Full text of Review (Federal Reserve Bank of St. Louis) : September 1973

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FEDERAL RESERVE BANK
OF ST. LOUIS
SEPTEMBER 1973

Vol. 55, No.



CONTENTS
The State of the Monetarist Debate ......
Commentary: Lawrence R. Klein and
Karl Brunner...............................

2
9

A Value Added Tax and Factors
Affecting Its Economic Im p a ct............... 15

9

The State of the Monetarist Debate
by LEONALL C. ANDERSEN
T he follow ing paper was presented last spring as part of a series o f public lectures held at the fol­
lowing universities: T he Ohio State University; University of California at Los Angeles; and University
o f Southern California.
As indicated by the title, the purpose o f the p ap er is to discuss those issues w hich appear to have
divided econom ists into two camps: monetarist and post-Keynesian. To further this objective, two
discussants o f opposing viewpoints w ere invited to comm ent on the Andersen presentation. Professor
Law rence R. Klein o f the W harton School o f Finance, University o f Pennsylvania, provides comments
from a post-Keynesian point of view. Professor Karl Brunner o f the University o f R ochester dis­
cusses the issues from a monetarist position.

I OR OVER thirty-five years there has been con­
tinuing debate between two prominent schools of eco­
nomic thought. In recent years these two schools have
been characterized by the labels “monetarist” and
“post-Keynesian” economics. Some major participants
on the monetarist side are professors Karl Brunner,
Milton Friedman, and Allan Meltzer. The post-Key­
nesian side is represented by such academic econo­
mists as Lawrence Klein, Franco Modigliani, Paul
Samuelson, and James Tobin.
The debate has been ongoing since the publication
of Keynes’ General Theory in the mid-1980s. It be­
came particularly heated in the late 1940s, and in the
1950s post-Keynesian views dominated macro-economic theory and economic stabilization policy. The
debate was reopened in the late 1950s, and beginning
in the mid-1960s the monetarist view began to be
recognized as a serious challenge to post-Keynesian
economics.
The debate has ranged over three major fields of
interest to economists. These are macro-economic
theory, economic stabilization policy, and economic
research methodology. My remarks today will concen­
trate primarily on the stabilization aspects of the
debate, although I will of necessity bring in some
discussion of the other two.
For purposes of this discussion, I will focus on six
topics of the economic stabilization aspect of the de­
bate. These are: the impact of monetary actions, the
impact of fiscal actions, the trade-off between infla­
tion and unemployment, the factors influencing inter­
est rates, the degree of stability inherent in the
economy, and the appropriate time horizon for stabili­
zation policy. In discussing each of these topics, I
will first summarize the contending views in the last
half of the 1960s. Then, I will summarize the progress

Page 2


made in reconciling these views up to the present
time.
I want to point out that my analysis of these topics
is from the point of view of an active participant on
the monetarist side of the debate. The analysis re­
flects my view of the debate and may not agree, in all
aspects, with the views of other participants — mone­
tarists or post-Keynesians. In addition, for purposes of
this discussion, I will contrast two polar positions. It
must be recognized, however, that there are many
who consider themselves to be in some middle-of-theroad position on many of the issues.

THE IMPACT OF MONEY
A Post-Keynesian View
Let us now examine the first issue — the role of
money as an important driving force in the economy.
Paul Samuelson, in commenting on the debate, has
provided an excellent summary of the post-Keynesian
view regarding money.1
As a limit upon the stimulus stemming from money
creation by orthodox open-market operations, must
be reckoned the fact that as the central bank pumps
new money into the system, it is in return taking
from the system an almost equal quantum of money
substitutes in the form of government securities.
What needs to be stressed is the fact that one can­
not expect money created by this process alone . . .
to have at all the same functional relationship to the
level of the GNP and of the price index as could be
the case for money created by gold mining or money
created by the printing press of national govern­
ments or the Fed and used to finance public expen­
ditures in excess of tax receipts.2
xPaul A. Samuelson, “Reflections on the Merits and Demerits
of Monetarism,” in Issues in Fiscal and Monetary Policy: The
Eclectic Economist Views the Controversy, ed. James J. Dia­
mond (DePaul University, 1971), pp. 7-21.
2Ibid., pp. 8-9.

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

Samuelson continues this analysis by pointing out
that money creation in today’s economy does not
necessarily reflect creation of wealth, and thereby
exerts no direct influence on aggregate demand. Cre­
ation of money, however, does change interest rates
which in turn influence aggregate demand. He then
points out that research of the late 1930s and 1940s
led economists to reject money because interest rates
were found to exert little influence on aggregate
demand.
Samuelson then presents his view of recent eco­
nomic history by stating that Pigou’s real balance
effect of money on consumption served to reconcile
the deep cleavage between neo-classical theory and
the Keynesian revolution. He then contends that
. . . by the 1950’s and 1960’s an accumulating body
of analysis and data had led to a strong belief that
open-market and discount operations by the central
bank could have pronounced macroeconomic effects

upon investment and consumption spending in the
succeeding several months and quarters.3
Despite this strong contention regarding the influ­
ence of monetary actions, post-Keynesian analysis,
until recently, has persisted in denigrating the influ­
ence of money because of the rather weak, or long
delayed, response of aggregate demand to changes in
interest rates. Econometric models continued to stress
the interest rate channel and shied away from in­
corporating any influence of real money balances. For
example, when simulations of the original KleinGoldberger model of the late 1950s showed that the
real balance effect swamped all other influences, the
monetary sector was dropped from the model because
such a result was deemed “unrealistic” and
“implausible.”4

A Monetarist View
Now for the other side of this issue. The mone­
tarists contend that changes in money exert a strong
force on aggregate demand (measured in nominal
terms), the price level, and output. In determining
the impact of money, it is further contended that a
distinction must be made between nominal and real
economic magnitudes and between the short run and
the long run.
Changes in the trend growth of money are consid­
ered the dominant, not the exclusive, determinant of
the trend of nominal GNP and the price level. Long3Ibid., p . 1 2 .
4Arthur S. Goldberger, Impact Multipliers and Dynamic Prop­
erties of the Klein-Goldberger Model (Amsterdam: NorthHolland Publishing Company, 1959), pp. 84-85.



SEPTEM BER

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run movements in output are little influenced by
changes in the growth rate of money. Trend move­
ments in output are essentially determined by the
growth of such factors as the labor force, natural
resources, capital stock, and technology. In the short
run, however, changes in the trend growth of money
or pronounced variations around a given trend exert
a significant, but temporary, impact on output. The
timing and magnitude of such impact depends on
initial conditions at the time of a change in money
growth. Two major indicators of initial conditions are
the level of resource utilization and the expected rate
of inflation.
Monetarists do not maintain, as asserted by many
post-Keynesians, that money is the only influence on
either nominal or real economic magnitudes. Other
factors which exert a significant influence are factors
which change the demand for money, productivity,
and factor endowment. There is even room in this
analysis for Keynes’ “animal spirits” on the part of
businessmen. The key proposition is that changes in
money dominate other short-run influences on output
and other long-run influences on the price level and
nominal aggregate demand. I will have more to say
later in this regard.

