UNIT II

The Keynesian Theory of Money and Prices (Assumptions, Superiority and Criticisms) |
Economics
Keynes does not agree with the older quantity theorists that there is a direct and proportional
relationship between quantity of money and prices. According to him, the effect of a change in
the quantity of money on prices is indirect and non-proportional.

Keynes complains “that economics has been divided into two compartments with no doors or
windows between the theory of value and the theory of money and prices.” This dichotomy
between the relative price level (as determined by demand and supply of goods) and the absolute
price level (as determined by demand and supply of money) arises from the failure of the
classical monetary economists to integrate value theory with monetary theory. Consequently,
changes in the money supply affect only the absolute price level but exercise no influence on the
relative price level.

Further, Keynes criticises the classical theory of static equilibrium in which money is regarded as
neutral and does not influence the economy’s real equilibrium relating to relative prices.
According to him, the problems of the real world are related to the theory of shifting equilibrium
whereas money enters as a “link between the present and future”.

Keynes’s Reformulated Quantity Theory of Money:

The Keynesian reformulated quantity theory of money is based on the following:

Assumptions:
1. All factors of production are in perfectly elastic supply so long as there is any unemployment.

2. All unemployed factors are homogeneous, perfectly divisible and interchangeable.

3. There are constant returns to scale so that prices do not rise or fall as output increases.

4. Effective demand and quantity of money change in the same proportion so long as there are
any unemployed resources.

Given these assumptions, the Keynesian chain of causation between changes in the quantity of
money and in prices is an indirect one through the rate of interest. So when the quantity of
money is increased, its first impact is on the rate of interest which tends to fall. Given the
marginal efficiency of capita], a fall in the rate of interest will increase the volume of investment.
The increased investment will raise effective demand through the multiplier effect thereby
increasing income, output and employment. Since the supply curve of factors of production is
perfectly elastic in a situation of unemployment, wage and non-wage factors are available at
constant rate of remuneration. There being constant returns to scale, prices do not rise with the
increase in output so long as there is any unemployment.

Under the circumstances, output and employment will increase in the same proportion as
effective demand, and the effective demand will increase in the same proportion as the quantity
of money. But “once full employment is reached, output ceases to respond at all to changes in
the supply of money and so in effective demand. The elasticity of supply of output in response to
changes in the supply, which was infinite as long as there was unemployment falls to zero. The
entire effect of changes in the supply of money is exerted on prices, which rise in exact
proportion with the increase in effective demand.”

Thus so long as there is unemployment, output will change in the same proportion as the quantity
of money, and there will be no change in prices; and when there is full employment, prices will
change in the same proportion as the quantity of money. Therefore, the reformulated quantity
theory of money stresses the point that with increase in the quantity of money prices rise only
when the level of full employment is reached, and not before this.

This reformulated quantity theory of money is illustrated in Figure 67.1 (A) and (B) where OTC
is the output curve relating to the quantity of money and PRC is the price curve relating to the
quantity of money. Panel A of the figure shows that as the quantity of money increases from О to
M, the level of output also rises along the ОТ portion of the OTC curve.

As the quantity of money reaches OM level, full employment output OQF is being produced. But
after point T the output curve becomes vertical because any further increase in the quantity of
money cannot raise output beyond the full employment level OQF.
Panel В of the figure shows the relationship between quantity of money and prices. So long as
there is unemployment, prices remain constant whatever the increase in the quantity of money.
Prices start rising only after the full employment level is reached.

In the figure, the price level OP remains constant at the OM quantity of money corresponding to
the full employment level of output OQ1. But an increase in the quantity of money above OM
raises prices in the same proportion as the quantity of money. This is shown by the RC portion of
the price curve PRC.
Keynes himself pointed out that the real world is so complicated that the simplifying
assumptions, upon which the reformulated quantity theory of money is based, will not hold.
According to him, the following possible complications would qualify the statement that so long
as there is unemployment, employment will change in the same proportion as the quantity of
money, and when there is full employment, prices will change in the same proportion as the
quantity of money.”

(1) “Effective demand will not change in exact proportion to the quantity of money.

(2) Since resources are homogenous, there will be diminishing, and not constant returns as
employment gradually increases.

(3) Since resources are not interchangeable, some commodities will reach a condition of inelastic
supply while there are still unemployed resources available for the production of other
commodities.

(4) The wage-unit will tend to rise, before full employment has been reached.

(5) The remunerations of factors entering into marginal cost will not all change in the same
proportion.”

Taking into account these complications, it is clear that the reformulated quantity theory of
money does not hold. An increase in effective demand will not change in exact proportion to the
quantity of money, but it will partly spend itself in increasing output and partly in increasing the
price level. So long as there are unemployed resources, the general price level will not rise much
as output increases. But a sudden large increase in aggregate demand will encounter bottlenecks
when resources are still unemployed.
It may be that the supply of some factors becomes inelastic or others may be in short supply and
are not interchangeable. This may lead to increase in marginal cost and price. Price would
accordingly rise above average unit cost and profits would increase rapidly which, in turn, tend
to raise money wages owing to trade union pressures. Diminishing returns may also set in. As
full employment is reached, the elasticity of supply of output falls to zero and prices rise in
proportion to the increase in the quantity of money.

The complicated model of the Keynesian theory of money and prices is shown diagrammatically
in Figure 67.2 in terms of aggregate supply (S) and aggregate demand (D) curves. The price level
is measured on the vertical axis and output on the horizontal axis.

According to Keynes, an increase in the quantity of money increases aggregate money demand
on investment as a result of the fall in the rate of interest. This increases output and employment
in the beginning but not the price level. In the figure, the increase in the aggregate money
demand from D1 to D2 raises output from OQ1 to OQ2 but the price level remains constant at OP.
As aggregate money demand increases further from D2 to D3 output increases from OQ2 to
OQ3 and the price level also rises to OP3.
This is because costs rise as bottlenecks develop through the immobility of resources.
Diminishing returns set in and less efficient labour and capital are employed. Output increases at
a slower rate than a given increase in aggregate money demand, and this leads to higher prices.
As full employment is approached, bottlenecks increase. Further-more, rising prices lead to
increased demand, especially for stocks. Thus prices rise at an increasing rate. This is shown
over the range in the figure.

But when the economy reaches the full employment level of output, any further increase in
aggregate money demand brings about a proportionate increase in the price level but output
remains unchanged at that level. This is shown in the figure when the demand curve D5 shifts
upward to D6 and the price level increases from OP5 to OP6 while the level of output remains
constant at OQF.
Superiority of the Keynesian Theory over the Traditional Quantity Theory of Money:
The Keynesian theory of money and prices is superior to the traditional quantity theory of money
for the following reasons.

