ers

The Model Extended. Full Employment

§. THe EXISTENCE OF A BANKING SYSTEM AND OF
FINANCIAL INTERMEDIARIES?® XI: 5 Macroeconomics

Our entire argument until thispointhas been based on the assump- (9) P=440.
tion that moneyis of the outside variety: thatis, representing or based p ‘
economic
on the debt of a unit (the government) exogenous to the In other words, the net financial assets of the private sector consist
system itself. Let us now take account of the fact that in reality most
aid

only_of theoutside money whichitholds: its inside money isoffset

the
money in a modern economy the type: that is, based on
ence of
debt of endogenous economic units. This in turn is a consequ _ Private Nonfinancial Sector
creation of a
the fact thatmoney in such an economy is largely the !
private baoking system." 7 0 mee :
Bondsissued by firms B
Money M r
In orderto fix olir ideas, let us divide the economy into three sectors:
the private Bt
the private nonfinancial sector (households and firms), Bonds held by households i Net worth pw
As the first step in the
banking sector, and the government sector.
sheets of these sectors are Tangible assets "pA
analysis, assume that the respective balance
as shown on p. 296. : BI
gross B
For the sake of concreteness, thefirst balance sheet records the M+ nm + pA —+pw
more elegant r
amounts of bonds issued and held, though it would be
debit side the net amount issued by the
merely to designate on the Private Banking Sector
set
nonfinancial sector (BY — B*). Bonds are‘assumedtobethesoleas B»
- ofthe _ ban banking system and money the sole debt of governm ent. By | :
dto be exo- a Money (demand deposits) M@’
definition,©’and M”are the respective quantities (agsiime Bonds held by banks
cial
genously determined) of inside and outside money. The nonfinan —-—- 1
sector1s assumed tobe indifferent.3510,whichofthestmoneysholds. Be
~
{
t M

Theneirealwealth of this sector is 5

By Bl Pi oi,
nea | GovernmentSector
<=

(1) of Wea AS geaceop"

Cumulated deficits on Money(hand-to-hand
ars

(and hence M’
where tangiblebssets A are assumed to remain constant current account D currency)
of the de-
ignored) throughout the subsequent discussion. Makinguse
rere

D M”’
finitions
(8) M=M +M" and Bl = B+ B, hy_acorresponding debt to the banking s stem.2? In accordance with
as well as the fact that B’/r = M’, this reduces to our usual practice—and disregarding the equilibrated labor market—
~~

we must then rewrite the system of equations of Chapter X:1 as

Gurley and Shaw's
26 The basic indebtedness of this and the following section to
(10) F(Yor , 2) = Yo
Me
on wir.

will be i Hh,
pathbreaking work on Money in a Theory of Finance (op. cit.)
.

e
Thave also drawn freely on my review article of this book in the American Economi \ Dp
Review, LI (1961), 95-116
a

—-—- 405.
27d
2? This was first pointed out b cki;> “Professor Pigou on the ‘Classical
Stationary State--—-A Comment,” Economic Journal, LTV (1944), 131-32.
prettr e

296
 i
x :5
nt SREays

: Full Employme “
AC

nded
The Model Exte ny
1 Ms\ Me
rp
p Ey
L(y ; Ms) ME
e ie . :
Macroeconomics

)those que
XU: 5
12 o D any of the goods,
the leveLof p
Heth

e €X0- he
antities which ar
for
- l de ma nd s
not affect the priv
ate rea demands for
subs cripts in di ca te
tion(1 1) re esent
pr im pact on the excess
thetwoterms.inequaancial and banking
ue of its
where the zero wh er e, is still determinat
e by vi rt
(say) departure of
the price level
rm in ed , and ' rd
genously dete
wa
part of the nonfin bonds and money.
Th us an up
pply of bonds—
the generate an excess su
cae oe
nd foTr bonds7 on a oe jevel will
.
se in-
dema
the neeeert erms the three eforiteeuiiorium excess demand for money—which will rai the
te role to each of ese roles i
ennateen e
ly:
sectors, respective as si gn s 2 se pa ra matc hed by an equa l and hence cause
commodities,
del

ew
th
The foregoing mo insideOn, TanEdRtoY tal. Then ature of
terest, hence redu
ce the demand for
level. In terms of Fi
gure XI-2,

oS
e, in its OwD e again to its ori al
gin
7

ti ti es : ou ts id carn
ap pe ar
e a
s ile wh
money quan mo ne y
price level to declin CC.is.2 horizontalline, ain in

