Money in an open economy 265

The devaluation automatically raises the domestic price level, which creates
an excess demand for money and hence the payments surplus. On the other
hand, we have argued on pages 245–6 above that the payments surplus resulting
from the devaluation may be part of the process that creates an excess supply
of money, with its inflationary consequences.
A similar story applies to the case of imported inflation. The strong version
of the MABP completely neglects the monetary channel of imported inflation.
Instead, it focuses solely on the direct-price-transmission channel. As in the
case of devaluation, it is higher prices (imported from abroad) that cause an
excess demand for money and hence a payments surplus. We conjecture that
it is the failure to recognize that massive surpluses were imposed on countries
in 1971 and again in 1973 that led to widespread misdiagnoses of the
breakdown of the Bretton Woods system and of the acceleration of worldwide
inflation that followed (see Rabin, 1977; Rabin and Yeager, 1982 and pages
258–60 above).
Advocates of the strong version of the MABP believe that the domestic
money supply is always ‘demand-determined’. They thus commit the same
errors as those economists who argue that when the monetary authority pursues
interest rate targeting, the money supply is always demand-determined (see
pages 118–20 above).
The strong version of the MAXR is analogous to the strong version of the
MABP. It too is a theory that happens not to be generally valid. It unequivocally
associates a currency’s depreciation on the foreign exchange market with an
excess supply of money and an appreciation with an excess demand for money.
While these associations may be typical, they are not necessary. Rabin and
Yeager (1982) provide counterexamples to the strong version of the MAXR as
well as to the strong version of the MABP. (In several of his articles and in his
book of 2002, Norman C. Miller also recognizes the errors of the strong

1. This definition accords with the ‘official-reserve-transactions’ (ORT) concept.
2. See Yeager (1976b, pp. 651–2) for a full discussion of these points. Dorn (1999, p. 314)
recogizes the argument presented here. Kenen (2000, p. 113) notes that ‘a system of stable but
adjustable exchange rates’ is an oxymoron, since ‘stability is incompatible with adjustability’.
3. Yeager (1976b) documents Germany’s struggle against imported inflation from the early
1950s until the system’s demise.
4. The international currency crises of the 1990s have spawned an enormous literature. Flood
and Marion (1998) present a technical review of this research, some of which dates back to
the early 1980s.
5. Under the Bretton Woods system, rate fluctuations of one percent on either side of the peg
were allowed, but in reality they were usually held to 0.75 percent. The Smithsonian agreement
of 1971 widened the permissible range to 2.25 percent on either side.

140) attributes the variability in exchange rates to the wider variability in inflation rates among countries. p. 69) also recognizes this point 9. p. 72) correctly identifies the system as an ‘engine of worldwide inflation’. p. Greenfield (1994. . 7. to what was going on’. 10.266 Monetary theory 6. maybe over-reaction. p. Triffin (1966) diagnoses the contradictions inherent in the system. Meiselman (1975. but ‘all asset-price models based on underlying fundamentals work poorly’. 8. He points out that trying to maintain fixed rates under these conditions would have posed major problems. Friedman (1999. He views this exchange rate variability as a ‘necessary reaction. especially the conflict between the liquidity and confidence problems. Taylor (1995) reviews the literature on exchange rates and notes that most models cannot forecast better than the random walk. 41) argue that not only exchange rate models. Flood and Marion (1998.

We do not claim that this view of the interest rate is the only valid one. that interest is the price paid for an inde- pendent and elementary factor of production which may be called either waiting or use of capital. He put this use on a par with other factors of production. according to the point of view from which it is looked at’. land.[W]aiting is a genuine scarce factor of production. broadly interpreted.J. What factors determine the interest rate? What functions does it perform in a market economy? While it is convenient to speak of ‘the interest rate’ as well as of ‘the wage rate’. he obtains advanced availability.. as basically a real phenomenon and addresses the following two questions. and clear up certain puzzles by resurrecting the view that the interest rate is the price of ‘waiting’. Eucken (1954).R. ‘once and for all. 370) ‘reaffirmed the reality of waiting as one of the primary factors of production. a factor of production. INTEREST AS A FACTOR PRICE We can simplify capital and interest theory. Waiting has the dimensions of value over time. we recognize that in reality no single rate of either kind prevails. Interest rate theory This chapter views the interest rate. Dorfman (1959. Fisher (1930 [1955]). co-ordinate with labor.1 Cassel (1903 [1956].. 367. The approach we take here is compatible with other approaches to the interest rate (for example. Böhm-Bawerk (1959). compare Chapter 2).2 Waiting so conceived enables the person demanding or acquiring it to devote productive resources to his own purposes sooner or on a larger scale than he otherwise could.. etc. pp. 67) regarded it as settled. Yeager (1994b) cites the contributions of the following to interest rate theory: Allais (1947). Hirshleifer (1970) and Wicksell (1934). A. Waiting is the service performed by holding financial and physical assets instead of selling them and devoting the proceeds to current consumption or to other current exercise of command over resources. We invoke the distinc- tion made in Chapters 1 and 9 between an approach and theory.The unit of waiting [may be taken as] one unit of consumption deferred for one unit of time’. tie it in better with general micro theory.. p.10. Turgot noted over two centuries ago that the interest rate is ‘the price given for the use of a certain quantity of value during a certain time’. Cassell (1903 [1956]). The person who supplies or 267 .

