Patinkins monetary theory

145

wealth away from creditors toward debtors, making creditors economically

weaker and debtors economically stronger in expressing their tastes in market
transactions. Unless the tastes of the two groups happen, by fantastic coincidence, to be similar in just the right way, not merely the price level but also the
pattern of relative prices undergoes at least some change. Perfect indexing of
all debts to prices in the first place would avoid these particular distribution
effects. Other distribution effects occur because increases in the quantity of
money cannot occur uniformly in practice. Some people receive the new money
relatively early or benefit from a lag in price increases of things they buy behind
those of things they sell; others suffer in opposite positions. In other discussions, such effects are important; but Patinkin justifiably abstracts from what
are mere fringe complications for his exposition of the bare logic of the quantity
theory. The complications of reality can be better understood through
comparison with the extreme case of their absence.
In his comparative statics, Patinkin does not assume that the real or nominal
flow of spending on commodities is proportional to the total of real or nominal
money balances held. Those propositions are true, but they follow as conclusions instead of being needed as assumptions. The distinction between
individual and market experiments helps clarify this remark. In the individual
experiment, people do not necessarily exercise demand for commodities in
proportion to their holdings of real or nominal cash balances. A doubling of
the money supply, ceteris paribus, would probably not exactly double desired
nominal spending. In the market experiment, however, we increase the money
supply and inquire into the nature of the new equilibrium position. The resulting
change of prices in proportion to money, with relative prices and real quantities
remaining unchanged, means that all nominal money magnitudes, including
total purchases of commodities evaluated at their money prices, change in the
same proportion (see Patinkin, 1954, pp. 1478). This proposition is a result,
not an assumption, of the analysis.
Patinkin also needs no assumptions about the strength of the real-balance
effect. How strong the upward pressures are that an increased nominal (and
temporarily increased real) money supply exerts upon commodity prices is
unimportant to the comparative statics. Those pressures might be feeble and
work slowly. They might even work only indirectly, through the interest rate,
as in the unrealistic case of a commodity demand function lacking any realbalance term. Even so, prices would not come to rest before reaching the level
that made actual and demanded real quantities of money equal again at their
original level. The question of how quickly and easily a new monetary equilibrium is reached is different from the questions of comparative statics.
Just as Patinkin need not assume any specific strength of the real-balance
effect in the commodity market or any specific form of the commodity demand
function, so he need not assume any specific form of the demand-for-money

146

Monetary theory

function. For example, he can recognize the influence of the interest rate on
the demand for money. It is no paradox to say that the quantity of money
demanded depends on the interest rate but that the interest rate does not depend
on the quantity of money. The first proposition relates to an individual
experiment, the second to a market experiment (see pages 11314 above). When
a change in the quantity of money has completed its effects, the interest rate will
have returned to its original level and so will not lead people to demand real
balances different from those initially held. (Compare pages above in which
we allude to temporary changes in the rate during the adjustment process.)
Patinkin can also recognize motives beyond the transactions-precautionary
motive for holding money even in equilibrium. Contrary to what Keynes seemed
to suggest (1936, pp. 2089), it is not necessary to rule out the speculative
motive in equilibrium. People may indeed hold idle cash balances. What is
important is that they be concerned with their real sizes.
Finally, it is unnecessary for Patinkin to assume away rigidities as such. The
assumed absence of money illusion already rules out, for example, workers
stipulating for wages in nominal terms instead of being solely concerned with
real wages. It rules out anyones insisting on a particular nominal price for a
commodity regardless of other prices.
Now we must explain money illusion and its absence. People suffer from
it if their behavior depends in some respects on the mere numbers the nominal
money magnitudes attached to the real situation confronting them, quite apart
from what those numbers mean for the realities. If, for example, all prices,
incomes, holdings of money and other financial assets, and all debts should
double in nominal money terms, leaving relative prices, real incomes, real
money holdings and all other realities quite unchanged, and if people nevertheless altered the real quantities of things that they attempted to exchange on
the markets, they would be suffering from money illusion. People are illusionfree if a change affecting neither relative prices, the rate of interest, real income,
nor the real values of money holdings and other assets and debts leaves all real
aspects of economic behavior unchanged, the only difference being the height
of the nominal money magnitudes attached to those unchanged realities. People
free of illusion will react to real changes, including changes in real cash
balances, whether brought about by a change in the nominal money supply or
by a change in the absolute price level.
Of course, people are not totally free of money illusion in the sense defined;
and it helps in understanding the concept to review the bits of illusion that do
exist in reality such as the requirement for reporting automobile accidents
causing damage above a stated dollar amount and the income tax brackets
formerly (before indexing) defined by dollar amounts. The relevance of Patinkins
analysis depends only on peoples being essentially free of money illusion, with
its real-world examples making the analysis fuzzy only at the fringes.