cannes ae =
ti ty of
ferent. The Tot
al quan
the iquane tities of outside s. as ta aeembhonden Poet
bleone in whartedic
is, however, dif . In contrae st,e systemC d - ( 1 5 )i Sim ila rly , an d ag
ly si de of (1 2) entities:thatis, ndcurves.Jemai
n as there depicted.
right on the supp pr imary analytical thea a (say) decrease
are no t th em se lv es en to coincide . 1§-20, 44, 237),
and inside money E War isb les On ly "because they happ ts and with con tra st wi th ou r main discussion (pp
s the system (13)-(
5) not through the
ET asse ‘ neyinfluence
sry SepAT stem with the sum of net financial in the quantity of mo site and matching
changes directly
in g sy al l return to this 1: ro ug h the op po
in the fo re go
-respectively. W e sh
wealth effect, bu t th Graphically,
mand fo r bo nd s, a sup pli es of bonds and money.
the banks’ de (pp. 307f.). "generated in th
e exc ess and LL, which
the next section en Mj = Mo an
d
&8 equ al leftward shifts in BB
distin ct io n in
of th e outside type th ap - these changes ap pe ar
ntal co.28) 08)
ne y is
Clearly, if all mo (10)-(12) reduces to that of the pr
ec ed in g ch unchanged, horizo
site ex- again intersect on an neutral in both of
the foregoing cases.
Mj =9, 8° that
system t co ntext is the oppo say , mo ne y 3s
onomy with both
inside
, =O andthe
th e pr es en Needless to
terest to us in E , howeveTEN r, in anec
ters. Of more jn old
ily, an increa. se In
.

iyO B E T E = ity nee d eA nCe e T Saie SATOSET

can readily ver
npteeterF

treme aonire
: Spate ter
as the reader
For , yield a
?
ne y. :
or
te emetene eoeren®
and outsideTh moe . "
(10){12)ne eTwill not
duces to
el cia
y In sys tem
foregoing system
Pcyeerepadeerns
se typ es of mo ne OF sepeenre
aera
int erest,
only one of the tinichanged rate
of
ge mig eee eh

F(Y 1) = Yo:
s cmap
Jevelat’an
neyheppento
eet YET ERETE
increased price
:

n Ol wuisideranccinsideTo
propofti6 ately
(13)
THERETERNSDotOFaort
ft

B(Yo.5)* 7%
1

ion.”°
(4) increase in thesamePL ion alizes the interpret
ation of Keynes on
des
p. 264.
cribed
par agr aph rat y hav e bee n
28 Note how this s of a pur e inside-money econom hot omy issue
per tie he dic
L(Yo,7
=e: 29 The foregoing pro ug! wit hou te re reference tot val idi ty of the
w, tho On ‘the
by Gurley and Sha 81-82). See also the cécent emphasis. reprinting of
toeE the the
(15) i to
72- 15, igl ian
is that diche (op. cit., PP- attached by Mod
sy st em ty) e in the postscript ory of Interest and
rt y of th is
theee real (commodi dichotomy in this cas on “Liquidity Preference and the The t, Princeton, 1960),
A significant pa
changewhich tak ee\
inrara
AES Solelyeamr lary
Mod iani in SaeeMone
cle Haz
(ed. H.igl lit
RC Ge TE rT AL ta kes PA his well-known artitics of Keynesian Economics by
ecogenous
te re h
Portreeof nanos!
1a enous angewhic Money” in The Cri
been cynesian Jaborated
ana there
dis r maffr
efore TOTIEe ted by any exog pp. 183-84.This has
Real Phenomena,” Foolew
of Economies and
sectorT
ae
e— 1
w) sector. Furthermor Its Int era cti on.wi th
tary(bond and Te , and 251)— Mechanism and plement, pp. bi,83-88 of the
etofore (pp. 180,242
mone bed in our discussion tter in
place solelyin the
our ‘Si scu ssi on her e wealth SratisTes, RLV (i583); Supdynamic inconsistency descri
and in contrast with now stems from the assumption that th nt {rom
.no sma
| B
WHe Note how the type of -19) does not exist in the present case. for of the system
. dichotomization iste
nsIST ab
nt er se invalid dichotomy
(pp. 177 analysis, the stabilitynnre
l-balale rrism coONS
effect
nce ee ENy s we Carry out thepacenenave pe cege een
market
10 rm o of the reaalDa
three
in athe fo changes in p do whic h two of the te stean Veeeane mat tat gas oie
lity
an element of artifitciathe
effectr at this implies that
.
ia sp it e th e fa ct th * isconsistently at
r OUT res ent as sumptions there isult B tha re
at ets. Bu t de n un de of a
“SNBTETOOthat evey: ‘forit would disappear Simplya5 & res Jthatthe demand for
al]m EOTR ;
.
et: om , .8!
\ aboutthedichot nds, cackWier 1s OND,Tes “or Fetitn below. ae
297

