A Brief History of Monetary Disequilibrium

On numerous occasions I have outlined, for lack of a better term, monetary disequilibrium theory. The core of this approach is that monetary equilibrium can be expressed by a modified equation of exchange:

mBV = PY

where m is the money multiplier, B is the monetary base, V is velocity, and PY is nominal income/expenditure. The monetary base is determined by the central bank, the money multiplier reflects changes in the demand for the components of the monetary base — currency + bank reserves — and velocity represents changes in the demand for a more broadly defined monetary aggregate.

This equation is an equilibrium relationship that holds regardless of the determination of variables. In other words, it holds whether money is exogenous or endogenous. Nonetheless, this equation essentially summarizes the determination of nominal income, or more specifically, the price level in the context of a broader general equilibrium framework. One can articulate a model with an asset market with equilibrium conditions for the the supply and demand for currency, bank reserves, deposits, and other monetary assets as well as capital. In addition, there is a goods market that summarizes production decisions. The equilibrium relations in the asset and goods market determine the real variables of the system. The equation of exchange then closes the system by determining the price level.

Put simply, the classical dichotomy suggests that real variables are determined by other real variables and that nominal variables are determined by other nominal variables. In other words, to understand the role of money and nominal income, we can focus on the equation of exchange because it closes the system.

Now, there could be two objections to this proposition. First, one might argue that the classical dichotomy is false because money is not neutral — whether in the short-run or the long-run. Second, one might argue that such a dichotomization is irrelevant as it abstracts from reality.

On the second point I will simply quote the late Jurg Niehans (1978: 9 – 10):

The worst that can be said about the dichotomy is that its proponents were not quite clear about what they did and thus could not explain it to the satisfaction of scholarly critics. What they, in fact, accomplished was a conceptual partitioning or decomposition of the general equilibrium system, logically akin to the Slutsky decomposition of the effect of price on demand and many decompositions in other sciences. Such a decomposition does not occur in the real world; it would require a controlled experiment under artificially imposed conditions. these condition require that certain things are held constant that, in reality, are variable. In the Slutsky decomposition this artificial constancy relates to real income (in defining the substitution effect) and relative prices (in defining the income effect). In the neoclassical dichotomy it relates to excess demand for money (in the real part) and relative prices (in the monetary part). While Slutsky’s substitution effect is “income compensated”, the real part of the neoclassical system is “cash compensated.” To reject the neoclassical dichotomy on the ground that cash compensation does not take place in the real world is analogous to a rejection of the Slutsky decomposition on the ground that income compensation does not take place in the real world. Microeconomics did not sink so deep.

In addition, on the first point, I will point out that indeed it is my belief and I think that of virtually all others familiar with monetary disequilibrium theory that money is not neutral — at least in the short-run. As a result, fluctuations on the left-hand side of the equation of exchange will effect nominal income through effects on both the price level and real production. However, since the focus on this blog — as well as those of Scott Sumner, David Beckworth, Bill Woolsey, and others — has been on the collapse of nominal income, the classical dichotomy is a useful device for simplifying the analysis. In fact, introducing some sort of friction, like sticky prices, would bolster the case for preventing monetary disequilibrium as it would necessarily imply a division of the changes in nominal income between prices and real GDP.

In other words, even in a world of fully flexible prices and neutral money, fluctuations in the supply and demand for money cause changes in nominal income. As a result, those who subscribe to monetary disequilibrium theory often advocate stabilizing nominal income. (It also doesn’t hurt that there is also substantial disagreement about how fluctuations in nominal income are divided between prices and output.) In addition, this simplifying assumption allows us to focus solely on the equation of exchange even when we extend the analysis to the case of sticky prices.

With these (important) theoretical points out of the way, we can now discuss fluctuations in nominal income solely in the context of the equation of exchange. As articulated in the equation of exchange and given the theoretical assumptions above, changes in the demand for base money, changes in the demand for assets contained in broader monetary aggregates, and changes in the supply of base money cause fluctuations in nominal income. Under the assumption of money neutrality — even if its only long-run money neutrality — these fluctuations correspond with changes in the price level.

If one extends this analysis by using the assumption of sticky prices, then fluctuations in the supply and demand for money can have real effects. Again, Friedman and Schwartz implicitly adopted this framework in (1963a, 1963b) and more explicitly in (1982). In “Money and Business Cycles”, they summarized the causes of several major economic depressions as follows:

1875-78: Political pressure for resumption led to a decline in high-powered money, and the banking crisis in 1873 and subsequent bank failures to a shift by the public from deposits to currency and to a fall in the deposit-reserve ratio.

1892-94: Agitation for silver and destabilizing movements in Treasury cash produced fears of imminent abandonment of the gold standard by the United States and thereby an outflow of capital which trenched on gold stocks. Those effects were intensified by the banking panic of 1893, which produced a sharp decline, first in the deposit-currency ratio and then in the deposit-reserve ratio.

1907-8: The banking panic of 1907 led to a sharp decline in the deposit-currency ratio and a protective attempt by banks to raise their own reserve balances, and so to a subsequent fall in the deposit-reserve ratio.

1920-1: Sharp rises in Federal Reserve discount rates in January 1920 and again in June 1920 produced, with some lag, a sharp contraction in Federal Reserve credit outstanding, and thereby in high-powered money and the money stock.

1929-33: An initial mild decline in the money stock from 1929 to 1930, accompanying a decline in Federal Reserve credit outstanding, was converted into a sharp decline by a wave of bank failures beginning in late 1930. Those failures produced (1) widespread attempts by the public to convert deposits into currency and hence a decline in the deposit-currency ratio, and (2) a scramble for liquidity by the banks and hence a decline in the deposit-reserve ratio. The decline in the money stock was intensified after September 1931 by deflationary actions on the part of the Federal Reserve System, in response to England’s departure from gold, which led to still further bank failures and even sharper declines in the deposit ratios. Yet the Federal Reserve at all times had the power to preven the decline in the money stock or to increase it to any desired degree, by providing enough high-powered money to satisfy the banks’ desire for liquidity, and almost surely without any serious threat to the gold standard.

1937-8: The doubling of legal reserve requirements in a series of steps effective in 1936 and early 1937, accompanied by Treasury sterilization of gold purchases, led to a halt in the growth rate of high-powered money and attempts by banks to restore their reserves in excess of requirements. The decline in the money stock reflected largely the resultant decline in the deposit-reserve ratio.

Along these lines, the points that David Beckworh, Scott Sumner, Bill Woolsey, and myself have been trying to make — whether implicitly or explicitly — is that monetary disequilibrium theory applies to the current situation. Declines in velocity and the money multiplier — increases in the demand for money — have put downward pressure on nominal income. The Fed has increased the monetary base substantially to offset these fluctuations, but not sufficiently. There is a consistent pattern throughout monetary history of the causes of sharp reductions in nominal income. That pattern is an excess demand for money.