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Contents

Preface vi
Acknowledgments viii

Introduction 1

1 An American Keynesian 10

2 Transforming the IS-LM Model Sector by Sector 24

3 Consumption, Rationing, and Tobit Estimation:

Tobin as an Econometrician 44

4 Portfolio Balance, Money Demand, and Money Creation 63

5 Tobin’s q and the Theory of Investment 73

6 Money and Long-Run Economic Growth 90

7 To Improve the World: Limiting the Domain

of Inequality 106

8 Taming Speculation: The Tobin Tax 113

9 Tobin’s Legacy and Modern Macroeconomics 130

Notes 156

Bibliography 166

Index 191

v
Preface

I had the privilege and good fortune to know James Tobin and to
study with him. I came to Yale as an economics graduate student in
1978 already intending to work in the history of economic thought,
and specifically on John Maynard Keynes, after a bachelor’s degree
in history and economics at McGill. This choice of field was, then as
now, regarded by leading North American economics departments
as eccentric at best: in my first year at Yale, the only course offered
in the history of economic thought was Harry Miskimin’s history
department graduate course on French mercantilism, a fine course
but perhaps a bit specialized.
But Jim Tobin, who had taken Joseph Schumpeter’s sequence
of courses in the history of economic analysis while at Harvard,
provided encouragement and support (as did the economic historian
William Parker and, among untenured faculty, Katsuhito Iwai and
David Levine). After I had taken his courses in “Money and Finance”
(one taught jointly with John Taylor, then a visiting professor), I was
the teaching assistant for his course “The Keynesian Revolution and
the Counter-Revolutions,” and he supervised my dissertation, based
on surviving student notes of Keynes’s lectures (then being edited
by T. K. Rymes at Carleton). This dissertation, accepted in 1983,
eventually became the basis of my book, The Origins of the Keynesian
Revolution (1988).
In 1992, I returned to Yale as a visiting fellow to spend a sabbatical
and a leave as one of the two assistant editors (with Kevin Foster) for
William Barber’s edition of The Works of Irving Fisher (14 volumes,
1997), for which Jim was consulting editor. Studying with Jim, and
discussing Keynes, Fisher, and the history of macroeconomics with
him, was a wonderful experience for a then-young historian of
macroeconomics – and not least the day in October 1981 that his
Nobel Memorial Prize was announced. Jim liked to recount that the
telephone call from Stockholm had gone to an unrelated teenage
Yale sophomore, the only “James Tobin” actually living on the Yale
campus, but the student’s roommate had refused to wake him with

vi
 Preface vii

the news of the prize – and it was later discovered that the student
had previously received several phone calls from journalists and had
shared with them his opinions about politics and economics.
This is not a biography but rather, in keeping with the aims of
the Great Thinkers in Economics series, a book about James Tobin
as an economist, examining his contributions to economics, prima-
rily in monetary economics and macroeconomics (such as his money
demand models, the corridor of stability, Tobin’s q theory of invest-
ment, and the Tobin separation theorem), but also extended to
applied econometrics (notably the Tobit estimator and the 1950 food
demand study) and to proposals to fight poverty and inequality.
Beyond surveying his contributions, I consider the reasons for the
decline in influence of his approach to monetary economics, and
suggest that aspects of his work are of renewed interest in the wake
of the global financial crisis. In particular, I draw attention to his
modelling from 1975 onward of a “corridor of stability” – models of
economies that are self-adjusting most of the time but not for infre-
quent large shocks – as an alternative to models of economies that
are either always stable or never stable.
The theme of this book is that James Tobin’s work in economics was
not just an assortment of individual contributions, but a coherent
research program shaped by how he first came to economics: during
the Great Depression of the 1930s that followed a stock market crash
and a breakdown of financial intermediation, reading Keynes’s
General Theory (before even reading an economic principles text-
book) with a bent for expressing ideas in formal ideas, and seeing
economics as a path to economic stabilization, not as a collection of
abstract puzzles.
Acknowledgments

In researching and writing this book, I have benefited from, and

am grateful for, financial support from Brock University’s Faculty of
Social Sciences and Committee for Research in the Social Sciences,
and for a sabbatical in which to complete the manuscript. I am
also grateful for visiting fellowships at the Center for the History of
Political Economy at Duke University from September to December
2013 and at the John F. Kennedy Institute for North American Studies
at the Free University of Berlin from April to July 2014. I thank the
editor of this series, Tony Thirlwall, for his comments on the manu-
script, and for his invitation to write this book.
Earlier versions of much of this material were presented at confer-
ences (at which I received many helpful comments) and published
in conference proceedings. For permission to make use of material
drawn from co-authored papers, both published and unpublished,
I am grateful to Harald Hagemann for material in Chapter 5, to
Steven N. Durlauf for material in Chapter 6, and to Mohammed
H. I. Dore for material in Chapter 8. I thank Duke University Press
and the editor of History of Political Economy, Kevin D. Hoover, for
permission to reprint in revised form three articles that appeared in
the annual conference supplement to HOPE: “James Tobin and the
Transformation of the IS-LM Model,” in Michel DeVroey and Kevin
D. Hoover, eds. The IS-LM Model: Its Rise, Fall, and Strange Persistence,
Annual Supplement to History of Political Economy 36 (2004), 165–189;
“James Tobin and Growth Theory: Financial Factors and Long-Run
Economic Growth” (with Steven N. Durlauf), in Mauro Boianovsky
and Kevin D. Hoover, eds. Robert Solow and the Development of
Growth Economics, Annual Supplement to History of Political Economy
41 (2009), 182–199; and “Tobin as an Econometrician,” in Marcel
Boumans, Arianne Dupont-Kiefer, and Mary S. Morgan, eds.
Histories on Econometrics, Annual Supplement to History of Political
Economy 43 (2011), 166–187. I am grateful for comments on these
papers from conference participants, the editors of the supplements,
anonymous referees, and, for the 2009 paper on long-run growth,
Donald Hester.

viii
 Acknowledgments ix

For discussion of these and other papers, I thank the participants

in the University of Toronto workshop in the history of economic
thought, particularly Avi Cohen, Susan Howson, J. Allan Hynes,
David Laidler, Donald Moggridge, and Allan Olley, and also partici-
pants in sessions at annual conferences of the Canadian Economics
Association, the History of Economics Society, and the Allied Social
Science Associations.
I am grateful to the volume editors and to Edward Elgar Publishing
for permission to reprint in revised form two papers that appeared in
conference volumes published by Edward Elgar Publishing: “Minsky
and Tobin on the Instability of a Monetary Economy,” in Marc
Lavoie and Mario Seccareccia, eds., Central Banking in the Modern
World (Cheltenham, UK, and Northampton, MA: Edward Elgar,
2004), 226–243, and “Tobin, Globalization, and Capital Flows,” in
Claude Gnos and Louis-Phillipe Rochon, eds., Monetary Policy and
Financial Stability (Cheltenham, UK, and Northampton, MA: Edward
Elgar, 2009), 190–205. I thank the volume editors and conference
participants for their comments.
I thank the volume editors and Harvard University Press for
permission to reprint in revised form a paper from the proceedings
of the Keynes symposium at Sophia University in Tokyo: “Tobin’s
Keynesianism,” reprinted by permission of the publisher from The
Return to the Keynes, edited by Bradley Bateman, Toshiaki Hirai, and
Maria Cristina Marcuzzo, pp. 94–107, Cambridge, Mass.: The Belknap
Press of Harvard University Press, Copyright © 2010 by the President
and Fellows of Harvard College. I am grateful to the editors, sympo-
sium participants, and referees for their comments.
I am grateful to the Eastern Economic Journal and Palgrave Macmillan
for their stated policy of permitting authors to reuse their articles in
their own books, which permits me to make use of “On Limiting the
Domain of Inequality: The Legacy of James Tobin,” Eastern Economic
Journal 29:4 (Fall 2003), 559–564, and I am grateful to the late Kenneth
Koford for his invitation to contribute to that symposium in memory
of James Tobin, the first occasion on which I wrote about Jim.
I thank the Manuscripts and Archives Section of the Yale University
Library for permission to quote in Chapter 9 several brief passages
from two sets of unpublished lectures given by Tobin – the John
Danz Lectures presented at the University of Washington in 1974
and the Gaston Eyskens Lectures presented at the University of
Leuven in 1982.
Introduction

An economist’s life, in and beyond the ivory tower

James Tobin, winner of the 1981 Royal Bank of Sweden Prize in

Economic Science in Memory of Alfred Nobel, was the outstanding
monetary economist among American Keynesians. He is known to
the public for the proposed Tobin tax to curb international currency
speculation and to the economics profession for contributions
ranging from the Tobit estimator for limited dependent variables and
the Tobin separation theorem in portfolio choice through Tobin’s q
in investment theory to the Nordhaus-Tobin Measure of Economic
Welfare (a pioneering work of “green accounting”). Tobin vigorously
upheld, first against Milton Friedman’s monetarism and then against
New Classical economics, the Keynesian vision of an active role for
government in stimulating output, employment, and growth and
in preventing depressions in an economy that was not automati-
cally self-stabilizing. In the first debate with Friedman (see, e.g., the
exchange in Gordon 1974), Tobin largely persuaded the economics
profession that money demand does respond to interest rates, and
both monetary and fiscal policy matter for short-run aggregate
demand. “In retrospect,” reflected Tobin (in Colander 1999, 120),
“that controversy doesn’t look as important as the one between
Keynesian economics and New Classical macroeconomics – about
whether or not the actual economy is best described as a continuous
full-employment solution.” In Tobin’s later years, the mainstream
of macroeconomics and monetary economics moved away from his
modeling approach toward representative agent models and New

11
12 James Tobin

Classical macroeconomics, but confidence in economic stability and

automatic restoration of full employment has been shaken by the
global financial and economic crisis that began in 2007, renewing
interest in stability and full employment as things to be achieved
rather than to be assumed.
Tobin was born on March 5, 1918, in Champaign, Illinois, the son
of a social worker and of a journalist who was director of press rela-
tions for the University of Illinois Athletic Association. His child-
hood home was full of books and magazines. Growing up in the
Great Depression made a lasting impression on Tobin: “I think that
a lot of contemporary economists who never had any experience
with that catastrophe regard it as some kind of aberration so that
they don’t have to worry about accommodating it in their theories
of macroeconomics. They just dismiss it as something that didn’t
happen or that they can’t explain. But for people who did grow up in
the depression, it was an obsession” (Tobin in Shiller 1999, 869).
Educated at the university’s experimental high school (later cele-
brated for the number of Nobel Prizes won by its graduates), Tobin
went to Harvard on a scholarship in 1935, receiving his AB in 1939,
MA in 1940 and, after wartime service, his PhD in 1947. He went to
Washington, DC, in the summer of 1941 to work first in the civilian
supply part of the Office of Price Administration and Civilian Supply
and then at the War Production Board. He enlisted in the US Navy
after Pearl Harbor. In April 1942, he was called to duty, went to
school to become an officer in 90 days, and then served as navigator
and second in command of the destroyer USS Kearny. Returning to
Harvard in January 1946, Tobin completed his dissertation on saving
by April 1947, despite a heavy teaching load as a teaching fellow.
From 1947 to 1950 he was a junior fellow in Harvard’s Society of
Fellows, which “was meant to be a substitute for a doctor’s degree,
not a postdoctoral position. But they waived that requirement ... for
veterans like me, because they could understand that the first thing
I wanted when I got back was to get a degree” (Tobin in Colander
1999, 119).
Tobin’s time at Harvard was shaped by reading Keynes’s newly-
published General Theory of Employment, Interest and Money (1936) –
the first economics book Tobin ever read – and by contact with
such outstanding professors as Alvin Hansen, Wassily Leontief,
Joseph Schumpeter, and Edwin B. Wilson (see Tobin 1976a
 Introduction 13

on Hansen, Tobin 1991b on Schumpeter) and with perhaps even

more outstanding economics students such as Paul Samuelson, Lloyd
Metzler, Trygve Haavelmo, Robert Heilbroner, and, after the war,
Robert Solow and Hyman Minsky.
While Tobin was a junior fellow, he met a beginning Harvard grad-
uate student and future Nobel laureate, Robert Solow, later his closest
friend in his generation of economists: “Jim must have finished his
Ph.D. thesis by then, and would soon decamp for Yale, neither the
first nor the last in a series of humongous Harvard blunders” (Solow
2004, 657). In contrast to his sense of equality with Solow, Tobin was
always somewhat in awe of Solow’s MIT colleague, the Nobel laureate
Paul Samuelson. Tobin spent the last year of his Harvard junior
fellowship across the Atlantic at “the other Cambridge,” visiting
Richard Stone’s Department of Applied Economics (DAE), writing
econometric papers about food demand and about how to estimate
the demand for rationed goods, and befriending Harry Johnson (see
Tobin’s reminiscences of that year in Tobin 1978c, an obituary of
Harry Johnson).
Herman Wouk’s novel The Caine Mutiny (1951) offers a glimpse of
Tobin training to be a naval officer (and perhaps the source of the
name of the Tobit estimator): “A mandarin-like midshipman named
Tobit, with a domed forehead, measured quiet speech, and a mind
like a sponge, was ahead of the field by a spacious percentage.”
Courted by many US economics departments while in Harvard’s
Society of Fellows, Tobin joined Yale University in New Haven,
Connecticut in 1950: “Yale made the best offer, associate profes-
sorship right away” (Tobin in Shiller 1999, 874). His wife Betty (the
former Elizabeth Ringo, an economics student he met in 1946) had
“said she’d go anyplace except New Haven, but we went to New Haven
and she loved it” (Tobin in Colander 1999, 119). He was promoted to
full professor in 1955 (the year the American Economic Association
awarded him the John Bates Clark Medal for the best US economist
under 40 years old) and to Sterling Professor of Economics in 1957,
the year before his presidency of the Econometric Society.
Summers were spent in Wisconsin, at

this family place which I have actually gone to all my life, from
the time I was a small child, a baby indeed, to now. It’s a gathering
point not only for our family and children and grandchildren but
14 James Tobin

for the extended families, my brother and cousins and their fami-
lies, and for succeeding generations ... It happened that my wife,
Betty, whom I met in Cambridge, Massachusetts, in 1946, far from
Wisconsin, was from Wisconsin, too, and had grown up not too
far from the place I had gone to. (Tobin in Shiller 1999, 890)

Tobin retired as Sterling Professor Emeritus in 1988, but continued

to teach undergraduate courses for another decade, and lived in New
Haven with Betty, in the same house they had bought in 1951, until
his death on March 11, 2002. He was intellectually active to the end:
“In fact,” wrote Paul Krugman (2002) in his obituary of Tobin, “I was
on a panel with him just last week, where he argued strongly that
the current situation called for more domestic spending, not more
tax cuts.”
In 1953, Jacob Marshak and Tjalling Koopmans, the leaders of the
Cowles Commission for Research in Economics, invited Tobin to
move to the University of Chicago to direct the Cowles Commission,
which was then the world’s foremost center of econometrics and
mathematical economics but was on uneasy terms with the rest of
the university’s economics department (see Shiller in Colander 1999,
130). Tobin (in Shiller 1999, 875) recalled,

Although the Cowles appointment carried with it a professorship

in the University of Chicago economics department, when I asked
the chairman [Theodore Schultz, a future Nobel laureate] if the
department would have been interested in me without the Cowles
connection, he said “No.” I felt bad when I phoned Tjalling to turn
down the offer. To my surprise he didn’t seem disappointed. He
immediately asked me if Yale might be interested in his spending
his sabbatical in 1954–55 at Yale ... Tjalling came, the negotiations
to move the commission to Yale started right away, and in 1955
the Cowles Foundation was established with me as its director.

Two decades later Koopmans was Yale’s first Nobel laureate in

economics.
Tobin directed the Cowles Foundation for seven years and chaired
Yale’s Department of Economics for six years. Arthur Okun, who
went on from Yale to chair the President’s Council of Economic
Advisers and co-founded the Brookings Papers on Economic Activity,
 Introduction 15

was particularly close to Tobin and to his approach to macroeco-

nomics (see Okun 1981, which was published posthumously). Tobin
(in Colander 1999, 120) recalled that “what people meant by the
Yale school ... is identified with my, and Art Okun’s, macroeconomic
and monetary views and teachings. (The importance of the late Art
Okun, and the loss to all economists of his premature death, can’t
be exaggerated.)”
Others at Yale whom Tobin “regarded as sympathetic to my views
in macroeconomics” were

Ray Fair; Bill Brainard, who was a partner in developing a lot of

what I did in the models we were just discussing; Bill Nordhaus,
who was a student of mine, and a collaborator of mine not so
much in macro but in other things like MEW (the measure of
economic welfare); and Bob Shiller, who’s, again, not a student
of mine or a collaborator, but who thinks about macroeconomic
things in similar ways to me and Bill Brainard. (Tobin in Colander
1999, 124–125; see Brainard and Tobin 1968, Tobin and Brainard
1977, Brainard, Nordhaus, and Watts 1991, Fair 1974–76, 1977,
1979, 1984, 1994, 2004, Nordhaus and Tobin 1972, Shiller 1989,
1999, 2000).

All of these were part of the Cowles Foundation 11.00 a.m. coffee
group,

but it includes other people, too: Chris Sims, who’s an advocate

of real business cycles; Martin Shubik, a very interesting guy, but
I don’t think of him as a member of any particular school except
his own; John Geanakoplos, who is sympathetic to my macro
views but who wants to reconcile them to Arrow/Debreu [general
equilibrium]; Herb Scarf, a math theorist; and T. N. Srinivasan, a
tough neoclassical economist. (Tobin in Colander 1999, 120)

William Fellner, an earlier Yale colleague, was a good friend of Tobin

despite very different approaches to macroeconomics (see Fellner
1946, 1976).
Tobin’s academic career of teaching and research experienced only
one major interruption. His work on a major treatise on monetary
theory, comparable in scale to Don Patinkin’s Money, Interest and
16 James Tobin

Prices (1956), was halted by his service for 20 months in 1961 and
1962 on President John F. Kennedy’s Council of Economic Advisers.
On leave from Yale, Tobin put aside the manuscript, which eventu-
ally became Money, Credit and Capital (Tobin with Golub 1998).
Robert Solow, who took leave from MIT to join the council’s staff,
recalled, “Jim Tobin was clearly the intellectual leader of the Kennedy
Council” (Solow 2004, 658). During the 1960 presidential campaign,
the Kennedy Democrats criticized the incumbent Republican
administration for not promoting economic growth sufficiently.
Tobin, who, like the Kennedy brothers, had been a Harvard under-
graduate in the 1930s, wrote several memoranda and position papers
on economic growth to the Kennedy campaign in the summer of
1960 (despite his informing Ted Sorenson that he preferred Adlai
Stevenson for the nomination). These memoranda are the basis of
a July 1960 New Republic article entitled “Growth through Taxation”
(reprinted in Tobin 1966b) in which he called for a combination of
easy monetary policy (to stimulate investment) and tight fiscal policy
(to control inflation), using tax revenues to increase public saving.
“But,” he said, “[Kennedy] didn’t quite want to do that – to raise taxes
to increase the rate of growth!” (Tobin in Shiller 1999, 882).
One of Tobin’s recommendations was to limit tax deductions
for advertising. When his nomination to the council came up for
Senate confirmation, recalled Tobin (in Shiller 1999, 882), “One of
the senators on the committee asked me about this proposal – which
he regarded as a really terrible thing. And so, I was in a little trouble
because of this idea, but they weren’t that worried about who was on
the council in those days.”
Tobin reminisced that when President Kennedy asked him to join
the council, “I said, ‘Well I don’t think that I am the type for that; I’m
an ivory-tower economist,’ and he said, ‘Well, that’s the best kind, I’m
going to be an ivory-tower president,’ and I said, ‘Well, that’s the best
kind’” (in Shiller 1999, 879–880, cf. Colander 1999). Under the chair-
manship of Walter Heller, the Kennedy Council of Economic Advisers
propounded the “New Economics,” a Keynesian approach that saw
an active role for government in both stabilizing the economy and
raising the rate of economic growth (see Tobin 1974b, Tobin and
Weidenbaum, eds. 1988, and Bernstein 2001). Contrary to Tobin’s
1960 New Republic article, the Kennedy Council became associated
with aggregate demand stimulus through a tax cut (as in Tobin’s New
Republic article “Tax Cut Harvest” in March 1964).
 Introduction 17

Tobin’s work at the council was reflected in his 1963 Ely Lecture
to the American Economic Association on “Economic Growth as an
Objective of Government Policy” and in magazine articles collected
with that lecture in his book, National Economic Policy (1966). But
even that collection of writings on public policy, mostly in non-ac-
ademic magazines, was published by a university press, as was his
volume of reflections on The New Economics One Decade Older (1974).
After leaving Washington, Tobin continued as a consultant to the
council until 1968.
When accepting Tobin’s resignation from the council to return to
Yale, President Kennedy wrote,

I remember your protesting, in our telephone conversation prior

to your appointment, that you were an “ivory tower economist.” If
so, you have convincingly demonstrated that the ivory tower can
produce public servants of remarkable effectiveness. Your ideas –
on domestic policies for stability and growth, and on many other
issues – have been lucid and reasoned, and your advocacy of them
has been forceful and persuasive. I have both enjoyed and bene-
fited from our exchange, and I wish to express my appreciation for
your dedicated service. The impact of your contribution will long
be felt in the economic policy of my Administration ... Your advice,
whether from within or without the Government, will always
be received with interest and respect in this Administration.
(Kennedy to Tobin, July 12, 1962, Tobin Papers 2004-M-088, Box
7, Folder: Resignation Letter)

The next document in the folder is a telegram from Robert F. Kennedy

after the assassination, reporting that the president’s body would be
resting in the East Room of the White House.

Overview

Self-identification as a Keynesian (later as Old Keynesian) was central

to Tobin’s view of himself as an economist. Keynes’s legacy has been
intensely contested among many claimants, so what Tobin meant
by accepting and embracing that label is central to understanding
Tobin as an economist (see Chapter 1, “An American Keynesian”).
Influenced by John Hicks as well as by Keynes, Tobin helped Alvin
Hansen present Keynesian economics through the IS-LM framework
18 James Tobin

of equations and diagrams, and then devoted his career to devel-

oping optimizing microeconomic foundations for each sector of
the IS-LM framework with consistency between stocks and flows
(Chapter 2, “Transforming the IS-LM Model Sector by Sector”). In
the words of Paul Krugman (2002), Tobin “took the crude, mecha-
nistic Keynesianism prevalent in the 1940’s and transformed it into
a far more sophisticated doctrine, one that focused on the tradeoffs
investors make as they balance risk, return and liquidity.”
In contrast to later New Classical methodology that linked markets
and sectors through the budget constraint of an optimizing repre-
sentative agent, Tobin modeled optimization sector by sector,
emphasizing stock-flow consistency and imposing plausible restric-
tions on the partial derivatives of demand functions, avoiding any
assumption of a continuously clearing labor market. The first sector
of the IS-LM framework that Tobin developed was consumption and
saving, the S of the IS curve. His dissertation was on savings decisions
(stressing asset holdings as a determinant of saving), and his early
articles, which brought him the John Bates Clark Medal in 1955 and
the presidency of the Econometric Society, were on savings decisions
and on modeling consumer demand (Chapter 3, “Consumption,
Rationing and Logit Estimation: Tobin as an Econometrician”). As
late as 1968, after more than a decade as a leading monetary econo-
mist, it was as an expert on the consumption function that Tobin
contributed to the International Encyclopedia of the Social Sciences.
Tobin’s articles from 1956 onward, analyzing demand for money
as a means of payment and as an asset in the context of multi-asset
portfolio equilibrium and the creation of money by the banking
system (liquidity preference and money supply, the L and M of
the LM curve), were of fundamental importance for monetary
economics (Chapter 4, “Portfolio Balance, Money Demand, and
Money Creation”), and always kept in mind the transmission mech-
anism for monetary policy to affect the real economy. Beginning
in 1968, Tobin and his Yale colleague and former graduate student,
William Brainard, introduced Tobin’s q (the ratio of the market value
of capital assets to their replacement cost) as the determinant of
investment (the I of the IS curve) and thus as the channel through
which monetary policy acts on the real economy, a concept with
roots in Keynes’s writings (Chapter 5, “Tobin’s q and the Theory of
Investment”).
 Introduction 19

If monetary policy affects investment decisions, it can have lasting,

non-neutral effects on capital stock, productive capacity, and real
output, even in the long-run with full employment, as Tobin argued
in papers introducing money into long-run models of economic
growth (Chapter 6, “Money and Long-Run Economic Growth”). He
was also a key figure in the creation of the neoclassical growth model
and, with his Yale colleague and former student, William Nordhaus,
a pioneer in what is now called “green accounting,” the creation of
a “Measure of Economic Welfare” that adjusted economic growth
figures for changes in environmental quality, leisure, traffic conges-
tion, crime, and other factors to obtain a clearer sense of how living
standards had changed.
Tobin’s view, shaped by the Great Depression of the 1930s, of
economics as a way to improve people’s lives, rather than primarily
to solve intellectual puzzles, was also expressed through his sweeping
proposals for diminishing inequality and eliminating severe poverty
in the United States (Chapter 7, “To Improve the World: Limiting
the Domain of Inequality,” which takes its subtitle from the title of
Tobin’s Simons Lecture). His proposal for international monetary
reform, to inhibit international speculative flows of “hot money”
and to protect the leeway for domestic stabilization policies by
taxing currency trades, are better known to the general public than
his domestic proposals, and have been taken up by groups who do
not share Tobin’s commitment to free trade in goods and services
(Chapter 8, “Taming Speculation: The Tobin Tax”).
Chapter 9 (“Tobin’s Legacy and Modern Macroeconomics”) exam-
ines the relationship between Tobin’s economics and the mainstream
of modern macroeconomics and monetary economics, exploring the
differences in the methodology and the reasons why the mainstream
moved away from Tobin’s vision, but also finding that much of
Tobin’s contribution remains relevant, notably his analysis of econo-
mies with a corridor of stability, that self-adjust for small demand
shocks but require active stabilization policy to cope with exception-
ally large shocks.
1
An American Keynesian

Introduction

In September 1936, when James Tobin was an 18-year-old sophomore

taking “Principles of Economics” (Ec A) at Harvard, his tutor, Spencer
Pollard (a graduate student who was also the instructor of Tobin’s Ec
A section) “decided that for tutorial he and I, mainly I, should read
‘this new book from England. They say it may be important.’ So I
plunged in, being too young and ignorant to know that I was too
young and ignorant” to begin the study of economics by reading
Keynes’s The General Theory of Employment, Interest and Money (Tobin
1988, 662). Pollard was right: the book did turn out to be important,
not least for its lasting role in shaping Tobin’s intellectual develop-
ment. Tobin (1992, 1993) remained proud to call himself an “Old
Keynesian” in contrast to New Keynesian, New Classical, and Post
Keynesian, and, when Harcourt and Riach (1997) edited A “Second
Edition” of The General Theory, it was fitting that they invited Tobin
(1997) to contribute the overview chapter, with the first part of the
chapter written “as J. M. Keynes.”1 Although Sir John Hicks (1935,
1937, 1939) and Irving Fisher also influenced Tobin2, his approach to
economics was always most deeply shaped by Keynes and by Tobin’s
experience growing up during the Great Depression of the 1930s.
Throughout his career, Tobin was concerned with developing
macroeconomic theory that would be relevant for stabilization
policy – to prevent another depression and to improve people’s lives
by promoting growth and stability – rather than with analytical

10
 An American Keynesian 11

problem-solving for its own sake. The Great Depression was associ-
ated with the breakdown of the US banking system and with Keynes’s
argument that depression due to inadequate effective demand was a
distinctive problem of a monetary economy as opposed to a barter
economy. More than any of the other leading American Keynesians
of his generation, such as Nobel laureates Paul Samuelson, Robert
Solow, Franco Modigliani, and Lawrence Klein, Tobin concerned
himself with the functioning and malfunctioning of the monetary
system, telling David Colander (1999, 121) “I differed from that
group [American Keynesians in the 1950s] in that I taught that
monetary policy was a possible tool of macroeconomic policy and
that to neglect it was a mistake.”
Tobin set himself apart from Keynes’s disciples at Cambridge
University (such as Joan Robinson, Richard Kahn, and Nicholas
Kaldor) and their Post Keynesian allies in the United States because he
objected to “throwing away the insights of neoclassical economics”
(in Colander 1999, 121). Even his late-career mellowing toward
the British side of the Cambridge capital controversies was subti-
tled, “A Neoclassical Kaldor-Robinson Exercise” (Tobin 1989b). But
he also stood aside from New Keynesians: ‘If it means people like
Greg Mankiw, I don’t regard them as Keynesians. I don’t think they
have involuntary unemployment or absence of market clearing,’ just
nominal wage and price stickiness, in contrast to Keynes’s insistence
that nominal wage and price flexibility could not be relied upon to
eliminate unemployment.” (Tobin in Colander 1999, 124; Keynes
1936, Chapter 19).
Tobin thus staked a distinctive claim to Keynes’s contested
heritage. He reiterated this claim to be a Keynesian throughout
his career, using Keynes’s term “liquidity preference” in the
title of his article on demand for money as an asset (Tobin
1958a), linking the proposed Tobin tax to restrain international
currency speculation to Keynes’s proposed turnover tax to curb
stock market speculation (Keynes 1936, 160; Tobin 1984a), and
building his theory of investment around Tobin’s q (Brainard and
Tobin 1968, Tobin and Brainard 1977), a concept closely related
in both substance and notation to the Q of Keynes’s Treatise on
Money (1930), notation that Keynes had chosen because of Alfred
Marshall’s quasi-rents.
12 James Tobin

The central propositions of Keynes’s General Theory

according to Tobin

In “How Dead is Keynes?” Tobin (1977a) summarized the central

message of Keynes’s General Theory in four propositions and argued
that reports of the death of Keynes, like those of the demise of Mark
Twain, were much exaggerated:

None of the four central Keynesian propositions is inconsistent

with the contemporary economic scene here or in other advanced
democratic capitalist countries. At least the first three fit the facts
extremely well. Indeed the middle 70s follow the Keynesian script
better than any post-war period except the early 60s. It hardly
seems the time for a funeral. (460)

What Keynes meant to convey as his central message is hotly

contested, with a huge literature emphasizing nominal wage sticki-
ness, or discretionary policy, or fundamental uncertainty, or rejec-
tion of Say’s Law, or the spending multiplier. But while Tobin’s four
central Keynesian propositions do not settle the controversies over
what Keynes meant (let alone the controversies over whether Keynes
was, in some sense, right), they show what being a Keynesian meant
to Tobin.
Tobin’s first central Keynesian proposition was that “In modern
industrial capitalist societies, wages respond slowly to excess demand
or supply, especially slowly to excess supply,” so that over “a long
short run” fluctuations in aggregate demand affect real output,
not just prices. A corollary of this was the second proposition: “the
vulnerability of economies like ours to lengthy bouts of involuntary
unemployment.” The only distinctively Keynesian aspect of Tobin’s
first two central Keynesian propositions was the insistence on the
phenomenon of involuntary unemployment, an excess supply of
labor in a non-clearing labor market. Replace “involuntary unem-
ployment” with “high unemployment” in the second proposition,
and the two propositions would be acceptable to David Hume in
1752, Henry Thornton in 1802, Alfred Marshall in 1887, or Milton
Friedman (1968). Tobin (1977a, 459–60) pointed to the high unem-
ployment since 1974 as supporting evidence, insisting that the
increased unemployment was indeed involuntary: “People willing
 An American Keynesian 13

to work at or below prevailing real wages cannot find jobs. They have
no effective way to signal their availability.” By contrast, in Friedman
(1968) with adaptive expectations and the expectations-augmented
Phillips curve, and in Lucas (1981a) with the monetary-mispercep-
tions version of New Classical economics, the labor market clears,
but the labor demand curve shifts as workers are fooled by monetary
shocks into misperceiving the real wage.
Tobin’s first two Keynesian propositions summarized widely
shared views (although New Classical economists would be troubled
by the very idea of involuntary behavior), and came to textbook
Keynesianism from Chapter 2 of Keynes (1936), in which Keynes
discussed the two classical postulates of the labor market. Keynes
accepted the first classical postulate – that the real wage is equal to the
marginal product of labor (that is, firms are competitive and on the
labor demand curve) – but rejected the second one that the utility of
the real wage is equal to the marginal disutility of labor (that is, labor
is on the labor supply curve). Although Keynes’s Chapter 2 provided
an account of why staggered contracts and concern of workers with
relative wages could make nominal wages sticky downwards without
any money illusion (a precursor of the more formal modeling of
Taylor 19803), the textbook version and Tobin’s first two Keynesian
propositions were consistent with the claim that Keynesian analysis,
however practically important, was theoretically trivial: just a clas-
sical system with a sticky nominal wage rate. Emphasizing slow
adjustment of prices and money wages implied viewing Keynesian
unemployment as a disequilibrium situation, a short-run phenom-
enon of transition periods, rather than accepting Keynes’s claim to
have shown the possibility of equilibrium with involuntary unem-
ployment (excess supply of labor).
Writing as J. M. Keynes for A “Second Edition” of The General Theory,
Tobin (1997, 7) held that Keynes (1936, Chapter 2)

leaned too far to the classical side, as I learned shortly after the
book was published, thanks to the empirical studies of [John]
Dunlop and [Lorie] Tarshis. If the first classical postulate were
correct, then we would expect real wages – measured in terms
of labour’s product rather than workers’ consumption – to move
counter-cyclically. However, Dunlop and Tarshis found that prod-
uct-wages were, if anything, pro-cyclical. This is not a fatal flaw
14 James Tobin

in the general theory; quite the contrary: my essential proposi-

tions remain unscathed. ... If increases in aggregate demand can
raise employment and output without diminishing real wages, so
much the better! ... Nothing is lost by recognizing that imperfect
competition and sluggish price adjustment may result in depar-
tures from marginal cost pricing, especially in short runs.

(See articles by Dunlop, Tarshis, Keynes, and Ruggles reprinted,

together with Tobin 1941, in Dimand 2002, Volume VIII.)
Tobin’s third central Keynesian proposition was that:

Capital formation depends on long run appraisals of profit expec-

tations and risks and on business attitudes toward bearing the
risks. These are not simple predictable functions of current and
recent economic events. Variations of the marginal efficiency of
capital contain, for all practical purposes, important elements
of autonomy and exogeneity. (1977a, 460, cf. Keynes 1936,
Chapter 12, “The State of Long-Term Expectation”)

This emphasis on autonomous shifts of long-period expectations

(Keynes’s “animal spirits”) rejected the rational expectations hypoth-
esis introduced into macroeconomics in the 1970s by Robert Lucas
(1981a) and Thomas Sargent and Neil Wallace (1976), as well as
the endogenous, adaptive expectations of Friedman (1968). Tobin’s
emphasis on fluctuations in long-period expectations of future profits
fit with a view that the Wall Street crash of October 1929 mattered for
investment and the Great Depression (the market value of equity, the
numerator of Tobin’s q, is the present discounted value of expected
future after-tax net earnings), in contrast to Friedman and Schwartz
(1963), who reinterpreted the Great Depression as a Great Contraction
of the money supply resulting from mistaken Federal Reserve policy.
Tobin’s third central Keynesian proposition also undermined attempts
(for instance by Minsky 1981 and Crotty 1990) to contrast an alleg-
edly neoclassical Tobin’s q, supposedly based on a known probability
distribution of underlying fundamental variables, with a more truly
Keynesian approach that recognized fundamental uncertainty and
exogenous shifts in long-period expectations.
The fourth central Keynesian proposition in Tobin (1977a),
following Chapter 19 of The General Theory, held that “Even if money
 An American Keynesian 15

wages and prices were responsive to market excess demands and

supplies, their flexibility would not necessarily stabilize monetary
economies subject to demand and supply shocks.” This proposition,
advanced vigorously by Tobin (1975, 1980a, 1992, 1993), placed the
Keynesian challenge to what Keynes termed “classical economics” on
a level of core theory. Keynesianism, as interpreted by Tobin, could
not be dismissed as nothing more than the empirical observation (or
arbitrary assumption) that money wage rates are sticky downwards.
Even if prices and money wages responded promptly, the economy
might fail to automatically readjust to potential output after a large
negative demand shock and might require government interven-
tion to restore full employment. Making money wages more flexible
by eliminating trade unions, minimum wage laws, and unemploy-
ment compensation might just make things worse. Tobin’s fourth
Keynesian proposition, and the emphasis on Chapter 19 as crucial to
understanding the message of Keynes’s General Theory, were central
to Tobin’s Keynesianism: involuntary unemployment might be a
disequilibrium phenomenon, but the system might not have any
mechanism to move it back to the full employment equilibrium after
a sufficiently large negative demand shock.
Tobin stressed Keynes’s Chapter 19 on changes in money wages
rather than Chapter 17 on the “peculiar properties of money”: its
zero elasticity of production and zero elasticity of substitution (in
contrast to Tobin’s view of money as an imperfect substitute for other
assets, and of an endogenous money supply with a finite elasticity of
supply). Tobin (1977a, 460) endorsed “Keynes’s challenge to accepted
doctrine that market mechanisms are inherently self-correcting and
stabilizing.” Unlike his first three central Keynesian propositions,
Tobin did not claim empirical support for the fourth proposition:
since money wages and prices did not in fact respond rapidly to excess
demands and supplies, there could not be much direct evidence of
what would happen in that counterfactual situation. The case for
the fourth proposition had to be made, as in Tobin (1975), at a theo-
retical level. It was a case that he only made explicitly and formally
from the 1970s onward, when Keynesianism was under challenge
from natural rate of unemployment theories, first the monetarism
of Friedman (1968), and then the New Classical economics of Lucas
(1981a), which claimed the demand stimulus could increase employ-
ment and output only by tricking workers into accepting a lower real
16 James Tobin

wage that they thought were getting. Unfortunately, Robert Lucas

(1981b), in his review article about Tobin (1980a), did not engage
with Tobin’s first lecture about disequilibrium dynamics, stability,
and failure of self-adjustment, concentrating instead on protesting
against the description in Tobin’s second lecture of Lucas’s New
Classical approach as “Monetarism, Mark II,” merely Friedman’s
natural rate of unemployment hypothesis and expectations-ad-
justed Phillips curve with rational expectations in place of adaptive
expectations.
“Writing as J. M. Keynes,” Tobin (1997, 4) stated,

The central questions before economists of our generation are:

“Does our market capitalist economy, left to itself, without govern-
ment intervention, utilize fully its labor force and other produc-
tive resources? Does it systematically return, reasonably swiftly, to
a full employment state whenever displaced from it?” The faith of
the classical economists assures us “yes.” The answer of The General
Theory is “no.” ... Fortunately, it appears that the remedies lie in
government fiscal and monetary policies and leave intact the basic
political, economic and social institutions of democracy and capi-
talism [contrary to the faith of the young Marxists who, to Keynes’s
dismay, were prominent in the Cambridge Apostles in the 1930s].

Writing as himself, Tobin (1997, 27) concluded “Classical faith that

demand-deficient economies will recover on their own failed theo-
retical and empirical challenge in Keynes’s day. It fails now again,
more than half a century later.”

Microeconomic foundations for IS-LM

Tobin was present at the creation of Alvin Hansen’s one-good version

of the IS-LM model of goods market and money market equilibrium
that became the mainstay of American Keynesian teaching. Tobin,
then a junior member of Harvard’s Society of Fellows, and Seymour
Harris, as editor of the Economic Handbook Series, were the only
people thanked in the preface to Hansen (1949, vi) for reading and
commenting on the manuscript, and Hansen (1949, 168n), when
citing Tobin (1947–48), declared “I have relied heavily upon his
analysis.” Tobin (1947–48) had used the IS and LM curves (named
 An American Keynesian 17

for Investment, Saving, Liquidity Preference, and Money Supply),

and the small system of simultaneous equations underlying them,
to show that the preference of pioneer monetarist Clark Warburton
(1945) for monetary policy rather than fiscal policy rested on an
unstated assumption that the demand for money was insensitive to
changes in the interest rate.
Post Keynesians rejected the IS-LM model as underplaying the
importance of fundamental, uninsurable uncertainty (as distinct
from insurable risk), and because Keynes would never have counte-
nanced representing his theory by a system of simultaneous equa-
tions – although it turns out that a four-equation IS-LM model first
appears in a lecture by Keynes in December 1933, attended by David
Champernowne and Brian Reddaway, who later published the first
models equivalent to IS-LM (Dimand 2007). Monetarists such as
Milton Friedman also shunned the IS-LM diagram as being drawn for
a given price level (e.g., the critiques of the “Yale school” by Brunner
1971 and Meltzer 1989), except when Friedman used it in Gordon
(1974) in an attempt to communicate with his Keynesian critics – an
instance later cited by some Post Keynesians as evidence that main-
stream American Keynesian users of IS-LM were really classical rather
than Keynesian. Tobin (1980a, Lecture I) responded to this mone-
tarist objection to IS-LM by using IS-LM diagrams with the interest
rate and price level on the axes to analyze situations of full employ-
ment, drawing the curves for given output. Tobin continued to find
the IS-LM framework useful, but devoted his career to extending it
and providing richer and deeper microeconomic foundations for
its investment, consumption, money demand, and money supply
components, particularly with regard to a full range of assets and to
stock-flow consistency. Tobin (1980a, 73) began the third and last of
his Yrjö Jahnsson Lectures by saying that he would

be particularly concerned with the Keynesian model and the

famous IS/LM formalization by Sir John Hicks [1937]. ... I shall
consider critically its possible interpretations, some objections to
them raised by others, and some of my own. Yet I want to begin
by saying that I do not think the apparatus is discredited. I still
believe that, carefully used and taught, it is a powerful instru-
ment for understanding our economies and the impacts of poli-
cies upon them.
18 James Tobin

Tobin (1980a, 94) ended that lecture with

one major general conclusion, namely the robustness of the

standard results of Hicksian IS/LM analysis. They survive in these
models in which time, flows, and stocks are more precisely and
satisfactorily modeled, in which time is allowed for flows to affect
the stocks of government liabilities and of other assets too, in
which the menu of distinct assets is as large as desired.

Many of the extensions that Tobin made to the asset market side of
the IS-LM framework pioneered by Hicks (1937) were in the spirit
of Hicks (1935), where Hicks had argued for treating the theory of
money as an application of general economic theory to portfolio
choice.4 Tobin (in Gordon 1974, 77n) observed that “The synthesis
of the last twenty-five years certainly contains many elements not
in the General Theory (Keynes 1936). Perhaps it should be called
Hicksian, since it derives not only from his IS-LM article but, more
importantly, from his classic paper on money (Hicks 1935).”
Tobin’s doctoral dissertation was on consumption and saving, intro-
ducing wealth as well as income as an argument in the consumption
function. Tobin’s q theory of investment dealt with the other part
of the IS (investment/saving) goods market equilibrium condition.
Tobin offered microeconomic foundations for both the liquidity pref-
erence (money demand) and the money supply components of the
LM money market equilibrium condition, making it just one of many
asset market clearing conditions. He developed a model of the opti-
mizing commercial banking firm and used it to study how, in a world
of many assets that are imperfectly substitutable for each other, the
endogenous money supply is affected by changes in the monetary
base, a choice variable controlled by the monetary authority (Tobin
with Golub 1998), since endogeneity of the money supply does not by
itself imply a horizontal LM curve (in contrast to Moore 1988).
Keynes (1936) was the first to write money demand as a function of
income and the interest rate, although others had come close before,
such as Irving Fisher in 1930 when he identified the nominal interest
rate as the marginal opportunity cost of holding real cash balances.
Tobin sought to ground such a demand function for non-interest-
bearing, fiat money in the decisions of rational, optimizing individ-
uals. Tobin (1956), like William Baumol (1952) and Maurice Allais
 An American Keynesian 19

(1947) (see Baumol and Tobin 1989 on Allais’s priority), derived the
square root rule for the inventory-theoretic approach to the transac-
tions demand for money from minimization of the total costs of cash
management, consisting of the transaction cost incurred whenever
interest-bearing assets were converted into means of payment, plus
the interest foregone by holding part of one’s wealth as money.
Tobin’s “Liquidity Preference as Behavior towards Risk” (1958a)
considered the demand for money as an asset that risk-averse inves-
tors held in portfolios even though its expected return of zero was
strictly less than the expected return on risky assets, because holding
money was riskless in nominal terms. Keynes (1936) had assumed
that agents held a fixed expectation of what the interest rate would
be in the future, but Tobin, as he told Shiller (1999, 885),

wanted to have an explanation for the demand for money that

didn’t depend on there being a different interest rate from the one
which the model produced. That’s perfectly good rational expec-
tations methodology ... that’s what that article was all about. It
wasn’t about creating the CAPM model or the separation theorem.
The separation theorem just came out naturally from the way I
was modeling this thing.