are two types 0 footnote 39

oththeserates. CE aisu Johnson, '* Monetary Theory and
jes depen sonbcil
eo , PP- 82- 86. Ci. Its Interaction
Gurley and Shaw
, op. ism and
. “ Monetary Mechan
icy ,” op. cit . P- 342 and Modigliani,
Pol 87. unaffected
ena,” op. cil.. P- ne will eave CC
: with Real Phenom X1- 2, @ dou bli ng of inside money alo
In terms of Figure
— . 298
:
7
 XI: 5
The Model Extended: Full Employment
h assumes that °
Within the framework of the foregoing model—whic
two types of money are independently
the respective quantities of these XI: 5 Macroeconomics
rtion ate increa se would be highly coin-
determined—such anequipropo
has_not, however,be nized is
en recogCPOEUT that this demand ofthe banking system for bonds in equation (11) is now
repres-
.. efden tal _indeed.. What E ETI pee
istic one.. Thus, fOr ented by M'/p — M;/p, and the supply of money in equation (12) by
ereer arr mopar ES is

assumption of independence1s generally an unreal

r
Mf are x

ties “of money are M"|p + M'/p. Furthermore, the foregoing assumptionseffectively intro-
" example, in TaaRy "bankingystems these TWOquanti
significantly related by virtue of the fact that
also fulfils
outside money duce a new goodanalysis,hand-to-hand Currency, demanded by
the“functio n ofreserves (or reserv e-subs titute s) for the demand de- both banks and 1nanc} jor. By equations (16) and(17),
r

-. 2 eSRae
d, this" was a majo
meean

posits,whichconstitute the inside money. Indee the equilibrium condition for this goodis
in which the neoclassical
characteristic of the gold-standard world (t+ c)M' = Mo.
, it might well be that an (18)
economists were writing. Correspondingly

+eite.
money in such a system Assume for simplicity that equilibrium always prevails in the market
equiproportionate change in outside and inside
prece ding paragraph, but for hand-to-hand currency. Then—substituting from equation
(18),
is not the chance happening implied by the ph—
ionships. the precedin g paragra
the determinate consequenceof structural relat and taking account.also of the argumen t of
recon sider the balance sheet of
In order to bring out this pointlet us the system of equations (13)-(15) becomes
ion to holding bonds, this
‘the banking sector and assume that, in addit
sector also holds reserves in the form of outsi
de money My as a fixed
. (19) F(Your MSP a) = Yo.
ratio c of its demand deposits; that is,

(16)
4
M' =~ M;. (20) a(Yo, 5,rpMea) +o =
t+ec p

Let us also assume that the nonfinancial

sector maintains a constant
(21) (Yer ea) =
y (hand-to-hand currency)
ratio t between its holdings of outside mone
P t+c p

M® and demand deposits; that is," where the parameter « should for the moment be ignored.
-the
MistM'- The-foregoing equations.bring outthe crucial fact that, under
(ce
neoclassical assumptions of a fractional-reservebanking system which
not affect the representation nor that of
As the reader can readily verily, this does is always “ioaned up,” neither the volume of bank credit
m (10)- (12). On the other hand, the demand deposits is exoperduisly “deter mined. Corres pondin glyy, it is
of net financial assets in syste
the effects . of_(sa y)_ane xpansi on in M’
meaningless to inquire about
model—ignoring
upon the system. The only exogenousvariables of the
the
as far to the right; hencewit wentes
while shifting BB and LL less than twice ately . On the other
interest ratea nd increa sepric es less than propo rtion the quanti ty of outsid e money M"; the
equilibrium ren a
while again the parameter a—lare
e will shift CC twice as far to the right, ratio ¢
a:
hand, a doubling of outside money alon
ards to a lesser extent ; hence it will raise intere st while required reserve ratio c; an theCutrency-demand-deposit
shifting BB and LL rightw
pro ortionately. ae As can readily be determined from (19)-(2’ 1), a change in M.* will cause
again increasing thelevelthan chasing Power of Money(rev.
f een pee eTYR
from (18) we
a proportionate change 10 p, whileleavingrunaffected;
. J
assum ption s are Fai t Fishe r,Pur
"aI Hoth of these
Pigou, “The Value of Money," op. cit., other
ed., New York, 1913), pp. 50-51, and by also"See thatifwillchangeJ’ in the same proportion. On the
,
t—which by
hand, it should be emphasized that a change in either c or
pp. 165-66. demand
between hand-to-hand currency and
The assumption of a constant ratio and empiri cal study of the . vere
onate change in inside
.
istic. For a theore tical
deposits is, of course, highly unreal -its very nature does not cause an equiproporti
:

