RDP 1978-01: Two Essays in Monetary Economics 6. Concluding Remarks

The material discussed in this essay leaves little doubt that monetary disturbances have important implications for the economy. While there are a variety of channels by which this can occur, a strong case can be made that a disequilibrium real balance effect on expenditure has a key role in the transmission mechanism. This effect is conditional only on a stable long run demand function for money, and combines with the notion that money is a buffer stock to explain why recent instability in money demand functions estimated in the conventional way may be due to misspecification of the dynamic structure of economic models.

If money is a buffer stock, excess money is likely to spill into asset as well as goods markets; such spillover effects provide an explanation for the direct influence of excess money on the balance of payments which has been detected in several studies. It must be noted, however, that the channels by which this occurs are not yet fully understood in terms of reactions of individual economic agents. The direct effect on the balance of payments is reinforced by the indirect effects operating through the influence of excess money on expenditure.

There is relatively little work on the effect of monetary disequilibrium on the prices and yields of assets, although an interesting study by Artis and Lewis (1976) suggests that this channel may be important.^[1] This channel would provide an explicit link between the direct and indirect effects of excess money discussed in Section 2, and further evidence about the interactions of domestic variables and the balance of payments.

The direct effect of excess money on domestic goods prices reported in studies with recent data provide a further indirect channel whereby monetary disequilibrium influences the balance of payments. This channel seems only to be important in recent years, and may be due to a change in the way in which price expectations are generated under the post-Bretton Woods system in which exchange rates are encouraged to adjust to correct disequilibrium in the balance of payments. As with the balance of payments adjustment mechanism, this channel is not yet widely researched and further work is necessary to increase our understanding of it.

If future work verifies the importance of this link in the transmission mechanism, it would provide further impetus towards the reconciliation of closed economy and open economy macro models. In the short run, the economy would act as if it were closed, with domestic price and output reactions to an increase in the money supply tending to offset the direct monetary effects on the balance of payments, by raising the demand for money. In the longer run the outcome would depend on what happened to the exchange rate. If it remained fixed excess money would be removed through the balance of payments as output returned to its equilibrium value and prices adjusted towards the long run values determined by world prices. If exchange rates were flexible, the price adjustment would not be constrained by considerations of purchasing parity, excess real balances would be eliminated by domestic inflation, and the economy would act as if it were closed even in the long run.

A final point which should be emphasised is that the most appropriate definition of “money” has received little or no explicit research in the framework of dynamic analysis discussed in this paper. Existing results have been obtained with a variety of measures, from “base money” to relatively broad definitions such as “M3”, and the basic insights appear to be relatively robust with respect to alternative measures. It is to be expected, however, that further work in this area will increase our understanding of the way in which monetary disturbances interact with economic activity.

Footnote

Also relevant is the study by Cagan (1972) of the time profile of response of nominal interest rates to increased money. For a view of the transmission mechanism emphasising changes in relative prices, see Meltzer (1977). [1]