Keynes’s reformulated quantity theory of money is superior to the traditional approach in that he
discards the old view that the relationship between the quantity of money and prices is direct and
proportional. Instead, he establishes an indirect and non-proportional relationship between
quantity of money and prices.

In establishing such a relationship, Keynes brought about a transition from a pure monetary
theory of prices to a monetary theory of output and employment. In so doing, he integrates
monetary theory with value theory. He integrates monetary theory with value theory and also
with the theory of output and employment through the rate of interest.

In fact, the integration between monetary theory and value theory is done through the theory of
output in which the rate of interest plays the crucial role. When the quantity of money increases
the rate of interest falls which increases the volume of investment and aggregate demand thereby
raising output and employment. In this way, monetary theory is integrated with the theory of
output and employment.

As output and employment increase they further raise the demand for factors of production.
Consequently, certain bottlenecks appear which raise the marginal cost including money wage
rates. Thus prices start rising.

Monetary theory is integrated with value theory in this way. The Keynesian theory is, therefore,
superior to the traditional quantity theory of money because it does not keep the real and
monetary sectors of the economy into two separate compartments with ‘no doors or windows
between the theory of value and the theory of money and prices.’

Again, the traditional quantity theory is based on the unrealistic assumption of full employment
of resources. Under this assumption, a given increase in the quantity of money always leads to a
proportionate increase in the price level. Keynes, on the other hand, believes that full
employment is an exception.
Therefore, so long as there is unemployment, output and employment will change in the same
proportion as the quantity of money, but there will be no change in prices; and when there is full
employment, prices will change in the same proportion as the quantity of money. Thus the
Keynesian analysis is superior to the traditional analysis because it studies the relationship
between the quantity of money and prices both under unemployment and full employment
situations.

Further, the Keynesian theory is superior to the traditional quantity theory of money in that it
emphasises important policy implications. The traditional theory believes that every increase in
the quantity of money leads to inflation.

Keynes, on the other hand, establishes that so long as there is unemployment, the rise in prices is
gradual and there is no danger of inflation. It is only when the economy reaches the level of full
employment that the rise in prices is inflationary with every increase in the quantity of money.
Thus “this approach has the virtue of emphasising that the objectives of full employment and
price stability may be inherently irreconcilable.”

Criticisms of Keynes Theory of Money and Prices:

Keynes’ views on money and prices have been criticised by the monetarists on the following
grounds.

1. Direct Relation:
Keynes mistakenly took prices as fixed so that the effect of money appears in his analysis in
terms of quantity of goods traded rather than their average prices. That is why Keynes adopted
an indirect mechanism through bond prices, interest rates and investment of the effects of
monetary changes on economic activity. But the actual effects of monetary changes are direct
rather than indirect.

2. Stable Demand for Money:

Keynes assumed that monetary changes were largely absorbed by changes in the demand for
money. But Friedman has shown on the basis of his empirical studies that the demand for money
is highly stable.

3. Nature of Money:
Keynes failed to understand the true nature of money. He believed that money could be
exchanged for bonds only. In fact, money can be exchanged for many different types of assets
like bonds, securities, physical assets, human wealth, etc.
4. Effect of Money:
Since Keynes wrote for a depression period, this led him to conclude that money had little effect
on income. According to Friedman, it was the contraction of money that precipitated the
depression. It was, therefore, wrong on the part of Keynes to argue that money had little effect on
income. Money does affect national income.

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Friedman’s Theory of the Demand for Money (Theory and Criticisms)

Friedman’s Theory:
In his reformulation of the quantity theory, Friedman asserts that “the quantity theory is in the
first instance a theory of the demand for money. It is not a theory of output, or of money income,
or of the price level.” The demand for money on the part of ultimate wealth holders is formally
identical with that of the demand for a consumption service. He regards the amount of real cash
balances (M/P) as a commodity which is demanded because it yields services to the person who
holds it. Thus money is an asset or capital good. Hence the demand for money forms part of
capital or wealth theory.

For ultimate wealth holders, the demand for money, in real terms, may be expected to be a
function primarily of the following variables:

1. Total Wealth:
The total wealth is the analogue of the budget constraint. It is the total that must be divided
among various forms of assets. In practice, estimates of total wealth are seldom available.
Instead, income may serve as an index of wealth. Thus, according to Friedman, income is a
surrogate of wealth.

2. The Division of Wealth between Human and Non-Human Forms:

The major source of wealth is the productive capacity of human beings which is human wealth.
But the conversion of human wealth into non-human wealth or the reverse is subject to
institutional constraints. This can be done by using current earnings to purchase non-human
wealth or by using non-human wealth to finance the acquisition of skills. Thus the fraction of
total wealth in the form of non-human wealth is an additional important variable. Friedman calls
the ratio of non-human to human wealth or the ratio of wealth to income as w.
3. The Expected Rates of Return on Money and Other Assets:
These rates of return are the counterparts of the prices of a commodity and its substitutes and
complements in the theory of consumer demand. The nominal rate of return may be zero as it
generally is on currency, or negative as it sometimes is on demand deposits, subject to net
service charges, or positive as it is on demand deposits on which interest is paid, and generally
on time deposits. The nominal rate of return on other assets consists of two parts: first, any
currently paid yield or cost, such as interest on bonds, dividends on equities, and costs of storage
on physical assets, and second, changes in the prices of these assets which become especially
important under conditions of inflation or deflation.

4. Other Variables:
Variables other than income may affect the utility attached to the services of money which
determine liquidity proper. Besides liquidity, variables are the tastes and preferences of wealth
holders. Another variable is trading in existing capital goods by ultimate wealth holders. These
variables also determine the demand function for money along-with other forms of wealth. Such
variables are noted as u by Friedman.

Broadly, total wealth includes all sources of income or consumable services. It is capitalised
income. By income, Friedman means “permanent income” which is the average expected yield
on wealth during its life time.

Wealth can be held in five different forms: money, bonds, equities, physical goods, and human
capital. Each form of wealth has a unique characteristic of its own and a different yield.

1. Money is taken in the broadest sense to include currency, demand deposits and time deposits
which yield interest on deposits. Thus money is luxury good. It also yields real return in the form
of convenience, security, etc. to the holder which is measured in terms of the general price level
(P).

