RDP 1978-01: Two Essays in Monetary Economics 3. Output Effects of Monetary Fluctuations

The output effects of domestic monetary and other stabilisation policy changes are perhaps less controversial than the implications for inflation and the balance of payments. In both closed and open economy models, there are a variety of channels by which changes in government spending or taxation policy, changes in interest rates or wealth, or in the availability of credit, can work to change output in the short run.^[1]

In his Economic Theory in Retrospect, Blaug (1968) identifies the interest rate, or indirect channel for the effects of money on real economic activity, and thus on prices, with the writings of Thornton, Ricardo, Mill, Wicksell and Keynes. According to Blaug, these writers largely ignored the direct channel emphasised by Cantillon, Hume, Marshall, Pigou, Robertson and Patinkin.^[2] It is clear from the discussion that both traditions were in terms of a disequilibrium effect, in the sense that the economy was believed eventually to return to the original real equilibrium following a monetary disturbance.

Among those writers who thought in terms of a direct monetary effect on aggregate expenditure, there is some ambiguity about whether wealth (“Pigou”) effects are being considered, or what could be called disequilibrium real balance effects. Since this has econometric implications of considerable relevance for the analysis of economic dynamics, it is worth setting out two simplified consumption functions to make the distinction clear. The first is a version of the conventional consumption function, with real wealth (w) as well as current income (y) as a determinant of desired consumption . Actual consumption is assumed to adjust to desired consumption with a lag represented by a first order proportional adjustment mechanism.^[1]

With the substitution of real money balances (^M/_P) as a proxy for wealth, as in many early studies of “the” real balance effect, the following estimating equation is obtained:

This can be contrasted with the following equation, which includes a disequilibrium real balance effect:^[2]

The conventional^[3] estimating equation corresponding to this is as follows:

Comparing equations (4) and (6), it is clear that the dynamics of adjustment are different in each case, as illustrated by the fact that the coefficients on each right hand side variable (except for the lagged dependent) are different. In equation (6) the parameter on income is lower than in equation (4), reflecting the fact that in the second specification a rise in income increases the demand for money, as well as increasing desired consumption, and this means that the short run effect of changes in income on consumption is less in the second case.^[1]

The majority of econometricians have assumed that the relevant “direct effect” is a wealth effect of the sort suggested by equation 3, even though a considerable proportion of modern “money” is interest bearing. This is indicated, for example, by Patinkin (1965) in his appendix M on “Empirical Investigations of the Real Balance Effect”, where equations analogous to equation (4) above are criticized since “they give the impression that it is real balances per se which influence consumption, instead of real balances as a component of total wealth”.^[2]

There is however a tradition, especially among the earlier writers mentioned above, to distinguish clearly a disequilibrium real balance effect of the sort implied by equation 5, Thus for example, D.H. Robertson writes;

“In the face of a progressive rise of prices and reduction in the real value of money stocks … people would try to restore the real value of their money balances, and a Consumers' strike would take … place … “.^[1]

Blaug is equally explicit:

“It was a commonplace of classical analysis that an increase in the quantity of money affects prices directly through its prior effect on demand: the increase in money in receipts generates an increase in the outflow of expenditures because people are satisfied with their existing holdings of cash balances”.^[2]

In A Theoretical Framework for Monetary Analysis, Friedman makes it clear that a disequilibrium real balance effect on expenditure is a crucial element in his view of the transmission mechanism:

“For monetary theory, the key question is the process of adjustment to a discrepancy between the nominal quantity of money demanded and the nominal quantity supplied. The key insight of the quantity-theory approach is that such a discrepancy will be manifested primarily in attempted spending, thence in the rate of change of nominal income”.^[3]

With price adjustment relatively sticky in the short run, the change in nominal income implies a transitory change in real output.

It must be stressed that a disequilibrium real balance effect will be relevant whether or not “money” is net wealth; all that is required is that the private sector has a determinate money to income ratio and that disturbances from the supply side of the money market occur. Recent evidence, obtained from dynamic models including expenditure functions analogous to equation (5) rather than equation (3), suggests that a disequilibrium real balance effect on expenditure is quite important.^[1] This evidence is in some ways more consistent with the view of the adjustment mechanism represented by writers such as Cantillon, Hume, Robertson and Friedman than with what is probably the current majority view which stresses wealth effects.

