetary authorities sought higher
interest rates; consequently, the rate of growth of the
base ( and money stock) slowed markedly for a period.
Shortly thereafter economic activity slowed and unem­

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

ployment rose. Monetary authorities then shifted ob­
jectives and attempted to lower market interest rates
to stimulate economic activity; consequentiy, the base
increased more rapidly. This rapid monetary expan­
sion, after a lag, placed further upward pressure on
prices, setting the basis for a future round of monetary
restraint.15

Conclusions
This article emphasizes a number of propositions
which may be summarized as follows:
1. The trend rate of growth of the money stock plays
a major role in determining the trend rate of
growth of prices. Marked and sustained changes
in the growth rate of the money stock are followed
by short-run variations in output and employment.
15Examples of such short-run destabilizing monetary actions
have been noted in this Bank’s Review. See Reprints 17, 22,
28, 39, 57, and 68, for annual reviews of monetary actions
for the years 1965 through 1970, respectively. A study of the
released “Minutes of the Federal Open Market Committee”
for the years prior to 1965 indicates that monetary develop­
ments were similar in earlier years.




JANUARY 1972

2. Growth of the money stock is dominated by
growth of the monetary base.
3. Even though monetary authorities can independ­
ently control movements in the monetary base,
growth of the base has been greatly influenced by
growth of Government debt and concern about
movements in market interest rates.

A steady, moderate rate of monetary expansion can
help foster noninflationary growth and promote sta­
bility. Such a course of monetary expansion may be
difficult to achieve at the present time, unless impedi­
ments to such expansion are reduced. The Federal
Government deficit during fiscal year 1972 is expected
to be extremely large, representing a substantial de­
mand for credit, which in turn, would be expected
to exert upward pressure on market interest rates.
Public sentiment against high or rising interest rates is
deeply imbedded in traditional American thought.
A step towards lessening the influence of these im­
pediments would be for market interest rates to receive
less emphasis in the determination of monetary actions.

Page 9

A Critical Look at Monetarist Economics
by RONALD L. TEIGEN

Ronald L. Teigen is an Associate Professor of Economics at the University of Michigan. He
received a PhD degree in Economics from Massachusetts Institute of Technology. Professor
Teigen is the author of several articles in monetary economics, and is co-author with Warren L.
Smith of R e a d i n g s i n M o n e y , N a t i o n a l I n c o m e , a n d S t a b i l i z a t i o n P o l i c y . This paper was pre­
sented at the Annual Conference of College and University Professors of the Federal Reserve
Bank of St. Louis on November 12,1971.

U N TIL JU ST a few years ago, the viewpoint
which lately has come to be known as “monetarist”
was not taken very seriously by anyone except a few
dedicated disciples. Its central postulate — that
changes in the level of aggregate money income were
due essentially to prior money stock changes —was
viewed as a totally inadequate oversimplification, es­
pecially since the proponents of this approach failed
to provide an adequately detailed explanation of the
theoretical structure upon which this tenet was
based.1 The empirical evidence presented in support
of this “quantity theory” viewpoint was subjected to
criticism so severe that the evidence has never been
taken very seriously.2
'In particular, Milton Friedman’s well-known article, “The
Quantity Theory of Money — A Restatement,” in M. Friedman,
ed., Studies in the Quantity Theory of Money (Chicago:
University of Chicago Press, 1956), pp. 3-21, which has
been cited as the basis for much monetarist work, has been
shown by Don Patinkin to be a sophisticated version of Keynes’
liquidity preference theory rather than the up-to-date state­
ment of an alleged Chicago oral tradition that monetarists
take it to be. See Don Patinkin, “The Chicago Tradition, the
Quantity Theory, and Friedman,” Journal of Money, Credit
and Banking (February 1969), pp. 46-70.
2I am referring chiefly to the controversy triggered by the
work of Milton Friedman and his associates in the late 1950s
and early 1960s, especially Friedman’s evidence on lags
observed between changes in the rate of change of the
money stock and changes in GNP, as presented in his paper,
“The Supply of Money and Changes in Prices and Output,”
Joint Economic Committee, U.S. Congress, 1958, and else­
where, and in the Milton Friedman and David Meiselman
paper on, “The Relative Stability of Monetary Velocity and
the Investment Multiplier in the United States, 1897-1958,”
in Commission on Money and Credit, Stabilization Policies
(Englewood Cliffs, N.J.: Prentice-Hall, Inc., 1963). The
regression results reported in the latter paper were severely
criticized by Donald Hester in the November 1964 Review of
Economics and Statistics and by Albert Ando-Franco Modig­
liani and Michael DePrano-Thomas Mayer in the September
1965 American Economic Review. The lead-lag observations
discussed in the former paper were criticized by John M.
Culbertson in the December 1960 Journal of Political Econ­
omy, and by James Tobin in the May 1970 Quarterly
Journal of Economics.
Digitized for Page 10
FRASER


However, recent years have witnessed something
of a turnaround. The conventional wisdom as em­
bodied in modem Keynesian theory has been cast
into doubt, while monetarist thinking has increased
greatly in popularity, to the point where its propo­
nents, and even some of its critics, speak of a “mone­
tarist revolution”.3 The reasons for this rather sudden
change are no doubt related in part to the apparent
inconsistency of the Keynesian analysis (or at least
an elementary version of it) with economic events in
the United States during the late 1960s,4 in some
3See Karl Brunner, “The ‘Monetarist Revolution’ in Monetary
Theory,” Weltwirtschaftliches Archiv (No. 1, 1970), pp. 1-30,
and Harry G. Johnson, “The Keynesian Revolution and the
Monetarist Counter-Revolution,” American Economic Review,
Papers and Proceedings (May 1971), pp. 1-14.
4The apparent failure of the income tax surcharge of June
1968 to reduce aggregate demand rapidly has been inter­
preted by some to be evidence of the failure of the “new”
economics. However, it is not at all clear that the surtax was
ineffective. In a recently-published study by Arthur Okun,
evidence is provided that, at least in some categories of
spending (nondurable goods and services in particular), the
surcharge seems to have reduced demand substantially. But
in other categories ( especially demand for new automo­
biles) no reduction is apparent. See Arthur M. Okun, “The
Personal Tax Surcharge and Consumer Demand, 1968-70,”
Brookings Papers on Economic Activity (No. 1, 1971), pp.
167-204. More generally, the notion that demand should have
been observed to fall after the surtax was imposed is based
on simplistic and partial analysis. When the surtax is analyzed
within the context of a complete model (in which govern­
ment spending is taken into account), and one which in­
corporates the sophisticated theories of consumption be­
havior recently developed — the “permanent income” hypo­
thesis of Milton Friedman or the “life-cycle” hypothesis of
Albert Ando and Franco Modigliani —there appear a number
of considerations which suggest that no substantial diminu­
tion of total demand could be anticipated. This point of view
is argued persuasively by Robert Eisner in his paper, “Fiscal
and Monetary Policy Reconsidered,” American Economic
Review (December 1969), pp. 897-905. Eisner reasons that
rising Government expenditure had been expanding demand
rapidly at the time when the surtax was enacted; furthermore,
under the Friedman and Ando-Modigliani theories, which
postulate that it is some long-run measure of income or
wealth rather than current-period income which determines

JANUARY

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

degree to monetarist criticism of Keynesian analysis
(mostly directed at a very elementary version of it),
and in part to other causes, including substantial de­
velopment by the monetarists of their own theoretical
position, as well as the appearance of new and more
convincing empirical findings.5
While the increase in popularity of monetarism has
been rapid, and the rate of growth of the monetarist
literature impressive, a critical literature has also ap­
peared, charging that monetarist theory has turned
out largely to consist of old concepts clothed in new
names, and that the empirical evidence purportedly
supporting the monetarist position is biased and un­
dependable.6 The purpose of the present paper is to
attempt to summarize in a general way the main fea­
tures of the present monetarist theoretical stance, and
to examine the monetarist view of modem Keynes­
ianism. Since much of the debate bears directly on
the stabilization policy process and the relative use­
fulness of different instruments of policy, particular
attention will be given to the nature of the transmis­
sion mechanism under the two approaches. The em­
pirical evidence will not be discussed in a systematic
way in this paper, although reference will be made to
it, where appropriate, in the discussion of the theories.
In conducting this comparison, I shall attempt to
identify issues between the two camps which are real,
and those which seem to be false.

The Structure of Monetarist Thought
Although the roots of modem monetarist thought
extend far back in time (the writings of classical
economists are often cited, Irving Fisher being partic­
ularly popular), it is only lately that detailed exposi­
tions of this theory have begun to appear. In this
paper, no systematic discussion of the entire literature
a household’s living standard, a temporary tax change (such
as the 1968 surcharge) would be expected to have only
minor effects on spending because it does not change longrun expected income significantly. See Milton Friedman, A
Theory of the Consumption Function (Princeton, N.J.: Prince­
ton University Press, 1957), and Albert Ando and Franco
Modigliani, “The ‘Life-Cycle’ Hypothesis of Saving: Aggre­
gate Implications and Tests,” American Economic Review
(March 1963), pp. 55-84.
5Harry Johnson, “The Keynesian Revolution and the Mone­
tarist Counter-Revolution, ’ suggests that the successful mone­
tarist upsurge may also be due to the factors related to the
conversion of the “Keynesian revolution” of the 1930s into
the economic orthodoxy of the 1960s.
6Ibid., for a general discussion of monetarist theory and its
relationship to Keynesian orthodoxy. There have been pub­
lished a large number of papers critical of the recent mone­
tarist empirical studies; references to some are given in
footnote 2, and a summary of the criticism of more recent
monetarist empirical work is contained in Ronald L. Teigen,
“The Keynesian-Monetarist Debate in the U.S.; A Summary
and Evaluation,” Statsokonomisk Tidsskrift (January 1970),
pp. 1-27.



1972

will be undertaken. Instead, important summary
statements which recently have become available in
articles by Andersen, Brunner, Fand, Friedman, and
others will be taken to be representative of presentday monetarist thought.7

Models, Assertions and Themes
As a useful starting point in establishing a general
framework for the discussion to follow, we may refer
to recent articles by Brunner and Friedman contain­
ing inclusive statements of the monetarist position.8
Friedman provides an explicit statement of the staticequilibrium structure which he views as being con­
sistent with both the monetarist and Keynesian schools
of thought. The theme he stresses — that it is the
particular features of or assumptions about particular
characteristics of the general analytic structure, rather
than the fundamental nature of the structure itself,
which differentiate monetarists and Keynesians — also
appears in the writings of Brunner and others. In
summary form, the model set out by Friedman is as
follows:
(1 )

|

= C ( J , r) + I(r)

(2 ) Mo = p*L( — r )
P
(3 ) Y = py

where Y is money income, p is the general price level,
r is the rate of interest, M0 is the nominal exogenouslyset money stock,9 y is real income or output, and C,
7Some of the important articles include Leonall C. Andersen,
“A Monetarist View of Demand Management: The United
States Experience,” this Review (September 1971), pp. 1-11;
Leonall C. Andersen and Keith M. Carlson, “A Monetarist
Model for Economic Stabilization,” this Review (April 1970),
pp. 7-25; Leonall C. Andersen and Jerry L. Jordan, “Monetary
and Fiscal Actions: A Test of Their Relative Importance in
Economic Stabilization,” this Review (November 1968), pp.
11-24; Karl Brunner, “The Role of Money and Monetary
Policy,” this Review (July 1968), pp. 9-24; idem, “The
‘Monetarist Revolution’ in Monetary Theory;” idem, “A Sur­
vey of Selected Issues in Monetary Theory,” Schweizerische
Zeitschrift fiir Volkswirtschaft und Statistik (No. 1, 1971),
pp. 1-146; idem, “The Monetarist View of Keynesian Ideas,”
Lloyds Bank Review (October 1971), pp. 35-49; David I. Fand,
“Keynesian Monetary Theories, Stabilization Policy and the
Recent Inflation,” Journal of Money, Credit, and Banking
(August 1969), pp. 556-87; idem, “Monetarism and Fiscalism,’ Banca Nazionale del Lavoro Quarterly Review (Sep­
tember 1970), pp. 275-89; idem, “A Monetarist Model of the
Monetary Process,” Journal of Finance (May 1970), pp.
275-89; Milton Friedman, “A Theoretical Framework for
Monetary Analysis,” Journal of Political Economy (M arch/
April 1970), pp. 193-238; idem, “A Monetarist Theory of
National Income,” Journal of Political Economy (M arch/
April 1971), pp. 323-37.
8Friedman, “A Theoretical Framework,” and Brunner, “The
‘Monetarist Revolution’.”
!)In one version of Friedman’s statement, the money supply is
made a function of the interest rate rather than being as­
sumed to be exogenous. However, this makes no essential
difference to the present discussion, as Friedman points out.
Page 11

