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FEDERAL RESERVE B A N K
OF ST. L O U IS
NOVEMBER 1974

Digitized for Vol. 56, No.
FRASER


Inflation, Recession — W hat’s a
Policymaker To Do?
An Address by Darryl R. Francis
Channels of Monetary Influence:
A Survey ...............................

1
1

3
8

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

0

NOVEMBER

R e p rin t S e rie s

V ER T H E YEARS certain articles appearing in the R e v i e w have proven helpful to banks,
educational institutions, business organizations, and others. To satisfy the demand for these
articles, our reprint series has been made available on request. The following articles have
been added to the series in the past six years. Please indicate the title and num ber of article in
your request to: Research Department, Federal Reserve Bank of St. Louis, P. O. Box 442,
St. Louis, Mo. 63166.
NUMBER
TITLE OF ARTICLE
33. An Approach to Monetary and Fiscal Management
34. Monetary and Fiscal Actions: A Test of Their Relative Importance
in Economic Stabilization
35. A Program of Budget Restraint
36. The Relation Between Prices and Employment: Two Views
37. Monetary and Fiscal Actions: A Test of Their Relative Importance in
Economic Stabilization — Comment and Reply
38. Towards a Rational Exchange Policy: Some Reflections on the
British Experience
39. Federal Open Market Committee Decisions in 1968 —
A Year of Watchful Waiting
40. Controlling Money
41. The Case fo r Flexible Exchange Rates, 1969
42. An Explanation of Federal Reserve Actions (1933-68)
43. International Monetary Reform and the "Crawling Peg”
Comment and Reply
44. The Influence of Economic Activity on the Money Stock: Comment; Reply;
and Additional Empirical Evidence on the Reverse-Causation Argument
45. A Historical Analysis of the Credit Crunch of 1966
46. Elements of Money Stock Determination
47. Monetary and Fiscal Influences on Economic Activity —
The Historical Evidence
48. The Effects of Inflation (1960-68)
49. Interest Rates and Price Level Changes, 1952-69
50. The New, New Economics and Monetary Policy
51. Some Issues in Monetary Economics
52. Monetary and Fiscal Influences on Economic Activity: The Foreign Experience
53. The Administration of Regulation Q
54. Money Supply and Time Deposits, 1914-69
55. A Monetarist Model fo r Economic Stabilization
56. Neutralization of the Money Stock, and Comment
57. Federal Open Market Committee Decisions in 1969 —
Year of Monetary Restraint
58. Metropolitan Area Growth: A Test of Export Base Concepts
59. Selecting a Monetary Ind ica to r— Evidence from the United States and
Other Developed Countries
60. The “ Crowding Out” of Private Expenditures by Fiscal Policy Actions
61. Aggregate Price Changes and Price Expectations
62. The Revised Money Stock: Explanation and Illustrations
63. Expectations, Money and the Stock Market
64. Population, The Labor Force, and Potential Output: Implications for
the St. Louis Model
65. Observations on Stabilization Management
66. The Implementation Problem of Monetary Policy
67. Controlling Money in an Open Economy: The German Case
68. The Year 1970: A "M odest” Beginning for Monetary Aggregates
69. Central Banks and the Money Supply
70. A Monetarist View of Demand Management: The United States Experience
71. High Employment Without Inflation: On the Attainment of Admirable Goals
72. Money Stock Control and Its Implications fo r Monetary Policy
73. German Banks as Financial Department Stores
74. Two Critiques of Monetarism
75. Projecting With the St. Louis Model: A Progress Report
76. Monetary Expansion and Federal Open Market Committee
Operating Strategy in 1971
77. Measurement of the Domestic Money Stock
78. An Appropriate International Currency — Gold, Dollars, or SDRs
79. FOMC Policy Actions in 1972
80. The State of the Monetarist Debate
Commentary: Lawrence R. Klein and Karl Brunner
81. The Russian Wheat Deal — Hindsight vs. Foresight
82. A Comparative Static Analysis of Some Monetarist Propositions
83. Balance-of-Payments Deficits: Measurement and Interpretation
84. Real Money Balances: A Misleading Indicator of Monetary Actions
85. The Federal Open Market Committee in 1973
Digitized for Page 2
FRASER


ISSUE
November 1968
November 1968
March 1969
March 1969
April 1969
April 1969
May 1969
May 1969
June 1969
July 1969
February 1969
July 1969
August 1969
September 1969
October 1969
November 1969
November 1969
December 1969
January 1970
January 1970
February 1970
February 1970
March 1970
April 1970
May 1970
June 1970
July 1970
September 1970
October 1970
November 1970
January 1971
January 1971
February 1971
December 1970
March 1971
April 1971
May 1971
August 1971
September 1971
September 1971
October 1971
November 1971
January 1972
February 1972
March 1972
May 1972
August 1972
March 1973
September 1973
October 1973
December 1973
November 1973
February 1974
April 1974

1974

Inflation, Recession —W hat’s a Policymaker To Do?
A Presentation by DARRYL R. FRANCIS, President, Federal Reserve Rank of St. Louis,
Refore the Illinois Economic Association,
Peoria, Illinois, October 25, 1974

T

A T IS good to have this opportunity to discuss with
you some of the problems confronting policymakers
during these troubled economic times. Early last year
the pace of real growth in the U.S. economy started to
slow, and in the first three quarters of 1974 the na­
tion’s output of goods and services declined. At about
the same time that output started to slow, the pace
of inflation accelerated.

Before turning to these problems of policy formula­
tion, I would like to review briefly our recent eco­
nomic experience. As we are all painfully aware, the
U.S. economy is currently undergoing some uncom­
fortable adjustments. To provide some perspective on
recent developments I would like you to examine with
me the first chart among the set that has been dis­
tributed to you.

From the standpoint of a policymaker trying to
formulate a strategy for stabilization policy, these two
developments appear to be in direct conflict with one
another. The slowdown in real growth, carrying with
it a threat of rising unemployment, suggests that mon­
etary and fiscal policies should be stimulative. The
quickening and persistence of inflation, on the other
hand, seems to call for monetary and fiscal restraint.
This conjunction of developments, which is called
“stagflation” by some, thus poses a dilemma for
policymakers.

By way of introductory comment, I want to empha­
size the importance of keeping our perspective as we
attempt to analyze and understand our recent eco­
nomic experiences. I find charts of this type very
useful in this respect — providing a visual summary of
the U.S. economy over the last two decades. I will
return to this point later, but I feel that our current
state of economic disarray is related in large measure
to a lack of perspective in the formulation of economic
policy, both now and in the past.

The basis for the dilemma is the common belief
that inflation and unemployment can, in some sense,
be viewed as symmetrical problems. By symmetrical,
I mean opposite sides of the policy coin — when
economic policy is too stimulative, you get inflation;
when policy is too restrictive, you get increased un­
employment. In many policy discussions this dilemma
is couched in terms of the so-called Phillips curve.
During the course of my remarks I will point out
what I consider to be some major deficiencies under­
lying the notion of the Phillips curve, that is, an ap­
parent trade-off between inflation and unemployment.
Recent economic experience along with recent re­
search results suggest that we need to modify our
thinking about this relation. These recent develop­
ments in economic thinking carry important implica­
tions for stabilization strategy.



L et me begin by reviewing recent trends in the
growth of the money stock, which are shown in the
top tier of Chart I. Since early 1972, the nation’s
money stock has increased at a 6.8 percent annual
rate. This rate of expansion represents a step-up from
the 6 percent average rate of increase from late 1966
to early 1972. These average rates of money expansion
for the last eight years compare with a 3.4 percent
average rate of increase during the early 1960s and
a 1.8 percent average rate of expansion during most
of the decade of the 1950s.
Look now at the second tier in Chart I, which
shows the general movement of prices over the last
two decades. I feel that the top two tiers of this chart
provide support for the proposition that inflation is a
monetary phenomenon. The general movement of
prices is closely related to the trend rate of monetary
expansion.
Page 3

FEDERAL RESERVE

B A N K O F ST. L O U I S

NOVEMBER

RATIO SCALE
\
BILLIONS OF DOLLARS---------- f

280 M oney Stock
— Seasonally A djusted —'

l is t qtr 52

RATIO SCALE

1958=100

P

W vm ,

|

H G eneral Price Index
Q
Seasonally Adjusted

1st qtr 52

1__
1
RATIO SCALE
'W & W /.
BILLIONS OF DOLLARS

600 Real O utput
S e a s o n a lly A d usted

3rd qlr

1st qtr 73

3rd qU.74

___1 _U
_
PERCENT

|

H P H

I

. U nem ploym ent Rate

1st qtr '52

n—
&—
Latest d a ta p lo tte d : 3rd qu arte r


Page 4


3rd qlr

1974

FEDERAL

RESERVE

B A N K O F ST. L O U I S

To understand better the recent acceleration of
prices, a shaded area has been included representing
the period when the price-wage control program was
in effect. In retrospect, it appears that controls had
the effect of keeping reported prices down in late
1971 and throughout 1972; but it should be clear that
such measures have only temporary effects, especially
when the rate of monetary expansion is left unchecked.
Consequently, I think the very rapid 9.0 percent rate
of price advance since late 1972 is in large part a
catch-up phenomenon following the period of controls.
Some analysts attribute the recent outburst of infla­
tion to the operation of special factors — the oil em­
bargo, the Russian wheat deal, two devaluations of
the dollar, and so on. These events are labeled as
special factors because they appear to be beyond the
control of our monetary and fiscal authorities. I find
it impossible to swallow this “special factor” explana­
tion of inflation. If we maintain our perspective, we
note that, in part, these special factors occurred in re­
sponse to conditions created by previous mistakes in
economic policy.
Our current energy problems are not completely
unrelated to the increased demand for energy associ­
ated with the rapid pace of economic expansion in
1972 and 1973, an expansion fueled by very stimu­
lative monetary and fiscal actions. The supply of do­
mestic energy, on the other hand, was discouraged by
implementing an economic policy of wage and price
controls. Furthermore, the worldwide inflation should
not be considered a special factor since it is related to
the rapid monetary expansion in the United States.
W ith a system of fixed exchange rates where the dollar
serves as a reserve currency, the rapid monetary ex­
pansion in the United States resulted in a rapid accu­
mulation of worldwide reserves, which, in turn, led to
monetary expansion and inflation in other countries.
I am not willing to accept the special factor explana­
tion of inflation because that explanation removes the
focus from inflation as a monetary phenomenon. By
losing such a focus I think we are abdicating our
responsibilities as policymakers. Pretending that the
bulk of our inflation is caused by factors other than
excessive monetary expansion runs a great risk that
the rate of monetary expansion will be stepped up
further in an attempt to avoid possible reductions in
real output growth currently.
An examination of recent trends in output and un­
employment (third and fourth tiers of Chart I) sug­
gests that current economic activity is very sluggish.
Real output remains below the level of early 1973,