To Shiller’s suggestion that Tobin (1958a) laid the foundations for the
Capital Asset Pricing Model (CAPM), Tobin responded:

The CAPM really amounts to the dual of what I was doing ... I was
taking the prices and inquiring what the quantities are to get a
demand for money function, whereas CAPM takes quantities as
given and inquires what the prices must be. So, yes, it is a fact that
[John] Lintner [1965] and [William] Sharpe [1964] did the dual.
It hadn’t occurred to me to do that because it wasn’t what I was
looking for. I never was a part of the finance fraternity.

Tobin developed a multi-asset framework, in which money was an

imperfect substitute for other assets, with asset demands linked across
markets by the adding-up constraint that asset demands have to sum
to wealth, and with flows of saving and investment changing the
stocks of assets over time. The adding-up constraint (or, in another
model, Walras’s Law summing individual budget constraints) makes
20 James Tobin

one of the asset market clearing conditions redundant, but Brainard

and Tobin (1968) warned about the pitfall of implausible implied
elasticities for the omitted demand function. Brunner and Meltzer
(1993) also developed a multi-asset model, but Tobin expressed
amazement that “at the same time they have multiasset substitut-
able assets and yet, in the end, they come to a monetarist result
which seems to be inconsistent with the assumed substitutability
among assets, including the substitutability of some assets for money
proper” (Colander 1999, 124). While incorporating wealth as an
adding-up constraint, stock-flow consistency, and optimization in
models of specific functions such as money demand, Tobin refused
to think of markets as linked by the budget constraint of an opti-
mizing representative agent (see Geweke 1985, Kirman 1992, and
Hartley 1997 on representative agent models). Tobin held that these
models were totally unsuited to analyzing the macroeconomic coor-
dination problem posed by Keynes. He objected strongly to claims
that overlapping generations (OLG) models, dependent on the very
strong assumptions that money is the only asset and that the number
of successive generations is infinite, provide rigorous microeconomic
foundations for the existence and positive value of fiat money (see
his comments in Kareken and Wallace 1980 and in Colander 1999).
While Tobin emphatically did not consider OLG models a satisfac-
tory explanation for the positive value of fiat money, he found them
useful for analyzing intertemporal consumption choice.
Willem Buiter (2003, F590–F591) observes:

During the 1960s, 1970s, and 1980s, Tobin made a number of

key contributions to the theory and empirics of the life-cycle
model, putting it in an Allais-Samuelson overlapping generations
(OLG) setting ... The empirical methodology employed is an early
example of simulation using calibration. With only a modicum
of hyperbole, one could describe Tobin as the methodological
Godfather of the RBC [real business cycle] school and method-
ology of Kydland and Prescott!5

Is the economic system self-adjusting?

The fourth central Keynesian proposition identified by Tobin (1977)

was that even if money wages and prices were flexible, their flexibility
 An American Keynesian 21

would not necessarily ensure stability. According to Keizo Nagatani

(1981, 117):

The stability question to which Keynes addressed himself in the

General Theory and that Tobin (1975) discussed is now interpreted
as the question whether or not the sequence of temporary equi-
libria will converge to a short-run equilibrium. This, I believe, is
the fundamental problem in macroeconomics. But this is also
a very complex problem, to which only a partial answer can be
given.

(See also Driskill and Sheffrin 1986, De Long and Summers 1986,
and Chadha 1989 as examples of the debate ignited by Tobin 1975.)
Tobin (1975) presented what he called a Walras–Keynes–Phillips
model in which, even if the model had a unique equilibrium at poten-
tial output Y* (which Tobin emphasized was not, in fact, his opinion),
output might continue to diverge further from potential output after
a negative demand shock, despite incorporating the Pigou–Haberler
real balance effect in the model. The resulting unemployment would
be a phenomenon of disequilibrium dynamics, but if there was no
convergence to the full employment equilibrium, it did not matter
that the system described by the model lacked an unemployment
equilibrium. The stabilizing Pigou–Haberler real balance effect of a
lower price level (implying a larger real value of outside money, hence
higher wealth, hence more consumption) could be swamped by the
destabilizing effects of a falling price level. Expectations of falling
prices reduce the opportunity cost of holding real money balances,
and hence increase the demand for real money balances, a leftward
shift of the LM curve.
Tobin (1980a, Lecture I), like Minsky (1975), also invoked the debt-
deflation process described by Irving Fisher (1933): the rising real
value of inside debt denominated in nominal terms does not wash
out, because the increased risk of bankruptcy raises risk premiums
on loans, and because the transfer of real wealth from borrowers to
lenders depresses spending, since they presumably were sorted into
borrowers and lenders by their different propensities to spend. The
volume of inside debt far exceeds the quantity of outside money on
which the real balance effect acts. Don Patinkin (1956), like A. C.
Pigou (1947), had concluded that the real balance effect proved in
theory that wage flexibility could restore full employment after a
22 James Tobin

negative demand shock even if the nominal interest rate could not
decline (e.g., if it had fallen to zero), and even if in practice expan-
sion of aggregate demand would be a faster route to full employment
than wage cutting (but Patinkin also drew attention to the negative
effect of falling prices on investment demand). Tobin (1975) argued
that Pigou’s case against Keynes was not established even in theory.
Clower (1984) and Leijonhufvud (1968, 1981) had also interpreted
Keynes as challenging classical economics on theory, not just policy,
but on the grounds that Walras’ Law did not hold for quantity-con-
strained demands (the amount of labor that an unemployed worker
cannot sell multiplied by the prevailing wage that the worker is not
receiving should not count in the worker’s budget constraint), rather
than the dynamics of adjustment. Tobin told Colander (1999) that
he had nothing against the Clower–Leijonhufvud approach, but did
not feel that he had been much instructed by it.
Tobin (1997, 12–13) writes, “as Keynes” in the supposed second
edition of The General Theory,

In Chapter 19 I emphasized the negative effects of increasing

debt burdens, and Professor Fisher has made a convincing case
that debt burdens augmented by deflation exacerbated the Great
Depression in the United States. I also agree with Professor Fisher
that, whatever may be the effects of lowering the level of money-
wages and prices, the process of moving to a lower level is counter-
productive. Expectations of deflation are equivalent to an increase
in interest rates. For these reasons, I do not regard Professor Pigou’s
counterthrust as a refutation of the general theory on an abstract
theoretical plane, a fortiori on the plane of practical policy. Indeed,
I remain of the opinion that a fairly stable money-wage will result
in less volatility both of output and employment and of prices.

Tobin (1975) stated the crucial necessary condition for stability in his
model, but did not present the derivation. The necessary and suffi-
cient conditions for stability in Tobin’s 1975 Walras–Keynes–Phillips
model are derived in Bruno and Dimand (2009), where it is shown
that Tobin’s 1975 WKP model possesses a corridor of stability, such
as Leijonhufvud called for in 1973 (reprinted in Leijonhufvud 1981,
103–29). That is, the model is self-adjusting for small shocks, but
can be pushed outside the corridor of stability by a sufficiently large
 An American Keynesian 23

negative demand shock, so that it then moves even further away

from potential output. This feature of the model captures the intui-
tion that Great Depressions happen only occasionally: most of the
time, markets adjust. The reason for the corridor of stability is that
one of the stabilizing forces, the so-called Keynes effect, by which a
lower price level increases the real money supply, and so lowers the
interest rate, weakens and then vanishes as the nominal interest rate
falls toward zero.

Conclusion: an “Old Keynesian” counterattacks

Tobin remained proud to call himself an “Old Keynesian,” not a

New, neo- or Post Keynesian (see Purvis 1982 and Buiter 2003 on
the full range of his contributions to economics). His disequilibrium
dynamic interpretation of Keynes, making Chapter 19 central to The
General Theory, set Tobin apart both from Keynes’s opponents and
from the defenders of Keynesian unemployment equilibrium. Tobin
(1975, 1977a, 1980a, 1992, 1993, 1997) developed and expounded
this disequilibrium dynamic version of Keynes as a counterattack
against natural rate of unemployment theories, showing that even
if there were a unique natural rate equilibrium, the system need not
be self-adjusting in the absence of governmental stabilization after a
sufficiently large negative demand shock.
Chapter 19 of Keynes’s General Theory first appeared as central to
Tobin’s interpretation of Keynes in 1975, joined by Fisher (1933) in
1980. Too neoclassical for many Post Keynesians, Tobin grounded
asset demand functions (including money demand) and consump-
tion decisions in the optimizing behavior of rational individuals, and
emphasized adding-up constraints and stock-flow consistency, but he
rejected representative agent models with continuous labor market
clearing as useless for understanding the macroeconomic coordina-
tion problem. His approach, strongly influenced by Hicks (1935) and
Fisher (1933) as well as by Keynes (1936, Chapters 12 and 19), was
recognizably distinct from the rest of the American Keynesian main-
stream, which paid less attention to the monetary system, to multi-
asset modeling, and to disequilibrium dynamics.
2
Transforming the IS-LM Model
Sector By Sector

Transforming IS-LM

James Tobin was one of the second generation of American “Old

Keynesians” (Tobin 1992, 1993), the generation that first encoun-
tered economics in the Great Depression rather than, like Alvin
Hansen or Seymour Harris, discovering Keynes after becoming econ-
omists. He played a leading role in the transformation of the IS-LM
model with simple equations for the money market and the flow
of investment into a modeling framework with a much more fully
developed treatment of asset markets and investment, and mounted
a spirited defense of this approach against New Classical critiques.
After taking part as a student and post-doctoral fellow in Alvin
Hansen’s reformulation of IS-LM, Tobin’s subsequent career centered
on replacing the money market equilibrium equation and the invest-
ment function of the IS-LM model with what he termed a “General
Equilibrium Approach to Monetary Theory” (the title of Tobin’s 1969
contribution to the inaugural issue of the Journal of Money, Credit and
Banking), replacing “the interest rate” with a menu of asset returns,
and paying attention to stock-flow dynamics. This was a general
equilibrium approach in the sense that equilibria in the various
markets for stocks of assets were linked by the adding-up constraint
on wealth (the demands for individual assets must add up to total
wealth). Failure to impose the wealth constraint in earlier models led
to “Pitfalls in Financial Model-Building” (Brainard and Tobin 1968).
Tobin’s approach involved optimization in deriving, for instance, the
Allais–Baumol–Tobin square root rule for the transactions demand

24
 Transforming the IS-LM Model Sector By Sector 25

for money and in the mean-variance analysis of portfolio balance

(given a quadratic loss function or a normal distribution of returns).
However, his approach was not general equilibrium in the New
Classical (or equilibrium business cycle) sense of continuous clearing
of goods, labor, and asset markets linked by the budget constraints of
optimizing representative agents (a modeling strategy which Tobin
argued vigorously against).
In his Nobel lecture, Tobin (1982a, 24) held forth:

Hicks’s “IS-LM” version of Keynesian and classical theories has

been especially influential, reaching not just professional econo-
mists but, as the standard macromodel of textbooks, also gener-
ations of college students. Its simple apparatus is the trained
intuition of many of us when we confront questions of policy
and analysis, whatever more elaborate methods we may employ
in further study. But the framework has a number of defects
that have limited its usefulness and subjected it to attack. In this
lecture, I wish to describe an alternative framework, which tries
to repair some of those effects. At the same time, I shall argue, the
major conclusions of the Keynes-Hicks apparatus remain intact.

In keeping with his emphasis on a vector of asset prices rather than

a single interest rate, Tobin modeled investment as a function of
q, the ratio of the market value of corporate assets to the replace-
ment cost of the underlying capital stock (with adjustment costs
allowing q to differ from unity). Tobin’s attention to asset stocks and
adding-up constraints (related to the work of Blinder and Solow 1973,
1974) had implications throughout the IS-LM framework. Tobin
used his extended IS-LM framework to expound “Old Keynesian”
concerns about macroeconomic stabilization in his Yrjö Jahnsson
Lectures on Asset Accumulation and Economic Activity (1980a),
while the Backus, Brainard, Smith, and Tobin (1980) “Model of US
Financial and Nonfinancial Economic Behavior” illustrates how his
approach translated into more formal modeling, and Tobin (1992,
1993) offered a spirited defense of the continued usefulness of the
American Keynesian approach. Beyond reformulating the compo-
nents of the IS and LM equilibrium conditions (the consumption,
investment, money demand, and money supply functions), Tobin
also reworked the graphical presentation of IS-LM when that suited
26 James Tobin

his exposition: Figures 1 to 5 of the discussion of real balance effects

in Tobin (1980, 14–17) drew IS and LM curves in interest rate (r) and
price level (p) space, for given real national product Y and nominal
stock M (contrary to occasional monetarist statements that IS-LM is
inherently a fixed-price framework), while Figures 6 and 7 reverted
to the traditional (r, Y) space.

Present at the creation of American Keynesianism

Alvin Hansen, through his books (Hansen 1949, 1953) and his (and
John H. Williams’s) Fiscal Policy seminar at Harvard’s Graduate
School of Public Administration (now the Kennedy School of
Government), was so influential in introducing the IS-LM represen-
tation of Keynes’s General Theory into North American economics
that the IS-LM diagram became known as the “Hicks–Hansen
diagram” (see Young 1987, 115–121, on Hansen’s role in the insti-
tutionalization of IS-LM; Tobin 1976a on Hansen’s seminar; and
Samuelson’s interview in Colander and Landreth 1996, 164, for an
example of use of the term “Hicks–Hansen diagram”). While Hicks
(1937) used his SILL diagram to offer “a suggested interpretation” of
Keynes, Hansen presented IS-LM as the only valid representation of
The General Theory. Hansen (1949, 71n), in his book’s only mention
of Hicks1, acknowledged “The analysis given in this chapter is based
on Keynes’s General Theory; but heavy reliance is placed upon the
brilliant work of J. R. Hicks” (1937).
Hansen had not always been an admirer of Keynes. A severe critic
of the “fundamental equations” of Keynes’s Treatise on Money, Hansen
had also reviewed The General Theory unfavorably in the Journal of
Political Economy (deleting the most hostile sections of the review
when reprinting it in Hansen 1938). Reminiscing in 1972 about his
early days as a Keynesian, Hansen recalled that even John Maurice
Clark “wasn’t really intellectually friendly to Keynesian economics”
(Colander and Landreth 1996, 104). However, Hansen had written
to Clark in 1934 that “your analysis still follows too much along
the Keynes lines” of The Means to Prosperity (Keynes 1933) and that
“Keynes’ analysis I regard as definitely wrong” (Hansen to Clark,
August 8, 1934, in appendix to Fiorito 2001, 31). After Hansen moved
to Harvard in September 1937, contact with Keynesian students stim-
ulated Hansen’s rethinking his view of The General Theory.
 Transforming the IS-LM Model Sector By Sector 27

One of those Keynesian students, and the one with most influence on
the IS-LM framework of Hansen (1949), was James Tobin. When Tobin
was an 18-year-old Harvard sophomore taking principles of economics
(Ec A) in 1936, his tutor, Spencer Pollard (a graduate student who was
also teaching his principles section), “decided that for tutorial he and
I, mainly I, should read ‘this new book from England. They say it may
be important.’ So I plunged in, being too young and ignorant to know
that I was too young and ignorant” to begin studying economics with
The General Theory (Tobin 1988, 662). Apart from Seymour Harris,
editor of the Economics Handbooks Series in which Hansen (1949)
appeared, Tobin (then a Junior Fellow at Harvard, 1947–1950) was the
only person thanked for pre-publication reading and comments on
Hansen (1949, vi). Hansen (1949, 168n), when citing Tobin (1947–48),
stated, “I have relied heavily upon his analysis.”
Tobin (1947–48), using IS and LM curves and the underlying equa-
tions, showed that Clark Warburton’s proto-monetarist argument for
monetary policy, rather than fiscal policy, rested on an unstated implicit
assumption of the interest inelasticity demand for cash balances
(Warburton 1945), and demurred from William Fellner’s belief that
demand for cash balances was not very interest elastic (Fellner 1946).
Hansen (1949, 59) also cited Tobin (1947–48) for a “more sophisticated
view” (that is, more sophisticated than the “naïve quantity theory of
money”) of how an increase in cash balances increases investment
by lowering the interest rate. Expanding on this discussion, Hansen
(1953, 148–151) introduced “a new ‘sophisticated’ curve which I shall
label LIS” that incorporated the liquidity preference, saving, and
investment-demand functions to show the relationship between the
interest rate and the desired amount of money L (in i, L space, rather
than the i, Y space of the IS and LM curves2), when account is taken of
the effect of the interest rate on the level of income (along the IS curve)
and hence on the transactions demand for money.
On “The Modern Theory of Wages and Employment,” Hansen (1949,
126n) referred to “the exceptionally able statement by James Tobin in
The New Economics, edited by S. E. Harris [1947].” Tobin was present at
the creation of the mainstream American Keynesian IS-LM framework
at the Harvard of Hansen and Harris, and the more technical parts
of Hansen (1949) explicitly relied on Tobin (1947–48)3. Tobin eventu-
ally wrote a companion volume in the same series (Tobin with Golub
1998). In 1949, Seymour Harris invited Joseph Schumpeter (Tobin’s
28 James Tobin

dissertation adviser) to cover the theory of money and banking (in

the same Economic Handbook series as Hansen [1949]) with a manu-
script already under contract to McGraw-Hill since 1946, but that
spot in the series was finally filled by Tobin in 1998.4
The IS-LM portions of Hansen (1949, 1953), built around diagrams
and equations, were more formal than was usual for Hansen – and it
was these more formal IS-LM sections that became the most influen-
tial portions of the books and perhaps the most influential of any of
Hansen’s writings. Other current or former participants in Hansen’s
Fiscal Policy seminar were formalizing aspects of American Keynesian
macroeconomics in other ways at the time, such as Paul Samuelson
(a Harvard Junior Fellow in 1937–40) on multiplier-accelerator inter-
action and on the 45-degree Keynesian cross diagram (writing up
the latter for Hansen’s Festschrift in 1948), Richard Goodwin on
the nonlinear accelerator and the persistence of business cycles, or
William Salant on the balanced budget multiplier (see Samuelson’s
interview in Colander and Landreth 1996, 166). But IS-LM reached
Hansen (1949) by way of Tobin (1947–48), and then the IS-LM discus-
sion in Hansen’s Guide to Keynes (1953) was based on Hansen (1949).
Tobin recalled that “There wasn’t much Walras at Harvard then,
until Hicks finally came out with Value and Capital [1939]” (Shiller
1999, 870), and that he “attended as an undergraduate a course on
general equilibrium theory with Schumpeter as teacher and people
such as Paul Samuelson, Lloyd Metzler, and R. G. D. Allen as students.
As you know, Hicks, Allen and Samuelson basically imported general
equilibrium theory from the Continent into Anglo-Saxon economics”
(Klamer 1984, 100).5
Since Tobin graduated in 1939, these recollections, taken together,
suggest that Tobin studied Hicks’s general equilibrium theorizing as
soon as Value and Capital was published, in the company of Hicks’s
sometime co-author Allen and of Samuelson, then completing the
dissertation that became his Foundations of Economic Analysis (1947);
they also suggest that this study prepared Tobin to introduce Hansen
to Hicks (1937).
Although Tobin was an enthusiastic Keynesian, his undergraduate
thesis (which was the basis for his first article, Tobin 1941, and his
chapter in Harris 1947) rejected Keynes’s argument that reductions
in money wage rates cannot be relied upon to reduce unemployment,
on the grounds that Keynes was assuming that people act differently
 Transforming the IS-LM Model Sector By Sector 29

as wage earners (subject to what Irving Fisher termed “money illu-

sion”) from how they behave as consumers. In this undergraduate
thesis, Tobin followed one of his teachers, Wassily Leontief (1936),
who labeled money illusion in the labor supply schedule the “funda-
mental assumption” of Keynes’s system. Tobin’s acceptance in 1947
of money illusion as a realistic assumption stands in contrast to his
later view (e.g., Tobin 1972), and presumably reflects the influence
of Leontief on Tobin’s undergraduate thesis. Later, Tobin (1972)
recognized and accepted the argument of Keynes (1936, Chapter 2)
that workers could quite rationally (without any money illusion –
mistaking money wage changes for real wage changes) resist money
wage reductions as unsynchronized contracts expire, because such
money wage cuts alter relative wages, while a price level increase
would reduce the purchasing power of all wages at the same time.
Tobin was sympathetic to the formalization of this staggered-
contracts approach by John Taylor (1980, author’s recollection
of a graduate course on money and finance taught by Tobin and
Taylor in 1979–80, when Taylor was visiting Yale). Significantly, the
publications resulting from Tobin’s undergraduate thesis show his
longstanding concern with the rationality of the assumed behavior
underlying Keynesian economics.

Revising the IS curve

Although Tobin is best known as a monetary economist and for the

q theory of investment, he wrote his Harvard doctoral dissertation
(accepted in 1947) on the other building block of the IS curve, the
consumption function. When he contributed to the International
Encyclopedia of the Social Sciences two decades later, he did so as an
expert on the consumption function (Tobin 1968c). Responding
to theories of consumption advanced by James Duesenberry in his
Harvard dissertation, and by Dorothy Stahl Brady and Rose Director
Friedman in a National Bureau of Economic Research conference
volume, Tobin (1951) presented empirical evidence that absolute
income (as in Keynes 1936) performed better than relative income
to explain consumption. However, he advocated including wealth
as well as absolute income in the consumption function, to better
explain cross-section data. Tobin (1951) argued that differences in
saving propensities between white and black households in the
30 James Tobin

same city reflected differences in household wealth. The inclu-

sion of wealth as an argument in the consumption function was a
step toward subsequent consumption theories (Milton Friedman’s
permanent income hypothesis and the Modigliani-Brumberg-Ando
life-cycle hypothesis) and also toward rediscovery of Irving Fisher’s
two-period optimal consumption smoothing diagram relating
consumption to the present discounted value of expected lifetime
income, given perfect credit markets (Fisher 1907, 409).
Given that Tobin’s 1947 dissertation added wealth as an argument in
the consumption function, it is striking that Hansen (1949) included
wealth as an argument in the consumption, investment, and money
demand functions of his IS-LM model6 (an innovation noted by
Darity and Young 1995, 27). However, rather than continuing to take
a leading role in formulating new theories of the consumption func-
tion, Tobin’s continuing interest in analyzing data on consumption
decisions (e.g., for automobiles, where for many households spending
in a given year would be zero) led him in the later 1950s to the latent
variable method for estimating limited dependent variable models
(where the dependent variable is continuous over strictly positive
values but zero for a nontrivial portion of the population) that Arthur
Goldberger labeled “Tobit analysis” (Shiller 1999, 873, 876–877).
Tobin’s dissertation contributed to the development of models
linking consumption to the present discounted value of expected
lifetime after-tax income. Tobin (1980a, Lecture III) was critical of
Robert Barro’s debt neutrality (or Ricardian equivalence) proposi-
tion that, given the level of government spending, lump-sum tax
cuts have no effect on the position of the IS curve, an implication
of combining such a forward-looking theory of consumption with
additional strong assumptions. Tobin objected particularly to the
unrealism of the assumption of perfect credit markets (no liquidity
constraints or credit rationing), which holds that consumers can
borrow against expected future earnings at the same interest rate
that they would receive on their savings. If these interest rates
differed, a consumer whose inter-temporal indifference curve was
tangent to the kink in the inter-temporal consumption possibility
frontier would have consumption determined by current after-tax
income, a return to Keynes’s simple absolute-income consumption
function and a retreat from the Fisherian approach to which Tobin’s
1947 dissertation had contributed.
 Transforming the IS-LM Model Sector By Sector 31

Tobin’s most famous contribution to economics was the q theory of

investment (Brainard and Tobin 1968, Tobin 1969, Tobin and Brainard
1977, Purvis 1982), which related net investment to q, the ratio of the
market value of equity to the replacement cost of the capital stock
underlying the equity. The name suggests an affinity to the Q (either
windfall profits or expected above-normal returns, depending on the
passage one cites) that drove investment decisions in Keynes’s Treatise
on Money (1930), which in turn owed its name to Marshall’s quasi-
rents, but Tobin did not recall choosing the symbol q for that reason.
When the economy has its desired capital stock, q would equal one,
and gross investment would just cover depreciation. If q exceeds one,
entrepreneurs can make a profit by adding to their capital stock and
issuing equity, selling the new equity for the present discounted value
of the expected stream of earnings from the additional capital stock.
Hayashi (1982) offered a neoclassical reinterpretation of q, in which
deviations of q from one are explained by adjustment costs. Tobin,
however, insisted that Hayashi’s q is a shadow price of an optimal
program solution, whereas the Tobin-Brainard q is an observable
market variable, “a datum for individual agents, created by monetary
policy interacting with the economy, a datum to which individuals
and firms respond in their investments” (Shiller 1999, 887–888).
Tobin’s goal was to subsume both the investment function under-
lying the IS curve and the money demand and money supply func-
tions underlying the LM curve into a more general theory of asset
accumulation.

Microeconomic foundations of the LM curve

Tobin’s most widely reprinted articles (e.g., Tobin 1956, 1958a) were
part of his intensive effort to ground the LM curve (money market
equilibrium) in the optimizing behavior of rational agents. Keynes
(1936) wrote the demand for real money balances (liquidity prefer-
ence, measured in wage-units) as a function of income (because of the
transactions motive for holding money) and the interest rate (because
of the speculative motive). Despite his overall sympathy for Keynes’s
General Theory, Tobin was dissatisfied with Keynes’s treatment of
both transactions and speculative motives. He did not consider that
Keynes had explained why people hold money and near-money
even though other marketable assets have higher yields, or why the
32 James Tobin

demand for money and near-money is empirically observed to vary

inversely with those yields. Tobin (1983, 165) recalled: “The reason for
my dissatisfaction was that Keynes’s ‘speculative motive’ for money
demand seemed, in modern parlance, to violate the canons of rational
expectations7.” As Tobin interpreted Keynes, Keynes assumed that an
agent must hold the same expectation of short-term returns on all
assets the agent chooses to hold. Otherwise, the agent would wish
to shift his or her portfolio entirely out of the lower-yielding assets
into the highest-yielding asset. Money and low-yield short securities
are thus held by those agents who expect capital losses on long-term
bonds (because of an increase in interest rates) sufficient that their
expected net short-term yields on bonds would be no higher than
on money and near-money. Tobin (1983, 166) accepted that many
financiers in the 1930s might have continued to regard the higher
interest rates of the 1920s as normal, but “Eventually expectations
must accord with experience.” A reduction in current interest rates
could induce expectations of a future rise in interest rates (reversion
to normal levels), “But clearly if Keynes’s speculators had, individu-
ally or in aggregate, unbiased expectations, there would be no justi-
fication for a liquidity preference function with negative sensitivity
to the current rate of interest.”
Tobin (1958a) reformulated the demand for money as an asset –
Keynes’s speculative motive for holding money – as the behavior of
risk-averse investors to risk (as distinct from fundamental Keynesian
or Knightian uncertainty). Investors have preferences over the distri-
bution of returns to their overall portfolios, rather than individual
assets. Money and highly liquid short securities such as Treasury bills
(near-money) differ from other assets not only in expected return (zero
nominal return on narrowly defined money, lower nominal returns on
Treasury bills and interest-bearing bank deposits than on other assets)
but also in risk (with money as a riskless asset in nominal terms, or,
allowing for changes in the purchasing power of money, a less risky
asset in real terms). While Keynes’s liquidity preference theory implied
that each agent would own only one asset (see Bernstein 1992, 48, for
a quotation from Keynes against portfolio diversification8), Tobin’s
investors would hold a mix of money and other assets. Tobin (1982a,
173) emphasized, “John R. Hicks’ 1935 article has been an inspiration
and challenge to me and many other monetary economists” (see Maes
1991). In addition to Hicks (1935), Harry Markowitz (1952, 1959) strongly
 Transforming the IS-LM Model Sector By Sector 33

influenced Tobin’s approach. Markowitz, who spent the 1955–1956

academic year at Yale at the Cowles Foundation turning his 1955
Chicago dissertation on selection of an optimal portfolio of risky assets
(which Milton Friedman had proposed rejecting as “not economics”)
into a Cowles monograph (Markowitz 1959, see also Bernstein 1992
on Friedman’s view of Markowitz’s thesis). The Cowles Commission
had moved from the University of Chicago to Yale in 1955 (changing
its name to the Cowles Foundation for Research in Economics) when
Tobin became its director (after he declined to move to Chicago). Tobin
(1958a) noted that “Markowitz’s main interest is prescription of rules
of rational behavior for investors; the main concern of this paper is the
implications for economic theory, mainly comparative statics, that can
be derived from assuming that investors do in fact follow such rules.”
Tobin (1958a) also differed from Markowitz (1952) in showing
that, if there is a riskless asset, the division of the portfolio between
risky and riskless assets and Markowitz’s optimal diversification
of the risky part of the portfolio among different risky assets are
two separate decisions. There is an optimal portfolio of risky assets,
which will be the same for all investors. Each investor’s degree of risk
aversion then determines the fraction of the investor’s wealth to be
invested in that optimal portfolio of risky assets, with the remainder
invested in the riskless asset. This remained a purely theoretical
result, unused by financial practitioners, until 1961, when William
Sharpe (writing a UCLA doctoral dissertation unofficially supervised
by Markowitz) discovered that one need only determine how each
stock co-varied with the market index, not with every other stock,
reducing the computing time for a single run of a simplified Tobin/
Markowitz model from 33 minutes to 30 seconds (Sharpe 1964,
Harrison 1997, 177).
To be a strict representation of the maximization of expected utility,
Tobin’s mean-variance diagram for portfolio choice required either
that asset returns are normally distributed (so that the distribution
of returns has only two parameters) or that investors have quadratic
utility functions (so that the investors care only about the first two
moments of the distribution) (see Tobin 1984b). When Karl Borch and
Martin Feldstein objected in 1969 that Tobin’s two-parameter mean-
variance analysis was only an approximation, Tobin argued that it
improved on the previously prevailing one-parameter approximation
(expected return plus a constant, unexplained risk premium). Given
34 James Tobin

that investors in Tobin (1958a) know the correct probability distribu-

tions for asset returns, Tobin later reflected, “My theory of liquidity
preference as behavior toward risk was built on a rational expecta-
tions model long before the terminology” (Shiller 1999, 878).
The treatment of money in Tobin (1958a) as one of many assets, each
having a distribution of returns with some particular mean and vari-
ance, was the basis of the “general equilibrium approach to monetary
theory” of Tobin (1969), in which a vector of market-clearing asset
prices (and hence asset returns) is determined by the whole range of
asset supplies and demands, providing a channel through which open-
market operations changing the relative supplies of money and bonds
affect the cost of capital (Tobin and Brainard 1977). Work on this
approach by Tobin and his associates at the Cowles Foundation, most
notably his doctoral student and then colleague William Brainard,
was gathered in three Cowles Foundation monographs (Hester and
Tobin 1967a, 1967b, 1967c – for example, Tobin 1958a was reprinted
in Hester and Tobin 1967a). While the post-1955 Cowles Foundation
provided an institutional base for Tobin and his collaborators, Tobin
and Shiller were at pains to emphasize in Colander (1999) that Cowles
was not the same as the “Yale school” (or Tobin school) of mone-
tary economics: many or most Cowles researchers worked on non-
Keynesian macroeconomics (Fellner 1976) or on econometrics, game
theory, or mathematical general equilibrium theory.
Keynes’s presentation of the transactions motive for holding
money offered no reason for an inverse relation between money
demand and interest (even though Fisher 1930, 216, had already
stated the marginal opportunity cost of holding money), and simply
posited a direct relation between liquidity preference and income,
with no derivation of how much money should be held for a given
rate of spending. Independently of each other (and of any knowledge
of Allais 1947, see Baumol and Tobin 1989), Baumol (1952) and Tobin
(1956) derived the transactions demand for money from the need to
use money (the generally accepted medium of exchange) as means of
payment and the existence of transactions costs of converting funds
from interest-bearing assets into money. Optimizing agents would
choose to hold the average level of money balances that minimized
the costs of asset management, balancing higher transactions costs
(from lower average money balances and consequently more trans-
actions between bonds and money) against foregone interest (from
 Transforming the IS-LM Model Sector By Sector 35

higher average money balances and consequently lower average bond

holdings). Assuming that all income would be spent at a steady rate
during a pay period, Allais (1947, 238–241, translated in Baumol and
Tobin 1989), Baumol (1952), and Tobin (1956) solved for the optimal
number of transactions between bonds and money per pay period.
The resulting square root rule, already familiar in the literature on
optimal inventories, related optimal holdings of nominal money
balances directly to the square root of nominal income and nominal
transactions costs, and inversely to the square root of the nominal
interest rate (neglecting the constraint that the number of trans-
actions be an integer). Baumol (1952), on the basis of information
from Thomson M. Whitin, noted the independent formulation of
the square root rule for optimal inventories by half a dozen authors
between 1925 and 1927.9
Tobin also reworked the other building block of the LM curve, the
money supply, developing a simple model of a commercial banking
firm, based on a bank’s precautionary demand for safe liquid assets
(both primary reserves and secondary reserves). While “endogenous
money” in some Post Keynesian writing has come to mean a perfectly
elastic money supply at a fixed interest rate set by the central bank
(“horizontalism”), Tobin (1982b; Tobin with Golub 1998, Chapter 7)
linked reserves to deposits through the optimizing portfolio choices
of banks facing risk.
The publication dates are misleading. According to Tobin with
Golub (1998, xxiii), “Chapter 7 was published in Tobin (1982b)
virtually as it had been circulating in draft” as part of a manuscript
drafted between 1958 and 1960, but put aside when Tobin joined the
President’s Council of Economic Advisers in 1961.
Tobin (1969) pulled together his work on the components of LM
with the q theory of investment first presented in Brainard and Tobin
(1968). Tobin (1982a, 45) reflected in his Nobel lecture that in 1969,

I tried to generalize the stock equilibrium of asset prices and quan-

tities to a larger collection of assets while winding up nonetheless
with a single LM locus to be juxtaposed with an IS locus. This
condensation, I now recognize, is not in general attainable. The
major points of the 1969 paper did not depend on this feature, but
the blending of stock adjustments and savings flows advocated in
this lecture seems to me a preferable approach.
36 James Tobin

The problem identified by Tobin (1982a) is that the equations under-

lying the LM curve concern the asset prices that induce wealth-
owners, constrained by the net worth created by past savings (revalued
at current asset prices), to hold the existing stocks of assets (also
predetermined, apart from open market operations of the monetary
authority). The saving function underlying the IS curve gives the flow
of additions to accumulated wealth, but not how wealth-owners wish
to distribute that accumulation across alternative assets. In particular,
Tobin wished to extend the standard textbook IS-LM framework to
track how investment, government deficits, and international capital
flows affect asset stocks. Making such extensions still led to

conventional macroeconomic results, qualitatively the same as

comparable conclusions of IS-LM apparatus. Note, however, that –
contrary to the classical Mundell conclusion that monetary poli-
cies work and fiscal policies do not work in a regime of floating
exchange rates – expansionary policies of both kinds are here
effective. (Tobin 1982a, 49 – see also Mundell 1968, Tobin 1980a,
76–77, and especially Tobin and de Macedo 1980)

Backus, Brainard, Smith, and Tobin (1980), Backus and Purvis (1980),
Purvis (1978), Smith and Brainard (1976), Tobin and Buiter (1976,
1980a), and Tobin and de Macedo (1980) together represent a major
effort to implement simplified prototype models of the integrated
stock-flow modeling advocated in Tobin (1982a). Referring to this
project, Tobin (1980a, 95) wrote:

Although models of this type in some sense “vindicate” IS/LM anal-

ysis, this is not their sole or principal purpose. Their richer struc-
tural detail permits the analysis of policies and exogenous shocks
for which more primitive and more highly aggregated models are
ill-suited. The vector of endogenous variables is also larger, and in
particular effects on financial prices and quantities can be traced.

Appropriately, Purvis (1980) rebutted the claim of Karl Brunner

and Alan Meltzer (in Stein 1976) that the multi-asset nature of their
models set them apart from Tobin-style models. Indeed, Brunner
(1971, 168 n5, 173 n17), in a review article on Hester and Tobin
(1967a, 1967b, 1967c), twice stressed the consistency of the Tobin-
 Transforming the IS-LM Model Sector By Sector 37

Brainard and Brunner–Meltzer money-supply theories, as well as

repeatedly and emphatically acknowledging the valuable contribu-
tion of “Yale” portfolio analysis to monetary theory (see also Meltzer
1989). Stanley Fischer (1988, 1 n1) finds that “Brunner and Meltzer’s
basic analytic model [in Stein 1976] is not dissimilar to Tobin’s (1969)
three asset model.”
Notwithstanding this similarity, Brunner (1971, 169–170) criticized
“Yale” for treating the use of money as a medium of exchange as some-
thing to be taken for granted, rather than derived from rigorous micr-
oeconomic foundations. In a witticism celebrated by Laidler (1991,
651–653), Brunner (1971, 168–169) described the work of Tobin and
his associates as “a remarkable combination of Schmoller and Walras”
that offered both “elegant syntactical exercises” of portfolio optimiza-
tion with uncertain empirical content and “skilful manipulation of
large masses of data” to the neglect of “the middle range where anal-
ysis emerges in the form of explicitly constructed empirical hypoth-
eses with a definitely assessable content.” Tobin’s associate Gary Smith
(1989, 1692–1693) also expresses this problem of combining the theory
of portfolio optimization, implying many explanatory variables in
asset demand functions, with available data:

Because of the strong intercorrelations among the available data,

the implementation of the Yale approach is inevitably plagued by
severe multicollinearity problems. While monetarism is too simple,
the Yale approach is too complex. Some [e.g., Owen 1986] accept
the high standard deviations and low t-values, observing that the
data are not adequate for answering the questions asked. Some
researchers try to get more precise estimates by using exclusion
restrictions; others have tried more flexible Bayesian procedures for
incorporating prior information [e.g., Smith and Brainard 1976].

The modeling effort of Tobin and his associates was not sustained,
perhaps because of the enormous funding and data requirements of
such a modeling approach (and also because of the early deaths of
Douglas Purvis and Arthur Okun, leading macroeconomists whose
work was close to Tobin’s10). When computing costs plummeted in
later years, fashions in macroeconomics had changed. Shiller (1999,
888) posed the question, “So what happened to your general equilib-
rium approach to monetary theory? It seemed to be a movement for a
38 James Tobin

while, right? Here at Yale a lot of people were doing this, and I haven’t
heard about such work lately,” to which Tobin only replied, “Well,
people would rather do the other thing because it’s easier.” The fact
that other forms of computable general equilibrium (CGE), numer-
ical general equilibrium (NGE), or applied general equilibrium (AGE)
modeling continued as a flourishing cottage industry (using the fixed
point algorithm of Tobin’s Yale and Cowles colleague, Herbert Scarf),
although equally subject to the Lucas (1976) critique (that models
estimated with data generated under a particular policy regime may
change if the policy is changed), is consistent with this explanation
for the disappearance of Tobin-style general equilibrium modeling.

An Old Keynesian and modern macroeconomics

Like Tobin, other leading American Keynesians constructed opti-

mizing foundations for particular building blocks of the IS-LM frame-
work (although Tobin was unusual in working on all of consumption,
investment, money demand, money supply, and international
payments). Franco Modigliani, a pioneer in adapting Hicks’s two-
sector IS-LM model into a one-sector model and shifting its focus
from the liquidity trap to nominal wage rigidity (Modigliani 1944,
De Vroey 2000), is a notable example for the life-cycle hypothesis
of consumption and saving. Thomas Sargent acknowledged, “When
you go back and look at the history of macroeconomics since the
’30s, there’s an underlying effort to build more and more optimizing
theory underneath the decision rules of Keynesian economics, such
as in the consumption function, the portfolio schedule, and the
investment schedule” but he dismissed these as “essentially partial
equilibrium exercises which were then put together at the end” as in
the Brookings model of 1965 (Klamer 1984, 65–66). Tobin, however,
took a different kind of “general equilibrium approach to mone-
tary theory” (1969), linking asset markets through the adding-up
constraint for wealth, rather than through optimization by a repre-
sentative agent (or, in the case of overlapping generations models,
two representative agents). Brainard and Tobin (1968) criticized
models, such as the Federal Reserve-MIT-Penn or MIT-Penn-SSRC
(FMP or MPS) model of Franco Modigliani and Albert Ando, which
omitted the adding-up constraint for wealth and failed to include all
asset markets, often implying implausible demand elasticities for the
omitted asset market (cf. Tobin in Shiller 1999, 877). Even though
 Transforming the IS-LM Model Sector By Sector 39

Walras’s Law implied that the equilibrium condition for one market
was redundant, it would be better to include all asset markets and
make wealth explicitly the sum of asset values.
Tobin’s modeling approach paid careful attention not only to this
adding-up constraint but also to the government budget constraint
and its implications for the dynamics of asset stocks. But, as Shiller
(1999, 888) told Tobin, “You ... had general equilibrium in a sense
different from what we think now.” Tobin’s general equilibrium
was not that of equilibrium business cycle theory (either the mone-
tary misperceptions variant, such as Lucas 1981a, or real business
cycles), which links markets through the optimization of representa-
tive agents subject to budget constraints. Tobin rejected continuous
market clearing, denied that faster adjustment necessarily implies
greater stability, and objected to representative agent models as an
arbitrary evasion of coordination problems. He refused to identify
general equilibrium modeling with a single representative agent
acting optimally in all markets at all times. He was equally unim-
pressed with the overlapping generations extension of representative
agent models (anticipated by Allais 1947), which provides a rigorous
justification for a positive value of fiat money – provided that one
assumes that no other stores of value exist and that the number
of time periods is infinite (see Tobin in Colander 1999, 124, on
Judgement Day and the existence of money, and Tobin’s comments
on overlapping generations models in Kareken and Wallace 1980).
Tobin’s version of general equilibrium stressed the consistency of stock-
flow relationships and the interrelationships of asset markets through
the adding-up constraint on wealth. As Smith (1989, 1692) observed,

Tobin sometimes integrates household consumption-saving

and portfolio-allocation decisions, essentially taking the Yale
approach back one step, from wealth allocation to income allo-
cation. It can be taken back another step by allowing the labor
supply decision to be part of the integrated framework. However,
institutional constraints and labor market disequilibria often
make labor income predetermined in the short run

so Tobin refused to take that additional step.

Representative agent models exclude considerations of distribution
or coordination, since the economy is presented as a number of iden-
tical agents. Since agents are identical, they do not exchange with
40 James Tobin

each other in equilibrium, and the equilibrium values of variables are

those values that lead representative agents not to trade (see Kirman
1992, Hartley 1997). Walrasian general equilibrium analysis did not
permit agents to trade at other than equilibrium prices, but in repre-
sentative agent models they don’t trade at equilibrium prices either.
Increased unemployment in a representative agent model means a
bit more leisure for everyone, rather than some people becoming
completely unemployed. In a real business cycles model, with no
misperceptions, such increased unemployment would reflect either
a preference shock increasing the taste for leisure, or a technology
shock making household production more productive relative to paid
employment. Such a view brings to mind Dennis Robertson’s 1930

attempt to convince the Macmillan Committee that mass unem-

ployment was attributable to the satiation of human wants ... a sati-
ation that should have produced a general reduction in working
hours but unfortunately and inexplicably operated instead differ-
entially to reduce the working hours of a substantial part of the
population to absolute zero. (Harry Johnson in Johnson and
Johnson 1978, 210, 187)

John Geweke (1985) argues that the assumptions needed for consistent
aggregation to a representative agent model are at least as heroic and
arbitrary as those underlying the aggregate functions of Keynesian
economics. Sonnenschein (1972), Debreu (1974), and Mantel (1976)
showed that the standard assumptions about individual agents, such
as strict convexity and monotonic preferences, are not sufficient for
uniqueness and stability of equilibrium. That would require assump-
tions about how individuals are related to each other, such as identical
preferences – which is just what is implied by arbitrarily assuming
the existence of a representative agent (see Kirman 1992). Standard
assumptions about preferences, endowments, and technology imply
no more than Walras’s Law and continuity for aggregate excess
demand functions (Rizvi 1997). Tobin recognized no need to accept
that New Classical models were based on consistent microeconomic
foundations that yield unique and stable equilibria. Tobin (1975)
argued that even a model with a unique full-employment equilib-
rium could be unstable for large negative demand shocks. If the
claim to firmer microeconomic foundations was rejected, the case
 Transforming the IS-LM Model Sector By Sector 41

for New Classical economics rested on empirical claims, and Tobin

accepted the finding of his Cowles colleague, Ray Fair (1979), that
New Classical models were no better at out-of-sample forecasting (see
also Mishkin 1983).
Tobin (1992, 25) insisted,

It is not true that only an arbitrary and gratuitous assumption of

complete rigidity, converting nominal demand shocks into real
demand shocks, brings into play Keynes’s multipliers and other
demand-determining processes (including the IS/LM curves
taught to generations of college students). Any degree of sticki-
ness that prevents complete instantaneous price adjustment has
the same qualitative implications.11

It is possible to construct models with nominal stickiness in which

anticipated aggregate demand shifts are nonetheless neutral (e.g.,
McCallum 1979), but it is uncommon. Tobin argued for slug-
gish adjustment (on behavioral grounds, as well as an optimizing
response to adjustment costs), and invoked Okun (1981) as providing
a microeconomic justification for such sluggish adjustment, based
on monopolistic competition (see Tobin’s concluding remarks in
Tobin, ed. 1983).
Tobin (1975; 1980a, Lecture I) went beyond this to argue that faster
adjustment of wages and prices might even be destabilizing (as in
Keynes 1936, Chapter 19, and Fisher 193312). Falling prices are not the
same as lower prices. The Pigou-Haberler real balance effect might
show that, in comparative statics, a lower price level is associated with
a higher level of aggregate demand even in a liquidity trap (because
of the higher real value of outside money, the monetary base that is
part of net wealth, which affects consumption). However, expected
deflation lowers the opportunity cost of holding real money balances,
and so raises real interest rates. Unanticipated deflation raises the
real value of inside nominal debt, which vastly exceeds the amount
of outside money. The effect of a transfer of wealth from debtors to
creditors (who presumably became creditors and debtors because of
differing propensities to spend) and of higher risk premiums in real
interest rates because of increased risk of bankruptcy, could swamp
the Pigou-Haberler real balance effect, so that money wage cuts
and price deflation (resulting from an excess supply of labor) could
42 James Tobin

further reduce real aggregate demand, moving the economy further

away from full employment. Real aggregate demand depends on
both the price level and the rate of change of the price level. Speed of
price adjustment plausibly increases the further the economy is from
full-employment equilibrium. Tobin (1992, 1993) cited De Long and
Summers (1986) and Chadha (1989) in support of his argument that
increased price flexibility need not be stabilizing, and that instability
was more likely the further a demand shock took the economy away
from full-employment equilibrium. An economy could be self-sta-
bilizing for small demand shocks, but not for large demand shocks
(hence government intervention could be needed for stabilization in
the face of large shocks, as in the 1930s). Tobin invoked the finding
by Shiller (1989) that financial markets fluctuate excessively. Tobin
(1992, 1993) did not, however, cite Driskill and Sheffrin (1986), who
reached the opposite conclusion that, within their model, increasing
price flexibility would be stabilizing. Unfortunately, Lucas (1981b)
concentrated primarily on the fairness or otherwise of the presenta-
tion of New Classical economics as “Monetarism, Mark II” in Lecture
II of Tobin (1980a), rather than on the stability questions raised in
Lecture I, so debate on this issue has never been fully joined.