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

I, and L stand for the consumption, investment, and
demand-for-money functions, respectively.
Equation (1) is of course the familiar IS curve,
from which can be obtained all combinations of real
income and the interest rate which will make the flow
of planned spending equal to available output, and
hence will result in equilibrium in the market for
goods and services. Equation (2 ) is the LM curve,
which yields all combinations of real income, the in­
terest rate, and the price level which will equate the
demand for real balances with the real value of the
nominal money stock. Equation (3 ) is a definition
relating nominal income and real income or output
through the price level. There are of course other
markets which could be considered, but which are not
explicitly accounted for in equations (1) or (2); in
particular, the bond and labor markets are not made
explicit. Friedman argues that the assumptions made
by the two camps in order to accommodate these
markets and simultaneously close the system of equa­
tions constitute a fundamental point of difference be­
tween monetarists and Keynesians. As written in equa­
tions ( l ) - ( 3 ) , the model posited by Friedman con­
tains four endogenous variables —Y, p, r, and y — and
therefore is underdetermined. Monetarism is said by
Friedman to include with the above equations a vast
number of additional relationships; specifically, a
whole Walrasian system of demand equations, supply
equations, equilibrium conditions, etc., which in and
of themselves determine y, the level of real output.
The inclusion of a Walrasian system of course implies
that the equilibrium position of the model is one of
full employment. (There is no such implication for
the short-run dynamics of the system, however.) With
real output predetermined from the standpoint of
equations ( l ) - ( 3 ) , equation (1) can be solved for
the equilibrium value of the interest rate, and (2)
yields the equilibrium price level. Elementary manip­
ulation of this system gives the result that only the
price level (and the money wage rate, which is not
made explicit in equations (1) - ( 3 ) ) will change in
response to a money stock change; the equilibrium
value of the interest rate is not shifted, and therefore
is said to be determined only by “real” variables.10
In other words, this version of the model displays the
well known “classical dichotomy.”
According to Friedman, the Keysian approach util­
izes a much different and less satisfactory procedure
luThis statement is not accurate if the system contains a gov­
ernment sector which issues money-fixed claims against it­
self, and if real wealth is an argument in the expenditure
functions, and/or if the government establishes a tax-expenditure system based on nominal variables.

Page 12


JANUARY 1972

by assuming that the price level, rather than real in­
come, is determined outside of the postulated struc­
ture (Friedman refers to “. . . a deus ex machina with
no underpinning in economic theory.”).1 By taking
1
the price level to be exogenous with respect to this
structure, the number of variables again is reduced to
three (Y, y, and r in this case). However, the system
no longer is dichotomized, and all of the variables
now are determined jointly rather than recursively.
In particular, the static equilibrium levels of both real
income and the interest rate can now be changed by
both money stock and expenditure changes.1It would be a mistake to conclude from the forego­
ing discussion that monetarists view themselves as
differing from Keynesians only in terms of the assump­
tions utilized to provide a unique equilibrium solution
to die static IS-LM model. There are several other
typically monetarist assumptions about the static and
dynamic dimensions of this system. Recently, Karl
Brunner has introduced four propositions which he
asserts are “defining characteristics of the monetarist
position.” These are: (1 ) the transmission mechanism
for monetary impulses involves a very general kind
of portfolio adjustment process ultimately affecting the
relationship between the market price of physical as­
sets and their production cost, rather than only the
relationship between borrowing costs and the internal
rates of return on potential acquisitions of new physi­
cal capital, as is asserted to be the mechanism char­
acteristic of modem Keynesian analysis; (2 ) most of
11Friedman, “A Theoretical Framework,” p. 222.
12ln a more recent article, Friedman has proposed another
means of closing this system of equations, which he labels a
“third way” to distinguish it from the two procedures out­
lined in the body of the present paper. He views this ap­
proach as intermediate in respect to its theoretical position
vis-a-vis the others. However, since it reduces to a relation­
ship between income and the past history of the money
stock, as Friedman demonstrates, it seems clearly to fit in
with the monetarist point of view. In this approach, it is
assumed that the current market rate of interest and the ex­
pected market rate are kept equal by the actions of asset
holders. The expected market rate, in turn, is set by the ex­
pected real rate plus the expected rate of price change
(which by definition is the difference between the expected
rate of change of nominal income and of real output). By
assuming the expected real rate of interest, the expected
rate of growth of real output, and the expected rate of
growth of nominal income all to be determined outside the
system, the market rate of interest is made into a variable
determined outside the system also. Assuming further that
the income elasticity of demand for money is unity, Fried­
man establishes a direct link between nominal income and
the money stock (because under his assumptions, velocity
becomes a predetermined variable); this, in turn, enables
the “real” sector to be solved. One of the features of this
procedure is that it provides an alternative to the assump­
tion of full employment. However, it entails some disadvan­
tages of its own, which are noted in the section of the present
paper entitled “Stabilization Policy.” See Friedman, “A
Monetary Theory of Nominal Income.”

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

the destabilizing shocks experienced by the system
arise from decisions of the government with respect
to tax, expenditure, and monetary policy, rather than
from the instability of private investment or of some
other aspect of private-sector behavior, as the Key­
nesian view is said to assume. A related belief is that
the demand-for-money function is very stable, while
the policy-determined supply of money balances is
unstable; (3 ) monetary impulses are the dominant
factor in explaining changes in the pace of economic
activity, in contrast to the Keynesian position which
assertedly takes real impulses as primary; (4 ) in
analyzing die determinants of change in the level of
aggregate activity, detailed knowledge of “allocative
detail” about the working of financial markets and
institutions is of secondary importance and can be
disregarded. This implies that the relationship be­
tween policy instruments and economic activity can
be captured in a very small-scale model —perhaps
even in one equation —while the Keynesian position
is that knowledge of allocative detail (e.g., substitu­
tion relationships between various financial assets) is
necessary for the proper understanding of policy
processes, implying a need for complex structural
models.13

JANUARY 1972

The quantity theorist accepts the empirical hypoth­
esis that the demand for money is highly stable —
more stable than functions such as the consumption
function that are offered as alternative key relations.
. . . . [T ]h e stability he expects is in the functional
relation between the quantity of money demanded
and the variables that determine i t . . . [and] he must
sharply limit, and be prepared to specify explicitly,
the variables that it is empirically important to in­
clude in the function. F o r to expand the number of
variables regarded as significant is to empty the hy­
pothesis 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 indefinitely
large number of variables.15

(2) A particular aspect of the demand for money
emphasized by monetarists is that, in their analysis,
the stable demand for money is concerned with real,
not nominal, balances, while the authorities control
the nominal supply, which tends to be quite variable
relative to demand.16 This state of affairs is usually
contrasted with the Keynesian case, in which the de­
mand for money is said to be a demand for nominal
balances, either because it is (incorrectly) specified
that way,17 or because, as in Friedman’s discussion
summarized above, the price level is fixed so that real
and nominal balances are the same. Monetarists use
The statements by Brunner and Friedman are at­
this distinction as part of a rationalization for their
tempts to sketch the fundamental structure of mone­
contention that their analysis implies a much broader
tarism. As such, they do not emphasize or even iden­
concept of the transmission mechanism for monetary
tify explicitly some of the specific characteristic
impulses than does the Keynesian model, being based
themes which permeate monetarist writing, including
on a very general portfolio adjustment process work­
their own. Several such themes can be identified.
ing through changes in a broad spectrum of asset
(1)
Great importance is attached to the demand- yields and price level changes, in contrast to the nar­
for-money function, and it is in fact the central be­
row cost of credit channel which is implied by the
havioral relationship in the monetarist model.14 Par­
Keynesian demand-for-money function. This point is
ticular stress is laid on its stability, by which is meant
developed further in the section entitled “The Trans­
not only that the variance of its error term is small,
mission Mechanism for Monetary Impulses” below.
but much more importantiy, tiiat it contains very few
arguments. Friedman has written that:
(3 ) Further, monetarists believe the interest elastic­
13These “defining characteristics” are discussed at some length
in Brunner, “The ‘Monetarist Revolution’,” Section II.
14Thus, for example, David Fand states, “The quantity theory,
in its post-Keynesian reformulation, is a theory of the de­
mand for money and a theory of money income,” “Keyne­
sian Monetary Theories,” p. 561. Also, he writes, “. . . the
modem quantity theory uses the money demand function
to predict the level of money income and prices if output is
given, or changes in money income if output varies with
changes in [the money stock],” “Monetarism and Fiscalism,” p. 228. Friedman has written, “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,” “The Quantity Theory of Money —
A Restatement,” p. 16.




ity of demand for money balances to be quite low.
15Friedman, “The Quantity Theory of Money — A Restatement,”
p. 16.
16On this point Fand writes, “The sharp distinction drawn be­
tween the supply determined nominal money stock and the
demand determined real stock — a key feature of monetar­
ism —endows the authorities with elfective control over the
nominal money stock, while severely limiting the extent,
and the circumstances, in which they may hope to influence
the real value of this stock. If the former assumption ex­
tends their control over nominal variables, the latter as­
sumption severely limits their influence and control on en­
dogenous variables such as the real money stock.” See
“Monetarism and Fiscalism,” pp. 280-81.
17This view is taken by David I. Fand in, “Some Issues in
Monetary Economics,” Banca Nazionale del Lavoro Quar­
terly Review (September 1969), pp. 228-9 and footnote
24, p. 229.
Page 13

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

Until recently, it was generally thought that they
viewed this elasticity to be zero so that the demand
for money was linked directly to income as implied
by the naive quantity theory. However, such a view
has been rejected outright by Friedman and others;18
if it ever was held, the accumulation of empirical
evidence to the contrary has ma'de it untenable now.19
Presently, monetarists take the reputedly different
views held by themselves and Keynesians on the size
of this elasticity as a basis for contrasting inferences
about the expected behavior of velocity in response
to a monetary shift. A substantial interest elasticity of
demand for money, said to be the Keynesian position,
is viewed as implying unstable velocity; Keynesians
are viewed by monetarists as not being able to “de­
pend” on the stability of velocity, for as the money
stock rises and falls, offsetting velocity changes insu­
late the rest of the system to a great extent. On the
other hand, while not believing velocity to be per­
fectly constant, monetarists take the position that
..
although marginal and average velocity differ, the
velocity function is sufficiently stable to provide a re­
lation between changes in money and changes in
money income.”20 In other words, some, but not
much, short-run variation in velocity may be ex­
pected.21 To some monetarists, the essential differ­
ence between the two positions is summed up in the
demand for money-velocity nexus. Fand writes:
The post-Keynesian quantity and income theories
thus differ sharply in their analysis of the money
demand function. In the modem quantity theory it
serves as a velocity function relating either money
and money income or marginal changes in money
and money income . . .; in the income theory, it
serves as a liquidity preference theory of interest
rates, or of changes in interest rates (if the price
level is given and determined independently of the
monetary secto r).22

Although it has become fairly common practice to dis­
cuss the behavior of velocity in terms of the proper­
ties of the demand-for-money function, it is improper
to do so because observed velocity depends on all of
the behavior —real and monetary —in the macroeco­
18Milton Friedman, “Interest Rates and the Demand for
Money,” Journal of Law and Economics (October 1966),
pp. 71-86.
19Some of this evidence is summarized in David Laidler,
The Demand for Money: Theories and Evidence (Scranton,
Pa.: International Textbook Company, 1969).
20Fand, “Keynesian Monetary Theories,” pp. 563-4.
21Monetarists do not necessarily expect velocity to change
inversely with changes in the money stock. Friedman re­
cently has written that “. . . the effect on [velocity] is
empirically not to absorb the change in M, as Keynesian
analysis implies, but often to reinforce it. . .
“A Theoreti­
cal Framework,” p. 217.
22See Fand, “Some Issues,” p. 228.