NOVEMBER

19 74

and since late last year unemployment has been ris­
ing. However, if we maintain our perspective, we note
that output is still up at a 3.1 percent average annual
rate from the end of the 1969-70 recession, and total
civilian employment has increased at a 2.5 percent
average rate during the same period.
Let me now turn to the issue that I raised
earlier — is it appropriate to treat inflation and
unemployment as symmetrical problems in policy
discussions? The result of such discussions is that
stabilization policy should attempt to walk a tightrope
between these two problems, providing just the right
growth of total demand so that neither inflation nor
unemployment occurs.
Recent experience is again reminding us, however,
that inflation and unemployment can emerge simul­
taneously, as we have just seen in Chart I. Inflation
persisting in the face of rising unemployment cur­
rently runs counter to predictions based on the Phil­
lips curve. In other words, the Phillips curve does
not provide an adequate explanation for events as
they seem to be evolving now. At the present time
there does not seem to be a “right” amount of total
demand that will permit the achievement of b oth
full employment and price stability.
To understand better the nature of the relationship
between inflation and unemployment, let us now turn
to the rest of the charts that have been distributed to
you. Chart II is a scatter diagram of the inflationunemployment experience of the United States from
1953 through 1973. Each dot represents a year in that
period. The unemployment rate has ranged from a
low of 2.9 percent of the labor force in 1953 to a high
of 6.8 percent in 1958, and the average for the entire
period was 4.9 percent. The inflation rate, as measured
by the annual rate of change in the consumer price
index, has varied between minus 0.5 and plus 8.4 per­
cent for the 1953-73 period, averaging 2,6 percent
per year. Indications are that 1974 will record about
a 5.5 percent average rate of unemployment and al­
most a 12 percent advance in prices.
Examination of Chart II clearly demonstrates that
there does not exist any systematic relationship be­
tween inflation and unemployment. W hat we do ob­
serve is a greater tendency for the unemployment
rate to cluster about its mean than does the inflation
rate. Association of dates with the dots also indicates
that the inflation rate has moved progressively higher
since the mid-1960s. For all years since 1966, the infla­
tion rate has been above the average for the 1953-73
period, but the unemployment rate has not remained
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 I S

NOVEMBER

C h a rt II

C h a rt III

Prices a n d U n e m p lo y m e n t

19 74

U n e m p lo y m e n t a n d M o n e y

Cn M e P s
o s mr rice

1953-1973

C
onsoaor Prim

f M 'M t

P e rce n t

9 ------------- r------------ --------------1------------ — ---------------------------------------------------

1953-1973

U n e m p l o y m e n t R ate
P ercent

0

1

AVERAGE
9°
AVERAC E 4 .9%;

Unem ploym ent Rat*
Percent

VERAC; e 3 6%

197*3

1 9 5 8 .^
19*61

,9 * 4

1960

j 1970

19*69

1963

19*71
19*72

1964

1962 19*59

19 70

----------------AVERAGE 4.9%

1973

1955

19*68

1966

19*65

1956

19*57

196*6

197 1

19*67
196 8

1969

19*72*

195/

1953

1956
AVERAGE 2.6%
1956
1959
1 9 6 0 * - '9 6
*196

1965

1961
19*53

1955

0

1954

1

2

3

4

5

6

7

8

Money

1

2

3

4

5

6

7

8

Unemployment

Rote
S o u rc e : U.S. D e p a rtm e n t o f L a b o r
U n e m p lo y m e n t ro te is th e a v e r a g e fo r th e y e a r in d ic a te d . R ates o l c h a n g e fo r p ric e s a re
c o m p u te d fo r th e y e a r e n d in g in fo u rth q u a r te r o f y e a r in d ic a te d .

below the average, as followers of the Phillips curve
would lead us to believe.
Charts I I I and IV allow us to examine the relation­
ships between inflation and unemployment relative to
the key determinant of growth in total demand — the
rate of monetary expansion. Consider first the relation­
ship between monetary growth and unemployment
presented in Chart III. Examination of this chart fails
to indicate any systematic relationship between the
two variables. In other words, the level of unemploy­
ment does not appear to bear a directly observable
relationship to the trend rate of monetary expansion as
measured by a two-year average rate of change. W hat
Chart I II does imply is that over the last twenty years
the lev el of the unemployment rate in the U.S. econ­
omy has taken on values quite independently of the
trend rate of monetary growth. Based on this cursory
examination of the data, I conclude that the trend rate
of monetary expansion over a period as long as two
years contributes little to the explanation of move­
ments in the unemployment rate. I might add, how­
ever, that this conclusion does not deny any transitory
effects of short-run monetary accelerations and decel­
erations on employment and unemployment.

servations fall in either the lower left or upper right
quadrant. The relatively loose fit does indicate other
factors have an influence on the movement of prices
C h o r t IV

Prices a n d M o n e y

1953-1973

C o n s u m e r Pri ce s
Perc ent

<

0

S ources: B o a rd o f G o v e rn o rs o f th e F e d e ra l R eserve System
a n d U.S. D e p a rtm e n t o f L a b o r
U n e m p lo y m e n t R ate is the a v e r a g e fo r th e y e a r in d ic a te d . Rates o f c h a n g e fo r m o n e y a re
fo r th e tw o y e a r p e r io d e n d in g in th e fo u r th q u a r te r o f th e y e a r in d ic a te d . M o n e y is
d e fin e d as c u rre n c y a n d d e m a n d d e p o s its h e ld b y th e n o n -b a n k p u b lic .

>

------------------- ----------------------------------------.----------------- LI------------------- ----------------------------------------1 . ,
|L------------------- 1

it

C o n s u m e r Pri ce s
Ptrcnnt

9

3 6 c:
197 3

19 70
1969

196 8

1966

1971

1972

1957
1967
1956

•

AVER AG E 2 .6 %
1958
1960

962

1959
J
1963

19*65
19 64

1961
19 53
19*55
195 4

1

2

3

4

5

6

7

Money

Consider now the relationship between inflation
and monetary growth presented in Chart IV. The
relationship is closer than that between unemploy­
ment and money. Nineteen of the twenty-three ob­
Digitized for Page 6
FRASER


S o u rce s: B o a rd o f G o v e r n o rs o f th e F e d e ra l R eserve S ystem
a n d U .S. D e p a r tm e n t o f L a b o r
R ates o f c h a n g e f o r p r ic e s a r e c o m p u te d fo r th e y e a r e n d in g in fo u r th q u a r te r o f th e y e a r
in d ic a te d . R ate s o f c h a n g e fo r m o n e y a r e fo r th e tw o y e a r p e r io d e n d in g in th e fo u rth
q u a r te r o f th e y e a r in d ic a te d . M o n e y is d e fin e d a s c u rre n c y a n d d e m a n d d e p o s its h e ld
b y th e n o n - b a n k p u b lic .

FEDERAL

RESERVE

B A N K O F ST. L O U I S

in a given year. But when we talk about the “problem
of inflation”, I think it is safe to say that the funda­
mental cause is excessive money growth, and the
cure is to slow down the rate of money expansion.
After examining these three charts I conclude that
a sustainable low level of unemployment can n ot be
obtained for the “purchase price” of a higher rate of
inflation. It should be pointed out, however, that for
short periods a relationship between inflation and un­
employment may exist, but the experience of the last
four or five years has provided evidence casting seri­
ous doubt on the validity of the Phillips curve rela­
tion over the longer run.
Whether or not there is a systematic and lasting
trade-off between unemployment and inflation is not
just an academic question. The presence or absence
of such a trade-off carries important implications for
stabilization policy. If there is no trade-off, but policy­
makers act as if one exists, any attempt to use ag­
gregate demand policies to achieve unemployment
below the rate dictated by the forces of supply and
demand will result in accelerating inflation.
On the basis of evidence presented in these charts,
the implication is that monetary policy should be
formulated with an eye toward controlling inflation,
for this is the variable that is systematically related
to the rate of monetary growth. The trend growth of
money, in turn, is subject to control by the monetary
authorities.
Monetary actions do have an effect on unemploy­
ment, but this effect is transitory in nature. From
early 1952 to the fall of 1962, when monetary growth
averaged 1.8 percent, unemployment averaged 4.9
percent of the labor force; from the fall of 1962 to the
end of 1966, when money accelerated to a 3.8 per­
cent rate of growth, unemployment also averaged 4.9
percent. Since 1966, with money rising in excess of 6
percent per year, unemployment has averaged 4.7
percent. On the other hand, accelerating money
growth was accompanied by accelerating inflation.
This experience leads me to conclude that the un­
employment rate should not serve as a guide to mone­
tary policy.
If aggregate demand policies are to be formulated
with a primary focus on the price level, other policy
tools are required to deal with the problems of un­
employment. I think that the sooner we realize the
limitations of conventional macroeconomic policy in




NOVEMBER

19 74

reducing unemployment, the better off we will be.
And this realization also implies that we must look
to employment policies, rather than aggregate de­
mand policies, as a means of dealing with the prob­
lems of unemployment.
By employment policies I mean Federal govern­
ment actions geared toward improving the efficiency
of operation of labor markets. The government can
take steps to encourage improved job skills and can
assist in the dissemination of information relating
to job openings. Certain structural impediments to the
efficient operation of our labor markets should be
removed or modified, such as minimum wage laws
and restrictions on occupational mobility. Further­
more, I feel that our whole system of unemployment
compensation deserves closer study to see if the sys­
tem actually diminishes the incentive to work while
encouraging seasonal fluctuations in the demand for
labor.
By way of summary, I have raised some questions
about the symmetrical treatment of unemployment
and inflation in the formulation of stabilization policy.
W hen there appears to be a conflict of goals, the
policymaker has to choose more of one to get less of
the other. That, at least, is the advice that flows from
the tradition of the Phillips curve. And, I might add,
experience shows economic policy has been formu­
lated in that way, with varying emphasis on unem­
ployment and inflation, depending on prevailing
circumstances.
If unemployment over the longer run is recognized
as depending primarily on the real forces of supply
and demand in labor markets, and inflation is recog­
nized as depending primarily on the trend growth of
money, then our policy strategy has to be modified
accordingly. I feel the evidence supports the conclu­
sion that monetary policy should be formulated with
a longer-term focus. Such a focus implies that infla­
tion, rather than unemployment, should serve as the
primary guideline for aggregate demand policy. This
is not to say that we as policymakers should ignore
unemployment; rather, long-term benefits to society
will be greater if we hold to a relatively stable path
of monetary growth than if we react to every wiggle
of the unemployment rate. The chief contribution
that aggregate demand policies can make to our em­
ployment goals is the avoidance of sharp shifts in
policy. The past mistakes of aggregate demand policy
in this regard are all too familiar.