Conclusion

Opening the final lecture (“Portfolio Choice and Asset Accumulation”)

of his Yrjö Jahnsson Lectures, Tobin (1980a, 73) announced that he
would

be particularly concerned with the Keynesian model and the

famous IS/LM formalization of it by Sir John Hicks. ... I shall
consider critically its possible interpretations, some objections to
them raised by others, and some of my own. Yet I want to begin
by saying that I do not think the apparatus is discredited. I still
believe that, carefully used and taught, it is a powerful instru-
ment for understanding our economies and the impacts of poli-
cies upon them.

At the end of the lecture, Tobin (1980a, 94) offered

one major general conclusion, namely the robustness of the

standard results of Hicksian IS/LM analysis. They survive in these
 Transforming the IS-LM Model Sector By Sector 43

models in which time, flows, and stocks are more precisely and
satisfactorily modeled, in which time is allowed for flows to affect
the stocks of government liabilities and of other assets too, in
which the menu of distinct assets is as large as desired.

Tobin transformed the IS-LM analysis (which he had helped Hansen

introduce into North America) by introducing wealth as an argu-
ment in the consumption function, formulating the q theory of
investment, proposing optimizing decision rules for portfolio choice
(both for money demand in a multi-asset setting and, through port-
folio choices by banks, for money supply), linking asset markets
through the adding-up constraint for wealth, and treating invest-
ment, international capital flows, and government budget deficits
as changes in stocks of assets (and, in Tobin 1955a, with a extension
to long-run growth theory, a year before the better known articles
of Robert Solow and Trevor Swan), but he did so within the spirit of
the IS-LM framework, continuing to view it as a useful and powerful
instrument. Many of the changes that Tobin made to the frame-
work inherited from Hicks (1937) were in the spirit of Hicks (1935),
treating money as one of many assets, and Tobin first encountered
general equilibrium through Hicks (1939). Tobin’s concern for stock-
flow consistency, adding-up constraints, and portfolio optimization
never led him to accept the uniqueness and stability of classical full-
employment equilibrium. His disequilibrium dynamic interpreta-
tion of Keynes (enriched by the deft-deflation process of Fisher 1933),
led Tobin (1997, 20) to conclude that “given the non-linearities of the
relevant equations, the system may be stable in the neighbourhood
of equilibrium but unstable to large displacements,” so the economy
is self-adjusting in normal times but requires active stabilization
policy (as formulated in an IS-LM framework) to respond to major
demand shocks, as in the Great Depression.
3
Consumption, Rationing and
Tobit Estimation Tobin as an
Econometrician

Introduction: both an econometrician and a monetary

theorist

Best known as a monetary and macroeconomic theorist, described

by Willem Buiter (2003, F585) as “the greatest macroeconomist of
his generation” (see also Purvis 1982, 1991, Myhrman 1982), James
Tobin was also actively engaged in empirical economics from his
second published paper and his dissertation onward (Tobin 1942,
1947) to such later empirical studies as Tobin and Brainard (1977,
1992). His dissertation and several of his early articles investigated
savings decisions, both theoretically and empirically, rather than a
monetary topic, and he made notable contributions to the study of
demand for food and for consumer durables. A pioneer in pooling
time-series data with cross-section budget studies, Tobin contrib-
uted to the development of new econometric techniques in the
1950s, notably the extension of probit analysis of limited dependent
variables that Goldberger (1964, 253–255) named the “Tobit model”
(Tobin 1955b, 1958b). A critic of some of the large “Keynesian”
macroeconometric models of the 1960s (Brainard and Tobin 1968),
he later championed an approach to empirical macroeconomic
modeling, based on his “general equilibrium approach to monetary
theory,” that contrasted sharply with New Classical models that
interpreted general equilibrium quite differently (Backus, Brainard,
Smith, and Tobin 1980).

44
 Consumption, Rationing and Tobit Estimation 45

Tobin’s 1950 pooling of time-series data with budget studies to

estimate US food demand was the subject of a “field experiment
in applied econometrics,” in which teams of researchers brought
up-to-date techniques to bear on Tobin’s data (Magnus and Morgan
1997, 1999, cf. Izan 1980, Reader 2008, Hendry and Mizon 2011),
and Goldberger’s term, “Tobit model,” is well known (and Hooper
and Nerlove 1970 reprinted Tobin 1958b), but, apart from those two
contributions, his role as an econometrician has been overshad-
owed by his eminence as a macroeconomic theorist. One anony-
mous referee on an earlier version of this chapter for the History of
Political Economy supplement “Histories on Econometrics” in 2011,
raised the possibility that “Tobin’s empirical work and work on LDV
[limited dependent variable] modeling merited a second Nobel prize
(possibly when the prizes in microeconometrics were given).” In
contrast, another anonymous referee wonders by what criteria one
could even “enrol Tobin as an econometrician, as distinct from a
user of econometrics.”
I argue that Tobin’s innovative combination of time-series data
with household budget surveys in his 1947 thesis on consumer saving
and his 1950 food demand study, and his 1955b and 1958b papers
on limited dependent variables were contributions to econometrics,
not just use of existing econometric techniques by an applied econo-
mist. That Tobin’s doctoral dissertation established him as a talented
applied econometrician is remarkable, given the lamentable state of
the teaching of economic statistics at Harvard at the time: he later
spoke of “teaching myself econometrics” (Tobin in Colander 1999,
393), as was also true of many of his generation of econometricians.

Self-taught at Harvard

As a student at Harvard (BA 1939, MA 1940, PhD 1947), Tobin found

that “The professors who taught economic statistics were idiosyn-
cratic in the methods they used and quite suspicious of methods
used in mathematical statistical theory. ... Students like me, who were
interested in formal statistical theory, took refuge in the mathematics
department” where he took a “very good” course in mathematical
statistics from “an eminent scholar and wonderful teacher, E. V.
Huntington” (Tobin in Breit and Spencer 1999, 123; Tobin in Magnus
and Morgan 1997, 648). Like Paul Samuelson, Tobin also studied with
46 James Tobin

Edwin B. Wilson, a mathematical statistician in Harvard’s Public

Health School (Tobin in Colander 1999, 394, Samuelson [1947] 1983,
xix, 453). Tobin learned little econometrics from the economics
department, apart from one year in which a visiting Swiss econom-
etrician, Hans Staehle, taught statistical demand analysis (Tobin in
Magnus and Morgan 1997, Shiller 1999, 875–876). Influenced by
Staehle’s course, Tobin (1950) cited Staehle (1937, 1945), as well as
citing Staehle (1937) in his 1947 thesis. Tobin (1997, 648) recalled,

In what was called “Business Cycles” Professor Edwin Frickey was

decomposing time series into seasonal, cyclical and trend compo-
nents. I never did understand how he was doing it, nor could he
show us how to do it ourselves. The senior economic statistics
teacher, Professor William Leonard Crum, thought that his duty
was to warn us about all the “booby traps,” all the things that could
go wrong. Those of us interested in econometrics had to study it
on our own, reading the outputs of the Cowles Commission, then
in Chicago.

Crum was best known for his critique of the Literary Digest ’s noto-
rious public opinion poll in the 1936 presidential election, which,
based on more than two million responses to ten million ques-
tionnaires mailed to registered owners of automobiles and tele-
phones, predicted that Alf Landon would decisively defeat Franklin
Roosevelt – proving that a random sample is more important than
a large sample. Unfortunately, Crum argued in several articles that
the poll understated the size of the impending Landon landslide
(Galbraith 1981, 45 – 46).
Stephen Stigler (1996) discusses the emergence of mathematical
statistics as a distinct discipline in the 1930s: the Harvard economic
statisticians were among the statisticians left behind by the separa-
tion of mathematical statistics from the rest of statistics. Fortunately
for Harvard students interested in econometrics, “We also discovered
that regressions, although scorned by professors Crum and Frickey,
were alive and well under the aegis of Professor John D. Black’s
program in agricultural economics. In the basement of Littauer
Center we could use his electromechanical or manual Marchands
and Monroes,” recalled Tobin (in Breit and Spencer 1999, 123, cf.
Robert Solow in Breit and Spencer 1995, 191, on the scandalously bad
 Consumption, Rationing and Tobit Estimation 47

teaching of economic statistics at Harvard after World War II, and

Renfro 2010 on the role of computing technology).
By using such calculators, Tobin was able, while working on his
dissertation on the consumption function and his food demand
study, to carry out a regression with three independent variables in
three days: “Since you were not going to do many of those, you tried
to be sure that your specification is what you really want to test”
(Tobin in Shiller 1999, 878). This had the effect of insulating his
early work from any temptation to engage in specification searches
yielding spurious relationships: “I’m not saying it’s a bad thing to
have all this computing power, but the theory of significance tests
was based on the view that you were only going to do one computa-
tion” (Tobin in Shiller 1999, 878, cf. Edward Leamer 1978 on specifi-
cation searches and his paper in Magnus and Morgan 1997, 1999).
An indication of the subsequent advance of computing tech-
nology in econometrics was Tobin’s announcement (1958b, 24n)
that Richard Rosett of the Cowles Foundation “has programmed the
iterative estimation procedure of this paper for the IBM Type 650
Data-Processing Machine [one of the last computers to use vacuum
tubes] and has applied the technique to a problem involving 14 inde-
pendent variables.”
More important than the formal teaching in economic statistics
was contact with the research at the Cowles Commission, notably
through Trygve Haavelmo, whose 1944 Econometrica supplement and
Cowles Commission paper (and 1946 Oslo dissertation) “was written
while he was visiting Harvard in 1941 and circulated in mimeographed
form” then titled “On the Theory and Measurement of Economic
Relations” (Morgan 1990, 242n; Anderson 1991, Bjerkholt 2007).
Leonid Hurwicz read Haavelmo’s manuscript while at Harvard and
MIT in 1941 before joining the Cowles Commission in January 1942,
and it also influenced Lawrence Klein, who came to study at MIT in
1942 (Epstein 1987, 62). Similarly, Paul Samuelson’s 1941 Harvard
dissertation “Foundations of Analytical Economics: The Operational
Significance of Economic Theory” (published as Foundations of
Economic Analysis [1947] 1983) did more to convey formal economic
theory to Tobin’s generation of top Harvard economics students
than did the teaching by the faculty – with the exception of Wassily
Leontief (an advisor for Tobin’s undergraduate honours essay, Solow’s
tutor, and a member of Samuelson’s dissertation committee).
48 James Tobin

Tobin’s doctoral dissertation, A Theoretical and Statistical Analysis

of Consumer Saving (Tobin 1947), provides a striking illustration of
the extent to which he and his fellow Harvard graduate students
taught themselves econometrics rather than crediting the faculty
with teaching them: his thesis did not mention supervision, help, or
advice from any Harvard faculty member, and did not even name his
nominal supervisor, Joseph Schumpeter. However, Tobin 1947, 14,
26, cited Schumpeter’s and Alvin Hansen’s Review of Economics and
Statistics memorial articles on Keynes, cited Schumpeter on Keynes’s
consumption function as a spectacular example of an unintended
contribution by pure theory to applied research, and cited Hansen
on adjusting the consumption function for changes in per capita
productivity. The clearest example in Tobin’s thesis of any influence
from direct contact with a senior scholar relates not to a Harvard
professor, but to John Hicks’s November 1946 visit to Harvard’s fiscal
policy seminar, where he discussed measuring the consumption
function in terms of employment devoted to producing consump-
tion goods (Tobin 1947, 25), not a central issue in the thesis. As far as
the statistical analysis was concerned, James Tobin’s doctoral disser-
tation adviser was James Tobin. He did so as part of a remarkable
gathering of young scholars: seven Nobel laureates in economics
other than Tobin appear in this paragraph and the preceding one
(Haavelmo, Hicks, Hurwicz, Klein, Leontief, Samuelson, and Solow).
Tobin took an empirical as well as a theoretical approach to mone-
tary economics from early in his career: Lawrence Klein credits A. J.
Brown (1939) and Tobin (1947–48) as the first “to render [Keynes’s]
liquidity preference function operational and then to estimate its
parameters” (Bodkin, Klein, and Marwah 1991; Klein 1997, 132).
Tobin engaged both as a theorist and as an empirical researcher,
not just with monetary topics, but with each of the components of
the Hicks-Hansen IS-LM framework for aggregate demand: invest-
ment (Tobin’s q), saving and consumption (1947), money demand
(from 1947b onward), and money supply. While working on money
demand (1947b) after his return to Harvard from wartime service
in the Navy, Tobin wrote his thesis on the consumption function
(1947), and it was as an expert on the consumption function that
two decades later he was invited to contribute to the International
Encyclopedia of the Social Sciences (Tobin 1968c).
 Consumption, Rationing and Tobit Estimation 49

A theoretical and statistical analysis of consumer saving

On April 1, 1947, a little more than a year after his January 1946
demobilization (and despite teaching sections of the introductory
course each semester), Tobin submitted a 313-page dissertation on the
consumption function, complete with six tables, three figures, nine
charts, and handwritten mathematical formulae. Earlier statistical
studies of consumption and savings, such as Samuelson (1941), had
regarded the almost perfect correlation of aggregate consumption
with aggregate disposable income between the wars as verification
of the simple Keynesian consumption function, but that simple rela-
tionship fared poorly in forecasting postwar demand in the United
States. Instead of an induced decline in consumption as government
spending contracted, returning the economy to the Great Depression,
consumers spent their wartime savings as consumer goods became
increasingly available. As Tobin told Shiller (1999, 873), “the ques-
tion was, ‘What variable was missing from that simple consumption
function, which fitted the interwar period so well?’ It’s all very well
to say with hindsight it’s obvious that that didn’t make sense, but the
question of what did make sense was still up for grabs.”
Following a chapter reviewing the literature on the Keynesian
consumption function and its adaptation for statistical use and
forecasting, Tobin (1947) wrote chapters on “The Determinants
of Consumer Saving: Theoretical,” “On the Factors Determining
Consumer Saving: Statistical,” and “The Effect of Asset Holdings
on Saving: Some Theoretical Implications.” A decade before Milton
Friedman’s permanent income hypothesis or Franco Modigliani’s
life-cycle hypothesis about consumption decisions, but a decade after
Keynes had recognized changes in wealth as something that could
shift the consumption function, Tobin introduced asset holdings
(and debts) as an argument in the consumption and saving functions.
He also analyzed the effect of changes in the income distribution.
As an admirer of Irving Fisher as well as of John Maynard Keynes
(see Tobin 1967a on Fisher and life-cycle saving), Tobin preferred an
intertemporal view of consumption and savings decisions: adding
wealth as an argument in the previously static Keynesian consump-
tion function made the analysis dynamic, because saving in one
period added to wealth and so affected next period’s consumption
and saving. This intertemporal perspective led Tobin to reject the
50 James Tobin

relative-income hypothesis advanced in another Harvard dissertation

of the time, later published as Duesenberry (1949). Tobin summarized
his main result, the dependence of consumption and saving deci-
sions on wealth holdings, in a Festschrift essay for Harvard professor
John Henry Williams (Tobin 1951) and in a paper to the American
Economic Association (Tobin 1952a), but the bulk of the thesis
remained unpublished. As Buiter (2003, F609) remarks, Section 3.3
of Tobin (1952a), on “The Public Debt as Private Wealth,” discussed
the possibility of what became known as debt neutrality or Ricardian
equivalence. Tobin later expressed grave doubt as to whether debt
neutrality would hold in practice (as indeed had David Ricardo, who
called for a one-time wealth tax to pay off Britain’s entire national
debt at the end of the Napoleonic Wars). Together with his former
graduate student, Walter Dolde, Tobin returned to the study of saving,
analyzing the effects of Social Security and government finances on
saving decisions (Tobin and Dolde 1971, Dolde and Tobin 1983).
In view of his 1950 food demand study, it is noteworthy that the
first two sections of the statistical chapter of Tobin’s thesis were enti-
tled, “Critique of the Derivation of Consumption Functions from
Correlation of Time Series” and “Possible Advantages of the Budget
Approach to the Income-Saving Relationship.” While the theoret-
ical advance in Tobin’s thesis was the introduction of wealth as the
missing variable in the consumption function, the statistical focus
of the thesis was on using household budget surveys to get around
the very strong collinearity among US macroeconomic time series
in his sample period. Despite the extent to which Harvard graduate
students then had to teach themselves econometrics, Tobin handled
the statistical issues adroitly, for example offering a proof that, if the
variance of consumption exceeded that of income, there would be a
higher correlation between consumption and income than between
saving and income (Tobin 1947, 154), and then deriving the same
result from the assumption that the marginal propensity to consume
exceeds the marginal propensity to save (1947, 155). This result led
Tobin to model the saving function rather than the consumption
function, to avoid overstating the evidence for the relationship.

The food demand study

Tobin spent the 1949–50 academic year, the last of his three years
as a Junior Fellow in Harvard’s Society of Fellows, in England at
 Consumption, Rationing and Tobit Estimation 51

Cambridge University’s Department of Applied Economics (DAE),

which was directed by Richard Stone. Tobin (1978c, 451) recalled
the department then as “pretty much an island unto itself, detached
from college life and ignored by the regular faculty,” but the DAE had,
from the perspective of an econometrician, “a great group of people:
not only Durbin and Watson, but also Michael Farrell who, alas, died
young, and Hendrik Houthakker. Orcutt and Cochrane had been
there the year before” (Tobin in Magnus and Morgan 1997, 649).
Durbin and Watson, like the future Nobel laureate Stone, gave
Tobin advice on completing his paper on “A Statistical Demand
Function for Food in the USA” (1950), just as they were working on
their now-famous test for serial correlation (Durbin and Watson
1950–51), while Henk Houthaker collaborated with him on a series
of papers on estimating what the demand for rationed foodstuffs
would be if they were not rationed (British food rationing lasted until
1954), combining British time series data from 1920 to 1938 with two
pre-war household expenditure surveys (Tobin and Houthaker 1951,
Houthaker and Tobin 1952, cf. Tobin 1952b surveying the theory
of rationing). Stone made the DAE a leading center for econometric
studies of consumer demand, beginning with Stone (1945), a focus
that followed his earlier empirical work on the Keynesian concepts of
the multiplier and marginal propensity to consume (Gilbert 1991).
Although finished at the DAE, Tobin’s food demand study was
largely written while still at the other Cambridge, and he “had been
in England only three months when I gave it as a paper at the Royal
Statistical Society in London, quite an awesome scene, quite formal,
very non-American,” with published commentary from seven discus-
sants (including such notable names as Charles Carter and Robin
Marris), to each of whom Tobin replied. The extensive comments
varied widely in insight and relevance, as Tobin indicated in his
replies, and when Tobin reprinted his 1950 article in his Essays in
Economics (1971–96, 2), he omitted all of the discussion and replies
except Stone’s comment and his reply to Stone. Stone called atten-
tion to a difference between the definition of consumption in Tobin’s
cross-section budget data (food consumption measured in dollars)
and that used in the time series data (measured using a price-weighted
index of physical commodities). In his reply, Tobin acknowledged
that “This difference has much more serious effects on estimates of
income elasticity than I had anticipated” (1971–96, 2, 442). Tobin
(1997, 649) later reflected, “Evidently, if the definitional discrepancy
52 James Tobin

were rectified, then the difference in estimates of income elasticity,

between the time series and the 1941 and subsequent budget studies,
probably would be diminished.” Addressing the teams of researchers
who had reexamined his food demand study in the Magnus–Morgan
field experiment, he added cuttingly, “It is unfortunate that nobody
has done that: it seems that it is not hard to do now.”
One aspect of Tobin’s work (1950) – his combination of time-series
data with cross-section household budget studies (as in his disserta-
tion) – attracted continued notice from time to time (e.g., Izan 1980),
but such attention paled in comparison to the intense scrutiny that
Tobin’s article received “as an example of ‘good applied economet-
rics’” in a “field trial experiment in applied econometrics” organized
by Jan Magnus and Mary Morgan (1995, 1997, 1999). Motivated by
conflicts among competing econometric methodologies (see Pagan
1987 for a survey, and Hendry, Leamer, and Poirier 1990 for debate),
Magnus and Morgan (1997, 460) wished “to take a specified data set
and let several researchers carry out the same set of applied econo-
metrics tasks but with different methods, approaches and beliefs” to
make it possible “to assess, within the environment of our experi-
ment, the differences between the several ways of doing economet-
rics in a practical application.” To have “a neutral base line against
which to judge the different approaches we picked a ‘classic paper’ in
applied econometrics, one which everyone could agree had been, at
its time, the best applied econometrics could offer.” This was Tobin’s
1950 work, and they called on the teams of experimenters “to assess
not only ‘the differences between the several ways of doing econo-
metrics in a practical application’ but also, since Tobin’s paper is not a
contemporary one, ‘the advantage (if any) of 45 years of econometric
theory since Tobin’s paper’ and ‘the impact of new economic theo-
ries’” (Magnus and Morgan 1997, 461). Participants were provided
with Tobin’s original US time series for the period 1912–1948 (with the
wartime rationing years 1942–1944 omitted) and the 1941 US house-
hold expenditure survey that he used, as well as a revised series for
1912 to 1989, additional household surveys conducted in 1950, 1960–
1961, and 1972–1973, as well as Dutch time series, and three Dutch
budget surveys (for 1965, 1980 and 1988). With this data, and their
own preferred methodology, each team was to perform four specified
tasks and a fifth task that each team was to design for itself.
 Consumption, Rationing and Tobit Estimation 53

Participants included leading proponents of competing econo-

metric methodologies such as Edward Leamer, the Bayesian econom-
etrician noted for his skepticism about specification searches
(Leamer 1978, 1983), and David Hendry, whose general-to-specific
methodology and exhortation to “test, test, test” (Hendry 1980,
2000) implied a very different attitude to statistical testing of alter-
native specifications (Hendry 1999 appeared in Magnus and Morgan
1999, but not in the 1997 journal issue). Tobin told Robert Shiller
(1999, 876) that he was “actually quite pleased that my article was
selected. One reason it was chosen was that it was self-contained. It
had all the data in the article and explained exactly what was done,
what calculations were made.”
Soon after the call for participants was published in May 1995, Jan
Magnus wrote to Tobin on June 18, inviting him to take part in the
workshop as one of the assessors. Tobin replied on July 16 from his
summer home in Wisconsin that he was “naturally pleased” by the
selection of his paper as an example of good applied econometrics,
but that “I’m afraid I’m not well enough versed in modern econo-
metric methods to be an assessor. When your results are available,
maybe some thoughts will occur to me to communicate to your
workshop. We’ll see.” The same day, Tobin wrote to Alvin Klevorick,
the director of the Cowles Foundation, that “It occurred to me that it
might be interesting if econometricians at Cowles or at elsewhere at
Yale wanted to join the fun,” and Klevorick circulated such a sugges-
tion to members of Cowles and of Yale’s economics department
(apparently without response).
Magnus seems not to have received Tobin’s letter of July 16, because
on December 3, 1995, Magnus wrote to Tobin that, “You may have
heard of the experiment that Professor Mary Morgan and I are organ-
izing. I wrote to you a few months ago announcing this experiment
enclosing a copy of the announcement from the Journal of Applied
Econometrics” and informing Tobin that he would be visiting Peter
Phillips at Yale on December 13 and 14 (Yale University Library 2008,
MS 1746 Box 14).
Thirty-nine individuals or teams responded to the call for partici-
pants in the May 1995 issue of the Journal of Applied Econometrics
(Magnus and Morgan 1995; 1997, 467): fourteen from the United
States, seven from Britain, four from the Netherlands, eight from the
54 James Tobin

rest of Europe, and six from the rest of the world. Only eight teams
(four American, two Dutch, one British, and one Finnish) ultimately
submitted reports, which were presented at the December 1996 work-
shop at Tilburg University in the Netherlands and then published
along with the comments by eight assessors (each of whom assessed
three reports) and by Tobin.
Ironically, the submission of reports by only eight out of thirty-
nine teams may have resulted in what Tobin, in a fax to Magnus on
February 4, 1997, described as a “selection bias against calculations that
agreed with the 1950 conclusions.” Tobin’s one-sentence fax accompa-
nied a copy of a January 26, 1997, letter to him from Nancy Wulwick
of the State University of New York (SUNY) at Binghamton. Wulwick
reported that two teams, Robert Basmann and Bong Joon Yoon of
SUNY Binghamton and Esfandiar Maasoumi of Southern Methodist
University in Dallas, did not submit final reports because their tests
produced results close to Tobin’s (for example, identifying the same
outliers as Tobin had, the observations for the World War II years).
Finding nothing that they had not expected, Basmann and Maasoumi
felt they had nothing new to report, a reaction that Wulwick attributed
to their having been trained as statisticians rather than as econometri-
cians (Yale University Library, MS 1746, Box 14). The published account
of the field experiment in the 1997 supplement to the Journal of Applied
Econometrics did not raise this issue of possible selection bias when
reporting the low rate of completion of final reports.
Notwithstanding this possible selection bias, Anton Barten’s
assessment (in Magnus and Morgan 1999, 270) was that “Tobin’s
original contribution appears to be robust against recent develop-
ments of a methodological nature. That is a comforting thought. If
our empirical results are very sensitive to the way the data is handled
one would feel suspicious about the outcomes in general.” Tobin,
interviewed by Shiller (1999, 876), also felt that “they really didn’t
come out with anything spectacularly different from what I had
done at the time.” The main criticism of Tobin (1950) that emerged
in the workshop was of his imposition upon his time-series regres-
sion of an income elasticity obtained from the cross-section house-
hold budget study. The motivation was the reason Tobin used both
time-series and budget survey data in his 1947 dissertation and 1950
food demand study: collinearity among time-series in his sample
period. He explained, “The reason everything looked so good – the
 Consumption, Rationing and Tobit Estimation 55

Keynesian consumption function looked great – is that consump-

tion, and almost everything else, move with the pervasive busi-
ness cycle” (Tobin in Magnus and Morgan 1997, 649). He conceded,
“Maybe things aren’t so collinear now. We have longer series and
more ‘natural’ experiments” (see also Tobin 1947, 171–172, on the
close correlation of other variables with income as a reason for
drawing on household budget surveys), but,

At the same time, I don’t agree in principle that if the time-series

regression gives a different number from the budget study esti-
mate the time series is right and the budget study wrong. No.
What worried me was that whatever number you assumed for
the income elasticity, a regression estimate of the price elasticity
would be the same number with a negative sign. I showed this
collinearity in my paper with Frisch’s confluence analysis, now
an archaic technique no one would use. It was high-tech in the
1940s. (Tobin in Magnus and Morgan 1997, 649)

From Probit to Tobit

Tobin’s concern with understanding consumption spending deci-

sion came from his concern, as a macroeconomist whose intellectual
development was shaped by reading Keynes during the Depression,
with consumption as the largest component of aggregate expendi-
ture. Indeed, Keynes’s General Theory was the first economics book
Tobin ever read. The close correlation of all macroeconomic time
series, including consumption, over two world wars and the interwar
period, led Tobin to turn in his thesis and his food demand study
to cross-section budget surveys for elasticity estimates. This concern
with understanding consumption decisions, motivated by a focus
on how to use policy to achieve macroeconomic stability natural to
someone entering economics during the Depression of the 1930s, in
turn led to whatever otherwise would appear as an uncharacteristic
contribution to pure econometric technique: the Tobit estimator.
Having used household budget surveys in his thesis on the consump-
tion function and then in his food demand study, Tobin wanted to
use survey data from George Katona’s Survey Research Center at the
University of Michigan to further investigate consumption decisions
(Tobin 1959). Tobin spent a semester at the Survey Research Center
56 James Tobin

in 1953–1954 as one of the Center’s post-doctoral fellows funded by

the Carnegie Foundation (Tobin 1955b).
In household surveys of purchases of consumer durables, expendi-
tures by most households in most periods would be zero (and would
never be negative). According to Tobin,

To use all the zeros as if they were just other observations would
not seem like the right thing to do. It was more likely that there
was a decision “buy” or “not buy,” and then if “buy” there was a
decision how much to spend, depending on income, family size,
and other variables, so that’s why I developed the “Tobit analysis”
rather than ordinary regression. (Shiller 1999, 876)

Symmetric to this lower bound, Tobin’s survey of the theory of rationing

dealt with the case of an upper bound on purchases (Tobin 1952b).
When Tobin “first came to Yale [in 1950] there wasn’t much more
statistics here than there had been at Harvard when I was a graduate
student” except for Chester Bliss, a biostatistician trained under R. A.
Fisher, who “was doing probit analysis – biological, pharmaceutical data,
poisons, and so on” (Tobin, in Shiller 1999, 876, cf. mention in Tobin
1955b of the Bliss-Fisher maximum likelihood solution in multiple
probit analysis). Citations in Tobin (1955b) to Farrell (1954a) and in
Tobin (1959) to Farrell (1954b) suggest that Tobin had already encoun-
tered probit analysis in the 1949–1950 academic year, when both he
and Michael Farrell were at Cambridge University’s Department of
Applied Economics. A referee for Dimand (2011) draws attention to
Hald (1949) and Aitchinson (1955) as other contributors to this litera-
ture but suggests, “Tobin was probably not aware of these papers.”
When the Cowles Commission for Research in Economics left the
University of Chicago in 1955 to become the Cowles Foundation at
Yale University (the alma mater of Alfred Cowles), the first Cowles
Foundation discussion paper was “Multiple Probit Regression of
Dichotomous Economic Variables” by the new research director
of Cowles, James Tobin. There, Tobin (1955b), like Farrell (1954a,
1954b), applied to economics a technique already familiar in
biometrics for dealing with variables that could take values only of
zero or one: “to cite a variable from a neighboring social science, the
head of the household either likes Ike or does not” (Tobin 1955b,
447)1. Tobin (1955b) used data from 1036 households that had been
 Consumption, Rationing and Tobit Estimation 57

interviewed twice, in early 1952 and then in early 1953, by the

Survey Research Center for the Board of Governors of the Federal
Reserve System. The dependent variable W was equal to one if the
household reported buying “an automobile or any large household
good (e.g., TV, washing machine, refrigerator) during 1952”, and if
not, to zero. Such a purchase would be made if the index I, a linear
combination of independent variables, exceeded a critical value, so
the probit analysis involved maximum likelihood estimation of the
coefficients in that linear combination. Farrell (1954a) had related
US automobile purchases to disposable income alone, but Tobin
(1955b), following his dissertation, used both disposable income and
liquid asset holdings (bank deposits plus savings bonds) as explana-
tory variables (Tobin 1958b used the ratio of liquid assets to dispos-
able income). Tobin’s “Multiple Probit Regression of Dichotomous
Economic Variables” (1955b), although cited in the literature (for
example, by Goldberger 1964, 251), was not published for 20 years,
when Tobin included it in a volume of his collected essays.
Tobin’s Econometrica article on “Estimation of Limited Dependent
Variables” (1958b) brought together probit and multiple regression
analysis to deal with cases where a variable has an upper or lower
bound and takes on the limiting value for many respondents (as with
probit analysis), but where the value of the dependent variable is also
of interest: “It is inefficient to throw away information on the value
of the dependent variable when it is available,” Tobin wrote. So,
instead of the dependent variable being either zero or one depending
on whether the index I exceeded a critical value, it would be either
zero or the index I minus the critical value. Tobin (1958b), which was
chosen for reprinting in a selection of notable articles on economet-
rics from Econometrica (Hooper and Nerlove 1970), initiated a large
literature (surveyed by Amemiya 1984, cf. Fair 1977).
Arthur Goldberger (1964, 253–254), in a leading graduate econo-
metrics textbook, named this approach the Tobit model. Tobin
(interviewed by Shiller 1999, 877) recalled “a novel by Herman
Wouk, a friend of mine in the officers’ training school in 1942,
called The Caine Mutiny, where I appear for one or two sentences in
the first chapter, and I’m named in a thinly disguised way as Tobit.
I asked Arthur Goldberger why he used this label in his statistics
text, whether it was The Caine Mutiny or just the elision of Tobin and
‘probit’. He wouldn’t say. So I don’t know.”
58 James Tobin

As a contribution to econometric technique, Tobit analysis might

appear anomalous in Tobin’s career, but, like his 1950 food demand
study and his articles on rationing, it fit into a chain of his writings
on consumption that started with his 1947 dissertation. These writ-
ings shared two distinctive features: use of household survey data
in addition to time series, and introduction of asset holdings as an
explanatory variable in addition to disposable income. Together with
Tobin’s q theory of investment, his work on money demand and asset
market equilibrium, and his analysis of commercial banks as creators
of money, his work on consumption and saving decisions formed
part of a larger project: the provision of optimizing microeconomic
foundations for each of the components of aggregate demand in the
Keynesian macroeconomic model.

Tobin’s general equilibrium approach to monetary

modeling

Tobin told an interviewer, Robert Shiller (1999, 870), that “introduc-

tion to economics, taking the elementary course and reading Keynes,
was simultaneous in my sophomore year. ... I found it pretty exciting
because this whole idea of setting up a macro model as a system
of simultaneous equations appealed to my intellect,” a recollection
that led Shiller to remark skeptically, “I wouldn’t think of looking at
Keynes’s General Theory for the inspiration for explicit simultaneous
equation macroeconomic models.” Tobin insisted that Keynes (1936)
did provide such inspiration “if you looked at it from the right point
of view.”
Tobin helped Alvin Hansen expound the Hicks-Hansen IS-LM
interpretation of Keynes in diagrams and simultaneous equations.
He was introduced to the econometrics of simultaneous equations
models, what became known as the Cowles Commission approach,
through Haavelmo’s 1944 Econometrica supplement using probability
theory in econometrics (written at Harvard in 1941, while Tobin was
a graduate student there, and circulated as Cowles Commission Paper
No. 4) and Lawrence Klein’s 1950 Cowles monograph on Keynesian
macroeconometric models of the US economy, cited before publica-
tion in Tobin’s 1947 thesis. Tobin (1947) also cited journal articles by
Cowles director Jacob Marschak and by Jacob Mosak, and a Cowles
monograph by Mosak.
 Consumption, Rationing and Tobit Estimation 59

Tobin’s personal contact with Marschak and with Tjalling Koopmans

(Marschak’s successor as Cowles director) began in December 1948,
when he was Marschak’s discussant at the AEA/Econometric Society
annual meetings (Shiller 1999, 875). Statistical issues of how to iden-
tify and estimate simultaneous equations, raised by Haavelmo (see
Epstein 1987, Morgan 1990, Anderson 1991, and Qin 1993), were
explored in Cowles monographs edited by Koopmans (1950) and by
Hood and Koopmans (1953). Tobin took a sympathetic interest in
these developments, although the limitations of available computa-
tion (three days to perform a single-equation linear regression with
three variables) precluded using any but single-equation methods in
Tobin’s dissertation, notwithstanding Haavelmo’s discussion of the
statistical implications of simultaneity.
In recent years, despite changing fashions in macroeconometric
modeling (see Bodkin, Klein, and Marwah 1991, Dimand 1997,
Colander 1999), the Cowles Commission approach to Keynesian
simultaneous-equation structural models has been continued by
Tobin’s Yale and Cowles Foundation colleague Ray Fair (1974–76,
1984, 1994, 2004), as well as by Klein’s Project LINK modeling the
world economy (Klein 1997).
Tobin’s sympathy for the project of Keynesian structural macr-
oeconometric modeling did not imply uncritical approval of
the actual models. William Brainard and Tobin (1968) criticized
the pitfall of neglecting the adding-up constraint on wealth in the
MIT-Pennsylvania-Social Science Research Council (MPS) or Federal
Reserve-MIT-Pennsylvania (FMP) model of Franco Modigliani and
Alberto Ando (see also Gary Smith 1975 and Douglas Purvis 1978,
by associates of Tobin). Asset demands have to sum to total wealth,
so failing to explicitly model every asset market can result in unrea-
sonable implied demand elasticities for the equation suppressed as
redundant.
When Robert Shiller (1999, 878) asked Tobin about another criti-
cism of macroeconometrics, the complaint by Edward Leamer (1978,
1983) and Clive Granger that specification searches result in spurious
relations with meaningless significance tests, Tobin agreed, “That’s a
good criticism,” but then added pointedly, “I recall hearing Tjalling
Koopmans point it out, years ago.” Such structural macroeconomic
models also lost popularity due to the criticism of Lucas (1976) that
they should not be used for policy evaluation because the model
60 James Tobin

parameters are not invariant to policy regime changes and the skep-
ticism of Liu (1960) and Sims (1980) about whether there really is
enough a priori information to impose the exclusionary restrictions
needed to identify the equations, leading Sims to advocate vector
autoregression (VAR) techniques recalling the atheoretical statistical
approach of Burns and Mitchell to business cycles (see Hendry and
Morgan 1995 on the “measurement without theory” controversy
sparked by Koopmans’s critique of Burns and Mitchell, and Epstein
1987, Chapter 7).
In Hester and Tobin (eds. 1967a, 1967b, 1967c), Tobin and his
students developed an approach to modeling a monetary economy
with multiple assets, with a theoretical overview in Tobin’s “General
Equilibrium Approach to Monetary Theory” (1969). Backus, Brainard,
Smith, and Tobin (1980) and Backus and Purvis (1980) attempted to
construct an empirical macroeconometric model embodying this
approach. “General equilibrium” for Tobin and his associates recog-
nized the adding-up constraint on asset demands, consistency of stocks
and flows, and the optimizing foundations of individual sectors (such
as the Allais–Baumol–Tobin square root rule for transactions demand
for money, the Markowitz–Tobin mean-variance approach to port-
folio choice, Tobin’s q theory of investment), but it emphatically did
not involve the linkage of markets through the budget constraint of
a single optimizing representative agent (see Buiter 2003, F615–F621).
Such representative agent models assume away Keynesian coordina-
tion problems and provide consistent aggregation of microeconomic
decisions only under very stringent assumptions (see Geweke 1985,
Kirman, 1992, Hartley 1997). But the multi-asset models of Tobin and
his associates had the problem of many explanatory variables in asset
demand functions with limited data.
Gary Smith (1989, 1692–1693) acknowledged,

Because of the strong intercorrelations among the available data,

the implementation of the Yale approach is inevitably plagued
by severe multicollinearity problems. While monetarism is too
simple, the Yale approach is too complex. Some [e.g., Owen 1986]
accept the high standard deviations and low t-values, observing
that the data are not adequate for answering the questions asked.
Some researchers try to get more precise estimates by using
exclusion restrictions; others have tried more flexible Bayesian
 Consumption, Rationing and Tobit Estimation 61

procedures for incorporating prior information [e.g., Smith and

Brainard 1976].

Ironically, Tobin’s career as an econometrician had come full circle:

it began, in his dissertation and his food demand and rationing
studies, with the use of household survey data to try to get around
the co-movement of available macroeconomic time series, and
ended with his general equilibrium approach to monetary modeling
plagued by the very same co-movement of available time series –
whereas such co-movement was a help rather than a hindrance for
T. C. Liu, whose concern was with unconditional forecasting rather
than structural identification (Liu 1960, Chao and Huang 2011).

Conclusion

Although best known as a Keynesian macroeconomist and mone-

tary theorist, James Tobin was an active empirical economist from
his second publication (Tobin 1942), through his dissertation, until
nearly the close of his career (Tobin and Brainard 1992). Despite the
weak teaching in econometrics available at Harvard when he was a
student, he became a skilled and successful econometrician, contrib-
uting to econometric methodology (the Tobit model of 1958) and
producing work in applied econometrics that has stood up well to
intense later scrutiny (Tobin 1950, Magnus and Morgan 1997, 1999).
His early work centered on the introduction of asset holdings into
the consumption function and the use of survey data to deal with
the co-movement of available time series (many economists are leery
of survey data, but one of his Cowles colleagues, Truman Bewley
[1999], made noteworthy use of surveys to investigate the Keynesian
question of why wage rates don’t fall in recessions).
His direct contribution to microeconometric techniques, in Tobin
(1947, 1950, 1955b, 1958b), ended when he joined the President’s
Council of Economic Advisers at the beginning of 1961, but he
remained involved in macroeconometric modeling after his return
from Washington (Brainard and Tobin 1968, Backus, Brainard,
Smith, and Tobin 1980). Tobin’s later work in monetary modeling
was hampered by that same co-movement of available time series.
Tobin’s econometric endeavors stemmed from the same source as his
macroeconomic theorizing: coming to economics during the Great
62 James Tobin

Depression by reading Keynes, he was concerned with macroeco-

nomic stabilization through management of aggregate demand to
prevent another Great Depression, and therefore wished to under-
stand the decisions determining consumption, the largest compo-
nent of aggregate demand. His career as an econometrician was not
separate from his other intellectual concerns, but was an integral
part of being a Keynesian macroeconomist who also cared about
Fisherian intertemporal optimization.
4
Portfolio Balance, Money
Demand, and Money Creation

Tobin’s doctoral dissertation dealt with consumption and saving

decisions, and the articles based on that dissertation (together with
his econometric papers on food demand and rationing) put him on
the path to receiving the John Bates Clark Medal in 1955, awarded by
the American Economic Association every two years to an American
economist under the age of 40 who has already made significant
contributions to knowledge (the only previous winners were Paul
Samuelson, Kenneth Boulding, and Milton Friedman). But in the
late 1950s and the 1960s, Tobin’s main research interest turned from
understanding saving (the S of the IS curve) to exploring the opti-
mizing microeconomic foundations of the money demand (liquidity
preference), money creation and asset market equilibrium under-
lying the LM (liquidity/money) curve, which lead to his writing
some of his most influential articles (Tobin 1956, 1958a, 1961,
1963). Although the analysis in these articles was theoretical, Tobin
was well aware of the policy relevance of the nature of the money
demand function. Already in 1947 (in an article also noteworthy for
its empirical estimation of a money demand function depending
on income and interest), Tobin opened a critique of an article by
pioneer monetarist Clark Warburton and of a book by William
Fellner (later Tobin’s colleague at Yale) by declaring, “The contention
of this paper is that the demand for cash balances is unlikely to be
perfectly inelastic with respect to the rate of interest, and that policy
conclusions which depend on the assumption that the demand for
cash balances is interest inelastic are therefore likely to be incorrect”

63
64 James Tobin

(1947–48, in Tobin 1971–1996, Vol. 1, p. 27, cf. Fellner 1946 and the
articles collected in Warburton 1966).
Tobin’s monetary articles in the late 1950s and early 1960s were
fragments of a manuscript on monetary theory, put aside when
Tobin joined President Kennedy’s Council of Economic Advisers, and
eventually published as Money, Credit and Capital (Tobin with Golub
1998). Draft chapters of “the Tobin manuscript” were used in Yale
courses from the late 1950s to the early 1980s, and influenced the
articles by Tobin and his students (notably William Brainard) that
were collected in three Cowles Foundation monographs edited by
Donald Hester and Tobin (1967a, 1967b, 1967c), which were viewed
as the authoritative presentation of the “Yale School of money,”
so named by Karl Brunner (1971) in contrast to Milton Friedman’s
monetarist “Chicago School.”
The differences between Yale and Chicago, and more specifically
between Tobin and Friedman, in exchanges such as that in Milton
Friedman’s Monetary Framework (Gordon, ed., 1974), concerned
formally modeling of money demand functions in the context of
competing visions of the nature of money and the role of govern-
ment in macroeconomic stabilization (but also see Tobin 1976b as
a reminder that differing macroeconomic visions were compatible
with respect and admiration). For Friedman and his students contrib-
uting to Studies in the Quantity Theory of Money (Friedman, ed., 1956),
money had a unique status among assets as the generally accepted
medium of exchange, with changes in the quantity of money deter-
mining only nominal variables such as the price level in the long run,
but driving fluctuations in real economic activity in the short run.
As the title of Friedman’s 1956 volume indicated, they consciously
upheld continuity with the tradition of the quantity theory of money
as expressed by David Hume in 1752 and Irving Fisher in 1911.
For Tobin and his students contributing to the Cowles monographs
(Hester and Tobin, eds. 1967 a, 1967b, 1967c), money was one among
many assets, with each asset an imperfect substitute for other assets,
and these substitution relations provided a channel for monetary
policy to affect real economic activity, not just nominal variables.
The transactions role of money, and the central bank’s control over
the quantity of and nominal return on high-powered money (the
monetary base), were distinctive characteristics of money, but every
other asset was also distinctive in some way.
 Portfolio Balance, Money Demand, and Money Creation 65

Ironically, during earlier American debates over monetary theory

half a century before Friedman and Tobin, Yale had been the strong-
hold of the quantity theory, because of the presence of Irving Fisher
(1911), while J. Laurence Laughlin and his students at the University
of Chicago denied that changes in the quantity of money were the
main explanation of changes in prices. Despite their contrasting
attitudes in regard to the quantity theory of money, Tobin and
Friedman shared a warm respect for Fisher as the outstanding US
scientific economist of his day (despite the destruction of Fisher’s
public reputation by his October 1929 statement that stock prices
had reached a permanently high plateau). As Willem Buiter (2003,
p. F622) noted, “The two economists Tobin admired most were John
Maynard Keynes and Irving Fisher.”