Page 14


JANUARY

1972

nomic system. This point will be discussed in greater
detail below.
(4 ) The final monetarist theme which I shall men­
tion is concerned with the nature of the response of
interest rates to a monetary shift. Monetarists distin­
guish three components in the observed movement of
interest rates: a “liquidity” effect, which is the im­
mediate response before income or other variables
have changed, and thus is expected to be in the oppo­
site direction of the monetary shift; an “income” ef­
fect, which is the induced reaction of interest rates to
the change in income brought about by the monetary
impulse, and hence is expected to be in the same di­
rection as the money stock change; and a “price
expectations” effect, which comes about because
monetary changes cause lenders and borrowers to
anticipate a changing price level and lead lenders to
protect themselves against the expected depreciation
in the value of their funds by charging higher rates.
This last effect would cause market interest rates to
change in the same direction as the monetary
change.23
In looking back over this summary of monetarist
thought, it becomes quite apparent that there is a
good deal of truth to Friedman’s contention that the
differences between Keynesians and monetarists are
essentially empirical rather than theoretical, having
to do with the assumptions made about specific
aspects of the commonly-accepted structure, the rela­
tive stability and importance in the analysis of differ­
ent functional relationships, the sizes of various elasti­
cities, etc.24 There appears to be little disagreement
between the two camps over the specification of
Friedman’s basic model.25 And of Brunner’s four
23For a discussion of these distinctions, see e.g. William Gib­
son, “Interest Rates and Monetary Policy,” Journal of
Political Economy (May/Iune 1970), pp. 431-55.
24This position is expressed in several of Friedman’s writings;
for example, see Milton Friedman and David Meiselman,
“The Relative Stability,” p. 168, and Milton Friedman,
“Post-War Trends in Monetary Theory and Policy,” Na­
tional Banking Review (September 1964), reprinted in M.
Friedman, The Optimum Quantity of Money and Other
Essays (London: Macmillan and Co., Ltd., 1969), p. 73.
25Not all monetarists view this particular model as an appro­
priate description on which to build an analysis, however.
Brunner recently wrote, “It is useful to emphasize . . . that
the logic of the monetarist analysis based on the relative
price theory approach requires that attention be directed to
the interaction between output market, credit market and
Walrasian money market. This requirement cannot be satis­
fied by the general framework used by Friedman. This
framework is the standard IS-LM analysis offered in an es­
sentially Keynesian spirit. And this very choice of basic
framework actually creates the analytical problems clearly
recognized by Friedman in his subsequent discussion. . . .
Our analysis . . . established however that the standard
IS-LM diagram is not a very useful device for the analysis
of monetary processes.” Karl Brunner, “A Survey of Selected
Issues in Monetary Theory,” p. 82.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

points, at least two are essentially empirical (points
numbered (2 ) and (3 ) above), while one of the re­
maining two (point (1 ) above) makes a distinction
between monetarist and Keynesian views of the trans­
mission mechanism which I believe is false with re­
spect to current post-Keynesian income-expenditure
analysis. Only his last point — that it is appropriate to
study the relationship between policy instruments and
economic activity without depending on knowledge
of “allocative detail” — appears to be one about which
there are genuine differences at the theoretical (or
perhaps more properly, the methodological) level.
Finally, among the four monetarist themes mentioned
above, the third one is clearly empirical in nature, and
monetarists and Keynesians both in fact hold that this
elasticity is nonzero but small in absolute value. In the
next section, it is demonstrated that modern Keynes­
ians take the price level to be endogenous, which sug­
gests that the monetarist-Keynesian distinctions sum­
marized above as the second theme are not valid. I
shall try to show below that monetarist emphasis on
the importance of the demand-for-money relationship
(the first theme) is unwarranted, at least in so far as
this relationship is viewed as the basis for predicting
velocity. I shall also show that the two components of
interest rate change in response to a monetary impulse
identified in theme four as monetarist are either clearly
present in or at least consistent with Keynesian analy­
sis and assumption.

Monetarism, Keynesianism and the
Price Level
As already noted above, monetarists see one of the
essential differences between the two sides to be the
question of the determinants of the price level in
comparative static equilibrium analysis. Keynesians
are said to take prices to be fixed so that monetary
shifts are reflected in output changes, while quantity
theorists believe that monetary changes affect only
the price level in this sort of analysis, with real output
being determined by a separate subsector of the
system.
There is no doubt whatsoever that many practi­
tioners of the Keynesian viewpoint have assumed that
prices could conveniently be taken as given for some
problems — especially those associated with substan­
tial unemployment — and that it has often been con­
venient for simplicity of exposition in undergraduate
classroom exercises or for other purposes to make the
assumption of rigid prices. It is quite dubious, how­
ever, that this assumption, or the liquidity trap as­
sumption which also has been an important element



JANUARY 1972

in the monetarist view of Keynesianism, reflects the
thinking of most Keynesian economists today.26
Rather, the standard static “complete Keynesian sys­
tem” is widely recognized to be one in which the
general price level is one of the variables determined
by the interaction of the system, and hence is free to
move, but to be one in which there are imperfections
in the labor market —most typically, a money wage
rate which is inflexible downwards. In other words,
rather than assuming that prices are fixed as a means
of making the simple static model determinate, mod­
em Keynesians introduce an aggregated labor market
and production function into the analysis.27 This could
be viewed as the Keynesian equivalent of the “Wal­
rasian system of equations” asserted by Friedman to
be the hallmark of the adherents to the modern quan­
tity theory approach. It is of course much less satis­
factory in that all labor market activity and all kinds
of production are aggregated into perhaps as few as
two equations (i.e., a reduced-form labor market
equation and an aggregate production function)
rather than having each market and each activity
represented by specific equations. It is more satisfac­
tory on two counts: first, the equations at least are
explicitly specified, and second, these equations do not
yield the full employment outcome, as is typically
the case when depending on a Walrasian system.28
26The liquidity trap is rejected by most economists today be­
cause little support for it has been found in the many
empirical studies of the demand for money which have
recently been made. For a summary of some of this evi­
dence, see Ronald L. Teigen, “The Demand for and Sup­
ply of Money,” W. L. Smith and R. L. Teigen, eds.,
Readings in Money, National Income, and Stabilization
Policy, rev. ed. (Homewood, 111.: Richard D. Irwin, Inc.,
1970), Table 2, p. 98, or “The Importance of Money,” Bank
of England Quarterly Bulletin (June 1970), pp. 159-198.
27As evidence for the assertion that modern post-Keynesian
static analysis in its most general form typically assumes the
price level to be an endogenous variable, and that the system of
equations usually is made determinate by introducing a supply
subsector consisting of a labor market and aggregate produc­
tion function, the following standard works are cited:
Gardner Ackley, Macroeconomic Theory (New York: Mac­
millan, 1961), Chap. IX; R.G.D. Allen, Macro-Economic
Theory (London: Macmillan, 1967), Chap. 7, esp. sections
7.6-7.8; Martin J. Bailey, National Income and the Price Level,
2nd. ed. (New York: McGraw-Hill, 1971), Chap. 3, esp. sec­
tion 2; Robert S. Holbrook, “The Interest Rate, the Price
Level, and Aggregate Output,” in W .L. Smith and R.L.
Teigen, eds., Readings in Money, National Income, and
Stabilization Policy, rev. ed.; Franco Modigliani, “The Mone­
tary Mechanism and its Interaction with Real Phenomena,”
Review of Economics and Statistics (February 1963 Sup­
plement); and Warren L. Smith, “A Graphical Exposition
of the Complete Keynesian System,” Southern Economic
Journal (October 1956), reprinted in W. Smith and R.
Teigen, eds., Readings in Money, National Income, and
Stabilization Policy, rev. ed., as well as in several other
standard collections of readings in macroeconomics.
28This discussion is not meant to imply that the simple static
Keynesian system contains an adequate description of the
processes which determine the price level. It states simply
that the price level is an endogenous variable in the moael.
Page 15

JANUARY 1972

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

The essential difference in this regard between
Keynesians and monetarists therefore would appear
to be that the former view all prices (including
wages) as flexible, while the latter consider all prices
except the money wage rate to be flexible (money
wages are viewed as inflexible, at least in a down­
ward direction, due to such structural phenomena as
minimum wage laws, union contracts, and the like).
This distinction has significant implications for the
analysis.
In the first place, the Keynesian treatment now
cannot be said to be fundamentally less satisfactory
than the monetarist one in terms of methodology, ex­
cept perhaps on grounds having to do with problems
of aggregation ( Friedman, it will be recalled, used the
pejorative term “deus ex machina” to describe what he
understood to be the Keynesian approach). Rather, the
difference now lies in the analytic usefulness of the
assumptions themselves. Is it more appropriate to
assume that wages and prices are flexible, or that
money wages are sticky while prices can adjust? The
answer to this question depends on the nature of the
problem being studied in any particular case, and
this suggests that an important difference between
the two schools of thought may be that Keynesians
are more concerned with short-run analysis (for in­
stance, that related to countercyclical stabilization)
while monetarist assumptions are more consistent
with long-run analysis.
Second, dropping the rigid-price assumption tends
to reduce the basis for the heavy emphasis placed by
monetarists on the demand-for-money function and its
properties. One place where such emphasis is evident
is in the discussion of velocity. We turn next to an
inquiry into the factors affecting velocity, with partic­
ular emphasis on the relationship of velocity to the
demand-for-money function.

general demand-for-money function ( — = L(y, r))
would be characteristic of both. This point can be
demonstrated quite easily. First we note that
the definition of velocity implies the following
relationship:
(4 ) E

= E
y«M o

+ E
yM 0

-1 ,
p *m 0

where E stands for elasticities calculated on the basis
of the interaction of the entire structure, so that (for
instance) E ,. m0
represents the elasticity of real out­
put with respect to changes in the nominal money
stock when the response of the entire economic system
to the money stock change is taken into account. To
distinguish such “systemic” elasticities from “partial”
elasticities —those calculated along one function only
— the symbol r] will be used to represent partial
elasticities. Thus, for instance, r]L r will stand for the
>
interest elasticity of the demand for real balances,
holding income and other variables constant.
Under the monetarist assumption of flexible wages
and prices, real output is determined uniquely by
Friedman’s “Walrasian system” and, as he points out,
is to be considered as predetermined from the stand­
point of equations (1) - (3). This means that a mone­
tary shift cannot change real output (i.e., the multi­
plier
= 0 ), so that E ,.M , which is defined to be
w j dM
o
0
~dM ~’ a^ 's zero- By differentiating equations (1)
S0
-(3) with respect to M0 while holding y constant, it
is easy to show that the elasticity E P , which is equal
.M
t o Mo dp
j ias a v a Jlle 0 f unity. Inserting these results
p dMo

The Demand-for-Money Function and Velocity

into (4 ) gives the quantity theory result that E V = 0,
.M
the “stable velocity” result referred to previously. It is
important to note that no particular assumptions
unique to the monetarist position were made about
the demand for money per se; the assumption which
yielded this result was that the demand for labor and
the supply of labor both were functions of the real
wage rate, and that the market was always cleared.

Monetarists, as we have already noted, tend to
think of the demand-for-money function as a “stable
velocity function” while holding that Keynesians view
velocity as unstable, justifying this position by appeal
to contrasting assumptions about the price level and
the interest elasticity of demand for money (see e.g.
the quotes from Fand and others above). The fact of
the matter is that the behavior of velocity under the
two approaches in response to a monetary shift de­
pends basically on the assumptions made about the
labor market, not about the demand for money or
about prices, since, as we have seen, both approaches
take prices as flexible and, if that is the case, the same

On the other hand, let us consider the Keynesian
case, which we now define as one in which money
wages are sticky (i.e., there exists money illusion in
the supply of labor), but in which the price level is an
endogenous variable. To analyze this case, we must
add three equations to the basic model: an aggregate
production function (equation (5 ) below); a labor
market summary equation which states that the sup­
ply of labor services per unit time (N ) is infinitely
elastic over a wide range of employment at whatever
money wage rate prevails, and that the demand for
labor ( N D) is determined by the real wage (w )
( equation ( 6 ) ) ; and a definition which states that the


Page 16


F E D E R A L R E S E R V E B A N K O F ST. L O U IS

JANUARY

real wage is the ratio of the money wage rate (W )
and the price level ( equation ( 7) ) . The bar over the
money wage rate indicates that it is being held constand here.-” This gives:
(5 ) y = y(N )
(6 ) N = ND(w )

By differentiating the system defined by equations
( l ) - ( 3 ) and (5) - (7) totally with respect to M0,
expressions for the systemic elasticities E ,.m o and E p.m0
can be found. They are as follows (see the appendix
for their derivation):
(8 ) E

y .M

= ----------------------- 1---------------------T1

T1

S*y

L *r

------------------+

n

—n

l

n

— --------------------

w

n

n D

_
rn
n

y*N

n

u
N • w

n

S»y
w

n
L »r
----------- +
-T l
St

T1

—

1

To summarize, the main point of this exercise was
to show that, using a common model with no special
assumptions about the properties of the demand for
money, it has been possible to derive “monetarist” and
“Keynesian” results for the response of velocity to a
monetary shift. It is improper to speak of the demand
for money as a “velocity function”, especially in the
monetarist case where it is assumed that money wages
are flexible so that the system equilibriates at full
employment. In that case, the velocity elasticity will
be zero no matter what the sizes of the demand-formoney elasticities.
Eliminating the rigid-price assumption as a basic
point of difference between the two schools reduces
the basis for monetarist emphasis on the demand for
money for other reasons besides its implications for
velocity. It also is important for monetarist views
on differences in the nature of the transmission mech­
anism for monetary policy. It is to this subject that we
turn next.