Page 7

Channels of Monetary Influence: A Survey*
ROGER W. SPENCER

^ .M O N G the numerous controversies surrounding
“money”, few are further from resolution than the is­
sue of how money affects the economy. Compounding
the controversy is the fact that the arguments ad­
vanced are not divided neatly along so-called mone­
tarist and nonmonetarist lines, but are separated by
other criteria.
To be sure, monetarists have long taken exception
to the intellectual straitjacket of the Keynesian
framework which limited the influence of monetary
actions to the response of investment to interest rate
changes. However, the monetarist alternatives offered
have been far from uniform. Certainly, monetary ac­
tions result in the change of more than one relative
price — the interest rate — and one type of spending
—- investment. However, substantial disagreement
among monetarists ( as well as other economists) per­
sists beyond this point.
There is basic agreement that at less than full em­
ployment, changes in the rate of growth of the money
supply affect output and employment before prices, a
proposition which may be traced back at least two
hundred years (Hume [4 8 ]), but this tells nothing
about how total spending and its components react to
monetary actions. It is necessary to examine the
changes in relative prices and wealth associated with
monetary impulses to gain insight into the moneyspending relation.
W hen the existing money stock (however defined)
either exceeds or falls short of the quantity demanded,
wealth and/or relative prices change and this sets off
both substitution and wealth effects, as indicated in
the accompanying diagram.1 The changes in relative
“The author acknowledges the helpful comments on earlier
drafts of George Kaufman, Thomas Mayer, John Pippenger,
Robert Rasche, William Rawson, Clark Warburton, and
William Yohe. They are blameless for remaining errors.
'The “correct” definition of money and the determinants of
money demand and supply functions are matters closely re­
lated to, but beyond the scope of the present article. Another
limitation is that because of the large number of authors sur­
veyed, only the briefest of summaries can be given here. In
some cases, this results in considerable oversimplification of
complex analyses.
Substitution and wealth effects are treated here as essentially
equivalent to substitution and income effects of generallyDigitized for Page 8
FRASER


prices typically involve changes in the rates of return
on real capital and financial assets as well as changes
in the prices of goods and services. Ways in which
changes in wealth may influence spending include
movements in real cash balances and changes in the
market value of equities.
There remains considerable disagreement about the
relative importance of these factors in the transmis­
sion of monetary inpulses. This is not surprising, given
the history of the relative price and wealth relations.
Keynes, as well as prominent economists who pre­
ceded him, was ambiguous on the subject. This article
first traces the early development of these two factors
and then analyzes more recent work in each area.

HISTORICAL BACKGROUND
Among the better early efforts to explain the
money-spending linkages were those of Irving Fisher
and Knut Wicksell. W riting around the turn of the
century, they both maintained a short-run view of the
transmission process which was dominated by interest
rate movements and a long-run view in which the key
role was played by changes in real cash balances
Money
\
Price Level /

Fisher and Wicksell
Fisher, like other neoclassical writers, determined
that output was at its full-employment level in the
long run. In the short (or transitional) run, however,
business cycles occurred in Fisher’s time, as well as in
other periods before and since. Consequently, macroeconomic analysts have continued to attempt expla­
nations of this phenomenon. Fisher’s view of the
business cycle depended strongly on “sticky” interest
rates.2
accepted price theory. Although monetary-induced changes
in relative prices or changes in wealth may generate both
substitution and wealth effects, the relative price change has
often been associated more with substitution effects and the
wealth change more with wealth effects; we will follow that
practice.
2See especially Fisher’s Chapter 4, “Disturbance of Equation
and of Purchasing Power During Transition Periods,” in
Fisher [25], In later years, Fisher [24] associated severe
swings of the business cycle with changes in debt activity.

FEDERAL. R E S E R V E B A N K O F ST

LOUIS

NOVEMBER

19 74

The M o n e ta r y T ra n sm issio n Process

This relative price effect ( via interest rates) was set
off by an increase in the money stock relative to the
quantity of money demanded. The nominal money
supply may be assumed to have increased due to a
rise in the gold stock and, consequently, bank re­
serves. W ith the additional assumption that output
and velocity were fixed initially, a rise in the commod­
ity price level was expected to be associated with the
money supply increase. Because Fisher assumed that
the commodity price rise preceded the increase in in­
terest rates, with interest costs being viewed as a sig­
nificant component of firms’ operating costs, the rise in
the price level produced an increase in firms’ profits.
A continued increase in demand deposits (through
business investment loan demand) relative to cur­
rency resulted in yet further increases in prices and
profits. Eventually, however, excess reserves would
run out, the interest rate would become “unstuck” and
would rise even faster than commodity prices. W ith
the rise in firms’ costs of operation, there would occur
a decline in profits and investment and a sharp in­
crease in bankruptcies. The downward phase of the
cycle was reversed when excess reserves again rose
and the interest rate had fallen accordingly.
W icksell’s well-known “cumulative process” also
captured cyclical movements of the economy largely
through interest rate changes. Some initial disturb­
ance, such as an innovation or technological break­
through would foster an increase in the desire to



invest at the prevailing interest rate. The demand for
loanable funds would then rise as would the “normal”
or “natural” rate of interest, the rate “at which the
d em an d fo r loan capital an d th e su pply o f savings
exactly agree” (W icksell [89], p. 193). If, however,
the banking community failed to realize that invest­
ment demand had risen, they would maintain the
same m arket rate of interest through increases in the
money supply which, given the usual classical assump­
tions, would result in commodity price rises.
Note that at this point the money supply has risen,
observed interest rates have been kept low in relation
to the normal rate, and business spending has been
the component of aggregate demand which has in­
creased. After some period of time, the banks’ reserve
position deteriorates and monetary growth is curbed.
The market rate of interest rises to the level of the
natural rate, an action which leads to the elimination
of excess aggregate demand and price level increases.
In the above short-run dynamic analyses, both
Fisher and Wicksell relied on the relative price
mechanism inherent in a money-interest rates-investment framework. However, in their approach to the
determination of long-run equilibrium, interest rates
and investment were replaced by a treatment of the
role of real cash balances.
Fisher’s real balance explanation began with an as­
sumed doubling of the money supply:
Page 9

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

Suppose, for a moment, that a doubling in the cur­
rency in circulation should not at once raise prices,
but should halve the velocities instead; such a result
would evidently upset for each individual the ad­
justment which he had made of cash on hand. Prices
being unchanged, he now has double the amount
of money and deposits which his convenience had
taught him to keep on hand.3
W ith the apparent increase in wealth, everyone
tries to reduce their cash balances by purchasing
goods and services, according to Fisher. Because ve­
locity (V ) and output (Q ) in the equation of ex­
change MV = PQ are determined to be fixed in the
long run, a doubling of the money supply ( M ) cannot
generate any increased holdings of goods and services,
but must result in a doubling of the price level ( P ).
Wicksell also saw real balances as the adjusting
variable on the return path to restoring long-run equi­
librium after the economy had been disturbed by an
exogenous shock.
Now let us suppose that for some reason or other
commodity prices rise while the stock of money
remains unchanged, or that the stock of money is
diminished while prices remain temporarily un­
changed. The cash balances will gradually appear to
be too small in relation to the new level of prices . . .
I therefore seek to enlarge my balance. This can only
be done — neglecting for the present the possibility
of borrowing, etc. — through a reduction in my d e­
mand for goods and services, or through an increase
in the supply of my own commodity . . . or through
both together.4
The reduction in demand and/or increase in supply
will cause commodity prices to fall until they have
reached their equilibrium level. Neither Wicksell nor
Fisher mentioned the money-interest rates-investment
spending channel of monetary influence in their anal­
yses of movements to long-run equilibrium. Both fo­
cused on changes in real cash balances without
explaining in detail the substitution and wealth proc­
esses involved. Although their long-run vs. short-run
analyses were similar in many respects, Fisher was
probably more noted for his long-run quantity theory
views and Wicksell more for his short-run cumulative
process.

Keynes
Like Wicksell and Fisher, Keynes’ position on the
monetary transmission mechanism was somewhat
aFisher [25], p. 153.
^Wicksell, [90], pp. 39-40. Wicksell’s treatment of the real
balance effect is considered superior to Fisher’s because the
former avoided the trap of dichotomizing the determination
of relative prices and the absolute price level. See Patinkin
[63],
Page 10




NOVEMBER

ambiguous. Some
found little or no
price effects while
having advanced a

19 74

critics have contended that he
role for either wealth or relative
others have credited Keynes with
significant role for both.

Keynes’ substitution effect, which was a part of
a relatively early portfolio choice model, stressed
the money-interest rates-investment spending channel.
Did Keynes think changes in the rate of growth of the
money supply affected interest rates? There seems to
be little doubt that he did. The principal evidence to
the contrary may be found in the following passage
from T h e G en eral T heory o f E m p loy m en t Interest
and M oney:
There is the possibility, for the reasons discussed
above, that, after the rate of interest has fallen to a
certain level, liquidity-preference may become vir­
tually absolute in the sense that almost everyone
prefers cash to holding a debt which yields so low a
rate of interest. In this event the monetary authority
would have lost effective control over the rate of
interest. But whilst this limiting case might become
practically important in future, I know of no exam­
ple of it hitherto. Indeed, owing to the unwillingness
of most monetary authorities to deal boldly in debts
of long term, there has not been much opportunity
for a test. Moreover, if such a situation were to
arise, it would mean that the public authority itself
could borrow through the banking system on an
unlimited scale at a nominal [very low] rate of
interest.8
Note that after raising the possibility that a “liquidity
trap” situation could conceivably arise in the future,
Keynes immediately disavowed its existence under
conditions (the low employment, low interest rate pe­
riod of the 1930s) in which Keynesian analysis sug­
gested it would likely occur.
Begarding the second part of the money-interest
rates-investment channel, there is considerable evi­
dence that Keynes thought investment to be quite
responsive to interest rate changes ( Leijonhufvud
[53], pp. 157-185). However, the interest sensitivity
of investment was restricted in the main to long-term
rates, which changed only slowly.
There are a number of wealth effects to be found in
T h e G en eral T h eory which relate to either price-in­
duced changes in wealth (changes in wealth associ­
ated with changes in the absolute price level) or interest-induced movements in wealth ( changes in
wealth associated with changes in yields). Of the
basic price-induced and interest-induced wealth ef­
fects, it has been alleged that “Keynes stated both
■
’’Keynes [51], p. 207. Bracketed expression supplied.

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

parts of the wealth effect, emphasized their impor­
tance, and then let wealth slip through his fingers by
his failure to build it into his analysis.” (Pesek and
Saving [64], p. 2 1 ). This criticism is unjustified to the
extent that those parts of Keynes’ analyses which sub­
sequently enjoyed sustained popularity are not neces­
sarily those parts favored by Keynes. For example,
the “liquidity trap” was not an intrinsic part of Keynes’
analysis (h e denied its occurrence); yet it became
closely associated with his name as one of his major
contributions.
It is easy to see how Keynes’ wealth effects were
overlooked by those analysts quick to interpret and
popularize his basic theory. Keynes brought up the
price-induced wealth effect and minimized its signi­
ficance in the same passage: “It is, therefore, on the
effect of a falling wage- and price-level on the de­
mand for money that those who believe in the selfadjusting quality of the economic system must rest the
weight of their argument; though I am not aware that
they have done so. If the quantity of money is itself
a function of the wage- and price-level [a variant of
the real bills doctrine], there is indeed, nothing to
hope in this direction.””
Keynes endorsed interest-induced wealth effects
more vigorously, but made it clear that even these
were of secondary importance. As a man well ac­
quainted with the stock market and windfall gains
and losses, he thought interest-induced “windfall ef­
fects” had only a minor influence on spending habits.
For if a man is enjoying a windfall increment in
the value of his capital, it is natural that his motives
towards current spending should be strengthened,
even though in terms of income his capital is worth
no more than before; . . . Apart from this, the main
conclusion suggested by experience is, I think, that
the short-period influence of the rate of interest . . .
is secondary and relatively unimportant, except, per­
haps, where unusually large changes are in question.7
There is, however, sufficient question about Keynes’
view of wealth effects, which appear frequently in
T h e G en eral T h eory , to spark a continuing debate.8
W hat Keynes actually meant is less significant than his
failure to give either monetary-induced substitution
or wealth effects a leading part in his attack against
orthodox, classical theory. By vacillating on the im­
®Keynes [51], p. 206. Bracketed expression supplied.
7Keynes [51], p. 94.
8See Keynes [51], pp. 92-93, 319. Among the participants
in the Keynes wealth effect debate have been Ackley [1],
Patinkin [63], Pesek and Saving [64], and Leijonhufvud
[53],



NOVEMBER

19 74

portance of the two major channels of monetary in­
fluence, Keynes in effect was inviting his interpreters
to close off the channels completely.