The interest-elasticity of transactions demand for cash

Tobin (1956) derived the demand for money as a means of payment

from optimization on the part of people who traded off the transac-
tions costs incurred when selling bonds (or the value of time spent
going to the bank to make a withdrawal from an interest-bearing
savings account) when they ran out of cash to spend, against the
interest foregone by holding more of their wealth as cash instead
of as interest-bearing assets. The resulting demand function for
nominal cash balances depended directly on the square root of
nominal income and of the nominal transaction cost and inversely
on the square root of the interest rate.
A similar result had been obtained and published, unknown to
Tobin, by William Baumol (1952), and, unknown to Baumol or Tobin,
in French by Maurice Allais (1947) (see Baumol and Tobin 1989).
Francis Ysidro Edgeworth (1888) had derived a square root rule for the
demand for reserves by banks, rather than for the demand for cash
balances by households. A money demand function dependent on the
interest rate (and therefore an upward-sloping rather than vertical LM
curve) implied that an increase in government spending (a rightward
shift of the IS curve) would not simply crowd out an equal amount of
private investment by forcing up the interest rate, in contrast to argu-
ments advanced by Milton Friedman in 1959 and 1966 for a completely
interest-inelastic money demand function (see the exchange between
Friedman and Tobin in Gordon 1974). Ironically, the responsiveness of
66 James Tobin

demand for real money balances to the nominal interest (the opportu-
nity cost of holding real balances), denied in Friedman’s 1959paper on
money demand, was the basis of his 1969 analysis of the social cost of
even perfectly anticipated inflation (Friedman 1969). Of more lasting
concern to the economics profession than the disputes over the rela-
tive slopes of the IS and LM curves, having the demand for real money
balances depend on the nominal interest rate provided a link between
nominal and real variables, and thus a channel for monetary policy to
affect the real economy, regardless of whether money wages were rigid
(as in Tobin 1965b).

Liquidity preference as behavior toward risk

“Nearly two decades of drawing downward-sloping liquidity prefer-

ence curves in textbooks and on classroom blackboards should not
blind us to the basic implausibility of the behavior they describe,”
warned Tobin (1958a, 65). “Why should anyone hold the non-interest
bearing obligations of the government instead of its interest-bearing
obligations?” For the analysis of how the costliness of trading assets
causes agents to hold cash balances for payments purposes, and how
those balances are determined by the trade-off between transactions
costs and foregone interest, Tobin referred to his 1956 article.
But money is also held for investment reasons, as part of a port-
folio of assets. Keynes (1936) discussed the speculative demand for
money: people may hold money because they think that the interest
rate – and thus the price of bonds – will fall, by enough that the
capital loss to bondholders would more than offset their interest
income. A person would compare the current interest rate with what
he or she expected the interest rate to be next period, and would
accordingly hold either only cash or only bonds. As read by Tobin,
Keynes derived the downward-sloping liquidity preference schedule
from different wealth-holders each having a fixed opinion of what
the future interest rate will be. Tobin drew attention to this remark
by Keynes (1936, 172):

It is interesting that the stability of the system and its sensitive-

ness to changes in the quantity of money should be so dependent
on the existence of a variety of opinions about what is uncertain.
Best of all that we should know the future. But if not then, if we
 Portfolio Balance, Money Demand, and Money Creation 67

are to control the activity of the economic system by changing the

quantity of money, it is important that opinions should differ.

Tobin was troubled by this approach: why should people with the
same information have different beliefs about the future interest
rate, and why should their expectations have no obvious connec-
tion to the predictions of the model? Why, given Keynes’s emphasis
on uncertainty about future income and spending as a reason for
holding money and on uncertainty about the profitability of invest-
ment projects, should people act as if they held their expectations
of the future interest rate with certainty? This subjective certainty
would cause wealth-holders to choose completely undiversified port-
folios, either all cash or all bonds, contrary to the analysis of optimal
diversification by Harry Markowitz (1952), who used linear program-
ming to find combinations of risky assets that minimized risk (the
variance of expected return) for each given level of expected return.
Instead of assuming that each investor held with certainty some
expectation of the future interest rate, Tobin (1958a, 1965c) followed
Markowitz (1952, 1959) in attributing to each investor a subjective
probability distribution over the return on each asset, and prefer-
ences over the mean and variance of returns on their portfolios.
Given the same information, all investors would hold the same prob-
ability distribution over expected returns, but each investor would
have his or her preferences, represented by a map of indifference
curves over risk and expected return. Tobin went beyond Markowitz
by assuming that one asset – money – was riskless, having a fixed
return (whether zero or some positive number). This led him to what
others named “the Tobin separation theorem”: the division of an
investor’s portfolio between risky assets and the riskless asset would
be independent of the composition of the investor’s bundle of risky
assets (only one risky asset would be held by anyone, the one with
the highest expected return). Each rational investor would combine
risky assets in proportions that followed from Markowitz’s analysis.
What fraction of the investor’s total wealth would be invested in
risky assets would depend on how risk averse that investor happened
to be. “Don’t put all your eggs in one basket,” Tobin’s attempt to
summarize modern portfolio theory to journalists when he won the
Nobel Memorial Prize, provoked cartoons of a television news anchor
announcing the award of the Nobel Prize in medicine for “An apple
68 James Tobin

a day keeps the doctor away.” Willem Buiter (2003, F587) remarks
that the Tobin separation theorem would be better expressed as,
“Regardless of your degree of risk aversion and caution, you will only
need two baskets for all your eggs.”
When reprinting his 1958 article, Tobin (1971–96, Vol. 1, p. 270)
expanded a footnote to explain,

For the purposes of this paper, “cash” should not necessarily be

identified with means of payment, i.e. currency and bank deposits.
In most advanced economies, these are dominated for investment
balances by equally safe and lossproof assets which bear interest,
notably time and saving deposits. This article really refers to the
choice and interest differential between those assets and market
instruments on which capital losses may occur as a result of interest
rate movements. I must apologize that the “bonds” of the previous
article [Tobin 1956] are the “cash” of this article. Another way to
put it is that [Tobin 1956] concerns the short-term rate, and this
chapter the differential between long-term and short-term rates.

The mean-variance analysis of portfolio choice by Markowitz and

Tobin is exact only if people have quadratic utility functions (so that
they only care about the first two moments of the probability distri-
bution of asset returns) or if asset returns are normally distributed (so
that the distribution is fully described by its first two moments). But
even if the analysis is otherwise only approximately correct, a two-
parameter analysis is an improvement over the previously prevailing
one-parameter analysis (maximize expected return net of some
fixed risk premiums), as Tobin pointed out to critics (see Tobin 1983,
1984b). Money is a risky asset in real terms, since the purchasing
power of money varies, so that strictly speaking the safe asset with an
exogenously fixed return should be US Treasury Inflation-Protected
Securities (TIPS) or British Government index-linked bonds. Since
expectations are represented by a subjective probability distribution,
the model deals with risk (as the title of Tobin 1958a states) rather
than fundamental uncertainty in the sense of Knight (1921) or Keynes
(1936, chapter 12), under which no probability distribution could be
used because there is not even a complete list of possible outcomes –
yet that is still an advance over assuming that each investor holds
with certainty a different expectation of the future interest rate.
 Portfolio Balance, Money Demand, and Money Creation 69

Tobin’s 1958 model of demand for money as an asset, like his

1956 model of transactions demand for money, illustrates the way
he introduced optimizing microeconomic foundations into the
IS-LM framework sector by sector. While Markowitz was concerned
with how a rational, optimizing investor should make portfolio
choices, Tobin’s focus was on the asset demand functions, asset
market equilibrium, and implications for monetary policy that
would result if investors acted in accordance with Markowitz’s
analysis.

Commercial banks as creators of “money”

Tobin (1961, 1963, 1969, 1982a) moved on from these specific models
of money demand to a vision of money as one among a vast array
of assets that are imperfect substitutes for each other. Referring
admiringly to John Hicks’s “Suggestion for Simplifying the Theory
of Money” (1935) in a talk to the American Economic Association’s
annual meeting, Tobin (1961, 26, 28) called for the construction of “a
general equilibrium theory of the capital account ... the proportions
in which various assets and debts appear in portfolios and balance
sheets ... Income and capital accounts are linked by accounting iden-
tities – e.g., increase in net worth equals saving plus capital apprecia-
tion – and by technological and financial stock-flow relations.”
He urged “abandoning the convenience of assuming that all assets
but one are perfect substitutes.” He recognized that

The price of this advance in realism and relevance is the neces-

sity to explain not just one market determined rate of return
but a whole structure. The structure of rates may be pictured as
strung between two poles, anchored at one end by the zero own-
rate conventionally borne by currency (and by the central bank
discount rate) and at the other end by the marginal productivity
of the capital stock. Among assets that are not perfect substitutes,
the structure of rates will depend on relative supplies ... In such a
synthesis, monetary policy falls in proper perspective. The quan-
tity of money can affect the terms on which the community will
hold capital, but it is not the only asset supply that can do so.
The net monetary position of the public is important, but so is its
composition.
70 James Tobin

In a paper that was reprinted as the lead chapter of Hester and Tobin
(1967c), Tobin (1963, 411) went to expound a “new view” of mone-
tary economics that

tends to blur the sharp traditional distinctions between money

and other assets and between commercial banks and other finan-
cial intermediaries; to focus on demands for and supplies of the
whole spectrum of assets rather than on the quantity and velocity
of “money”; and to regard the structure of interest rates, asset
yields, and credit availabilities rather than the quantity of money
as the linkage between monetary and financial institutions and
policies on the one hand and the economy on the other ... One
of the incidental advantages of this theoretical development is
to effect something of a reconciliation between the economics
teacher and the practical banker.

Tobin and his current and former graduate students presented this
“new view” in three Cowles monographs (Hester and Tobin 1967a,
1967b, 1967c) that provided the basis for Tobin’s vision of “A General
Equilibrium Approach to Monetary Theory” (1969) in the inaugural
issue of the Journal of Money, Credit and Banking. What Tobin meant
by general equilibrium involved markets linking by adding-up
constraints on wealth, rather than by the budget constraint of an
optimizing representative agent (see Chapters 2 and 9 of this book).
This “new view” was not exclusively a Yale creation; in particular,
Tobin (1961, 1963) drew attention to work in the same spirit by John
Gurley and Edward Shaw (1960), which he enjoyed contrasting with
slightly earlier monetarist statements by Shaw.
Ironically, by the time that Tobin won the Nobel Memorial Prize in
1981, the influence of this “new view” or “Yale School” was receding
in monetary economics. The burgeoning field of finance stressed arbi-
trage that equalized rates of return, rather than imperfect substitution
that allowed changes in the relative supplies of assets to change their
relative rates of return. Empirically, disaggregated multi-asset models
suffered from the extent of their data and computational require-
ments, from highly collinear data series, from doubts about whether
there really are enough a priori restrictions to identify the structural
equations, and from the lack of closed-form solutions to the nonlinear
differential equations describing how variables changed over time in
 Portfolio Balance, Money Demand, and Money Creation 71

such models or, lacking closed-form solutions, the ability circa 1980
to compute numerical solutions to those equations (see Chapter 9).
Twenty or twenty-five years later, programs existed to carry out such
numerical solutions, but by then, monetary economics had moved on
to other modeling approaches, notably dynamic stochastic general
equilibrium (DSGE) models based on explicit dynamic optimization
by a representative agent (see Tobin 1987b for his sharply critical view
of such developments). The shift in emphasis in macroeconomic
policy discussion in the 1970s and early 1980s to concern with infla-
tion focused attention on the growth rate of the quantity of money,
with several countries adopting rules for increasing some monetary
aggregate by a fixed percentage each year.
But financial innovation caused such monetary aggregate targets to
be abandoned in the 1980s. By what became known as Goodhart’s Law
(named after Charles Goodhart of the London School of Economics,
an advisor to the Bank of England), targeting some particular mone-
tary aggregate changed its relationship to other monetary aggregates
and financial instruments, and to nominal income. Reaching back to
the pure credit economy of Knut Wicksell’s Interest and Prices (1898),
Michael Woodford (Interest and Prices, 2003) and others eliminated
the special role of the quantity of money in their models of the trans-
mission of monetary policy to the economy, positing instead that
central banks chose interest rate targets.
Drawing on Keynes’s Treatise on Money (1930) as well as on Wicksell
(1898), Post Keynesian economists such as Basil Moore (Horizontalists
and Verticalists, 1988) argued that the money supply is determined
endogenously by the banks, so that the money supply curve is hori-
zontal at an interest rate equal to the central bank’s discount rate
plus a fixed mark-up, in contrast to the quantity theory view of a
money supply curve that is vertical at the quantity of money set by
the central bank, regardless of the interest rate.
Tobin’s approach to the endogenous creation of money by commer-
cial banks offered a more fruitful and plausible middle path between
these extremes (see Tobin 1991a). Sketched in “Commercial Banks
as Creators of ‘Money’” (1963), Tobin’s analysis of money creation
was modeled more formally in “A Simple Model of the Commercial
Banking Firm” (1982b), published in the Scandinavian Journal of
Economics in 1982 and as a chapter in Money, Credit and Capital (Tobin
with Golub 1998), but first drafted in the late 1950s as part of the
72 James Tobin

“Tobin manuscript” on money. Instead of either treating the interest

rate charged by banks as a fixed mark-up over the central bank’s
discount rate or the quantity of money created by the banks as a fixed
multiple of the monetary base (currency plus bank reserves) created
by the central bank, Tobin (1982b) modeled the lending decisions and
demand for excess reserves by optimizing commercial banks subject
to random shocks to deposits (see also Edgeworth 1888 for a much
earlier exercise in the same spirit). The central bank’s discount rate
and open-market operations would affect these decisions, but only
through the process of endogenous money creation by optimizing
banks. The resulting money supply curve, relating the quantity of
money supplied to the interest rate, would be upward sloping rather
than vertical or horizontal. Publication of this model in 1982, more
than two decades after it was drafted, completed Tobin’s project of
providing, sector by sector, optimizing microeconomic foundations
for each part of the IS-LM model of aggregate demand: money supply
as well as money demand (1956, 1958a), saving (his 1947 dissertation
and related articles), and investment (Tobin’s q).
5
Tobin’s q and the Theory of
Investment

Introduction

As he indicated in the title of his Asset Accumulation and Economic

Activity (1980), James Tobin’s contribution to monetary theory
centered on how asset markets affect real economic activity. Tobin
came to economics during the Great Depression of the 1930s, and
emerged from the Depression and his initial immersion in the
economics of Keynes with an abiding concern for policy-relevant
macroeconomic theory, looking for a channel allowing public policy
to stabilize real economic activity and avoid a recurrence of the mass
unemployment of the 1930s. Reflecting the formative influences
of the 1930s, Tobin always regarded large-scale unemployment as a
social problem, rather than as voluntary investment in search and
consumption of leisure, and shared Keynes’s view of the volatility of
private investment as the force driving economic fluctuations.
The sequence of the Great Depression following the Wall Street
crash of October 1929 led naturally to thinking about how stock
market booms and crashes would affect investment and economic
activity. Tobin’s q provided such a link, positing the dependence
of investment on q, the ratio of the market value of equity to the
replacement cost of the underlying capital assets, with central bank
policy affecting investment by acting on the vector of asset prices
that clears the whole range of interrelated asset markets (Brainard
and Tobin 1968, Tobin 1969, Tobin and Brainard 1977, Tobin 1978b,
1982a). This ratio became closely identified with Tobin and Yale
macroeconomics: Tobin recalled that around 1970, some of his Yale

73
74 James Tobin

graduate students produced a T-shirt emblazoned “Yale School” on

the back and “q is all that matters” on the front, as a response to the
claim attributed to Chicago School monetarists that “M is all that
matters” (Tobin, interviewed by Colander 1999, 120).
Tobin is best known to the general public for his advocacy of a
Tobin tax on international currency transactions, but among econo-
mists, his name is most closely associated with Tobin’s q, as a guide to
understanding the determinants of investment, the transmission of
monetary policy to the real economy, and asset market movements.
Writing in the Financial Times about possible ways to tell whether
stock prices are too high, John Authers (2014, 20) reports that “By
far the best measure, it turns out, is q. Graphed on a chart, q and
hindsight value look almost identical. If you want to know whether
hindsight will deem today’s market to have been cheap or expensive,
you are best to look at q.”

Sources and influences

What are the historical roots of Tobin’s q? Tobin and Brainard (1977,
237–238), Tobin (1978b, 422), and Tobin and Golub (1998, 148) quoted
a striking passage from Keynes’s General Theory (1936, 151):

The daily revaluations of the Stock Exchange, though they are

primarily made to facilitate transfers of old investments between
one individual and another, inevitably exert a decisive influence
on the rate of current investment. For there is no sense in building
up a new enterprise at a cost greater than that at which a similar
enterprise can be purchased; whilst there is an inducement to
spend on a new project what may seem an extravagant sum, if it
can be floated off on the Stock Exchange at an immediate profit.

Tobin and Brainard (1977, 244) and Tobin and Golub (1998,
150) argued,

Since Keynes (1936) discusses at length independent variations

in the marginal efficiency of capital and the rate of interest, he
does not really imagine that investment adjusts the capital stock
rapidly enough to keep them continuously equal. Indeed the real
message is that investment is related to discrepancies between the
 Tobin’s q and the Theory of Investment 75

marginal efficiency and the interest rate. This is in the tradition

of Wicksell and of Keynes’s earlier work (1930).

Tobin and Golub (1998, 150n) appended to this sentence a footnote

stating:

Gunnar Myrdal (1931, 1933) long ago anticipated q, even called

it Q! However, his Q was not a ratio but the absolute difference
between market value and replacement cost. His articles were in
Swedish and German, never English, not known to the authors
of q until Klaus Schmidt, a graduate student at Johann Wolfgang
Goethe University at Frankfurt called them to the author’s atten-
tion in 1994. See Schmidt (1995).

However, Myrdal’s Monetary Equilibrium has been available in English

since 1939, translated by N. Stolper and by Tobin’s Harvard contempo-
rary, Robert Bryce, who, having attended Keynes’s lectures from 1932
to 1934, was a Keynesian missionary among the heathen of the other
Cambridge as a visiting fellow from 1935 to 1937 (interviewed in
Colander and Landreth 1996), before rising to the top of the Canadian
public service. The availability since 1939 of the Bryce/Stolper trans-
lation (reissued in the Kelley Reprints of Economic Classics in 1962
and 1965) contradicts Schmidt’s argument that “Unfortunately,
language barriers apparently prevented these ideas from propagation
into a broader academic community, as Myrdal published his arti-
cles in such ‘exotic’ languages as Swedish and German” (Schmidt
1995, 199)1. Furthermore, it was not only Gunnar Myrdal who used
the symbol Q for the difference between the market value and the
replacement cost of the capital stock; so did John Maynard Keynes in
his Treatise on Money (1930), a work carefully studied by Myrdal and
cited in Myrdal’s Monetary Equilibrium more often than any other
non-Swedish work. Schmidt’s article is entitled “Tobin’s q? Myrdal’s
Q! An example of the value of knowing foreign languages” (1995),
the last phrase implicitly referring to Myrdal’s stricture that

J. M. Keynes’ new, brilliant, though not always clear, work, A

Treatise on Money, is completely permeated by Wicksell’s influ-
ence. Nevertheless Keynes’ work, too, suffers somewhat from the
attractive Anglo-Saxon kind of unnecessary originality, which
76 James Tobin

has its roots in certain systematic gaps in the knowledge of the

German language on the part of the majority of English econo-
mists.2 (Myrdal 1939, 8–9)

Language barriers are not the only source of unnecessary originality.

So is failure to pursue references to earlier literature. Schmidt (1995),
and following him Tobin and Golub (1998), did not notice that Myrdal
(1931, 1933, 1939) chose the symbol Q with the expectation that his
readers would be familiar with the Q of Keynes’s Treatise, and hence
could not notice that Keynes (1930) in turn had selected the symbol Q
for an intended audience that would think of Marshall’s quasi-rents.
In his generous acceptance (in his textbook with Golub) of
Schmidt’s claim for Myrdal’s priority (comparable to the equally
generous announcement by Baumol and Tobin (1989) of Maurice
Allais’s priority on the square-root rule for inventory approach to the
transactions demand for money), Tobin did not mention Keynes’s
Treatise on Money. It is striking that the only reference to Keynes
(1930) in Schmidt’s article is when Schmidt mentions that, when
he interviewed Tobin, Tobin identified Keynes’s Treatise on Money as
an important historical source of his own ideas, and viewed his q
variable as being in the tradition of Keynes’s Treatise and of Wicksell
(Schmidt 1995, 197), just as in the sentence quoted above from Tobin
and Golub (1998, 150) that precedes the footnote acknowledging
Schmidt on Myrdal. Unfortunately, neither Tobin’s remark nor
Myrdal’s citations and comments led Schmidt to pursue the reference
to Keynes (1930), where he would have discovered Keynes’s use of the
symbol and concept Q. Tobin also drew attention to the relevance of
Wicksell (1898) when he told Shiller (1999, 887–888) that q “relates
to the old Wicksellian idea, the difference between the market rate
of interest and the ‘natural’ rate of interest. In fact, it’s easy to have a
little model which shows that they’re the same thing.”

Keynes’s Q: Profits in A Treatise on Money

The General Theory was not Keynes’s first attempt to revolutionize how
economists think the functioning of the economy as a whole. The
impact of The General Theory has overshadowed his once-celebrated
Treatise on Money (1930), and the terminology of modern macroeco-
nomics that stems from The General Theory (in which investment
 Tobin’s q and the Theory of Investment 77

and saving are identically equal ex post, but actual investment can
differ from desired investment through unintended changes in
inventories) has displaced the distinctive terminology that Keynes
introduced in 1930 (in which investment differs from saving except
in equilibrium). The notation of the Treatise is not made easier for
the modern reader by Keynes’s choice of the letter O as the symbol
for Output as a whole (the sum of R, the physical volume of new
consumption goods, and C, the physical volume of new capital
goods), which, since the capital letter O is easily mistaken for zero,
gives his “Fundamental Equations for the Price Level” the startling
appearance of involving division by zero.
Unlike the General Theory, Keynes’s Treatise lacked a theory of the
determination of output as whole: the Treatise ’s two Fundamental
Equations were tautologies, and imperfect ones at that. As Alvin
Hansen pointed out (and Richard Kahn had noted even before publi-
cation), the Fundamental Equations were also marred by implicitly
assuming the same rate of technical progress in the consumer goods
and capital goods sectors, allowing convenient comparison of phys-
ical units of output in the two sectors.
The heart of Keynes’s analysis in the Treatise was not the cumber-
some apparatus of the Fundamental Equations, but rather the argu-
ment that investment is driven by what he called “profits,” Q. Q
was the sum of Q1, profits in the consumption goods sector, and Q2,
profits in the investment goods sector: Q2 = I – I’, where investment I
is the market value of the flow of current output of capital goods and
I’ is the cost of production of those capital goods, and Q1 = I’ – S, so
that profits Q = I – S, investment minus saving. Investment depends
on the interest rate and on Q, because investment decisions depend
on the expected stream of returns on investment and on the interest
rate at which they are discounted, with Q affecting expectations (see
Dimand 1986, 433–434, 440, for derivation of Keynes’s Fundamental
Equations and for a proposed formalization of the model implicit in
Books III and IV of A Treatise on Money).
Keynes (1930) usually restricted Q to unanticipated profits or
losses of entrepreneurs, excluding such windfalls from E, the normal
(expected) earnings of the factors of production (equal to the total
cost of production), and from S (saving). For most of the Treatise, Q is
an ex post realization, a measure of surprise that serves entrepreneurs
as an additional piece of information to use in forming expectations
78 James Tobin

of the future profitability of investment. Realized windfall profits

play the same role as a measure of surprise in A Treatise on Money
as undesired changes in inventories play in The General Theory. The
crucial difference is that positive windfall profits cause investment
to increase and so windfall profits (Q = I – S) increase further, in
a Wicksellian cumulative inflation, while in The General Theory, an
unintended reduction in inventories leads firms to increase output,
reducing the gap between output and desired expenditure, as well as,
by increasing saving, reducing the gap between saving and desired
investment. In Keynes’s Treatise on Money, as in Wicksell ([1898] 1936,
1907), a cumulative inflation or deflation could continue until a
change in the interest rate (brought about by the central bank or a by
the response of banks to pressure on their reserves) restored equality
of investment and saving (in Wicksell’s terminology, changed the
market rate of interest to be equal to the natural rate of interest),
since Keynes (1930) lacked the equilibrating role of the dependence
of saving on income. The equilibrium condition of Keynes (1930)
was Q = 0, in which case there would be no tendency for cumulative
inflation or deflation.
In one striking passage, however, Keynes (1930, I, 159) switched
from treating profits Q as realized windfalls to observe:

We have spoken so far as if entrepreneurs were influenced in

their prospective arrangements entirely by reference to whether
they were making a profit or loss on their current output as they
market it. In so far, however, as production takes time ... and in so
far as entrepreneurs are able at the beginning of a production-pe-
riod to forecast the relationship between saving and investment
at the end of this production-period, it is obviously the antici-
pated profit or loss on new business just concluded, which influ-
ences them in deciding the scale on which to produce and the
offers which it is worthwhile to make to the factors of production.
Strictly speaking, we should say that it is the anticipated profit or
loss which is the mainspring of change, and that it is by causing
anticipations of the appropriate kind that the banking system is
able to influence the price-level.

Interpreted in this anticipatory sense, Keynes’s Q2 = I – I’ is greater

than, equal to, or less than zero as Tobin’s q (which would be I/I’ in
 Tobin’s q and the Theory of Investment 79

the notation of Keynes’s Treatise) is greater than, equal to, or less than
one (Dimand 1988, 27–28, see also Perelman 1989).

Myrdal’s Q: Ex ante and ex post in monetary equilibrium

Myrdal’s work, which translates as Monetary Equilibrium, was first

published in Swedish in the volume of Ekonomisk Tidskrift (now the
Scandinavian Journal of Economics) dated 1931 (but actually printed in
the summer 1932), and was based on a series of lectures on Wicksell’s
monetary theory delivered by Myrdal at the Geneva Post Graduate
Institute for International Studies and at Stockholm University. In
September 1931, Myrdal drafted a version for submission to the
Journal of Political Economy, but the manuscript became too long for
a journal article (Dostaler 1990, 201). Instead, an expanded German
translation was published in 1933 in a collective volume edited
by Friedrich Hayek, and an English translation from the German
appeared in 1939. The German edition included three introductory
chapters not in the Swedish version (for a total of nine chapters)
and omitted “certain sections containing contributions toward the
settlement of purely Swedish controversies” (defending Wicksell’s
equilibrium concept of a normal rate of interest against what Myrdal
regarded as Lindahl’s exclusive focus on dynamics rather than
equilibrium) while the English version translated the German text
“without consequential modifications” apart from omission of an
attempt to demonstrate the identity of two of Wicksell’s equilibrium
conditions (Myrdal 1939, vi). Myrdal (1939, 32n) cautioned that “The
reader should note that the remarks on the work of Keynes and Hayek
in the next section of the present essay were written in the spring of
1932; those on Keynes refer specifically to his Treatise on Money.” To
other references to “to-day”, “actual conditions” and “the present
time,” Myrdal (1939, 1, 162n, 170) added “Spring 1932” in a footnote
or parenthetical remark.
The published texts make it clear that by the spring of 1932, Myrdal
was thoroughly familiar with Keynes’s Treatise on Money, and regarded
it as highly important. Leijonhufvud (1981, 135) argues that A Treatise
on Money was within the Wicksellian tradition, whereas, because of
its emphasis on liquidity preference to the exclusion of loanable
funds, The General Theory was not. Indeed, Myrdal’s attention to
Keynes’s writings preceded the October 1930 publication of A Treatise
80 James Tobin

on Money. Erik Lindahl (1929, 90), in his Economic Journal review of

Myrdal’s 1927 dissertation (of which Lindahl had been an examiner),
observed that “The author, who in this chapter [on risk and uncer-
tainty] delivers a criticism on F. H. Knight and on Irving Fisher, has
obviously been influenced a good deal by J. M. Keynes’ Treatise on
Probability” (see also Lindahl 1996, 30, on Myrdal’s dissertation).
Myrdal (1933, 408; 1939, 79, 85) defined the profit margin for a single
firm as q’ = c1’- r1’: that is, the profit margin q’ is equal to the “Value of
existing real capital” minus the “Cost of reproduction of existing real
capital.” For the economy as a whole, Myrdal’s Q is the summation
of the q for each firm. Myrdal restated Wicksell’s equilibrium condi-
tion as holding that when Q is zero, there would be no tendency for
the system to go into cumulative inflation or deflation. Like Keynes
(1930), but unlike Tobin’s q, Myrdal’s Q is a difference, rather than a
ratio. Myrdal (1939, 61n) stated: “These revenue or cost gains or losses
would correspond to the ‘windfalls’ of Keynes, if Keynes had defined
this notion clearly, which he certainly has not done.”
This is both a fair criticism of A Treatise on Money, and an exact
statement of the relationship between Myrdal’s Q and Keynes’s Q.
Keynes (1930) sometimes treated Q as an ex post concept, sometimes
(notably Keynes 1930, I, 159) as ex ante, while Myrdal’s contribution
was to clarify the ex ante/ex post distinction, sorting out Keynes’s
muddling of the two, and to emphasize the Wicksellian roots of
the approach. Myrdal chose the symbol Q as an explicit reference
to Keynes’s Q, because what he was doing was sorting out Keynes’s
inconsistent usage of the term – just as Keynes was engaged, during
his 1932 Cambridge lectures, in sorting out that same inconsistency
of the Treatise. (It was in his 1933 lectures that he moved beyond the
Treatise to a theory of the determination of output as a whole.)
Schmidt (1995, 188) has, however, found an interesting passage
in Myrdal’s original Swedish article (Myrdal 1931, 231–233) that
defined q as a ratio, with the equilibrium condition q = C1/R1 = 1,
as in Tobin’s work. In the German version, Myrdal (1933, 431–434)
reverted to the equilibrium condition Q = C1 – R1 = 0, treating Q as
a difference as in Keynes (1930), and this carried over to the English
translation, Myrdal (1939).
Schmidt (1995, 175) declares that honesty requires that a concept
such as the Phillips curve, Pigou effect, Fisher theorem, Wicksellian
process analysis, or Tobin’s q be named for the original discoverer, and
 Tobin’s q and the Theory of Investment 81

hence q should be Myrdal’s Q. However, the outstanding contribution

of Myrdal’s early monetary theorizing is not Q, a notation that he used
because it had been used in Keynes (1930), but the distinction between
ex ante and ex post, terms which appear first in the introductory chap-
ters added to the 1933 German edition (see Otto Steiger’s New Palgrave
entries “Ex ante and ex post” and “Monetary equilibrium”). The concep-
tual distinction is Myrdal’s, although credit for the wording may be
shared with Myrdal’s pupil and translator, Gerhard Mackenroth, and
Lindahl had used the term ex post (but not ex ante) in 1924 book proofs
(but not in the final published version in 1929). In his Swedish article,
Myrdal (1931, 208 and 230) used “antecipationer” and “anteciperad”
for ex ante and “i efterhand” (“with hindsight”) for ex post.3
Swedish monetary theory, including Myrdal (1933), attracted atten-
tion among English-speaking economists in the early 1930s, with
Ohlin giving the Newmarch Lectures at University College, London, in
1932, the Finlay Lectures at University College, Dublin, in 1934 (Keynes
had been the Finlay Lecturer for 1933), and the Marshall Lectures at
Cambridge in November 1936, a month after Keynes addressed the
Political Economy Club in Stockholm (where the younger Swedish
economists criticized Keynes as too classical). An English translation of
Wicksell’s Interest and Prices by Keynes’s close associate, Richard Kahn,
sponsored by the Royal Economic Society (of which Keynes was secre-
tary), and with an introduction by Bertil Ohlin, was begun in 1929,
as a by-product of correspondence between Keynes and Ohlin related
to their Economic Journal exchange over the German transfer problem,
although the translation was not published until 1936 (see Keynes to
Ohlin, January 5, 1931, in Keynes 1979, XXIX, 8–9, on delays in Ohlin’s
writing of the introduction). Myrdal (1933) influenced Hayek’s LSE
colleague J. R. Hicks,4 whose Economica review of the Hayek volume
of which Myrdal’s monograph was part (Hicks 1934) made Myrdal’s
ideas available to readers of English. Robert Bryce, one of the two
translators of Myrdal’s Monetary Equilibrium (1939), had, after gradu-
ating from the University of Toronto in engineering in 1932, attended
Keynes’s lectures in Cambridge for three years, summarized Keynes’s
lectures in “An Introduction to a Monetary Theory of Employment”
(in Keynes 1979, XXIX, 132–150), presented to four sessions of Hayek’s
LSE seminar early in 1935, and then spent two years at Harvard on a
visiting fellowship, spreading the Keynesian message in an informal
seminar that he organized with Paul Sweezy – an association with a
82 James Tobin

Marxian economist that caused some embarrassment in the Cold

War 1950s when Bryce was Clerk of the Privy Council of Canada and
Secretary to the Cabinet (see Bryce 1988 and the interview with Bryce
in Colander and Landreth 1996). Through Bryce, Myrdal’s work was
known among at least some of the young Keynesians at Harvard in
the 1930s. Bryce came to Harvard in 1935, the year Tobin arrived as an
undergraduate, but Bryce’s contacts were with graduate students and
faculty. Tobin later told Schmidt that he was not familiar with Myrdal’s
contributions to monetary economics, although he knew of Myrdal as
one of the writers building on Wicksell’s ideas (Schmidt 1995, 177).
Myrdal’s Monetary Equilibrium was among his contributions noted
in 1974 in the citation for his Nobel Memorial Prize, which he shared
with Hayek as fellow contributors to the Wicksellian tradition in the
1930s, despite their political differences. Velupillai (1988) has viewed
Myrdal (1931, 1933, 1939), with his emphasis on ex ante expectations
and defense of the equilibrium concept of a normal rate of interest,
as an anticipation of rational expectations equilibrium macroeco-
nomics, which, as Dostaler (1990, 217) remarks, “would not have
made Myrdal very happy, any happier than he was to share the Nobel
Memorial Prize with Hayek.”
The extensive studies on the Stockholm School by historians of
economics have not neglected Myrdal (see especially the papers in
Dostaler, Éthier, and Lepage 1992). The unfamiliarity of his name
among contemporary macroeconomists is not due to his writing in
exotic languages or to someone else taking credit for his contribu-
tions, but to advanced students of macroeconomics being taught
little about the past of their subject.

Keynes’s Q in his lectures: Marshallian quasi-rents

At the same time that Myrdal (1933) was distinguishing ex ante

and ex post magnitudes, Keynes himself was reworking his concept
of Q, adopting the expectational view sketched in Keynes (1930, I,
159) rather than the interpretation of Q as unanticipated windfalls.
Since his return to Cambridge in 1919 from the wartime treasury and
the Versailles Peace Conference, Keynes’s lecturing had consisted only
of a single annual series of eight lectures on the subject of whatever
he was writing at the time, so his lectures from 1932 to 1935 were,
in effect, a succession of drafts of The General Theory. T. K. Rymes
 Tobin’s q and the Theory of Investment 83

assembled copies of all the surviving sets of student notes on these

lectures (reproduced in Rymes 1987), and essayed a reconstruction
of them (Rymes 1989), which Tobin viewed enthusiastically, sending
one of his doctoral students to Ottawa to study the notes and discuss
them with Rymes (see Dimand 1988). The longest runs of notes are
by two Canadians who came to Cambridge in 1932 from Toronto:
Robert Bryce on Keynes’s lectures in the Michaelmas terms (October
to December) of 1932, 1933, and 1934, and Lorie Tarshis on the four
lecture series from 1932 to 1935.
In Michaelmas 1932, Keynes still kept to the windfall interpreta-
tion of Q:

The costs of production equal the sum of the variable and fixed
(or contractual) costs and entrepreneur’s inducement, the sum of
all three. If actual sales proceeds exceed the costs, the surplus will
be called the net or windfall profit, Q. Windfall profits are zero
in equilibrium. When Q is positive or negative, it means that if
entrepreneurs could start over again, they would revise their scale
of output. (October 17, 1932, Rymes 1989, 56) “Q = I – S” (October
24, 1932, Rymes 1989, 60)

A year later, however, Keynes’s students recorded:

The variable cost, E, is the cost to which the entrepreneur commits

himself when he makes a short-period decision to employ people.
When he makes a decision of this nature, he has an expecta-
tion of sales proceeds. The excess of these total expectations of
sales proceeds over E is Q the expected quasi rents. E + Q equal
expected sales receipts = Y. Q represents entrepreneurial expecta-
tions for the current production period. ... Marshall, when he was
referring to quasi-rent, had in view not the long-term expectation
in terms of equipment but rather the short-period concept. He
did not explain whether he meant the short period or the ex post
facto, after the event, calculation. The meaning that Keynes gives,
expected quasi-rents, is more suitable for Keynes and Marshall.
(November 6, 1933, Rymes 1989, 103–104)

Keynes emphasized that “the expectation over the short period ... is
the only thing that matters. The ex post facto result has no
84 James Tobin

significance except as it influences expectations over the short

period” (Rymes 1989, 104).
However, windfalls reappeared in that lecture as A, windfall appre-
ciation. According to Tarshis’s notes (but not those of Bryce, Marvin
Fallgatter, or Walter Salant), Keynes then said, “Consumption is
some function of income and windfall appreciation, C = f(Y, A)” with
Y = C + I (Dimand 1988, 162; Rymes 1989, 106), the first statement
of the consumption function (from which A was later dropped).
The following year, lecturing on user cost, Keynes remarked that
“Marshall’s quasi-rent ... is a short-period one, it is either an expec-
tation or what you actually get. Marshall didn’t say which but the
context suggests it is the expectations concept” (November 19, 1934,
Rymes 1989, 145).
The one respect in which Tobin’s q was closer to Myrdal’s Q than
to Keynes’s 1930 usage of Q was that, in the Treatise, Keynes usually
treated Q as an unanticipated windfall, sometimes as an expectation.
That divergence was gone by the time of Keynes’s 1933 lectures on
“The Monetary Theory of Production,” in which Q is clearly defined
as expected quasi-rents, in the same year that Myrdal introduced the
distinction between ex ante and ex post in the introductory chapters
added to the 1933 German edition of his monograph. These 1933
developments were independent, because Keynes first read Myrdal’s
Monetary Equilibrium in the 1939 English translation, which he anno-
tated favorably (Dostaler 1990, 200). Lindahl discussed Myrdal on
investment and saving ex ante and ex post in a manuscript he sent to
Keynes (in Keynes 1979, XXIX, 123–131), but that was in November
1934, a year after Keynes’s lecture on Q as expected quasi-rent. Keynes’s
lectures, by invoking Marshall’s term, quasi-rent (see Marshall 1920,
412, 424–426, 622–628), suggest an explanation for his choice of the
symbol Q, which Myrdal then adopted from Keynes (1930)5.

Keynes’s Q, Myrdal’s Q, Tobin’s q

Tobin (1978, 422) stated, “I have, not very imaginatively, called the
ratio q.” Schmidt (1995, 189) claims that in his 1978 remark Tobin
ascribed to himself the naming of the concept, but attaches no
significance to Tobin’s disclaimer of imaginativeness or originality in
naming the ratio. Schmidt presents quotations from Myrdal (1933)
and Tobin (but no quotations from Keynes 1930) in parallel columns
 Tobin’s q and the Theory of Investment 85

that, according to Schmidt (1995, 189), “show that Myrdal really

has anticipated Tobin’s q-theory thoroughly.” Indeed, “Myrdal’s
achievement of anticipation gains almost prophetic characteristics”
(Schmidt 1995, 188). Schmidt (1997, 197) concludes by comparing his
rediscovery of Myrdal’s Q to the rediscovery of Irving Fisher (1926),
which was republished in 1973 under the title “Lost and Found: I
Discovered the Phillips Curve – Irving Fisher.”
Notwithstanding the overly generous acceptance of Schmidt’s
claim by Tobin with Golub (1998, 150n), what Schmidt has actually
shown is that both Myrdal and Tobin were correct in their claims
to have read Keynes’s Treatise on Money, and that Tobin had grounds
for describing himself as an “Old Keynesian.” Tobin’s q-theory of
investment has roots in Keynes’s Treatise on Money (1930) and General
Theory (1936, 151) and, at one remove in Marshall’s concept of quasi-
rents, and, far from assuming that stock markets efficiently reflect
fundamental valuations, provides a channel for monetary policy and
stock price bubbles and crashes to affect real investment. Myrdal’s
contribution to monetary economics was the ex ante/ex post distinc-
tion, not the q-theory of investment.

