RDP 7704: Money and Money–Income: An Essay on the “Transmission Mechanism” I. Introduction

It is now widely agreed that variations in the quantity of money are an important cause, some would argue a dominant one, of variations in money income, and particularly of those variations which are long sustained over time.^[1] There can be no ignoring the simple but undeniable fact that during the last decade it has been those countries which have paid the most attention to the behavior of their money supplies that have suffered the least from instability in money income, and those which have paid the least attention to monetary policy that have experienced the most instability in money income. Nevertheless, the subject matter of this essay, the nature of the causative links between money and money income—the “transmission mechanism”—is still controversial. Until recently, questions about the transmission mechanism were treated as mainly empirical in nature. Debates were about quantitative rather than qualitative matters, and were carried on in terms of a common theoretical structure. That structure was usually one form or another of the IS-LM model, which proved extremely flexible in its ability to accommodate opposing points of view as to how the macroeconomy operated. Disagreements thus seemed susceptible to resolution in terms of empirical tests designed to throw light upon one or another of the parameters of such a model. It provided an agenda for empirical research in macroeconomics, whose results were expected to lead to, among other things, a consensus on the role of money in the macroeconomy and hence on the appropriate design of monetary policy.

To give but one well-known example, much of the debate between Friedmen and his critics (Gordon (1974)) was conducted in terms of IS-LM analysis and from that debate there seemed to emerge a consensus that the issues between the participants were quantitative rather than qualitative in nature.

Quantitative knowledge has certainly grown rapidly in recent years. However, it is the contention of this essay that recent research has not so much filled gaps in our knowledge about an agreed theoretical framework, as it has cast doubt upon the usefulness of that framework as a research agenda. In particular, research on price-output interaction, on the consequences of fiscal policy for the behavior of the money supply, and on questions prompted by the openness of certain economies, has emphasized the influence of expectations about price level behavior on the activities of economic agents. This research will be discussed in some detail below, and it will be argued that it should lead us not just to reassess the answers to questions about the transmission mechanism, but to rethink the questions themselves. This is not, perhaps, a conclusion that all would accept, and a good deal of recent work has been cast in traditional IS-LM terms. It would give a misleading impression of the current state or knowledge to ignore such research. I shall begin with an account of it but, because there already exist at least three recent surveys of various subsets of this work, this account will be reasonably brief.^[2]

Footnotes

Meltzer (1977) in particular stresses the importance of distinguishing between the effects of sustained changes in the rate of monetary expansion, on the one hand, and of once and for all real shocks on the other, when analyzing the causes of variations in the inflation rate. [1]

See Fisher and Sheppard (1974), Fisher and Sparks (1975), Gc,odhart (1975), Ch. 9. Note that taidler (1971) provides an earlier survey. [2]