L .y

Here S stands for the savings function; otherwise all
of the notation has already been defined. The usual
slope assumptions are made, and on the basis of these
assumptions, both of these systemic elasticities will be
positive.30 Whether velocity will rise, fall, or remain
constant in the face of a monetary shift depends on
the sizes of all of the partial elasticities and their
relationships to one another as given by these expres­
sions. The demand-for-money elasticities play a role,
but are by no means the only relevant elasticities. In
general, we would not expect the elasticity of velocity
with respect to nominal money balances to be minus
unity in value, as the “liquidity trap” assumption im­
plies. It will approach that value if ^ L r or ^ s are
very large, or if the term ( r|^ —r|^ ) is very close to
29This is the simplest method of introducing a Keynesian-type
assumption into the analysis; it is by no means the only
possible way of doing so. The nature of and reasons for the
existence of money illusion in the labor market is the subject
of a considerable amount of literature. See, for example, Axel
Leijonhufvud, On Keynesian Economics and the Economics of
Keynes (London: Oxford University Press, 1968).
30It is assumed that T
)g>r is either positive or, if negative, that
it is smaller in size than the absolute value of n , . A
11»r
listing of all the slope assumptions is given in the appendix.
:;|Since the numerator of the expression for rig>y is one minus
the MFC, r|g,y is not expected to be large. As noted in
footnote 26, belief in a very large interest elasticity of
demand for money (tlL.r ) is not a characteristic Keynesian
stance. Reference to the summaries of available empirical
evidence mentioned in that footnote will show that this
elasticity actually appears to be rather small (almost cer­
tainly less than unity in absolute value, and in many studies
smaller in absolute value than 0.2).



1972

The Transmission Mechanism
for Monetary Impulses
One of the most characteristic themes of mone­
tarism is the heavy emphasis which is placed on dif­
ferences between the quantities of money demanded
and supplied as the prime factor motivating spending
and, hence, changes in income and prices. Friedman
and others have explained again and again how the
authorities can change the nominal money stock, but
how it is money holders who determine the velocity
with which that stock is used, and ultimately who
determine the stock of real balances through the ef­
fects of spending decisions on the price level. As
Friedman puts it, “The key insight of the quantitytheory approach is that such a discrepancy [between
the demand for and supply of money] will be mani­
fested primarily in attempted spending, thence in the
rate of change in nominal income.”32 In other words,
when households and firms are holding more cash
balances than are desired at current levels of income
and interest rates, they convert these excess balances
into other assets, both financial and physical; the
market value of physical assets ultimately changes,
making the production of new assets more attractive.
The change in the general price level which occurs as
a result of this process, and the change in output, both
work toward a re-equating of the real value of the
nominal money stock and the demand for real bal­
ances. Thus the monetarists clearly embrace a very
32Friedman, “A Theoretical Framework,” p. 225.
Page 17

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

general kind of portfolio adjustment view of the trans­
mission mechanism in which the relevant portfolio
contains financial and physical assets of all kinds.33
It will be recalled that this is the first of Brunner’s
four “defining characteristics.” At the same time,
monetarists have been taking Keynesian analysis to
task for focusing almost exclusively on interest rates
representing the “cost of finance” as the channel
through which monetary impulses are felt. The fol­
lowing quotation makes these distinctions very clear:
The Income-Expenditure theory of the Fiscalists
adopts a particular transmission mechanism to an­
alyze the effects of a change in the money stock (or
its growth rate) on the real economy. It assumes
that money changes will affect output or prices only
through its effect on a set of conventional yields —
on the market interest rate of a small group of finan­
cial assets, such as government or corporate bonds. A
given change in the money stock will have a calcul­
able effect on these interest rates . . . given by the
liquidity preference analysis, and the interest rate
changes are then used to derive the change in invest­
ment spending, the induced effects on income and
consumption, etc.
Monetarists, following the Quantity theory, do not
accept this transmission mechanism and this liquidity
preference theory of interest rates for several reasons:
First, they suggest that an increase in money may
directly affect expenditures, prices, and a wide vari­
ety of implicit yields on physical assets, and need
not be restricted to a small set of conventional yields
on financial assets. Second, they view the demand
for money as determining the desired quantity of real
balances, and not the level of interest rates. Third,
and most fundamentally, they reject the notion that
the authorities can change the stock of real balances
— an endogenous variable — and thereby bring about
a permanent change in interest rates. . . .
Monetarists reject the liquidity preference interest
rate theory because it applies only as long as we
can equate an increase in nominal money with a
permanent increase in real balances. This suggests
that the liquidity preference theory may be useful as
a theory of the short run interest rate changes — the
liquidity effect — associated with the impact effects of
nominal money changes.34

Statements like this, and the quotation from Fried­
man in footnote 14 indicate that monetarists believe
their view of the transmission mechanism to differ
from the position they impute to the Keynesian camp
most essentially in differences in assumptions about
characteristics of the demand-for-money function. The
interpretation of the interest rate term in this function
plays a role; so does the question of price flexibility.
33A description of the classes of assets involved and the na­
ture of their yields is given in Milton Friedman, “The
Quantity Theory of Money — A Restatement.”
34Fand, “A Monetarist Model,” pp. 280-81.
Digitized for Page 18
FRASER


JANUARY 1972

As the preceding discussion and quotation indicate,
monetarists think of their own view as an extremely
general one. The interest rate term in their model
really stands for a vector of yields on many assets,
some of them financial yields determined in the
money and capital markets, and some of them implicit
yields on real assets. A monetary impulse sooner or
later affects all of these yields, and hence adjusts the
demand for real balances directly as well as indirectly
through the effects of yield changes on income. At
the same time, changes in the price level which result
will adjust the real value of the nominal money sup­
ply. Therefore the adjustment process is seen as being
summarized in the characteristics of the demand-forreal balances function and its relationship to the
nominal money supply. Keynesians are said to include
only a few market-determined yields on financial as­
sets in their liquidity-preference function; further­
more, the price level is exogenously determined.
Therefore the process of adjustment to a monetary
impulse is supposedly seen by them in much nar­
rower terms —the entire process takes place through
adjustment of the demand for money, and basically is
said to focus on the cost of credit as reflected in mar­
ket interest rates. Furthermore, the belief in a sub­
stantial interest elasticity of demand for money, often
attributed to Keynesians, means that a monetary im­
pulse will have a relatively small effect even on these
rates.
These distinctions must be regarded as artificial.
First, there is nothing inherent in the Keynesian sys­
tem which is inconsistent with the introduction of a
general portfolio adjustment transmission mechanism;
and, indeed, there has been a substantial development
in this direction in Keynesian thinking and practice
during the last several years. On the theoretical side,
the work of Tobin and others may be cited, while at
the operational level, the developers of the Federal
Reserve Board-MIT econometric model of the U. S.
economy have attempted to incorporate such a mech­
anism into their model.35 While all of the problems in­
volved in this attempt have not yet been solved, work
is continuing and improvements will be made.
Second, as we have already shown, Keynesians take
the price level to be endogenous, and thus recognize
35For a non-monetarist example of the development of portfolio
theory, see James Tobin, “An Essay on Principles of Debt
Management,” in Commission on Money and Credit, Fiscal
and Debt Management Policies (Englewood Cliffs, N.J.:
Prentice-Hall Inc., 1963), pp. 143-218, esp. Part II. Features
of the Federal Reserve Board-MIT model are discussed in
Frank de Leeuw and Edward M. Gramlich, “The Channels
of Monetary Policy,” Federal Reserve Bulletin (June 1969),
pp. 472-91.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

the same process of adjustment of the nominal money
supply through price level changes as the monetarists.38
There remain certain problems with monetarist
thought on two subjects related to the transmission
mechanism. One is a misunderstanding, in my opinion,
of the relationship between money and interest rates
implied by Keynesian theory. The other has to do
with the monetarist position on the money stock as a
force driving income through the portfolio process
mentioned above.

Liquidity preference theory, money, and the rate of
interest — Monetarists view themselves as holding a
“monetary theory of the price level” under which
monetary shifts are reflected (in the longer run, at
least) primarily in price level changes. They take the
stance that Keynesians hold a “monetary theory of the
interest rate.” Under this phrase, at least two posi­
tions are subsumed. Some monetarists seem to think
that Keynesians see the money supply together with
the demand-for-money function (specified in nominal
terms) as determining the level of interest rates.
Others recognize that the interest rate in Keynesian
analysis is determined jointly as one of the outcomes
of an interacting system of relationships rather than
just by one behavioral relationship (i.e., by some ver­
sion of an IS-LM system like Friedman’s summary
model). Whichever view is held, however, it is as­
serted that Keynesian analysis leads to the conclusion
that monetary shifts result in interest rate changes in
the opposite direction, while monetarist analysis sug­
gests that movements of M and r in the same direction
will be observed.37
Neither version of the “monetary theory of the in­
terest rate” is an accurate representation of Keynes­
36Semantic as well as real issues are involved in discussions of
this subject. For example, Brunner labels anyone who sub­
scribes to a portfolio adjustment view of the monetary trans­
mission mechanism a “weak monetarist”. See Karl Brunner,
“The Role of Monetary Policy,” this Review (July 1968),
pp. 9-24.
37As an example of the first of these positions, the following
quotation from a recent article by Fand is offered: “In the
Keynesian theory the exogenously given quantity of money,
together with the liquidity preference function, determines
the interest rate.” Fand, “Keynesian Monetary Theories,”
p. 564. The second is illustrated by a quotation from
Zwick: “The alternative concepts of Keynes and Fisher con­
cerning the adjustment of the economy to monetary changes
are mirrored in their different notions concerning interest
rate determination and the response of interest rates to
monetary changes. The IS-LM framework suggests that, so
long as the IS and LM schedules represent independent
relations, a monetary expansion causes interest rates to fall
because of the outward shift of the LM schedule. In tiie
Fisherian model, a monetary increase raises the level of
expenditures; the upward response of loan demand due to
the increased expenditures causes interest rates to rise.”
Burton Zwick, “The Adjustment of the Economy to Mone­
tary Changes,” Journal of Political Economy (January/
February 1971), p. 78.



JANUARY

1972

ian thought, for both imply that an expansionary
monetary impulse (for example) can only result in a
lower interest rate in the new equilibrium. In other
words, it appears that of the two monetary effects on
interest rates often mentioned by monetarists which
are relevant for static analysis —the liquidity effect
and the income effect — Keynesians are supposed to
recognize only the liquidity effect, or more generally,
are supposed to be basing their analysis on assump­
tions which can only result in an inverse relationship
between monetary impulses and interest rate changes.
This is certainly not the case. When the entire struc­
ture is taken into account, rather than only the liquid­
ity preference function, the level of interest rates in
the new equilibrium relative to the initial position is
determined by a number of elasticities, most impor­
tantly those which are the determinants of the slope
of the IS curve. If its slope is positive —which is the
case if all of the propensities to spend with respect
to total income sum to more than unity — then both
income and interest rates will be higher in the new
equilibrium than in the old.38 This is such a wellknown case as to require no further comment.
Of course, equilibrium positions are not observed in
the real world; instead, the economy is always in
transition, moving toward resting points, which them­
selves are repeatedly being disturbed. It may be in­
ferred from some monetarist writings that it is the
observed tendency of interest rates and money to
move in the same direction which is thought to be
inconsistent with Keynesianism, rather than the possi­
bility that money and interest rates can move together
in terms of comparative equilibrium points. In other
words, the discussion may refer to the dynamics of the
system, rather than the comparative statics. In this
area, the monetarists have done us all a service by
stressing the possible importance of price-expectation
effects on interest rates, a phenomenon which typi­
cally has not been incorporated into dynamic Keynes­
ian models. I will argue that observed parallel move­
ments between money and interest rates are quite con­
sistent with the basic IS-LM structure (no matter
which way the IS curve slopes), given the reasonable
and widely-accepted premise that the monetary sector
adjusts much more rapidly than the real sector to ex38An upward-sloping IS curve cannot be obtained from Fried­
man’s summary model, because only consumption spending
is related to income in that model, and the notion that the
MPC is less than unity is a fundamental postulate of macro­
economic analysis. However, the level of income might well
appear in other expenditure functions, such as the invest­
ment relationship (where the rationalization would be that
investment depends on profits, which in turn are a function
of the level of income).
Page 19