THE RELATIVE PRICE RELATION
The most frequently cited of the relative price rela­
tions, money-interest rates-investment, obviously con­
sists of a money-interest rates channel and an interest
rates-investment channel. Closure of either of these
channels would eliminate a basic route through which
money is presumed to affect spending. This route was
virtually sealed off by early interpreters of Keynes
( among others) and not re-opened for about a quarter
of a century.

Closed and Re-Opened
The initial part of the money-interest rates-invest­
ment channel was attacked indirectly through innu­
endo rather than directly either by overpowering
theory or evidence. Although Keynes repeatedly
stressed the importance of the money-interest rates
linkage, J. R. Hicks, the chief architect of the IS-LM
“Keynesian” framework, failed to pass along Keynes’
emphasis. In Hicks’ [44] relatively brief article which
became the most popular condensed version of
Keynes, Hicks focused on the liquidity trap as one of
Keynes’ major contributions upsetting neoclassical
theory. Nowhere did he indicate that Keynes was un­
aware of any such situation actually having occurred.
The adoption of such slogans as “you can’t push on a
string,” or “you can lead a horse to water, but you
can’t make him drink” provided popular support for
Hicks’ interpretation of Keynes’ view of the moneyinterest rates channel in periods of economic slack.
Empirical studies of the late 1930s were the main
instrument employed to seal off the interest ratesinvestment channel. Researchers in England and the
United States published results of surveys in which
businessmen were questioned about the importance
of the interest rate in their investment decisions.9 A
vast majority indicated that interest rates had little or
no effect on their decisions to invest. These studies
were cited prominently by Alvin Hansen [39] in his
1938 American Economic Association presidential ad­
dress as evidence of the impotence of monetary pol­
icy. Moreover, as Samuelson recently noted, “. . . peo9See Henderson [42], Meade and Andrews [57], and Ebersole [21].
For a humorous criticism of the survey approach, see Eisner
[22], pp. 29-40. A more recent example of tne survey approach
is found in Crockett, Friend, and Shavell [18].
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 I S

pie like Sir John Hicks said that as far as short-term
investment is concerned, interest is of no consequence
as a cost; and as far as long-term investment is con­
cerned, uncertainty is so great that it completely
swamps interest, which leaves you with only a mini­
scule of intermediate investment that is interest
elastic.”10
The eventual re-birth of the relative price channel
did not occur until well into the 1950s, although the
seeds were planted long before. The emergence of
portfolio choice models in the 1950s and 1960s ushered
in, among other channels, the old money-interest
rates-investment route.
Much of the literature dealing with portfolio choice
models has been associated with money demand
studies. Portfolio choice theory, however, provides the
rationale for the holding of any asset in one’s portfolio,
including money. Instead of focusing on the individ­
ual’s or firm’s income statement which deals with
flows, portfolio choice analysis stresses the stock rela­
tionships which are found on the asset and liability
sides of the balance sheet. The basic assumptions are
that: ( 1 ) other things equal, everyone equates the
marginal rate of return on each asset in the portfolio —
allowing for risk (in terms of variance of return and
exclusive of price level movements), costs of acquiring
information and of conducting transactions; and (2 )
an increase in the supply of any asset (on a macro
level) will lower the price of that asset relative to all
others. The increased supply of the asset leads to
diminishing marginal returns per unit of the asset,
thereby motivating the wealth holder to attempt to
substitute or exchange some of the asset whose price
has fallen for some of those whose price has not.
Changes in relative prices are a consequence of
wealth holders’ efforts to restore equilibrium to their
portfolio — that is, equate all marginal rates of re­
turn. The initial disturbance, a change in the stock of
any asset, may produce a chain of substitution effects
as wealth holders react to changing asset yields.
Although certain types of money have a zero nomi­
nal rate of return by law, money continues to be held
in the portfolio for at least two reasons. First, as op­
posed to equities, for example (which may carry sub­
stantial risk along with a relatively high mean rate of
return), money holding is less risky. Second, money
economizes on the use of real resources in the gather­
ing of information and in the conduct of transactions.
An implication of this latter characteristic is that
10Samuelson [70], p. 41.
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1974

money is held to bridge the gap between income
receipts and expenditures.11
Which assets, besides money, are included in the
portfolio? Much of the controversy surrounding the
portfolio choice framework has centered on the an­
swer to this question. The early portfolio choice
models greatly limited the range of assets and rates
of return. Pigou [65] sketched a rough money-capital
model, while Keynes [51] added government and
private debt to the menu. By assuming perfect sub­
stitutability between capital and bonds, Keynes had
only the yield differential between money and one
other asset (he chose bonds) to explain. Patinkin’s
model [63] was similar to Keynes’ in terms of assets
included and yields explained.
A major change in the approach to the number of
assets and yields to be examined occurred in the early
1960s. Tobin [77], Brunner and Meltzer [9], and
Friedman [28] all expanded the portfolio menu, but
in varying degrees.1- The differing approaches of
these contemporary monetary economists will be ex­
amined in some detail.

Three Views on the Relative Price Relation
Tobin ([7 7 ], p. 36) suggested that “a minimal pro­
gram for a theory of the capital account” should in­
clude six assets — all of which, except the capital
stock, are financial assets — and six yields. The num­
ber of assets is only slightly greater than the earlier
models, but a substantial step toward reality is taken
with the elimination of Keynes’ perfect substitutability
assumption. The choice of assets is closely restricted
to facilitate “purchasing definiteness in results at the
risk of errors of aggregation” (Tobin [77], p. 2 8 ). If
increases in the money supply happen to reduce the
supply price of capital — the rate which wealth hold­
ers require in order to hold in their portfolios the
current capital stock — below its marginal productiv­
ity, the capital stock will rise. This is the sole linkage
n To pursue further these distinctions would require a de­
tailed analysis of money demand, a project much beyond
the scope of this article. The interested reader may wish
to consult Pigou [65], Hicks [43], Tobin [77] and BrunnerMeltzer [10].
i-Cagan [13] also introduced a sketchy portfolio choice sce­
nario. More recently, he focused on money-interest rate
influences [14],
The relative price mechanism was also employed by
Warburton as early as 1946 to explain the transmission
process. “In practice the effects of a change in demand or
in supply, either of a specific commodity or of money (cir­
culating medium), are felt, first in some particular part of
the economy and spread from that part to the rest of the
economy through the medium of price differentials created
at each stage of adjustment.” Warburton [88], p. 85.

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

between the financial and real sectors. The “if” is nec­
essary because the increase in the supply of money —
which lowers the price of money relative to other
assets — may simply result in an increased demand
for financial assets, rather than for the capital stock
(real assets).
One infers from Tobin that an increase in the stock
of any of the financial assets in the macro portfolio is
about as likely to stimulate investment expenditures
as is money.13 In this view it is unclear as to whether
an increase in the money stock can lower the supply
price of capital directly without setting off a chain of
substitution effects ranging all through the spectrum
of assets with different shades of risk-return charac­
teristics. It is apparent from Tobin’s comparative
static framework, however, that no feedback from the
real to the financial sector occurs.
The types of real capital which are affected by
portfolio shuffling are delineated closely by BrunnerMeltzer [9], although the number of assets and rele­
vant yields in the macro portfolio are not. They clas­
sify three types of capital according to the relation
between asset prices and output prices — language
somewhat comparable with Tobin’s supply price of
capital and marginal productivity.14
Increases in real capital occur as ( not “if” ) a rise in
the stock of base money lowers the relative price of
base money and that of its close substitutes, resulting
in an increased demand for other assets, those assets
being dominated by real capital. “The increase in the
price of financial assets simultaneously raises real
capital’s market value relative to the capital stock’s
replacement costs and increases the desired stock rela­
tive to the actual stock.” (Brunner [5], p. 612). Real
capital is defined to exclude consumer nondurable
goods and services.lr’ Unlike Tobin (with regard to
his comparative static models), Brunner and Meltzer
([9 ], p. 379) view the monetary transmission mech­
anism as having important feedback effects.
13The view that financial or liquid assets other than money
(Mi) can about as likely affect the real sector, is advocated
more strongly by the Radcliffe Committee [17], Gurley
and Shaw [37], and Gramley and Chase [35], in what
became known as the “New View” (from Tobin [78]).
14Friedman’s [28] terminology is prices of services and prices
of sources as explained in the excerpt from Friedman in the
right-hand column of this page. A parallel semantic issue is
Tobin’s preference for the term “demand debt”, Friedman
for “high-powered money”, and Brunner-Meltzer for “base
money”.
15Brunner added the general thought that “The wealth, in­
come, and relative price effects involved in the whole
transmission process also tend to raise demand for non­
durable goods.” Brunner [5], p. 612.



NOVEMBER

19 74

Friedman [28], in his portfolio choice-relative price
analysis, is less formal than either Tobin or BrunnerMeltzer in that he attempts no classification of types
of real capital, portfolio assets, or relevant yields.
Friedman acknowledges that an increase in the
money supply affects the portfolio of the financial
sector first, but the subsequent increase in demand
may be as likely reflected next in consumer nondura­
bles as in any areas of real capital. Possible scenarios
are outlined by Friedman in several places.16 Ini­
tially, the prices of sources are raised relative to the
prices of services, thereby inducing investment and
consumer expenditures.
The key feature of this process is that it tends to
raise the prices of sources of both producer and
consumer services relative to the prices of the serv­
ices themselves; for example, to raise the prices of
houses relative to the rents of dwelling units, or the
cost of purchasing a car relative to the cost of rent­
ing one. It therefore encourages the production of
such sources (this is the stimulus to ‘investment’
conceived broadly as including a much wider range
of items than are ordinarily included in that term)
and, at the same time, the direct acquisition of
services rather than of the source (this is the stimu­
lus to ‘consumption’ relative to ‘savings’). But these
reactions in their turn tend to raise the prices of
services relative to the prices of sources, that is, to
undo the initial effects on interest rates [broadly
defined]. The final result may be a rise in expendi­
tures in all directions without any change in interest
at all.17