Recent Developments in the Debate
An integral part of the debate regarding the influ­
ence of money on economic activity is the different
views held regarding the economic function of money.
Some who denigrate the importance of money point
out that it is one asset which carries no monetary
yield. Others stress that money in today’s economy is
not wealth and conclude that changes in money have
little direct influence on spending decisions. Some
post-Keynesians view money as only one of a virtually
continuing spectrum of financial assets and thus be­
lieve it to be of only secondary importance.
A further argument advanced about the role of
money has been based upon the lack of synchroniza­
tion between transactors’ receipts and expenditures.
In such a case, it is desirable for market participants
to hold an inventory of money balances. This argu­
ment can be used to develop a model which delegates
a powerful role for money in influencing economic
activity. The post-Keynesians, however, have not pro­
duced such a model.
On the other side of the debate, empirical evidence
has been presented to support the view that money
matters to a considerable degree; but, until recently,
little attention has been given to producing a rigorous
Page 3

x

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

analysis of the role that money plays in a market
economy. In recent years, the view has been growing
that money does have an extremely important influ­
ence because it is the asset used by society which
minimizes the economic costs associated with collect­
ing market information and conducting market
transactions.
Brunner and Meltzer, using this cost of information
and transactions argument, have presented an ex­
tended analysis of the emergence of money in a
market economy. Their view of the role of money is
the following:
Our analysis extends the theory of exchange to in­
clude the cost of acquiring information about market
arrangements, relative prices, or exchange ratios. In­
dividuals search for those sequences of transactions,
called transaction chains, that minimize the cost of
acquiring information and transacting. The use of
assets with peculiar technical properties and low
marginal cost of acquiring information reduces these
costs. Money is such an asset, and the private and
social productivity of money are a direct conse­
quence of the saving in resources that the use of
money permits and of the extension of the market
system that occurs because of the reduction in the
cost of making exchanges.5
Thus, money as a medium of exchange, as a transac­
tion dominating asset, results from the opportunities
offered by the distribution of incomplete information
and the search by potential transactors to develop
transaction chains that save resources.6

What has been the outcome of the debate thus far
on the issue of the role of money in economic stabiliza­
tion? There is no doubt that money has been assigned
a more prominent role in recent years, but not to the
extent advocated by monetarists. Econometric model
builders have begun to give greater recognition to
money. For example, Lawrence Klein has reported
that the Wharton model now has a real money bal­
ance effect and that now the model predicts better.
Simulations of the M IT-FRB model, which had
Franco Modigliani as one of the principal architects,
demonstrate the long-run properties of money as
stressed by monetarists; namely, changes in money,
in the long run, influence mainly the price level.
In recent years, money has also received more at­
tention in the conduct of economic stabilization. For
years, post-Keynesians recommended that market in­
terest rates be the strategic variable to be controlled
in stabilization efforts. Policymakers tended to follow
BKarl Brunner and Alan H. Meltzer, “The Uses of Money:
Money in the Theory of an Exchange Economy,” The
American Economic Review (December 1971), p. 804.
6Ibid., p. 793.
Page 4




SEPTEM BER

1973

this recommendation almost exclusively until late in
the 1960s.
Attention has gradually shifted in recent years to­
ward more emphasis on money and less on inter­
est rates. From 1951 to 1966, the Federal Open
Market Committee stressed only market interest rates
and other measures of money market conditions. From
1966 to 1970, money or other monetary aggregates
served as a minor constraint on actions regarding
interest rates. In 1971, interest rates were manipu­
lated in an attempt to produce desired movements
in money. Finally in 1972, changes in reserves avail­
able for private deposits were formally set forth as a
means of controlling money. Such actions, however,
were constrained to a considerable degree by interest
rate considerations. Since 1969 the President’s Council
of Economic Advisers has recommended changes in
money and credit as a better guide for monetary ac­
tions than market interest rates.
Although the debate regarding money is less acri­
monious today, some important areas of contention
remain. A foremost one is in regard to the speed of
response of output, prices, and nominal GNP to a
change in money. Monetarist theories and empirical
studies point to a relatively quick, but short-lived,
response of output to a change in money growth, with
a longer time period required for prices to respond
fully. Post-Keynesian econometric models, on the
other hand, produce an impact of money changes
only over a much longer period.
Many economists now agree with the proposition
of monetarists that the long-run influence of money
is only on the price level, with no lasting impact on
output. Some, however, have distorted the monetarist
view by asserting that monetarists believe that these
long-run propositions also hold in the short run. For
example, Governor Andrew Brimmer of the Federal
Reserve System, in commenting last year on the de­
bate, concluded that “. . . there really is no difference
between modem monetarists and modem Keynesians
with respect to the long-run implications of their
theory.”7 But, he then asserts, “Monetarists appear to
argue that the reactions expected in the long-run can
also be expected to hold even in the short-run.”8 This
is simply incorrect.
Another major point of contention is the nature of
the monetary transmission mechanism. Post-Keyne­
7Andrew F. Brimmer, “Monetarist Criticism and the Conduct
of Flexible Monetary Policy in the United States” (Paper
presented at the Institute of Economics and Statistics, Oxford
University, Oxford, England, April 24, 1972), p. 8.
8Ibid., p. 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

sians have advanced their views of this mechanism
and have built empirical models based on their views.
On the other hand, monetarists, until recently, have
not developed such empirical models. Brunner and
Meltzer have now developed a theoretical model of
the transmission mechanism, which is based on rela­
tive price theory, and plan to make empirical tests of
its implications. At the Federal Reserve Bank of St.
Louis, we are in the process of spelling out our theory
of the channels by which changes in money influence
nominal GNP, the price level, and output. Along with
the theoretical work, we are attempting to estimate
the parameters of these channels of monetary
influence.

THE IMPACT OF FISCAL ACTIONS
Let us now turn our attention to the second issue —
the role of fiscal actions in economic stabilization. The
generally accepted view is that changes in Federal
Government expenditures and tax rates exert a strong
and rapid force on aggregate demand. Most mone­
tarists, but not all, contend that the influence of such
actions is transitory.
Post-Keynesians advance three main arguments for
the primacy of fiscal actions. Increases in Govern­
ment spending add directly to aggregate demand, and
reductions in tax rates increase disposable income,
thereby increasing aggregate demand. Both of these
actions are held to have a multiplier effect. Govern­
ment borrowing adds to wealth which increases
spending. With a constant money stock, higher inter­
est rates result which, in turn, reduce the quantity of
money demanded. To the extent that the velocity of
circulation increases, there is a fiscal impact on aggre­
gate demand.
Monetarists point out empirical evidence that the
Government expenditure multiplier, with a constant
money stock, is positive for a few quarters, but in the
long run it is zero. The argument frequently advanced
in support of such a response is the so-called “crowd­
ing-out” effect. In the absence of accompanying mone­
tary expansion, Government expenditures must be
financed by taxes or borrowing from the public. In
either case, command over resources is transferred
from the private sector to the Government, with the
result that there is no net addition to purchases. Only
in the case of a deficit financed by the monetary
sector does Government spending exert more than a
short-run positive influence on aggregate demand.
Such a response carries an implication opposite to
that postulated by Samuelson regarding money. Ac­



SEPTEM BER

1973

cording to Samuelson, money has an important influ­
ence only when it is created to finance Government
expenditures. Monetarists contend that Government
expenditures increase aggregate demand perma­
nently only if they are continually financed by creat­
ing money. Monetarists recognize, however, that Gov­
ernment spending financed by borrowing can have an
important indirect effect on spending because deficits
tend to induce central banks to increase money.
The fiscal aspect of the debate is far from being
resolved. The post-Keynesian view has continued to
be the dominant one in both macro-economic theory
and in stabilization policy. Monetarists, however, have
caused both theorists and model builders once again
to take specifically into consideration the financing
aspects of Government spending. These financing as­
pects, for the most part, had been dropped from both
these endeavors in the early 1950s when the crude
fiscal multiplier analysis came into vogue.
The general rejection of the challenging view has
been mainly the result of its failure to specify the
transmission mechanism whereby crowding-out oc­
curs. Economists such as Brunner and Meltzer and
Carl Christ have developed theoretical structures in
which the Government’s budget constraint plays an
important role. Such structures will be useful in iden­
tifying the conditions under which crowding-out oc­
curs. Monetarists continue to be skeptical regarding
the influence of fiscal actions when such influence is
measured without due regard given to financing
considerations.
One final point. Just as in the case of the role of
money, the debate over fiscal actions may be largely
one of timing. Both the M IT-FRB model and the
Data Resources model, which are built along postKeynesian lines, have a zero Government spending
multiplier with regard to real output. But this result
takes a fairly long period of time to accrue. On the
other hand, monetarists generally believe this same
result occurs within a much shorter time interval.

THE INFLATION-UNEMPLOYMENT
TRADE-OFF
I am sure you are familiar with the argument that
an economy must accept a high unemployment rate
in order to have a low rate of inflation, or that a low
unemployment rate can only be achieved at the cost
of a high rate of inflation. Monetarists, as well as
many other economists, reject this argument, con­
tending that in the long run the “normal” or “natural”
Page 5

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

SEPTEM BER

1973

unemployment rate will eventually evolve regardless
of the rate of inflation.

rate) instead of the comparatively less sharp trade­
off suggested in earlier empirical studies.