F E D E R A L . R E S E R V E B A N K O F ST. L O U IS

JANUARY 1972

temal shocks. Under this premise, observed values of
income and the rate of interest may be supposed, at
least approximately, to be such that the LM equation
is always satisfied during the process of adjustment
from one equilibrium to another, while the IS equa­
tion is not. I will argue further that price-expectation
effects are readily accommodated by this analysis.
The implications of these differing speeds of ad­
justment are illustrated on the accompanying figure,
which happens to be drawn with a downward-sloping
IS curve. Assume the system to be initially in equili­
brium at point F, so that the equilibrium values of the
interest rate and income levels are r and y. Now let
there occur an expansion of the money supply, so that
the LM curve shifts outward to a new position, LM'.
According to the assumption made above concerning
the relative speeds of adjustment of the monetary and
real sectors, this shift will result first in a fall in the
interest rate from its initial equilibrium level to a new
level, r'. It should be noted that this is the “liquidity
effect” which is recognized by monetarists as being
present both in then- own and in Keynesian thinking.
It represents a movement along the liquidity prefer­
ence function in response to a change in the money
supply, holding income constant. Next, income will
begin to respond, and income and the rate of interest
both will rise along the segment GH of LM ' to point
H, the final equilibrium position. This movement, of
course, reflects the “income effect.” If rising income
is accompanied by rising prices, there will also be an
induced shift of the LM curve during the transition.
For example, it might move to a position like LM " as
shown. Alternatively, it could move to a position to the
right of LM'.
Such LM shifts reflect the operation of two forces.
First, rising prices reduce the real value of the new
nominal money stock and “tighten the money market”
after the initial expansionary pulse. This has the
effect of moving the LM curve leftward. Second,
rising prices may engender expectations of future
price increases. If, as has been suggested, the demand
for money depends on nominal interest rates while
real expenditures are determined by real rates, then
the “price expectations effect” mentioned previously
would cause a rightward LM shift, resulting in a
lesser leftward overall shift in the LM curve than that
brought about due only to the drop in the real value
of the nominal money stock, or perhaps even a net
rightward movement (in this discussion, the vertical
axis is interpreted as measuring the real rate of inter­
est). If these effects are present, the adjustment path
followed from point G might be the dotted one instead
of the solidly-drawn one, and the system would end

Page 20


up at a point like J instead of H, so that the new
equilibrium income level would be y", and the equilib­
rium real interest rate r". Incidentally, if price-ex­
pectation effects are present, a value of r" for the real
rate is quite consistent with a market rate above r.
We may conclude from this discussion that there is
no reason to be surprised by the fact that during much
of the time following an increase in the money supply,
interest rates are observed to rise. A standard assump­
tion about relative speeds of adjustment, much used
by Keynesians, directly reflects both the “liquidity
effect” and the “monetary effect” often discussed by
monetarists, and is perfectly consistent with the pres­
ence of price expectation effects. Second, it is appro­
priate to point out that this entire discussion has been
carried out in the context of a pure multiplier model.
If accelerator effects are present, they may accentuate
the pure multiplier effects of a monetary shift on in­
terest rates, at least during parts of the adjustment
period. Finally, there is the likelihood that in many
cases in which interest rates and the money stock
move together, the monetary authorities are reacting
to shifts in spending. For instance, if total spending
rises, interest rates will go up and the monetary au­
thorities will often try to moderate the interest rate
increase by expansionary open market operations, re­
sulting in a rise in the money stock.

The monetarist view of money as a force driving
income — It is self-evident that monetarists typically
have assigned great importance to changes in the
money stock as the prime moving force behind in­
come changes. For instance, one of Brunner’s “de­

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

fining characteristics of monetarism” is that
. . the
monetarist analysis assigns the monetary forces a
dominant position among all the impulses working on
the economic process.”'iu And, of course, Friedman’s
investigations into the lead-lag relationship between
changes in the rate of change of the money stock and
changes in income are too well-known to require fur­
ther comment.40 At the same time, monetarist writ­
ings often seem to suggest that Keynesians view
monetary policy as ineffective.
Keynesians view monetary policy as effective and
useful, and to suggest the opposite is to raise false
issues. But this does not mean that they necessarily
consider changes in the money stock to have particu­
lar causal significance. Monetary policy is carried out
through the traditional instruments — open market op­
erations, discount rate changes, and variations in re­
serve requirements — and not by direct manipulation
of the money stock. It is true that in simplified ver­
sions of the Keynesian model, monetary policy is
represented by the money stock, which is assumed to
be controlled by the authorities and which replaces
the instruments named above. It is also possible that
the authorities could control the nominal money
stock to almost any desired degree of precision. But
in the real world, or in the more sophisticated models
of it, the nominal money stock is not exogenous, nor
has it been controlled as an objective of policy by the
central bank in the United States; it, or its compo­
nents, are determined jointly by the central bank, the
commercial banks, and the public, and it is basically
a passive outcome of the interaction of the economic
system, not a driving force.
The doubt that Keynesians feel concerning mone­
tarist assertions about the potency of money stock
changes reflects the fact that monetarist descriptions
of the adjustment process themselves seem to give no
particular reason for regarding money stock changes
as causal. These descriptions typically run as follows,
using an open market purchase of Treasury bills as
an example:41 at the outset, there is an exchange of
assets between the central bank and a Government
securities dealer, with the central bank giving the
dealer its cheek drawn on itself in exchange for bills.
S0Brunner, “The ‘Monetarist Revolution’,” p. 7.
40Milton Friedman, “The Supply of Money and Changes in
Prices and Output,” in The Relationship of Prices to Eco­
nomic Stability and Growth, Compendium of Papers Sub­
mitted by Panelists Appearing Before the Joint Economic
Committee, 85th Congress, 2nd sess., 1958, pp. 241-56.
+lSee, for instance, Milton Friedman and David Meiselman,
“The Relative Stability,” Sec. VII, and Milton Friedman
and Anna J. Schwartz, “Money and Business Cycles,” Re­
view of Economics and Statistics (February 1963 Supple­
ment), esp. pp. 60-61.



JANUARY 1972

This exchange results in the following: (1 ) a reduc­
tion in the yield on bills, with consequent disequili­
brium among holders of securities; (2 ) an increase of
bank reserves of an equivalent amount (disregarding
drains into currency holdings, etc.); (3 ) an initial
increase in the money supply of the same amount
as the transaction; and (4 ) a decrease in bill holdings
by the private sector, with a concomitant increase in
the central bank’s portfolio. In a process described in
some detail by Friedman and Schwartz, the next step
will involve action to readjust portfolios in response to
yield and wealth changes; meanwhile, banks will be
interested in expanding loans on the basis of their
newly-acquired reserves (and incidentally in creating
new deposits). Eventually the adjustment affects the
yield on equities and therefore the market value of
the existing stock of physical capital. The existing
capital stock will rise in value, stimulating the produc­
tion of new capital and thus causing income to rise.
There may also be other effects, such as direct effects
on spending of changes in wealth.
The question would seem to be whether it is the
initial increase in the money stock, the full increase
(including the new deposits generated as a conse­
quence of loan decisions), the increase in bank re­
serves, the reduction in private bill holdings, the fall
in yields, the increase in the central bank’s portfolio,
or some other factor which is responsible for the in­
come change. Rather than arbitrarily selecting some
one factor from this list, it would seem preferable to
take die more general view that the initiating force
was the disturbance of a portfolio equilibrium, effected
in this case through open market operations. (Such
a disturbance, with similar effects, could arise for
other reasons: e.g., if there were a change in wealthholders’ preferences for holding a particular security
category at existing yields.) The change in the money
stock is properly viewed as one of the several results
(along with changes in income, interest rates, prices,
etc.) of this disturbance. Such a position of course
implies that monetary policy is effective, but does
not assign the starring role in the drama to changes
in the money stock.

Stabilization Policy
Modem Keynesian static analysis, based on the
complete Keynesian system with flexible prices and
inflexible money wages, yields the result that both
monetary and fiscal policy are able to effect changes
in income, interest rates, prices, employment, and
other variables. Monetarist analysis, however, takes
the position that only monetary policy has significant
effects on the pace of economic activity, at least in
Page 21

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

the short run. This suggests that the two schools of
thought disagree not in their views about monetary
policy, but rather on the effectiveness of fiscal policy.
Until recently, monetarists were interpreted as bas­
ing their belief that fiscal policy is ineffective directly
on the presumed existence of a stable demand-formoney function with zero interest elasticity, together
with the assumption of an exogenously-set money
stock. Such a demand-for-money function links money
and income directly together, so that income cannot
change unless the money stock changes. Shifts in gov­
ernment spending financed by bond issue, for in­
stance, were said to result in interest rate changes of
sufficient magnitude to reduce private spending to
the degree required to keep total demand at a con­
stant level.
However, given the many research studies which
show otherwise, it has become impossible to maintain
that the interest elasticity of the demand for money
is zero. This development has had a considerable
effect on the tone of monetarist discussions. Thus
Fand, in discussing stabilization policy, refers to
. .
the exceptional case of a completely (interest) in­
elastic demand for money.42 Furthermore, a relevant
recent finding is that the supply of money is interestelastic, and that this is sufficient to loosen the tight
link between the money stock and income even if the
interest elasticity of demand is zero.
Therefore monetarists have had to rationalize their
dismissal of fiscal policy in other ways. Some have
tried to find other means of solidifying the moneyincome link and of segregating the monetary sector
from the remainder of the system by neutralizing the
connection provided by the interest rate. One way of
doing so is by considering the interest rate to be de­
termined exogenously. This, in effect, is the procedure
followed by Friedman in his paper entitled, “A Mone­
tary Theory of National Income.”43 If interest rates
do not respond to changes in real and financial vari­
ables, the rigid money-ineome connection is preserved.
This may be considered the most extreme approach,
because under it fiscal policy does not even affect the
rate of interest and the division of output among the
various sectors.
Another way is to make the standard quantitytheory assumption of flexible wages and prices, and
hence full employment, while accepting the fact that
the demand for and supply of money balances are
interest-elastic. In such a world, fiscal policy cannot
4-Fand, “Monetarism and Fiscalism,” p. 289 (italics added).
43See the discussion of this approach in footnote 12.

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Federal Reserve Bank of St. Louis

JANUARY

1972

affect the levels of real variables like output or em­
ployment, which are entirely determined by the labor
market and the production technology of the system
— but then, neither can monetary policy.
Assumptions are not a matter of logic, assuming
that they are internally consistent. In weighing these
various approaches to the analysis of stabilization pol­
icy, the most important questions probably should be:
Which of the alternative approaches is the most
realistic and the most relevant for the real-world
question of fiscal policy’s effectiveness? Is it the case
of flexible wages and prices, so that full employment
is the rule and not the exception, and neither mone­
tary policy nor fiscal policy can affect the level of
real activity? Is it the case involving exogenouslydetermined interest rates, so that fiscal policy cannot
even affect the division of output, let alone the level
of activity? Or is it the case of flexible prices but a
sticky wage level, in which case monetary and fiscal
policy both are capable of affecting the level of real
activity?
Brunner has taken a somewhat different approach
to the analysis of fiscal policy than have most other
monetarists. He asserts that fiscal policy is ineffective
or perverse because the effects on asset values due to
interest-rate changes of the cumulation or decumula­
tion of claims against the Government held by the
public, resulting from a fiscal policy deficit or surplus,
outweigh the direct effects on the flow of output and
income of new spending and taxing and of the
changes in the stock of financial claims held by the
private sector which result.44 This position implies
the view that the disturbance of portfolio equilibrium
from any source (not only money stock changes) has
powerful repercussions, and thus paradoxically tends
to downgrade the importance of changes in the money
stock. As far as is known, this position is not supported
directly by empirical evidence.

Summary
In this paper, I have attempted to sketch the main
outlines of monetarist thought and to examine some
aspects of the monetarist view of Keynesian analysis.
In doing so, I have paid particular attention to the
roles of the instruments of stabilization policy under
the two views.
My examination of the monetarist-Keynesian debate
has indicated that the version of Keynesianism which
the monetarists use to establish a contrast for their
own point of view is out of date and inadequate — a
"Karl Brunner, “The ‘Monetarist Revolution’.”

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

“vulgar” version of post-Keynesian thinking, to use
Professor Johnson’s term. When it is recognized that
Keynesianism implies sticky wages and money illu­
sion in the labor market rather than rigid prices, and
that portfolio adjustment as the basis for the trans­
mission of monetary impulses is not only consistent
with the Keynesian approach but indeed is being
built into Keynesian models, it is seen that there is
very little if anything in monetarist theory which is
new and different. Rather, the two approaches di­
verge in ways which basically are methodological and
operational. The monetarists are willing to commit
themselves to the use of very simple, very small ( even
one-equation) models for policy analysis; Keynesians
typically are not. On this point, the monetarist stance
seems to be a matter of faith rather than logic; the
common theoretical basis on which both positions rest
certainly implies the use of a structural approach.45
There certainly are substantial differences in the kinds
of operational assumptions that are made about par­
ticular dimensions of the theoretical structure, and
these have implications of various kinds for policy.
The typical Keynesian assumption of money wage
inflexibility is consistent with a shorter-run analysis; it
leads to the conclusion that both monetary policy and
fiscal policy can affect the level of activity. The typical
monetarist assumption of wage and price flexibility
(i.e., of full employment) is more relevant for the
analysis of secular changes.
This assumption essentially bypasses the whole
question of short-run policy effects. For the long run,
paradoxically, it suggests that fiscal policy is more
important and interesting than monetary policy, for
fiscal policy at least changes the rate of interest (un­
less the rate of interest is exogenously determined),
and therefore the division of output, and presumably
affects growth; whereas monetary policy affects only
prices, money wages, and the like.46 There appear to
4BKarl Brunner has written, “The monetarist disregards . . .
the allocative detail of credit markets when examining pat­
terns of allocation behavior. . . . Such detail is simply as­
serted . . . to be irrelevant for aggregative explanation.” Ibid.,
p. 15.
46The reservations expressed in footnote 10 apply to this state­
ment also.




