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Monetary theory

Valavanis (1955), echoed by Ackley (1961) and Tsiang (1966), interpret this
result as leaving room for a separate Cambridge or Fisher equation representing determination of the absolute price level. According to Valavanis (1955,
pp. 356–61, 366–7), the mirror image excess-demand function for money,
instead of describing decisions and behavior regarding money, just passively
reflects commodity-market behavior; hence it is not contradicted by a quantity
theory equation grafted onto the system. Valavanis contends (in Tsiang’s
paraphrase, 1966, p. 334n) that the mirror image function is ‘totally different
from the kind of demand for money shown in the quantity equation’. Valavanis
and Tsiang apparently mean that the commodity functions describe what are
fundamentally supplies and demands occurring as if in a barter economy, with
money a mere lubricant of exchanges, and that it is pointless if not downright
illegitimate to infer a mirror image function for money from the commoditymarket functions.
Accepting for the sake of argument Patinkin’s interpretation of the mirror
image condition implied by the homogeneous commodity functions as saying
that no particular price level is necessary for monetary equilibrium and that
any absolute price level will do if relative prices are correct, the Valavanis camp
replies that the additional Cambridge or Fisher equation ‘selects’ from the innumerable price levels compatible with the mirror image the one particular price
level that provides equilibrium for a given quantity of money (see, in particular,
Ackley, 1961, p. 123). At that price level the quantity of money is just adequate,
especially in view of institutionally determined transactions ‘needs’.
All this is a misconception. The contemplated mirror image equation, which
sets the excess-demand function equal to zero to specify monetary equilibrium,
leaves no room for selecting out a specific price level. It does not say that any
price level will do as far as it itself is concerned and that further information is
necessary to specify the equilibrium price level. Instead, it flatly denies that
any particular price level characterizes equilibrium. Selection of a particular
equilibrium price level contradicts and does not merely supplement the mirror
image. It is no answer to dismiss the mirror image equation as a mere armchair
implication of the commodity equations. If these equations refer to human
decisions and desired market behavior, then anything they mathematically imply
must do so just as fully. How can people’s behavior regarding money be affected
by the absolute price level unless their behavior regarding supplies and demands
for other things is also affected by it? After all, each transaction involves not
only money but also some other thing.
Rather than accept homogeneous commodity excess-demand functions whose
mirror image implies indeterminacy of the absolute price level, we must realize
that the excess demands for commodities do indeed depend to some extent on
the absolute price level, given the quantity of money, and not merely on relative
prices. An equivalent statement is that those excess demands also depend on the

For now. The most that could be made of the distinction would be to conceive of the Cambridge or Fisher equation as a sort of simplification or condensation of the correct mirror image equation.Patinkin’s monetary theory 161 real money supply. These real ‘givens’ determine the dependent real variables: relative prices. useful when one does not wish to apply the full general-equilibrium analysis to price level determination. 180–81). This situation is comparable to the case presented earlier in which the real-balance effect appears in the bond market but not in the commodity markets. Though containing less detail. pp. Then the corresponding mirror image excess-demand equation for money does not imply indeterminacy. then prices would be determinate. A VALID DICHOTOMY Patinkin recognizes one valid dichotomy: the equilibrium values of relative prices. then the absolute price level would still be indeterminate – for the reasons given above. On the other hand. for exclusion of the real-balance effect from the commodity markets is unrealistic empirically. an arbitrary doubling of all prices would disturb equilibrium in the bond market. The analysis divides into two stages. p. forcing prices back down to their original level. the interest rate and the real money supply. starting from general equilibrium. In the second stage the nominal money supply determines – again in the special sense explained below – the absolute price level. that equation would neither contradict nor supplement the mirror image equation. tastes and resources are the independent real variables. As Patinkin argues (1965. which in turn would lower the demand for commodities. . and technology also in a model of an economy with production. The resulting excess supply of bonds would raise the interest rate. Properly formulated. An increase in the quantity of money does not disturb any of the equilibrium real values determined in the first stage. In the first. But as Patinkin argues (1965. the interest rate. 180). if the absolute price level appeared as an argument in the bond excess-demand function. and any supposed distinction between it and an additional monetary equation simply vanishes. the two equations amount to the same thing and cannot contradict each other. this variation of the dichotomy is also unacceptable. if the model of the invalid dichotomy were expanded to include bonds and if the bond excess-demand function were also homogeneous of degree zero in prices. while it raises the price level equiproportionately in the second stage (given the assumptions of the quantity theory). and the real quantity of money are independent of the nominal quantity of money and can be determined – ‘determined’ in a special sense explained below – even without knowledge of it.