2. Bonds are defined as claim to a time stream of payments that are fixed in nominal units.

3. Equities are defined as a claim to a time stream of payments that are fixed in real units.

4. Physical goods or non-human goods are inventories of producer and consumer durable.

5. Human capital is the productive capacity of human beings. Thus each form of wealth has a
unique characteristic of its own and a different yield either explicitly in the form of interest,
dividends, labour income, etc., or implicitly in the form of services of money measured in terms
of P, and inventories. The present discounted value of these expected income flows from these
five forms of wealth constitutes the current value of wealth which can be expressed as:

W = y/r

Where W is the current value of total wealth, Y is the total flow of expected income from the
five forms of wealth, and r is the interest rate. This equation shows that wealth is capitalised
income. Friedman in his latest empirical study Monetary Trends in the United States and the
United Kingdom (1982) gives the following demand function for money for an individual wealth
holder with slightly different notations from his original study of 1956 as:

M/P = f (y, w; Rm, Rb, Re, gp, u)

Where M is the total stock of money demanded; P is the price level; у is the real income; w is the
fraction of wealth in non-human form: Rm is the expected nominal rate of return on money; Rb is
the expected rate of return on bonds, including expected changes in their prices; Re is the
expected nominal rate of return on equities, including expected changes in their prices; gp=(1/P)
(dP/dt) is the expected rate of change of prices of goods and hence the expected nominal rate of
return on physical assets; and и stands for variables other than income that may affect the utility
attached to the services of money.
The demand function for business is roughly similar, although the division of total wealth and
human wealth is not very useful since a firm can buy and sell in the market place and hire its
human wealth at will. But the other factors are important.

The aggregate demand function for money is the summation of individual demand functions with
M and у referring to per capita money holdings and per capita real income respectively, and w to
the fraction of aggregate wealth in nonhuman form.

The demand function for money leads to the conclusion that a rise in expected yields on different
assets (Rb, Re and gp) reduces the amount of money demanded by a wealth holder, and that an
increase in wealth raises the demand for money. The income to which cash balances (M/P) are
adjusted is the expected long term level of income rather than current income being received.
Empirical evidence suggests that the income elasticity of demand for money is greater than unity
which means that income velocity is falling over the long run. This means that the long run
demand for money function is stable and is relatively interest inelastic, as shown in fig. 68.1.
where MD is the demand for money curve. If there is change in the interest rate, the long-run
demand for money is negligible.
In Friedman’s restatement of the quantity theory of money, the supply of money is independent
of the demand for money. The supply of money is unstable due to the actions of monetary
authorities. On the other hand, the demand for money is stable. It means that money which
people want to hold in cash or bank deposits is related in a fixed way to their permanent income.

If the central bank increases the supply of money by purchasing securities, people who sell
securities will find their holdings of money have increased in relation to their permanent income.
They will, therefore, spend their excess holdings of money partly on assets and partly on
consumer goods and services.

This spending will reduce their money balances and at the same time raise the nominal income.
On the contrary, a reduction in the money supply by selling securities on the part of the central
bank will reduce the holdings of money of the buyers of securities in relation to their permanent
income.

They will, therefore, raise their money holdings partly by selling their assets and partly by
reducing their consumption expenditure on goods and services. This will tend to reduce nominal
income. Thus, on both counts, the demand for money remains stable. According to Friedman, a
change in the supply of money causes a proportionate change in the price level or income or in
both. Given the demand for money, it is possible to predict the effects of changes in the supply of
money on total expenditure and income.

If the economy is operating at less than full employment level, an increase in the supply of
money will raise output and employment with a rise in total expenditure. But this is only possible
in the short run. Friedman’s quantity theory of money is explained in terms of Figure 68.2.
Where income (Y) is measured on the vertical axis and the demand for the supply of money are
measured on the horizontal axis. MD is the demand for money curve which varies with income.
MS is the money supply curve which is perfectly inelastic to changes in income. The two curves
intersect at E and determine the equilibrium income OY. If the money supply rises, the MS curve
shifts to the right to M1S1. As a result, the money supply is greater than the demand for money
which raises total expenditure until new equilibrium is established at E1 between MD and M1S1,
curves. The income rises to OY1.

Thus Friedman presents the quantity theory as the theory of the demand for money and the
demand for money is assumed to depend on asset prices or relative returns and wealth or income.
He shows how a theory of the stable demand for money becomes a theory of prices and output.
A discrepancy between the nominal quantity of money demanded and the nominal quantity of
money supplied will be evident primarily in attempted spending. As the demand for money
changes in response to changes in its determinants, it follows that substantial changes in prices or
nominal income are almost invariably the result of changes in the nominal supply of money.

Its Criticisms:
Friedman’s reformulation of the quantity theory of money has evoked much controversy and has
led to empirical verification on the part of the Keynesians and the Monetarists. Some of the
criticisms levelled against the theory are discussed as under.

1. Very Broad Definition of Money:

Friedman has been criticised for using the broad definition of money which not only includes
currency and demand deposits (М1) but also time deposits with commercial banks (M2). This
broad definition leads to the obvious conclusion that the interest elasticity of the demand for
money is negligible. If the rate of interest increases on time deposits, the demand for them (M 2)
rises. But the demand for currency and demand deposits (M1) falls.
So the overall effect of the rate of interest will be negligible on the demand for money. But
Friedman’s analysis is weak in that he does not make a choice between long-term and short-term
interest rates. In fact, if demand deposits (M1) are used a short-term rate is preferable, while a
long-term rate is better with time deposits (M2). Such an interest rate structure is bound to
influence the demand for money.
2. Money not a Luxury Good:
Friedman regards money as a luxury good because of the inclusion of time deposits in money.
This is based on his finding that there is higher trend rate of the money supply than income in the
United States. But no such ‘luxury effect’ has been found in the case of England.

3. More Importance to Wealth Variables:

In Friedman’s demand for money function, wealth variables are preferable to income and the
operation of wealth and income variables simultaneously does not seem to be justified. As
pointed out by Johnson, income is the return on wealth, and wealth is the present value of
income. The presence of the rate of interest and one of these variables in the demand for money
function would appear to make the other superfluous.

4. Money Supply not Exogenous:

Friedman takes the supply of money to be unstable. The supply of money is varied by the
monetary authorities in an exogenous manner in Friedman’s system. But the fact is that in the
United States the money supply consists of bank deposits created by changes in bank lending.
Bank lending, in turn, is based upon bank reserves which expand and contract with (a) deposits
and withdrawals of currency by non-bank financial intermediaries; (b) borrowings by
commercial banks from the Federal Reserve System; (c) inflows and outflows of money from
and to abroad: and (d) purchase and sale of securities by the Federal Reserve System. The first
three items definitely impart an endogenous element to the money supply. Thus the money
supply is not exclusively exogenous, as assumed by Friedman. It is mostly endogenous.

5. Ignores the Effect of Other Variables on Money Supply:

Friedman also ignores the effect of prices, output or interest rates on the money supply. But there
is considerable empirical evidence that the money supply can be expressed as a function of the
above variables.

6. Does not consider Time Factor:

Friedman does not tell about the timing and speed of adjustment or the length of time to which
his theory applies.