JANUARY 1972

be some analytic confusions in many monetarist dis­
cussions. I have tried to show above that it is incor­
rect to view the demand-for-money function as a
velocity relationship from either point of view. In the
monetarist case, this is especially true because the
stability of velocity in the face of monetary changes
depends on assumptions about the labor market and
is unrelated to the characteristics of the demandfor-money relationship. It also appears that mone­
tarist fascination with the money stock is unwar­
ranted by monetarist logic, which seems to me to
place great emphasis on portfolio disequilibrium as a
potent driving force in the economy. It does not fol­
low from this view, as a matter of logic, that observed
changes in the money stock have any particular sig­
nificance as a causative force.
On the positive side, monetarists have contributed
to the development of macroeconomic thought by
stressing that the links relied upon for years by most
Keynesians to connect the real and monetary sectors
overlook entirely the important substitution and
wealth effects which are the concomitants of portfolio
adjustment. They also have called our attention to the
distinction, apparently first made by Irving Fisher
many years ago, between market and real interest
rates, and therefore to the potentially important role
of price expectations in dynamic macroeconomics.
These phenomena are extraordinarily difficult to cap­
ture in empirical models, but work is proceeding
along these lines. It is to be hoped that during the
next few years, they will be made standard features
of Keynesian (that is, structural) theoretical and
empirical models, and that dependable evidence will
be gathered so that the real questions which divide
us — chiefly, in my opinion, the question raised by
Brunner and others concerning the need for largescale structural models for aggregative analysis —can
be answered satisfactorily.

This article and the accompanying one by
Robert H. Rasche are available as Reprint No. 74

Appendix begins on following page.

Page 23

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

JANUARY 1972

APPENDIX

Following are the derivations which underlie equations
( 4 ) , ( 8 ) , and ( 9 ) in the text. They are based on equa­
tions ( l ) - ( 3 ) and ( 5 ) - ( 7 ) , which are reproduced here
for convenience:
(1 ) y = C (y,r) + I(r)
(2 ) ^

= L (y ,r)

B. The Monetarist Case
Monetarists assume that wages and prices are flexible
so that real output, y, may be considered exogenous for
the purpose of static analysis, and only equations ( 1 ) and
( 2 ) are relevant. Differentiating ( 1 ) , which is the IS
curve, yields:

Mm 0

(3 ) Y = py
(5 ) y = y(N )

W

(B .2) (C r + Ir)

The following slope assumptions are used throughout:
O < C y < 1; C,. < O or, if positive, C r < |I,.|; I r < O;
L y > O; L r < O; y N > O; N “ < O.

dMo

dr
dy
+ Lr
( B .3 ) Ly
T J-*r
J dMo
dMo
dMo

Equation (4 ) in the text is an expression for the
elasticity of velocity with respect to a monetary shift, and
is reproduced for convenience:
=

E

y*M

+ E

-

1 dY
Mo dM„

dY
dM0

, d>
'

dM(,

= E

+ y

dp
dM0

+ E

1, which is equation (4 ).

This result is derived only from definitions. Next we
investigate the values of E y. M o and E p.m0 , and there­
fore of E v.m , which are implied by monetarist and
Keynesian assumptions respectively.

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Federal Reserve Bank of St. Louis

dr
dM0

= 0, (B .3) reduces to:

= E -m g = 1 -

Substituting these findings into (A .3 ), we find that E t . m0
= 0 using static analysis under monetarist assumptions.

C. The Keynesian Case
Keynesians take money wages to be inflexible while
prices are an endogenous variable. This means that real
income or output may no longer be considered exogenous;
instead, it becomes endogenous, and equations ( 5 ) - ( 7 )
are added to the IS-LM system as represented by ( 1 ) and
(2 ) in order to close the set of equations.
and

Ep.ii , we must again differentiate the system totally with
respect to M0, now treating y as a variable. In addition

Substituting (A .2) into (A .l) and multiplying the re­
sulting equation by 1 ° yields
(A .3) E

7 ^

=

To derive expressions for the elasticities E y.M
o

From ( 3 ) , we have

(A.2)

(B '4 )

Mo dp
. Since we have
p2 dM0

i.

Thus we have:
dV
dM0

= 0.

P*Mn

It is derived by differentiating the expression for velocity
(V =
) with respect to the money stock, and convert­
ing the result into elasticity form.

(A .l)

clMo

Differentiating the LM curve (2 ) yields:

A. The Elasticity of Velocity

y*M n

dy
dM0

= 0, which implies that

dy
found that, in this case, ,,-r

(4 ) E

dr
dM0

However, if y is exogenous to this system,
= 0 so
,i ,
.
ClMo
that we get:

(6 ) N = ND(w )
(7 ) w =

+ (Cr + Ir)

to equations ( B .l ) and (B .3 ), this differentiation yields
W dp
w p2 dMo

, td

< > BE
“

which is derived by differentiating equations ( 5 ) - ( 7 ) and
substituting where possible.
It will be convenient to make some further substitu­
tions. First, since the MPC with respect to income is one
minus the MPS with respect to income, and since the

JANUARY 1972

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

MPC with respect to the interest rate is the negative of
the MPS with respect to the interest rate, we make the
substitutions (1-C y) = Sy and C r = —Sr, where S stands
for the saving function (the model implies S = S ( y ,r ) ) .
Second, ( C .l ) can be used to eliminate the term involving
~~

in (B .3 ). Making these substitutions and collecting

terms yields the following pair of equations in the two
variables

and

dy
(C .2 ) Sy
dM0

(C.3) (Ly

=

(C .6 ) E
(Ir — Sr)
Mo

W yNN £

)

dr

dMc

n

dy
+ L, dr
dM„
' dM0

gives;

n •w

£ _ z

(b ) to find the systemic elasticity E y.M , both sides of
(C .4 ) must be multiplied by — . Carrying out these
^
operations and cancelling terms where possible, we get

^

q

< 0 is that
S -r

l<n (In l ) +n
S*y

L-r

L*y

(In - n
Ir

S-r

Thus the larger in value are r)giy,

|).
and | L>r | , the
r|

more likely it is that E v. m < 0- Finally, for nonzero but
finite values of r)y< and t) ndw , E y.M and E p.M
N
o
owill
tend toward zero (and E V M toward — 1) if ri S .y or
.
1

O

n

S‘y L*r




S*r

pends on a special case of equation (C .5 ) in which the last
denominator term approaches zero. W hether E V. M is posi­
(
tive or negative in this case depends on whether E y M is
> ^
greater or smaller than unity. The condition for E V
,M

Ir

It

—n

zero and the response of velocity to a monetary shift de­

In-n

"x H
z.x’

—n

I* r

brought about by a monetary shift, so that E
= 0
and E p.M = 1, resulting in stable velocity. Second, if
o
either >
1
or r| D are extremely large, E M approaches

(a ) each of the propensities (or partial derivatives)
shown in the denominator may be converted into a partial
elasticity by using the relationship between any two
variables x and z given by the definition of a partial
and thus
elasticity; i.e., if z = f ( x ) , then r|z.x
fv

n

n

n

S*y L t

in th e system . F irst, if eith er r|y v or r| ndw
>
are zero,
output will not change in response to a real wage change

To convert this into elasticity form, two steps are needed:

n

n

y*N ND*w

From (C .5 ) and (C .6 ), it can be seen that the behavior
of velocity now depends on all of the partial elasticities

________ p__________
dy __
Mo
SvLr
dM0
+ Ly
__
Ir—Sr ' '
WyNNw

(C .5 ) E y. Mo =

n

p*Mo

= 0

Solving these equations for

(C .4 )

To find an expression for the systemic elasticity E p.M ,
equation (C .4 ) is substituted into ( C .l ) and a systemic
expression f o r ^ j ^ is derived. When this expression is
multiplied by
, the partial derivatives are converted to
elasticities, and the necessary algebra is carried out, the
following expression results:

S*r

r|L*r '[ are very large, or if (ri i* r —n o * r.) is very close to
a
zero in value. A large value for f] L>y would also give this
i

+ n

L,)'

n

n

y*N ND*w

result.

Page 25

Comments on a Monetarist Approach to
Demand Management
by ROBERT H. RASCHE

Robert H. Rasche is Assistant Professor of Economics at the Wharton School o f Finance and
Commerce, University of Pennsylvania. He received a PhD degree in Economics from the Uni­
versity of Michigan. Professor Rasche has been closely involved in the development of the FRBMIT econometric model of the United States economy. The author is on leave during the 197172 academic year and is a visiting scholar at the Federal Reserve Bank of St. Louis. This paper
was presented at the Annual Conference of College and University Professors o f the Federal
Reserve Bank of St. Louis on November 12, 1971.
CASUAL reading of the popular discussion of
stabilization policy over the past four or five years
would suggest that the definition of a monetarist was
firmly established. In the monetarist camp are Milton
Friedman, Karl Brunner, Allan Meltzer, and the model
of the St. Louis Federal Reserve Bank. Among the
nonmonetarists are Walter Heller, Gardner Ackley,
Arthur Okun, James Tobin, and the large econome­
tric models such as the Wharton model and the FRBM IT model. Sometimes the distinction between the
two groups has been summarized in the allegation
that a monetarist is one who not only believes that
money matters, but also believes that money is the
only thing which matters.1
A close reading of the writings of those associated
with both points of view, suggests that distinctions are
not completely clear at the level of monetary theory.
Leonall C. Andersen has characterized the mone­
tarist position on stabilization policy as holding that
“the major impact of monetary actions is . . . on longrun movements in nominal economic variables such as
nominal GNP, the general price level, and market in­
terest rates. Long-run movements in real economic
variables such as output and employment are con­
sidered to be little influenced, if at all, by monetary
actions.”- On the other hand he admits a clear role
for fiscal policy, if not the conventional stabilization
policy role: “their [fiscal actions] main impact is on
long-run movements of real output. . . . In the short
run, fiscal actions . . . exert some but little lasting in­
fluence on nominal GNP expansion and, therefore,
have little effect on short-run movements of output
and employment.”3
1Walter W. Heller, “Is Monetary Policy Being Oversold?”, in
Milton Friedman and Walter W. Heller, Monetary vs. Fiscal
Policy (New York: W.W. Norton & Co., Inc., 1969), p. 16.
2Leonall C. Andersen, “A Monetarist View of Demand Man­
agement: The United States Experience,” this Review (Sep­
tember 1971), p. 4.
3Ibid., p. 4.

Page 26


The question is what theoretical framework can
produce these types of conclusions, and can it be
tested? Again quoting the Andersen paper, “monetary
actions . . . are considered a disturbance which influ­
ences the acquisition of financial and real assets. Rates
of return on real and financial assets and market prices
adjust to create a new equilibrium position of the
economy; therefore these changes are considered the
main channels of monetary influence on aggregate
demand.”4
Thus the monetarist conception of what has been
called the transmission mechanism is one of monetary
disturbances which change interest rates and the rela­
tive prices of real and financial assets. Such changes
induce a reallocation of asset portfolios which can in­
clude changes in the demand for real assets. Finally,
the portfolio adjustments and relative price changes
can change the demand for consumables. In an earlier
article in this Review, Karl Brunner characterizes a
similar position as the “weak monetarist thesis.”5
This construct of the world is apparently one which
is widely accepted among monetary economists today
and thus does not discriminate among the monetarist
and nonmonetarist positions. Certainly a whole suc­
cession of writings by James Tobin suggests an ex­
planation quite consistent with this view of the trans­
mission mechanism of monetary policy.6 In fact, An­
dersen admits that he would view his mechanism as
“close to the Tobin view, except that it takes into
consideration many more rates of return and market
prices of goods and services.”7 An examination of the
*Ibid., p. 3 (italics are added).
8Karl Brunner, “The Role of Money and Monetary Policy,”
this Review (July 1968), pp. 18-19.
6James Tobin, “An Essay on Principles of Debt Management,”
in Commission on Money and Credit, Fiscal and Debt
Management Policies (Englewood Cliff, N.J.: Prentice-Hall
Inc., 1963) pp. 143-218; and, “A General Equilibrium Ap­
proach to Monetary Theory,” Journal of Money, Credit and
Banking (February 1969) pp. 15-29.
7Andersen, “A Monetarist View,” p. 3.