starting from equilibrium. as in Figure 5. one more equation. Doubling the price level makes the individual holder want a nominal cash balance less than twice as large as before.) Similarly. the curve was a rectangular hyperbola. That level is simply the ratio of the given nominal money supply to the real money supply determined in the first stage of analysis. (‘Determined’ in this special context means ‘calculated’ or ‘made calculable’. Doubling the money supply leaves the equilibrium values of relative prices. The valid dichotomy is purely conceptual. and so – until prices change – does the real money supply. Patinkin notes. so prices must double to restore real balances to their initial equilibrium level. The valid dichotomy recognizes that given all this information. Actually. since the real and monetary independent variables are ‘specified’ simultaneously in an actual economy. notes Patinkin (1965. The invalid dichotomy states that given all the commodity and bond equations and the money supply. believed that the demand for nominal money as a function of the inverse of the price level had uniform unitary elasticity. but it serves as a vehicle for exposing and resolving some confusions that also spawned the homogeneity postulate and the invalid dichotomy. the demand curve for nominal money is steeper than a rectangular hyperbola. and halving the price level makes him want a nominal cash balance more than half as large as before. the absolute price level is already determined. 173). UNIFORM UNITARY ELASTICITY OF DEMAND FOR MONEY Many neoclassical writers. Doubling or halving the price level reduces or increases the desired real balance. p. We assume that people’s taste for real balances has not changed. an elasticity of (minus) 1. the money supply doubles. a distinct monetary equation. Evidently they envisaged alternative vertical money supply curves intersecting it for equilibrium price levels. The reason for this result in the individual experiment is that doubling the price level reduces the purchasing . its elasticity is less than 1 in absolute value. It is a simple ratio and therefore no monetary equation distinct from the mirror image is necessary or even permissible.11. the nominal money supply ‘determines’ the absolute price level in the second stage. Again we use ‘determined’ in the special sense of ‘calculated’ or ‘made calculable’. is needed to determine the absolute price level. This issue of elasticity is not important in its own right. the interest rate and the real quantity of money unaffected.162 Monetary theory Suppose that. These variables are ‘determined’ apart from the nominal quantity of money: they can be calculated from sufficiently detailed equilibrium equations without knowledge of this quantity.

The market demand function is conceptually generated by totaling the quantities of money that all holders would desire at each of the different conceivable price levels. its holder must economize on various uses of his income or wealth. We also restrict our analysis to Patinkin’s narrow view of the real-balance effect as a wealth effect. including even the holding of real cash balances. presumably has an elasticity less than 1 in absolute value with respect to the purchasing power of the money unit. This point about elasticity helps clarify and emphasize the distinction already introduced between individual experiments and market experiments. The lessthan-unit-elastic money demand curve describes an individual experiment. Halving the price level makes a money-holder wealthier and able to afford somewhat larger allocations of wealth in various directions. and being thus slightly impoverished in real terms. Anyway. .Patinkin’s monetary theory Purchasing MD power of the dollar (reciprocal of the price level) MS0 163 2MS0 1/P0 1/2P0 Stock of money demanded and in existence Figure 5. realistically. including a larger allocation to his real cash balance. the market demand curve for nominal cash balances. In addition. (We assume. for reasons already explained. like the individual demand curve. this function generally depends upon not only relative prices and total real income and wealth (including real cash balances). that real money holdings are a normal as opposed to inferior good.) So far we have been considering an individual holder’s demand for money.11 Uniform unitary elasticity of the demand for money power of a nominal cash balance. but also the distribution of income and wealth among members of the community.

In summary. the demand curve for nominal money . its total real purchasing power is the same. On the other hand.12 The market-equilibrium curve for money Curve EE is a rectangular hyperbola. the market-equilibrium curve portrays the result of a series of conceptual market experiments.164 Monetary theory Quite distinct from it is a market-equilibrium curve. This characteristic of EE simply illustrates the rigid quantity theory but does not prove it.12 the market-equilibrium curve EE joins the points of equilibrium of alternative supplies of money and their corresponding demands. Whatever the nominal quantity of money. Although desirable in principle. the further to the right the demand curve appears. In the present case. even though the latter does. It shows that the equilibrium purchasing power of the money unit is inversely related to the quantity of money. the stock of actual cash balances does enter into the real wealth of economic units at each price level and does affect their demands for various things. which portrays the strict quantity theory and does have unit elasticity. even including cash balances. In Figure 5. Clarifying the distinction between a demand curve for cash balances and a market-equilibrium curve helps us see that the former curve does not have unit elasticity. that is. it has unit elasticity. Purchasing EE power of the dollar (reciprocal of the price level) MS1 MS2 MS3 MD1 MD 2 MD3 EE Stock of money demanded and in existence Figure 5. it is not always possible to keep supply factors and demand factors in separate categories. Awkwardly enough. Yet it is useful. the position of each money demand curve depends in part on the actual money supply: the larger the supply.