liquidity and the like. (Compare the portfolio-balance condition for equilibrium in Chapter 2. In other contexts. ‘the cost of capital’. Waiting can be supplied or performed and demanded or avoided in many ways besides granting and obtaining loans.268 Monetary theory performs waiting postpones the use for his own purposes of resources over which he could have exercised current command. provides deeper understanding of the logic of a price system by applying that logic to a challenging phenomenon. ‘shortage of capital’. particularly those concerned with what the interest rate is a payment for and what its functions are. substitution. Some economists old and recent. as factors of production and not to probe more deeply or theorize more abstractly. have denied that waiting is a distinct productive factor. is a matter of convenience in each particular context (see pages 41–2 above). such as a borrower. labor – like waiting – is not always irksome.) Consider business firms deciding whether to buy automobiles or rent them. . it is helpful to regard it as a factor price and probe into the factor’s nature. The buyer of the service. more generally. ‘the capital market’. It helps show what sort of opportunity cost the interest rate measures and. In some respects waiting is an unfortunate term. It helps us bypass the supposed need to distinguish between goods that do and goods that do not properly count as physical capital. and arbitrage tend to make waiting performed by lending. by holding an investment in capital goods or in land. it is idle to argue over whether the thing whose price is the interest rate is or is not ‘really’ a productive factor. apparently not seeing that the supposed issue is spurious. The higher the interest rate on loans in relation to rental charges. even including Irving Fisher. But the term ‘labor’ runs into similar embarrassments. In some contexts it is convenient to regard machines. Despite what the term suggests. Competition. and just how to conceive of the production function itself. he is paying someone else to do waiting for him. demand and derived demand. or their services. It figures in explaining how international trade in goods can tend to equalize interest rates internationally like other factor prices. Their doing so will tend to reduce loan rates and increase rates of return in the car rental business. The buyer is not performing labor but paying someone else to perform it for him. To interpret capital as waiting gives intelligible meaning to such familiar phrases as ‘interest on capital’. It does not describe the service bought and sold equally well from both the buyer’s and seller’s points of view. Actually. It enlists familiar concepts of supply. What to count as inputs into a production function. It permits handling the odd case of a negative interest rate. is not acquiring waiting but avoiding it. and by acting in other ways all bear the same net rate of return – with obvious qualifications about risk. and ‘international capital movements’. the less firms will borrow to buy cars and the more they will rent them. buildings and other capital goods.

The house occupier’s own influence on the general level of interest rates should be about the same in the two cases. the greater the borrowing to buy cars and the less the volume of renting. A firm employing capital goods in its operations is playing . If. A firm that itself finances its holdings of capital and intermediate goods while it awaits their ripening into salable products is thereby contributing to the aggregate supply of waiting as well as to the demand. again tending to bring the interest rate on loans and rental charges in relation to the values of cars into an equilibrium relation. This precept warns against forgetting the literal and ‘narrow’ definition of the interest rate as the price of loans. conversely. It also illuminates the pervasiveness and fundamentally ‘real’ character of the interest rate. having the lender perform the waiting. subject to qualifications already mentioned (again compare Chapter 2). Someone who rents a machine. He might rent the house. How changes in wants. WAITING FURTHER EXAMINED This section presents a few examples of the demand for and supply of waiting. An occupier of a house might demand waiting in two ways. Interest rate theory 269 Conversely. or technology affect such price relations should be explainable in terms of the explicit interest rate determined on the loan market and of substi- tution and arbitrage between loans and other forms in which people supply and demand waiting. One methodological point is worth mentioning. paying for its services month by month and letting the landlord wait to receive the value of those services over time. intending to become a renter when he returns. Our emphasis on the mutual determination of marginal yields illustrates the superficiality of theories that consider only the loan market. then his thriftiness adds to the supply of waiting and does tend to reduce interest rates. Alternatively. (We have argued throughout this book that the interest rate is not the price of money. then his behavior tends to raise interest rates. which by its very nature incorporates waiting. or else pays for the house out of already accumu- lated savings that would otherwise have been spent on current consumption. resources. But if he has become more thrifty and instead of renting a house buys one after saving to accumulate the purchase price or at least a large downpayment. The marginal yields (MERs) on bonds. land and all sorts of capital goods tend to become equal. is demanding waiting while its owner is supplying it. a house owner sells his house and spends the proceeds on a world tour. the lower the loan rate in relation to rental charges. the occupier might buy a house with borrowed money. money and liquidity preference.) No doubt only small portions of total supplies of and demands for waiting confront each other directly on the market for loans. equities.