With regard to this issue, post-Keynesians have
generally relied more on empirical evidence, while
proponents of the alternative view have relied more
on theoretical arguments. This is an interesting re­
versal of approaches from those used in the two
previous issues.

Both sides, however, are in quite general agree­
ment regarding the desirability of actions to improve
the functioning of our labor and commodity markets.
Be there no trade-off, a sharp one, or a relatively
mild one, it is agreed that less restricted markets
would tend to reduce the rate of unemployment as­
sociated with any given rate of inflation.

In simple form, most empirical studies of the inflation-unemployment trade-off have proceeded in the
following manner. The price level is said to be a
markup of labor costs, which depend on wage rates
and productivity. Wage rate changes, in turn, are
postulated to be negatively related to the degree of
slack in the labor market, measured by the unemploy­
ment rate. Empirical studies have found it possible to
measure such relationships; thus, post-Keynesians con­
clude that the above mentioned trade-off exists.
Monetarists have developed mostly theoretical ar­
guments in support of the “no trade-off” proposition.
It is not denied that a short-run trade-off exists, but
it is denied that such a trade-off exists in the long run.
The crucial consideration involves the formation of
price expectations, a variable generally neglected un­
til recently in post-Keynesian analysis.
I will not go through this very complicated analysis.
Instead, I will merely point out the conclusion that
when prices rise at a constant rate, and if the ex­
pected rate of price change is the same, the unem­
ployment rate will be at its normal rate and will
remain there until a shock occurs. This normal un­
employment rate is determined by such factors as
cost of labor market information, labor mobility, job
discrimination, and laws and organizations which im­
pede the free functioning of the labor market.
This trade-off issue is far from being settled. It is
quite generally agreed that the crucial consideration
is the manner in which price expectations are formed.
No trade-off exists unless price expectations are
formed in such a manner that in the long run ex­
pected price changes fully reflect actual price changes.
Empirical evidence presented to date has proven to
be inconclusive —there is support for both sides of
the debate.
In one respect, some post-Keynesians have moved
closer, but not completely, to accepting the no trade­
off view. Simulations of several prominent econome­
tric models give results which show a very sharp
trade-off relationship (that is, a large change in infla­
tion, but a very small change in the unemployment

Page 6


FACTORS INFLUENCING
MARKET INTEREST RATES
The next issue in the debate which I will discuss
is the one regarding the factors influencing market
interest rates. This issue has basically revolved around
the distinction between real and nominal interest
rates. Another important point of difference has been
the market in which interest rates are determined.
Post-Keynesians have advanced the view that the
short-term interest rate is basically determined by the
demand for and the supply of money balances in
what they call the “money market.” The short-term
rate is then postulated to influence the long-term via
a term structure relationship. Finally, there is a re­
sponse of interest-sensitive components of aggregate
demand, followed by an aggregate demand feed­
back on the interest rate.
For years, the price level was held constant in a
large body of post-Keynesian analyses, with the result
that all variables were in real terms, including interest
rates. Monetarists have revived the much earlier view
of Irving Fisher regarding interest rates. They focus
on the nominal rate of interest, which is determined
by factors influencing the real rate of interest, and
takes into consideration the expected rate of inflation.
According to this analysis, the real interest rate is
determined by a multiplicity of factors traditionally
summarized in the phrase “productivity and thrift.”
The nominal interest rate, in equilibrium, is equal to
the real interest rate plus the expected rate of
inflation.
This analysis has led monetarists to summarize the
factors which influence market interest rates as the
liquidity or money effect, the output effect, and the
expected rate of inflation. An increase in the rate of
money growth first decreases market interest rates,
but then output rises in response to the faster money
growth. This results in an increase in the demand for
credit and interest rates rise. Finally, inflation in­
creases, and, to the extent that this is reflected in

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

expectations of inflation, an inflation premium is in­
corporated into market interest rates.
Experience with inflation since the mid-1960s has
led most economists to incorporate price expectations
into their interest rate analysis. Econometric model
builders found it necessary to introduce this factor
because, prior to doing so, their models had forecast
interest rate movements rather badly in the inflation­
ary period of the late 1960s. Outside of this change,
however, their interest rate mechanism has remained
essentially as outlined earlier.
A sharp controversy has existed regarding the ap­
propriate role of interest rates in monetary policy.
The conventional view has stressed interest rates as
the key variable to be manipulated by the central
bank in seeking to achieve its stabilization goals. High
and rising interest rates have been interpreted as in­
dicating monetary restraint. The opposing view in­
sists that the central bank has very imperfect control
over market interest rates in any period other than a
very short one, and that a prolonged period of high
and rising rates indicates monetary ease.
Even though some policy advisers, such as the Coun­
cil of Economic Advisers and some members of the
Federal Open Market Committee, have accepted the
view that interest rates contain a price expectations
component, interest rates still play an important role
in stabilization policy. In addition, there has been
almost a complete lack of understanding on the part of
Congress in both regarding the modern view of in­
terest rates and in applying this view to stabilization
policy prescriptions.

DEGREE OF INHERENT
ECONOMIC STABILITY
I now turn to the next issue — the dispute regard­
ing the monetarist contention that the economy is
inherently stable. Post-Keynesians contend otherwise.
Samuelson has summarized a few factors which he
believes affect money GNP even if money is held
constant:
(1 ) . . . any significant changes in thriftiness and
the propensity to consume . . . . (2 ) . . . an
exogenous burst of investment opportunities or
animal spirits. . . ,9

The alternative view does not deny that such fac­
tors exert a significant influence on GNP, output, and
the price level. But it does challenge the conventional
9Samuelson, “Reflections on the Merits and Demerits of Mone­
tarism,” p. 7.



SEPTEM BER

1973

view that these factors lead necessarily to recurring
fluctuations in output and prices which are of a cycli­
cal nature or that there does not exist a self-correction
mechanism. Monetarists contend that our economic
system is such that disturbing forces, including even
changes in money growth, are rather rapidly absorbed
and that output will naturally revert to its long-run
growth path following a disturbance.
Little empirical evidence has been produced in sup­
port of either view. Post-Keynesians offer simulations
of the response of their models to shocks, while the
challengers have appealed more to casual empiricism.
Moreover, monetarists have not been convinced by
post-Keynesian evidence which does not involve hold­
ing the growth of money constant.
This issue is also far from being resolved, but one
significant step has been taken toward resolution.
There is quite general agreement that the role of
price expectations is very important. One crucial con­
dition necessary to yield monetarists’ results is that
the current rate of inflation should respond to the
expected rate of inflation, however the expectation
is formed, with a coefficient of one.
As in the case of several of the other issues in the
debate, the central point of contention of the inherent
stability issue appears to be a matter of timing. Sev­
eral econometric models built along post-Keynesian
lines show, by simulation experiments, that shocks are
absorbed over a fairly long period of time and do not
produce cycles. On the other hand, monetarists postu­
late a shorter period for adjustment.

APPROPRIATE TIME HORIZON
FOR STABILIZATION POLICY
Let us now turn to the final issue —the appropriate
time horizon for stabilization policy. Post-Keynesians,
with their view that the economy is basically unstable,
have advocated very active stabilization actions in the
short run. Even if a disturbance is absorbed, the time
interval is considered to be so long that economic
welfare will be greatly reduced if short-run stabiliza­
tion actions are not taken. Some have expressed the
belief that the economy can be turned around on a
dime; therefore, in the case of high unemployment,
stimulus can be applied until inflation rears its ugly
head and then restraint can be applied to curb infla­
tion. The term “fine-tuning” has been applied to this
view. Since they hold that fiscal actions are powerful
and have a relatively quick effect, and that changes
in money have a very slow effect, the former tool of
economic stabilization is preferred.
Page 7

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

Monetarists, on the other hand, prefer a relatively
stable growth of money over fairly long intervals of
time. This position is based on the view that changes
in money exert a strong, short-run effect on output,
but little influence in the longer run. It is also based
on the belief that the economy is inherently stable,
thereby requiring no off-setting actions. Furthermore,
it is contended that short-run stabilization actions
have, in the past, been exercised in such a manner as
to create economic instability, and thereby have re­
duced economic welfare.
This issue is far from being resolved, if it ever can
be, because it involves one’s notion of economic wel­
fare. It will persist even if there is conclusive evi­
dence of a short-run, but short-lived impact of stabili­
zation actions on output and employment and a
long-run impact on the price level.
According to Robert Solow, a prominent postKeynesian,
. . . there is a trade-off between the speed of price
increase and the real state of the economy. It is less
favorable in the long run than it is at first. It may not
be ‘permanent’; but it lasts long enough for me.10

Monetarists contend, on the other hand, that failure
to take into consideration the long-run price level im­
plications of stabilization actions in seeking short-run
output and employment objectives seriously threatens
economic welfare because the long run may very well
be much shorter than usually believed. If such is the
case, stabilization actions based on Keynes’ dictum,
“In the long-run we are all dead,” may lead to a
serious loss of economic welfare for those living today.