7. No Positive Correlation between Money Supply and Money GNP:

Money supply and money GNP have been found to be positively correlated in Friedman’s
findings. But, according to Kaldor, in Britain the best correlation is to be found between the
quarterly variations in the amount of cash held in the form of notes and coins by the public and
corresponding variations in personal consumption at market prices, and not between money
supply and the GNP.

8. Conclusion:
Despite these criticisms, “Friedman’s application to monetary theory of the basic principle of
capital theory—that is the yield on capital, and capital the present value of income—is probably
the most important development in monetary theory since Keynes’s General Theory. Its
theoretical significance lies in the conceptual integration of wealth and income as influences on
behaviour.”

Friedman Vs Keynes:
Friedman’s demand for money function differs from that of Keynes’s in many ways which are
discussed as under.

First, Friedman uses a broader definition of money than that of Keynes in order to explain his
demand for money function. He treats money as an asset or capital good capable of serving as a
temporary abode of purchasing power. It is held for the stream of income or consumable services
which it renders. On the other hand, the Keynesian definition of money consists of demand
deposits and non-interest bearing debt of the government.

Second, Friedman postulates a demand for money function quite different from that of Keynes.
The demand for money on the part of wealth holders is a function of many variables. These are
Rm, the yield on money; Rb, the yield on bonds; Re, the yield on securities; gp, the yield on
physical assets; and u referring to other variables. In the Keynesian theory, the demand for
money as an asset is confined to just bonds where interest rates are the relevant cost of holding
money.
Third, there is also the difference between the monetary mechanisms of Keynes and Friedman as
to how changes in the quantity of money affect economic activity. According to Keynes,
monetary changes affect economic activity indirectly through bond prices and interest rates.

The monetary authorities increase the money supply by purchasing bonds which raises their
prices and reduces the yield on them. Lower yield on bonds induces people to put their money
elsewhere, such as investment in new productive capital that will increase output and income. On
the other hand, in Friedman’s theory monetary disturbances will directly affect prices and
production of all types of goods since people will buy or sell any asset held by them. Friedman
emphasises that the market interest rates play only a small part of the total spectrum of rates that
are relevant.

Fourth, there is the difference between the two approaches with regard to the motives for holding
money balances. Keynes divides money balances into “active” and “idle” categories. The former
consist of transactions and precautionary motives, and the latter consist of the speculative motive
for holding money. On the other hand, Friedman makes no such division of money balances.

According to him, money is held for a variety of different purposes which determine the total
volume of assets held such as money, physical assets, total wealth, human wealth, and general
preferences, tastes and anticipations.

Fifth, in his analysis, Friedman introduces permanent income and nominal income to explain his
theory. Permanent income is the amount a wealth holder can consume while maintaining his
wealth intact. Nominal income is measured in the prevailing units of currency. It depends on
both prices and quantities of goods traded. Keynes, on the other hand, does not make such a
distinction.

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Patinkin’s monetary model of quantity theory of money.

In 1956 there appeared a monumental work by Don Patinkin which, inter alia, demonstrated the
rigid conditions required for the strict proportionality rule of the quantity theory whilst
simultaneously launching a severe attack upon the Cambridge analysis.

Patinkin’s main point of contention was that the advocates of the cash balance approach had
failed to understand the true nature of the quantity theory.

Their failure was revealed in the dichotomy which they maintained between the goods market
and the money market. Far from integrating the two, as had been claimed, Patinkin held that the
neo-classical economists had kept the two rigidly apart.

An increase in the stock of money was assumed to generate an increase in the absolute price
level but to exercise no real influence upon the market for commodities. One purpose of
Patinkin’s analysis was that only by exerting an influence upon the market for commodities, via
the real balance effect, could the strict quantity theory be maintained.
Part of Patinkin’s attack revolved round the nature of the demand curve for money, which
according to Patinkin, Cambridge School had generally assumed to be a rectangular hyperbola
with constant unit elasticity of the demand for money. As a matter of fact, such a demand curve
was implicit in the argument that a doubling of the money stock would induce a doubling of the
price level.

Patinkin used the ‘real balance effect’ to demonstrate that the demand curve for money could not
be of the shape of a rectangular hyperbola (i.e., the elasticity of demand for money cannot be
assumed to be unity except in a stationary state), and moreover, such a demand curve would
contradict the strict quantity theory assertion which the Cambridge quantity theorists were trying
to establish Patinkin’s main point is that cash balance approach ignored the real balance effect
and assumed the absence of money illusion under the assumption of ‘homogeneity postulate’
and, therefore, failed to bring about a correct relation between the theory of money and the
theory of value.

The homogeneity postulate implies that the demand functions in the real sectors are assumed to
be insensitive to the changes in the absolute level of money prices (i.e., with changes in the
quantity of money there will be equi-proportional changes in all money prices), which indicates
absence of money illusion and the real balance effect. But this is valid only in a pure barter
economy, where there are no money holdings and as such the concept of absolute price level has
no or little meaning. The money economy in reality, cannot be without money illusion.

Assumptions:
Patinkin has been able to show the validity and the rehabilitation of the classical quantity theory
of money through Keynesian tools with the help of and on the basis of certain basic assumptions:
for example, it is assumed that an initial equilibrium exists in the economy, that the system is
stable, that there are no destabilizing expectations and finally there are no other factors except
those which are specially assumed during the analysis. Again, consumption functions remains
stable [the ratio of the flow of consumption expenditure on goods to the stock of money (income
velocity) must also be stable.

Further, it is assumed that there are no distribution effects, that is, the level and composition of
aggregate expenditures are not affected by the way in which the newly injected money is
distributed amongst initial recipients and the reaction of creditors and debtors to a changing price
level offset each other. It is also assumed that there is no money illusion. Thus, Patinkin has
discussed the validity of the quantity theory only under conditions of full employment, as
according to him Keynes questioned its validity even under conditions of full employment.

In Patinkin’s approach we reach the same conclusion as in the old quantity theory of money but
we employ modern analytical framework of income-expenditure approach or what is called the
Keynesian approach. In other words, Patinkin has rehabilitated the truth contained in the old
quantity theory of money with modern Keynesian tools.

Let us be clear that Patinkin first criticised the so called classical dichotomy of money and then
rehabilitated it through a different route. The classical dichotomy which treated relative prices as
being determined by real demands (tastes) and real supplies (production conditions), and the
money price level as depending on the quantity of money in relation to the demand for money.

In such classical dichotomy there is a real theory of relative prices and a monetary theory of the
level of prices, and these are treated as being separate problems, so that in analysing what
determines relative prices one does not have to introduce money; whereas in analysing what
determines the level of money prices, one does not have to introduce the theory of relative prices.
The problem here is (before Patinkin has been) how these two theories can be reconciled—once
this has been done, the other problem is— whether the reconciliation permits one to arrive at the
classical proposition that an increase in the quantity of money will increase all prices in the same
proportion, so that relative prices are not dependent on the quantity of money.