A Comparison of Three Views
The Friedman, Tobin, and Brunner-Meltzer views
of the monetary substitution effect are distinguished
by a number of points of agreement and disagree­
ment. The three views are coincident in the following:
( 1 ) the total response of the financial sector to a
change in the money supply occurs b e fo r e the total
response of the real sector; (2 ) money as a medium of
exchange is of less significance than money as an asset
with regard to the portfolio choice transmission mech­
anism; (3 ) changes in rates of return or yields on real
or financial assets are the key elements in the trans­
mission process.
To a large extent, the differences in the three views
are due not so much to contradictory theories, but
16Friedman [28], Friedman-Meiselman [33], FriedmanSchwartz [34]. Other attempts at pinning down the open
market purchase-bank reserves-interest rates, etc., channels
can be found in Cagan [13], Davis [19], and Ettin [23].
17Friedman [28], p. 462. Bracketed expression supplied. The
latter part of this quote represents one of Friedman’s inter­
pretations of the feedback effect.
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 I S

rather shades of emphasis among similar approaches.
Because Tobin insists on a formal separation of the
capital account (stocks) from the production and in­
come account (flow s), he is led to highlight different
aspects of the portfolio choice process than Friedman
and Brunner-Meltzer.18
Tobin gives the impression that portfolio choice
analysis adds little to the Keynesian (not Keynes’ )
view of money-interest rates-investment. Given a con­
sumption function dependent on income, but not
wealth or relative prices, consumption can be affected
by monetary actions only a fter investment via the
standard Keynesian multiplier. In his portfolio choice
analysis, the potential end result of the shuffling of
portfolios is a change in real capital;19 feedback ef­
fects from the real to the financial sector do not fit
into Tobin’s capital account approach. Tobin specific­
ally draws attention to the insignificance of money’s
medium of exchange property vis a vis its zero nomi­
nal rate of return in his portfolio analysis and gener­
ally denigrates money’s “uniqueness”. Changes in
money may set off a chain of portfolio reverberations
which results in a change in desired real capital, or it
may not.
Friedman’s avoidance of formal, structural models
which specify any unique monetary transmission
process has probably contributed significantly to the
charge that monetarists’ views of how money works
are locked in a “black box”.20 Friedman’s informal
tracing of possible monetary channels stresses the
point that consumer spending is as likely to be the real
sector component first to respond to monetary actions
as is investment spending. Although changes in yields
are the key to portfolio adjustments, “These effects
can be described as operating on ‘interest rates,’ if a
more cosmopolitan interpretation of ‘interest rates’ is
adopted than the usual one which refers to a small
range of marketable securities” (Friedm an [28],
p. 462).
Brunner-Meltzer tread a path between Tobin and
Friedman in their methodological approach to port­
18“Treatment of the capital account separately from the pro­
duction and income account of the economy is only a first
step, a simplification to be justified by convenience rather
than realism” (Tobin [81], p. 15). It appears, however, that
Tobin’s efforts at moving toward greater realism (Tobin
[84]) are inhibited by the “General Equilibrium Approach”
(Tobin [81]).
19In an informal analysis, Tobin added consumer durables to
the list of “storable and durable” goods — or real capital —influenced in the monetary transmission process. See Tobin
[80],
20Friedman’s formal model [30], [31] sheds little light on
specific monetary transmission linkages.
Digitized forPage 14
FRASER


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1974

folio analysis. Like Tobin, they attempt to organize
the pattern of response of the real sector to monetary
impulses and eventually construct a formal model
(Brunner-M eltzer [1 2 ]). They also emphasize the sig­
nificance of real capital in the process with only minor
references to such spending components as consumer
nondurable goods and services.
Like Friedman, Brunner-Meltzer do not attach “if”
considerations to the money-real sector linkage, nor do
they stress long substitution chains relating money
and other financial assets. Their view is also similar
to Friedman’s in that they: (1 ) emphasize financial
sector-real sector feedbacks; (2 ) do not denigrate
money as an indicator of monetary actions; and (3 )
stress relative prices, of which yields on securities are
only a part. Brunner points out that “Every change in
relative prices of assets ( that is, durables) with differ­
ent temporal yield streams involves also a change in
suitably defined interest rates.”21
In their money demand theory, Brunner-Meltzer
[10] dwell on the medium of exchange property of
money, but this property does not appear specifically
in their formal model [12] of the transm ission mech­
anism. Relative prices in the 1972 model take the
form of asset (including securities) prices and output
prices, but no distinction is made between investment
and consumer goods prices. Finally, in spite of their
criticism of IS-LM models which reflect a “Keynesian”
approach to the transmission mechanism, they grant
that if changes in the stock of government debt were
presumed to have no effect on wealth, “our model
could be pressed into the standard, IS-LM frame­
work” (Brunner-M eltzer [11], p. 953).
In summation, these three approaches to tracing
monetary impulses are probably not as different as
they at first appear. Once the semantic issues are put
aside and the preferences for formal vs. informal
models are understood, the Tobin, Brunner-Meltzer,
Friedman approaches to the relative price channels
of monetary influence are quite similar. It remains to
be resolved, however, if more is to be gained by
Tobin’s admittedly heroic abstractions from reality,
Friedman’s apparent presumption that the channels
are too complex to be captured in any economic
21Brunner [8], p. 27. He adds that “The general role of
interest rates does not distinguish therefore between the
Keynesian and non-Keynesian positions. The crucial differ­
ence occurs in the range of the interest rates recognized to
operate in the process. The Keynesian position restricts this
range to a narrow class of financial assets, whereas the rela­
tive price theory includes interest rates over the whole
spectrum of assets and liabilities occurring in balance-sheets
of households and firms” (Brunner [8], p. 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 I S

model, or Brunner-Meltzer’s approach somewhere be­
tween these two in terms of answering the questions
of the academic fraternity and the general public of
how money works.

Other Developments in the
Relative Price Relation
Two extensions of the relative price relation which,
although out of the mainstream of monetary trans­
mission research, merit elaboration are (1 ) credit ra­
tioning and (2 ) the overshoot, or feedback, phenome­
non. The former involves the allocation of resources
by price an d nonprice criteria, and the latter is a
consequence of the dynamic adjustment of the eco­
nomy to a monetary shock.
C red it R ationing — So long as the price mechanism
functions in an open market with complete factor and
product homogeneity, resources (including credit)
are rationed by price. In so-called “imperfect” mar­
kets, however, non-price discriminatory practices
abound. Among borrowers who are the same in every
respect but one, net worth for example, lenders may
advance one borrower credit at an X percent rate and
another borrower zero credit at any interest rate. At
least, that is one implication of the term “credit ra­
tioning”. As used here, “global” credit rationing is de­
fined to indicate a reduction in (the rate of) total
spending due to a rise in the non-observed interest
price of loans.
Traditionally, “local” credit rationing has been asso­
ciated with the behavior of commercial banks in ex­
tending loans in a period of “tight credit”. Arguments
for commercial bank credit rationing were advanced
in 1951 by Robert Roosa [68]. He asserted that in
periods of falling security prices ( rising interest rates),
bankers prefer to pass over relatively more lucrative
commercial loans and continue to hold on to their
securities in order to avoid a recorded capital loss.
Moreover, Roosa contended that banks preferred to
hold securities as a means of countering the uncer­
tainty fostered by the monetary authorities during
critical, high-interest rate periods.
Paul Samuelson [69] objected to this analysis on
the grounds that it did not conform to the usual tenets
of profit-maximizing behavior of the firm. He argued
that the usual way of rationing anything in “short
supply” was to allow a higher price to do the ration­
ing. Samuelson would not agree that over any other
than a very brief period, bankers would hold their
assets in relatively low-yielding securities, while ra­
tioning a set volume of loans at a fixed interest rate.



NOVEMBER

1974

Subsequently, additional arguments were employed
to buttress the credit rationing view.*2 One of these
was that default risk increased relatively more for
loans than for securities in tight credit periods. An­
other was that the banking industry is oligopolistic
and is better off to restrict the volume of loans rather
than lend out to the point required by the competi­
tive market solution.
Legal interest ceilings have been invoked more re­
cently in explanations of the working of credit ration­
ing. The basic idea is that a financial institution might
be perfectly willing to lend to a borrower at X percent
in accord with such criteria as size of loan, default
risk, and compensating balance requirements, but if
usury or other laws set a ceiling at Y percent which
happens to be below X percent, the prospective
borrower will not obtain the loan. He may be able to
obtain funds from some other source, such as from a
lending facility in a state whose ceiling is higher, or
from an effectively unregulated private individual.
There are, however, considerable costs of information
involved in addition to the higher interest costs which
may cause the potential borrower to drop out (that is,
be rationed out) of the funds market.
Interest ceilings also affect the flows of funds into
financial and nonfinancial institutions. When market
interest rates rise above rates payable (considering
liquidity, risk, maturity, and tax factors) by savings
institutions and state and local governments, many
savers put their funds into less regulated securities
markets. The bypassed institutions accordingly cut
back their lending activities. Whether the re-channel­
ing of credit results in a reduction of total spending,
however, is another matter — one which is rarely
treated in the credit rationing literature.
One study, for example, found that Regulation Q
ceilings encouraged savers to bypass commercial
banks in certain tight credit situations, allegedy forc­
ing commercial banks to curtail credit extensions.23
Since bank credit is only one component of total
credit, it cannot be assumed that a reduction in total
credit or total spending could be attributed to the
workings of Regulation Q. According to the authors
of the study, the reduction of credit available to com­
mercial bank customers “would presumably occur to
the benefit of customers of other intermediaries
--Lindbeck [55], Hodgman [47], and Kane [50] are among
those who have substantially advanced the credit rationing
literature.
-3Federal Reserve Regulation Q places a ceiling on interest
rates payable by member banks on time and savings accounts.
Page 15

FEDERAL

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B A N K O F ST. L O U I S

and/or of those firms able to raise funds directly in
the market.”24
If it is presumed that credit rationing at one insti­
tution is not offset by increased loan activity else­
where, then “global” credit rationing, which is accom­
panied by a slowing in the rate of total spending,
occurs. Because all observed interest rates do not nec­
essarily capture a rise in the relative price of credit
as represented by greater information and transac­
tions costs (which are assumed to include such costs
as increased compensating balances), interest rate
changes alone would not give a complete picture of
the effectiveness of monetary actions. In certain tight
credit situations, interest rates rise to slow down
spending. But after some point at which interest yields
are confronted by legal rate ceilings, interest rates
would not give a correct picture of the true cost of
credit. An important implication of this analysis is that
interest rates likely emit inconsistent signals with re­
spect to monetary influences on spending via relative
price changes.
O versh oot E ffe c t — The “overshoot effect” is analo­
gous to the previously-mentioned feedback effect, in
which the real sector reacts back upon the financial
sector, with the original disturbance having come
from the financial sector. Although the overshoot may
occur by way of relative price or wealth influences,
the vast majority of the literature on this topic is
couched in a relative price framework. The term
“overshoot” is indicative of the tendency of the initial
adjustment of such economic variables as interest
rates and income to exceed the steady-state levels.
Friedman is often identified as the current leading
advocate of this thesis, but the argument has its roots
in studies by Fisher, Wicksell, Keynes, and Tooke.25
Friedman [28], [29], [33] pointed out in several
places that changes in the money supply and interest
rates are inversely related for only a short period. A
rise in the money supply, for example, is associated
with a fall in interest rates initially. After some period
of time, the fall in interest rates will have stimulated
spending and the demand for credit. The rise in the
- lJaffee and Modigliani [49], pp. 871-72. Although Jaffee
and Modigliani suggest that credit rationing of commercial
banks is offset by increased loan activity in other areas, the
reverse does not necessarily hold. The FRB-MIT model,
with which Modigliani has been closely associated, finds a
credit rationing effect through non-commercial bank savings
institutions not offset by increased commercial bank activity.
See deLeeuw and Gramlich [20].
25See Fisher [25], Wicksell [89] (natural interest rate vs.
market interest rate), Keynes [51] (the Gibson paradox),
and Tooke [86] (the Ricardo-Tooke Conundrum).
Page 16