Tobin’s q: Asset markets and economic activity

Tobin was content to be labeled an “Old Keynesian” macroeconomist,

as distinct from New Keynesian or Keynesian, and considered his
work to be in the tradition of Keynes (1936), whatever the divergence
in detail, such as his perception (and that of his colleague and former
student, William Brainard) of a stock-flow confusion in Keynes’s
General Theory exposition of his theory of investment. Equating the
marginal efficiency of capital to the market rate of interest, as Keynes
(1936) did, would determine the desired stock of capital, not deter-
mine a flow of spending on net investment. However, adjustment
costs could prevent the capital stock from always being equal to its
desired level. A capital goods producing sector with given capacity
would have an upward-sloping supply curve for capital goods6. Tobin
(1980a, 89) stressed that “Adjustment costs incident to capital accu-
mulation rise with the rate of investment. Businesses must incur
these costs in addition to the normal prices of the commodities they
are installing as productive capital.” The speed at which the capital
stock was adjusted toward its desired level would depend on how
86 James Tobin

far the marginal efficiency of capital was from the interest rate: “In
this view we were in the tradition of Wicksell and of the Keynes of A
Treatise on Money (who occasionally reappears in the General Theory)”
(Tobin and Brainard 1990, 68).
Marginal efficiency is a subjective expectation, not directly observ-
able. However, Tobin and Brainard showed that, when the expected
stream of returns on a capital asset is the same across periods, the
ratio of the marginal efficiency of capital to the interest rate is equal
to the ratio of the market valuation of corporations by the stock
and bond markets to the replacement cost of the underlying capital
assets. Tobin (interviewed by Shiller 1999, 887) emphasized this as
the crucial difference between his q and Hayashi’s “neoclassical inter-
pretation” of q (Hayashi 1982, cf. Buiter 2003, F599). Tobin stressed
that Hayashi’s q is “a shadow price of an optimal program solution”
incorporating adjustment costs, “not something you actually could
measure as a market variable,” while the numerator of Tobin’s q is
observable in stock and bond markets.
Given that Tobin came to economics during the depression that
followed the Wall Street crash of October 1929 (see Green 1971),
it was fitting that his theory of investment provided a channel for
stock market bubbles and crashes to affect investment and aggre-
gate demand. In their response to Post Keynesian criticism by Crotty
(1990), Tobin and Brainard (1990, 71) insisted that in Tobin and
Brainard (1977) and other articles, “we followed Keynes in believing
that speculation makes market prices diverge from fundamental
values,” a view shared with their younger Yale colleague Robert Shiller
(see Tobin 1984a, Shiller 1989, 1999, 2000, Colander 1999, Buiter
2003, F589). The q-theory was offered as having policy relevance:
“For example, many financial economists and pundits interpreted
the low and even negative real-interest rates of the stagflationary
periods of the 1970s as indicative of easy monetary and credit condi-
tions. But the low q’s of the same period signaled bad weather for
investment. We think the central bank should keep its eye on q”
(Tobin and Brainard 1990, 68–69).
At least one central banker might have been inclined to do so.
Furstenberg (1977, 34) reports that, before Tobin and Brainard
expounded the theory of q, Alan Greenspan (1959) and Yehuda
Grunfeld (1960) were the first to use variables similar to q in
 Tobin’s q and the Theory of Investment 87

empirical investigations of the effect of stock prices on corporate

investment. Tobin’s q has since been used with varying success as
a determinant of investment in numerous empirical studies (e.g.,
Chan-Lee and Torres 1987, McFarland 1988, Blanchard, Rhee, and
Summers 1993, Kim 1998), with Sensenbrenner (1991) concluding
that q worked well to explain investment in six OECD countries
once investment inertia was included. The valuation of intangible
assets and of irreproducible assets such as land is an empirical diffi-
culty for the denominator of q (Buiter 2003, F600). Lindenberg and
Ross (1981) have taken a cross-sectional approach to q as an index
of monopoly power. While Tobin looked to changes in the capital
stock to bring q back toward its equilibrium value of one, others,
such as Smithers and Wright (2000), upon finding that Wall Street’s
q was then well above two (higher than at the previous peaks in
1929 and 1968), looked to changes in stock prices to bring q closer
to one.

Tobin, q, and the Post Keynesians

Tobin’s claim that his q-theory of investment was in the spirit of

Keynes was challenged by some Post Keynesian economists. Hyman
Minsky (1981, 1982, 1986), like Tobin an admirer of Keynes (1936,
chapter 19) and Fisher (1933), and like Tobin a student of Joseph
Schumpeter and Wassily Leontief at Harvard (Tobin’s and Minsky’s
times at Harvard overlapped from 1946 to 1949), dismissed Tobin
as being neoclassical rather than Keynesian at heart. Tobin (1989a,
75) protested that Minsky (1986, 5n, 133–138) “accuses the misguided
Keynesians of embracing the Pigou-Patinkin real balance effect as a
proof that flexibility of wages and prices ensures full employment
so that governmental macroeconomic interventions are not needed.
This is just not true. I, for example, say the opposite in publica-
tions that Minsky knows and actually cites” such as Tobin (1975,
1980a). Tobin (1989a, 73) declared, “this ‘post-Keynesian’ theory
[mark-up pricing] is not convincingly linked to the central message
of the book [Minsky 1986], the financial theory of business cycles.
Minsky’s excellent account of asset pricing and investment decisions
is separable from his theory of prices, wages and profit. It sounds like
‘q’ theory to me.”
88 James Tobin

James Crotty (1990) also contrasted a Keynesian Minsky with a

neoclassical Tobin. Tobin and Brainard (1990, 66–67) responded by
insisting on their agreement with Keynes’s

stress in chapter 12 of the General Theory on the inevitable role

of non-rational attitudes – optimism and confidence or their
opposites – in forming estimates of the marginal efficiency of
capital ... Nothing excuses [Crotty’s] charge that “Tobin places
Keynes’s stamp of approval on rational expectations, efficient-
markets general equilibrium models that are the modern exten-
sions of the classical theory Keynes so vehemently opposed”.

Tobin and Brainard (1990, 71) also took umbrage at Crotty’s remark
about “Tobin’s stable and efficient financial markets,” protesting
that

We did not use the word “stable.” Our word “efficient” referred
only to technical market-clearing efficiency. We did not say or
mean that stock markets come up continuously with funda-
mental valuations. In this 1977 article, which Crotty cites, and in
others on “q,” we followed Keynes in believing that speculation
makes prices diverge from fundamental valuations. Again putting
his own words in Tobin’s mouth, Crotty says in his footnote 9
that in his 1984 article, “Tobin appears to recant his belief in
the valuation efficiency of financial markets.” The term “valua-
tion efficiency” does not appear in our 1977 article, and no other
writing of ours, individual or joint, asserts such a belief. Tobin has
nothing to recant.

Conclusion

Tobin’s q, developed jointly with William Brainard, displays the

distinctive features of Tobin’s approach to monetary economics and
macroeconomics. It is “something you could actually measure,” the
ratio of observable variables relevant to decision-makers deciding on
investment, rather than the shadow price of an optimal programming
problem. The market value of capital assets, which is the numerator
of Tobin’s q ratio, is the channel through which changes in expec-
tations of future profitability, waves of optimism and pessimism
 Tobin’s q and the Theory of Investment 89

(Keynes’s “animal spirits”), and speculative bubbles affect invest-

ment and output, allowing for a narrative in which the Wall Street
crash of 1929 is relevant to the ensuing Great Depression during
which Tobin came to economics. Tobin’s q is relevant for policy, a
variable to which central banks should pay attention, with the asset
prices in its numerator being the channel through which monetary
policy can counteract fluctuations in investment. Tobin’s q is firmly
rooted in Tobin’s reading of Keynes, A Treatise on Money as well as
The General Theory, while avoiding a stock-flow confusion that Tobin
perceived in Keynes’s General Theory (q = 1 when the capital stock
is at its desired level, not the flow of investment). As Authers (2014)
reports, Tobin’s q continues to have empirical importance for under-
standing movements in asset prices as well as investment.
6
Money and Long-Run Economic
Growth

Introduction: a monetary economist in growth theory

James Tobin, while primarily identified with short-run Keynesian

macroeconomics and monetary economics, is less well remembered
as a growth economist, despite his continuing interest in growth
throughout his career. Tobin’s early work placed him near the origins
of modern growth economics. Robert Solow (2004, 657)1 recalls that
Tobin “published ‘A Dynamic Aggregative Model’ at just the time
when I was working on economic growth, so I recognized a master
hand.” According to Tobin (Breit and Spencer 1990, 130–131), “My
1955 piece, ‘A Dynamic Aggregative Model,’ may be my favorite; it
was the most fun to write. It differed from the other growth litera-
ture by explicitly introducing monetary government debt as a store
of value, a vehicle of saving alternative to real capital, and by gener-
ating a business cycle that interrupted the growth process.”
That said, Tobin’s analysis has failed to claim a place as a classic in
the literature. Willem Buiter (2003, F596) argues:

His “Dynamic Aggregative Model” (Tobin, 1955a) has not received

the credit it deserves ... Not only does Tobin’s model have the key
features of the one-sector neoclassical growth model (a neoclas-
sical two-factor production function in capital and labour,
smooth capital-labour substitution, competitive factor markets),
it includes several other features (outside fiat money in the asset
menu, money wage inflexibility and business cycle fluctuations).

90
 Money and Long-Run Economic Growth 91

Tobin’s (1965b, 1968a, 1986a, 1986b) subsequent work on long-run

economic growth and capital formation in a monetary economy
(see also Haliassos and Tobin 1990, Tobin with Golub 1998) proved
to be more influential, even though it was less ambitious. Tobin’s
Fisher Lecture to the Econometric Society on “Money and Economic
Growth” (1965b) attracted considerable attention (see Johnson 1967,
Solow 1970, chapter 4, Foley and Sidrauski 1971, Stein 1971, Patinkin
1972). According to Orphanides and Solow (1990, 257),

Tobin’s 1965 paper succeeded in framing the question that has

dominated the literature since: Does the rate of monetary growth
have any long-run effect on the real rate of interest, capital-inten-
sity, output and welfare? He also established the framework within
which the question would be debated: portfolio choice, where fiat
money is one of several competing assets. It has turned out to
be difficult to assess the ‘practical’ relevance of the Tobin effect
precisely because equally plausible models of portfolio balance
can yield quite different answers. ... Once again, we observe that
seemingly small variations in a model change the conclusion
regarding the effect of inflation on capital accumulation.

Even here, while Tobin’s work generated a literature, it is not a major

component of current growth economics.

A dynamic aggregative model

Roy Harrod (1939, 1948, 1952) and Evsey Domar (1946, 1957) repre-
sented the state of the art when Tobin (and Robert Solow and Trevor
Swan) turned to growth theory. The models of Harrod and Domar
were widely interpreted as assuming fixed factor proportions and
savings propensities, resulting in an unstable, “knife-edge” equilib-
rium. While Nicholas Kaldor (1956) proposed to eliminate this insta-
bility by making the propensity to save endogenous, depending on
the distribution of income between wages and profits, Tobin (1960a)
found the implications of this device to be untenable. Pilvin (1953),
Tobin (1955a), Solow (1956), and Swan (1956) eliminated the knife-
edge property of the equilibrium path via a richer specification of
the aggregate production function: substitution between capital and
labor rendered steady-state growth a stable equilibrium (although
92 James Tobin

Swan 1956 denied that Harrod’s theory led to a knife-edge equilib-

rium, and argued that he was only formalizing Harrod’s adjustment
mechanism).
Tobin (1955a, p. 103) objected:

Contemporary theoretical models of the business cycle and of

economic growth typically possess two related characteristics: (1)
they assume production functions that allow for no substitution
between factors, and (2) the variables are all real magnitudes; mone-
tary and price phenomena have no significance. Because of these
characteristics, these models present a rigid and angular picture
of the economic process: straight and narrow paths from which
the slightest deviation spells disaster, abrupt and sharp reversals,
intractable ceilings and floors. The models are highly suggestive,
but their representation of the economy arouses the suspicion that
they have left out some essential mechanisms of adjustment. The
purpose of this paper is to suggest a simple aggregative model that
allows for substitution possibilities and for monetary effects.

Tobin (1955a) had factor substitution possibilities in common with

Solow (1956) and Swan (1956), but the introduction of money in
growth models was distinctively Tobin’s contribution, in keeping
with the central role of money in his life’s work in economics. While
the models of Solow (1956) and Swan (1956) yielded only steady-state
paths of capacity growth in a fully employed economy, Tobin’s 1955
model had three possibilities: steady growth, cycles, or “continuing
underemployment – ‘stagnation’ during which positive investment
increases the capital stock and possibly the level of real income. This
outcome, like the cycle, depends on some kind of price or monetary
inflexibility” (1955a, 103).
Tobin (1955a) assumed that the aggregate production function
exhibited constant returns in capital and labor, so that the marginal
products of the factor inputs depend only on the proportion in which
inputs are used. Tobin’s model was thus in line with Solow (1956) and
Swan (1956). Tobin moved beyond their single-asset world by intro-
ducing money. There are only two stores of value: physical capital (K)
and currency (M). M has an exogenous own-rate of interest (assumed
to be zero), and the quantity of M is also exogenous, with changes in
the money supply level generated by government budget surpluses or
 Money and Long-Run Economic Growth 93

deficits. Real wealth (W) is equal to K + M/p, and portfolio balance

(owners of wealth are content with the division of their wealth
between capital and money) is determined by the standard money
market equilibrium condition M/p = L(K, r, Y). The partial deriva-
tives of L (the liquidity preference function) with respect to its three
arguments are non-negative, strictly negative, and strictly positive,
respectively. According to Tobin,

Requirements for transactions balances of currency are assumed,

as is customary, to depend on income ... Given their real wealth,
W, owners of wealth will wish to hold a larger amount of capital,
and a smaller amount of currency, the higher the rent on capital,
r. Given the rent on capital, owners of wealth will desire to put
some part of any increment of their wealth into capital and some
part into currency. (1955a, 105)

Wealth-owners are assumed risk averse:

The principle of “not putting all your eggs in one basket” explains
why a risk-avoiding investor may well hold a diversified portfolio
even when the expected returns of all the assets in it are not
identical. For the present purpose it explains why an owner of
wealth will hold currency in excess of transactions requirements,
even when its expected return is zero and the expected return on
capital is positive. (1955a, 106–107)

Tobin (1955a, 105) identified portfolio balance as “the one of the

four building blocks of the model that introduces possibly uncon-
ventional and unfamiliar material into the structure.” Several of his
section headings look unconventional from the vantage point of
what has become the neoclassical growth model: “Technical Progress
and Price Deflation,” “Monetary Expansion as an Alternative to Price
Deflation,” “Wage Inflexibility as an Obstacle to Growth,” “Wage
Inflexibility and Cyclical Fluctuations,” and “Wage Inflexibility and
Stagnation.” In their 1956 articles on the neoclassical growth model,
both Robert Solow and Trevor Swan assumed that full employment
was maintained by appropriate Keynesian policies operating offstage
to keep investment (including public investment by the govern-
ment) equal to the full-employment level of saving. Tobin (1955a)
94 James Tobin

incorporated both cyclical fluctuations and long-run capacity growth

in one model. Because his article covered so much ground, the role
of capital-labor substitution in a one-sector growth model stood out
more clearly in Solow (1956) and Swan (1956), where it was the central
theme, than in Tobin (1955a), which was concerned to “provide a
link, generally absent in other models, between the world of real
magnitudes and the world of money and prices” (1955a, p. 113). The
portfolio balance framework (along with assuming that the supply
of labor depends on the real wage, rather than being exogenous) led
Tobin, unlike Solow or Swan, to a model in which “Growth is possible
at a great variety of rates and is not necessarily precluded when the
labor supply grows slowly or remains constant” (1955a, 113) because
an appropriate inflation rate can induce capital deepening.
Tobin (1955a, 113) reached further conclusions beyond the scope
of the neoclassical growth model.

In the absence of monetary expansion and technological

progress ... growth with stable or increasing employment cannot
continue if the money-wage rate is inflexible downward. Given
wage inflexibility, the system may alternate between high and low
levels of employment and, concurrently, between periods of price
inflation and deflation. ... Alternatively, the system may ‘stagnate’
at less than full employment, quite conceivably with capital growth
and reduction of employment occurring at the same time.

Although Tobin (1955a) was reprinted in such widely read collections

as Stiglitz and Uzawa (1969) and Sen (1970), the paper proved to play
little role in growth economics. This lack of impact is reflected in
the single textual reference to Tobin (1955a) in Hahn and Matthews’
(1964) classic survey of growth theory.
Why did the paper, despite its scholarly brilliance, fail to influence
growth economics? One reason is that the range of topics covered and
the multiplicity of possible outcomes lessened its impact, as compared
to Solow (1956) or Tobin (1965), each of which had a clear, unmistak-
able central message. Buiter (2003) shares this view: “It is probably the
vast ambition of the paper and its failure to deliver on all of its objec-
tives that account for the too limited recognition it has received.”
A second reason would appear to involve the utility of the
model in terms of empirical analysis. Solow’s model has proven
 Money and Long-Run Economic Growth 95

to be extraordinarily useful for interpreting empirical patterns. It

is important to recognize that the link between the Solow model
and empirical growth patterns emerged after the publication of the
paper; Solow (1970) provides links between theory and empirics that
are absent in Solow (1956). And perhaps equally important, Solow’s
theoretical analysis was quickly followed by “Technical Change and
the Aggregate Production Function” (1957), which played a key role
in empirical growth work in the 1960s through the early 1980s (e.g.,
Denison 1967, 1985) and indeed continues to be relevant.
By contrast, the theoretical success of Tobin’s “A Dynamic
Aggregative Model” concerned issues whose empirical salience was
unclear. The capacity of a model to produce stagnation, for example,
was of empirical interest from the perspective of the Great Depression,
but not for the post-war economic experience. More generally, “A
Dynamic Aggregate Model” did not provide new insights on the
growth/fluctuations relationship beyond an approach in which
long-run phenomena are modeled via the Solow model, and short-run
phenomena are modeled via IS-LM analysis.

Money and economic growth

Tobin (1965b) returned to analyzing the effect on monetary factors

on the capital intensity of a growing economy. The message of this
paper is clearly summarized in its concluding paragraph (p. 684):

In classical theory, the interest rate and the capital intensity of

the economy are determined by “productivity and thrift,” that
is, by the interaction of technology and savings propensities.
This is true both in the short run, when capital is being accumu-
lated at a rate different from the growth of the labor force, and
in the long-run stationary or “moving stationary” equilibrium,
when capital intensity is constant. Keynes gave reasons why in
the short run monetary factors and portfolio decisions modify,
and in some circumstances dominate, the determination of the
interest rate and the process of capital accumulation ... a similar
proposition is true for the long run. The equilibrium interest rate
and degree of capital intensity are in general affected by mone-
tary supplies and portfolio behavior, as well as by technology
and thrift.
96 James Tobin

Although Tobin was concerned with finding a long-run analogue

to Keynes’s short-run integration of real and monetary factors, this
analysis, unlike his paper of a decade earlier, excluded “the familiar
possibility ... that downward stickiness of money wages prevents or
limits deflation and substitutes underproduction and underemploy-
ment” (1965b, 684). In “A Dynamic Aggregative Model,” much had
depended, or appeared to depend, on money-wage rigidity, diverting
attention from the importance of having two assets rather than one
in a growth model, which stood out unmistakably in “Money and
Economic Growth.” Eliminating price rigidities from the analysis,
Tobin directly addressed the distinction between neutrality and
super-neutrality of money, and argued that super-neutrality fails
because of portfolio substitution effects. As Patinkin (1987) noted, by
doing this, Tobin challenged classic arguments of Irving Fisher (1896,
1907) which concluded that super-neutrality, via the Fisher effect on
interest rates, will only be violated if economic actors suffer from
expectational errors (as Fisher believed they did); interestingly, Tobin
did not highlight this disagreement in his Irving Fisher Lecture or in
his biographical sketch of Fisher (Tobin 1987).
Tobin (1965b, 676) noted, “In a closed economy clearly the impor-
tant alternative stores of value are monetary assets. It is their yields
which set limits on the acceptable rates of return on real capital and
on the acceptable degree of capital intensity.” He treated money and
capital as substitutes from the point of view of the wealth holder,
alternative stores of value2. A higher rate of monetary expansion and
hence of inflation raises the opportunity cost of holding real money
balances (reduces the real rate of return on holding money), and so
leads to portfolio balance with a lower real rate of return on capital
and a greater capital intensity. A somewhat similar analysis, for an
increase in the inflation rate in a short-run IS-LM model rather than
a long-run growth model (and hence dealing with the flow of invest-
ment rather than the stock of capital), had been made by Robert
Mundell (1963), who pointed out that investment depends on real
interest but money demand on nominal interest, so that a change
in the expected rate of inflation changes the level of output and real
interest at which the IS curve intersects the LM curve.
Tobin’s 1965 conclusion challenged economists used to thinking
of the non-neutrality of money as a short-run phenomenon, attribut-
able to rigid money wages: in the long run, inflation had real costs,
 Money and Long-Run Economic Growth 97

but somehow did not affect real behavior or real variables (see Stein
1971 and Foley and Sidrauski 1971 on responses to Tobin 1965b).
In such neoclassical models, capital formation was determined by
the proportion of income saved, without an independent investment
function, whereas Tobin stressed portfolio choice between capital
and money. As Solow (1970, 69–70) put it,

It appears, then, that money is not neutral in a growing economy,

at least not in this very long-run sense: the real characteristics of
the steady state depend on the rate of monetary growth ... The study
of the non-steady-state behaviour of a monetary economy raises
questions more difficult than any we have seen so far. They have
only begun to be studied in the literature and there is still a lot to
be found out. (see also Orphanides and Solow 1990, 233–234)

The key to Tobin’s result – a higher money supply growth rate leads
to greater capital intensity – was his treatment of the capital and
money as substitutes in wealth portfolios (perfect substitutes in
Tobin 1968a3), together with the assumption that real private saving
is a given fraction of real disposable income. With those two assump-
tions, an inflation-induced reduction in the holding of money
increases capital. This general finding has not proven to be robust
across economic environments.
Different results were obtained by Stanley Fischer (1974, 1979), who
instead considered the demand for money by business firms, which
are assumed to hold cash balances as a means of reducing transac-
tions costs rather than as a store of wealth. For firms, money func-
tions as a factor of production4, and Fischer suggested that money
and capital, considered as factor inputs, would be complements,
rather than substitutes. In that case, smaller real money balances
(due to inflation) would mean a lower marginal product of capital at
any level of the capital stock, and so a lower real rate of return that
would cause savers to hold a lower level of real wealth. Further, it
has proven to be the case that what might appear to be innocuous
changes in model specification can reverse the long-run effects of
changes in money growth on output. For example, an overlapping
generations model with agents who live for two periods can provide
explicit optimizing foundations for the Tobin effect (Drazen 1981),
with higher inflation increasing the capital stock, provided that
98 James Tobin

the seigniorage from money creation is given to the young, but the
reverse is true if the seigniorage is given to the old. But in another
overlapping generations model, the Tobin effect dominates even if
all the seigniorage is given to the old5 (Orphanides and Solow 1990,
245–246, Haliassos and Tobin 1990, 300–301).

On the costs and benefits of alternative money growth

rules

Tobin (1986a, 10) stated that in 1965, “I did not introduce explicitly the
real costs of keeping money scarce but simply emphasized the gains
from capital accumulation. One purpose of this paper is to remedy the
imbalance of the old paper.” After reviewing criticisms of his earlier
paper by Sidrauski and Fischer, Tobin (1986a, 10–11) observed,

Clearly the infinite horizons attributed to savers are a crucial

element in models which deny that money and capital are
substitutes in wealth holdings. Savers with shorter horizons, for
example, mortal life-cycle savers, will have finite capacities for
accumulating wealth. They will not be willing to hold whatever
amounts of every asset provide returns that meet some constant
threshold of time preference. ... In my paper here, wealth demand
is modeled as life-cycle savings theory.

Tobin (1986a) also differed from his 1965 article by having a govern-
ment budget constraint (which returned to the modeling assumption
of “A Dynamic Aggregative Model”), with budget deficits financed by
creation of fiat money, so that he could model “the long-run tradeoff
between ‘taxation’ of money balances by inflation and explicit taxa-
tion of the earnings of capital and labor” (1986a, 14).
Milton Friedman (1969, 1–50) had earlier examined the social loss
from scarcity of real money balances when fiat money (unlike gold)
is socially costless to produce, taking capital intensity as unaffected
by monetary policy, and so found that it would be optimal to satiate
the economy with real balances by having deflation equal to the
real rate of return on capital, so that the private opportunity cost of
holding real cash balances (nominal interest) is equal to zero, which
is the social cost of creating real balances.
Phelps (1979, vol. 1, chapters 6–8) argued that, in the absence of
non-distorting lump-sum taxes, it would not be optimal to set the
 Money and Long-Run Economic Growth 99

inflation tax to zero when other distorting taxes were imposed to

pay for public goods6. The “Golden Rule” literature found that the
level of capital intensity that maximizes steady-state consumption
occurs when the real rate of return on capital equals the growth rate
of the economy (Allais 1947, Phelps 1979). Tobin (1986a) brought
these two literatures together, analyzing the trade-off between
deviations from real balance satiation and deviations from “Golden
Rule” capital intensity, and concluded that in some cases it would be
optimal to have positive inflation, increasing capital intensity at the
cost of reducing real balances.
Tobin’s analysis of the joint effects of money growth on real
balance levels and capital accumulation had relevance to policy
debates at the time. Martin Feldstein (1979) had argued that, as long
as the growth rate of the economy is at least as large as the discount
rate, any finite temporary loss in output is worth paying to achieve a
permanent reduction in inflation, but Tobin’s trade-off sidestepped
Feldstein’s result, because the gain in output from increased capital
intensity is just as permanent as the reduction in shoe-leather costs
from increased real cash balances. Tobin (1986a, 23) concluded, “The
main point is that the position of the economy may be ... one char-
acterized simultaneously by: positive inflation, after-tax real interest
rate less than the growth rate, and steady-state consumption less than
it would be with a lower tax rate and higher inflation. ... It cannot be
excluded a priori as Feldstein has done.”
While Tobin won this particular theoretical argument, debates
over trade-offs of this type have become relatively unimportant
in the modern macroeconomic literature, which typically assumes
away the possibility of Tobin’s type of long-run non-neutrality when
deciding on monetary policy. But it does accommodate the view that
reducing business cycle volatility can be justified, even if it requires
long-run inflation.

Economic growth as an objective of government policy

Tobin’s subsequent growth writings are very much policy-driven.

Tobin (1964, 1) told the American Economic Association,

Growth has become a good word. And the better a word becomes,
the more it is invoked to bless a variety of causes and the more
it loses specific meaning. At least in professional economic
100 James Tobin

discussion, we need to give a definite and distinctive meaning

to growth as a policy objective. Let it be neither a synonym for
good things in general nor a fashionable way to describe other
economic objectives. Let growth be something it is possible to
oppose as well as to favor, depending on judgments of social
priorities and opportunities.

In keeping with his articles on how expansionary monetary policy

could increase the capital intensity of steady-state growth, Tobin
(1964, 10–11) argued

(1) that the government might legitimately have a growth policy,

and indeed could scarcely avoid having one, even if private
markets were perfect; (2) that capital markets are far from perfect
and that private saving decisions are therefore based on an over-
conservative estimate of the social return to saving; and (3) that
the terms on which even so advanced an economy as our own can
trade present for future consumption seem to be very attractive.

Tobin began his concluding paragraph by remarking cautiously, “The

evidence is uncertain and there is a clear need for more refined and
reliable estimates of the parameters on which the issue turns.” But
he promptly moved on to a much more definite statement: “I believe
the evidence suggests that policy to accelerate growth, to move the
economy to a higher path, would pay. That is, the return to a higher
saving and investment ratio would be positive, if evaluated by a
reasonable set of social time preference interest rates. This seems to
me the strongest reason for advocating growth policy.”
Tobin (1964) underlined his belief that real variables were not
independent, even in long-run growth, of monetary variables, which
monetary and fiscal policy could alter. He felt that imperfect capital
markets and overly cautious savers would, in the absence of govern-
ment policy to promote capital accumulation, keep capital intensity
below the “Golden Rule” level that would maximize consumption
per capita. Positive externalities of investment (not just investment
in research and development, but any form of Arrow’s “learning by
doing” in which B can learn from A’s doing) make the social return
on capital accumulation greater than the private return. Tobin
argues that government can and should improve social welfare
 Money and Long-Run Economic Growth 101

by raising steady state per capita consumption by using monetary

policy and (since the two are linked through money creation to
finance budget deficits) fiscal policy to increase capital intensity. This
theme in Tobin’s work carried over to long-run growth theory the
concerns of two works that deeply influenced Tobin from the start
of his career: the first economics book he ever read, Keynes’s General
Theory (1936) on the role for government to improve the welfare of
a monetary economy by offsetting shortfalls in investment, and
Hicks’s “Suggestion for Simplifying the Theory of Money” (1935) on
applying economic analysis to understand why people hold money
even though other assets pay higher returns (see Chapters 1 and 2 of
this book, on these influences).
While Tobin’s writings on growth became increasingly policy-
oriented, he did not stray far from his earlier theoretical contribu-
tion. Among his later writings, Tobin (1986a, 1986b) and Haliassos
and Tobin (1990) formalized the welfare trade-off between capital
intensity and scarcity of real money balances. In these papers, Tobin
posed the question of the impact of financial factors on long-run
economic growth, the interrelatedness of real and monetary varia-
bles that was central to his work in monetary economics. He did so in
a style consistent with his other work, using asset demand functions
with restrictions on partial derivatives and linking markets through
the adding-up constraint on wealth rather than through the budget
constraint of an assumed representative agent (see Solow 2004 and
Chapter 2 on Tobin’s methodology). But the answers to the questions
Tobin posed on the growth effects of monetary policy proved to be
very sensitive to seemingly minor modifications in how models are
specified, so that Orphanides and Solow (1990, 257) found, “We end
where Stein ended 20 years ago.”

Tobin as a growth theorist from the vantage point of

modern macroeconomics

Tobin’s efforts to integrate short-run and long-run macroeconomic

outcomes, as developed in “A Dynamic Aggregative Model” and
“Money and Economic Growth” are remarkably prescient in terms
of subsequent general methodological developments in macroeco-
nomics, while the specific ways he proposed to achieve this synthesis
have not generally been adopted. The real business cycle approach of
102 James Tobin

Finn Kydland and Edward Prescott explicitly attempts to achieve this

integration, but does so in a way that is the converse of Tobin’s. While
Tobin’s objective was to integrate what are conventionally regarded
as short-run factors, such as wage and price rigidity and portfolio
balance requirements into the long-run determination of output, the
Kydland–Prescott program attempts to interpret short-run fluctua-
tions via traditional long-run factors such as shocks to the aggregate
production function (Kydland and Prescott 1990). This strategy is
reflected in the key role that the Brock–Mirman (1972) stochastic
growth model and associated generalizations play in the real busi-
ness cycle literature.
Tobin never found the methodology of real business cycles persua-
sive, nor did he accept that it had consistent microeconomic foun-
dations in any meaningful way. He was critical of representative
agent models that avoid Keynesian coordination problems only by
assuming that the economy behaves as if there is only one agent, of
overlapping generations models that provide rigorous foundations
for a positive value of fiat money only by assuming that no other
assets exist, and of modelers who claim consistent microeconomic
foundations while neglecting stock/flow consistency (Tobin 1980a,
Colander 1999, Solow 2004).
In contrast, the primary legatee of Tobin’s views on short-run
fluctuations, the New Keynesian macroeconomics school, generally
avoids addressing growth issues. This literature very much focuses
on explaining short-run data patterns and evaluating alternative
policy rules, with a primary focus on monetary policy. This school
of thought explicitly distinguishes between cyclical and trend
components to data, whether the trend is based on a deterministic
function of time, unit roots, or some distinction between more and
less smooth data components such as the cycles produced by the
Hodrick–Prescott filter. Woodford’s monumental Interest and Prices
(2003) does not contain any discussion of growth issues (or refer-
ence to any of Tobin’s work). The evaluation of monetary policy is
conducted entirely on the basis of cyclical behavior.
Relative to the time period in which Tobin worked, economic
growth plays a much more prominent role in contemporary macr-
oeconomics. The new growth literature, as initiated by Robert Lucas
(1988) and Paul Romer (1986), does contain facets that are reminis-
cent of Tobin’s ideas, though these are often indirect. In order to
 Money and Long-Run Economic Growth 103

focus our discussion of the contemporary literature, we consider

the papers published in a 1996 issue of the Federal Reserve Bank
of St. Louis Review which contains the proceedings of one of their
annual economic policy conferences, this one titled “Price Stability
and Economic Growth.” This issue summarizes well macroeconomic
thinking about the inflation/growth nexus at the end of the first
decade of the new growth economics via two theoretical papers
(Chari, Jones, and Manuelli 1996, Choi, Smith, and Boyd 1996) and
two empirical studies (Barro 1996, Bruno and Easterly 1996). Chari,
Jones and Manuelli (1996, 56) conclude,

Inflation rates per se have negligible effects on growth rates, but

financial regulations and the interaction of inflation with such
regulations have substantial effects on growth. This analysis
suggests that researchers interested in studying the effects of mone-
tary policy should shift their focus away from printing money
and toward the study of banking and financial regulation.

In isolation, this sounds very similar to the style of macroeconomics

pioneered by Tobin. However, the formal analysis both in Chari,
Jones, and Manuelli (1996) and in Choi, Smith and Boyd (1996) use
very different microeconomic foundations from Tobin’s. Chari, Jones
and Manuelli employ cash-in-advance and shopping time models
(in which there is a trade-off between time spent shopping and the
use of money) to understand money demand; Tobin-style portfolio
considerations do not arise. Choi, Smith and Boyd employ a frame-
work closer in spirit to Tobin, but focus on how inflation can exac-
erbate adverse selection problems in financial markets. When these
considerations are absent, their model produces results similar to
Tobin’s. However, in a market where default on the part of borrowers
is a problem greater inflation may lead to selection toward riskier
types. For our purposes, what is important is that both of the papers
emphasize how inflation can lower growth, in direct opposition to
Tobin’s focus on how inflation, by making capital a more attractive
asset, can enhance growth.
This emphasis on how inflation can reduce growth reflects the
consensus in empirical growth literature that this is in fact the case.
Both the Barro and Bruno and Easterly contributions to the sympo-
sium find a negative relationship between inflation and growth,
104 James Tobin

although this effect appears to be non-linear (see Sarel 1996): the

evidence is stronger when one isolates the effects of very high infla-
tion rates, rates outside the experience of the OECD economies. This
evidence appears to be relatively robust in the sense that evidence
of a negative relationship between inflation and growth survives
in the presence of a range of competing explanations (see Durlauf,
Kourtellos, and Tan 2008 for a recent study of this type).
While interpreting the cross-country growth regressions underpin-
ning this conclusion is problematic (see Brock and Durlauf 2001 and
Durlauf, Johnson and Temple 2005 for a delineation of the issues), the
consensus that inflation is not growth-enhancing has been associ-
ated with theoretical approaches very different from that employed
by Tobin. On the other hand, Tobin’s emphasis on financial interme-
diation as fundamental to understanding the monetary transmission
mechanism is reflected in the modern money/growth literature.
Finally, there is an important sense in which Tobin’s views on
growth reflect a different orientation than the contemporaneous
growth literature. Tobin’s writings did not make broad claims about
the growth differences between economies, but rather focused on
growth in contexts such as the United States; this orientation is also
found in Solow’s classic growth papers. Further, his focus was typi-
cally not on the determinants of steady-state growth; his analysis of
a positive relationship between money and growth has to do with
equilibrium levels of capital intensity, which influence the steady-
state level of output (suitably normalized by population and the
state of technology) but not the steady-state growth rate of per capita
output per se. For steady-state behavior, Tobin (1998, 149) wrote,

A list of sensible policies, one might say conservative policies,

includes basic science, R & D, education and training, public
infrastructure, and carefully designed incentives for both private
public sectors to consume less and invest more. If everyone is
patient with gains measured in tenths of a percentage point over
the coming decades, these policies can pay off. With luck, new
technologies may bring dramatic improvements in the growth rate.
The computer and communications revolutions may well bear
fruit in the next century.
 Money and Long-Run Economic Growth 105

The analysis of knowledge and technical progress as endogenous

outcomes had to wait for another generation of macroeconomists,
exemplified by Aghion and Howitt (1999), in addition to Romer
(1986) and Lucas (1988).

Conclusion

The questions Tobin raised about money and long-run economic

growth remain important, but definitive answers to them remain
elusive, even in light of the new growth economics. For instance,
Sarel (1996) presented evidence that the relationship is non-linear,
finding inflation and growth positively related up to an inflation
rate of 5 percent a year but negatively related for faster inflation.
Tobin’s vision of the integration of short-run and long-run macr-
oeconomic phenomena is, ironically, primarily accepted by the real
business cycle view of macroeconomics, one that is antithetical to
Tobin’s perspective on economic fluctuations. Perhaps this will not
prove to be the case in the next decades of growth analysis, as efforts
to integrate shorter and longer runs move toward a more balanced
view of supply and demand factors.
7
To Improve the World: Limiting the
Domain of Inequality

James Tobin is best known as an “Old Keynesian” macroeconomist

and monetary economist, as was emphasized in the 1981 Royal Bank
of Sweden Nobel Prize citation. His keen devotion to the reduction
of poverty, inequality, and discrimination is less well known. This
commitment extended beyond academic research: at the Tobin
memorial at Yale in April 2002, political scientist Robert Dahl
recalled how he and Tobin had spent the “Freedom Summer” of 1964
in Mississippi, hoping that the presence of two Yale professors would
afford some protection to the student volunteers in the civil rights
movement (see Dahl and Tobin 1993). Tobin was acutely aware of
living in the country’s richest state and in one of its ten poorest cities
(see Tobin 1996a, 252, comparing incomes in New Haven and the
rest of its county), a concern that also led him to chair New Haven’s
City Plan Commission from 1967 to 1970.
Tobin (1970, 263) recalled

When a distinguished colleague in political science asked me

about ten years ago why economists did not talk about the distri-
bution of income any more, I followed my pro forma denial of his
factual premise by replying that the potential gains to the poor
from full employment and growth were much larger, and much
less socially and politically divisive, than those from redistribu-
tion. One reason that distribution has returned to the forefront
of professional and public attention is that great progress was
made in the post-war period, and especially in the 1960’s, toward
solving the problems of full employment and growth.
106
 To Improve the World 107

The first two sections following the introduction of “On Improving

the Economic Status of the Negro” (Tobin 1965a) were titled “The
Importance of a Tight Labor Market” and “Why Don’t We Have a Tight
Labor Market?” In addition to stimulating aggregate demand to avoid
slack in labor markets, Tobin also advocated selective employment and
wage subsidies to increase the number of jobs at full employment, later
considered to be examples of supply-side policy (Baily and Tobin 1977).
Beyond working for Keynesian macroeconomic policies that would
diminish poverty by encouraging economic growth and low unem-
ployment, Tobin presented, from the 1960s onward, an ambitious
program for social policy. In “It Can be Done! Conquering Poverty
in the US by 1976” (1967b), Tobin held that R. Sargent Shriver’s goal
of eliminating poverty by the Bicentennial could be achieved, not by
reliance on the programs of Shriver’s Office of Economic Opportunity
(programs to improve health, education, vocational training, and
community development) but rather by macroeconomic policies
for general prosperity combined with means-tested cash transfers
such as a negative income tax. As a recent member of the President’s
Council of Economic Advisers, Tobin was recalled to Washington in
December 1963 to work on the 1964 Economic Report of the President,
editing the chapter (principally written by Robert Lampman) that
outlined the War on Poverty (Tobin 1996b, 231). Tobin (1965a, 1966a,
1967b, 1968b, 1970) went beyond the Great Society’s War on Poverty
to propose large-scale means-tested cash transfers to reduce poverty
without interfering with market determination of relative prices, a
position that he shared with Milton Friedman (1962, 191–192) and
Friedrich Hayek. He wished to pair this with “non-market egalitarian
distributions of commodities essential to life and citizenship” (1970,
276), such as education, food stamps, and basic housing, a position
that contrasted with Friedman’s Chicago School approach and that
was emphasized in Tobin’s Henry Simons Lecture at the University
of Chicago, “On Limiting the Domain of Inequality” (1970).
Tobin, Pechman, and Mieszkowski (1967, 1) stated that many
eligible poor people did not receive local welfare because

recipients are subject to numerous indignities by the procedures

employed to enforce the means test and other conditions to deter-
mine who is eligible for help and how much. ... Administration of
public assistance is now largely a matter of policing the behavior
108 James Tobin

of the poor to prevent them from “cheating” the taxpayers, rather

than a program for helping them improve their economic status
through their own efforts.

This view of public assistance resembles that of Frances Fox Piven

and Richard Cloward (Regulating the Poor, 1971) of public welfare as
a system of social control – an analytical standpoint that generates
considerable controversy, as indicated by the title and subtitle of
Who’s Afraid of Frances Fox Piven? The Essential Writings of the Professor
Glenn Beck Loves to Hate (Piven 2011). The deliberate imposition of
indignities and stigma to discourage resorting to public assistance
was in keeping with the recommendations of Nassau Senior and
Edwin Chadwick in the British Poor Law Report of 1834 (Checkland
and Checkland 1974, Persky 1997).
Furthermore, Tobin, Pechman, and Mieszkowski (1967, 1) noted
that “The means test is in effect a 100 percent tax on the welfare
recipient’s own earnings; for every dollar he earns, his assistance is
reduced by a dollar” (as Tobin 1965, 892, also noted). Until 1967, Aid to
Families with Dependent Children (AFDC) featured such an effective
100 percent implicit tax rate (Besley and Coate 1995, 190n), a prohibi-
tive disincentive to work that risked trapping recipients in the welfare
system. Tobin (1965, 891–892) suggested instead a lower effective tax
rate in the form of reducing assistance payments (Tobin, Pechman,
and Mieszkowski 1967, 27, recommended a rate of 40 percent) so that
the working poor would receive some public assistance until they
earned three times the basic income guarantee. Tobin, Pechman, and
Mieszkowski (1967, 26) recognized that while those already receiving
AFDC or other assistance with an effective tax rate of 100 percent
would have an incentive to work more under the proposed negative
income tax (NIT), other recipients of NIT “work and earn less when
the government makes them better off and raises their marginal tax
rate from 0 or 14–20 percent to 33 or 50 percent.”
The net effect on incentives to work has been highly controver-
sial in studies of the outcomes of the New Jersey Negative Income
Tax Experiment (Pechman and Timpane 1975) and the Seattle and
Denver Income Maintenance Experiments (to which the Fall 1980
issue of the Journal of Human Resources Vol. 15 was devoted), leading
to a literature on how to design income-maintenance programs when
it is not possible to observe how much work-effort would be provided
 To Improve the World 109

in the absence of an income guarantee (see Besley and Coate 1995,

and references given there).
In contrast to Richard Herrnstein and Charles Murray (The Bell
Curve, 1994), who attributed persistent poverty to inherited differ-
ences in intelligence, Tobin emphasized institutions, notably adap-
tation of behavior to the 100 percent marginal tax rate implicit
in the existing welfare system. Tobin’s standpoint recalls that of
John Stuart Mill, who rejected racial or ethnic explanations for the
poverty of the Irish peasantry, focusing instead on land-tenure laws
that gave neither landowner nor tenant incentive to invest in raising
productivity.
Like Tobin, Milton Friedman (1962, 192) stressed the importance
of replacing a fixed minimum with a combination of a guaranteed
minimum income and a continued incentive to earn income, a
proposal previously mentioned by George Stigler (1946). Friedman
(1962, 194) estimated that “A program which supplemented the
incomes of the 20 percent of the consumer units with the lowest
incomes so as to raise them to the lowest income of the rest would
cost less than half of what we are now spending” (see Tobin,
Pechman, and Mieszkowski 1967, 23–27, and Tobin 1968, 103–105,
for estimates of the budgetary cost of different negative income tax
plans). The problem is that the poor do not have enough purchasing
power, not that the relative price of housing or some other good is
incorrect. Cash transfers are preferable to in-kind transfers because
the recipient is able to choose how to spend the transfer. “While
concerned laymen who observe people with shabby housing or too
little to eat instinctively want to provide them with decent housing
and adequate food, economists instinctively want to provide them
with more cash income” (Tobin 1970, 264).
Where Tobin (1970, 276–277) diverged from Friedman and the
Chicago School was in his advocacy of “specific egalitarianism,”
which he defined as “non-market egalitarian distributions of
commodities essential to life and citizenship” that are in inelastic
supply: “In some instances, notably education and medical care, a
specific egalitarian distribution today may be essential for improving
the distribution of human capital and earning capacity tomorrow.”
He recognized medical care and housing as difficult practical cases
whose supply is inelastic in the short run but responsive to demand
in the long run. Willem Buiter (2003, p. 622) remarks that, “In this
110 James Tobin

paper Tobin is willing to consider, and provides a lucid analysis of, a

range of very radical reform proposals.”
Speaking about “socialized medicine” at the University of Chicago,
in a lecture named for one of the Chicago School’s founding heroes,
Tobin (1970, 274) teased his audience by arguing, “Although this
prospect may shock many people today, including many at the
University of Chicago, it would not have shocked Henry Simons.”
He quoted Simons (1948, 68) on the “remarkable opportunities for
extending the range of socialized consumption (medical services,
recreation, education, music, drama, etc.).” As examples of specific
egalitarianism, Tobin (1970, 269–270) wished to preclude purchase
of substitutes by military draftees (as had been common during the
American Civil War) or the sale of votes (as in England’s “rotten
boroughs” before the Reform Bill), because votes are in intrinsically
short supply and “A vote market would concentrate political power
in the rich, and especially in those who owe their wealth to govern-
ment privilege.”
In contrast, Friedman (1962, 194–195) worried about recipients of
negative income tax or of old-age pensions being allowed to vote, lest
the system “be converted into one under which a majority imposes
taxes for its own benefit on an unwilling minority.” Tobin worried
that the rich have too much political power, Friedman that the poor
have too much political power.
Looking back, Tobin (1996b, 232) concluded sadly,

I am afraid that it’s a mistake to declare wars against social and

economic conditions or national crusades for societal reforms.
The goals are elusive, the troops unruly, the enemies amorphous.
Wars on poverty, energy dependence and drugs have proved to
be incapable of sustaining the degrees of commitment essential
to their prosecution, even by the Presidents who declared them.
William James longed for moral equivalents of war, but evidently
Americans can’t do better than football.