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The influence of price expectations on market interest
rates is almost universally accepted, and the primacy
of interest rates as a tool of economic stabilization has
been seriously challenged. Although the stable mone­
tary growth rule has not been generally accepted,
there is a quite general acceptance of the proposition
that money growth should be less variable than in the
1950s and 1960s. The proposition that inflation is pri­
marily a monetary phenomenon, however, has not
generally been accepted in stabilization policy.
Two main developments are desirable if this debate
is to be resolved. The first involves monetarists and
the second, post-Keynesians. Monetarists must spell
out, in greater detail than up to now, the channels
by which money influences nominal GNP, the price
level, and output. Lawrence Klein, in commenting on
the Wharton model and the academic version of the
M IT-FRB model, has laid down this challenge to the
monetarists:
Each combines fiscal with monetary analysis; each
has the usual kind of fiscal multiplier; each can
measure up to any purely monetarist model yet con­
ceived as far as accuracy of performance is con­
cerned; and each is explicit about the channels of
monetary influence in a structural way. They stand
as challenges to the monetarist points of view.11

I will now conclude by summarizing the changes
in views regarding economic stabilization that have
occurred over recent years. Then, I will present my
views regarding some steps which are needed to be
taken if the debate is to be resolved.

As I mentioned several times, monetarists are rising
to this challenge. However, if the debate is to be
resolved, post-Keynesians must be willing to examine
a different approach to macro-economics from their
own and to consider different types of evidence.
Some monetarists have rejected the traditional static
IS-LM paradigm as an adequate framework for pre­
senting their views. They are investigating alterna­
tives based on relative price theory. Furthermore,
they believe that explicitly dynamic analysis will be
more useful than static analysis. Costs of information,
adjustment, and transactions play a central role in this
theorizing. With regard to evidence, the testing of
simple hypotheses is deemed to be more useful than
the building of elaborate structural models.

I believe that most observers will agree that money
is now receiving more attention in economic theory,
econometric model building, and stabilization policy
than it did just five years ago. In addition, greater
consideration is given to financing considerations in
discussions regarding the influence of fiscal actions.

In conclusion, I am heartened that progress has
been made in recent years in delineating the main
issues of the debate and in resolving some of them.
Moreover, the debate is less acrimonious than earlier.
It is my expectation that great strides will be made
in resolving the remaining issues in the near future.

,0Robert M. Solow, Price Expectations and the Behavior of
the Price Level (Manchester, England: Manchester Uni­
versity Press, 1969), p. 17.

11Lawrence R. Klein, “Empirical Evidence on Fiscal and
Monetary Models,” in Issues in Fiscal and Monetary Policy:
The Eclectic Economist Views The Controversy, p. 49.

PRESENT STATE OF THE DEBATE

This presentation and the accom panying commentary are available as Reprint No. 80.

Page 8


Commentary on
“The State of the Monetarist Debate”

LAWRENCE R. KLEIN

KARL BRUNNER

NO TE: The relevant passage from the Andersen
paper appears in italics preceding each of Professor
Klein’s comments.

Leonall C. Andersen’s account of the issues is
stated so well that I was immediately drawn into a
detailed reading of this fascinating material. Of
course, since I stand on the “other side” of the de­
bate, I felt compelled to take issue with specific
points although I found the piece, as a whole, very
attractive.
E conom etric m odels continued to stress the interest
rate channel an d shied aw ay from incorporating any
influence o f real m oney balances. F or exam ple,
w hen simulations o f the original K lein-G oldberger
m od el o f the late 1950s sh ow ed that the real balance
effect sw am ped all other influences, the monetary
sector w as d ro p p ed from the m odel becau se such a
result w as d eem ed “unrealistic” and "im plausible”.
(p. 3, left col., 3rd para.)

It is true that Arthur Goldberger found that
“money market effects swamped all other effeots . . .
in an implausible way” when he computed dynamic
multipliers for the model. It is also the case that re­
sults that looked implausible in 1959 may not appear
to be so today. This does not mean, however, that
the monetary sector was dropped from the model,
as Andersen asserts. It merely means that this sector
was dropped for Goldberger’s method of evaluation
of dynamic multipliers from a linear approximation
to the model. They were not otherwise dropped.

Leonall C. Andersen notes correctly that theoretical
issues, policy problems, and research strategy have
been closely related in recent controversies. This in­
terrelation may be recognized by rearranging the is­
sues covered by Andersen into four broad groups
which summarize the central contentions of the con­
troversies. An explicit restatement of the nature of
the issues seems useful in order to remove irrelevant
contentions or misconceptions concerning the propo­
sitions involved. My summary is guided by the four
questions entered at the head of each section below.

(1) How Do Money and Fiscal Policy
Influence Economic Activity?
The orthodox Keynesian view contends that all
information bearing on the transmission of monetary
impulses is contained in the slope properties of the
IS-LM diagram. A Pigovian modification includes
shifts in the IS curve associated with the real balance
effect. The evolution of the neo-Keynesian views
flattened the slope of the IS curve. Keynesian analy­
sis thus gradually reassessed the influence of money
and monetary policy.

With today’s technology for digital evaluation of
multipliers, we do not make linear approximations.
Also, we do not necessarily make ceteris paribus

These changes in the perspective concerning the
relative strength of monetary impulses did not modify
the comparative role of fiscal and monetary policy in
a stabilization program. The primary role was still
assigned to fiscal policy with monetary policy con­
fined to a “passively permissive” role. This concept of

(Continued on p. 10)

(Continued on p. 12)




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

calculations of dynamic multipliers. More often, we
make mutatis mutandis evaluations of dynamic mul­
tipliers; that is, we compute deviations from an “equi­
librium” (or “control” or “baseline”) dynamic path.
Along such a path reserves can grow in an accom­
modating fashion, and other exogenous variables can
also change as they will. In a generalized approach
to dynamic multiplier analysis, we would not neces­
sarily find that monetary effects swamp all other
effects.
C hanges in the trend growth o f m oney are consid­
ered th e dom inant, not the exclusive, determ inant of
th e trend o f nom inal GNP and the price level. Longrun m ovem ents in output are little influenced hy
changes in the growth rate o f m oney. Trend m ove­
m ents in output are essentially determ in ed hy the
grow th o f such factors as the labor force, natural re­
sources, capital stock, and technology, (p. 3, left
col., 5th para.)

The claim here is that the trend growth of money
is the dominant determinant of both nominal GNP
and the price level. This is an imputation of remark­
able power to money. If the economy is at full capac­
ity or full employment real GNP and if it is asserted
that money determines price level, then it is trivial
to say that it also determines nominal GNP. If the
economy is not necessarily at full equilibrium, then
it is remarkable, indeed, that money is such a power­
ful variable that it is predominant in the determina­
tion of both nominal GNP and price level. I don’t
believe a word of it.
T here is no dou bt that m oney has b een assigned a
m ore prom inent role in recent years, but not to the
extent ad v ocated by monetarists. Econom etric jnodel
builders h ave begun to give greater recognition to
m oney. F or exam ple, L aw ren ce Klein has reported
that the W harton m odel now has a real m oney b al­
an ce effect an d that now the m odel predicts better.
Simulations o f the M IT-FRB m odel, w hich had
Franco M odigliani as one o f the principal architects,
dem onstrate the long-run properties o f m oney as
stressed by monetarists; namely, changes in money,
in the long run, influence mainly th e price level.
(p. 4, left col., 2nd para.)