This particular property is described technically as neutrality of money. If money is neutral, an

increase in the quantity of money will merely raise the level of money prices without changing
relative prices and the rate of interest (which is a particular relative price). In Pigou’s
terminology, money will be simply a ‘veil’ covering the underlying operations of the real system.

According to Patinkin this contradiction could be removed and classical theory reconstituted by
making the demand and supply functions depend on real cash balances as well as relative prices.
While this would eliminate the dichotomy, it would preserve the basic features of the classical
monetary theory and particularly the invariance of the real equilibrium of the economy (relative
prices and the rate of interest) with respect to changes in the quantity of money.

The real balance effect has been one of the most important innovations in thought concerning the
quantity theory of money. This is also called ‘Pigou Effect’, because it was developed by him but
Don Patinkin criticized the narrow sense in which the term real balance effect was used by Pigou
and he used it in a wider sense.
Suppose a person holds certain money balances and price level falls, the result will be an
increase in the real value of these balances. The person will have a larger stock of money than
previously, in real terms, though not in nominal units. Similarly, if the private sector of the
economy, taken as a whole, has money balances larger than its net debts, than a fall in the price
level will lead to increased spending and the quantity theory of money to that extent stands
modified, the important variable to watch is not M, but M/P, that is, real money balances. The
real balance effect and the demand for money substitutes go to constitute important
modifications of the quantity theory of money.

Thus, we find that the solution to this problem, as Patinkin develops it, is to introduce the stock
of real balances held by individuals as an influence on their demand for goods. The real balance
effect, therefore, is an essential element of the mechanism which works to produce equilibrium
in the money market. Suppose, for example, that for some reason prices fall below their
equilibrium level—this will increase the real wealth of the cash-holders—lead them to spend
more money—and that in turn will drive prices back towards equilibrium.

Thus, the real balance effect is the force behind the working of the quantity theory. Similarly if
there is a chance to increase in the price level, this will reduce people’s real balances and
therefore lead them to rebuild their balances by spending less, this in turn will force prices back
down, so that the presence of real balances as an influence on demands ensures the stability of
the price level. Thus, the introduction of the real balance effect disposed of classical dichotomy,
that is, it makes it impossible to talk about relative prices without introducing money; but it
nevertheless preserve the classical proposition that the real equilibrium of the system will not be
affected by the amount of money, all that will be affected will be the level of prices.

“Once the real and monetary data of an economy with outside money are specified”, says
Patinkin, “the equilibrium value of relative prices, the rate of interest, and the absolute price level
are simultaneously determined by all the markets of the economy.”

According to Patinkin, “The dynamic grouping of the absolute price level towards its equilibrium
value will—through the real balance effect—react back on the commodity markets and hence the
relative prices.” Hence, the integration of monetary and value theory through the explicit
introduction of real balances as a determinant of the behaviour and the reconstitution of classical
monetary theory, is the main theme and contribution of Patinkin’s monumentally scholarly
work—Money, Interest and Prices.
Keynes criticized the old quantity theory of money on two grounds: that velocity of circulation is
not a constant of economic behaviour and that the theory was valid only under highly rigid
assumptions. Don Patinkin agrees in his approach to the problem that the Keynesian analysis and
economic variables provide more dependable interrelationships than does the velocity of
circulation. In other words, a breakdown of expenditure into the sum of C and I is more useful
analytical device than the breakdown into the product of the stock of money and the velocity of
circulation.

Patinkin assumes full employment and deals with the above-mentioned criticism of Keynes that
even under rigid assumptions the quantity theory is not valid unless certain other conditions are
also fulfilled. According to Patinkin, these other conditions mentioned by Keynes (besides, full
employment) are that the propensity to hoard [that part of the demand for money which depends
upon the rate of interest—M2(r)] should always be zero in equilibrium and that the effective
demand (AD) should increase in the same proportion as the quantity of money—this will depend
on the shapes of LP, MEC, CF functions.
Don Patinkin has shown that irrespective of the values of the marginal propensities to consume
and invest and the existence of a non-zero propensity to hoard; an increase in the quantity of
money must ultimately bring about a proportional increase in prices (leaving the interest rate
unaffected) once the real balance effects are brought into the picture. Thus, Keynes’ argument
that the above conditions must be fulfilled has been proved incorrect by Patinkin.

Further, with the help of real balance effect Patinkin shows that the quantity theory will hold
good even in the extreme Keynesian case where the initial increase in the quantity of money
directly affects only the demand for bonds (M2) and finally Patinkin has shown that a change in
the quantity of money does not ultimately affect the rate of interest—even though a change in the
rate of interest does affect the amount of money demanded.
Real Balance Effect:
The term ‘real balance effect’ was coined by Patinkin to denote the influence of changes in the
real stock of money on consumption expenditure, that is, a change in consumption expenditure as
a result of changes in the real value of the stock of money in circulation. This influence was
taken into consideration by Pigou also under what we call ‘Pigou Effect’, which Patinkin
described as a bad terminological choice. Pigou effect was used in a narrow sense to denote the
influence on consumption only, but the term real balance effect, has been made more meaningful
and useful by including in it all likely influences of changes in the stock of real balances.
In other words it considers the behavioural effects of changes in the real stock of money. The
term has been used by Patinkin in a wider sense so as to include the net wealth, effect, portfolio
effect, Cambridge effect, as well as any other effect one might think of. Patinkin used the term
real balance effect to include all the aspects of real balances in the first edition of his book. It is
in the second edition of his book that Patinkin emphasises the net wealth aspect of real balances
though he does not completely exclude other aspects as detailed above.

Unless the term is used in a wider sense so as to include all the aspects of real balances, its use is
likely to be misleading and may fail to describe a generalized theory of people’s reactions to
changes in the stock of real balances. The use of the term in the wider sense as enunciated above
also helps us to resolve the paradox—that income is the main determinant of expenditure on the
micro level and wealth is a significant determinant of income on the macro level.

The analysis of the real balance effect listed three motives why people would alter their spending
and, therefore, demand for money in response to a change in the aggregate stock of money. First,
the demand for money is a function of the level of wealth. The wealthier the people, the more the
expenditure on goods; second, they hold money for security as a part of their diversified
portfolios; third, just as the demand for every superior good increases with a rise in income, so
does the demand for money. Individuals usually desire that their cash balances should bear a
given relation to their yearly income.

Therefore, other things being equal—wealth, portfolio structure and income determine the
demand for money as also the spending decisions. Hence, corresponding to these three motives
of the demand for money, there are three different aspects of the real balance effect—each of
which may operate either directly on the demand for commodities or may operate indirectly by
stimulating the demand for financial assets (securities etc.), raising their prices, lowering the
interest rate, stimulating investments, increasing incomes, resulting in a rise in demand for
commodities.