Demand for Currency Relative to the .°?

actual relationship, see Phillip Cagan, “The
Total Mone y Suppl y,” Journ al of Politi cal Econo my, LXV1 (1958), 303-28. and outsidemoney—will not have this neutral impact onthe system
by Guricy and Shaw, op. cif,
299 . 32 This is essentially the kind of change considered ;
‘
pp. 82-86.
300 :
The Model Extended: Full Employment XI: 5
Before leaving this subject we should note that theneutrality associa- Macroeconomics
XIT:6
ted g
With changeinTHequantityoFoutsidemoneynotdependenton e “Tiquid”) than the primary
the fixity of the ratios described by equations (16) and (17). It suffices a security which is more attractive (mor
owers. This increased liqui ny can
instead that the functional relationships between bank reséfVesand securities issued by the ultimate borr
an increase intneeae a
demand deposits, on the one hand,andcurrency and demand deposits, be represented in system (19)-(20) by
for bonds”upwards, an ; a at
on the other, be free of moneyillusion. This will becomeclearer from which is assumed to shift the demand ge in a on the deman
Chan
the discussion of the next section.” morfeydownwards.Ifthedirect ‘fectof the
the impact of aoe inter-
small,
Until now banks have been assumed to be the only kind of financial for commodities is assumed to be
te..can then be analyzed as on
institution. With the helpoftheforegoingsystemtheargument can, mediaries in reducing theinterestsa <= stills
however, be extended to other kinds of financial intermediaries: in- . 251-52 above.
surance cOmpaniés, savingsandloan associations, mutualfunds,and is also. possible to bring out the essential a
Pray speak somewhat
rmediaries.» Lo
Rw * .

betweenbanking and nonbanoking inte

7 : i
soforth.Thesé intermediaries canfruitfully be conceived as processing 7 “ye

iari és #0 n0m e ations

plants whose effective function it is to transform the bondsissued by loosely, both of theseinterme: th
ded and supplied. ut, from
firms into securities which the ultimate lenders (i.e., households) con- the terms on which bondsaredeman em does
e this
a
bofidm-s owa
equa —-Tn(20) a above
tion ve,, the banking systr
sider more suitable for their needs. Intermediaries are able to profit i potatofwna
view
and (as a resu ; ne
dem
from this transformation process by exploiting “economies of scale in through the second component of this 7 i
lute level of reserves or 7
lending and borrowing. On the lending side, the intermediary can invest genous change in either the abso h the au ae
and manage investments in primary securities at unit costs far below king intermediaries do $0 throug
ratio); whereas nonban
. Alternatively, in some a .
the experience of most individual lenders. The sheer size of its portfolio bonds, and hencethefirst component s of the mon ey
parison In term
permits a significant reduction in risks through diversification. It can familiar terms, we can make the com
that the bank ing system affects the economy by
schedule: maturities so that chances of liquidity crises are minimized. equation (21) and say ingi nter
g in unmediarie do
deshy
eas nonbankin
The mutual or cooperative is sometimes favored with tax benefits that changing the supply of money;; wher
money, andhence the
are not available to the individual saver. On the borrowing side, the so by changing «, hence the demand for ia
intermediary with a large numberof depositors can normally rely on a of circulation. Note, howe ver, that in both caeee
edDyWHE}Fesulting change in the
predictable schedule of claims for repayment andso can get along with a eri Sgenouschangesitt-velocity, caus
portfolio that is relatively illiquid.’’** inte rest rate.
Corre
In other words; theresult of déevéloping nonbanking financial inter-
mediaries(like that of improving distributive techniques in the securities G SYSTEM AND OF
market) is to ee ultimate lenders with the possibility of purchasing 6. THe EXISTENCE OF A BANKIN
ED)
FINANCIAL INTERMEDIARIES (CONTINU
to a pure inside-money economy
Let us now return, for simplicity,
Needless to say, nether system (19)}~(21)~-nor the more general one (10)-(12)—is
dichotomized.
b
of the —
and explore somefurther aspects
d that the quantity of inside
*3 The problems of a banking system have also been formally analyzed by Leif
Johansen, ‘The Role of the Banking System in a Macroeconomic Model,” Star- Tn system (AVIS) aboveit wis Assume
mption 1s hardly consistent
money is exogenously given. Such an assu
sokonomisk TiHessket (1956) as translated in International Economic Papers, No. 8
(1958), pp. 91-110. Johangen’sconcern,however,.is with.asystem.,whoseabsolute ing system, interest-
zfaire bank
price levelis fixed. Correspondingly, his analysisdeals ee diferentquestions. Sth the supposed operationsofalaisse
should be assumed that this system
See also Karl Brunner, “A Schemafor the Suppiy Theory of Money,” International ed in maximizing profits. Instead it
ndent on the real wage rate an
has 6 supply function for money depe
Economic Review, If (1961), 79-109, and the references there cited on’p. 79 footnote 2;
and Assar Lindbeck, A Study in Monetary Analysis (Stockholm, 1963), Chapters IV-VI,
considered constatitlithe present
34 Gurley and Shaw,op. cit., p. 194. the rate of interest. Since the formeris
301 198-99, 202.
's central theses; cf., op. cit., pp.
. 96 This is one of Gurley and Shaw
- 302
 The Model Extended: Full Employment ALL 36
discussion, we can then simply write