It is true that econometric model builders are now
giving greater recognition to money, but I don’t
think the right reasons are conveyed to the reader.
(i)
It should be remembered that Tinbergen de­
voted a great deal of attention to the money market
in trying to interpret the 1920s in his celebrated
League of Nations study. In my own work, I have
studied real balance effects since early model build­
ing efforts at the Cowles Commission in the late

Page 10


SEPTEM BER

1 9 73

1940s (Econom ic Fluctuations in the United States,
1921-1941). I took up the problem again in micro
econometric studies of the Surveys of Consumer
Finances ( Contributions of Survey M ethods to E co­
nom ics) and introduced real balance effects in the
original formulations of the Klein-Goldberger Model
in the early 1950s. There is nothing unusual about
the fact that such effects appear again in the new
Wharton Model (Mark I II). It is just a continuation
of research started more than 25 years ago and quite
unrelated to today’s monetarist debate.
(ii) As early as 1960, when a planning committee
was outlining work for the SSRC model project
(later the Brookings Model), the executive allocated
responsibility to Daniel Brill and associates of the
Federal Reserve Board for the development of a
monetary sector, on a par with all other sectors. We
recognized the importance of monetary factors from
the start, but not along the lines now pursued by
the monetarist school.
(iii) The reason why more attention is now being
paid to monetary aspects in econometric model con­
struction is that present samples of data cover a
richer experience that was not previously available.
The wartime accumulation of liquid assets first stim­
ulated our curiosity, but it was not until the mid1950s that interest rates showed appreciable vari­
ance. The monetary crises of 1966 and 1969-70 again
enriched our data experience. The whole history of
macro-econometric model building has been one of
expansion through system enlargements, inclusion of
more detail, and direction of added attention to
specific sectors. It is no surprise that increased atten­
tion to the monetary sector should be taken up now,
especially as flow-of-funds data become more ac­
cessible. In a similar way, increasing attention is
being paid to the international sector, as the United
States has more trade and payments crises. Gradually,
model builders will cover all sectors of contemporary
interest.
Both th e M IT-FR B m od el an d th e D ata Resources
m odel, w hich are built along post-Keynesian lines,
h av e a zero G overnm ent spending m ultiplier with
regard to real output, (p. 5, right col., 3rd para.)

Most American models, other than the St. Louis
model, imply fiscal multipliers that rise fairly quickly
to values between 2.0 and 3.0. They fluctuate in a
narrow range for a number of years and then de­
cline. This is brought out clearly in the analysis of
the NBER/NSF Seminar on Model Comparison
[G. Fromm and L. R. Klein, American Econom ic

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

Review (May 1973).] For the only period of policy
relevance (before many other changes, besides the
original fiscal policy change, have taken place) the
fiscal multipliers are estimated to be substantial by a
broad consensus. In a practical sense, for purposes
of economic policy formulation, the latest results
seem to cause no change in the standard analysis of
the fiscal school.
Monetarists h ave d ev elo p ed mostly theoretical ar­
gum ents in support o f the “no trade-off” [inflationunemployment] proposition. It is not d en ied that a
short-run trade-off exists, but it is d en ied that such
a trade-off exists in the long run. T he crucial con ­
sideration involves the form ation o f price ex pecta­
tions, a variable generally n eglected until recently in
post-Keynesian analysis, (p. 6, left col., 3rd para.)

Surely, it is not right to say that the post-Keynesian
analysis has neglected, until fairly recently, price
expectations. A variable representing such expecta­
tions has always been in the theoretical and the
associated econometric analyses. I would say that
careful analysis of this variable has a thirty-five year
history. In some cases price expectations were em­
pirically represented by distributed lags of prices and
in other cases by direct measurement in sample sur­
veys. It is a difficult variable to measure properly,
and the surrogates have not always been good, but
it has never been neglected. One might criticize the
simple approximations to anticipated prices that I
used in Econom ic Fluctuations, but the recognition
of the significance of expectations was quite explicit.
. . . w hen prices rise at a constant rate, and if the
ex p ected rate o f price change is the sam e, the un­
em ploym en t rate will b e at its normal rate and will
rem ain there until a shock occurs. This normal
unem ploym ent rate is determ ined by such factors as
cost o f labor m arket information, labor m obility, job
discrimination, an d laws an d organizations w hich
im p ed e the fre e functioning o f the labor inarket. (p.
6, left col., 4th para.)

The concept of a “normal unemployment rate” as
it is used in modern macro-analysis does not seem to
me to be very useful. To a large extent, it is used
euphemistically to cover up real problems in achiev­
ing what is easily measurable as a broadly accepted
statistical target of full employment at 4.0 percent.
For my own tastes, I think that 4.0 percent is a
pretty poor performance target for a modem indus­
trial state and would prefer the range of 3.0-3.5 per­
cent. In any event, I think that it would be unfortu­
nate if the monetarist-fiscalist debate got locked into
assumed agreement on the so-called “normal unem­
ployment rate” as a target.



SEPTEM BER

1973

I now turn to the next issue - th e dispute regarding
th e m onetarist contention that th e econom y is in­
herently stable. Post-Keynesians contend otherw ise.
Samuelson has sum m arized a few factors w hich h e
b eliev es affect m oney GNP even if m oney is h eld
constant:
“(1) . . . any significant changes in thriftiness
an d the propensity to consum e . . . . (2) . . . an
exogenous burst o f investm ent opportunities or
anim al spirits . . .
(p. 7, left col., 4th para.)

I don’t think that it is correct to say that PostKeynesians contend that the economy is inherently
unstable. They may contend that it is oscillatory or
subject to fluctuations and that it has a tendency to
move about a position of underemployment equili­
brium, but this is far different from saying that the
economy is unstable. The quotation cited from Paul
Samuelson is one that I would commonly associate
with a theory of the business cycle that he taught me
three decades ago, with an ancestry related to
Spiethoff, Tougan Baranovsky, Schumpetter, and
Hansen. Their views can be superimposed on the
Keynesian system, to derive a formally stable cycli­
cal process.
Little em pirical ev id en ce has b een prod u ced in
support o f either view [degree of economic stability].
Post-Keijnesians offer simulations o f the response of
their m odels to shocks, w hile th e challengers ap p eal
m ore to casual em piricism , (p. 7, right col., 1st para.)

The Wharton Model (Econom etric M odels of Cy­
clical Behavior) and the Klein-Goldberger Model
(“The Dynamic Properties of the Klein-Goldberger
Model,” Adelman and Adelman; “On The Possibility
of Another ’29”) have been shocked in many sepa­
rate studies. A number of these have been published.
They consider both once-and-for-all exogenous and
repeated stochastic shocks. A persistent finding is
that the models of the underlying dynamic economic
system are quite stable. In the case of once-and-forall shocks, there is a strong tendency for the system
to return to a long-run growth path after a severely
damped oscillatory movement. In the cases of sto­
chastic shocks, a stable oscillatory movement occurs.
A. L. Nagar’s stochastic simulations of the Brookings
Model ( The Brookings M odel: Some Further Re­
sults) appear also to be stable.
As in th e case o f several o f the other issues in the
d eb ate, th e central point o f contention o f th e inher­
ent stability issue ap p ears to b e a m atter o f timing.
Several econom etric m odels built along post-K eyne­
sian lines show, by simulation experim ents, that
shocks are ab so rb ed over a fairly long p eriod o f time
and d o not prod u ce cycles. On th e oth er hand, m onePage 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

tarists postulate a shorter period fo r adjustment, (p.
7, right col., 3rd para.)

As noted in the preceding comment, simulations
of econometric models built along post-Keynesian
lines do show important business cycle characteris­
tics. It is a strong claim on the part of such model
builders that these systems are capable of generating
the cycle, as it has been historically measured, when
the models are subjected to repeated shocks in sto­
chastic simulations. I regard this as a basic validation
feature of contemporary econometric model building
research, and this is an integral part of my challenge
to the monetarists, to see whether they can do as
well in reproducing accepted measures of cyclical
characteristics from simulations of their models. I am
disappointed in their not following this line of eco­
nometric research.
L et us now turn to the final issue — the appropriate
tim e horizon fo r stabilization policy. Post-Keynesians,
with their view that the econom y is basically un­
stable, have ad v ocated very active stabilization a c ­
tions in the short run. (p. 7, right col., 4th para.)