Net Wealth Effect:

Net wealth effect is the first and important aspect of the real balance effect. According to this
interpretation, an increase in real balances produces an increase in spending because it changes
one’s net wealth holding, which by definition includes currency, net claims of the private
domestic sector on foreigners and net claims of the private sector on the government sector.
Hence, consumption is a function of net wealth, rising or falling as real balances increase or
decrease.
An increase in real balances results in individuals increasing their spending on goods because
they are wealthier, or they have come to hold too much money in their portfolios, or because
their balances have become too large in relation to their incomes.

Clearly, the direct net wealth aspect has become identified primarily with the term real balance
effect. Besides, there is an indirect process also through which changes in real balances affect
expenditures—an increase in real balances stimulates initially the demand for financial assets
(securities), which in turn, reduces interest rates making investments more attractive, stimulating
incomes and expenditures. Some writers simply emphasize the direct net wealth aspect.

They include, G. Ackley, Fellner, Mishan, Collery. These authors primarily associate the term
real balance effect with the net wealth aspect, to the exclusion of all others. Other economists
point out to the indirect operation of the real balance effect. Harrod and later on Mishan
supported the view that there is an indirect effect of real balance phenomenon. Therefore, the
real balance effect in its most general sense covers both the direct and indirect methods by which
changes in real balances affect consumer spending.

Portfolio Aspect:
James Tobin is the chief exponent of this view, who is supported by Metzler. According to the
portfolio aspect of the real balance effect, a decrease in price level causes investor’s portfolios to
consist of more money than desired in proportion to the portfolio. Accordingly, they spend more
and their effort to restore the actual to the desired amount of money changes the price level until
equilibrium is restored. In their attempt to remedy the situation, individuals spend their excess
supply of money directly on the physical assets or indirectly in the financial market (for
securities etc.).

Equilibrium is restored when prices change (rise or fall) to such an extent that real balances once
again come to bear the desired relation to the value of the portfolios. A distinguishing feature of
the portfolio aspect is that people increase or decrease their expenditures in order to restore their
stock of money to the optimum level with respect to their asset portfolio.

Cambridge Aspect:
This is the third aspect of the real balance effect. It differs from others in that it views the
demand for money primarily as a function of income. According to Cambridge aspect, an
increase in the stock of real balances increases real balances relative to income. If previously one
held cash balances equal to 1/10th of the yearly income; then after an increase in real balances
one would, for example, hold cash balances equal to 1/5th of the yearly income. Finding
themselves with more than optimal fraction of income in money terms, people begin to spend
more.

If they spend for commodities the price level increases in accordance with the direct aspect; if
they spend on bonds (securities) the equilibrium will be restored through indirect process or
operation. In other words, equilibrium will be restored, when other things being equal, the price
level has risen in proportion to the increase in the money supply.

However, let us be clear that spending is influenced by, how wealthy people feel they are their
portfolio balance and the relation of cash balances to income. The wealth effect, the portfolio
effect and the Cambridge aspect of the real balance effect are all interrelated and it is merely for
the sake of convenience that a division amongst the three aspects of the real balance effect is
made.

Critical Evaluation:
This is Patinkin’s solution to the problem but it has not been accepted. The basic disagreements
centre on whether or not it is necessary to retain this real balance effect in the real analysis.
Patinkin’s model may be considered as an elegant refinement of the traditional quantity theory
and its value lies in specifying precisely the necessary conditions for the strict proportionality of
the quantity theory to hold and in analysing in detail the mechanism by which the change in the
stock of money takes effect—the real balance effect.

Although Patinkin’s analysis is said to be the formally incomplete because it fails to provide an
explanation of full long run equilibrium, yet the integration of product and monetary markets
through the real balance effect represented a significant improvement over earlier treatments. For
the first time, the nature of the wealth effect is made explicit. What, however, is not analysed is
the manner in which the increase in monetary wealth comes about. A doubling of money
balances is simply assumed and the analysis rests entirely on the resultant effects.

The Patinkin effect fails to take into account the long-run equilibrium effect as has been pointed
out by Archibald and Lipsey and conceded by Patinkin in the second edition of his work. They
show that Patinkin’s analysis of the real balance effect is inadequate inasmuch as he confines
himself to the impact effect of a change in a price and does not work the analysis through to the
long-run equilibrium. The result of the debate is that the real balance effect must be considered
not as a necessary part of the general equilibrium theory but as a part of the analysis of monetary
stability, in that context it performs the functions of ensuring stability of the price level.
What one needs the real balance effect for is to ensure the stability of the price level; one does
not need it to determine the real equilibrium of the system; so long as one confines oneself to
equilibrium positions. The equilibrium obtained is no doubt a short-term equilibrium only
because further changes will be induced for income recipients in future time periods. Moreover,
it is very interesting to point out that if the analysis is extended to an infinite number of periods,
general long-run equilibrium is found to be perfectly consistent with – a unit elastic demand
curve for money—the real balance effect disappears. Therefore, this again raises a thorny
question of whether the quantity theory is a theory of short-run or long-run equilibrium or indeed
whether it should be considered a theory of equilibrium at all?

Even otherwise, it has been pointed out that if some kind of monetary effect has got to be
present, it need not necessarily be a real balance effect as the presence of real balance effect
implies that people do not suffer from money illusion—they hold money for what it will buy.

This assumption yields the classical monetary proposition that a doubling of the money supply
will lead to a doubling of prices and no change in real equilibrium. But a recent article by Cliff
Lloyd has shown that stability of price level can be attained without assuming simply that there
is a definite quantity of money which people want to hold. The mere fact that they want to hold
money and that the available quantity is fixed will ensure the stability of price level—but it will
not produce the neutrality of the money of the classical theory.

Further, G.L.S. Shackle has criticised Patinkin’s analysis. He feels that Keynes analysis took
account of money and uncertainties, whereas in Patinkin’ analysis the objective is to understand
the functioning of money economy under perfect interest and price certainty. He accepts that
once the ‘Pandora Box’ of expectations and interest and price uncertainty is opened on the world
of economic analysis, anything may happen and this makes all the difference between two
approaches. Patinkin’s treatment is a long-term equilibrium of pure choice, while Keynes
treatment is of short-term equilibrium of impure choice.