(22) M’=S().
P
If wesubstitute thisfunction in equations(14) and(15), we see that ry, Yielding a return
vs the price Jevelnolonger appears_as.@Variable ofsystem ({3)-(13),and market forces, determined by the
Correspondingly, the
balance shee

ee
henceobviously canriot be determined byit. Titdged, what we havehere Sector in the Preceding
section sho
is the indeterminacyofWicksell's ‘pure credit” economy. in, whichall follows:
matte NS,

" transactionsarecarriedout bychecks,whilebanks holdno reserves.*

The economic interpretation of this indeterminacy is straightforward:
In order for the absolute price,level ‘to be determined by market- Member Banks
equilibrating forces, changesin it must impinge onealbehavior in Reserves
R Money (demand depos}

>
some market—i.e., must create excess demands in some market. Now, Posits ‘
Bonds B aa
the joint assumptions ofa pure inside-money economy and the absence

SR ee
Oe
r
of distribution effects implies that there is no such impingement

21 yereneicsrhe ee te
on the real demands of the private sector for commodities, bonds, Be _
money, respectively. Similarly, the absence of reserve requirements R
+ =
; mi
(either legal or econgmic) impliesthat there is no impingement on the |
real demand andsupplyfunctions ofthe banking”sector.Hence’the Central Bank
economy does not generate resistanceto anyarbitrarychangein the
pricelevelAccordingly, there “is nothingto,prevent the frictionless Bonds 5:
flow of prices frori one Téveltoanother. Reserves R
In CONtFASt, ‘the ‘price level in system (19)-(21) aboveis determinate
_ because changes.in it impinge on the real value of the fixed nominal
quantity of outside money in the system and hence on the behaviorof

2
both the nonfinancial and banking sectors. An analogous resylt.can be
Gerived for the pure inside-money economy with Which we are now semene=aally that
member, banks are no
dealing BysiifiplyasSuiming that the banking system holds ‘reserves, — iene : en s, t subject to any,lega

Bats TY eweat AahoesShaEeSine a WE ae ON 6 Sin

but are Instead free l re-
-otay ae ees and to choose their opti
andthat the nominal quantityofthese reserves is exogenously.fixed.3” ’Habilities, inclusive
of reserves, As‘inthe
mum
In particular,~yssume thatthere exists a central bank which creates a eee ik tree case
s unit, thisdecision As

auestonwithhe? eleretveratanof raeoetnd ities

based ona cotiparison
reservessolelyBypurchasing bondsissued by firms. Assumealso that of
these reserves—which, by assumption, are more liquid than bonds—
i
dein ae oiite nee
’ terr return. since in the
yield a rate of return d’(lessthan r) and are heldonly bythemberbanks pti fon Tt o
foo to bear any lot
Present case
in order to meet temporary discrepancies between the flows of checksto erest, this means that
well as on other real variab
les (e.g,
38 See p. 594 below. present discussion are ass
ume d constant and hence
37 The following is adapted from the highly stimulating analysis developed by ingly, the system s rea ji &nored. Corres i) -
lsupply function of mo
Gurley and Shaw,op. cit., pp. 247-64 ney can now be ann
e
(23)
303 S(r a’), —s
38 Ibid,. pp. 257-58. -
|