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

writings of other nonmonetarist economists will show
similar consistencies with this view of the transmission
mechanism. Therefore “weak monetarism,” as a the­
oretical position, does not appear to be a monopoly
of the monetarists.
Given this apparent agreement on the theoretical
basis of the mechanism through which monetary policy
actions affect the economy, one can question whether
the “monetarist counterrevolution” is more than an
attempt at product differentiation, such as economists
usually associate with monopolistic competition. A
pragmatic view of the discussion suggests that at least
four substantive issues are involved: (1 ) the usefulness
of the IS-LM aggregate demand framework for policy
formulation; (2) the dynamic adjustment of the econ­
omy to a new equilibrium after a policy shock; (3)
the mode of conduct of monetary policy; and (4 ) an
econometric issue of large versus small models.

Limitations of Policy Prescriptions from the
IS-LM Framework
A major source of monetarist criticism has been the
use of the IS-LM framework for aggregative policy
analysis. In this Review, Ronald Teigen has attempted
to defend the IS-LM framework from one monetarist
accusation that this framework holds that an increase
in the stock of money lowers the interest rate and
raises output.8 He demonstrates that with certain
assumptions about the relative speeds of adjustment
of various markets, it is possible to show that interest
rates over time will first fall and then rise again as
the system returns to a new equilibrium.
At the same time Teigen admits that this framework
has ignored price expectations, and in addition, that
it is not easy to incorporate price expectations, a dy­
namic phenomenon, into the static framework. This
appears to sidestep the crux of the monetarist com­
plaints. Not only does the conventional IS-LM analysis
ignore price expectations, but it usually ignores effects
from changes in the level of prices. The omission of
such price level effects is possible only when the
macroeconomic model “ specified totally in terms of
is
real flow variables. In sophisticated analysis, such as
that of Martin Bailey, price level effects of various
kinds are introduced, and it can be shown that the
position of either the IS or the LM curve (in the
interest rate - real income plane) is dependent upon
the current price level.9
8Ronald L. Teigen, “A Critical Look at Monetarist Economics,”
this issue of the Review, pp. 19-20.
9Martin Bailey, National Income and the Price Level (New
York: McGraw-Hill, 1962).



JANUARY

1972

Most macro-economists will acknowledge the valid­
ity of the price level effect on the LM curve arising
from the specification of the demand for money as a
demand for real balances. Similarly, a specification of
the consumption function in terms of income and
wealth as implied by a permanent income or “life­
cycle” hypothesis will generate a family of IS curves,
one for each level of real wealth.10 Once both are con­
structed as functions of the price level, any policy
action which generates a change in the price level will
not only have a direct impact on the IS (fiscal policy)
or the LM (monetary policy) curve, but also will
cause additional shifts in both curves through the
changes in the price level. Under these circumstances,
simple multiplier calculations do not adequately rep­
resent the reaction of the economy to the policy action.
Accurate policy conclusions cannot be derived with­
out estimates of the parameters of the system.
The situation is further complicated when it is as­
sumed that monetary policy can affect the market
value of assets, such as corporate equities, through
induced changes in the rate of return on these assets.
Then the specification of a consumption-wealth rela­
tionship implies that any change in interest rates will
induce a shift in the IS curve.
Teigen has already indicated that it is difficult, if
not impossible, to incorporate dynamic phenomenon
such as price expectations into the static framework
of this construct.11 Yet, as the monetarists have rightly
pointed out, adjustments in specified behavioral rela­
tionships have to be made for such expectations under
conditions of anticipated inflation (and particularly
when the rate of inflation is anticipated to be
changing).
It appears that the monetarists have justifiable com­
plaints with the policy analysis derived from this
framework, which is common to popular macroeco­
nomic textbooks and past annual reports of the
Council of Economic Advisers, even if one is pre­
pared to accept the proposition that there are no deep
theoretical differences in the transmission mechanism
for monetary and fiscal policy.
In many respects the monetarist attack on the
IS-LM framework is fighting a “straw man.” Many of
the limitations of this highly aggregative framework,
such as those indicated above, have been attacked in
10It is not necessary to assume this kind of consumption func­
tion to generate such a family of curves. Price elasticities of
imports and exports with respect to domestic and foreign
prices, or income tax functions which have nominal income
elasticity greater than one, will generate the same effect.
11Teigen, “A Critical Look,” p. 19.
Page 27

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

larger econometric models of income determination.
This is not to say that these models have captured the
various effects with a high degree of precision. In
particular, the econometric problem of estimating dis­
tributed lags has proven particularly difficult, thus the
timing of responses to policy actions as implied by
large statistical models is a major area of uncertainty
at the present time.

The Process of Adjustment to Policy Actions
A close reading of the monetarist evaluation of the
relative strengths of monetary and fiscal policy leaves
the impression that they are not quite talking about
the same thing as the nonmonetarists. This can be
illustrated by the first quote from Andersen, above,
which sets out the transmission of monetary policy on
the economy as the adjustment of rates of return and
prices to a new equilibrium ( in the absence of further
exogenous shocks). A similar characterization has been
made in a recent analysis by Friedman in which he
distinguishes “Keynesian” analysis as a framework in
which prices are assumed exogenously constant.12
Most empirical models of income determination to­
day regard the price level as endogenously deter­
mined, with the independent variables in the price
level equation specified as money wage rates and
productivity separately or in a composite form as unit
labor costs.13 In addition, money wage rates are usu­
ally assumed to be endogenous variables in such
models. The behavior of wage rates in such models is
usually specified to follow a modified version of the
“Phillips Curve.”14 This specification is a disequilib­
rium mechanism which holds that, in the presence of
an excess demand or supply in the labor market ( usu­
ally measured by the unemployment rate), money
wage rates will change. However, it says nothing
about the nature of the equilibrium toward which the
market is presumably adjusting. This is a modification
of the early post-Keynesian models in which the
money wage rate was taken theoretically, if not em­
pirically, as fixed in the short run.
12Milton Friedman, “A Theoretical Framework for Monetary
Analysis,” Journal of Political Economy (March/April 1970),
pp. 193-238.
13See Lawrence R. Klein and Michael K. Evans, The Whar­
ton Economic Forecasting Model, 2nd ed., (Philadelphia:
University of Pennsylvania, 1968); Robert Rasche and
Harold T. Shapiro, “The F.R.B.-M.I.T. Econometric Model:
Its Special Features,” American Economic Review, Papers
and Proceedings (May 1968), pp. 123-149; and Otto Eck­
stein and Gary Fromm, “The Price Equation,” American
Economic Review (December 1968) pp. 1159-1183.
14A. W. Phillips, “The Relationship Between Unemployment
and the Rate of Change of Money Wage Rates in the
United Kingdom, 1861-1957,” Economica (November 1958),
pp. 283-299.

Page 28


JANUARY 1972

It seems appropriate to conclude that the mone­
tarists and their opponents are discussing policy effects
on the economy over two different time spans. The
nonmonetarists have implicitly concerned themselves
with models in which the labor market, at least, re­
mained in disequilibrium. The monetarists on the
other hand, in discussing policy impacts when the
“new equilibrium position of the economy” has been
achieved, implicitly appear to be concerned with the
period of time in which all markets, including the
labor market, have adjusted themselves to the policy
shock. The recent reinterpretation of the General
Theory by Leijonhufvud offers an explanation of this
debate in terms of the dynamics of the labor market.
He argues:
The revolutionary impact of Keynesian Economics
on contemporary thought stemmed in the main, we
have argued, from Keynes’ reversal cf the conven­
tional ranking of price and quantity velocities. In the
Keynesian models price velocities are not infinite; it
is sometimes said that the implications of the model
result from the assumption that money wages are
“rigid”. This usage can be misleading. Income-con­
strained processes result not only when price-level
velocity is zero, but w henever it is short of infinite.15

He further argues that this is an appropriate as­
sumption if there are substantial information costs as­
sociated with trading in the labor market, as recent
theories of labor market behavior have postulated:16
In the absence of perfect knowledge on the part of
transacting units or of any mechanism unrelated to
the trading process itself that would supply the
needed information costlessly, the presumption of
infinite price velocity disappears.17

Unfortunately, little attention has been given to
empirical investigation of the process by which labor
markets adjust to equilibrium. This adjustment pro­
cess has significant implications for the reaction of an
economic system to pure fiscal policy changes such
as increased government expenditures on goods and
services and increased real disposable income of con­
sumers through tax reductions unaccompanied by in­
creases in the money stock.
Acceptance of the Keynesian concepts of a con­
sumption function and an interest elasticity of the
15Axel Leijonhufvud, On Keynesian Economics and The Eco­
nomics of Keynes (New York: Oxford, 1968), p. 67.
16Armen A. Alchian, “Information Costs, Pricing, and Re­
source Unemployment,” pp. 27-52, and Charles C. Holt,
“Job Search, Phillips’ Wage Relations and Union Influence:
Theory and Evidence,” p. 53-123, both in E.S. Phelps et. al.
Microeconomic Foundations of Unemployment and Inflation
(New York: WAV. Norton & Co., 1970).
1‘ Leijonhufvud, On Keynesian Economics, p. 69.

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

demand for real cash balances, does not imply in­
creases in output and employment from the above
types of fiscal policy actions if the labor market is al­
lowed to adjust to the equihbrium supply and de­
mand functions which prevailed before the policy
shock.18 The restoration of such an equilibrium im­
plies the same real output and employment which pre­
vailed before the policy action, that is complete
“crowding out” of the fiscal stimulus in real terms.
Which elements of real private demand are displaced
by the fiscal stimulus will depend on the specifica­
tions of the sector demand functions.
If the money demand function is completely interest
inelastic then, when the new equilibrium is achieved,
velocity must be unchanged in the absence of an
accommodating monetary expansion, and complete
“crowding out” must also occur in nominal terms. With
an interest elastic money demand function, higher
prices can occur in the new equilibrium as a result of
higher nominal interest rates. In this case complete
“crowding out” will not occur in nominal terms.
The results of this model are consistent with the
monetarist position on the role of fiscal policy as out­
lined by Andersen and others. Therefore, if the ad­
justment process in the labor market is relatively
rapid, then the weight would seem to be with the
monetarist contention that fiscal policy is a relatively
weak tool for short-run stabilization. On the other
hand, if the adjustment is very slow, “transitory im­
pacts” of fiscal policy actions of the type usually de­
rived from income determination models exist, and
may have an important role in stabilization policy.19

The Conduct of Monetary Policy
A consistent characteristic of the monetarist posi­
tion is the insistence that monetary policy should be
conducted in terms of controlling the rate of growth
of monetary aggregates rather than controlling inter­
est rates or money market conditions. This position
can be traced back at least as far as early post-war
proposals of Friedman during the period when the
Federal Reserve was still supporting the price of
Government debt.20
In support of this position, the monetarists have
developed a number of valid objections to the money
market approach. First, they would hold that the view
18Gardner Ackley, Macroeconomic Theory (New York:
Macmillan, 1961), pp. 382-387.
19It is noteworthy in this respect that Friedman seems to
always be careful to acknowledge that there are short-run
“transitory” effects of fiscal policy actions on real output
and employment.
-"Milton Friedman, A Program for Monetary Stability ( New
York: Fordham University Press, 1959).