NOVEMBER

1974

demand for credit will tend to reverse the initial fall
in interest rates. If spending is continually stimulated,
demand pressures will force up the price level and
price anticipations which, in turn, add upward pres­
sures to interest yields.
The extent to which interest rates overshoot their
equilibrium value is dependent on many factors, in­
cluding initial conditions and the duration and degree
of monetary stimulus. It should be noted that the rise
in the price level lowers the real value of monetary
assets. At the higher price level, the quantity of money
demanded is less in real terms. Also, the rate of in­
crease of the money supply tends to slow automati­
cally due to “feedback effects through the monetary
mechanism” (Friedm an and Schwartz [34], p. 562).
Thus, prices, interest rates, money, and general eco­
nomic activity are all subject to the overshoot
phenomenon.
Similar dynamic analysis has been offered by Brunner-Meltzer. Through changes in wealth and relative
prices, they postulate that monetary impulses alter the
magnitude of and rate of return on the capital stock.
“Variations in the stock of real capital, of income ex­
pected from human wealth, or the yield expected from
real capital affect the allocation pattern of financial
assets, trigger the interest mechanism, and generate a
feedback to the asset prices of real capital.” Thus,
“monetary impulses not only affect the real processes
but real impulses feed back to financial processes.”26
Brunner also noted the role of price anticipations in
the feedback process and postulated that without
continuing money growth acceleration, initial output
and employment gains would be offset over time.27
Tobin’s basic comparative static framework revealed
no role for the overshoot effect. On at least two occa­
sions (Tobin [82], [8 4 ]), however, he engaged in
dynamic analysis. On both occasions he pointed out
that initial disturbances in the real sector which affect
the money supply ( endogenity of m oney) are a plau­
sible explanation of observed money-income relation­
ships. In one instance (Tobin and Brainard [84],
p. 119), he noted that an exogenous change in bank
reserves would produce an adjustment path of the
yield on real capital which overshoots and oscillates.
2(iBrunner-Meltzer [9], p. 379.
27Brunner [7], p. 13. Friedman ([29], p. 10) made the same
point regarding monetary acceleration via a comparison of
the market unemployment rate-natural unemployment rate
with the market interest rate-natural interest rate.
The feedback effects noted in the formal Brunner-Meltzer
model [12] are started by an initial disturbance in the out­
put market, and thus are not quite comparable to earlier
analysis.

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

Even the standard IS-LM framework can be al­
tered so as to give interest rate and income over­
shoots.28 It can be shown that differences in the ad­
justment pattern of investment to interest rates and
money demand to interest rates are capable of pro­
ducing interest rate and income overshoots. If invest­
ment is dependent at all on the current interest rate,
a sharp drop in interest rates can cause investment to
expand and income to rise; if money demand is a
function of income, there ensues a rise in money de­
mand which reacts back on interest rates.
It is possible to conjecture fairly complicated reac­
tion patterns to relative price changes, even without
such complications as an accelerator effect, or changes
in the absolute price level. Even working within a
simple analytical framework, it would be difficult for
policymakers to attempt to stabilize incomes or inter­
est rates if they did not know whether the adjustment
paths were monotonic or cyclical. Considerable empiri­
cal verification of the overshoot or cyclical process in
the “real” economy has been provided.29

NOVEMBER

1974

Real human wealth, wH is determined by the
,
present value of one’s expected lifetime income, a
concept related to permanent income or even dispos­
able income (with the appropriate lags), but not di­
rectly related to monetary actions. Real consumption
( c ) is assumed to be a function of both types of
wealth as described by
,
Wn .
h
C— c( W , --------).
H
p
The human wealth concept forms the typical Keyne­
sian element in the consumption function. The rela­
tion between nonhuman wealth (divided by the price
level), and consumption is probably less well
accepted.
Q
Because the arguments for the D and — elements
r
of the wealth effect are closely intertwined, they will
be discussed together as “Real Balance Effects”. The
PK section follows under the heading “Equity Effects”.

Real Balance Effects
THE WEALTH RELATION
The monetary channel of influence which operates
through changes in wealth is best approached by
examination of the linkages between wealth and
consumption. Although the substitution effect, in some
versions, is seen to work through consumer spending
as well as investment, the wealth effect has been
typically limited to the consumer sector. One defini­
tion of nonhuman money wealth is
W nh

= PK + D + r

where
P = price of real capital
K = stock of capital (PK = market value of equity)
D = monetary base plus fraction of bank debt not
counted in PK
G = government debt (one dollar multiplied by the
number of securities outstanding, each of which
is assumed to be a consol)
Q
r = market interest rate (— market value of outr
standing debt).
Monetary factors affect each of these components of
nonhuman money wealth in varying degrees.
28See Laidler [52], Smith [73], Tanner [74], and Tucker
[87],
29See Silber [72] and Christ’s ([16], pp. 444-45) review of
large econometric models.



As mentioned earlier, Keynes discussed several dif­
ferent real balance effects, but made little use of them
in his general framework. Ironically, it was the work
of a prominent Keynesian interpreter which sparked
renewed interest in real cash balances. Pigou, who
generally receives the lion’s share of the credit for
reviving real cash balances,30 was disturbed by Alvin
Hansen’s stagnation thesis.
Hansen [40] charged that even w ith flexible prices
and wages, a perpetual state of less than full employ­
ment could well be the natural resting place for the
economy. Such neoclassical economists as Pigou were
willing to concede that an assumption of inflexible
prices and wages could be consistent with the thesis
of a less than full employment state, but only given
this important assumption. Pigou demonstrated that
the rise in real cash balances associated with a falling
price level and unchanged money stock would in­
crease consumer spending, reduce saving, and thereby
permit the rate of interest to rise above some assumed
“liquidity trap” level.
By associating consumption with real cash balances,
Pigou drove a wedge into the small opening left for
monetary policy by the Keynesians of the late 1930s.
Because consumption comprises a much larger per­
centage of total spending than business fixed invest30Pigou [66]. See also Haberler [38] and Scitovszky [71].
Page 17

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ment, the potential for monetary policy to affect total
spending was greatly expanded. Pigou and others who
formulated real cash balance theories in the early
1940s did not claim much empirical significance for
this effect. Their concern was only to show that it was
theoretically plausible for the economy to return to
full employment under the assumption of price and
wage flexibility. They did not take up Keynes’ wind­
fall effect or any other aspect of the monetary wealth
effect. Thus, their concern was limited to the “D ”
portion of the nonhuman wealth definition, with the
relevant debt typically taken to be the government’s
demand debt (or monetary base).
Don Patinkin took up the discussion of real cash
balances in the post-war period.31 He also ignored
the interest-induced wealth effects and focused on
theoretical rather than empirical considerations. Patinkin’s chief contribution to the channels of influence
controversy was to spell out the interplay between the
positive real cash balance effect and the negative real
cash balance effect which combine to produce propor­
tionality between money and prices (the “quantity
theory” ) between periods of short-run equilibrium.32
Prominent among those disputing the usefulness of
the real cash balance approach have been Hicks and
Hansen, who also downgraded the monetary relative
price channel. Hansen’s [41] criticism of the real bal­
ance effect was limited to a short note in which he
agreed that the effect could theoretically bring a halt
to a downturn, but could not generate the spending
required to attain full employment.
Hicks devoted more effort to wealth considerations,
as demonstrated by the important role of wealth in
his landmark book, V alue an d C ap ital [45]. However,
neither in V alue an d C ap ital nor subsequently did he
attach much significance to a monetary wealth effect.
Hicks omitted real balance effects in V alue an d C a p i­
tal and only thirty years later did he find any use for
the concept at all.33 The dominant channel of mone­
31Patinkin [63]. Patinkin’s first articles on real cash balances
appeared in the late 1940s.
32The positive real balance effect associates the demand for
real balances (positively) with money and the negative
real balance effect associates the demand for real bal­
ances (inversely) with prices. The demand for goods is
related to one’s holding of real cash balances.
33Leijonhufvud noted Hicks’ lack of consideration for either
price-induced or interest-induced wealth effects in Value
and Capital. "It is interesting to note that the first edition of
Value and Capital did not take the real balance effect into
account. In the second edition, Hicks responded to the
criticisms of Lange and Mosak on that issue by admitting:
‘I was too much in love with the simplification which comes
from assuming that income-effects [Pigou effects] cancel
out when they appear on both sides of the market’ (p. 334).
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1974

tary influence, so long as no liquidity trap exists, was
through his portfolio choice-relative price route.
Exactly what should be included in the “D ” portion
of the real balance wealth definition has been the
subject of debate in more recent years. In most cases,
private debt typically is assumed to cancel out. How­
ever, Pesek and Saving [64] maintained that because
no interest is paid for demand deposits, wealth
(which accrues to bank stockholders) increases in
proportion to demand deposits. Thus, they would
count both inside money ( demand deposits) and out­
side money (monetary base) in net private wealth,
contraiy to the traditional view which counts only
outside money. To include all inside money as wealth,
however, would likely result in some double counting.
If the inside money benefits to banks are capitalized
in the value of the banks’ stock, as are the typical
gains to nonbank firms, the same inside money would
be found in the “D ” portion and the “PK” portion of
the wealth equation. To the extent that demand de­
posit gains are not capitalized instantaneously, there
should be some allowance made for the addition of
inside money to net wealth. The effect on spending
would be through additional outlays by bank
stockholders.
W hat about government securities (G ) held by the
public? Do these represent private wealth? They only
represent private wealth to the extent that the public
does not anticipate offsetting future tax increases to
G
term in the wealth
eliminate such debt. The ---r
equation may have some effect on spending through:
(1 ) changes in the magnitude of G; ( 2 ) changes in
the composition of G; and (3 ) changes in r.
One source of controversy concerning changes in
wealth has been the relation between G and D. The
two have frequently been summed (interest-bearing
debt plus non-interest bearing debt) in empirical and
theoretical investigations of the effects of “liquidity”
on the economy. If it can be assumed that G and D
are good substitutes, their composition is of less conWhile this did not lead him to reconsider also the assump­
tion that the wealth effects of interest changes cancel, it
may well be that the same remark applies also to this
problem.” (Leijonhufvud [53], p. 275).
Hicks eventually took note of the real cash balance ver­
sion of the wealth effect in a review of the first edition of
Patinkin’s book. Hicks missed the point initially that a rise in
real cash balances stimulates spending, as he later admitted
in his Critical Essays ([46], p. 52). In 1967 he recognized
the existence of a ‘liquidity pressure effect’ — but thought
it had merit only in restraining an expanding economy.
This concept, of course, is a variation on the monetary pol­
icy “can’t push on a string” thesis.