|
|
 The Model Extended: Full Employment XI:6

and its real demand functionforreserves,

XII :6
(24) G(r, a’). Macroeconomics
bonds, money, and reserves. Notethat
the quantity ofmoney is not
im the private banking
the same. time, i system’s' supply of moneyisi exogenous to thissystem, but isdetermined endog
lee no longer identical with its demand for bonds. The latter is Petree: enously.hy supply
function (23). Correspondingly,expansion
or contraction of bank
~“tnstead now representedby, say, U(1/F,d’) where, by the banks’ con- credithencemoney) in thismodel cantake place
only as
solidated balance sheet, of a priorchangein’one-of the givenconditionsofthe syste a result
m.
} From a somewhat unrigorous examinationOfthéTor
(25) u (=,-,d')
1
a) = S(r,st, da’)5 — G(r, a’).
iF egoin
leanbeSeen thataniyarbitrarydeparture“theprice1evég system it
&) equillbininyWill "generate Correctivetharket forces, Thus,l“Troform ex-
its
Note that, in contrast with (16) above, the supply of money does not lample,arbi traryincreaseinpwill decrease the real supply ofrese
rves
explicitly dependon jhe quantity ofreserves. Instead, both uemoney and thus create an excess supply of bonds in equation
(28) andan excess
supply function and the reserve demand function depend on the ame demand for reserves in equation (30). Correspondingly
, r will rise, thus
variables r and d’. By assumption,anincrease in r—or a decrease a decreasingthedemand for commoditiés and.driving the
price level down
ceaeeaaeadfetrosrves,Inbre,thegreaterteditren
i eir demandfor reserves. In brief,the greater thed -
once again. Thus the systemispresumably stable.
Someof the comparative-statics properties of the
system can also be
slBethe rates of returnon bondsand resérves, more banks readily established. Thusifthecentralbankwere to
il Want
will want totoshift
shift outof
out of thelatterand
latter and iinto theformer.
rm Correspond- double the volume
of reserves in thesystem, this wouldincrease the deman
ingly, the reserve ratio maintained by banks dependsinversely" on this dfor bonds,
hence temporarilydepress the interest rate and therebystimulate
differential rate of return. . Perera.
demand for the
commo dities, and hence push the price level upwards.
The remaining element of our modelis the central bank’s real supply eae
Final“equilibrium,would be established at a doubled price level, but
of reserves, which is also its real demand for bonds, By assumption,this With a rate of interest and yield on reserves which had
is simply returnedto’their
originallevels. The ‘nominal quantity of money in thene
wequilibrium
Ro Position would,ofcourse,also bedoubled.
(26) a)
Pp A similar result would obtain if the private banki
ng system shoul d
experience a “change in tastes” which would make
where Rp is. the. fixed. nominal. quantity.of. reserves. Correspondingly, it willing to work
with a smaller reserve ratio: if, that is, there occurs a
system (13)-(15) becomes shift in the liquidity
preference of the banking system in the form
of an upward shift in its
(27) F(Y),r) = Yo, demand for bonds and supply of money, while