JANUARY 1972

that monetary influences are channeled to aggregate
demand only through impacts of interest rates on in­
vestment demand is too narrow a view of the role of
monetary policy. It has been argued above that there
exists fairly widespread support for this argument to­
day, at least as a theoretical position. Second, they
would argue that observed market rates of interest
are nominal rates, and that in times of changing ex­
pectations of future inflation rates, the relevant inter­
est rates for economic decisionmaking are ex-ante real
rates of interest — nominal rates less the anticipated
rate of future inflation. Under these circumstances it
is possible that changes in nominal interest rates may
give a completely wrong impression of what is really
happening in terms of real rates of return.
As an example of this, the St. Louis Federal Reserve
Bank has published from time to time over the past
several years, estimates of a real interest rate series
which proposes to measure long-term yield such as
the corporate bond rate adjusted for inflationary an­
ticipations. The contrast in the behavior of this series
and the corresponding nominal series is quite striking.
It is well known that the nominal series has achieved
historically high levels in the past several years. On
the other hand, the proxy for the real rate has re­
mained remarkably steady over the latter part of the
decade. One can object, of course, to the techniques
used to approximate this series. Nevertheless, the
monetarists have made a valuable contribution in em­
phasizing this distinction, because the existence of
“inflation premiums” in market interest rates, particu­
larly long-term rates, over the past several years is
now widely acknowledged.21
An additional argument which has not been ad­
vanced by the monetarists to my knowledge, can be
derived from recent work in investment theory. Con­
siderable empirical testing has now been done on the
neoclassical theory of investment which is most closely
associated with the work of Jorgenson.22 This theory
indicates that interest rates are but one component
of the quasi rent on new capital, which is a postu­
21For example, “Financial Developments in the Third Quarter
of 1971,’ Federal Reserve Bulletin (November 1971), p.
871, states:
The key factor contributing to interest rate de­
clines, however, was the marked change in market
expectations triggered by the President’s new eco­
nomic program. Expectations of inflation, and hence
the inflationary premium on interest rates, appear to
have been reduced by the temporary freeze on wages
and prices and by the indication that a program of
strong continuing controls would follow.
22Robert E. Hall and Dale W. Jorgenson, “Application of the
Theory of Optimum Capital Accumulation, ’ pp. 9-60, and
Charles W. Bischoff, “The Effect of Alternative Lag Dis­
tributions,” pp. 61-130, both in Gary Fromm, ed., Tax
Incentives ana Capital Spending (Washington: the Brook­
ings Institution, 1971).
Page 29

F E D E R A L R E S E R V E B A N K O F ST. L O U I S

JANUARY 1972

lated determinant of investment activity. Various tax
policy actions can also affect the rate of return on
capital, and it is the net effect of the changes in
interest rates and these tax policy actions which is the
relevant influence on investment behavior. In particu­
lar, in discussions of monetary policy in late 1971,
arguments that interest rates must be brought down
to stimulate investment may be overly emotional.
With the resumption of permanent tax credits on
equipment, and the reduction of useful lives allowed
for tax purposes earlier in the year through the revi­
sion of Treasury regulations, it is likely that the net
effect on investment demand through the so called
“cost of capital” channel would be expansionary, even
if interest rates were to rise significantly over the first
part of next year.

priate at this point.25 It appears inappropriate to ar­
gue about the stability of the demand for money
function, in the sense that the aggregate demand for
real cash balances can be thought of as a stable func­
tion of a few parameters.26 This proposition has been
implicitly accepted by all empirical research into the
nature of this function.27 It is also true that most of
these studies have concluded that statistically signifi­
cant interest elasticities of money demand do exist.
On the other hand the studies which have attempted
to distinguish between short-run and long-run interest
elasticities have consistently found that the short-run
elasticities are quite small relative to the long-run
elasticities because of a relatively slow speed of ad­
justment back to the long-run function after a distur­
bance from an initial portfolio equilibrium position.

If these arguments are valid in minimizing the im­
portance of money market conditions as the target of
monetary policy, then the question which remains to
be answered is why concentrate on the rate of growth
of monetary aggregates. It would seem that there is
nothing in the “weak monetarist thesis,” as outlined
above, which is sufficient to call for the conduct of
monetary policy in terms of controlling the rate of
growth of monetary aggregates. The theory must be
supplemented by additional hypotheses about the
short-run behavior of velocity.

It should be noted that these propositions say
nothing about the control of the money stock through
open market operations aimed at money market con­
ditions versus control through open market operations
aimed at reserve aggregate targets. This issue involves
the elasticity of the supply function for money, rather
than the demand function, and goes beyond the scope
of the present discussion.

Brunner establishes a necessary condition for this
policy orientation in what he calls the “strong mone­
tarist thesis,” which maintains that the variability of
monetary impulses is also large relative to the speed
at which the economy absorbs the impact of environ­
mental changes.23 It does not seem totally appropriate
to interpret this statement as holding that velocity is
( or must b e ) constant in the short run, as some recent
commentators seem to imply.24 All that appears nec­
essary is that if velocity changes, it must change in a
manner which is predictable from the time path of
past or predicted future behavior of the money supply.
It can be demonstrated with currently popular formu­
lations of the money demand function that the lower
the short-run interest elasticity of the demand for
money, the more likely this condition will be met. We
shall return to this point in the next section where
some comments are presented on the St. Louis
equation.

The discussion up to this point has centered on
monetarism as monetary theory and its prescriptions
for monetary policy. It seems appropriate to conclude
with some remarks on the St. Louis equation.

Several remarks on the current state of empirical
research on the money demand function are appro2:iBrunner, “The Role of Money and Monetary Policy,” p. 19.
-'Paul A. Samuelson, “Reflections on the Merits and Demerits
of Monetarism,” in James J. Diamond, ed., Issues in Fiscal
and Monetary Policy: The Eclectic Economist Views The
Controversy (DePaul University, 1971), pp. 7-21.

Page 30


The St. Louis Equation

This regression has been the subject of varied inter­
pretation since it first appeared. In their original arti­
cle Andersen and Jordan state:
This article does not attempt to test rival economic
theories of the mechanism by which monetary and
fiscal actions influence economic activity. Neither is
it intended to develop evidence bearing directly on
any causal relationships implied by such theories.
More elaborate procedures than those used here
would be required in order to test any theories under­
lying the familiar statements regarding results ex­
pected from monetary and fiscal actions. However,
empirical relationships are developed between fre­
quently used measures of stabilization actions and
economic activity. These relationships are consistent
2r,A useful summary of research on the money demand func­
tion is provided in David Laidler, The Demand for Money:
Theories and Evidence (Scranton, Pa.: International Text­
book Co., 1969).
2tiMilton Friedman, “The Quantity Theory of Money — A
Restatement,” in Studies in the Quantity Theory of Money
(Chicago: University of Chicago Press, 1956), pp. 3-21.
27The derivation of regression estimates of any function pre­
supposes stability of that function, in the Friedman sense,
over the sample period.

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

with the implications of some theories of stabiliza­
tion policy and are inconsistent with others. . . ,28

A later article states:
This general specification represents the reduced
form for that class of structures which has AM
[changes in money stock] and A E [changes in F ed ­
eral expenditures] as exogenous variables. In this
form the total spending equation remains uncom­
mitted as to structure; it is potentially consistent
with both Keynesian and quantity theory models.-9

In the latter article, it was also noted that equations
had been constructed using percentage changes, rather
than first differences, and that the results were basi­
cally unaffected by the change in specification.
These equations and their established forecasting
properties have remained somewhat a mystery to eco­
nomists associated with the nonmonetarist position
and the tradition of large econometric models. It has
been subjected to numerous attacks on the choice of
independent variables and problems of statistical
bias.30 In general it would appear that the equation
has withstood these attacks surprisingly (or disturb­
ingly ) well.
We shall offer yet another interpretation of the St.
Louis equation which suggests that it is not a “reduced
form” of an unspecified system, but rather only one
component of the structural system. This interpreta­
tion of the St. Louis results is not sympathetic to the
view that the St. Louis equations are a competitive
econometric model of the United States economy.
Judged in this perspective, it is possible to rationalize
its forecasting performance.
Recognizing that percentage changes are approxi­
mately equal to changes in logarithms for small
changes, the St. Louis equation can be rewritten as:
(1 )

A ln Y = a +

2 |5i A l n M - i + 2 y i A l n E - i
i—0
i—0

where Y = GNP in current dollars
M = money stock
E = high-employment Government expendi­
tures.
28Leonall C. Andersen and Jerry L. Jordan, “Monetary and
Fiscal Actions: A Test of Their Relative Importance in
Economic Stabilization,” this Review (November 1968),
p. 11.
29Leonall C. Andersen and Keith M. Carlson, “A Monetarist
Model for Economic Stabilization,” this Review ( April
1970), p. 9.
30Frank de Leeuw and John Kalchbrenner, “Monetary and
Fiscal Actions: A Test of their Relative Importance in
Economic Stabilization — Comment,” this Review ( April
1969), pp. 6-11; and Edward M. Gramlich, “The Useful­
ness of Monetary and Fiscal Policy as Discretionary Stabili­
zation Tools,” Journal of Money, Credit, and Banking
(May 1971), pp. 506-532.



JANUARY

1972

This can in turn be conveniently transformed into a
velocity (V ) equation:
(2 ) AlnV = (A ln Y —AlnM ) = a + (|30 - 1 ) AlnM
+ Zpi AlnM -i + 2 yiA lnE-i
i—1

i= 0

Recent empirical formulations of the demand for
money function specify that in the long run velocity
is a function of interest rates, and assume that private
economic units adjust to their long-run equilibrium
cash balances with a lag. Such models can be trans­
formed into a specification:31
(3 ) AlnV = yo Ain g (r) + y i AlnMt + Z yi AlnMt-i
i= l

where r = interest rate.
If for the moment the interest rate term is ignored,
this equation appears quite similar to the transformed
Andersen-Jordan equation (1) above. It can be clearly
seen from this equation that such specifications of the
money demand function relate changes in velocity to
current and lagged changes in the money stock ( all in
logarithms). It further suggests that changes in inter­
est rates will induce additional changes in velocity.
Most economists would hold that changes in interest
rates and money stock are jointly determined, and
consequently, forecasts from equation (1), ignoring
the induced changes on interest rates from changes in
the money stock, will cause forecasting errors. How­
ever, if the short-run interest elasticity of the money
demand function is very small, then an estimated
equation omitting this term would most likely produce
a credible forecasting record. In addition, it is likely
that the distributed lag on high-employment Govern­
ment expenditures used by Andersen and Jordan is
correlated with interest rates in both the sample and
post sample periods, and serves as an effective proxy
variable for forecasting purposes.32

Summary
Monetarism and the monetarist approach to de­
mand management has raised many issues in the past
several years which have significantly influenced the
attitudes of professional economists on the question of
31See Appendix for the derivation.
32Equations of the form of (3 ) have been estimated using the
data of the current St. Louis forecasting equations, both
with and without the high-employment expenditure varia­
bles. Space constraints permit only the comment that the
interest rate variable, either a short-term rate such as the
Treasury bill rate, or a long-term rate such as the Cor­
porate Aaa rate, show up as highly significant variables,
though with very low short-run elasticities. Even with the
interest rate variable in the specification, some of the co­
efficients in the distributed lag on high-employment ex­
penditures remain significant.
Page 31

F E D E R A L R E S E R V E B A N K O F ST. L O U IS

JANUARY 1972

how to pursue stabilization policy. Monetarist models
have to date established a forecasting record which is
credible when compared to the more entrenched in­
come determination approach.

Assume that in the long run velocity is a function of
interest rates:

Recently, considerable work has been done to ela­
borate an extensive theoretical framework which pur­
portedly underlies the policy prescriptions and the
“reduced form” monetarist models of aggregate eco­
nomic activity. The comments above suggest that
much of this theoretical framework is shared with
economists of nonmonetarist persuasion, but that
there are a number of areas in which substantially
different views of the world exist. Unfortunately, few
attempts have been made by the monetarists and
nonmonetarists to identify the common and contrast­
ing elements of their theoretical constructs. Even less
work has been done to attempt to disprove the specific
hypotheses of market behavior in the areas of conflict,
most of which, I believe, involve the dynamics of
price adjustments.33 Only as such analysis becomes
available will we be able to resolve important policy
issues such as the relative strengths of fiscal and mone­
tary actions under various conditions of the economy,
and the speed at which policy actions affect aggregate
demand, employment, and prices.

(2) M ° = [ i ] Y = Yg(r) ^

33For example, Milton Friedman in , “A Theoretical Frame­
work,” argues that a major unresolved issue in his analysis
(as well as that of others) is the response of real output
and prices individually to policy shocks.

APPENDIX
The purpose of this appendix is to demonstrate the
derivation of equation (3 ) in the text from a money
demand specification.

(1) V = F ( r ) ^

dr

> 0

or
< 0

In addition private economic units are assumed to adjust
to their long run equilibrium cash balance positions with
a lag, which is usually specified as:

(J) M_i [

/
M_jJ

When this is expressed in logarithms it becomes:
(4) A l n M = 6 1 n M l>-

61n M_j

A more general form1 of the distributed lag adjustment
mechanism can be specified as:
lriM = /?0 l n M ° +

l n M_ j + . . . + /8n l n M _ n

Substituting for M “ gives:
(5)

l n M = /3 0 In [g(r)]+ /30 In Y + X/3; lnM_j
i= l

which can be rewritten as a velocity equation:
(6)

l n V = ( l n Y - l n M ) = -/3c l n [g(r)]+ ( 1 - / 3 J I n Y - £ f t ln M ,*
i=l

Taking first differences in the logs:
(7) A in V = -/80 Ain [g(r)] + (1 -/3 J A ln Y -

AlnM_;
i=l

which can be transformed to:
(8) AlnV = - j80A ln [g(r)] + (1-/S0) AlnV + (l-/30) A ln M - jfftA ln M .!

i-1

(9) A lnV = i-[-/ 8 0 A ln[g(r)] + (l-/30) A ln M - S f t A l n M . j l

PoL

i=i

iRobert M. Solow, “On a Family of Lag Distributions,”
Econometrica (April 1960), pp. 393-406.

This article and the accompanying one by Ronald L. Teigen are available os Reprint No. 74


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