SEPTEM BER

1973

At this point, I repeat earlier comments that postKeynesians do not hold the “. . . view that the eco­
nomy is basically unstable . . .
(Section entitled “Present State of the Debate”, p. 8)

Andersen sums up the debate nicely in these con­
cluding paragraphs. Without accepting his view
about the workings of the economy, I find that I can
accept his view of the issues and procedures for
continuing research on resolving some of the main
issues. Careful statistical study of the evidence fol­
lowing best econometric practice can probably do
much to settle some of the debatable issues. It is
extremely healthy and welcome to see the debate
shift from speculative theorizing, casual empirical
referencing, and unsupported asserting, to serious
work in applied econometrics. We may not resolve
matters, but we shall leam more about the crucial
issues and know where each side stands. We shall
probably find out what would be needed in order to
convince both sides of the correctness or incorrect­
ness of their positions.

KARL BRUNNER (continued)
policy is a consequence of the Keynesian interpreta­
tion of the transmission mechanism which persists
independently of the changes noted above. Apart
from a more or less significant real balance effect,
monetary impulses are conveyed in the usual Keyne­
sian view by the play of interest rates on financial
assets. Thus, the transmission of monetary impulses
depends on the responses of the small proportion of
expenditure categories with comparatively high bor­
rowing costs. The Keynesian view therefore implies
that applications of monetary policy burden a com­
paratively small sector with the task of swinging the
whole economy in the desired direction. This means
that this view of the transmission mechanism assigns
substantial social costs to the use of monetary policy.
In contrast, stabilization programs based on fiscal ad­
justments apparently impose lower social costs for
similar social benefits.
It is commonly known that monetarist analysis re­
jects the assessment of monetary and fiscal policies
offered by the Keynesian view. It is not commonly
understood, however, that the conflicting views bear­
ing on policy programs follow from a fundamental
difference in the conceptions governing the substitu­

Page 12


tion relations of money. Keynesians constrain the sub­
stitution to money and financial assets of a similar risk
class. On the other hand, monetarists postulate that
transactions dominating assets (that is, money) sub­
stitute in all directions over the whole array of other
assets. This difference implies that monetarist analysis
rejects the IS-LM framework as an adequate repre­
sentation of monetary processes.
Also, monetarist analysis does not accept the idea
that the slope properties of such diagrams contain all
the relevant information pertaining to the transmis­
sion of monetary impulses. In contrast, the credit
market, usually dismissed or disregarded in Keynesian
analysis, emerges with an important function in mone­
tarist analysis. It follows that the impact of monetary
actions on interest rates cannot be interpreted simply
as a “liquidity effect” resulting from the interaction
between money demand and money stock.
Furthermore, the role of the government sector’s
budget position and its impact on the economy via
asset markets are thus accessible to monetarist analy­
sis, but not to Keynesian analysis. Also, the Keynesian
distinction between the “direct effects” of fiscal pol­

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

icy and the “indirect effects” of monetary policy are
recognizably conditioned by the peculiarities of the
Keynesian transmission mechanism. Once the nature
of the contending views is properly understood, we
may hopefully move in our empirical research be­
yond Samuelson’s attempt to force the issue into the
Keynesian strait jacket by trying to reduce it to con­
flicting propositions about the interest elasticity of
money.

(2) Does the Economy Produce Self-sustaining
Fluctuations of Major Magnitudes?
Keynesians usually answer this question in the af­
firmative. The General Theory contains several pas­
sages emphasizing the tenuous nature of long-run
expectations and the unreliable gyrations of the mar­
ginal efficiency of investment. On the other hand,
monetarists stress the shock absorbing capacity of the
market process and the load factors usually produced
by an unstable government and policy process. It is
noteworthy that some of the exemplifications offered
in Keynes’ work, in spite of the general passages
mentioned, actually support the monetarist thesis.
The contentions swirling around the stability of the
economic process certainly require substantial further
examination. Keynesians usually postulate that inter­
action between economic and political processes sta­
bilize and at least do not destabilize the economy.
Monetarists, on the other side, argue that such inter­
action operates more frequently in a destabilizing and
welfare-reducing direction. It should be noted that
Keynesians offer little evidence supporting their views.
It is particularly noteworthy that all econometric mod­
els cast in a Keynesian mold, and examined in detail
thus far, imply the monetarist stability thesis and
reject the Keynesian thesis of an unstable process
generating self-sustaining fluctuations of substantial
magnitudes. But the monetarist case is not yet firmly
established and the issue will persist.

(3) Apart From An Unstable Process, What
Forces Produce Economic Fluctuations?
Fiscalist Keynesians answer with a description of
fiscal policy and stress the crucial significance of in­
formation about fiscal policy in order to appraise
future economic trends. Others emphasize the role of
a Wicksell-Keynes process and offer quotes about the
autonomous operation of “animal spirits” affecting the
anticipated real net yield on real capital. Monetarists,
of course, stress the role of monetary impulses ap­
proximated by relative changes of some measure of



SEPTEM BER

1973

the money stock. These differences in the views about
the driving impulse forces should not be miscon­
strued into absolute categories. They involve state­
ments asserting the com parative dominance and
persistence of specific impulses. Moreover, the mone­
tarist thesis does not require termination of empirical
research with a beautiful time series exhibiting ac­
celerations and decelerations of the money stock.
Some monetarists penetrated substantially “behind”
this phenomenon to establish a link between a coun­
try’s financial institutions and the nature of the policy
process. It follows, therefore, that the question of
exogeneity or endogeneity of the money stock attracts
only a mild interest for the resolution of our major
issues.

(4) Do W e Need the Allocative (Sectoral)
Details For The Understanding of An
Economy’s Macro-Behavior?
Many, but not necessarily all, Keynesians will an­
swer affirmatively. On the other hand, monetarists
emphasize the approximate separation of allocative
and aggregative processes. They assert that one set of
forces explains the position of relative price changes
under a given distribution of such changes, and an
essentially different set of forces explains the position
of the w hole distribution. They contend, therefore,
that a detailed description of which relative price
changes are located w here under the distribution,
yields no relevant information about the inflationary
thrust of an economy. Some aggregative significance
is, however, recognized for specific allocative pat­
terns (currency ratio, time deposit ratio, investment
ratio for the long-run resource effect but not for the
short-run demand effect).
There remains a fundamental conflict on this issue
which has molded substantial differences in research
strategy. The producers of large scale econometric
models are motivated by a denial of the monetarist
thesis, and the latter implies a research strategy ad­
dressed to small models, partial hypotheses, and a
gradual build-up of theories by combining relatively
“simple” building blocks. Monetarists would also claim
that they are less interested in technical sophistication
per se, and assign more weight to economic content.

Concluding Observations
Keynesian analysis usually resolves the problem of
interpreting monetary trends by relying on interest
rates. This decision is justified by references to the
central role of interest rates in the transmission mech­
anism of their models.
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

Monetarists claim, on the other hand, that Keyne­
sians have adopted, without analytic reasons, the
central bank tradition of gauging the tightness or ease
of monetary policy by the level of, or movements in,
market interest rates. The IS-LM diagram implies that
changes in interest rates would serve as a reliable
indicator of monetary events if the IS curve is rigidly
fixed and money demand is stable (ignoring the ef­
fects of changing price expectations on interest rates).
Monetarists, however, contend that in a world in
which the IS curve is changing and perhaps money
demand is shifting, interest rate movements do not
give reliable signals as to the tightness or ease of
monetary policy. Unfortunately, the nature of the
interpretation problem does not seem to be well under­
stood, and an ossified inheritance persists in the litera­
ture. On the other hand, some progress can be noted
in the determination of suitable policies and policy
procedures. Both analytic examinations and simula­
tions of econometric models have opened avenues
for exploration to resolve the issues of policy strategy


Page 14


SEPTEM BER

1973

which should be acceptable to all parties in the con­
troversy. The progress made in the analysis of the
determination problem of monetary policy eventually
may be matched by similar progress in the interpre­
tation problem.
And so, where do we stand? Surely, the questions
and positions have changed over the past twenty
years. Beyond the noise of the ongoing debate, the
gradual effect of searching examination was bound to
modify subtly the views of Keynesians and mone­
tarists. Moreover, the four major issues allow a variety
of combinations. Some economists may reject the
monetarist impulse hypothesis, but accept the mone­
tarist view of the transmission mechanism. The evolu­
tion of such a spectrum with a “middleground” should
enrich our future research activities. Such activities
should yield substantive results over the years to the
extent that economists successfully avoid the “media
propensity” of equating all issues with ideological
positions.