J.G. Gurley and E.S. Shaw have also criticised the static assumptions of Patinkin and have
enumerated and elucidated the conditions to show under which money will not be neutral. They
bring back into the analysis, the overall liquidity of the monetary and financial structure and
differing liquidity characteristics of different assets,’ which were excluded by the assumptions
made in Patinkin’s analysis, in which money is not itself a government debt but is issued by the
monetary authority against private debt (inside money as contrasted with the outside money).
They show that money cannot be neutral in a system containing inside and outside money.
Outside money is the money which comes from outside the private sector and simply exists. One
can think of outside money being gold coins in circulation or paper currency printed by the
government. Outside money represents wealth to which there corresponds no debt. Inside money
is the money created against private debt. It is typified by the bank deposits created by a private
banking system. These writers have shown that if the money supply consists of a combination of
inside and outside money, the classical neutrality of money does not hold good as claimed by
Patinkin. The main difference between Keynes and Patinkin

approaches is that Keynes assumed the price level given does not assume full employment,
whereas Patinkin has tried to establish the validity of the quantity theory by assuming full
employment but not the price level. Patinkin discussed the validity of the quantity theory under
full employment because Keynes questioned its validity even under conditions of full
employment.

Patinkin’s Monetary Model and Neutrality of Money:

The mechanism of Patinkin’s monetary model can be elaborated as follows:
Suppose there are four markets in the economy—goods, labour, bonds and money. In each of
these markets there is a demand function, there is a supply function and a statement of the
equilibrium condition, namely, a statement that prices, wages and interest rate are such that the
amount demanded in the market equals the amount supplied. By virtue of what we call ‘Walras
law’, we know that if equilibrium exists in any three of these markets, it must also exist in the
fourth.

Considering the markets for finished goods Keynes’ aggregate demand function would comprise
of consumption plus investment plus government demand. Following Keynes, we assume that
the real amount demanded of finished goods (E) varies directly with the level of national income
(K), and inversely, with the rate of interest (r).

Assume further that E also depends directly on the real value of cash balances held by the
community M0/P (where Mo is the amount of money in circulation assumed constant, and p is an
index of the prices of finished goods). In other words, a decrease in the price level, which
increases these real cash balances, is assumed to cause an increase in the aggregate amount of
goods demanded and vice versa.
Thus, the real aggregate demand function for goods is shown:
E = ƒ(Y, r, M0/P) …… (i)
Since, there exists full employment, therefore, the supply function of finished goods can be
written as:

Y – Y0 …(ii)
where, Y0 is the level of real national product (equal by definition to the level of real national
income) corresponding to full employment condition.
The statement of equilibrium in the goods market is then that the goods demanded equal
the goods supplied that is:
E = Y …(iii)

In the labour market let us assume that the demand for labour (Nd) is equal to the supply of
labour (Ns) at the real wage rate (W/p) Therefore,
Nd = g (W/p) …..(iv)
and Ns = h (W/p) …(v)
Therefore, Nd = Ns …….. (vi)
Thus, the full employment level of real national income Y0 (in the market for finished goods) is
directly related to the full employment level of employment No in the labour market.
In the money market, let us assume that the individual is concerned with the real value of cash
balances and that he holds or his demand for money is denoted by Md/P, and assume further as
Keynes, that this total demand is divided into transactions and precautionary demand varying
with the level of income (Y) and speculative demand varying inversely with the rate of interest
(r). Thus,

To complete the analysis we must examine the model from the viewpoint of general equilibrium
analysis. The above-mentioned nine equations and nine variables (E, Y, p, Nd, Ns w/p, Md, Ms, r)
can be reduced to the following three equations and three variables p, w and r and we get the
following equations for the initial period:
These are the conditions for equilibrium in the markets for goods, labour market and money
market. Further, assume that there exists a price level p0, a wage level w0, and interest rate r0,
whose joint existence (at p0, w0, r0), simultaneously satisfies the equilibrium conditions for all
the three markets.
In other words, the same set of values—P0, w0, and r0, simultaneously cause:
(a) The formation of an aggregate function showing that the aggregate amount demanded (AD) is
equal to the full employment output,

(b) Equalizes the amount demanded of labour with the supply,

(c) Equates the amount demanded for money with the supply of money. Under certain simple
assumptions, the equilibrium position described here must be a stable one.

For example, suppose an excess demand for the goods raises the absolute price level and an
excess demand for money raises the rate of interest and the labour market is always in
equilibrium (because there is very little lag between money, wages and prices). Also assume that
there are no destabilising expectations then, the above assumptions made about the forms and
slopes of the various demand and supply functions ensure the stability of the system.

The Effect of an Increase in the Quantity of Money:

The equilibrium position as described above prevails during a certain initial period (t). Now, let
us assume that there is a new injection of additional quantity of money into circulation which
disturbs the initial equilibrium position. We shall see how a new equilibrium position is
established (comparative statics) and how does the system converge to the new equilibrium
position over time (dynamics).

Suppose the amount of money in circulation increases from M0 to (1 + t) M0, where t is a

positive constant. It will be seen that a new equilibrium position will come to exist in which
prices and wages have risen in the same proportion as the amount of money and the rate of
interest has remained unchanged.
Thus, when the amount of money in circulation was M0, the equilibrium of the economy was
attained by p0, w0 and r0. But when the money increases to (I + t) M0 the new equilibrium is
attained at the price level (I + t) P0, wage rate (I + t) w0 and interest rate remaining unchanged at
ro. Now, when the prices rise in the same proportion as the amount of money, the real value of
cash balances is exactly the same as it was in the beginning or in the initial period t and the rate
of interest remains unchanged.
Hence, the new aggregate demand (function) must be identical with the aggregate demand
(function) of the initial period and as the market for goods was in equilibrium in the initial period
it must be in equilibrium now. Similarly, if wages and prices rise in the same proportion then the
real wage rate remains the same as it was in the initial period and, therefore, the labour market
which was in equilibrium at the initial real wage rate (w0) must be in equilibrium now.
The position in money market is slightly different. When the amount of money supplied has
increased from M0 to (I + t) M0, it is clear that the demand function (schedule) for money must
also change and if the demand schedule for money does not change and remains in its original
position, then it is obvious that the equilibrium cannot be attained at the initial rate of interest ro.
We know that the demand schedule for money cannot remain in its original position because the
nominal amount of money demanded depends upon the price level and if the price level
increases, so must also the demand for money.
In other words, in the initial period when the price level is p0 and the rate of interest is r0, people
wish to hold M0 (amount of money)—but when the price level has increased from p0 to (I + t) P0,
people must wish to hold the larger amount of money; say, (I + t) M0. Hence, when the amount
of money in circulation is (I + t) M0, the money market, too, is or becomes in equilibrium at the
price level (I + t) p0 because the demand for money has gone up to (I + t) M0 but the rate of
interest will remain unchanged at r0 as shown in the Fig. 29.1.

