RDP 1978-01: Two Essays in Monetary Economics 2. The Transmission Mechanism in General Terms

Recent developments in the monetary economics of the open economy have been initiated largely by H.G. Johnson and R.A. Mundell but they are harking back to a much older tradition exemplified best in the writing of David Hume. Hume stressed the tendency for the balance of payments to vary to equalise “somehow” the supply of money with the demand for money. Hume was agnostic about the possibility of understanding in detail the “hundred canals” whereby excess money flowed out of small open economies but was not agnostic about whether this would occur.^[1] An analogy can be drawn with the proposition that, in a closed economy, doubling the money stock will, eventually and approximately, double the price level. Prominent modern monetary economists, notably M. Friedman, appear similarly agnostic about the possibility of understanding in detail how the process occurs.^[2] Hume's analysis also includes the effect of an increase in the domestic money stock on domestic activity and prices, increasing imports and decreasing exports to produce a loss of international reserves. In this process reserves would be redistributed and prices would tend to equalise throughout the world economic system. The causation was from a monetary disturbance to domestic prices and the balance of payments and then to prices in the rest of the world^[3] and although later contributions include discussion of the capital account of the balance of payments, they do not alter the basic emphasis.

As recently as the “Treatise on Money” this view was standard among economists. Keynes included in the “Treatise” a lengthy discussion of the effects of Spanish Treasure on European prices, acting by a profit inflation and taking a long time to work its way through the system, and his other historical examples illustrate the point equally clearly. When the Depression of the 1930's shifted the emphasis to quantity adjustment, inflation theory lost favour and models of balance of payments adjustment downplayed price effects and substituted relatively mechanical multiplier analysis. This change in theoretical emphasis occurred at the time when macroeconometric model building became feasible, and has had a pervasive and long lasting influence on the large models used for forecasting and policy analysis. In the British case, to take an influential example, beliefs about zero or low price elasticities in international trade and payments were invoked to explain the continued balance of payments deficit following devaluation of the pound in 1967, and served to distract attention from the enormous domestic monetary expansion occurring at the same time. Ironically, when the International Monetary Fund insisted on quite severe monetary contraction in 1969 as a condition of further assistance, British economists asserted that the system was at last moving up a postulated “J-curve” in the balance of payments, i.e. finally responding to the devaluation induced change in relative prices.

The post-war resurgence of inflation has of course led to renewed interest in monetary economics. In the open economy case the modern contribution has stressed direct world price effects far more than Hume and his successors. For example., modern monetary models focus on the tendency for prices to move together throughout the world without necessarily involving trade or capital flows. Direct price effects (including a tendency for interest rates to equalise) lead to a view of the world with more rapid adjustment of prices in different countries than envisaged by Hume and the earlier writers. Much of the initial work in this area is presented in Frenkel and Johnson (1976), and consists of simple theoretical exercises and preliminary empirical tests of the basic propositions suggested by the theories. One important contribution is Johnson's widely cited article “The Monetary Approach to Balance of Payments Theory” (1972) which focuses on the long run in which domestic inflation rates equal the world inflation rate, domestic interest rates equal world interest rates and real income can be assumed to be given, and in this model an exogenous increase in domestic credit leads to an offsetting decrease in international reserves. Such models ignore the short run dynamic responses of prices and incomes which are of vital concern to the policymaker, and provide no reconciliation with standard payments models or received inflation theory. Some of these gaps are now being filled, however, especially with respect to the short run domestic effects of monetary disturbances, and this emphasis becomes especially important when exchange rates are more flexible.

Jonson and Kierzkowski (1975), Laidler (1975), Mussa (1974) and Parkin (1972 and 1974b) emphasise respectively the effect of disequilibrium in the money market on goods markets, the interrelationship of price and quantity adjustment, interest rate effects and the dynamic effects of differing rates of domestic credit expansion and unequal rates of growth in different sectors in models with traded and non-traded goods. Much of this work is surveyed and extended by Johnson (1975), who introduces non-money assets (“bonds”) and further disequilibrium effects. These modifications reintroduce domestic effects of monetary disequilibrium and help to reconcile the new approach with existing views of adjustment mechanisms. Even in the fixed exchange rate case induced price and output effects tend to soften the effect of monetary disequilibrium on the balance of payments, at least in the short run. Thus, for example, if an expansion of domestic credit raises the price of non-traded goods and increases consumption and output, it will be likely to raise the demand for money and other domestic assets and produce a less than proportionate effect on international reserves.^[4] These effects will be eroded in the longer run as, for example, a rise in the price of non-traded goods draws resources away from export industries and reduces reserves and the money stock.

Standard neo-Keynesian econometric models have incorporated monetary effects operating through interest rate changes, wealth effects on consumption and “availability” or credit rationing effects.^[5] Significant interest rate effects on investment are fairly well accepted, but appear to operate with relatively long lags. Wealth effects are usually empirically minor and somewhat suspect theoretically with a high proportion of money in modern economic systems consisting of inside or interest bearing money (similarly the wealth embodied in government bonds may be offset by future tax liabilities). Availability effects also seem theoretically and empirically unimportant

Footnotes

Hume (1955) “Of the Balance of Trade” p.77. [1]

Although Friedman has been highly influential both in carrying out and stimulating detailed empirical-historical studies and also in spelling out in qualitative terms the underlying process envisaged, as in Friedman and Schwartz (1963 a and b). [2]

Hume (1955) “Of Money” pp. 37–39. [3]

This provides an interpretation of the offset coefficients estimated by Kouri and Porter (1974) and Porter (1975) in a simple model of capital flows. [4]

Fisher and Sheppard (1972) provide a lengthy survey. A further and more critical discussion of the state of the art is given by [5]