Tobin (1977b, 477) lamented that “The majority is losing interest in

full employment and economic growth, and appears quite willing
to let youth and poor and minorities bear the brunt of anti-infla-
tionary policy.” The Nixon Administration’s Family Allowance
Plan, twice passed by the House of Representative, was blocked
 To Improve the World 111

in Senate committee by a coalition of conservatives opposed to a

guaranteed minimum income and liberals opposed to work require-
ments (Moynihan 1973). With Tobin as an advisor, Democratic
presidential nominee George McGovern proposed income redistri-
bution through the income tax, an attempt characterized by Tobin,
Brainard, Shoven, and Bulow (1973, 585) as “the 1972 debacle.”
The political tide turned so much against a guaranteed minimum
income that in 1996, after two presidential vetoes of bills that would
have also ended health benefits for the poor, AFDC was replaced by
block grants to states for “work-first,” time-limited temporary assist-
ance to needy families (TANF) (Blank 1997). Even re-authorization of
TANF became problematic (Blank and Haskins 2001, Peterson 2002).
Prevailing neo-conservative rhetoric recalls the argument of the
proponents of the New Poor Law of 1834 that family allowances and
other public assistance are merely “a bounty on indolence and vice,”
discouraging work, encouraging breeding, and raising tax burdens
(see Persky 1997, Checkland and Checkland 1974).
Despite these political setbacks and the continuing chilly political
climate, there is still a valuable message of hope in Tobin’s insist-
ence that alleviation of poverty, inequality, and racial discrimina-
tion “can be accomplished within existing political and economic
institutions” (Tobin 1965a, 878) by a combination of general egali-
tarianism (cash transfers guaranteeing a minimum income while
maintaining incentives to earn more) and specific egalitarianism in
health care and education. The historical record suggests that poverty
can be reduced by redistribution. Whatever the failures in achieving
the social and cultural goals of policy-makers, Christopher Jencks
(1992, 70–91) has shown that, contrary to the claims of Charles
Murray (1984), anti-poverty programs successfully combined with
economic growth to reduce the US poverty rate from 19 percent in
1965 to 13 percent in 1980, to reduce infant mortality among blacks
from 4.2 percent of live births in 1965 to 2.2 percent in 1980, and
to increase non-white life expectancy from 64.1 years in 1965 to
69.5 years in 1980. Even with regard to social and cultural goals of
policy-makers, Jencks points out that rising rates of illegitimacy and
divorce have been general throughout society, not just among recipi-
ents of public assistance.
Tobin’s views were contrary to those of Herrnstein and Murray
(1994) who held that redistribution cannot alleviate poverty and
112 James Tobin

inequality because the underlying causes are inherited genetic differ-

ences, to Murray’s belief (1984) that redistribution only worsens the
material conditions of the poor because of perverse incentives and
a culture of dependency, and to radicals’ arguments that effective
redistribution is impossible in a capitalist society. Tobin (1965a,
1966a, 1967b, 1968b, 1970, 1996a) believed in the power of govern-
ment to guarantee a basic standard of living, to limit the domain of
inequality, and to implement redistributive programs whose incen-
tives would be far preferable to the implicit 100 percent marginal tax
rate of earlier welfare programs. Tobin always offered such proposals
as a complement to Keynesian policies promoting economic growth
and full employment, not a substitute. A tight labor market was the
first condition for reducing poverty and inequality. The evidence
surveyed by Jencks (1992, especially chapter 2) indicates that even
the redistributive programs of 1965–1980, which did not go nearly
as far as Tobin proposed, considerably improved the material condi-
tions of the poor.
Tobin made a cogent and deeply felt case for acting to alleviate
poverty and to limit the domain of inequality. The political climate
is currently hostile to that case, as it is to Keynesian policies for macr-
oeconomic stabilization and full employment. That is no argument
against the desirability of such policies. Tobin is, rightly, remem-
bered primarily as a macroeconomist and monetary economist,
an outstanding “Old Keynesian.” In evaluating his message to the
economics profession, it should be remembered that his macroeco-
nomics was part of his wider commitment to bringing economic
analysis and reasoned argument into battle against unemployment,
instability, poverty, and inequality.
8
Taming Speculation: The Tobin Tax

Tobin and the global economy

James Tobin’s contributions to monetary macroeconomics, notably

portfolio balance models and the q theory of investment, did not
emphasize open-economy macroeconomics. To the wider public
who are interested in economic issues without being professional
economists, however, Tobin’s name brings to mind his proposal to
tax quicksilver international capital flows, which from 1984 onward
he linked to J. M. Keynes’s plan to inhibit stock market speculation
by taxing securities trades. Tobin first suggested what became known
as “the Tobin tax” in passing in 1972 during a series of lectures
honoring his teacher, Joseph Schumpeter – lectures that Tobin chose
to use to reflect on his experience on President Kennedy’s Council of
Economic Advisers (published as Tobin 1974b).
He devoted his Eastern Economic Association presidential address
to “A Proposal for Monetary Reform” (Tobin 1978a). Ignored at the
time of publication and long thereafter (Tobin said, “It sank like a
rock”), “A Proposal for Monetary Reform” eventually attracted so
much attention that it was reprinted in the same journal on the 25th
anniversary of its original publication: his most-cited paper and the
journal’s most-cited paper.
But his message has not necessarily been understood: Paul Krugman
(2002) holds that Tobin “is probably best known” to the general public
for two policies, the Kennedy tax cut and the Tobin tax on currency
trades, “both of which have been hijacked – his own word – by people
whose political views he did not share.” The posthumous publication

113
114 James Tobin

of World Finance and Economic Stability: Selected Essays of James Tobin

(2003), with a foreword by his former student, Janet Yellen (later chair
of the Federal Reserve Board), conveniently gathers his views on how
to increase the stability of the global financial system, and offers an
opportunity to tentatively evaluate his analysis in light of financial
crises and developments that have occurred since he first advanced
his proposal, comparing his approach with the diversely influential
views of Jagdish Bhagwati, Robert Mundell, and Joseph Stiglitz.
In an interview published in Der Spiegel on September 3, 2001,
Tobin declared, with specific reference to the French-based protest
organization ATTAC (Association pour une Taxe sur les Transactions
Financières pour l’Aide aux Citoyens),

I have nothing in common with practitioners of revolution against

“globalization.” ... I appreciate attention to my proposal, but much
of the praise comes from the wrong side. Look, I am an economist
and, like most economists, an advocate of free trade. Moreover, I
support the International Monetary Fund, the World Bank and
the World Trade Organization – everything that these movements
are attacking. They’re misusing my name. (Tobin 2003, 55)

A scholarly presentation of the ATTAC perspective is provided by

Heikki Patomäki in Democratising Globalisation: The Leverage of the
Tobin Tax (2001), which reprints Tobin (1978a) as an appendix.
Tobin was also misunderstood from the opposite side:
“Unfortunately, these activities [the United Nations Development
Program conference on the Tobin tax published as Huq, Kaul, and
Grunberg 1996] aroused the anger of Senators Dole and Helms, who
apparently thought, or pretended to think, that the idea was for the
UN to levy taxes on their constituents without votes of Congress”
(Tobin 2003, 50).

Contrary to suspicions raised by Senators Jesse Helms and Bob

Dole in election year 1996, I was not advocating UN taxes. I would
expect each national government to levy and collect the agreed
tax by its regular procedures and to decide for itself what to do
with the revenues, which might provide inducements to partici-
pate. (“An idea that gained currency but lost clarity,” in Tobin
2003, 63)
 Taming Speculation 115

Tobin (2003, 40) noted that President Mitterand of France, speaking

favorably of the Tobin tax at the World Social Summit in Copenhagen
in 1994, also seemed to think of it primarily as source of revenue for
worthy multilateral purposes.
In his Fred Hirsch Memorial Lecture, “On the Efficiency of the
Financial System,” Tobin (1984a, 8) remarked,

Keynes’s pessimism on the long-term rationality of securities

markets led him to the view that the liquidity these markets
provide is a mixed blessing. “The spectacle ... has sometimes moved
me towards the conclusion that to make the purchase of an invest-
ment permanent and indissoluble, like marriage (sic!) except by
reason of death or other great cause, might be a useful remedy.
But he concluded that illiquidity “would be the worse evil, because
it would push savers towards hoarding of money.” Anyway, he advo-
cated as a halfway measure a “substantial ... transfer tax ... with a view
of mitigating the predominance of speculation over enterprise in
the United States” [1936, 160]. For similar reasons, I have advocated
an international transfer tax on transactions across currencies.

Tobin was skeptical of the macro-efficiency of financial markets, and

was impressed by the findings of his younger Yale colleague. Robert
Shiller (collected in Shiller 1989, 2000) that stock prices fluctuate
more than is justified by changes in underlying fundamentals, a result
comparable to Paul Krugman’s claim that exchange rates were exces-
sively volatile in the 1980s (Krugman 1989, 1992, see also Dornbusch
1976 and Rogoff 2002 on exchange rate overshooting). Tobin feared
that bubbles and excess volatility in financial markets could have
“real economic consequences devastating for particular sectors and
whole economies” (Eichengreen, Tobin, and Wyplosz 1995, 164).
As an Old Keynesian proponent of aggregate demand management
for macroeconomic stabilization, shaped by the experience of the
Great Depression, Tobin was especially concerned lest volatile port-
folio capital flows and currency speculation constrain domestic stabi-
lization policies, just as the gold standard had constrained domestic
policies during the Great Depression. Such portfolio capital flows
had become larger and more volatile because “Obstacles to interna-
tional capital movements have been reduced, in the Third World as
well as the First. (I must say however, that my own bank is slow and
116 James Tobin

expensive when confronted with a check or wire transfer in a foreign

currency. I assume that recent MBAs at Goldman Sachs are spared
these annoyances)” (Tobin 2003, 4).
Tobin (1978a) identified the basic problem of the international
monetary system as,

Goods and labor move, in response to international price signals,

much more sluggishly than fluid funds. Prices in goods and
labor markets move much more sluggishly, in response to excess
supply or demand, than the prices of financial assets, including
exchange rates. These facts of life are essentially the same whether
exchange rates are floating or fixed [cf. the Dornbusch over-
shooting model].

Consequently, Tobin saw only

two ways to go. One is toward a common currency, common

monetary and fiscal policy, and economic integration. The other
is toward greater financial segmentation between nations or
currency areas, permitting their central banks and governments
greater autonomy in policies tailored to their specific economic
institutions and objectives. The first direction, however appealing,
is clearly not a viable option in the foreseeable future, that is, the
twentieth century. I therefore regretfully recommend the second,
and my proposal is to throw some sand in the wheels of our exces-
sively efficient international money markets.

Notice that this clear statement differs in two ways from the repre-
sentation of the Tobin tax proposal by many both of its proponents
and opponents: the goal is to reduce the international mobility of
liquid funds, with no objection to free trade in goods, and the use to
which the resulting tax revenues might be put is entirely incidental
to Tobin’s intention. Tobin was a free trader, and the Tobin tax is
not a scheme to raise revenue. Also notice Tobin’s depiction of the
“two ways to go”: Robert Mundell (1973a, 1973b) took the other path,
advocating a European currency a century after the experiment of
the Latin Monetary Union and after Walter Bagehot’s proposal for a
joint Anglo-American-German currency to parallel, and eventually
to merge with, the Latin Monetary Union (Dimand and Dore 2000).
 Taming Speculation 117

Contrary to Tobin’s prediction, this path did lead to the creation of

the euro before the end of the twentieth century but the survival of
the euro zone remains in doubt.
According to Tobin (1978a, 524), financial markets are “incredibly
efficient” in

a mechanical sense: transactions costs are low, communications

are speedy, prices are instantaneously kept in line all over the
world, credit enables participants to take large long or short posi-
tions at will or whim. Whether the market is “efficient” in the
deeper economic-informational sense is very dubious. ... As a tech-
nical matter, we know that a rational expectations equilibrium
in markets of this kind is a saddle point. That is, there is only a
singular path that leads from disequilibrium to equilibrium. If the
markets are not on that path, or if they don’t jump to it from wher-
ever they are, they can follow any of a number of paths that lead
away from equilibrium – paths along which, nonetheless, expecta-
tions are on average fulfilled. Such deviant paths are innocuous in
markets – as for rare coins, precious metals, baseball cards, Swiss
francs – which are sideshows to the real economic circus. But they
are far from innocuous in foreign exchange markets whose prices
are of major economic consequence.

(The inclusion of precious metals and Swiss francs in the list of

markets analogous in importance to that for baseball cards teased
gold bugs and the “gnomes of Zurich.”)
Tobin wrote that he was

naturally disappointed by the proposal’s summary rejection.

Usually, those of my professional colleagues who took any notice
of it at all rejected it on the same general grounds that incline
economists to dismiss out of hand any interferences with market
competition, including, of course, tariffs and other barriers to
international trade in goods and services. They seemed to presume
that the same reasoning extends to trade in financial assets. Those
who did make specific objections said the tax would damage the
liquidity of currency markets. They said it would move the world’s
currency markets to tax-free jurisdictions, like Indonesia or the
Cayman Islands. They said it wouldn’t keep exchange rates from
118 James Tobin

fluctuating; it wouldn’t save overvalued currencies from specula-

tive attacks and devaluations. And they said those things as if I
had overlooked them. Most disappointing and surprising, critics
seemed to miss what I regarded as the essential property of the
transactions tax – the beauty part – that this simple, one-param-
eter tax would automatically penalize short-horizon round trips,
while negligibly affecting the incentives for commodity trade and
long-term capital investments. (Tobin 2003, 40, from his prologue
to Haq, Kaul, and Grunberg 1996)

A few recent commentators, notably Paul Davidson (1997), deny the

“beauty part” of Tobin’s proposal, arguing that the Tobin tax would
impose a severe burden on commodity trade and long-term invest-
ment without being large enough to impede speculative flows (so
that direct controls on capital flows are needed, rather than a small
tax), but most (including other Post Keynesians such as Arestis and
Sawyer 1997) agree that a heavier (but not necessarily sufficiently
heavy) burden would fall on speculative short-term flows of funds.
As Tobin pointed out, “A 0.2 per cent tax on a round trip to another
currency costs 48 per cent a year if transacted every business day, 10
per cent if every week, 2.4 per cent if every month. But it is a trivial
charge on commodity trade or long-term foreign investment” (2003,
40). Such a tax would not be nearly large enough to prevent a specu-
lative attack on a overvalued fixed exchange rate in such exceptional
circumstances as when the Bank of England provided speculators
with a “one-way bet” in September 1992 (heads the speculators win,
tails they break even) or the speculative attacks on fixed exchange
rates in the East Asian crisis of 1997, but would work by diminishing
the pool of speculative funds by reducing the overall profitability of
currency speculation.
Davidson’s criticism had a non–Post Keynesian predecessor:
Rudiger Dornbusch (1988, 256) sympathized with the goal of the
Tobin tax, but wrote,

It might be argued that it is too late for stopping the flow of inter-
national capital, that throwing sand in the wheels is no longer
sufficient. But why stop there and not use rocks? An operational
way of doing this is to combine the stability of inflation and real
activity that comes from fixed rates with a dual exchange rate
 Taming Speculation 119

system for capital account transactions. If capital markets are

irrational and primarily speculative it might be as well to detach
them altogether from an influence on real activity. Rather than
use scarce macropolicy tools to adapt the real sector to the idiosyn-
crasy of financial markets, a separate exchange rate would detach
the capital account and deprive it from distorting influences on
trade and inflation.

However, in an UNCTAD paper in 1997, Dornbusch was more enthu-

siastic about the Tobin tax:

A financial transactions tax is no panacea, just as gun control

would not stop all murder; poison and knives would make a come-
back. ... A financial transactions tax will not stop speculation alto-
gether. But it certainly will help lengthen the horizon and focus
the mind of capital markets on enterprise and investment rather
than trading. ... True, some trading will move offshore. But the risk
is easily exaggerated, and in any event it can be checked. ... The
G-7 has not done anything useful for years. Why not surprise the
world with a genuine innovation? ... [A] financial transactions tax
can tame capital flows ... [making] the world capital market safe
for development finance. (quoted by McQuaig 1998, 167–168)

While Tobin (1974b, 1978a) attracted little discussion beyond

“dismissive footnotes,” the dramatic increase in the volume of
foreign exchange trading, the speculative attacks that drove Britain
and Sweden from the European Monetary System in September
1992, the Mexican crisis of 1994, the Brazilian and East Asian crises
of 1997–1998, and the Russian crisis of 1999 created a more atten-
tive audience for Eichengreen, Tobin, and Wyplosz (1995). Haq,
Kaul, and Grunberg (1996), Michalos (1997), Griffith-Jones (1998),
Griffith-Jones, Montes, and Nasution (2000), and Dasgupta, Uzan,
and Wilson (2001), among others, gave sympathetic consideration
to the Tobin tax and other possible measures to reduce the volatility
of global capital flows, while Hammond (1997) provides an example
of the indignant response of the financial institutions on whose
transactions such a tax would be levied (with R. Glenn Hubbard,
later chair of the Council of Economic Advisers under the second
President Bush, among its contributors).
120 James Tobin

Bhagwati: surprisingly close to Tobin on capital flows and

globalization

Jagdish Bhagwati of Columbia University is an exceptionally eloquent

defender of free trade and the scourge of protectionism (Bhagwati
1988, 1998, 2000, 2004). Unlike Tobin, Mundell, and Stiglitz,
Bhagwati has not yet won the Nobel Memorial Prize, but correction
of this oversight is widely expected. Many of Bhagwati’s articles in
neoclassical trade theory (treated as an application of general equilib-
rium analysis), and his influential graduate textbook in the field, are
co-authored by T. N. Srinivasan, Tobin’s Yale colleague and friend.
Bhagwati highlights the benefits to all parties of outsourcing jobs
to developing countries, and strenuously denies that the theoretical
possibilities of gains from strategic trade policy weaken the practical
and empirical case for free trade. On the back cover of Bhagwati
(2000), Sylvia Ostry warns, correctly, “Beware anti-globalizers! Your
most formidable opponent speaks out with his customary eloquence,
wit, and incisive reasoning.”
One might naturally suppose that Bhagwati and Tobin would have
opposing views about controls on global capital flows, just as one
might expect Bhagwati, as the author of In Defense of Globalization
(2004), to have looked approvingly on the proposed Multilateral
Agreement on Investment (MAI) and Free Trade Agreement of the
Americas (FTAA). But people are more complex than 20-second
sound bites: Tobin, acclaimed by opponents of globalization such as
ATTAC in France, and Bhagwati, defender of globalization, presented
strikingly similar analyses. As Bhagwati (2000, 13) told an NBER
conference on capital controls (by videotape), “But somehow, the
public expects that if you are for one sort of globalization, you must
logically be for another: that free trade, free DFI, free capital flows,
free immigration, free love, free ... whatever should go together!
Well, they are wrong.” Thus Bhagwati (2000, 313) opposed the MAI
because it was “conceived as a set of rights of corporations, instead
of systematically including their obligations. The latter would also
require that notions such as the ‘stakeholder’ obligations of corpora-
tions to the communities they operate in should also be laid down by
the agreement.” Bhagwati (1998, chapters 25–30, 2000, chapter 27)
insists that “free trade agreements” such as FTAA are really trade-
diverting “preferential trading agreements,” an unconscious echo of
 Taming Speculation 121

Adam Smith’s critique of the Methuen Treaty on the exchange of

Portuguese wine for English cloth.
Responding to the East Asian financial crisis in “The Capital
Myth: The Difference between Trade in Widgets and Dollars” in
Foreign Affairs in 1998 (reprinted as chapter 1 of Bhagwati 2000),
Bhagwati insisted that “the claims of enormous benefits from free
capital mobility are not persuasive” and that unregulated flows
of portfolio capital could destabilize developing economies. He
followed this by telling an NBER conference on capital controls
“Why Free Capital Mobility May Be Hazardous to Your Health”
(Bhagwati 2000, chapter 2) and writing in the Wall Street Journal on
“Free Trade, Yes; Free Capital Flows, Maybe” (reprinted in Bhagwati
2000, chapter 3). Writing in 1998, Bhagwati (2000, 17) not only
deplored IMF pressure for capital account liberalization, but also
argued

that the IMF can, and indeed did in the current Asian crisis, gets
its conditionality badly wrong as well. I am persuaded by Sachs
and Radelet’s arguments, and by a recent brilliant essay by Max
Corden, that the IMF should not have gone in for deflationary
policy but should have instead undertaken a Keynesian-style
reflationary policy to offset the initial and induced effect of the
capital outflow.

This position was in accord with Stiglitz (2002) and with Tobin’s
Old Keynesianism: in July 1998, Tobin published “Tighten belt? No,
spend cash” in The Straits Times (reprinted in Tobin 2003).
Bhagwati (2000, xvii) remarks, “The subsequent writings in late
1998 on capital flow controls by Paul Krugman (in Fortune and
elsewhere) and by Joe Stiglitz (from the World Bank) supported
the position that I had taken. Over time, Barry Eichengreen, IMF’s
adviser on the subject, also appears to have had a change of heart
on the matter.” Eichengreen was a co-author of Eichengreen, Tobin,
and Wyplosz (1995), the article that revived the Tobin tax as an
approach to capital controls, and wrote the conclusion to Haq, Kaul,
and Grunberg (1996), as well as co-authoring the volume’s opening
chapter with Wyplosz, so Bhagwati’s claim that his 1998 article
converted Eichengreen from opposition to capital flow controls may
be discounted for chronological reasons.
122 James Tobin

Bhagwati’s cautious support for capital controls did not extend to

considering whether the Tobin tax should be part of such controls
(Tobin’s name is absent from the indexes of Bhagwati 1998 and
2000, just as Bhagwati’s name is absent from the index of Stiglitz
2002 and appears only once in the index of Stiglitz 2003, in connec-
tion with intellectual property rights, not capital flows or condi-
tionality). Nonetheless, he shares with Tobin (and, as he notes,
Krugman 1998, Eichengreen 1999, and Stiglitz) an insistence on a
fundamental asymmetry between the case for free movement of
goods and foreign direct investment and the case for free move-
ment of portfolio investment. Richard N. Cooper (1998) also warned
that, given imperfect information, free capital flows would lead to
excessively risky behavior and to large, costly crises. Tobin stood not
with the anti-globalization movement (except as regards portfolio
capital flows), but with a group of leading mainstream economists
at major US universities who debunk protectionist fallacies, both
long-standing and new, about trade in goods (see Bhagwati 1988 or
Krugman 1997) but recognize the destabilizing potential of unreg-
ulated short-term, speculative portfolio flows. What distinguished
Tobin (1974b, 1978a, 2003) from Bhagwati, Cooper, Dornbusch, or
Krugman on the regulation of portfolio capital flows, apart from the
specifics of the form of intervention he proposed, was that he raised
the issue two decades earlier.
Why did the dominant “Washington consensus” diverge so sharply
on capital account liberalization from the views of such prominent
economic theorists? Bhagwati (2000, xvii), as befits the founding
editor of Economics and Politics and a pioneering student of Directly
Unproductive (DUP) rent-seeking lobbying, reports that his essay on
“The Capital Myth”

also introduced into the public domain and into the political-
economy literature the nonconspiratorial concept of the “Wall
Street-Treasury complex” with which I, in the spirit of Dwight
Eisenhower’s military-industrial complex and Wright Mills’s
concept of the “power elite,” sought to explain how powerful
lobbying “interests” on Wall Street, working within a network of
like-minded people moving back and forth between Washington
and Wall Street, had combined with a growing shift to markets
imprudently extended to capital flows to push the developing
 Taming Speculation 123

countries into a hasty embrace of capital account convertibility

without adequate safeguards.

No feature of Stiglitz (2002) caused more offense, notably to the

reviewer in The Economist (June 8, 2002), than the suggestion that
the move of Stanley Fischer (now vice-chair of the Federal Reserve)
from the IMF to a Citigroup vice-chairmanship resulted from like-
minded networking with former Treasury Secretary Robert Rubin,
chairman of the executive committee of Citigroup’s board. The
Washington consensus or Wall Street-Treasury complex does not
welcome dissent – see Linda McQuaig (1998, chapter 5) and Rodney
Schmidt (1997) on the reaction of Canada’s Department of Finance
to an internal working paper that was so indelicate as to conclude
that a Tobin tax would be feasible (resulting in Schmidt’s abrupt
departure from the Finance Department in Ottawa to an aid agency
in Hanoi).

Stiglitz and Tobin against the Washington consensus

As chair of President Clinton’s Council of Economic Advisers, then as

chief economist of the World Bank, and after his return to Columbia,
Joseph Stiglitz spoke out against the Washington consensus (Rubin
and Summers at the Treasury, Greenspan at the Federal Reserve,
Fischer at the IMF), which urged capital account liberalization upon
developing countries and used the conditionality of IMF lending to
promote contractionary policies in response to financial crises (see
Fischer 2003, Rubin and Weisberg 2003). For both Stiglitz and Tobin,
the Mexican crisis of 1994, the successive Brazilian, East Asian, and
Russian financial crises from 1997 to 1999, and the Turkish and
Argentine crises of 2001 served as object lessons of the disruptive
dangers of hasty capital account liberalization. As both a neoclas-
sical microeconomic theorist (sharing the 2001 Nobel Memorial
Prize for research on the economics of asymmetric information) and
a New Keynesian macroeconomist, Stiglitz shares both Tobin’s tech-
nical insight into how markets work and his conviction that there
is a role for aggregate demand management to stabilize output and
employment.
When Tobin gave the keynote address on “Financial Globalization:
Can National Currencies Survive?” to the Annual World Bank
124 James Tobin

Conference on Development Economics in 1998, he protested,

“Given my lack of experience and expertise in the World Bank’s
world, I am unqualified to speak at this conference. But my old
friend and onetime colleague Joseph Stiglitz insisted that I do so
anyway” (Tobin 2003, 22). That Stiglitz would insist on Tobin giving
the keynote address is not surprising: Tobin, a Nobel laureate and
fellow Keynesian, sympathetic to capital controls and critical of the
IMF response to the East Asian crisis, was a prestigious ally. What is
surprising is how gingerly Stiglitz avoids invoking any such alliance
in his subsequent best-selling books. Tobin’s name does not appear
in The Roaring Nineties (Stiglitz 2003), Stiglitz’s history of a decade
of financial crises and turbulent capital flows, and of his battles
against the Washington consensus, nor in Joseph Stiglitz and the
World Bank: The Rebel Within (Chang 2001), a collection of nine of
Stiglitz’s speeches. Tobin’s only appearance in Globalization and Its
Discontents (Stiglitz 2002, 265–266) is buried in the 12th endnote to
the final chapter, a note that teases Lawrence Summers for having,
in his pre-Treasury days, written “an article that could be inter-
preted as supporting the principles underlying the tax” (Summers
and Summers 1989). In that note, Stiglitz takes care to draw atten-
tion to Stiglitz (1989) on “significant implementation problems,
especially in a world in which the tax is not imposed universally
and in which derivatives and other complicated financial instru-
ments have become prevalent.” Granted, Stiglitz had reservations
about the Tobin tax as the appropriate mechanism for controlling
capital flows, but why doesn’t he express any acknowledgement that
he and Tobin held the same views on why capital flows needed to
be controlled and on the folly of the IMF’s advice to developing
countries?
The answer is, I think, not the same as the explanation of why
Bhagwati does not discuss the closeness of his views to Tobin’s.
Bhagwati independently discovered in 1998 the asymmetry between
the case for free trade and the case for free capital mobility. Apparently
oblivious to any previous expressions of that asymmetry, he inter-
preted the subsequent writings of Eichengreen, Krugman, and Stiglitz
as evidence that he had converted them in 1998, notwithstanding,
for instance, Eichengreen’s participation in Eichengreen, Tobin, and
Wyplosz (1995) and in Huq, Kaul, and Grunberg (1996).
 Taming Speculation 125

Stiglitz, in contrast, has long been attentive to the Tobin tax

proposal (Stiglitz 1989) and had made a point of choosing Tobin
as keynote speaker for the 1998 World Bank conference. From the
point of view of influencing public opinion and public policy in
the United States, the problem is that the Tobin tax contains the
dread, demonized word “tax.” Capital account liberalization in
developing countries may be opposed, IMF orthodoxy about the
appropriate response to a financial crisis may be reversed, but a tax
cannot be proposed. While an adviser to the Dukakis campaign in
1988, Lawrence Summers wrote in the New Republic on “A Few Good
Taxes,” including the Tobin tax, a non-technical presentation of views
expressed in Summers and Summers (1989). Despite formidable later
contenders, that article may still rank as the outstanding example
of Summers’s political tactlessness, and provided a convenient stick
with which Republicans could beat the Dukakis campaign.

Mundell: the other path

Tobin (1978a) saw two paths for international monetary reform: a global
currency, or throwing sand into a too-well greased monetary mecha-
nism (a metaphor first used in his 1972 Janeway lectures in honor of
Schumpeter). Speculative attacks on exchange rates among national
currencies could be avoided either by some form of capital controls
(such as a tax on currency transactions) or by eliminating exchange
rates by abolishing the national currencies. If there are no exchange
rates, speculators cannot speculate on how they might change.
Just as Tobin and Mundell differed on whether the success
of the Kennedy tax cut was a Keynesian demand stimulus or a
triumph for supply-side economics, Robert Mundell (1973a,
1973b) differed from Tobin on international monetary reform by
taking the first path: offering a plan for a European currency that
expanded on his “Plan for a World Currency” presented to the
Joint Economic Committee of Congress in September 1968. Such
a currency now exists (see Mundell 2000 and Mundell and Clesse
2000 for Mundell’s perspective on the creation of the euro). The
key to Mundell’s divergence from Tobin on international monetary
reform is a feature of the Mundell-Fleming open-economy IS-LM
model of the 1960s: the assumption of perfect capital mobility
126 James Tobin

(perfect substitution between foreign and domestic assets, hence a

horizontal BP curve). Mundell accepted perfect capital mobility as
given, whereas Tobin sought to circumvent it by the imposition of
a small tax on currency trades.
Ronald McKinnon (2000) notes that, ironically, critics of
the European Monetary Union (EMU) and the euro, such as
Eichengreen (1997), base their argument on Mundell (1961), which
delineated the optimum currency area as one in which economic
shocks are symmetric, so that the same policy response is appro-
priate throughout the currency area. Mundell (1973a) argued that
having a common currency across countries would allow for better
risk-pooling and portfolio diversification to mitigate asymmetric
shocks, but the Greek, Cypriot, Portuguese, and Spanish financial
crises, with their associated bailouts and lingering high unemploy-
ment, indicate the difficulties with adjustment to asymmetric shocks
within a currency union. When Iceland’s banking system collapsed
(with bank liabilities seven times as large as Iceland’s GDP), its
currency lost half its value. When real estate bubbles burst in Ireland
and Spain, devastating their banks, their economies could not adjust
through exchange rate depreciation, because, unlike Iceland, they
had adopted the euro.
If wages in Portugal were too high for Portuguese products to be
competitive internationally, adjustment could not come through
the nominal exchange rate depreciating to offset the nominal wage
growth, but only from the slow, painful pressure of austerity and
unemployment on money wages and on prices. In Italy and Greece,
such austerity was imposed by unelected governments of techno-
crats, led by economics professors who were former European Union
or European Central Bank officials, displacing elected governments
at the insistence of the EU, ECB and IMF. (Ironically, the temporary
Italian prime minister, Mario Monti, had been Tobin’s PhD student
at Yale, and his Greek counterpart, Luca Papademos, a PhD student
and co-author of another American Keynesian Nobel laureate, Franco
Modigliani at MIT.) German voters grumbled about paying for bail-
outs to prevent southern European defaults (including defaults on
debts owed to German banks), but Germany’s trade surplus and the
southern European trade deficits persisted because the common
currency prevented a German currency appreciation relative to
southern Europe.
 Taming Speculation 127

Conclusion and prospect

Tobin doubted the efficiency of financial markets in any but a

mechanical sense, and proposed a tax on foreign exchange trans-
actions to help insulate domestic real economies from currency
speculation. His proposal stemmed from his more general view that
financial markets, moving along one or another of a multitude of
unstable paths, perhaps with expectations being fulfilled on average,
have real effects on sluggishly adjusting markets for goods and labor.
Although opponents of globalization such as ATTAC have taken up
the Tobin tax, he was no opponent of free movement of goods and
of long-term foreign direct investment. Rather, he insisted on the
asymmetry between the case for free capital mobility and the case for
free trade in goods, a view shared by Bhagwati and the late Rudiger
Dornbusch, critics of free capital mobility who are widely misunder-
stood as defenders of all forms of globalization. Like Joseph Stiglitz,
Tobin sharply criticized the IMF and the US Treasury for applying
pressure on developing countries to liberalize their capital accounts
and, when faced by financial crisis, to resort to demand contraction,
although (perhaps because his name is associated with a tax) Tobin is
little mentioned in Stiglitz’s books for the general public.
Mende and Menkhoff (2003) agree that “Tobin’s skepticism against
the fundamental evaluation efficiency of FX markets corresponds
well with the failure of relevant modeling efforts” but offer evidence
from microstructure that the tax rates now generally mentioned
(typically 0.02 percent on an interbank transaction, half on each
bank, or one-fiftieth of the rate mentioned in Tobin 1974b) are too
low to affect short-term speculation. (Cf. Song and Zhang 2005 on
how a securities transaction tax like the Tobin tax has both a vola-
tility-reducing effect through discouraging trading by destabilizing
speculators and a volatility-increasing effect as reduced liquidity
results in thin markets).
However, Tobin’s central message on international monetary
reform was not whether this rate or that rate was appropriate: it
was the need to insulate domestic real economies from the excess
volatility of international currency markets. Taking perfect or near-
perfect capital mobility as given, Mundell has taken the alternate
path to resolving the same perceived problem: eliminate the inter-
national capital markets, and their excess volatility, by submerging
128 James Tobin

multiple national currencies in a single international currency, at the

cost of denying national monetary authorities the power to respond
asymmetrically to asymmetric shocks – a cost whose significance has
been underlined by the euro crisis. Tobin’s message about the need
to preserve this power, and about the multiple unstable paths that
currency markets can follow, retains its importance.
One possibility for implementing the perhaps utopian Tobin tax
would be by linking it to another possibly utopian scheme: Edgar
L. Feige (now retired from the University of Wisconsin) has, since
1989, advocated replacing the personal and corporate income tax by
an “automated payment transaction tax” of perhaps 0.6 percent or
less, with no deductions or income tax returns, no compliance costs,
diminished incentive to expensively evade such a small tax, and
none of the perverse incentives of income taxes (Feige 2000, Akst
2003). After Feige advanced his plan at a Buenos Aires conference in
1989, several developing countries (including Argentina and Brazil)
experimented with it as a supplement to all existing taxes, which
missed Feige’s point: his proposed tax was to replace distorting taxes,
and was intended for developed countries where most payments
are made electronically, notably those flowing through the three
United States-based clearing systems: Fedwire, CHIPS, and SWIFT.
Implement Feige’s tax (with or without a slightly higher tax on
transactions involving more than one currency), and the Tobin tax
is implemented, retaining what Tobin termed “the beauty part” of
his proposal: the escalating effective tax rates on rapid-turnover
currency speculation.
Since Tobin wrote, high-frequency computerized trading has
increased in both scale and frequency to the point where high-
frequency trading algorithms account of half of US stock trades
and, at a time of reduced investment in crumbling transportation
infrastructure, $300 million was spent by Spread Networks to build
a tunnel for a fiber-optic cable through the Allegheny Mountains
in Pennsylvania to reduce communications time between Chicago
futures markets and New York stock markets by three milliseconds
(Lewis 2014). Such trading algorithms have been widely blamed for
the “flash crash” of May 2010, when the Dow Jones industrial average
abruptly dropped 600 points and then just as abruptly rebounded.
More generally, the global financial crisis that began in 2007 under-
mined confidence in claims that the growing scale and sophistication
 Taming Speculation 129

of financial trading ensured stability, and spurred renewed interest

in the Tobin tax and other financial transactions taxes. In 2013, Italy
imposed a tax on high-frequency trading in equities and derivatives,
“defined as trading automatically generated by a computer algo-
rithm and sent at an interval of less than half a second” (Pomeranets
2013, 30). Such single-country taxes are vulnerable to trading simply
moving offshore. But in January 2103, 11 EU and euro-zone members
(Austria, Belgium, Estonia, France, Germany, Greece, Portugal, Spain,
Italy, Slovakia and Slovenia) agreed to levy a tax of 0.1 percent (ten
basis points) on equity and debt trades and 0.01 percent (1 basis point)
on derivative trades; the tax was supposed to be levied on trading
involving residents of those states, or products issued in these states,
even if the transaction happened elsewhere (Pomeranets 2013, 26).
EU members Britain, Luxemburg and Sweden refused to participate,
and objected particularly to the claim to tax trades taking place in
their financial centers (Britain already had a stamp duty on share
purchases, stated by Pomeranets 2013 to have been in effect since
1694, but was considering repealing it for some shares).
The effect of the tax on volatility remains to be seen. Trade groups
such as the International Capital Market Association warn that the
tax will reduce the volume of short-term trading, but that, after all, is
the point, not the collection of revenue. Regardless of what happens
with that particular European financial transactions tax, Tobin’s
concern with taxes to inhibit excessive short-term financial trading
has gained renewed attention in the wake of the global financial
crisis, the euro crisis, and the growing use of high-frequency trading
algorithms.
9
Tobin’s Legacy and Modern
Macroeconomics

Introduction: an “Old Keynesian” among monetary

economists

James Tobin (1974, 1) began his John Danz Lectures by reminding

his audience that “John Maynard Keynes died in 1946, and his
General Theory of Employment, Interest and Money was published
ten years earlier. Yet Keynes and his book continue to dominate
economics.” A very few years later such a claim could not be made:
when Tobin opened his Eyskens Lectures at Leuven, Neo-Keynesian
Monetary Theory: A Restatement and Defense (1982c, 1–2), about “the
living tradition of Keynesian monetary theory, which has greatly
revised the letter of Keynes’s own writings, while remaining true to
its spirit,” he acknowledged that “Today of course the tradition is
under strong attack from a classical counter-revolution, espousing
the quantity theory, the real-nominal dichotomy, and the neutrality
of money.” As the subtitle of his Eyskens Lectures indicates, he had
moved to the defensive – even though the lecture series had been
rescheduled because he had to go to Stockholm on the original date
of the lectures to accept the Royal Bank of Sweden Prize in Economic
Science in Memory of Alfred Nobel.
Although Janet Yellen, nominated in October 2013 to chair the
Federal Reserve System, “decided to pursue a doctorate at Yale
University after hearing a speech by James Tobin, the economist she
still regards as her intellectual hero” (Appelbaum 2013a, A18) and
wrote the foreword to Tobin (2003),1 and Robert Shiller, one of the
Nobel laureates in economics the following week, was closely linked

130
 Tobin’s Legacy and Modern Macroeconomics 131

with Tobin and shares his views on financial market efficiency

(Tobin 1984, Colander 1999, Shiller 1999, Appelbaum 2013b), the
mainstream of monetary economics (at least until its confidence
was shaken by the financial crisis that began in 2007) moved away
from Tobin’s approach from the late 1970s onward (see, e.g., the
elegiac tone of Solow 2004). 2 Mainstream monetary economics (as
represented, for example, by textbooks such as McCallum 1989 and
Walsh 2003) moved far enough away from Tobin3 and Keynes –
before the current crisis – that Robert Lucas (2004, 12) could
describe himself, only partly in jest, as “a kind of witness from
a vanished culture, the heyday of Keynesian economics. It’s like
historians rushing to interview the last former slaves before they
died, or the last of the people who remembered growing up in a
Polish shtetl.”
In this chapter, I examine what Tobin meant when he termed his
approach “A General Equilibrium Approach to Monetary Theory”
(1969), how it contrasted with what others meant by general equi-
librium monetary economics, why Tobin’s approach failed to appeal
to monetary economists in the 1980s and later, and how Tobin’s
monetary economics relates to developments since 2007, particularly
his modeling of a corridor of stability (Tobin 1975, 1980a, 1993) and
his contention that Keynesian economics is not about unexplained
rigidity of nominal wages but that downward flexibility of money
wages may fail to eliminate unemployment (as in Keynes 1936,
chapter 19, “Changes in Money-Wages”).
Tobin accepted the label “Old Keynesian” (see e.g., Tobin 1993),
distinguishing his approach from New Keynesian economics (which
he considered as the addition of nominal rigidities such as menu
costs to what were otherwise New Classical rational expectations,
natural rate models) or Post Keynesian economics, which rejected
neoclassical microeconomics and optimization. Tobin belonged to
the generation that came to Keynesian economics in the late 1930s
and the 1940s, which notably included, in the United States, the
Nobel laureates Paul Samuelson, Robert Solow, and Franco Modigliani
at MIT and Lawrence Klein at the University of Pennsylvania (see
Klein 1946, Modigliani 1986, 2003, Solow 2004). Among the leaders
of that generation of American Keynesians, Tobin stood out for his
emphasis on financial intermediation in a multi-asset monetary-ex-
change economy.4
132 James Tobin

Introducing his Eyskens Lecture 2, “On the Stickiness of Wage and

Price Paths,” Tobin (1982c, 15) stated,

I want to emphasize that Keynesian theory is not solely or even

primarily a story of how nominal shocks are converted, by rigid or
sticky nominal prices, into real shocks. Keynes believed that real
demand shocks were the principal sources of economic fluctua-
tions, and he did not believe that flexibility of nominal prices and
wages could avoid these shocks and those fluctuations. Modern
“new classical” macroeconomists assume the opposite when they
use “flexibility” as a synonym for continuous and instantaneous
clearing of markets by prices.