Patinkin has shown that the same kind of equilibrium is possible even when the analysis is
dynamic, that is, through different time periods. The typical time paths of the variables would be
such as to generate equilibrating forces e.g., the quantity theorists assert that in the initial stages
after an increase in the amount of money the rate of interest would decline (from Or0 to Or1 in
Fig. 29.1); but that when prices begin to rise due to increase in money supply, the interest rate,
too, would rise again to its original level (from Or0 to Or1). In other words, with an increase in
the quantity of money the price level no doubt rises continuously towards the new equilibrium
level and the same will be true of the wage rates. Under these circumstances, Patinkin’s analysis
has shown that the interest rate may decline first but rises once again to its original value.
Equilibrium in the market can be established only at a rate of interest lower than r0, for only by
such reduction could individuals be induced to hold additional money available. But prices, on
the other hand, have also changed by now. Since the excess supply in money market shows
excess demand in the commodity market, this excess demand must result in raising the prices.
This, in turn, reacts back on the money market (through the multiplicative p in the demand for
money equation). In particular when the price level has finally doubled, the demand for money
must also double, bringing back the original rate of interest r0.
This is the crucial and central point of Patinkin’s analysis. It is true that during the process the
system may, at limes, ‘over-compensate’ and the price level and the interest rate may be at some
stage rise above their equilibrium values but, it cannot be denied, as claimed by Patinkin that an
increase in the quantity of money would raise the price level proportionately at the invariance
(un-alterability) of the rate of interest.

The whole process is bound to generate equilibrating forces which will lower the values of
various variables to their equilibrium positions. Thus, we see that once we keep in mind
Patinkin’s influence of the real cash balances in mind and an increase in the quantity of money
will cause an equi-proportionate increase in price level and money wages while leaving the rate
of interest unaffected (thereby maintaining the neutrality of money). Although we have reached
this conclusion, as does Patinkin, through modern analytical framework of income-expenditure
approach or the Keynesian approach but the result that emerges is that of the traditional quantity
theory of money.

Neutrality of Money:
The above analysis of Patinkin’s monetary model brings to light very clearly one of the salient
features of money or the quantity of money called the ‘neutrality of money’. If money is neutral,
an increase in the quantity of money will merely raise the level of money prices without
changing the relative prices and the interest rate. Patinkin (with the help of Keynesian
framework) arrives at the classical conclusion that relative prices and the rate of interest are
independent of the quantity of money.

The significance of his approach lies mainly in establishing the neutrality of money. However, it
is this neutrality of money, which has been the main object of attack by Gurley and Shaw in
their— ‘Money in a Theory of Finance’—the main purpose of this book is to elaborate
conditions under which money cannot be neutral. Gurley and Shaw severely criticized this
feature of neutrality of money, for establishing which Patinkin had taken so much pain. Gurley
and Shaw distinguished between outside money and inside money to show that the money will
not be neutral.

Gurley and Shaw with the help of different mathematical and monetary models show that if the
money supply consists of a combination of inside and outside money, the classical neutrality of
money does not hold good. A money supply consisting of a combination of inside and outside
money implies that changes in the quantity of money will not simply produce a movement up or
down in the general price level but will also produce changes in relative prices.

This conclusion is easy enough to understand—whenever the public holds a combination of

these kinds of money, a change in the quantity of one of them without a change in the other will
change the ratios in which people are obliged to hold assets and owe liabilities. If there is a
change in the amount of outside money alone without a change in the amount of inside money,
there must be a change in the ratios of the debt that backs the inside money to the outside money,
so that a change in the quantity of money involves a change in the real variables of the economic
system, as a whole.

For example, suppose there is only outside money in an economic system like gold coins and let
us suppose that the quantity of this money (gold coins) is doubled which simultaneously doubles
the price level, then we get back to the initial real situation—that is, all the relative prices are the
same and the ratio of real balances to everything else is the same as it was before.

Let us suppose, now that there are two kinds of money gold coins and bank deposits—suppose,
we double the amount of gold coins but do not change the amount of bank deposits-—then, if we
double the price level we can restore the real value of gold coins, but we will reduce the real
value of bank deposits and the assets backing them, so that the community cannot get back to the
situation, it started from.

Consequently, there must be some change somewhere else in the economic system to reconcile
people’s desires for assets and liabilities with the changed amounts that are available. This
analysis takes Gurley and Shaw several hundred pages to develop, but the key to it is, the
devising of a situation in which the ratios of assets change. The whole purpose of their analysis is
to show that money is not neutral. H.G. Johnson also endorses these views expressed by Gurley
and Shaw on the non-neutrality of money.
Lloyd Metzler has also repudiated the neutrality of money theory with the help of general
equilibrium model through IS and LM curves as shown in Fig. 29.2. In this diagram, we measure
income along OY and rate of interest along vertical Or. The initial equilibrium income and the
rate of interest corresponding to full employment are simultaneously determined by the
intersection of IS0 and LM0 curves at income Y0 and interest r0 respectively.
Now, if the central bank follows a policy of open market operations and begins purchasing
securities and bonds, the nominal stock of money will increase; this, in turn, will cause a shift in
the LM function from LM1 to LM2 which will determine equilibrium at a lower rate of interest
r1 and the income Y1 .There is, now, an excess of income over the full employment income.
This excess of income is shown by Y0 Y1 .This represents the inflationary gap. This will initiate
a process of inflation. The real balance effect will now become operative and the LM function
will shift to LM1. The IS function will also shift at the same time from IS0 to IS1, on account of a
reduction in consumption spending owing to a decline in the value of real balances.
The shifting of the LM curve to LM1 and IS0 curve to IS1 will restore the equilibrium again at full
employment income Y0 but the rate of interest has declined from r0 to r2. Hence, the money is not
neutral (because the rate of interest cannot be considered to remain unaffected).
Unless a few conditions are fulfilled the money cannot be neutral, for example, there must be an
absence of money illusion, wage-price flexibility, absence of distribution effects, absence of
government borrowing and open market operations and there is no combination of inside-outside
money. According to Patinkin, an individual suffering from money illusion reacts to the change
in money prices.

Money illusion constitutes a friction in the economic system and as such it makes it imperative
for the monetary authority to create just the right amount of nominal balances if the neutrality of
money is to be achieved. Similarly, flexibility of wages and prices is an important condition of
the neutrality of money. Rigidity of wages and prices will prevent the real balance effect from
making itself felt and hence it will become difficult to abolish inflationary pressures.

Money will, as a result, be non-neutral. The distribution effects imply the redistribution of real
incomes, goods balances and bond amongst the individuals and institutions following changes in
prices and stock of money. For example, a price increase may reduce the demand for consumer
goods and increase the demand for money and bonds bringing about a redistribution against high
consuming groups and in favour of high saving and lending groups.

Such a redistribution will mean a lowering in the rate of interest in case the quantity of money is
doubled. Money, under these circumstances (unless distribution effects are absent), cannot be
neutral. Again, the government borrowings and central banking open market operations have
non-neutral effects on the system. Money will be non-neutral, as already seen, if there is a
combination of inside-outside varieties of money.

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