a (rule) + Bao
its demand for reserves
shifts downwards or remains unchanged. In
1 1 \ Ro_ somewhat more familiar
terms, all that the foregoing describes is a suddenexpa
nsion of bank
credit,WHICHEreates AAAitgnal-inatiey_in..tbesystem. Onceagain,
(29) L(Y, r) = S(r, a’), new equilibrium position genera the
ted by such an expansion 1s marke
d by
a higher price leveland ‘nominal quantityofmoney.but an
(30) G(r, d
» = Re?” Unchanged
rateofinterest.BecaiiseATTha-thintifthesupplyfunctionof (29)—as
well, possibly, as in the demand function of (30)—
the rate of return on
where the equationsrefer respectively to the markets for commodities, reserves will, however, generallynotremainunchange
d.
Theinvariance of the equilibrium interest rate in both
. 305 cases refleets~the-fact—that-system-{277-(30/-UESCH
th ceding
IbESins ide-
money ecohomy inwhich—assuming full employment
—the commodity
306
 The Model Extended: Full Employment
XI 36
XII 76
market can be in equilibrium.atonly one rate Macroeconomics
¢ ofinterest. Hence. no
exogenouschangewhich occurs solely in otherpartsof the econo Separate variable of the system: thef
affectthis-tateIn~brief,-thesystem-is-dishotamyized. 29
my can ormer, because itno longer coincide
s
with the sum of net financial asset
™ s ;*° the latter, because it Do longer
Itjs,however,
clearfromtheanalysisof Section4 that thisdichotomy coincides with the demand ofthe bank
ing system for bonds.
would disappearifthesystem werealso to contain gover Finally, a changein the quantity of rese
nment bonds. rves intheforegoing system
In particular, if'we assume that the central bank return wil *Bensrally.n -longer-have. neutral effec
sto theiréasitry - ts. Such neutrality will, how.
the interest on the government bonds whichit ever, obtain if@ there is complete disc
holds—so that these ounting of the tax liability con-
bonds do not effectively represent a future tax liabil nected with govérnment bonds (i.e., k
ity—the net real = 0), and(b) these bonds are the
financial assets of the private sector are then sole asset held by the central bank. There are, of cours
betweenthe system corresponding to thes e,clearparallels
kVE xkye ype e assumptions and the gold-
=a Oso a = standard System, described by equation
s (19}+(21) above.
rp rp rp Let us nowreturn to thepureinside-money2
economydescribed by
where the three terms refer to the government bonds held eguatiotts'(27)~(30):Itisclear that the determinacyof
respectively
this system is a conseq the price level in
by the nonfinancia) sector, member banks, and the
central bank. These uéHce'Srassumptionthat the nominal supp
net bond holdings then appear-on the supply side. of of réServes is fixedat ‘Ro.TheSimplest“Way of ly
demo
“assumeinsteadthatthe central bank,just like priv nstrating this is to
equation (28) and
as an addit'cnal argument (representing the real-fi
nancial-asset effect ate banks, is interested
described on p. 290) of the demand functions FC in maximizing profits, and hence Provides
+), BC. ), and reserves in accordance with
L({__) in equations(27), (28), and (29), respectively. a supply function which (as usual) "dep
Correspondingly, retugaTPh at igen ceeends "onthealternative rates of
ee eee eee
the commoditymarket canbeinequi
combinations ofinterest tates andprilibriu m at an infinitenumberof
celevels, as exemplifiedbyour
usual CC curve. (31) Ae T(r, d’).
““This"more general PEsystem has several additionalproperties which P
Sinn 4“.
shotbetoted. First, itisobviously not a pure Inside-money econom Just as in the case of equation (22) 4

above, substituting: this supply

y. funct
Fordespite the fact tharall moneystillConsistsofbank debt in the form ion” int6“(27)-(30) Wolild:yield #RSTT
R Lmice level
of demand deposits, thesedeposits are now in part “backed”. wouldnotbeassignedanyrole, and hence
by.govern- could not be determined.
Ment debt and to thisws extent. represent, outside money. To be In terms ofour earlier argument (p.303);allT
CSE Pew ge eee exact, hatThisMeansis that
since in the aggregate no other economic
*
--the quantity -of such ‘money-in-the-economy equals kVé/rp
b

+ Viiep. unit in system (27)-(30)

Second, the foregoing modelgivesexpress Teacts to changes in absolute prices, then,
iontothealready noted inorder to SU
assurFE
e the deter-
fact(p.297)thatthe quantities of outsideand insidemoneyare not minacyof the BS
price level, the central bank must do
so. This is the be-
primaryanalytical gptities. Thus in contrast to the situation in havior
denied"byequation (3 1)butaffirmedbyequati
model
(10)-(12) GApp. 296-97 above,neither of these quantities appears as a latter implies that the central bank's supplyof on(26). For the
realreservesis inversely
"
Proportionate to the price level. On the
3° Cf. pp. 297-98 above. other hand, it is clear that this
7 is not a necessary condition for determinac
Note, however, that this dichotomy would disappear if the y.It sufficesinsteadthat the
nonfinancia! sector
also held reserves, sothatthe demand for commodities depende central bankactin |accordance with any supp
(cf. end of footnote 29 above). On the gtherhand,system.(27)-
d on a’ as well as r ly functionfor real reserves
(30),reflects a second which depends on absoluteprices—say
me
,
dichoto my—of quite a differentnature—whichwould Continue toprevail in thiscase REYereremneractAEs St ar) NNees et BIO

-ige,In
solely
particular,theequilibriumvalues0!F and2” Would COnLINUEtO BE delertii ned R
in the markets for commod ties and money, while the price level 32
(32)
in .the marketforBotidsand eserves." / "= is determined —
; = Wr,
(r, d’,p).
p)
SO BET RATT re coce Ranntier ae renee es
307 - “© Note that this is also true of model (3)}-(6)
on pp. 289-90,
ety rey Lee