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

cern than their sum.34 Early empirical investigations
of wealth effects published shortly after the accumula­
tion of much government debt in World W ar II often
tested the real balance effect as the sum of G and
D.35 Many found a strong relation between liquid
wealth and consumption. If this can be called a direct
channel, a more indirect route, via interest rates, has
been envisioned by others.
Tobin [79] emphasized aggregate monetary wealth
and its composition with respect to the effect on in­
terest rates. Not only does an increase in monetary
wealth relative to real assets lower the supply price of
capital and thereby induce investment, but an in­
crease in short-term government debt relative to long­
term debt (no change in aggregate debt) may achieve
the same result. These actions are closer to fiscal pol­
icy or debt management policy than to what is nor­
mally labeled monetary policy.
To the extent that monetary actions affect the
yields on government debt, there is an interest-in­
duced monetary wealth effect on consumption. If ex­
pansive monetary actions lower the “r” component of
G
—proportionately more than “G” in the wealth defini­
tion, nonhuman money wealth rises, as does (under
typical assumptions) consumption. Of course, a mone­
tary overshoot effect would reverse the fall in interest
rates and subsequently work in the opposite direction
on consumer expenditures. Also, if the rise in the price
of securities (fall in interest rates), induces those
wealth holders who have not yet purchased securities
to pay a higher price for their securities, this particu­
lar group may curtail their outlays for consumer
goods.36
;i4Proponents of the “New View” also add non-government,
non-bank liabilities, such as savings and loan shares, to the
total. See Brunner [6],
The Radeliffe Committee [17] found a role for money to
affect spending if it added to total liquidity, to include
funds made available by non-bank financial institutions.
John Gurley noted that the Committee “believes that
changes in these [interest] rates have had little direct effect
on spending; and it does not think that there is any direct,
close connection between the money supply and spending.
But while money is shoved out of the house through the
front door, for all to see, it does make its reappearance
surreptitiously through the back door as a part of general
liquidity: and the most important source of liquidity is the
large group of financial institutions.” Gurley [36], p. 685
Bracketed expression supplied.
35See Patinkin’s empirical chapter [63]. Lemer [54] theo­
rized that continued growth of government debt, as in
World War II, would eventually induce sufficient con­
sumer expenditures as to eliminate any excess of savings over
investment at full-employment income. He did not attempt
an empirical test, however.
3eSee Leijonhufvud ([53], pp. 241-42) for a discussion of
this effect. Lawrence Klein, who recognized the potential
of interest-induced changes in wealth to affect consumption



NOVEMBER

1974

As far as the real-balance effect, especially that part
which pertains to “D ” is concerned, there is little in­
dication that Tobin, Brunner-Meltzer, or Friedman
envision monetary influences as having much impact
through this channel.37 In at least two cases, however,
these leading monetary economists have found a strong
role for the money-equity channel. Their views on the
money-equity route will be discussed after mention of
some of the earlier proponents of this channel.

Equity Effect
How can monetary actions affect the market value
of equity, “PK”? One answer was provided by Lloyd
Metzler, who re-opened the equity channel in 1951
which had been described earlier by Keynes. Metzler
[58] was probably the first economist whose formal
model included the investment-borrowing costs chan­
nel and both aspects of the wealth channel — real
cash balances and private equities.38 Metzler, how­
ever, made the unusual assumption that the Federal
Reserve increases the money stock through purchases
of privately held common stock.
An increase in the money stock (in the Metzler
m odel), given full employment, results in a propor­
tional increase in prices and thus no change in con­
sumption with real balances remaining constant. The
Federal Reserve’s purchase of common stock low ers
net private wealth ( the volume of securities in private
hands falls) and consequently, consumer spending.
The fall in consumer expenditures is accompanied by
a rise in saving, a fall in the rate of interest, and the
consequent increase in capital intensity. Criticism of
Metzler’s model centered on his unusual assumptions,
which, among other results, gave a negative associa­
tion between monetary growth and consumer
spending.
The more orthodox conjecture, that monetary
growth, the market valuation of equities, and con­
inversely, related to the author recently that an inverse rela­
tion is more likely in the depression state, such as the 1930s,
than today.
37“Like Friedman (1970, pp. 206-7) we believe that the
real-balance effect is one of several explanations of long-run
changes in the IS curve. We agree, also, that the short-run
importance of the real-balance effect is small enough to
neglect in most developed economies where real balances
are a small part of wealth. In our analysis the size of the
traditional real-balance effect depends on the proportion of
money to total nonhuman wealth, a factor that is less than
.05 for the United States” ( Brunner and Meltzer [11],
p. 847).
'’’Tinbergen provided the first empirical test of an equitiesconsumption relation. Dividing consumption into that by
income earners and non-workers, he found that “a fall in
capital gains had already caused a decline in consumption
between 1928 and 1929” (Tinbergen [75], p. 78).
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F E D E R A L R E S E R V E B A N K O F ST

LOUIS

sumer spending are all positively related, has been
given theoretical and empirical support by Franco
Modigliani. Modigliani [59], [60] advanced formal
theoretical models in 1944 and 1963. He recognized a
role for wealth-consumption influences in his revised
model of the economy (called the “mid-50s” model)
which he acknowledged had been omitted from the
1944 model. His new consumption equation was

c = c<x,Mw , [ ^ ] >
where
X = real income
-

P

= Modigliani’s life-cycle aggregate labor income
variable39
r = the rate of return on (or cost of) capital

— = the net worth of the private sector.
P
The two latter monetary-related terms, the borrowing
cost variable and the wealth variable, appeared in
much the same form in the F R B -M IT model of the
later 1960s, a model with which Modigliani has been
closely identified.
The money-equities-consumption channel in the
F R B -M IT model hinges on the substitutability of
bonds and stocks. If an increase in demand for, say,
Treasury securities, by the Federal Reserve results in
lower yields and higher prices for these securities,
other investors could well be discouraged from pur­
chasing the now higher-priced Treasury securities, but
securities whose price was not initially affected by
the Federal Reserve action. To the extent that de­
mand is shifted to equities from Treasury securities
because of their higher price, there is a rise in com­
mon stock prices, which is reflected in a rise in PK.
The higher equity prices represent capital gains to
equity owners. The wealth effect portion of this proc­
ess is the inducement to spend on the part of equity
owners because of their increased net worth. Over a
sixteen-quarter period, the equity channel represents
45 percent of the entire monetary influence on total
spending in the F R B -M IT model.40
39Modigliani-Brumberg [62] in 1954 related consumption to
one’s expected income over his life span. The discounted
Y
value of “permanent” income is human wealth, or — = W.
Neither Modigliani-Brumberg nor Friedman [27] related
monetary-induced nonhuman wealth to consumption at this
early stage.
40deLeeuw and Gramlich [20], p. 487. Other simulations by
Modigliani of the FRB-MIT model indicate an even stronger
equities effect when alternate forms of the money-equitiesconsumption equations are run. Modigliani [61], however,
did not accept these as realistic.
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It is not likely that Friedman would credit any sort
of m on etary-in du ced nonhuman wealth effect as hav­
ing that much influence on spending. The relative
price channel dominates his discussion of the channels
of monetary influence in numerous articles (Friedm an
[28], [33], [3 4 ]). In more recent studies in which
Friedman developed a formal economic model, he
omitted wealth from the consumption function, using
Y
only C/p = f(— , r ).41 One indication that nonhuman
P
wealth is of some significance in his view of the
transmission process emerged in a recent article in
which he attempted to delineate initial and subse­
quent shifts in the IS-LM apparatus.42
Until recently, Tobin apparently shared Friedman’s
lack of enthusiasm for monetary-induced wealth effects
on consumption. His omission of wealth influences on
consumption may be found in his informal models of
the early 1960s as well as his more detailed models of
the late 1960s.43 It is not so much that Tobin denied a
wealth effect, rather that he preferred to keep stock
and flow variables separate. Thus, consumption (and
saving) were functions of flow variables — specifically
income — and not wealth, a stock concept. “The pro­
pensity to consume may depend upon interest rates,
but it does not depend d irectly on the existing mix of
asset supplies or on the rates at which these supplies
are growing.”44
In a significant departure from most of his previous
studies, Tobin [85] stressed the importance of wealth
effects in an article co-authored with Dolde in 1971.
They considered the “two major recognized channels
of monetary influence on consumption: (A ) changes
in wealth and in interest rates, ( B ) changes in liquid­
ity constraints.”45 They recognized the historical sig­
41Friedman recognized the inadequacy of the above con­
sumption function ([30], p. 223) and ([31], p. 331) “in
a full statement” ([30], p. 223), because it excluded
wealth, but he stated he was attempting to stick to Key­
nesian short-period analysis. In a much earlier study, Fried­
man [26] endorsed the real balance effect more vigorously.
42Friedman ([32], p. 916) discussed shifts in IS-LM curves
(first-round effects vs. subsequent effects) in a manner con­
sistent with the view that wealth influences subsequent
shifts. Friedman did not mention “wealth” but BlinderSolow [2] interpreted his discussion in that context.
43See Tobin’s early models [77], [78] and later models
[81], [84]. He did mention monetary influences on saving/
consumption in “Money, Capital, and Other Stores of Value”
[77], and gave the relation somewhat more prominence in
the earlier “Relative Income, Absolute Income, and Saving”
[76],
44Tobin [81], p. 16.
43Tobin-Dolde [85], p. 100. Tobin’s comments concerning
the volatility of the marginal propensity to consume, espe­
cially with respect to the 1968 tax surcharge, provide a

NOVEMBER

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

nificance of the Pigou effect, but wealth changes in
their study were associated with capital gains ( equity
effect). Their liquidity effect referred to the cost of
converting nonliquid assets to liquid form in a world
of imperfect capital markets. The level of the penalty
rate of interest (a relative price) inhibits or encour­
ages conversion of nonliquid to liquid assets.
Using a Modigliani-Brumberg life-cycle model, they
concluded that wealth (equity values), interest rates,
and the liqudity constraint all have important influ­
ences on consumer spending. Their model was basi­
cally a reduced form, in that they did not provide the
linkages between monetary policy actions and mone­
tary effects.
Brunner and Meltzer have long included a promi­
nent role for wealth effects in their view of the mone­
tary transmission process. “PK” is the component of
nonhuman wealth mentioned most favorably in their
analysis. For example, in discussing the chain of
events following an injection of base money, BrunnerMeltzer noted that “the resulting rise in the market
value of the public’s (nonhuman) wealth raises the
desired stock of capital III and the desired rate of
real consumption.”46 They further stated that relative
price effects also operate to increase real consumption
following the expansive monetary action.
At a later date Brunner again stressed the impor­
tance of “PK” relative to the real balance effect in the
transmission process. “The dominant portion of the
wealth adjustment induced by a monetary impulse
occurs beyond a real balance effect and depends on
the relative price change of existing real capital. The
monetarist analysis of the transmission mechanism de­
termines that this portion of the total wealth effect
thoroughly swamps the real balance or even the finan­
cial asset effects.”47
Real balances are included, however, in Brunner
and Meltzer’s [12] formal model. Total spending
clue as to why he chose to include wealth in the consump­
tion function. “Now if it had been true that the incomeflow theory of consumption was a resounding success, and
that its indications were being borne out all the time, then
we wouldn’t need to go into the wealth theory or the life­
cycle theory and all that. We wouldn’t need to seek a
fundamental theory about why savings ratios are what they
are and how they relate to various parameters. But we all
know that the cash income theory is not a resounding suc­
cess.” Tobin [83], p. 159.
48Brunner and Meltzer [9], p. 377. Capital III refers primarily
to certain types of consumer durable goods. Examples of the
other two types of capital delineated by Brunner and Melt­
zer are machinery and equipment (Type I) and houses
(Type II).
47Brunner [7], p. 5.