A Value Added Tax and Factors
Affecting Its Economic Impact"
by CHARLOTTE E. RUEBLING

A
VALUE ADDED TAX (VAT) has at times
been mentioned as a substitute for an existing tax or
as a source of new revenues in the United States.
While a VAT is not currently used in this country, it
is employed by many U.S. trading partners in Europe.
One purpose of this article is to provide a general
description of a VAT. A second purpose is to point
out that some consequences often expected as the
result of adopting any tax are conditioned by aspects
of the economic environment which can vary from
time to time. For example, discussions of a VAT have
centered on its possible effects on prices, income dis­
tribution, economic growth, and the balance of pay­
ments. To evaluate adequately the consequences of
a VAT or any other tax, circumstances such as the use
of revenues and accompanying monetary develop­
ments must be considered.

FEATURES OF A VAT
The Concept of Taxing Value Added
A tax often takes its name from the base on which
it is computed. For example, personal income taxes are
levied against a base of personal income, and retail
sales taxes are a proportion of final sales. Value added
taxes are no exception, being levied, in principle, on
the value of newly produced goods and services.
"The author appreciates helpful comments provided by Pro­
fessor Charles W. Meyer on an earlier draft of this article.



T a b le

I

European Countries Em ploying a V A T
Year
B e lg iu m
D e n m a rk
F ra n c e
G e rm a n y
Ir e la n d
It a ly
L u x e m b o u rg
N e t h e r la n d s
N o rw a y
Sw eden
U n it e d K i n g d o m

In t r o d u c e d
1971
1967
1 9 5 4 -5 5
1968
1972
1973
1970
1969
1970
1969
1973

Value added for a given period is conceptually
equivalent to all income —wages and salaries, rent,
interest, and profits — generated in the production of
aggregate output. A VAT nevertheless differs from
a general tax on incomes in that firms, rather than the
individuals who ultimately receive income, are re­
sponsible for paying the tax to the government.
A VAT is often considered to be essentially a retail
sales tax. However, a VAT differs from a retail sales
tax in that it is collected at each stage of the produc­
tion and distribution process, not solely at the stage
where a product is sold to the consumer.

Methods of Computing a VAT
There are three methods for computing an individ­
ual firm’s VAT. These are the addition, the subtrac­
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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. L O U I S

tion, and the credit or invoice methods. The ad­
dition and the subtraction methods involve different
approaches to computing the tax base. The credit
method calculates the tax liability itself, without re­
quiring explicit measure of a firm’s value added. In
practice these three computational procedures are
only approximately equivalent.1
The addition method of computing the VAT base
is to sum the firm’s payments of wages, salaries, in­
terest, rent, and profits. These payments represent
the firm’s contribution to the value of the economy’s
output in the period, or its “value added.” This base
multiplied by the tax rate indicates the amount owed
the government in value added taxes. The subtraction
method computes each firm’s value added as sales less
purchases of material inputs from other businesses.
The credit method computes the tax by applying the
tax rate to sales and then subtracting taxes paid on
purchases of components. Value added taxes in Euro­
pean countries are usually computed by the credit
method.

The Treatment of Capital
Three variations of VAT also arise through different
treatments of capital goods. The variations described
here are in terms of the subtraction method of com­
puting the VAT base. A gross product type VAT does
not allow purchases of capital goods to be subtracted
from a firm’s sales to determine its tax base. Any part
of the VAT assessed to the capital producer’s value
added which he is able to pass on as a higher price is
not recoverable by the purchaser through a tax base
reduction matching the purchase price of the capital.
An incom e type VAT reduces the firm’s tax base in
each period by the amount of its capital depreciation
in that period or by some proportion of the capital
purchase price. This type is analogous to net national
product, a measure of output which subtracts capital
consumed or used-up in producing the gross output
or “value added” for the period.
A consumption type VAT excludes from the tax
base the entire amount of capital expenditures in the
tax period.2 This type is somewhat more favorable, or
1See Alan A. Tait, Value Added Tax (London: McGraw-Hill,
1972), pp. 1-5.
2Norman Ture maintains that this variation has been mis­
named. The name promotes the view that it is a tax exclu­
sively on consumption. His analysis develops the proposition
that under certain conditions, this type of VAT is a propor­
tional tax on incomes of owners of productive facilities in
the forms of both labor and capital. Savers, who directly or
indirectly are owners of capital, do not escape the tax, be­
cause value added by capital is subject to the tax. For a

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1973

less unfavorable, to investment expenditure than the
other two.3 The total dollar amounts of tax base re­
ductions are ultimately the same under both the in­
come and consumption types. However, under the
consumption type, the firm purchasing capital ob­
tains a reduction of the base in the period in which
the capital is purchased. With the income type, the
reduction is spread over the depreciation period.
Thus cash available to the firm in the early years of
the capital’s use is greater than under the income
type. In general, European countries have adopted
the consumption type.

Rate Variations and Exemptions
Many VAT systems can be described as having a
basic rate, special rates for some goods and services,
and exemption status for certain economic activities
or specific goods and services.4 These features influ­
ence the nation’s aggregate effective tax base.
In language used with a VAT, to be “exempt”
means that there is no tax payable on sales and that
taxes paid on purchases in order to provide a good or
service are not recoverable from the government.
Various categories of economic activity have been
exempted in European countries either to simplify
administrative procedures, as when very small busi­
nesses are exempted, or to achieve special effects on
prices and the distribution of real income in the eco­
nomy. Banking and financial institutions offer services
to which the value-added concept is generally diffi­
cult to apply; consequently, these firms and services
are commonly exempted from a VAT. Government
and educational services, medicine, transportation,
and communications products and services are also
given interest rate, the tax on the goods produced with capital
raises the amount of net income firms must derive from a
capital asset in order to justify its purchase. In other words,
the tax reduces the demand for funds, and other things re­
maining the same, the interest earned by savers. See Charles
E. McLure, Ir., and Norman B. Ture, Value Added Tax:
Two Views (Washington, D.C.: American Enterprise Institute
for Public Policy Research, November 1972), pp. 88-92.
3See Carl Shoup, “Theory and Background of the Value
Added Tax,” National Tax Association Proceedings of the
Forty-Eighth Annual Conference, 1955, pp. 11-18, for ex­
planation of an “interest-exclusion variant” of the income
type which is equivalent to the consumption type. Also dis­
played is a proof demonstrating that the consumption type
does not discriminate in favor of or against capital as opposed
to a situation of no tax.
4See Tax Policy ( October-December, 1972) especially the
selections: B. Kenneth Sanden, “The Value-Added Tax—
What It Is; How It Works —Experience in Foreign Coun­
tries,” pp. 1-19; lohn S. Nolan, “How VAT Should Operate
in the United States,” p. 20-26; William I. Stoddard, “Effect
of VAT on Service Industries,” pp. 59-65; and Gordon
Insley, “The Value-Added Tax and Financial Institutions,”
pp. 72-78.

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often exempted. In some countries these and/or other
goods and services, considered “necessities,” are in­
stead taxed at a rate lower than the basic rate, while
some items, defined as luxury goods, are taxed at
rates higher than the basic rate.
If a firm’s sales are subject to a “zero” or “nil” rate,
then not only are sales free from tax liability, but the
firm also is entitled to a refund of taxes listed on the
invoices of purchased inputs. Exports are typically
subject to a zero rate in VAT laws and proposals.
The zero rate means that exporters do not pay tax on
their sales abroad and receive refunds for taxes paid
on purchases.