This theme, which recurred explicitly in Tobin’s writings from

1975 onward, is crucial to his understanding of what he meant by
calling himself an “Old Keynesian.” From 1975, Tobin (1975, 1980a,
1993, 1997) and, independently, Hyman Minsky (1975, 1982, 1986)6
insisted on chapter 19 as an integral part of the central message
of Keynes’s General Theory. Keynes, who was an outspoken critic
of Britain’s return to the gold exchange standard in 1925 at an
exchange rate that required a reduction of British prices and money
wages, was of course acutely aware that British money wage rates
fell only slowly in the face of substantial unemployment after “the
Norman conquest of $4.86,” and in chapter 2 of The General Theory,
he explained why, given overlapping contracts, workers who cared
about relative wages would, without any irrationality or money
illusion, resist money wage cuts without offering any comparable
resistance to price level increases that reduced the real wages of all
workers at the same time without affecting relative wages (Tobin
1982c, Lecture 2, 38).
Keynes’s chapter 2 analysis of overlapping contracts and relative
wages as a cause of downward rigidity of money wage rates was inde-
pendently reinvented by John Taylor (1980), whose work was hailed
as a great advance over Keynes’s supposed reliance on money illu-
sion.7 But Keynes, both in The General Theory and in his lectures in
the early 1930s (reconstructed from student notes in Rymes 1989),
also emphatically drew attention to the fact that money wage rates in
the United States had fallen by 30 percent from 1929 to 1932 without
preventing or eliminating mass unemployment and even without
reducing real wages, because the price level fell by slightly more (see
 Tobin’s Legacy and Modern Macroeconomics 133

Dighe 1997 and Dighe and Schmitt 2010 on what happened to US

money wages between the wars).
In chapter 19, Keynes dropped the simplifying assumption of given
money wages and argued that while a lower price level and lower
money wage rate would be expansionary, the same does not hold for
falling prices and money wages: deflation lowers the opportunity cost
of holding real money balances, causes consumers to defer purchases
until prices are lower, and, as Keynes (1931b) and Fisher (1933) had
stressed, raises the risk of bankruptcy and default because of debts
fixed in nominal terms.
As far as macroeconomics textbooks are concerned, these points
might never have been made. In the leading graduate macroeco-
nomics textbook, written by a self-identified “New Keynesian,”
David Romer (4th ed. 2012) treats “Keynes’s model” as just unex-
plained rigidity of the money wage rate (no overlapping contracts
and relative wages from chapter 2, no chapter 19) and, when
discussing the Great Depression in the US in the early 1930s, does
not mention that money wage rates went down, let alone down by
30 percent over three years.8 A literature debates whether the actions
and public statements of the Hoover Administration or those of the
Roosevelt Administration were to blame for the supposed failure of
money wage rates to fall in the Depression (e.g., Cole and Ohanian
2004); this literature takes for granted that a (further) reduction in
money wage rates would have reduced real wages in the same propor-
tion without affecting the price level. Even Roger Farmer (2010b,
180 n6), citing Cole and Ohanian (2004), writes, “In the first three
years of the Great Depression manufacturing wages rose slightly and
real wages increased,” a sentence that would be pointlessly repeti-
tive unless the “manufacturing wages” mentioned are nominal (and
unless the increase in real wages was not slight). I say “even Roger
Farmer (2010b)” because elsewhere in the same book (Farmer 2010b,
116) he emphasizes very clearly, “But money wages fell 30% between
1929 and 1932. Unemployment does not persist because wages are
inflexible.” Oddly, Farmer offers this sound observation as a refuta-
tion of Keynes and his followers who supposedly “assert that unem-
ployment persists because wages and prices are slow to adjust to clear
markets” as if Keynes, both in The General Theory and in his lectures,
did not repeatedly and vigorously invoke that very fall in US money
wages from 1929 to 1932 as evidence that downward inflexibility of
money wages was not the problem.9
134 James Tobin

Perhaps the one thing widely remembered about Keynes’s chapter 19,
before Tobin (1975) and Minsky (1975) renewed interest in it, was that
Keynes devoted an appendix to that chapter to criticism of Pigou’s
Theory of Unemployment (1933), but the point of Keynes’s critique was
forgotten. By looking only at the labor market, Pigou (1933) had to
conclude that a lower money wage would clear the market,10 whereas
Keynes argued that, with an endogenous price level, bargaining over
money wages would not adjust real wages to market-clearing levels.
Sometimes, when notice was taken of Tobin’s claim that in
Keynesian theory, the labor market might not clear for reasons other
than money illusion, and that downward flexibility of money wages
might not restore full employment, his position was ridiculed rather
than analyzed. Thus Stephen LeRoy (1985, 671–672), reviewing
in HOPE the proceedings of the Keynes Centenary Conference in
Cambridge, quoted Tobin as asking, “Why are labor markets not
always cleared by wages? Keynes’ ... answer is usually interpreted
to depend on an ad hoc nominal rigidity or stickiness in nominal
wages, and thus to attribute to workers irrational ‘money illusion.’ ... I
now think, however, that Keynes provides a theory free of this taint.”
Without mentioning that Tobin had formally modeled his argument
in Tobin (1975), or that Taylor (1980) had a formal model of stag-
gered contracts and relative wages in which workers rationally resist
nominal wage cuts, LeRoy protested,

It is this propensity to engage in such verbal argumentation

divorced from disciplined economic theorizing that critics of
Keynesian economics find so frustrating. Little wonder that recent
generations of graduate students – tired of trying to remember for
exam purposes that Keynesian unemployment is due to inertia in
nominal wage and price paths but not to ad hoc nominal rigidity
(or is it vice versa?) – have responded with enthusiasm when
invited by Lucas and others to take economic theory completely
seriously in thinking about macroeconomic issues!11

Encountering Keynes

James Tobin encountered economics and Keynes’s General Theory

simultaneously during the Great Depression, as an 18-year-old sopho-
more at Harvard in 1936.12 In addition to their courses, Harvard
 Tobin’s Legacy and Modern Macroeconomics 135

undergraduates had a weekly tutorial in their major. Tobin’s tutor,

Spencer Pollard, a graduate student who was also the instructor for
the “Principles of Economics” section Tobin was then taking,13
“decided that for tutorial he and I, mostly I, should read ‘this new
book from England. They say it may be important.’ So I plunged in,
being too young and ignorant to know that I was too young and igno-
rant” to begin studying economics with The General Theory (Klamer
1984, Colander 1999, Shiller 1999, Snowdon and Vane 2005, Dimand
2010a).
Reading Keynes’s General Theory during a depression, deep recession,
or economic crisis can be transformative even for such an established
Chicago economist as “law and economics” pioneer Judge Richard
Posner (2009a, “How I Became a Keynesian” 2009b, 2010), who was
shocked to find that the supposedly unreadable, refuted, and discred-
ited book made sense and provided insight into what was happening
in the world. The effect of the newly published book on a beginning
economics student in 1936 was deep and long-lasting: all his subse-
quent exploration of economics was affected by his initial encounter
with Keynes during the Depression. Others at Harvard were introduced
to Keynes by Robert Bryce, a Canadian (later eminent in the public
service) who became a Harvard graduate student, bringing with him
a paper on Keynes that he had presented at four successive meetings
of Hayek’s LSE seminar, based on notes that Bryce had taken at three
years of Keynes’s Cambridge lectures from 1932 to 1934. But before
Bryce arrived at Harvard, and before Harvard professor Alvin Hansen
famously was converted to Keynesianism between his two reviews of
the General Theory, one 18-year-old “Principles” student had already
read and largely (not entirely) accepted Keynes’s General Theory.
Unlike many of the Keynesians of his generation, Tobin’s
Keynesianism embraced the entire title of The General Theory of
Employment, Interest and Money instead of stopping with the word
Employment or, in the case of liquidity preference theorists at the
British Cambridge, Interest. For Tobin, the key to understanding and
dealing with Keynesian unemployment was that it was a phenom-
enon of a monetary economy, and required understanding of the
monetary system and financial assets. It is noteworthy that Alvin
Hansen’s Monetary Theory and Fiscal Policy (1949), the only one of his
books to focus on monetary theory rather than on fiscal policy or
business cycles, was the one among Hansen’s books to be strongly
136 James Tobin

influenced (with full acknowledgement) by Tobin, then a junior

fellow in Harvard’s Society of Fellows.
Coming to economics and Keynes in 1936, Tobin regarded high
levels of unemployment (25 percent unemployment in the US in
the worst of the Great Depression in 1932–1933 and back up to
17 percent during the recession of 1937, 22 percent unemployment
in Britain before Britain left the gold standard in 1931), lasting for
years, as self-evidently not the result of voluntary consumption of
leisure or investment in search, nor as the result of failure to know
what had happened to the price level. Involuntary unemployment,
like any form of involuntary behavior, has proven elusive to define
or measure (see De Vroey 2004). Tobin did not attempt to do so,
taking an attitude about whether there was involuntary unemploy-
ment in the 1930s that brings to mind Justice Potter Stewart, who,
when challenged to define pornography, replied, “I know it when I
see it.”14 Nor did Tobin care whether protracted high unemployment
in the 1930s, whether involuntary (however defined) or not, was an
equilibrium phenomenon or merely a very long-lasting disequilib-
rium: “The Great Depression is the Great Depression, the Treasury
View is still ridiculous, whether mass unemployment is a feature of
equilibrium or of prolonged disequilibrium” (1974, Lecture 1, 15).
Entering economics when he did (17 percent US unemployment
in 1937, lasting high unemployment in Britain where money wages
fell only slowly after Britain’s return to the gold standard but also
continuing high unemployment in the United States where money
wages fell 30 percent in the first three years of the Depression15), and
starting with Keynes, Tobin saw economics as a source not just of
knowledge (light) but also of dealing with practical problems (fruit).
As Janet Yellen said, “He encouraged his students to do work that was
about something, work that would not only meet a high intellectual
standard, but would improve the well-being of mankind”16 (quoted
by Appelbaum 2013a, A18).
In his unpublished John Danz Lectures, Tobin (1974, Lecture 1,
3) recalled his first teenaged reading of Keynes as

an exhilarating experience. Here was a theory of enough intel-

lectual rigor and elegance to challenge youthful minds with some
taste for the abstract and the mathematical. Here was an attack
on conventional wisdom appealing to young students, then as
 Tobin’s Legacy and Modern Macroeconomics 137

now quite ready to believe that most of their elders had personal
stakes in inherited error. Here were novel and far-reaching policy
implications promising solutions of the major economic ills of
the world, unemployment and depression. Here even, one could
hope, was the salvation of peace, freedom, and democracy, since
economic collapse and stagnation seemed to be the main sources
of the totalitarian threats of the 1930s.

When Tobin told Robert Shiller that he found Keynes (1936) “pretty
exciting because this whole idea of setting up a macro model as a
system of simultaneous equations appealed to my intellect,” Shiller
(1999, 870) responded, “I wouldn’t think of looking at Keynes’s General
Theory for the inspiration for explicit simultaneous equation macr-
oeconomic models; he didn’t do that there.”17 But Tobin insisted,

Well, that set it apart if you looked at it from the right point of
view. Other people were algebraizing models. Articles by Hicks
and others used algebra and geometry quite explicitly to expound
Keynes. Keynes’s book was setting off a whole new scheme of
economics – called then the “theory of output as a whole,” Joan
Robinson’s term for it. She made it appear quite distinct from the
ordinary Marshallian partial equilibrium, which we got in our
micro theory in our theory classes. That was what theory was in
those days at Harvard.

What Tobin took from Keynes was not just a view of public policy,
but, when formalized, a way to do economics: “In my opinion,
Keynes did revolutionize economic theory. But the revolution he
made was not the revolution he intended. The actual revolution was
more an innovation of method than of substance, and for this reason
probably more important” (Tobin 1974, Lecture 1, 9).
Next to Keynes, the leading influence on Tobin as an economics
student at Harvard in the 1930s was J. R. Hicks: his “Suggestion for
Simplifying the Theory of Money” (1935); his IS-LM paper “Mr. Keynes
and the Classics” (1937); Value and Capital (1939), where Tobin first
read about general equilibrium; and as a visitor at Harvard of R. G.
D. Allen, who had been Hicks’s co-author in demand theory. Tobin’s
dissertation (1947), which neglected to mention that Schumpeter
was (nominally) his thesis advisor, paid tribute to Hicks’s seminar
138 James Tobin

participation on a visit to Harvard in 1946. Hicks’s later clarifica-

tions, qualifications, and reservations concerning his early work in
Hicks (1974, 1980), came long after Tobin’s formative period, and
never had any comparable impact on Tobin.

Microeconomic foundations: optimization sector by

sector

Having assisted and influenced Alvin Hansen (1949) in presenting

the IS-LM framework to American economists with what became
known as the Hicks-Hansen IS-LM diagram (building on Hicks
1937, Modigliani 1944, and some early post-war articles by Tobin),
Tobin worked on providing optimizing rational-choice foundations
for each of the building blocks of the framework. He began with a
doctoral dissertation, A Theoretical and Statistical Analysis of Consumer
Saving (1947; Yale University Library 2008, MS 1746 Accession 2007-
M-009 Additional Material, Box 1), nominally supervised by Joseph
Schumpeter but, like Samuelson (1947), who was at Harvard just
before the war (published six years later because of the war) and
Haavelmo (1944), at Harvard in wartime exile from the University of
Oslo, Tobin effectively supervised his own thesis.
It was as an expert on the consumption and saving functions, not
on monetary economics, that Tobin was invited to contribute to the
1968 International Encyclopedia of the Social Sciences. Tobin’s disser-
tation pioneered the pooling of time series data with cross-section
budget studies. To resolve the puzzle that, empirically, time series
studies over long periods showed the marginal propensity to save
equal to the average propensity to save (so the average propensity
to save stays roughly constant as income grows over long periods
of time) while cross-section studies and time series studies over the
course of a business cycle show marginal propensity to save greater
than the average propensity (so the average propensity rises when
income rises), Tobin introduced household wealth as well as income
as an explanatory variable in the saving function (and hence in the
consumption function). Wealth would rise with income over long
periods of time, but not over the course of a single business cycle.
Bringing in wealth linked saving and consumption to past saving
(and thus past income), not just current income. This pointed the
way to, for example, the life-cycle saving hypothesis of Franco
 Tobin’s Legacy and Modern Macroeconomics 139

Modigliani, Richard Brumberg, and Alberta Ando, the empirical

implementation of which is a consumption function with wealth
and income as arguments.
Tobin’s modification of the saving function also involved the life-
long Tobin theme that the evolution of the stock of wealth had to
be consistent with the flow of saving. Keynes (1936) had modeled
consumption as a function only of current disposable income, but
added informal discussion of how other variables could affect the
size of the marginal propensity to consume (and in wartime Treasury
memoranda, Keynes denied that a temporary change in taxation, if
known to be temporary, would have much effect on spending).
From consumption and saving, Tobin (1956, 1958a) moved on to
model demand for money as optimizing behavior by rational, self-
interested individuals. Without then knowing either Allais (1947) or
Baumol (1952) (see Baumol and Tobin 1989) but presumably being
conscious of the literature on inventory investment18 (as Baumol was),
Tobin (1956) took an inventory-theoretic approach to the transactions
demand for money. Bonds pay interest, money does not, and goods can
only be purchased with money, not directly with bonds. Individuals
receive a paycheck at the beginning of each period, and spend it all
at a steady rate over the course of the period. If there were no costs to
selling bonds for money (or if the cost was a percentage of the value
of bonds sold), people would hold all their wealth in interest-bearing
bonds, continuously selling bonds at the same rate they spend the
proceeds of the bond sales. But if there is a lump-sum cost per transac-
tion between bonds and money (perhaps the value of the time spent
going to an ATM), optimizing individuals maximize income net of
transactions costs by trading off foregone interest against transactions
costs, deriving an optimal number of transactions per time period,
which gives average cash balances (money demand) as a function of
income, interest and transaction cost: optimization in one sector.
Tobin was bothered by Keynes’s analysis of demand for money as
an asset, according to which there was a distribution across indi-
viduals’ expectations of the interest rate’s future level, with each
individual believing with certainty some point-estimate of what the
interest would become. Bulls, who expected the interest rate to drop
from its current level, and therefore expected the market price of
securities to rise, would hold all their wealth as securities and none
as money. Bears (those who expected the interest rate to rise and the
140 James Tobin

price of securities to fall by enough to more than compensate for

the earnings from holding securities), would hold only money and
no securities. As the current interest rate moved past an individu-
al’s critical level, that individual would switch from holding only
money to holding only securities, or vice versa. The idea of someone
believing a point-estimate of the future interest rate with certainty
clashed with Keynes’s view of fundamental uncertainty; the idea
that individuals with the same information would hold different
expectations was troubling, and the result that people held either all
bonds or all money contradicted the analysis of optimal diversifica-
tion presented by Harry Markowitz (1952).
Markowitz then spent a year at Yale writing his Cowles monograph
on Portfolio Diversification (Markowitz 1959). Instead of each individual
making a different forecast of the rate of return on securities, despite
having the same information, Tobin (1958) assumed that, given the
same information, all individuals would have the same probability
distribution over the rate of return, which would be, given the avail-
able information, the correct distribution: “My theory of liquidity pref-
erence as behavior towards risk was built on a rational expectations
model long before the terminology”19 (Tobin, in Shiller 1999, 878).
Treating money as a riskless asset with an exogenously fixed return
(not necessarily zero) that was strictly lower than the expected return
on risky securities, Tobin (1958a) used a mean-variance analysis to
find the fraction of the portfolio that would be held in the riskless
asset, with the remainder held in a portfolio of risky assets optimally
diversified, following Markowitz’s theory20 (which was much simpli-
fied by William Sharpe and John Lintner in the mid-1960s as the
“capital asset pricing model,” which needed to consider only how
each asset’s return co-varied with the market basket, not how each
asset’s return co-varied with the return of every other asset).
The Tobin separation theorem showed that the proportion of the
total portfolio held in the riskless asset was independent of how the
portfolio of risky assets was diversified within itself (see Tobin with
Golub 1998, 89–91). This depended on treating money as a riskless
asset, which abstracted from the risk of changes in the purchasing
power of money (see Fisher 1928, which was Fisher’s fervent attempt
to persuade people to think of money as a risky asset).
In a 1969 reply (reprinted with Tobin 1958a in Tobin 1971–1996,
Volume I, 269) to comments by Karl Borch and Martin Feldstein,
 Tobin’s Legacy and Modern Macroeconomics 141

Tobin acknowledge that the mean-variance approach was exact only

if asset returns were normally distributed (since the normal distribu-
tion is fully described by its mean and variance), or if people have
quadratic utility functions (so that they only care about the first two
moments of the distribution of asset returns). Tobin wrote:

I do not believe it is an exaggeration to say that, until relatively

recently, the basic model of portfolio choice in economic theory
was a one-parameter model. Investors were assumed to rank port-
folios by reference to one parameter only – the expected return,
possibly corrected by an arbitrary “risk premium,” constant and
unexplained ... This extension from one moment to two was never
advertised as the complete job or the final word, and I think that
its critics in 1969 owe us more than demonstrations that it rests on
restrictive assumptions. They need to show us how a more general
and less vulnerable approach will yield the kind of comparative-
static results that economists are interested in. This need is satis-
fied neither by the elegant but nearly empty existence theorems
of state preference theory nor by normative prescriptions to the
individual that he should consult his utility and his subjective
probabilities and then maximize.

From money demand, Tobin turned to money supply in “The

Commercial Banking Firm: Firm” (1982b), drafted in the late 1950s
as a chapter of the manuscript21 that eventually became Tobin with
Golub, Money, Credit and Capital (1998, chapter 7, “The Banking Firm:
A Simple Model”), and in “Commercial Banks as Creators of ‘Money’”
(1963). Unlike the quantity theory of money, Tobin (1963, 1982b) did
not take the quantity of money as exogenously set by the central bank
(or, under the gold standard, by the stock of gold). Rather, the central
bank set the monetary base (outside money, that is currency plus
reserves with zero or other exogenously fixed rate of return), and then
optimizing financial institutions created financial assets including
inside money that were imperfect substitutes for each other.22
Monetary policy, open market creation, or destruction of outside
money would affect the economy by changing the market-clearing
rates of return on all these imperfectly substitutable assets, but the
central bank did not directly control either interest rates or the quan-
tity of money (Tobin 1982c, Lecture 1, 13–16). By changing these
142 James Tobin

market-clearing rates of return on financial assets, monetary policy

could affect investment by changing Tobin’s q, a concept introduced
by Brainard and Tobin (1968) and Tobin (1969). Post Keynesian exog-
enous money theorists such as Basil Moore (1988) interpret endog-
eneity of the money supply as implying a supply curve for money
(and an LM curve) horizontal at an interest rate set by the central
bank (or set by commercial banks at a constant mark-up over the
central bank’s discount rate), without explicit optimizing founda-
tions, in place of the quantity theory’s supply curve for money that is
vertical at a quantity of money set by the central bank (and a vertical
LM curve). Like the long-forgotten exercise by Edgeworth (1888),
Tobin (1963, 1982b) explicitly modeled money creation by opti-
mizing banks to derive an upward sloping supply curve for money:
higher interest rates induce banks to create more money by choosing
lower reserve/deposit ratios.
Tobin and Brainard (1968) and Tobin (1969) argued that invest-
ment depends on q, the ratio of the market value of capital assets
to their replacement cost. If q exceeds 1, a firm increases its market
value by investing in creating a new capital asset. If q is less than
1, firms will allow the capital stock to decrease through deprecia-
tion, and if it is 1, the capital stock is in equilibrium, with gross
investment equal to depreciation. The numerator of q, the market
value of capital assets equal to the present discounted value of the
expected stream of net earnings from owning the capital assets,
provides the channel for monetary policy, asset market fluctuations,
and changing expectations of future profitability to affect invest-
ment, a channel that makes the stock market crash of 1929 relevant
to the collapse of investment in the Great Depression. Tobin’s q was
offered as a common-sense generalization about behavior, not as the
result of a formal analysis of optimization by firms.
Tobin thus added informal optimizing foundations to each compo-
nent of the IS-LM model of aggregate demand: investment, saving,
liquidity preference (money demand), and money supply. Tobin and
Brainard (1968) and Tobin (1969, 1982a) linked sectors and markets,
including the markets for many imperfectly substitutable financial
assets, through balance-sheet identities and adding-up constraints,
and through the stock-flow consistency that was taken further by
Tobin and Buiter (1976, 1980a) and Backus, Brainard, Smith, and
Tobin (1980). But Tobin refused to link sectors and markets through
 Tobin’s Legacy and Modern Macroeconomics 143

the budget constraint of an optimizing representative agent or to

assume a continuously clearing labor market.

A “General Equilibrium Approach To Monetary Theory”

Having separately examined each of the components of Keynesian

aggregate demand (saving function, q theory of investment, trans-
actions demand for money, demand for money as an asset, the
banking system as creator of money), Tobin used the occasion of
the inaugural issue of the Journal of Money, Credit and Banking to
expound the “General Equilibrium Approach to Monetary Theory”
that brought together his work in monetary economics. What Tobin
(1969) presented as his “general equilibrium approach” had its intel-
lectual roots in J. R. Hicks’s “Suggestion for Simplifying the Theory
of Money” (1935) and Value and Capital (1939), as much as in Keynes
(1936). Although Tobin was well aware of subsequent technical
advances in general equilibrium theory, particularly Gerard Debreu’s
Theory of Value (1959), which was written at Yale and published as
a Cowles Foundation Monograph while Tobin directed the Cowles
Foundation, his approach was shaped by his initial encounter with
general equilibrium as a Harvard graduate student reading Hicks’s
newly published Value and Capital and Paul Samuelson’s 1941 PhD
dissertation, published after the war as Foundations of Economic
Analysis (1947). He also attended a course on general equilibrium,
nominally taught by Schumpeter but dominated by Samuelson,
Lloyd Metzler, and R. G. D. Allen.23 Tobin’s understanding of what
general equilibrium meant differed significantly from the use of that
term in later New Classical economics.
Tobin’s model of many assets that were imperfect substitutes for
each other was a general equilibrium model in which asset markets
were linked by the adding-up constraint that asset demands must
sum to total wealth, and in which changes in stocks were carefully
tied to flows. It was not a model in which all markets, including
the labor market, were linked through the budget constraint of a
single representative agent, a formulation unsuited to considering
macroeconomic coordination issues. The requirements for existence
of a representative agent have been shown to be as heroic as those
for existence of Keynesian aggregate functions (see Geweke 1985,
Kirman 1992, Hartley 1997). Tobin and Brainard (1968, 99) were
144 James Tobin

sharply, albeit obliquely, critical of existing Keynesian macro-econo-

metric models for insufficient attention to

the importance of explicit recognition of the essential interde-

pendence of markets in theoretical and empirical specification
of financial models. Failure to respect some elementary rela-
tionships – for example, those enforced by balance-sheet identi-
ties – can result in inadvertent but serious errors of econometric
inference and policy. This is true equally of equilibrium relation-
ships and of dynamic models of the behavior of the system in
disequilibrium. We will try to illustrate the basic point with the
help of computer simulations of a fictitious economy of our own
construction. This procedure guarantees us an Olympian knowl-
edge of the true structure that is generating the observations.
Therefore, it can exhibit some implications of specifications and
misspecifications that are inaccessible both to analytical inspec-
tion and to econometric treatment of actual data.

Brainard and Tobin (1968) and Tobin (1969) thus show what Tobin
meant by general equilibrium: not linkage through the budget
constraint of an optimizing representative agent, but careful atten-
tion to adding-up constraints for wealth, balance-sheet identities,
and stock-flow consistency.
Robert Solow (2004, 659), perhaps the economist closest to Tobin,
observed,

The first thing you will notice about “A General Equilibrium

Approach” is that its basic building blocks are net-asset-demand
functions, which determine the fraction of total wealth parked
in each specified asset as a function of the rates of return on the
various assets, plus the ratio of income to wealth (to allow for
“necessities” and “luxuries” among assets, and to connect up with
current flows) and also many unspecified predetermined vari-
ables that make sense in context. The signs of the various partial
derivatives are discussed in common-sense terms. There are no
optimizing consumers, who maximize the expected present
discounted values of infinite utility streams, no Euler equations.
So where are the “microfoundations”? The answer is that they
are embedded in those common-sense restrictions on partial
 Tobin’s Legacy and Modern Macroeconomics 145

derivatives. The usual homogeneity postulates and the adding-up

conditions imposed by budget constraints are also built into
Tobin’s specifications. ... The other big difference you will notice
between Tobin’s approach and today’s fashion is the absence of a
representative agent. ... One can take it for granted that agents are
heterogeneous, because they are. ... The economist’s responsibility
is to choose those asset-demand functions (or whatever) in such a
way that they leave adequate space for the market consequences
of the heterogeneities that happen to exist. That cannot be done
exactly ... All one can do is to try to make proper allowance, accept
criticism, and respect the data.24

For Tobin (1969),

The essential characteristic – the only distinction of money from

securities that matters for the results given above – is that the
interest rate on money is exogenously fixed by law or conven-
tion, while the rate of return on securities is endogenous, market
determined ... If the interest rate on money, as well as the rates
on all other financial assets, were flexible and endogenous, then
they would all simply adjust to the marginal efficiency of capital.
There would be no room for discrepancies between market and
natural rates of return on capital, between market valuation and
reproduction cost. There would be no room for monetary policy
to affect aggregate demand. The real economy would call the tune
for the financial sector, with no feedback in the other direction.
(as reprinted in Tobin 1971–1996, Volume I, 334–335)

He concluded, “According to this approach, the principal way in

which financial policies and events affect aggregate demand is by
changing the valuation of physical assets relative to their replacement
cost [Tobin’s q]. Monetary policies can accomplish such changes, but
other exogenous events can too” (1971–1996, Vol. I, 338). So, given
a fixed nominal return on money, open market operations matter
because they affect q, on which investment depends.
As Willem Buiter (2003, F590–F593) noted, Tobin found the
Maurice Allais-Paul Samuelson-Peter Diamond overlapping genera-
tions framework useful for analyzing Social Security systems, both
in his lectures at Yale and in papers such as Tobin and Dolde (1983),
146 James Tobin

and he selected Samuelson’s OLG article (Samuelson 1958) to be

reprinted in Tobin (2002).25 However, he firmly rejected claims that
OLG models in which money was the only way to hold wealth from
one period to another provide a rigorous explanation of the existence
and value of fiat money (see Tobin’s acerbic comments in Kareken
and Wallace 1980, 83–90, and Tobin in Colander 1999, 124). If it
was arbitrary for Allais (1947),26 Baumol (1952), and Tobin (1956) to
assume a lump-sum cost per transaction of selling bonds for money
(such as the value of the time taken up in transacting), so that opti-
mizing agents would hold positive balances of money even though
bonds paid a higher return, it was even more arbitrary to assume that
the cost of buying and selling other assets was infinite, so that only
money would exist in strictly positive quantities.

Losing influence

Starting in the late 1960s, Keynesian economics lost ground to mone-

tarism (Friedman 1968 and 1977) and to New Classical economics, first
in its rational expectations monetary-misperceptions versions (Lucas
1981a and 1996, see also Klamer 1984, Hoover 1988) and then as “real
business cycle” (RBC) theory, with a partly offsetting development of
New Keynesian economics (Mankiw and Romer, eds. 1991) that intro-
duced nominal rigidities into otherwise New Classical models. Partly
this was due to external factors: the resurgence of inflation as a policy
problem and the unresponsiveness of unemployment to aggregate
demand management. This situation created a receptive audience
for the Friedman–Phelps expectations-adjusted Phillips curve and
natural rate hypothesis, casting doubt on the ability of governments
to reduce unemployment below some “non-accelerating inflation rate
of unemployment” (NAIRU)27 without spiraling inflation, and for the
New Classical argument, adding rational expectations to the natural
rate hypothesis (or Lucas supply function) that no systematic mone-
tary policy could affect unemployment.
In contrast to the view of Keynes and Tobin that unemployment (in
excess of structural, seasonal and frictional levels) represented both
lost output and a psychic cost to the unemployment, the natural rate
hypothesis implies that reducing unemployment below the NAIRU
involves tricking people into surrendering voluntary consumption of
leisure, or giving up productive investment in search, in exchange for
 Tobin’s Legacy and Modern Macroeconomics 147

a smaller real wage that they believe they will get (such a reduction
in unemployment could still be socially desirable, as offsetting the
distorting effect on labor supply of marginal income tax rates). The
amount and duration of additional unemployment needed to lower
inflation and expected inflation by a certain amount, while far from
trivial, proved to be less than predicted by, for example, Tobin (1972).
There were also factors internal to the economics discipline, such
as the Lucas critique of economic policy evaluation (Lucas 1976,
Hoover 2003, 422–423). Jacob Marshak, Herbert Simons, and Tjalling
Koopmans28 at the Cowles Commission in Chicago in the late 1940s
and early 1950s, had recognized that the parameters of econometric
models were not invariant to changes in policy regime, but it was
Lucas who drew widespread attention to the implication that tradi-
tional structural models could not be used to evaluate the effects
of policy regime changes (hence the inclusion of Lucas 1976, like
Friedman 1968 and Barro 1974, in Landmark Papers in Macroeconomics
Selected by James Tobin, 2002).
But beyond these factors affecting Keynesian economics in general (at
least until the renewed public interest in Keynes since the global finan-
cial crisis began in 2007), there were issues specific to Tobin’s approach
to monetary economics that caused the influence of that approach in
monetary theory to erode, just when award of the Nobel Prize would
seem, to the public beyond the economics profession, to signal ultimate
professional recognition and acceptance. So, in terms of explaining the
dramatic waning of Tobin’s influence in monetary theory, this section
may be read as, in a sense, the case for the prosecution.
Interviewing Tobin, Robert Shiller (1999, 888) asked, “So what
happened to your general equilibrium approach to monetary theory?
It seemed to be a movement for a while, right? Here at Yale a lot of
people were doing this, and I haven’t heard about such work lately.”
Tobin responded, “Well, people would rather do the other thing
because it’s easier.” Certainly that is part of the reason for mone-
tary economists turning away from Tobin to New Classical models,
especially the real business cycle (equilibrium business cycle) non-
monetary variant of New Classical economics: assuming that the
economy is at potential output (Y = Y*) does ease the modeler’s life,
as does assuming the existence of a single representative agent (or, in
“overlapping generations” models, two representative agents, one old
and one young). The nonlinear differential equations describing the
148 James Tobin

motion of a disaggregated multi-asset model such as that of Backus

et al. (1980)29 did not have closed-form solutions, and using simula-
tion to solve the model numerically was a challenge to the computing
capacity of 1980.30 As Tobin said (in Shiller 1999, 889), “The whole
thing is not in fashion. The whole idea of modern finance does not
include imperfect substitution. I suppose in defense of ignoring it is
the fact that we weren’t actually able to solve the nonlinear equa-
tions with these adjustment mechanisms.”
By the time the SND (simulating nonlinear dynamics) package
of Chiarella, Flaschel, Khomin, and Zhu (2002) was available, and
was applied to modeling stock-flow consistent Tobin-style Keynesian
monetary growth dynamics in books by Chiarella and Flaschel
(2000), Charpe, Chiarella, Flaschel, and Semmler (2011), Asada,
Chiarella, Flaschel, and Franke (2012), and Chiarella, Flaschel, and
Semmler (2012, 2013), and in such articles as Asada, Chiarella,
Flaschel, Mouakil, Proano, and Semmler (2011), and Chiarella and Di
Guilmi (2011), the mainstream of monetary economics had moved
elsewhere (and the works cited in this sentence, although published
by respected outlets such as Cambridge University Press or the
Journal of Economic Dynamics and Control, were written by economists
at Australian, Japanese and Italian universities or at non-mainstream
US institutions such as the New School University, not at the top-
ranked US economics departments).
Computational difficulty interacted with other factors to turn the
trend of macro-econometric modeling in the 1980s. For example,
the Canadian inter-departmental econometric model (CANDIDE) –
a Keynesian model but not associated with Tobin or his stock-flow
consistent monetary growth modeling – was abandoned in the early
1980s partly because of concern with the Lucas critique of using
structural models for policy evaluation but also partly because its
sheer size and complexity (2084 equations by the time the Economic
Council of Canada gave up re-estimating it and using it for fore-
casting and policy evaluation) meant that it had to be estimated by
single-equation methods that were clearly inappropriate and that
the structure was too complex to grasp.
As Tobin’s sometime co-author Gary Smith (1989, 1692–1693)
remarked, in a review of Owen (1986), there simply was not enough
available data for a Tobin-style disaggregate portfolio choice model,
 Tobin’s Legacy and Modern Macroeconomics 149

given that portfolio optimization implied many explanatory vari-

ables in the asset demand functions:

Because of the strong intercorrelations among the available data,

the implementation of the Yale approach is inevitably plagued by
severe multicollinearity problems. While monetarism is too simple,
the Yale approach is too complex. Some [e.g. Owen 1986] accept
the high standard deviations and low t-values, observing that the
data are not adequate for answering the questions asked. Some
researchers try to get more precise estimates by using exclusion
restrictions; others [e.g. Smith and Brainard 1976] have tried more
flexible Bayesian procedures for incorporating prior information.

These problems affected empirical implementation of Tobin-style

models such as Backus et al. (1980). The Mundell–Tobin effect –
the non-superneutrality of money even with labor-market clearing
shown by Mundell (1963) for short-run IS-LM models and by Tobin
(1965b) for long-run neoclassical growth models (see also Tobin and
Buiter 1976, 1980a, Halliasos and Tobin 1990) – ran into difficulty
at the level of theory (see Orphanides and Solow 1990, Dimand
and Durlauf 2009). Mundell (1963) showed that, since investment
depends on the real interest rate, but the nominal interest rate is
the opportunity cost of holding real money balances, an increase
in expected inflation shifts the LM curve to the right (when real
interest is on the vertical axis) and moves the short-run IS/LM inter-
section to a lower real interest rate and higher level of real output Y.
Tobin (1965b) treated money and capital as portfolio substitutes in a
long-run neoclassical growth model, so that a faster rate of monetary
growth and thus of inflation would shift portfolio composition from
money to capital, increasing the capital intensity of the steady-state
growth path. Later Tobin papers (surveyed in Halliasos and Tobin
1990) included a government budget constraint, allowing analysis
of the optimal trade-off between the social cost of inflation (smaller
real money balances for transactions purposes mean higher transac-
tions costs, smaller precautionary balances make risk-averse agents
worse off) and the output gain from greater capital intensity. These
results contradicted the argument of Irving Fisher (1896) that the
rate of change of the money supply and of the price level would have
150 James Tobin

no real effects (in later language, would be “superneutral”) unless

people made mistakes in their inflation expectations (which Fisher
thought they did, see Fisher 1928). The Mundell–Tobin effect also
appeared to resolve the puzzle of Milton Friedman’s analysis of the
optimum quantity of money (Friedman 1969, 1–50), in which infla-
tion, by reducing demand for real money balances, reduces welfare
without having any other real effects.
But these results turned out to be sensitive to model specifications.
Real money balances were posited as an argument in the utility func-
tion by Miguel Sidrauski, as an argument in the production function
by David Levhari and Don Patinkin, and by Stanley Fischer: turning
money and capital into complements rather than substitutes (and
in the case of money in the production function, making money
an intermediate good subject to a public finance argument against
taxing intermediate goods). Allan Drazen (1981), in a two-period
overlapping generations (OLG) model with explicit optimizing
microfoundations, showed inflation increasing capital intensity (as
in Tobin 1965b) – provided the seigniorage from money creation is
given to the young, but the reverse if the seigniorage is given to the
old – while another OLG model had the Tobin effect dominating
regardless of which generation received the seigniorage (for refer-
ences and discussion, see Orphanides and Solow 1990, 245–246,
Halliasos and Tobin 1990, 300–301, Dimand and Durlauf 2009).
So, there is no presumption from economic theory that money is
superneutral in the long run, but what mattered to monetary econo-
mists was that the existence and direction of the non-neutral effect of
money growth on output and welfare in the long-run depends critically
on seemingly small and innocuous changes in exactly how a model
is specified. Sensible scholars do not wish to stake their careers on
what they might be able to produce in such a field. As Orphanides and
Solow (1990, 257) concluded in their Handbook of Monetary Economics
survey of “Money, Inflation and Growth”: “We end where Stein [1971]
ended 20 years ago.” The case for the Tobin effect in long-run mone-
tary growth models was not disproven, but the results were far from
robust, and the discussion wasn’t going forward, so monetary econo-
mists moved to other topics where robust results seemed attainable.
Tobin’s is by no means the only approach to monetary economics
to have some of its characteristic components fail to hold the profes-
sion’s attention, yet this does not mean that the central message of
 Tobin’s Legacy and Modern Macroeconomics 151

the approach lacks continuing interest. Friedman’s emphasis on the

costliness of inflation, on the endogeneity of expected inflation, on
inflation as a monetary phenomenon, and on monetary rules rather
than discretion retains lasting influence – yet the k% growth rule
for some monetary aggregate, attempted in Britain, Canada and
the United States in the late 1970s and early 1980s, was abandoned
because of “Goodhart’s law” (targeting a monetary aggregate changes
its relationship to nominal income and other monetary aggregates).
Central banks now target interest rates, not the growth of the money
supply, and the title of Michael Woodford’s Interest and Prices (2003)
underlines a return to the pure-credit economy of Knut Wicksell’s
Interest and Prices (1898), without a role for the quantity of money, in
contrast to the title of Don Patinkin’s Money, Interest and Prices (1965).
Friedman’s argument in 1959 and 1966 that the money demand func-
tion is completely insensitive to interest rates (so that fiscal policy
would be completely crowded out with a vertical LM curve) was
abandoned in 1969 to derive the optimum quantity of money from
the effect of nominal interest on money demand (Friedman 1969,
1–50). Even Friedman and Schwartz’s Monetary History (1963), attrib-
uting the Great Depression to mistaken Federal Reserve policy that
allowed the Great Contraction of the money supply, fit awkwardly
with rational expectations, which suggested that any systematic
monetary policy should have been fully anticipated. But no one
would doubt that Friedman has had a lasting impact on monetary
economics (and on policy discussions: see The Economist 2012, “The
Chicago question: What would Milton Friedman do now?”).
Similarly, the Lucas–Phelps islands model of monetary-misper-
ceptions New Classical economics could only explain the lasting
high unemployment of the 1930s if workers somehow took years to
learn of the Depression and the fall in the price level, and the coun-
tercyclical real wages of monetary-misperceptions New Classical
economics (and also of chapter 2 of Keynes’s General Theory) do
not appear clearly or consistently in the data, any more than the
pro-cyclical real wages of real business cycle theory. (RBC theory’s
unobservable technology shocks, being unobservable, have not been
contradicted by the data.)
Fairly early in the history of New Classical economics, Frederic
Mishkin’s A Rational Expectations Approach to Macroeconometrics:
Testing Policy Ineffectiveness and Efficient-Market Models (1983),
152 James Tobin

working within New Classical methodology, found empirical rejec-

tion of the joint hypothesis that expectations are rational and only
unanticipated money has real effects. Yet methodological aspects of
monetary-misperceptions New Classical economics, such as rational
expectations and the Lucas critique, shaped how monetary econo-
mists think and work. So, too, with Tobin’s approach: empirical
implementation of models with multiple, imperfectly substitutable
assets had problems with multicollinearity and with lack of explicit
solutions of the nonlinear equations describing adjustment. The
Tobin effect in long-run growth models depended on fine points of
model specification, but there still remains the message of paying
attention to stock-flow consistency, to imperfect substitution among
assets, and to modeling economies that are self-adjusting for shocks
up to some limit, but that do not automatically return to potential
output after infrequent large demand shocks.

Corridor of stability

Tobin of course recognized downward stickiness of money wages –

as in Britain following the return to the gold exchange standard at
the pre-war parity in 1925 – as a cause of unemployment, drawing
attention to the relative wage, overlapping contracts explanation
of such stickiness in Keynes (1936, chapter 2) and in John Taylor
(1980). George Akerlof’s and Janet Yellen’s efficiency-wage theory
(1986) and Tobin’s Yale colleague Truman Bewley (1999) showed that
the negative effects of wage cuts on morale and productivity could
deter employers from lowering wages in recession. New Keynesian
economics explored sources of nominal rigidities such as menu costs
and efficiency wages (Mankiw and Romer, eds. 1991, Gali 2008) and
real wage rigidities (Greenwald and Stiglitz 2003). Russell Cooper’s
Coordination Games: Complementarities and Macroeconomics (1998)31
used game theory and strategic complementarity to model the possi-
bility that if all firms hired more workers, the workers would spend
their wages in a way that justified the hiring, but that no firm acting
alone could do this. But where Tobin’s work has most relevance to
current research and current issues does not concern wage stickiness,
but, in the spirit of Keynes (1936, chapter 19), explores why adjust-
ment may fail, even with nominal flexibility, and why faster changes
of prices and nominal wages may make things worse, rather than
 Tobin’s Legacy and Modern Macroeconomics 153

better (Tobin 1975, 1980a, 1993), and Tobin’s argument that greater
microeconomic efficiency of the financial system, faster trading and
capital flows (Tobin 1984a and his writings on restraining specula-
tive international capital flows), a concern that links up with the
studies of overly volatile financial markets by his Yale colleague
Robert Shiller (1989, 2005, see also Colander 1999, Shiller 1999).
Tobin told Robert Shiller (1999, 871), “Keynes argued that even if
money wages were flexible that wouldn’t solve the problem. We would
still have a problem of the adequacy of aggregate demand.” Shiller
then asked, “And you bought that; you buy that?” Tobin responded,

Yes, I “bought that.” I “buy that.” I have presented the models in

which it would be quite reasonable. For one thing, the orthodox
proposition depends on the “real balance effect” of a lower price level.
That is quite dubious, because negative effects on debtors’ spending
could well offset positive effects on creditors. Secondly, expected
disinflation and deflation have negative effects on demand. Thus
the full employment equilibrium can easily be unstable.

As early as 1973, Axel Leijonhufvud (in papers reprinted in

Leijonhufvud 1981) had called for macroeconomic models that were
neither always stable (always self-adjusting back to full employment
after a shock) nor always unstable (not self-adjusting once knocked
off a knife-edge equilibrium), but that would instead be stable within
a “corridor of stability” but unstable for large shocks that pushed the
economy outside this corridor. Tobin (1975) provided an example of
such a model, possibly the first, without citation of Leijonhufvud (or
indeed of anyone except Keynes, Friedman, Blinder and Solow, and
Tobin and Buiter, although other names such as Pigou appeared in
the text without formal citation).
Tobin (1975, 1980a, 1993) pointed out that aggregate expenditure
will be a function not only of the price level, but also of the expected
rate of change of the price level. As Keynes (1936, chapter 19) had
stressed, a lower price level is expansionary (larger real money balances
lower the interest rate) but a falling price level is contractionary
(reducing the opportunity cost of holding real money balances). At
the lower bound for the nominal interest rate (whether at zero or
slightly above), a lower price level can no longer reduce interest rates,
while each additional percentage point of expected deflation raises
154 James Tobin

real interest by one percent, reducing investment. Even in such a

situation, the Pigou real balance effect of a lower price level will still
tend to increase consumption (larger real balances of outside money
mean larger household wealth, Pigou 1947), but Tobin (1980a) and
Minsky (1975, 1982) drew to Irving Fisher’s debt-deflation theory
of depressions (Fisher 1933), that increasing the real value of inside
debt does not simply transfer wealth between borrowers and lenders,
raising risk of bankruptcy and default, which raises risk premiums
and causes a scramble for liquidity (see also Keynes 1931b).
Tobin’s formal model, based on including expected inflation as well
as the price level as an argument in the aggregate expenditure func-
tion, derived a corridor of stability, with the economy self-adjusting
for shocks within the corridor but not for larger shocks taking it
beyond the corridor (see Tobin 1975, Palley 2008, Bruno and Dimand
2009, Dimand 2010a and 2010b). In such a model, faster adjustment
of prices and wages may narrow the corridor of stability. Tobin’s 1975
model was just illustrative of the possibilities, but it demonstrated
that the intuitively attractive notion of a corridor of stability, of an
economy usually self-adjusting but susceptible to macroeconomic
coordination failure in the face of large shocks, could be formally
modeled. Such models, together with Fisher’s debt-deflation process,
the Minsky moment, Keynes, and Shiller’s critique of efficient finan-
cial markets, have received increased attention since the global crisis
began in 2007, with textbooks of course lagging behind research and
public discussion.
Tobin contributed to optimizing foundations for money demand
(1956, 1958a) and money creation (1963, 1982b), to general equi-
librium linkage of markets (1969, 1982a), to rational expectations
(1958a), debt neutrality (1952a), and OLG models (Tobin and Dolde
1983), often objecting to the direction in which others later took
these ideas. Many of his distinctive contributions, like those of
other eminent monetary economists of the past, have lost influence,
partly for reasons specific to aspects of his work (multicollinearity in
models with many financial assets, no closed-form solution for the
nonlinear adjustment equations, results in monetary growth models
that are very sensitive to small changes in specification) and partly
due to more general trends away from Keynesianism and toward
other approaches. But his emphasis on stock-flow consistency (and
his suspicion of using models with a single optimizing representative
 Tobin’s Legacy and Modern Macroeconomics 155

agent to investigate macroeconomic coordination), his approach

to modeling economies that are self-adjusting within a corridor
of stability but not self-adjusting for large shocks, and his concern
that faster financial flows and faster price and wage adjustment may
be undesirable and destabilizing, remain on the agenda of modern
monetary theory.
Notes

1 An American Keynesian
1. Because a snowstorm closed airports on the US East Coast during the
American Economic Association meetings in San Francisco in January
1996, keeping Tobin in Connecticut, I found myself presenting a paper
by Tobin writing as Keynes to the AEA session marking the 60th anni-
versary of The General Theory.
2. Tobin was a consulting editor for Fisher (1997), and a contributor to
Dimand and Geanakoplos (2005), the proceedings of a Yale conference
on Fisher co-organized by Tobin. His earlier articles on Fisher are also
reprinted in the conference volume. Tobin’s close attention to Fisher’s
writings appears to have begun when he was writing (Tobin 1967a) for
Ten Economic Studies in the Tradition of Irving Fisher.
3. Tobin expressed a high opinion of Taylor’s work on staggered contracts
and relative wages when Tobin and Taylor jointly taught graduate money
and finance while Taylor was a visiting professor at Yale in 1979–80.
Later, Tobin took a sympathetic interest in the research of his Cowles
Foundation colleague Truman Bewley (1999), formerly an abstract math-
ematical economist, who (like Blinder 1991) took the daring methodo-
logical step of asking employers why they didn’t cut wages in recessions:
given staggered contracts and that workers care about relative wages,
money wage cuts reduce morale and productivity.
4. Tobin always emphasized his respect for Hicks, for instance traveling
to Glendon College of York University, Toronto, in the summer of 1987,
when Hicks, by then elderly and frail, was visiting there.
5. However, when Colander (1999) asked Tobin “How about real business-
cycle theorists?” Tobin replied “Well, that’s just the enemy.”