308
The Model Extended: Full Employment
As a special case of the foregoing generalization we might consider
the situation in a pure gold-standard economy. Here the central bank
creates reserves by buying gold instead of bonds. Indeedits demand for
gold—and henceits supply ofTeserves——is_ infinitely elastic at the ab-
solutepriceOFgold~whichit arbitrarily fixes. Correspondingly, the
quantityofgold—andhencethenominal value of bank reserves in the
system—is not fixed by the central bank, but is endogenously deter-
minéd by the cost structure of the domestic gold industry and by the
international specie-flow meclianism (which in turn depends on the
relation between domestic and foreign prices),
In brief, a necessary condition for the determinacy ofthe absolute
price level in the foregoing system (or, e uivalently, a necessary con-
diffon Tor money fo play a meaningful ik in this system)isthal’the
centralbankconcernitselfwithsomemoneyyalue—dndin thissense be
willing to suffer from money illusion. But this is a somewhat over-
dramatic statementofthe obvious and alreadyemiphasizedfact that in
order for money prices to have economic significance, someone’sreal
behavior must be dependent upon one or more ofthem.
The foregoing argument has been presented in a somewhat formal
fashion. It is therefore worth emphasizinginconclusion that it also
reflects some simple truths about monetary policy. Thus, for example,
the price indeterminacy which charactétizes”Some o theforegoing
systemercanbe iitesBretedasreflectingtheVislouscycleofinflation (or
deflation) generatedby apolicybased onthe “real bills doctrine.”
Fortheessenceofthisdoctrine is that the banking systemSHould
expand.credit inaccordance with the “legitimate needs of business ""—
where these “needs” aremeasured in moneyterms, and thitis increase
proportionately with the price level. Correspondingly, the_ nominal
money.-supply. function inherentin this doctfinéisalso directly propor- --
tionate to the pricelevel—as is explicit in equation (22), and implicit
in equation (31), Hence the indeterminacy of the absolute price level in
systems containing these, equations is simply a reflection of thé fact
thatany(say) upward price movementin such a system will—in accord-
ance with the ‘real: bills doctrine”—generate an ‘increased supply of
money which will enable the movementto continue indefinitely.*!
Another—and related—interpretation of money supply function (22)
“1 For a theoretical and historical discussion of the “real bills doctrine,” see L. W.
Mints, A History of Banking Theory (Chicago, 1945), ChapterITI. See also’ J. Viner,
ido
wegen seinerenee een
XIT 36
inet
a RR ty a i Sal te
XII :7 Macroeconomics
4
is in terms of an economywithastronglabor-unionnmovement, and
with the declared policy of maintaining an absolutely continuous state
offullemployment. "If the”tnionsweretheito-disturb an initalstate
of equilibrium by an upward movementof themoneywage rate, the
monetary authorit ies would be forced to expand the moneysupply in
the,same.proportion. In brief, in such an economythemoney wage
rate would be exogenously determined by the unions, whilethemoney
supply would be endogenously adapted by the monetaryauthorities
sostOHidintailtmAployment.This,of course,is one possible way
in Whichthé michdiscussed phenomenon of“‘cost inflation” can take
place.*?
Je
7. THE INFLUENCE OF EXPECTATIONS
Let us now return to the analysis of Chapters X-XI and see howit
is affected by taking account of expectations. Our contention is that,
though these expectations must obviously affect the dynamic adjust-
ment path ofthe system, they will not generally preventit from stabiliz-
ing itself at the new equilibrium position.
In judging the reasonableness of this contention, we must emphasize
that the analysis of preceding chapters deals with the effects of a once-
and-for-all increase in the quantity of money. The significance of this
remark can best be appreciated by noting that mostofthe traditionally
Studies in the Theoryof International Trade (New York, 1937), pp. 148-54, 234~43,
It might be noted that the pressures on the monetaryauthorities to act in accor-
dance with the ''real bills doctrine"’.are likely to be strongest just at that Stage of an
inflationary process where the iner: PriceJevelwouldotherwisecause.a.decrease
in the real ly of mone hich would tendtobring theprocessta.an.end, Needless
to’say, in its battle to offset these“disinflavionary pressures "’ by a further expansion
of the money supply, the business community wouldbejoinedbythelabor unions,
concerned_withthepossiblethreat(6[ullGiployment. And, under certain circum-
stances, it might even be joined by the treasury itself. For the price rise may increase
government expenditures more than tax receipts, and thus confront the treasury with
a budgetary deficit.
42 The literature on this subject is already voluminous. See, e.g., Charles L.
Schultze, Recent Inflation in the United States (Washington, D.C., 1959), and the
references therecited.
Onthe difficulties of distinguishing empirically between a "cost inflation” and a
“demand inflation” once the inflation has proceeded for some time, see A.C.
Harberger, ‘'The Dynamics of Inflation in Chile,” in Measurement in Economics:
Studies in Mathematical Economics and Econometrics in Memoryof Yehuda Grunfeld
(C. Christ, ef al., Stanford, 1963), pp. 219-50.
310