The question arises whether both wealth and disequilibrium real balance effects might be relevant. As noted in section 2 it is possible that a whole vector of asset disequilibrium effects would be relevant in a general dynamic model, although there are reasons why monetary disequilibrium might be expected to have a particularly important role which makes this variable a prime candidate for inclusion in econometric models. The inclusion of real income in defining desired consumption (as in equations (3) and (5)) could adequately proxy the scale effect of real wealth in models with a longer run orientation.^[2] It is perhaps in models seeking to explain closely short run fluctuations that wealth effects in the markets for bonds and real capital might need to be included in addition to income effects on expenditure, and these can be allowed for by adding further asset disequilibrium effects to equation (5).

Whatever the relative weight of the various mechanisms by which output effects of domestic monetary and budgetary policies occur, many economists believe that they are strong but transitory. In the long run the growth of output is constrained by the sort of structural factors considered in neoclassical growth models, but in the short run output will rise as a result of expansionary policies, particularly those which produce excess money balances. The converse to this is that there is no long-run trade-off between inflation and unemployment.

A crucial issue for policy analysis, how long is the long run, is the subject of considerable disagreement. Friedman has advanced the view that the output effects of expansionary monetary policy begin to show up within six to nine months, and that full adjustment can take decades.^[1] In the large macroeconometric models, such as the M.P.S. model of the U.S. economy, it appears that output returns to its equilibrium level following an increase in the money supply only “in the very long run”.^[2] In a version of the RBA76 model of the Australian economy, the influence on the growth of output of three different monetary impulses initially peaks after 1, 2 and 6 quarters, depending on the source of the monetary disturbance. As illustrated in the simulations presented in Jonson and Butlin (1977) from which these results derive, the response of the model is cyclical, but largely damped after ten years. In contrast to the results from empirical analysis, economists who are exploring the implications of “rational expectations” have devised models in which expansionary policies (for example) do not have even a short-term effect on output, and long-run equilibrium is achieved instantaneously.^[3] The conditions necessary for these models to be of direct relevance do not seem to be applicable to the real world, although the general issue of the interaction between policy rules and the reactions of economic agents is of considerable relevance, especially in the longer run.

Footnotes

As noted above, Fisher and Sheppard (1972), Brainard and Cooper (1975) and Laidler (1977) provide surveys of the extensive literature in this area. [1]

The basic distinction between direct and indirect effects is drawn by Blaug (1968) on pp.154–5, where he identifies Thornton and Ricardo with the “indirect mechanism” and Cantillon and Hume with the “direct mechanism”. On pp. 158–9, Ricardo and Mill are added to the list of writers concerned mainly with the “indirect mechanism”, and Wicksell's contribution is discussed on pp.619–626 This discussion is followed by one in which Keynes' approach is compared with that of Wicksell. Marshall's emphasis on the direct mechanism is documented on p.619. [2]

All parameters are assumed to be positive. [1]

The income elasticity of desired consumption in equations 3 and 5, and of the demand for money in equation 5, are constrained to be unity for analytic simplicity. In a macroeconomic model which contains other equations it is possible to investigate whether unitary income elasticities of demand are supported by the data, although there are theoretic reasons, relating to the steady state requirements of models, for assuming that they are unity. [2]

The word “conventional” is used here, since a minority of econometricians would write the theoretical equations in continuous time and estimate a discrete appropriation to the underlying differential equation, as discussed, for example, in Bergstrom (ed.), (1976). [3]

If the usual interest rate effects on and are included, a similar statement can be made about the net short run effect of a change in interest rates. [1]

Patinkin (1965), p.655. [2]

Robertson (1963), p.450. [1]

Blaug (1968) , pp.154–5. [2]

Gordon (1974), p.51. [3]

See the evidence for Australia presented by Jonson, Moses and Wymer (1976), and for a variety of countries in the forthcoming book on the work of the International Monetary Research Program, edited by Swoboda, Mussa and Wymer (1978). [1]

Especially if income is defined as permanent income. [2]

Friedman (1970, 1972). [1]

Modigliani (1975), p.241. [2]

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