The services of money

65

observed quantities as approximations to intended ones. Things are different

with money. It is not intentionally bought and sold in the same way that ordinary
commodities are. Instead, it functions as a medium of exchange and constitutes buffer stocks that individual holders are rather passively willing to let
build up and run down within only fuzzy limits of amount and time. People
are willing to accept additions to their cash balances brought about by the
monetary authoritys purchase of securities or foreign exchange without having
actually demanded (or intended) those additions in the first place. What touches
off a time-consuming process that eventually makes people demand the
increased quantity of money is the monetary disequilibrium caused by that
increase. The following chapters elaborate on this process. These considerations warrant doubt that the actual money supply always closely approximates
the quantity demanded.

NOTES
1. Compare Morgan (1965, pp. 478).
2. Yeager (1998) examines the close analogy between language and money and cites others
who have made this observation.
3. Moini (2001) views money as an abstract right. For that reason it possesses value. He distinguishes between money and the medium of exchange. The latter is the monetary instrument
used to record and convey information concerning these rights. Kocherlakota (1998)
recognizes the record-keeping role of money, which acts as a societal memory.
4. We recognize that the macute as an abstract unit is a historical myth, not a historical fact. See
Shah and Yeager (1994, p. 449), which also cites Schumpeter (1970, pp. 223, 35) and
Sommer (1929).
5. We use the term determinate in the sense of Patinkin (1965). The opposite of determinacy
would leave the price level and quantity of money unanchored and adrift, with a rise or fall
more likely to reinforce rather than restrain itself.
6. Swedberg (1991, pp. 812) recognizes the importance of the critical figure in Schumpeters
book (Shah and Yeager, 1994, p. 450n).
7. Shah and Yeager (1994) elaborate on Schumpeters views. They apply his analysis to the
unique monetary regime of Hong Kong, which prevailed from 1974 to 1983. That system
lacked a critical figure and therefore ultimately collapsed.
8. Hicks (1967) makes this distinction in The Two Triads. The first triad is three functions
that money performs for the economy as a whole. The second is three services of a cash
balance or an individuals three motives for holding money. How many functions and services
a particular economist distinguishes is, of course, somewhat arbitrary.
9. Mises (1912 [1934] [1981]) was one of the pioneers in applying utility theory to analysis of
the demand for money. As a pioneer he left some gaps and inconsistencies in his formulation.
A fundamental contribution that has heavily influenced our exposition is Hutt (1956).
10. This notion of balancing the costs of economizing on cash balances against the earnings on
funds otherwise invested is a key element in Baumols (1952) and Tobins (1956) theory of
the demand for transactions balances.
11. Building on Savings article, McCallum and Goodfriend (1987) present their shopping time
model. Like Saving, they include only consumption and leisure in the utility function. Real
balances enter only indirectly.

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12. The IRD can also be thought of as the marginal rate of time preference (see Chapter 10). It
should not be confused with the internal rate of return, which is the rate at which a projects
net present value equals zero.
13. Pages below explain why changes in the money supply may not affect the equilibrium interest
rate. For this reason we say transitionally. Furthermore, we abstract from any increases in
output. Our main concern is to show how an increase in the money supply can upset peoples
portfolios and thereby affect spending and prices. Later chapters discuss how changes in
nominal income are split between changes in output and prices.
14. Trescott (1989) argues that the augmented portfolio balance view typically found in the
literature is different from the view in which changes in the money supply directly affect
spending. He calls this latter view the disequilibrium real-balance effect.
15. The portfolio-balance effect is based on Zecher (1972). In section 2 Zecher spells out the
conditions for equilibrium: MER = IRD. While he does hint at the direct operation of the
portfolio-balance effect, he clearly embraces the indirect portfolio-adjustment model found
in the literature in section 5, which deals with how changes in the money supply affect
spending and unemployment.
16. When Greidanuss The Value of Money first appeared in 1932, his yield theory was an
important contribution, tying several loose ends together. Yet the book made little splash,
and even the second edition, in 1950, drew bad reviews. Readers were apparently not prepared
to read the book sympathetically enough to cope with awkward writing (or an awkward translation from the Dutch).
17. Krugman (1998) helped revive interest in the liquidity trap. Mired in a decade-long stagnation,
Japan allegedly fell into the trap since the nominal interest rate reached zero, its lower bound.
Monetary policy interpreted as a lowering of the interest rate thus became impotent. Pages
1379 below examine this episode.
18. This formulation spells out some hints provided by Patinkin (1965, pp. 225 and 349).
19. Economie et Intrt. The argument is scattered over approximately pp. 30070 of volume 1
and pp. 54090 of volume 2. Tobin, in a better known article (1965 [1979]), developed a
similar though less detailed argument. In Chapter 8 we consider some counter-effects or
overriding effects of inflation that obstruct capital formation.
20. Also see Moss (1976, pp. 1349).
21. Garrison (1981, pp. 7781 in particular) has persuasively argued that the theorem is not otiose.
22. Selgin (1994) recognizes the issues raised here. Selgin (1987) traces various errors in monetary
theory to failure to understand moneys yield.
23. Baumol and Tobin (1989) credit Allais (1947) for having already spelled out the essence of
their inventory-theoretic model of the transactions demand for money, although at the time
their articles were published neither was familiar with Allaiss model.