ISSUES CONCERNING THE EFFECTS
OF A VAT
The consequences of adoption of a VAT, or any
tax change, for inflation, income distribution, resource
allocation, economic growth, and a nation’s balance of
payments depend on the specific form of the tax and
the accompanying circumstances. This section of the
paper describes possible effects of a VAT, noting some
of the specific aspects of the tax and some of the con­
ditions in the economy which must be considered in
order to reach valid conclusions about whether those
effects will or will not follow the imposition of the
tax. The general categories of considerations discussed
are relevant for analysis of the effects of any tax
change, not merely one involving a VAT.
One inevitable change in circumstances accom­
panying any tax change and bearing on subsequent
economic developments is the possible use of new
revenues. New tax revenues may be used by the
government: (1) to purchase goods and services; (2)
to reduce or replace another tax; (3) to retire out­
standing debt; or (4) to hold balances in commercial
or central banks.
Monetary conditions also influence the effects some­
times associated with tax policy. Monetary policy and
tax policy are often considered separately from each
other. Commentators assessing the impact of one or
the other often implicitly assume definitions of these
terms which keep them distinct. One should keep in
mind, however, the following relationships between
monetary and tax policy. A decline in money can
result from one use of tax revenues —increasing Treas­
ury balances in commercial or Federal Reserve Banks.
Also, increases in the money stock can finance gov­
ernment expenditures. Additionally, changes in the
money stock have influences over objectives which



1973

tax policy often considers —namely, those relating to
inflation, economic growth and stability, income dis­
tribution, and the international balance of payments.
While monetary policy and the government budget
are not the only influences on these matters, both
are significant.

Inflation
The possibility of increases in the average price of
goods and services upon enactment of a VAT has
been a concern of Europeans, even though for some
countries the VAT replaced a similar tax known as a
turnover tax. For example, in the past year France
reduced its VAT rates, along with other measures,
reportedly for the purpose of combatting inflation.
Imposition of a VAT or a change in any tax rate,
by itself, cannot be considered inflationary or defla­
tionary. Even if sellers were able to raise prices to
cover the tax they pay, this would constitute a one­
time increase in their prices, but would not neces­
sarily lead to inflation, which is a continuous increase
in the average of prices over time.
Even associating a one-time increase in the level
of prices with a tax change would be accurate only
under special circumstances. A tax on a single good
could often be expected to raise the price of that
good and perhaps affect prices of related goods and
services.5 However, a rise in the general price level
cannot be maintained unless there is a rise in the
dollar amount of goods and services demanded rela­
tive to output. Assuming no decline in output, this
would require either expansion in the money stock or
decline in the public’s holdings of real money bal­
ances.6 If there were neither a rise in the money
stock nor an increase in the rate of money turnover,
buyers would be unable to make all of their previous
purchases at higher prices. A result of a widespread
attempt to raise prices would be reduction in the
real amount of goods and services sold, rollbacks in
some prices, and/or adjustments in production and
employment. Consequently, if a rise in the price level
is sustained with the imposition of a VAT or other
tax change, it is largely because of one or more of the
following: the tax has induced the monetary authori­
5For a formal analysis, see Armen A. Alchian and William R.
Allen, University Economics, 3rd edition (Belmont, Cali­
fornia: Wadsworth Publishing Company, Inc., 1967), pp.
324-328.
6In the framework of the quantity equation, MV = PT,
familiar to some readers, the reduction of average cash bal­
ances is equivalent to a rise in transactions velocity ( V )
which, in the presence of constant money stock ( M ) and full
employment (constant T ), would produce a rise in prices (P).
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ties to increase the money stock; the tax has induced
the public to attempt to reduce their holdings of
money balances; or the tax has acted as a disincentive
to production.

Income Distribution
Many believe a VAT to be a regressive tax — one
which takes a larger proportion of lower incomes than
high ones. An appropriate analysis of the effects of a
tax on income distribution requires consideration of
the specific form of the tax — including its rates and
exemptions — and the use of the revenues. Considera­
tion of how these in turn affect income distribution is
rather complex.
To illustrate, Great Britain replaced selective em­
ployment and special purchase taxes with a VAT,
effective April 1, 1973. This VAT has a basic rate of
10 percent and a zero rate on some items, including
food, housing, fuel, power, and passenger transport.
Under the special purchase taxes which were re­
placed, some luxury items were taxed at a rate of 25
percent while many items purchased more universally
were taxed at rates lower than 10 percent. The effect
of this tax substitution on income distribution is con­
tingent on how prices of commodities respond to the
elimination of one tax and the imposition of the other.
The substitution would usually be considered regres­
sive if prices of items purchased predominately by
lower income households rise relative to prices of
purchases made by higher income households. The
assumption, often made, that prices respond in direct
proportion to the tax change is usually unwarranted.7
The income distribution effect of adoption of a
consumption type VAT in the U.S. would depend on
a number of circumstances including, of course, its
rates and exemptions. The use of revenues — for ex­
ample, whether they were used to reduce or eliminate
corporate income taxes, social security taxes, or prop­
erty taxes, or whether they were used to increase
government spending — would help determine the
distribution of real income after the tax change. In
addition, accompanying monetary conditions would
influence the behavior of prices, which, in turn, affects
the distribution of real income.

Economic Growth
One objective apparent in discussions concerning
taxation is that the tax system encourage or at least
not impair the economy’s potential for and achieve­
ment of economic growth. What, then, are some of
7Alchian and Allen, pp. 324-328.

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the possible consequences of a VAT on growth? Once
again it depends to some extent on the policy actions
accompanying the VAT and responses to these ac­
tions. In general we need to ask whether the private
sector responds to a given tax substitution or increase
by: (1) reducing consumption; (2 ) reducing invest­
ment; or (3 ) increasing the supply of productive re­
sources to the market. Response (3) appears condu­
cive to growth. However, for the growth impact of
response (3) to be lasting, there must be balance
between demand and the resulting increase in the
supplies of goods. Slack in demand resulting in ac­
cumulations of unsold goods is a signal for a produc­
tion cutback (and/or a price decline) in a market
economy. In general, policies conducive to growth are
those which increase supplies of productive resources
and investment and those which foster conditions in
which an essential balance between aggregate sup­
plies and demands can be maintained.
The combination of responses (1), (2), and (3) to
adoption of a VAT is influenced by how the VAT, the
accompanying use of funds, and monetary conditions
affect prices of current versus future consumption8
and the conditions which lead resource owners to
hold or release their resources to the market. If mone­
tary conditions (rates of money stock growth and
money turnover) do not change, relative prices will
reflect the impact on prices of the tax for which the
VAT was substituted or the spending undertaken by
the government. A lowering of the relative price of
future consumption would in many circumstances be
conducive to growth of production in the economy.

Balance of Payments
A VAT, as opposed to some other taxes, is consid­
ered advantageous to an individual country’s balance
of trade. Provisions of the General Agreement on
Tariffs and Trade (GA TT) foster this effect. GATT
permits a rebate of indirect taxes, such as a VAT or
sales tax, on exports so that the destination price of
the export will exclude the tax, but does not permit
the effect of direct taxes, such as the corporate income
tax, to be excluded from the export price. In addition,
GATT allows a border tax on imports equivalent to
the importing country’s indirect tax. If direct taxes
have a positive effect on the prices of commodities,
which is reversed with elimination of the tax, the
8Future consumption implies saving and buying capital which
will yield a larger stock of consumption goods at some time
in the future than one is capable of acquiring in the
present. Interest rates, influenced by physical productivity of
capital and monetary conditions, measure the trade-off be­
tween present versus future consumption.

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

substitution of an indirect tax, such as a VAT, for a
direct tax would tend to increase a nation’s exports
and reduce its imports, given that other factors affect­
ing trade remain substantially the same. This is be­
cause the price to foreigners could be more attractive
within a framework imposing a VAT than one involv­
ing a direct tax.

SUMMARY
This article has discussed the concept of a value
added tax. Its main purpose, however, has been to
illustrate some of the necessary, but often overlooked,
ingredients for analysis of any tax proposal. To ana­
lyze the consequences of any tax change, the accom­
panying monetary conditions and the change in the




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amount of one or more of the possible uses of the
revenues must be considered.
Two basic points made in this article are: (1 ) the
consequences for income distribution, economic
growth, and the international balance of payments of
a VAT substitution in the tax structure depend largely
on what happens to prices; (2 ) the effects on prices
of the imposition of a VAT in place of another tax
depend to a considerable extent on monetary condi­
tions — the rate of growth of the money supply and
the velocity of money — and on the price-impact of
an alternative tax or other use of funds. In contrast
to some widely alleged consequences of a VAT, it is
noted that a VAT need not be followed by inflation
or greater inequality of income distribution.

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