2 Transforming the IS-LM Model Sector By Sector

1. In contrast, the index to Hansen (1953) has thirteen entries for Hicks,
suggesting that Hansen made a closer study of Hicks’s writings between
1949 and 1953.
2. While Hansen drew IS and LM in interest and real income space, Hicks
had drawn IS and LL in interest and nominal income space, with capital
goods and consumption goods aggregated only in nominal terms. See
Ingo Barens in Young and Zilberfarb (2000) and De Vroey (2000).
3. The papers by Roy Harrod and James Meade, presented to the same
Econometric Society session in Oxford in September 1936 as Hicks (1937)
and outlining similar systems of equations (Young 1987), were known at

156
 Notes 157

Harvard and reprinted in Harris (1947), immediately following Tobin’s

chapter, but did not offer any of the diagrammatic analysis that was
taken up by Tobin (1947–48) and Hansen (1949).
4. Parts of Schumpeter’s unfinished manuscript, originally to have
been published by Springer in 1930, appeared long after his death as
Schumpeter (1970, 1991, 2014) (see Messori 1997). After Schumpeter’s
death, Tobin was invited by Harris to write the money and banking
volume for the Economic Handbook series. Although he began drafting
it during a sabbatical in Geneva in 1958, it appeared four decades later as
Tobin with Golub (1998).
5. Yale’s first doctoral dissertation in economics, Irving Fisher’s Mathematical
Investigations in the Theory of Value and Prices (1892), was an earlier impor-
tation of general equilibrium analysis into North America, had been
forgotten, and was not cited by either Hicks (1939) or Samuelson (1947).
6. Hansen (1949) also included an accelerator effect in the investment func-
tion, perhaps influenced by Samuelson’s work on multiplier/accelerator
interaction, but his diagrammatic presentation reverted to a simpler
model without wealth or accelerator effects.
7. As an anonymous referee points out, this criticism could also have been
directed against the assumption of money illusion in Tobin’s chapter in
Harris (1947), discussed above.
8. See Bernstein (1992, 46–49) for similar advocacy of portfolio concen-
tration by John Burr Williams and Gerald Loeb, leading authorities on
portfolio investment whose books first appeared in the 1930s (that by
Williams as a Harvard doctoral dissertation). Ivo Maes (1991, 10) notes
that Paul Chambers (1934) had a graph of indifference curves between
risk and return similar to Tobin (1958a, 152), “But the risk under consid-
eration is different. Tobin is concerned about capital gains or losses,
something which is impossible in Chambers’ stationary state. Chambers
is concerned about uncertain future payments.”
9. Edgeworth (1888) derived a square root rule for optimal levels of bank
reserves against deposits, but in a different context (randomness in with-
drawals of deposits) more relevant to Keynes’s precautionary motive
for holding money. Wicksell ([1898] 1936, 57–58) echoed Edgeworth’s
analysis.
10. See Tobin’s “A Final Comment” (in Tobin, ed., 1983), concerning Okun’s
posthumously published Prices and Quantities: A Macroeconomic Analysis
(Okun 1981).
11. Tobin made a similar claim to the middle ground in his debate with
Friedman (in Gordon 1974), in which he argued that the validity of
the Keynesian–Hicksian approach did not depend on the slopes of
IS and LM, provided that the IS curve is not horizontal and the LM
curve is not vertical. He did not have to defend the usefulness of
IS-LM on that occasion, because Friedman had for once used IS-LM
to expound his approach, hoping to improve communication with
his critics.
158 Notes

12. Tobin (1997, 12–13), “writing as J. M. Keynes” for a “second edition”

to mark the sixtieth anniversary of The General Theory, wrote, “In
Chapter 19 I emphasized the negative effects of increasing debt burdens,
and Professor Fisher has made a convincing case that debt burdens
augmented by deflation exacerbated the Great Depression in the United
States. I also agree with Professor Fisher that, whatever may be the effects
of lowering the level of money-wages and prices, the process of moving
to a lower level is counterproductive. Expectations of deflation are
equivalent to an increase in interest rates.”

3 Consumption, Rationing and Tobit Estimation

1. “I like Ike”: political slogan expressing support for then-President Dwight
D. (Ike) Eisenhower.

5 Tobin’s q and the Theory of Investment

1. One may also doubt the claim by Schmidt (1995, 178) that the very
bad translations of Wicksell’s Interest and Prices and Lectures on Political
Economy from Swedish into German acted as a barrier to wider knowl-
edge of Wicksell’s monetary economics, since there is in fact no Swedish
original of Interest and Prices: Wicksell wrote the book in German, in
which he was fluent, and he corrected and revised the German transla-
tion of his Lectures. Wicksell presented a short summary of Interest and
Prices to Section F of the British Association in 1906, and then published
the summary in the Economic Journal (Wicksell 1907).
2. Myrdal’s remark should not be taken to imply that Keynes was uncon-
scious of Wicksell’s influence, or failed to acknowledge it in A Treatise on
Money (Keynes 1930, I, 154, 186, 190, 196–99):
There remains, however, one outstanding attempt at a systematic
treatment, namely Knut Wicksell’s Geldzins und Güterpreise [Interest
and Prices], published in German in 1898, a book which deserves
more fame and much more attention than it has received from
English-speaking economists. In substance and intention Wicksell’s
theory is closely akin (much more closely than Cassel’s version of
Wicksell) to the theory of this Treatise, though he was not successful,
in my opinion, in linking up his Theory of Bank-rate to the Quantity
Equations. (Keynes 1930, I, 186)
“There are many small indications, not lending themselves to quota-
tions, by which one writer can feel whether another writer has at the
back of his head the same root-ideas or different ones. On this test I feel
that what I am trying to say is the same at root as what Wicksell was
trying to say” (Keynes 1930, I, 198n).
3. Thanks to Hans-Michael Trautwein for calling attention to these
passages.
 Notes 159

4 . When reprinting his review in 1963, Hicks recalled that “For

the moment, however, I got more from Sweden than I did from
Cambridge. It was Myrdal’s Monetary Equilibrium which showed me
the power of a short-period analysis in which expectations (certain
or uncertain) are treated as data” (quoted by Dostaler 1990, 210).
Tobin later paid close attention to Hicks’s other macroeconomic
writings from the 1930s (see Tobin 1980a, 1982a, Dimand 2004a),
although not that review. Hicks (1991, 372) wrote of Myrdal’s
Monetary Equilibrium , “as criticism of Wicksell it has hardly even
now been superseded.”
5. Tobin told one of his graduate students that he and Brainard named
q without conscious reference to Keynes (Dimand 1986, 436), and told
another of his former graduate students that he chose the symbol q
“Because ‘p ’ was already taken” (Buiter 2003, F598).
6. Tobin and Brainard (1990, 68, 71n) credit Abba Lerner with having
emphasized short-run increasing marginal costs in the capital goods
industries and the stock-flow confusion in Keynes’s investment function
in 1940.

6 Money and Long-Run Economic Growth

1. Tobin (1955a, p. 103) thanked Solow for comments on the paper.
2. Tobin (1968a) remarked, “An economic historian would be puzzled by
the implication of section 1 that the development of monetary and
financial institutions is in some sense bad for real investment. Without
the safe assets made available by these institutions, how would the thrift
of the cautious saver have been mobilized? The conflict is largely super-
ficial. Financing of capital accumulation is the story of inside money, not
of outside money.”
3 . Tobin (1968b) also demonstrated that, if technology is changing, a
steady state with a transactions requirement for money will exist
only if technical progress is Harrod-neutral and occurs at the same
steady rate for both transactions technology and production of
goods.
4. Levhari and Patinkin (reprinted in Patinkin 1972) put money in the
production function in 1968.
5. Tobin (1980b) expressed strong reservations about how overlapping
generations models incorporate fiat money, so he might not have
welcomed such support (although, as Buiter 2003, F590–93, notes, Tobin
found the Allais-Samuelson-Diamond overlapping generations frame-
work useful for analyzing social security systems).
6. However, for models that view money as an intermediate good (rather
than, for example, putting money in the utility function as Sidrauski
did), there is a public finance argument against taxing intermediate
goods.
160 Notes

9 Tobin’s Legacy and Modern Macroeconomics

1. In the 1970s Tobin, Yellen, William Brainard, and Gary Smith worked on
a manuscript of a textbook on the intellectual development of macroeco-
nomics (Yale University Library 2008, MS 1746, Accession 2004-M-088,
Box 8), begun in the 1960s before Yellen’s arrival as a Yale graduate
student, but it never progressed nearly as far as the manuscript on mone-
tary theory, begun in the 1950s, that eventually became Tobin with Golub
(1998).
2. See Colander et al. (2009), Blanchard (2009) and Laidler (2010) on the
extent to which the crisis might change macroeconomics, and Colander,
ed. (2006) and Colander et al. (2008) for advocacy of moving beyond
dynamic stochastic general equilibrium (DSGE) models to agent-based
simulation, which harks back to the simulation model of Brainard and
Tobin (1968) as well as to the microsimulation studies of Tobin’s colleague,
Guy Orcutt.
3. The index to Snowdon and Vane (2005) has 46 entries for Tobin, but
that book is as much a history of modern macroeconomics as a survey of
current practice.
4. Among “monetarists” (a term coined by Brunner), Karl Brunner and Allan
Meltzer (1993) stood out for their emphasis on multiple, imperfectly
substitutable assets. Given the considerable resemblance between the
structures of their models, Tobin could never understand how Brunner
and Meltzer could get the monetarist result of money having such a
special role among the many imperfectly substitutable assets (apart from
the exogenous fixing of its own-rate of return), and Brunner and Meltzer
could never understand why Tobin didn’t get such a result (see Brunner
1971, Meltzer 1989, and the contributions of Brunner and Meltzer and of
Tobin to Gordon 1974).
5. The typescript of Lecture 2, which is 56 pages long, is not paginated.
Lecture 1, “Major Issues in Monetary Theory,” in typescript, and Lecture
3, “The Transmission of Monetary Impulses,” partly in typescript and
partly in manuscript, are paginated.
6. Minsky (1975) and Tobin (1980) also drew attention to Irving Fisher’s
long-neglected “Debt-Deflation Theory of Great Depressions” (1933).
Minsky and Tobin met as Harvard graduate students competing for the
attention of Leontief and Schumpeter, and their long, uneasy profes-
sional relationship included disagreements about the extent to which
they disagreed with each other (see Dimand 2004b, and Tobin, “The
Minsky Agenda for Reform,” presented 1999 and published in Tobin
2003).
7. Ironically, despite his prompt positive reaction to most of Keynes (1936),
Tobin’s undergraduate honors thesis, nominally supervised by his final-
year tutor, Edward Chamberlin, with more active advice from Wassily
Leontief, and published as Tobin (1941), saw money illusion in Keynes’s
chapter 2 labor supply schedule (a view of Keynes’s labor supply schedule
 Notes 161

also held by Leontief), rather than overlapping contracts and rational

concern with relative wages: “In fact the first thing I wrote and got
published [in 1941] was a piece of anti-Keynesian theory on his problem
of the relation of money wage and employment” (Tobin, interviewed in
Snowdon and Vane 2005, 151). Perhaps that is why Tobin, in his remarks
at the 1983 Keynes Centenary Conference, stated, “I now think, however,
that Keynes provides a theory free of this taint” of money illusion
(reprinted in Tobin 1987, 45, emphasis added). The concept of money illu-
sion is not due to Keynes, but to Irving Fisher, author of The Money Illusion
(1928). Tobin (1941), his “piece of anti-Keynesian theory,” was contempo-
raneous with a distinctly fiscalist and un-monetarist book called Taxing
to Prevent Inflation, a study submitted to the Treasury in the fall of 1941
and co-authored by Milton Friedman (published as Shoup, Friedman, and
Mack 1943).
8. Another fact no longer mentioned in macroeconomics textbooks such
as Romer (2012) is that US gross private domestic investment fell by
94 percent from $16.2 billion in 1929 to $1.0 billion in 1932 and $1.4
billion in 1933 (so that net private domestic investment, which had been
+$8.7 billion in 1929, became negative: -$5.1 billion in 1932 and -$4.3
billion in 1933), which might seem relevant to the Keynesian view of the
fall in equilibrium income in the Depression as the multiplier effect of a
fall in investment driven by a collapse of expectations of future profita-
bility as represented by Keynes’s marginal efficiency of capital or Tobin’s q
(the numerator of Tobin’s q is the market value of capital assets, the present
discounted value of the expected income stream from owning those
assets). Other possible explanations of the drop in investment include the
accelerator effect of the decline of output or transmission of the contrac-
tion of the money supply, but since even bare mention of the 94 percent
drop in gross investment has disappeared from the macroeconomics text-
books, the textbooks cannot discuss how to choose among competing
explanations of the unmentioned phenomenon. Farmer (2010a, 96) notes
“a drop in expenditure on new capital goods from 16% of GDP in 1929 to
6% in 1932” (including public as well as private spending).
9. In his lecture on October 16, 1933, Keynes declared, “the enormous cut in
money wages in the early 1930s in the United States did not have the effect
on unemployment one would expect” (Rymes 1989, 89). In chapter 2 of
The General Theory (1936, 9), Keynes wrote,
the contention that the unemployment which characterises a depres-
sion is due to a refusal by labor to accept a reduction in money wages
is not clearly supported by the facts. It is not very plausible to assert
that unemployment in the United States in 1932 was due to labor
obstinately refusing to accept a reduction of money wages or to its
obstinately demanding a real wage beyond what the productivity of
the economic machine was capable of furnishing.
See also Keynes (1936, chapter 19), Tobin (1975, 1980a, 1993, 1997), and
Dimand (2010a, 2010b).
162 Notes

10. Contrary to criticism of Pigou by some early Keynesians such as

Lawrence Klein (1946), Pigou always advocated, as a matter of practical
policy, aggregate demand expansion rather than wage cuts as the remedy
for unemployment, and considered both his 1933 volume and his later
articles on the real balance effect (e.g., Pigou 1947) as exercises in pure
theory without direct application to policy – hence Keynes’s ironic praise
of Lionel Robbins for advocating deflationary measures consistent with
his theoretical position.
11. Ironically, the “imperfect information” version of New Classical
economics presented in Lucas’s papers (reprinted in Lucas 1981a), in
which employment fluctuates because workers on imperfectly commu-
nicating islands mistake changes in money wages for changes in real
wages, is a formalization of money illusion. To explain the lasting unem-
ployment of the 1930s in this model would require assuming that US
workers took several years to hear about the Great Depression and the
decline in the price level.
12. Interviewed in Snowdon and Vane (2005, 149), Tobin said 19 years old,
but he was born in 1918, entered Harvard in 1935 (graduating in 1939),
and took “Principles of Economics” in 1936–37.
13. “The same crazy graduate student who was my Ec A instructor was also
my tutor” (Tobin, in Shiller 1999, 870); “I didn’t know any better so I
read it, and I didn’t feel it was that difficult” (Tobin, in Snowdon and
Vane 2005, 149).
14. It was reported by journalists Bob Woodward and Scott Armstrong
that, at screenings of films submitted as evidence in First Amendment
freedom of speech cases before the Supreme Court, law clerks would
happily exclaim, “That’s it! That’s it! I know it when I see it.”
15. “The second prong of Keynes’s argument is the futility of wage reduc-
tion. Prices may simply follow wages down, leaving employers with no
incentive to hire any more labor. Doesn’t orthodox theory teach that
price is governed by marginal variable cost?” (Tobin 1974, Lecture 1,
12–13).
16. In the 1970s, Tobin and William Nordhaus constructed a pioneering
“measure of economic welfare” (MEW), one of the first instances of
“green accounting.”
17. Keynes expressed his theory as a four-equation model in a lecture on
December 4, 1933, differing from later IS-LM models by explicitly
including “the state of the news” as an argument in each of the invest-
ment, consumption and liquidity preference (money demand) functions
(see Dimand 1988, 2007, Rymes 1989). David Champernowne and Brian
Reddaway, authors in 1936 of the first two journal articles with systems
of equations equivalent to IS-LM (Hicks’s priority in 1937 was for the
diagram, not the equations), attended Keynes’s lecture, as did Robert
Bryce. Regrettably, Keynes used the symbol W for “the state of the news”
in that lecture, despite having used W for the money wage rate earlier
in the eight-lecture series. Lorie Tarshis, who missed the December 4
 Notes 163

lecture and borrowed and copied Bryce’s notes for it, wrote in the margin
“What the Hell? Ask Bob.” Keynes did not include such a simultaneous
equations model in the book that emerged from his lectures, either
because he became dissatisfied with that tentative statement, or followed
Marshall’s celebrated advice to use mathematics as an aid to thought
but then to burn the mathematics (advice that Marshall did not follow
himself, relegating mathematics to the Mathematical Appendix of his
Principles but publishing the un-burnt appendix).
18. In an endnote added to the reprint of his 1956 article, Tobin (1971–1996,
Volume I, 240 n2) described Baumol (1952) as “a paper which I should
have read before writing this one but did not.” The only citation in Tobin
(1956) was to Hansen (1949), which to some extent was Tobin citing
himself.
19. Louis Bachelier’s 1900 dissertation on the theory of speculation built on
rational expectations even longer before the terminology existed, but
was known only to a few before its first English translation in 1964.
20. “Markowitz’s main interest is prescription of rules of rational behav-
iour for investors; the main concern of this paper is the implications for
economic theory, mainly comparative statics, that can be derived from
assuming that investors do in fact follow such rules” (Tobin 1971–1996,
Volume I, 271 n15).
21. Messori (1997) recounts the even longer history of the book: Tobin agreed
to write the book for McGraw-Hill’s Economic Handbook Series, edited
by Seymour Harris, after the death in 1950 of Joseph Schumpeter, who
had intended to revise and extend a manuscript of his on money (a frag-
ment has been translated as Schumpeter 1991), begun in the 1930s, into
two handbooks on money and banking. Tobin’s work on what became
Money, Credit and Capital was interrupted when he was appointed to
President Kennedy’s Council of Economic Advisers, but draft chapters
were used in Yale monetary and macroeconomics courses for decades.
22. “Milton Friedman has often said that only the monetary liabilities of
banks have macroeconomic significance, and he has excoriated central
bankers for their concerns about ‘credit.’ The common-sense neo-Key-
nesian view is that both sides of intermediary balance sheets matter”
(Tobin 1982c, Lecture 1, 14).
23. Tobin always treated Hicks and Samuelson with the utmost respect and
deference, for example when he travelled to Toronto in the summer of
1987 to be present for Hicks’s visit to Glendon College. Debreu left Yale
for the University of California at Berkeley in 1960 after not receiving
tenure (and later declined to return to take Tjalling Koopmans’s chair
on Koopmans’s retirement), apparently because the economics depart-
ment doubted that Debreu’s future contributions would be in economics
rather than mathematics. It is unlikely that in 1960, Yale’s economics
department would have denied tenure to anyone whom Tobin strongly
wished to receive tenure. Yale made some other curious tenure deci-
sions in economics in the early and mid-1960s, losing Mark Blaug and
164 Notes

Edmund Phelps while granting tenure and a named chair to at least one
person who never published again.
24. Solow (2004, 660) added, “It is not the general appeal to ‘microfounda-
tions’ that Tobin would have rejected in 1968 or 2002; it is rather the
extraordinarily limiting and implausible microfoundations that the
literature seems willing to accept. One could even question whether a
representative-agent model qualifies as microfoundations at all. I realize
that some fashionistas are in fact working to extend the standard model
to allow for heterogeneous agents and various frictions and non-standard
behaviour patterns. More power to them.”
25. Similarly, with regard to Ricardian equivalence (debt neutrality), Shiller
(1999, 872) remarked to Tobin, “In 1952 you were saying that there must
be some tendencies in the direction Ricardo specified” (referring to Tobin
1952, one of the articles following up on his PhD dissertation on saving),
Tobin replied, “Yes, I said that. In the same article I noted some of the
anti-Ricardian arguments of my later paper [Tobin and Buiter 1980b]. I get
credit for a lot of things like that, and then the ideas are pushed beyond
where I intended.” David Ricardo, after mentioning debt neutrality in
his 1820 Encyclopaedia Britannica article on “The Funding System,” had
also discussed in the next paragraph reasons why debt neutrality might
not hold. Thirty years before Barro (1974), John Maynard Keynes also
argued that government debt is not net wealth, in editorial correspond-
ence concerning Michal Kalecki’s 1944 Economic Journal comment on
Pigou’s first article on the real balance effect. Kalecki pointed out that
the real balance effect did not apply to the whole quantity of money,
just outside money (the monetary base) because inside money is some-
one’s liability as well as someone else’s asset. Keynes added that the real
balance effect did not apply to interest-bearing government debt either,
because the value of the bonds was the present value of the implied
liability of taxpayers (Dimand 1991).
26. See Baumol and Tobin (1989) on the priority of Allais’s 1947 derivation
of the square root rule for transactions demand for money – in the same
appendix as Allais’s anticipation of Samuelson’s OLG paper and the same
book as Allais’s anticipation of Phelps’s 1962 “Golden Rule of Economic
Growth” to maximize per capita consumption along a steady-state
growth path. Possibly Anglophone economists might have benefited
from reading French. Edgeworth (1888) had derived the square root rule
for the demand by banks for reserves.
27. The term NAIRU was coined by Tobin in 1980 (see Snowdon and Vane
2005, 402–403) to describe the actual meaning of that rate while taking
away the rhetorical advantage of the adjective “natural.” “Natural” and
“rational” are powerful words in economics: rational distributed lags
enjoyed a brief vogue until people noticed that the adjective only meant
that the lag coefficients were calculated as ratios.
28. Similarly, when Shiller (1999, 878) mentioned the spurious significance
tests resulting from specification searches as “another criticism of much
modern macroeconometrics,” Tobin replied,
 Notes 165

That’s a good criticism. I recall hearing Tjalling Koopmans point it

out, years ago ... The traditional tests wouldn’t apply if you mine data
that way. When I wrote my dissertation and when I wrote my article
on demand estimation it took three days to do a regression with
three independent variables. Since you were not going to do many
of those, you tried to sure to be sure that your specification is what
you really want to test ... I’m not saying it’s a bad thing to have all this
computing power, but the theory of significance tests was based on
the view that you were only going to do one computation.
29. It should be noted when this paper, “A Model of US Financial and
Nonfinancial Economic Behavior,” was reprinted in 1996, it was reti-
tled “Towards General Equilibrium Analysis with Careful Social
Accounting.”
30. For my assignments in econometrics courses in 1978–79, I ran regres-
sions using punch cards, at night in the Yale Computer Center, because
computing time was 80 percent cheaper at night.
31. On the back cover of Cooper (1998), Robert Hall wrote, “Finally, serious
economic theory to tell us what Keynes really meant,” but Keynes was
not mentioned in the text or bibliography.
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The First Economic Reports of Presidents Kennedy and Reagan (Cambridge, MA:
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J. Tobin and W. C. Brainard (1990) “On Crotty’s Critique of q Theory,” Journal
of Post Keynesian Economics 12(4), 543–549, as reprinted in Tobin (1996a),
66–71.
J. Tobin (1991a) “On the Endogeneity of Money Supply,” in Edward J. Nell and
Willi Semmler (eds.) Nicholas Kaldor and Mainstream Economics (London:
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J. Tobin (1991b) Foreword to E. Marz, Schumpeter (New Haven, CT: Yale
University Press).
J. Tobin (1992) “An Old Keynesian Counterattacks,” Eastern Economic Journal
18(4), 387–400.
J. Tobin and W. C. Brainard (1992) “On the Internationalization of Portfolios,”
Oxford Economic Papers 44, 553–565.
J. Tobin (1993) “Price Flexibility and Output Stability: An Old Keynesian
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J. Tobin (1996a) “Poverty in Relation to Macroeconomic Trends, Cycles and
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J. Tobin (1996b) Full Employment and Growth: Further Keynesian Essays on Policy
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J. Tobin (1997) “An Overview of The General Theory,” in Harcourt and Riach,
eds., A “Second Edition” of the General Theory, (London and New York:
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J. Tobin and S. S. Golub (1998) Money, Credit, and Capital (Boston: Irwin
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J. Tobin (2002) Landmark Papers in Macroeconomics Selected by J. Tobin
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J. Tobin (2003) World Finance and Economic Stability: Selected Essays of James
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Index
adaptive expectations, 13, 14, 16
adding-up constraint, 19–20, 23, 39
aggregate consumption, 49–50
aggregate demand, 1, 6, 12, 14, 22,
41–2, 48, 58, 62, 72, 86, 107, 115,
123, 142–3, 145–6, 153, 162n10
Aid to Families with Dependent
Children (AFDC), 107–8
Allais, Maurice, 18, 35, 65
Allais-Baumol-Tobin square root
rule, 19, 24–5, 35, 60, 65, 157n9,
164n27
American Keynesians, 10–23, 25–9,
131
Ando, Albert, 59, 139
animal spirits, 14, 89
applied general equilibrium (AGE),
38
asset markets, 18, 20, 24–5, 38–9, 43,
58–9, 63, 69, 73–4, 85–7, 142–3
asset prices, 25, 34–6, 73, 89
assets, 33, 34, 64
Authers, John, 74
automated payment transaction tax,
128
Bagehot, Walter, 116
balanced budget multiplier, 28
banking system, 8, 11, 78, 143
Barten, Anton, 54
Basmann, Robert, 54
Baumol, William, 18, 35, 65
Bhagwati, Jagdish, 114, 120–3
Black, John D., 46
Bliss, Chester, 56
bonds, 32, 34–5, 57, 65–8,
139–40, 146
Borch, Karl, 33
Boulding, Kenneth, 63
Brainard, William C., 5, 8, 20, 34,
38, 59, 64, 85, 86, 88, 143–4
Brown, A. J., 48
Brumberg, Richard, 139
191
Brunner, Karl, 36–7, 64
Bruno, Ryan, 22, 103, 154
Bryce, Robert, 82, 135
budget deficits, 98
Buiter, Willem, 20, 44, 65, 68, 90–1,
109–10, 145–6
business cycles, 39, 40, 46, 60, 101–2
Cambridge University, 11, 51
Canadian inter-departmental
econometric model (CANDIDE),
148
capital account liberalization, 122–3,
125
capital asset pricing model (CAPM), 19
capital controls, 121–2, 124
capital flows, 36, 43, 113, 119–27,
153
capital formation, 14, 91
cash, 65–6
cash transfers, 109
Champernowne, David, 17
Chicago School, 64, 65, 74, 109, 110
civil rights movement, 106
Clark, John Maurice, 26
classical economics, 15, 16, 22
Cloward, Richard, 108
Colander, David, 11
commercial banks, 69–72, 141
computable general equilibrium
(CGE), 38
computing technology, 47
consumer saving, 45, 48–50
consumption, 38
consumption decisions, 23, 30, 49,
55–6, 62
consumption function, 8, 18,
29–31, 47, 48, 49, 55, 61,
138–9
consumption theories, 30
Cooper, Richard, 122
coordination problem, 20, 23, 39, 60,
102
192 Index
Cowles Commission for Research in
Economics, 4, 5, 33, 34, 47, 56,
58, 59, 147
Crotty, James, 88
Crum, William Leonard, 46
currency, 92–3
markets, 127–8
speculation, 1, 11, 86, 88, 115, 118,
127, 128. see also Tobin tax
tax on trades, 1, 11, 74, 113–29
Cyprus, 126
Dahl, Robert, 106
Davidson, Paul, 118
debt-deflation process, 21
debt neutrality, 50, 164n26
deflation, 41, 133, 153–4
demand shocks, 21–3
Department of Applied Economics
(DAE), Cambridge University, 3,
51
Dimand, R. W., 14, 17, 22, 56, 59, 77,
79, 83, 84, 116, 135, 138, 149,
150, 154
Directly Unproductive (DIP) rent-
seeking lobbying, 122
discrimination, 106, 111
disequilibrium dynamics, 21, 23
doctoral dissertation, 48–50, 63, 138
Dolde, Walter, 50
Domar, Evsey, 91
Dornbusch, Rudiger, 118–19
Drazen, Allan, 150
Duesenberry, James, 29
Durbin, James, 51
‘Dynamic Aggregative Model’ (Tobin),
90–6
dynamic stochastic general
equilibrium (DSGE) models, 71,
160n2
econometrics, 44–62
Econometric Society, 8
economic activity, 85–7
economic growth, 90–105
alternative money growth rules,
98–9
dynamic aggregative model, 91–5
government policy and, 99–101
inflation and, 103–4
models of, 9
money and, 95–8
steady-state, 104–5, 149
economic stability, 2
economic system, as self-adjusting,
20–3
efficiency-wage theory, 152
Eichengreen, Barry, 126
empirical economics, 44
endogenous money, 15, 18, 35, 72
euro, 117, 125, 126, 128
European Central Bank, 126
European Monetary Union (EMU),
126
exchange rates, 115, 117–18, 125, 127
expansionary monetary policy,
99–101
Fair, Ray C., 5, 41, 59
Family Allowance Plan, 110–11
Farmer, Roger, 133
Farrell, Michael, 51, 56, 57
Federal Reserve-MIT-Penn model
(FMP), 38, 59
Feige, Edgar L., 128
Feldstein, Martin, 33
Fellner, William, 5, 27, 63
fiat money, 39, 98
financial crises, 119, 123, 126, 128–9,
131
financial markets, 115, 117–18, 127–9
fiscal policy, 1, 6, 17, 27, 100
Fischer, Stanley, 97, 123, 150
Fisher, Irving, 10, 18, 21, 29, 30, 49,
64, 65, 87, 133, 140, 149–50,
157n5, 160n6
flash crash, 128
food demand study, 45, 47, 50–5, 58
foreign direct investment, 127
Freedom Summer, 106
Free Trade Agreement of the Americas
(FTAA), 120
Frickey, Edwin, 46
Friedman, Milton, 1, 12–14, 16, 17,
30, 33, 63–6, 98, 107, 109, 110,
150, 151, 163n22
Friedman-Phelps expectations-
adjusted Phillips curve, 146
 Index 193

full employment, 2, 9, 15, 21–2, 42, Hayashi, Fumio, 31, 86

43, 107, 112, 134 Hayek, Friedrich A., 107, 135
Heilbroner, Robert, 3
Geanakoplos, John, 5 Heller, Walter, 6
general equilibrium, 38–44, 58–61, 71, Hendry, David, 53
143–6 Herrnstein, Richard, 109, 111–12
“General Equilibrium Approach to Hicks, John R., 7, 10, 18, 32, 43, 48,
Monetary Theory” (Tobin), 24, 69, 137–8, 159n4
34, 37–8, 44, 58–61, 131, 143–6 Hicks-Hansen diagram, 26, 48, 58, 138
General Theory of Employment, Interest high-frequency computerized trading,
and Money (Keynes), 2, 10, 12–16, 128, 129
23, 26–7, 55, 58, 74–7, 89, 101, household survey data, 52, 56, 58, 61
130–5 Hume, David, 12, 64
Germany, 126 Huntington, E. V., 45
Geweke, John, 40
global capital flows, 119–27 Iceland, 126
global currency, 125–6 imperfect information, 162n11
global economy, 113–19 income, 50
global financial crisis, 2, 128–9, 131, 147 income elasticity, 54
globalization, 114, 120–4 income redistribution, 111
Goldberger, Arthur, 30, 57 inequality, 106–12
“Golden Rule” literature, 99, 100 inflation, 71, 97–9, 103–4, 146, 149,
Golub, Stephen S., 6, 18, 27, 35, 64, 150, 151, 154
71, 74–5, 76, 85, 91, 140, 141 intellectual property rights, 122
Goodhart’s Law, 71, 151 interest-elasticity of transactions, 65–6
government interest rate, 24, 31–5, 66, 72, 139–40,
bonds, 68 151
economic growth as objective for, international currency transactions,
99–101 74, 113–29
role of, 1, 6 International Monetary Fund (IMF),
government budget constraint, 39, 121, 123, 127
98, 149 international monetary system,
Granger, Clive, 59 113–29
Great Depression, 2, 9, 10, 11, 14, 24, investment, 18, 31, 142
43, 49, 61–2, 73, 89, 115, 133–6, investment decisions, 8–9, 19, 66–9,
142, 151 139–40
Greece, 126 investment function, 24, 31, 97,
green accounting, 1, 9 157n6
Greenspan, Alan, 86–7 investment theory, 73–89
growth theory, 90–5, 101–5 see also Tobin’s q
Grunfeld, Yehuda, 86–7 IS curve, 29–31, 65–6
guaranteed minimum income, 109, 111 IS-LM framework, 7–8, 69, 72, 142–3,
157n11, 162n17
Haavelmo, Trygve, 3, 47 Hicks-Hansen diagram, 26, 48, 58,
Hansen, Alvin, 2, 7, 16, 24, 26, 27, 28, 138
30, 48, 58, 135–6, 138 microeconomic foundations for,
Harris, Seymour, 24, 27 16–20
Harrod, Roy F., 91 Mundell-Fleming open economy,
Harvard University, 2–3, 45–8 125–6
194 Index
IS-LM framework – continued
short-run, 149
Tobin’s analysis of, 24–43
transforming, 24–43
Italy, 126
Jencks, Christopher, 111
John Bates Clark Medal, 63
John Danz Lectures, 130, 136–7
Johnson, Harry G., 3
Kahn, Richard F., 11
Kaldor, Nicholas, 11, 91
Katona, George, 55–6
Kennedy, John F., 6, 7
Keynes, John Maynard, 2, 10, 11,
28–9, 62, 130, 133, 139
General Theory of Employment,
Interest and Money, 12–16, 23,
26–7, 55, 58, 74–7, 89, 101, 130,
132, 133–5
lectures by, 82–5
liquidity preference, 32
Q of, 76–9, 82–5
speculative motive, 31–2, 66
Treatise on Money, 11, 26, 71, 76–9,
85, 89
Keynes effect, 23
Keynesian economics, 1, 7–9
central propositions of, 12–16
erosion of influence of, 146–52
Klein, Lawrence, 11, 47, 48, 58, 131
Klevorick, Alvin, 53
knife-edge equilibrium, 91–2
Koopmans, Tjalling, 4, 59
Krugman, Paul, 4, 8, 113, 115, 121
Kydland, Finn, 102
labor demand curve, 13
labor markets, 13, 23, 112
Latin Monetary Union, 116
Laughlin, J. Laurence, 65
Leamer, Edward, 53, 59
Leijonhufvud, Axel, 153
Leontief, Wassily, 2, 29, 47, 87
LeRoy, Stephen, 134
Levhari, David, 150
life-cycle hypothesis, 38
liquidity/money (LM) curve, 31–8, 63,
65–6
see also IS-LM framework
liquidity preference, 18, 19, 31–4, 48,
66–9, 93, 140, 142
see also money demand
Liu, T. C., 60, 61
long-run expectations, 14
Lucas, Robert, 14, 16, 38, 42, 59,
102–3, 131, 147, 152
macroeconomic models, 44
macroeconomic theory, 10–11, 38–42,
101–5
Magnus, Jan, 52, 53, 54
market, as self-correcting, 15
Markowitz, Harry, 32–3, 67, 68, 140
Marschak, Jacob, 4, 58–9
Marshall, Alfred, 12
mathematical statistics, 46–7, 56
McGovern, George, 111
McKinnon, Ronald, 126
means testing, 107–8
Meltzer, Alan, 36–7, 160n4
Metzler, Lloyd, 3
microeconomics, 16–20
microeconomic theory, 31–8, 138–43
Minsky, Hyman, 3, 21, 87, 132
Mishkin, Frederic, 151–2
MIT-Penn-SSRC model (MPS), 38, 59
Modigliani, Franco, 11, 38, 59, 131,
138–9
monetarism, 1, 146, 149, 160n4
monetary economists, 130–4
Monetary Equilibrium (Myrdal), 79–82
monetary modeling, 58–61
monetary policy, 1, 6, 8–9, 17,
99–101, 141–2
monetary theory, 64–5, 69–72, 73,
143–6, 149–51
Monetary Theory and Fiscal Policy
(Hansen), 135–6
money, 34, 37
alternative money growth rules,
98–9
creation, 63, 69–72, 98, 141, 154
economic growth and, 95–8
endogenous, 15, 18, 35, 72
fiat, 39, 98
theory of, 18, 64–5, 69–72, 149–50
Money, Credit and Capital (Tobin with
Golub), 6, 64, 141

“Money and Economic Growth”
(Tobin), 91
money demand, 8, 18–20, 31–5, 63,
65–9, 139–40, 142, 154
money illusion, 29
money market equilibrium, 24
money supply, 15, 18, 35–7, 71, 72,
97, 141, 142, 149–50, 151
money wages, 13, 15, 20–1, 29, 66,
96–7, 126, 131–4, 152–3, 161n9
Morgan, Mary S., 52
Mosak, Jacob, 58
multi-asset model, 20
Multilateral Agreement on Investment
(MAI), 120
multiple regression analysis, 57
Mundell, Robert, 114, 116, 125–8,
149
Mundell-Tobin effect, 149, 150
Murray, Charles, 109, 111–12
Myrdal, Gunnar, 75–6, 79–82, 84–5,
158n2
Nagatani, Keizo, 21
natural rate of unemployment, 15, 23
near-money demand, 31–2
negative demand shocks, 15, 21–3,
40
negative income tax (NIT), 108–9
neoclassical growth model, 9, 93–4
New Classical economics, 1–2, 8, 10,
13–16, 40–1, 44, 131, 133, 146–8,
151–2, 162n11
New Economics, 6
new growth literature, 102–3
New Jersey Negative Income Tax
Experiment, 108–9
New Keyenesians, 10, 102, 131, 152
nominal wages, 11–13, 38, 126, 134,
152
non-accelerating inflation rate of
unemployment (NAIRU), 146–7,
164n28
Nordhaus, William D., 5, 9
Nordhaus-Tobin Measure of Economic
Welfare, 1, 9
numerical general equilibrium (NGE),
38
Okun, Arthur, 4–5, 37, 41
Index 195
Old Keynesians, 10, 23, 24, 38–42, 85,
106, 130–4
overlapping generations (OLG)
models, 20, 146–8, 150, 159n5
Papademos, Luca, 126
Patinkin, Don, 5–6, 21–2, 150, 151
Phelps, Edmund, 98–9
Phillips curve, 13, 146
physical capital, 92
Pigou, A. C., 21, 134, 154, 162n10
Pigou-Haberler real balance effect, 21,
41–2
Piven, Frances Fox, 108
Pollard, Spencer, 10, 27, 135
portfolio balance, 93
portfolio capital flows, 115–16
portfolio choice, 32–7, 66–9, 97,
140–1, 148–9
Portugal, 126
Posner, Richard, 135
Post Keynesians, 10, 23, 86, 87–8, 118,
131
poverty, 106–12
Prescott, Edward, 102
presidential election (1936), 46
President’s Council of Economic
Advisers, 6–7, 61, 64, 107, 113,
123
price flexibility, 41–2
price level, 153–4
probit regression, 56–7
production function, 92, 150
public assistance, 107–8, 109–12
public policy, 7
Purvis, Douglas, 37
Q
see also Tobin’s q
of Keynes, 76–9, 82–5
of Myrdal, 79–82, 84–5
q theory of investment, 31, 35–6
rational agents, 31–2
rational expectations, 14, 16, 19,
31–2, 34, 82, 88, 117, 131, 140,
146, 151–2
rationing, 56, 58
real aggregate demand, 42
real business cycles, 101–2, 146
196 Index

real wages, 13–16, 132, 133 square root rule, 19, 24–5, 35, 60, 65,
Reddaway, W. Brian, 17 157n9, 164n27
redistribution, 111–12 Srinivasan, T. N., 5, 120
relative wages, 29, 132 stability, 20–3, 42, 153, 154
representative agent models, 1, stabilization policy, 9–11, 112
39–41, 102, 143–4 Staehle, Hans, 46
Ricardian equivalence, 50, 164n26 steady-state growth, 104–5, 149
Ricardo, David, 164n26 Stevenson, Adlai, 6
risk, 33, 66–9, 140 Stigler, George, 109
risk aversion, 19 Stigler, Stephen, 46
Robertson, Dennis, 40 Stiglitz, Joseph, 114, 121, 123–5, 127
Robinson, Joan, 11 stochastic growth model, 102
Romer, Paul, 102–3, 133 stock-flow models, 36
Rubin, Robert, 123 Stone, Richard, 3, 51
Summers, Lawrence, 124
Salant, William, 28 supply-side economics, 125
Samuelson, Paul A., 3, 11, 28, 45, 47, Survey Research Center, 55–6
49, 63, 131 Swan, Trevor, 93–4
Sargent, Thomas, 14, 38 Sweezy, Paul, 81–2
saving function, 138–9
savings, 8, 29–30, 36, 38, 48, taxation, 98–9, 113–29
49–50 tax cuts, 6, 125
Scarf, Herbert, 5 Taylor, John, 29, 132
Schmidt, K. J. W., 80–1, 84–5 temporary assistance to needy families
Schumpeter, Joseph, 2, 27–8, 48, 87, (TANF), 111
113, 157n4 A Theoretical and Statistical Analysis
seigniorage, 98, 150 of Consumer Saving (Tobin), 48,
Sharpe, William, 33 49–50, 138
Shiller, Robert J., 5, 19, 39, 53, 58, 59, Thornton, Henry, 12
115, 130–1, 147, 153 time-series data, 44–5, 51–2, 54–5,
shocks, 15, 21–3, 40, 42, 155 58, 61
Shubik, Martin, 5 Tobin, Elizabeth, 3, 4
Sidrauski, Miguel, 150 Tobin, James
Simons, Henry, 110 doctoral dissertation of, 48, 49–50,
Sims, Christopher, 5, 60 63, 138
simulating nonlinear dynamics (SND), as econometrician, 44–62
148 economic growth and, 90–105
Smith, Gary, 37, 60–1, 148–9 influences on, 2–3, 7–8, 10, 45–6,
socialized medicine, 110 48, 134–8
social policy, 107–12 IS-LM framework analysis of, 24–43
Social Security, 50, 145–6 as Keynesian, 10–23, 130–8
social welfare, 100–1 legacy of, 130–55
Solow, Robert M., 3, 6, 11, 46–7, 90, life and career of, 1–9
93–5, 104, 131, 144–5 loss of influence of, 146–52
Sorenson, Theodore, 6 Tobin estimator, 1
Spain, 126 Tobin separation theorem, 1, 67, 140
specific egalitarianism, 109–10 Tobin’s q, 1, 8, 11, 14, 18, 31, 35–6,
speculative bubbles, 89 72, 73–89, 142
speculative motive, 31–3, 66 Tobin tax, 1, 11, 74, 113–29
 Index 197

Tobit estimator, 1, 55–8 Walras’s Law, 19–20, 22, 39, 40

Tobit model, 30, 44, 45, 57–8
transaction costs, 19
transaction motive, 31–2, 34–5
transfer payments, 109
Treatise on Money (Keynes), 11, 26, 71,
76–9, 85, 89
uncertainty, 17, 140
unemployment, 12–13, 15, 21, 23, 73,
107, 112, 132–6, 146–7, 152
University of Chicago, 4, 33
utility function, 150
vector autogression (VAR), 60
wage flexibility, 21–2
wages, 12, 13, 15, 41, 132–4, 152–3,
161n9
Wallace, Neil, 14
Wall-Street Treasury complex, 123
Walras-Keynes-Phillips model, 21,
22–3
Warburton, Clark, 17, 63
War on Poverty, 107
Washington consensus, 122–5
Watson, G. S., 51
wealth, 18, 20, 29–30, 39, 50,
93
wealth constraint, 24
welfare, 107–8, 109–12
Wicksell, Knut, 71, 158n1
Williams, John H., 26
Wilson, Edwin B., 2, 46
windfalls, 78
Woodford, Michael, 71, 102, 151
World Bank, 123
Wouk, Herman, 3
Wulwick, Nancy, 54
Yale School, 36–8, 64, 65, 70, 73–4,
149
Yale University, 3, 4–5, 17, 33
Yellen, Janet, 130
Yoon, Bong Joon, 54