Patinkins monetary theory

147

If people are substantially free of money illusion, a change in the quantity of

money not directly matched by a change in the demand for it must lead,
somehow, to a corresponding change in the price level. Similarly, a change in
the real purchasing power quantity of money demanded (perhaps because of
real economic growth), if not satisfied by a change in the nominal quantity of
money, must cause a change in the price level. Otherwise, people would be
holding larger or smaller money balances than they desired and would be trying
to adjust them in the way described by Wicksell. Pressures would be at work
on the price level until it had risen or fallen enough to make people content,
after all, with their nominal money holdings.

THE PROCESS UNDERLYING THE QUANTITY THEORY

By now we have gone beyond comparative statics. Patinkin examines the
process of response to a changed quantity of money. He assumes that output
remains at the full-employment level, leaving prices as the variable that
responds. Figure 5.1 represents the real aggregate demand for commodities as
depending on real balances and other variables. Line 0, as well as the similar
lines in shifted positions, slopes upward from left to right to represent the real
Real
aggregate
demand
per time
period

1
B
2
C
0
A

F(Y, M/P, r)

45
Y0

Figure 5.1

Aggregate real output

per time period

Aggregate real output and alternative demands for commodities

148

Monetary theory

demand for output as depending partly on real income itself. Line 0 represents
the aggregate demand function for the initial nominal and real money balances.
A vertical line at Y0 reflects the assumption of full-employment output. Point
A portrays initial equilibrium between aggregate demand and output.
Now the government engages in deficit spending financed by issuing new
money. The shift of the F( ) function line to position 1 represents the strengthening of real aggregate demand. Distance AB represents excess demand in the
commodity market. Next the government discontinues its deficit spending, and
aggregate demand falls to position 2. It does not yet fall all the way back to
position 0, since the already issued new money remains in circulation; and since
prices have not yet risen fully in proportion, real balances are larger and are
making the demand for commodities stronger than in the initial situation. Excess
demand of AC remains and exerts continuing upward pressure on prices.
Eventually, though, prices rise enough to reduce real money balances to their
initial level, and commodity demand is back in position 0. So precise an
outcome is an oversimplification, of course; but the points being made about
the nature of the process remain qualitatively valid. In actuality, the government
deficit spending would itself be a change in the realities of the situation, and it
would cause distribution effects.
If the rise of prices were at one stage to overshoot the mark, then real balances
would be lower than initially, and negative excess demand for commodities
would bring the overshot prices down to their new equilibrium level.
In principle, the interest rate enters into the adjustment process. Before prices
have caught up with the expanded money supply, people want to unload their
excessive real balances not only in buying commodities but also in buying bonds.
Their actions depress the interest rate, which further stimulates the demand for
commodities in accordance with the F( ) function. But as the rise in prices
continues to erode real balances, it also reverses the strengthening of demand
for bonds that had temporarily depressed the interest rate, which now recovers.
A stage in the adjustment process is barely conceivable at which prices have
not yet fully responded to the increased nominal money supply but at which
the increased real balances are being fully demanded, quite in accordance with
the demand-for-money function, because the interest rate is depressed (temporarily). With the demand for and supply of money again in equilibrium, why
doesnt the process simply come to a halt? The answer is that the monetary
equilibrium is merely a partial equilibrium. The bond and commodity markets
remain out of equilibrium. In particular, the depressed interest rate continues
causing excess demand in the commodity market. Prices and the rate undergo
further change, disrupting the temporary and partial monetary equilibrium.
Monetary equilibrium in this model cannot be fully restored except as part of
a general equilibrium of all markets.

Patinkins monetary theory

149

As noted on pages 102107, an excess demand for commodities matched

solely by an excess supply of bonds but not of money, as in the above partial
monetary equilibrium, is paradoxical. If such a situation did occur, the flexibility of bond prices and interest rates would tend to come into play, eliminating
any excess supply of bonds unaccompanied by an excess supply of money.
Moreover, the situation is implausible for another reason: how can a low interest
rate stimulate the demand for commodities if people are frustrated in getting all
the loans they want at that rate? (Recall that an excess supply of bonds is
equivalent to an excess demand for loans.) Ordinarily we think that a low rate
is stimulatory because it indicates cheap availability of credit, but things are
different if the low rate is a disequilibrium rate and credit is in short supply. Realistically, any excess demand for goods would be accompanied by at least some
excess supply of money, even if along with an excess supply of bonds as well.

PATINKINS DIAGRAMMATICS
Figure 5.2, presented earlier as Figure 4.1, includes lines (not necessarily straight
ones) representing pairs of price level and interest rate that equate supply and
demand for each of the three composite goods into which we now aggregate all
Interest
rate
Money
XSC
XDB
XSM
XDC
XDB
XSM
XDC
XSB
XSM

XSC
XDB
XDM

Bonds

XSC
XSB
XDM
XDC
XSB
XDM
Commodities
Price level

Figure 5.2

Conditions of equilibrium