1974

(which includes consumer spending) in that model is
influenced by, among other factors, nonhuman wealth.
Their nonhuman wealth variables include real capital,
the monetary base, the stock of government debt, and
the value of commercial banks’ monopoly position ex­
cluded from real capital (Pesek and Saving effect).
Formal economic models now routinely include
wealth and/or substitution effects on consumption.48
Few, if any, of the empirically-oriented, structural
models permit all the wealth effects on consumption
described above. For example, the F R B -M IT model
(Board of Governors [3 ]) has an equities effect but
no real balance effect; the Wharton Mark I II model
(M cCarthy [5 6 ]) has a real balance effect but no
equities effect. Only when model builders make al­
lowance for all possible monetary effects are so-called
structurally rich models as likely to reflect as signifi­
cant a money-spending impact as reduced form
models. There is, of course, a good possibility that yet
undiscovered wealth, relative price, and even mone­
tary income effects will be found in the monetary
channels of the future.

SUMMARY
This article surveyed the relative price and wealth
changes set in motion when the quantity of money
supplied changes relative to money demanded. Rela­
tive price and wealth changes were viewed as major
elements of the monetary transmission mechanism
around the turn of the century (in rudimentary fash­
ion) and in recent years, but in much of the inter­
vening period their role was subjected to considerable
question.
Fisher and Wicksell favored one approach in which
wealth was the dominant monetary force and another
in which relative prices were of more significance.
Keynes amplified both views, but his major interpret­
ers were not so inclined. It is, in fact, ironic that
J. R. Hicks, who formulated the IS-LM interpretation
of Keynes, downgraded both monetary wealth and
relative price influences, despite his pioneering re­
search into basic wealth [45] and portfolio choice
fields [43],
Real balance wealth effects were revived by Pigou,
Patinkin, and others while Metzler re-formulated the
equity wealth effect. Tobin, Brunner-Meltzer, and
Friedman advanced the portfolio choice-relative price
effect in the early 1960s, and with the exception of
48See, for example, Christ [15] and Rasche [67].
Page 21

EXAMPLES OF HOW MONEY WORKS
The following is an oversimplified description of monetary impulses working through the relative price
and wealth channels. The numbers are chosen entirely for illustrative purposes and bear no relation to
current actual magnitudes. This hypothesized scenario represents som e of the possible ways in which
spending might respond to a monetary injection. To begin, assume a sale of government bonds by the
Treasury to bond dealers, the bonds being subsequently purchased by the Federal Reserve.
Relative Price Channel

Wealth Channel

The purchase of government debt by the Federal
Reserve (Fed) increases bank reserves and lowers the
yield (raises the price) on Treasury securities. The
banks lend out (increase demand deposits) some mul­
tiple of the higher level of reserves by lowering bank
loan rates; the higher price of Treasury securities en­
courages investors to purchase securities whose prices
have not yet risen.

The issuance of government debt by the Treasury
results in a transfer of assets from transactor A (who
purchased the debt) to transactor B (paid by the
government with the proceeds from A). A holds an
asset, interest and principal on which can be paid off
by the government through, among other means, an
increase in taxes. To the extent that the public does
not anticipate the government raising taxes to pay off
its outstanding debt, government debt represents
wealth to the private sector. Whether taxes are antici­
pated or not, the value of a unit of government debt
falls with the rise in interest rates caused by the is­
suance of new debt.

At this point, the money supply has risen and in­
terest rates have declined. Borrowers obtained money
balances in order to purchase real assets (cars, houses,
machinery) and/or financial assets (stocks, bonds),
depending on the current and expected relative prices
of the assets. If real assets are purchased through
either consumer or investment expenditures, the price
of existing real capital rises. If financial assets are pur­
chased, the price of existing real capital rises via
capitalization of the assets. The rise in the price of
existing real capital encourages the production of ad­
ditional capital. Observed declines in interest rates
also represent lower borrowing costs, an additional
stimulus to the production of goods and services. The
lower costs may be interpreted as a fall in the rental
price for the services rendered by an asset. Moreover,
a fall in interest rates could eliminate the effects of
credit rationing, which are presumed to occur at high
levels of interest rates.
In other terms, if both consumption (c) and invest­
ment (i) depend on interest rates (r) and the price
of existing real capital (P) relative to the price level
P
P
(p ), then c = f (r, —) and i = g (r, — ). Both c and
P
P
p
i are stimulated if r falls from, sav, .04 to .02 and —
P
■
r
1
2
rises from — to y .

As the money supply rises, however, and new re­
cipients of money balances hire more workers, buy
more equipment, pay out larger dividends, or pay
higher wages, the price level begins to rise. The closer
the economy is to capacity operations, the more rapid
the increase in the price level. Moreover, demand for
credit expands, and this together with the price level
rise, puts upward pressure on market interest rates.
The result may be a return of the interest rate
and price variables to their earlier relations; that is,
c = f (.04,


Page 22


and i = g (.04,

Federal Reserve purchase of government debt,
however, unambiguously increases wealth because
the Fed cannot raise taxes, and its purchase of
government debt initially lowers interest rates. In
other words, if monetary nonhuman wealth consists
of outside money (D ), government bonds (G ) di­
vided by the market rate of interest (r), and the
price of capital (P) times the capital stock (K ), then
PG
+ PK. P < 1 indicates that wealth
W = D + holders believe some portion of the government debt
will be paid off by increased future taxes. Real nonhu­
man wealth, w, is obtained by deflating the above by the
^
Given initial
p
pr
p
values of D = 100, G = 200, K = 10,000, r = .04, P =
100 + (.5) (200)
+
.5, p = 1 and P = 1, then w =
1
1(.04)

price level, p, or w =

1( 10,000)

, and therefore, w = 100 + 2500 + 10,000
1
It is assumed that c = c(w ) where c > o; that is,
wealth positively influences consumption expenditures.
Issuance of new government debt by the Treasury
of 5 bonds is assumed to raise interest rates to
.041, such that this component of wealth remains
PG _ .5(205) _
2500. If the Fed purunchanged:
pr
1(.041)
chases the government debt, however, the change
,
o
,,
D , PG _
_
in the first two wealth components is: — + • —
—
p
pr
105
.5(200)
= 105 + 2500.
1
1(.04)
A number of other wealth effects may be distin­
guished, some of which are not related to a Fed
purchase of Treasury debt:
1) The Pigou effect normally associates a fall in the
price level with a constant level of D. Example:

Wealth Channel (cont.)
Value of — rises from —
^
P
1

100 to

100

~5

200 .

2) The real financial effect associates a fall in the
price level with a constant level of G. Example:
r ^G .
r
.5(200)
.5(200)
Value of — rises from
= 2500 to
pr
1( 04)
.5(.04)
= 5000. There is also a Keynes effect which goes
beyond the Pigou effect by assuming the rise in
real cash balances lowers interest rates and stim­
ulates investment.
3) Keynes’ windfall effect may apply to either the
government bonds or the capital stock portion
of nonhuman wealth:
A. a fall in interest rates. Example: Value of
PG .
r
.5(200)
.5(200)
— nses from
= 2500 to
=
pr
1(.04)
1(.02)
5000.
B. a rise in the price of real capital. Example:
Value of y
to

rises from K 1^ 000) -

io,000

= 20,000.1

4) The Pesek-Saving effect takes into account the
possibility that some commercial bank debt (de1Leijonhufvud ([53], pp. 324-25) provides a more de­
tailed description of effects 1-3 in the context of Keynes’
views on wealth-consumption influences.
Friedman, have also highlighted the equity wealth
effect.
These hardly exhaust all the ways in which mone­
tary impulses affect spending. For example, an income
effect occurs when the Treasury draws down its bank
balances to purchase goods and services. A decline in
Treasury deposits relative to demand deposits in­
creases the money supply (other things equal) and
income.
Alternatively, a rise in the money supply may be
associated with a change in relative prices and no
change in wealth. For example, a fall in currency
relative to demand deposits increases the money sup­
ply and lowers bank loan rates, but there is no rise
in real balances — if defined only as outside money
— and no change in Government debt.
Thus, depending on how the money supply is
caused to change relative to money demand, some
effects on spending are set in motion, but not neces­
sarily all. Moreover, the fact that initial conditions, to
include all relative prices, are never the same suggests
that under one set of circumstances initial monetary



mand deposits) is not adequately capitalized in
PK
the — term and should be included as a part
P
of D. Example: Assume a = .5 is the fraction of
demand deposits (dd) to be included in the
wealth term, such that if there is a rise in deii
i
i
r i D + a(dd)
mand deposits, the value of t h e ----------------term
P
.
,
100 + .5 (150)
100 + .5 (160)
rises fro m --------- —------ - = 175 to ----------—------- 180.
5) It should be noted that just as a rising price
level tends to offset the initially expansive ef­
fects of monetary actions through the relative
price effect, a rising price level also tends to
counter a monetary-induced wealth effect. Ex­
ample: An increase of the (outside) money stock
(D ) initially increased the value of nonhuman
,, ,
D , r c , PK
100
wealth from w = — + — + ------ = —------ 1
p
pr
p
1
.5(200)
1(10,000)
.............
200
12,600 to
1 (.04)
+
1
i
.5(200) 2(10,000)
25,200. But if the price
1(.02)
1
200
.5(200)
level also increases, w =
+
2
2(.04)
2 ( 10 ,000 )
11,350, which is a decline from
the initial value of wealth due to the effect of the
price rise on government debt.
effects may be on, say, consumer durable goods ex­
penditures, and under another set, state and local
government purchases. To follow explicitly the chan­
nels of monetary influence whenever there occurs a
change in the quantity of money supplied relative to
the quantity demanded, one would have to know as
a minimum the cause of the change in the money
supply, all relevant relative prices, and the impact of
other exogenous events on spending units. Add to this
the effect of feedback forces, both relative price and
wealth, and it becomes less surprising that the con­
tents of the monetary black box have been difficult to
unravel.
The complexity of the forces at work, however,
does not mean that one should despair of forecastin g
the effect of monetary influences on total spending
and rely on (presumably) more elementary tools to
guide economic activity. The effects of other policy
actions are also difficult to trace with certainty.49
49It has become clear in recent years that simply forecasting
the result of fiscal policy effects on total spending requires
more than reliance on some variation of the deceptively
simple relations Y = C + I + G and C = C(Y —T). These
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

NOVEMBER

The likelihood is that all possible channels of mone­
tary or other policy actions have not been spelled out
completely in any one model. There remains much
room for research which would narrow the gap be­
tween economic reality and economic models.
relations imply a direct link between government spending
(G) and total spending (Y), and between disposable in­
come (Y - T ), which includes tax changes, and consump­

1974

tion ( C ). What does not appear in these simple relations
are the vector of relative prices, the type of government
spending involved, how the government spending is to be
financed, and whether the tax changes are presumed to
be temporary or permanent.
Fiscal policy actions may also influence wealth and inter­
est rates in addition to income, the income effect presumably
being what is referred to as the direct effect of fiscal actions
on spending. Although monetary and fiscal channels of in­
fluence are both complex, only monetary actions have typ­
ically been viewed as operating within a black box.

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(QUARTERLY SUPPLEMENT)

Single co p ies o f th ese pu blication s are av ailable to th e p u b lic w ithout charge.
F o r inform ation w rite: R esea rch D epartm ent, F ed era l R eserv e B an k o f St. L ou is,
P. O. Box 442, St. L ou is, M issouri 63166.




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