3. Moneys demand and supply:

equilibrium and disequilibrium (1)
INTRODUCTION
Monetary equilibrium and disequilibrium figure among the most important yet
most misunderstood concepts of money/macro theory. Money in excess supply
or demand can have momentous consequences for the economy. When the
actual quantity of money exceeds or falls short of the total of cash balances
demanded at existing prices, things happen that tend to restore equilibrium
eventually. Instead of adjusting promptly to their new market-clearing levels,
many prices and wages are sticky, and for reasons that make excellent sense
to individual price-setters and wage-negotiators. Consequently, adjustment in
the short run involves quantities (output, real income and employment) rather
than prices alone.
Throughout we emphasize the interdependence of nonclearing markets and
the role of prices and wages in achieving or obstructing coordination. Our
analysis fills a void mentioned by Robert Gordon (1990b, pp. 11378) in his
exposition of new Keynesian economics:
An interesting aspect of recent U.S. new-Keynesian research is the near-total lack of
interest in the general equilibrium properties of non-market-clearing models. That
effort is viewed as having reached a quick dead end after the insights yielded in the
pioneering work of Barro and Herschel Grossman (1971, 1976), building on the
earlier contributions of Don Patinkin (1965), Clower, and Leijonhufvud...Much newKeynesian theorizing is riddled with inconsistencies as a result of its neglect of
constraints and spillovers...

For purposes of exposition we divide monetary-disequilibrium theory into

two components. The first focuses on disequilibrium between the demand for
and supply of money and explains moneys role in determining nominal income.
The second component, disequilibrium economics, explains how and why
changes in nominal income first show up as changes in quantity and only later
as changes in price. It builds on the contributions of Patinkin (1956, 1965),
Clower (1965 [1984], 1967 [1984]), Leijonhufvud (1968, 1981), and Barro and
Grossman (1971, 1976) mentioned in the passage above. We integrate elements
67

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Monetary theory

of both components thoughout as we concentrate on processes rather than

simple mechanics. Chapters 6 and 7 are specifically devoted to disequilibrium
economics, while this and following chapters take up the important issue of
monetary disequilibrium.
Four Assumptions
Four assumptions are crucial in this chapter. First, we suppose that the stock of
money, narrowly defined as media of exchange, is under the control of the
monetary authority. Admittedly, the authority might not use its power actively.
It might passively allow the quantity of money to drift under the influence of
production, prices and other conditions. For example, it might behave in
accordance with the real-bills doctrine (reviewed on pages 23940 below). Still,
such behavior would count as money supply policy. Inappropriate use of its
power would not belie the authoritys power over the money supply.
Second, our analysis presupposes either a closed economy or an open
economy with a floating exchange rate. An international monetary standard
such as the classical gold standard or pegged exchange rates removes the money
supply from the firm control of the domestic authority. The demand for nominal
money can then affect the actual quantity through the balance of payments, as
this chapter and Chapter 9 explain.
Third, we sharply distinguish actual money from nearmoneys that do not
circulate as media of exchange. Nearmoneys include noncheckable deposits in
financial intermediaries (Chapter 1 mentions some other examples). Institutional changes in the United States have made the distinction less sharp than it
once was. Still, maintaining it will help the reader understand past conditions.
Moreover, most of the discussion still applies to our current system.
Fourth, we assume the reader has some knowledge of the basics of money
and banking, such as the money creation process.

THE UNIQUENESS OF MONEY

The actual medium of exchange is distinctive in ways seldom fully appreciated. The differences between it and other liquid assets may be unimportant to
the individual holder, yet crucial to the economic system. An individual may
consider certain nearmoneys to be practically the same as actual money because
he can readily exchange them for it whenever he wants. But microexchangeability need not mean ready exchangeability of aggregates.
Certain assets do and others do not circulate as media of exchange. No
reluctance of sellers to accept the medium of exchange hampers anyones
spending it. The medium of exchange can burn holes in pockets in a way that

Moneys demand and supply (1)

69

nearmoneys do not. Supply creates its own demand, in a sense specified later,
more truly for the medium of exchange than for other things. These are observed
facts, or inferences from facts, not mere a priori truths or tautologies.
In comparing the medium of exchange with other financial assets, we must
go beyond asking what determines the amount of each that people demand to
hold. We must also consider the manner in which people acquire and dispose
of each asset and implement a change in their demand for it.

EQUILIBRIUM AND DISEQUILIBRIUM

Equilibrium means balancing. Demand equals supply in the sense explained
below, and no pressures are working to change prices and other variables. In
the sense that markets clear, the plans of different people mesh. People meet
no frustration in carrying out transactions they desire at the prevailing prices.
Disequilibrium means imbalance, discoordination of plans, and the frustration
of some desired transactions. Some variables are under pressure to change.
We say the economy is at full-employment equilibrium when it is at
potential output and no excess or deficiency of aggregate spending exists. Total
demand equals potential output or supply and not just actual output. Patinkin
(1965, p. 321), makes the crucial distinction between supply and output. In
the depths of depression, actual output is held down to the actual amount
demanded, yet an excess supply of goods prevails. Firms desire to supply more
but cannot find willing buyers at the going price level. Widespread frustration
persists among firms, who put downward pressure, weak though it may be, on
prices. In the analogous case of an excess supply of labor in depression, the
amount of labor actually carried out is limited to the amount demanded.
Frustrated (unemployed) workers put downward pressure on wages, which
again may be weak. Depression therefore is a disequilibrium as explained on
pages 945 below.
Full-employment equilibrium differs from the Walrasian general-equilibrium model in which all markets are clearing simultaneously. Such a
full-fledged equilibrium is of course a mere analytical concept, not a condition
found in actuality. Because we recognize that most markets are not perfectly
competitive and do not clear rapidly, some disequilibrium occurs on the micro
level even at full-employment equilibrium. But no deficiency or excess of
aggregate spending exists. Furthermore, no cyclical unemployment occurs
although some structural and frictional unemployment may be present. Most
importantly, at full-employment equilibrium, monetary equilibrium prevails in
all the senses mentioned in this chapter.
As Clark Warburton has argued (for example, 1966, selection 1, especially
pp. 267), a tendency toward market-clearing is inherent in the logic of market