Neoclassical Monetary and Cycle Theory Monetary Theory –Quantity Theory –Theory of monetary disturbances Quantity Theory (Fisher) –Irving Fisher –MV = PT –P is the passive element, V is a short term constant –Changes in M lead to changes in P

Neoclassical Monetary Theory Quantity Theory (Cambridge) –Cambridge Approach: Marshall –Emphasis on monetary demand or liquidity preference –M = PTk –M is money demand and k represents the demand for money balances as a proportion of the total monetary transactions –Demand for money very largely a transactions demand –Demand for a certain real balance

Say’s Law Say’s law part of Classical economics, but also adopted by many neoclassicals at least as a long run proposition Say’s law is the idea that there cannot be overproduction or underconsumption (in general) Tendency to equilibrium at full employment Basic idea is that all income will be spent –Savings become investment –People will not (generally) hold money except for transactions purposes

Say’s Law and the Real Balance Effect Can be departures from full employment equilibrium, but tendency to adjust back to full employment equilibrium Real Balance Effect (Direct mechanism) –Assume desire for liquidity increases or size of money supply falls –Money demand > money supply –People try to build up their money holdings and aggregate demand falls to below FE Agg supply –Price level declines

Say’s Law and the Real Balance Effect –Fall in price level increases the real value of people’s money balances, reducing money demand –This goes on until money demand = money supply and Agg demand rises back to = Agg supply at FE –Opposite sequence of events if desire for liquidity falls or money supply rises Also much discussion of other causes of fluctuations or cycles

Wicksell’s Monetary Theory of Cycles Based on the “indirect mechanism” through which monetary factors might have an effect Indirect as the mechanism works through the interest rate Distinction between real and market rates of interest Real rate of interest equates S and I (based on time preference and real rates of return), but is not directly observable Market rate of interest set by banks

Wicksell’s Monetary Theory of Cycles If the market rate is set below the real rate I > S and Agg D > Agg S Excess of I over private S is being financed by bank lending This bids up prices and factor incomes resulting in a cumulative upswing for as long as banks continue to lend When banks run out of excess reserves they will raise interest rates

Wicksell’s Monetary Theory of Cycles If market rate of interest is set above the real rate S > I and Agg S at FE > Agg D. This generates falling prices and factor incomes and a cumulative downswing for as long as banks are willing to accumulate excess reserves For stability need the market rate of interest to equal the real rate of interest

Neo-Wicksellian Cycle Theories: Hawtrey Hawtrey –Cycles can be explained entirely by monetary factors –Based on the operation of an international gold standard and metallic currencies or paper currencies backed by gold –Period of depression starts with high discount rates, a reduction in the active circulation of gold, and an increase in gold reserves –As gold reserves rise, discount rates fall and have a time of “cheap credit”

Neo-Wicksellian Cycle Theories: Hawtrey and Hayek –Gradual increase in employment and commodity prices –Decline in surplus gold reserves as gold drawn into circulation –Leads eventually to higher discount rates and growing unemployment and falling prices Hayek –Cycles due to divergences between real and market interest rates –But impact on the structure of production and overinvestment

Neo-Wicksellian Cycle Theories: Hayek –If market rate is below real rate then I > S –Borrowing demand for investment exceeds private saving –Bank lending to finance I bids resources away form consumption goods production –Higher prices for consumption goods leads to “forced saving” –Lengthening of the production period –Goes on until banks run out of excess reserves

Neo-Wicksellian Cycle Theories –This creates a crisis and unemployment –structure of production can only adjust back to compatibility with the level of voluntary savings slowly –People shed from capital intensive industries more rapidly than they can be reabsorbed For Wicksell, Hawtry, and Hayek monetary factors can affect real variables—more than just price level effects

Schumpeter’s Cycle Theory Joseph Schumpeter –Cycles due to real not monetary factors –Caused by innovation waves –Innovation in techniques, new trading opportunities, etc –New investment funded by bank credit leads to period of prosperity –Followers less successful and banks run out of reserves –Business failures and depression but a process of weeding out or “creative destruction”

Schumpeter’s Cycle Theory –Role of large firms and the incentive of monopoly profits –Dynamic rather than static efficiency –Schumpeter and the long run prospects of capitalism –Large corporations and the loss of entrepreneurial vitality

Debates Over Savings and Investment Many of the theories discussed talk about saving and investment, but these terms not always closely defined Keynes’s Treatise on Money 1930 –Defined I as the value of unconsumed output –S is income less consumption –Focus on price level stability

Saving and Investment –Savings and investment not brought into equality by interest rate adjustments –Investment decisions of entrepreneurs do not automatically match savings decisions by individuals –If I > S price level rises and increases profits and reduces real wages –This transfers income to capitalists with higher propensities to save until I = S

Saving and Investment Stockholm School –Distinction between planned and actual saving and investment –Ex ante: planned –Ex post: actual –Savings and investment can differ from each other ex ante but have to be brought into equality with each other ex post –If S > I ex ante, retailers find themselves with greater than planned inventories –This brings about a contraction in production until –S = I ex post