Channels of Monetary Influence: A Survey*ROGER W. SPENCER

MONG the numerous controversies surrounding“money’, few are further from resolution than the is-sue of how money affects the economy. Compoundingthe controversy is the Fact that the arguments ad~vanced are not divided neatly along so-called mone-tarist and nonmonetanst lines. but are separated byother criteria.

To be sure, rnonetansts have long taken exceptionto the intellectual straitjacket of the Keynesianframework which limited the influence of monetaryactions to the response of investment to iiflerest ratechanges. However, the monetarIst alternatives offeredhave been far from uniform. Certainly, monetary ac-tions result in the change of more than one relativeprice — the interest rate and one type of spending— investment. However, substantial disagreementamong rnonetansts (as sveii as other economists) per-sists beyond this point.

There is basic agreement that at less than full em-p]oyment, chai~gesin the rate of growth of the moneysupply affect output and employment before prices, aproposition which may be traced back at least twohundred years (Flume [48}), but this tells nothingabout how total spending and its components react tomonetary actions, It is necessary to examine thechanges in relative prices arid wealth associated withmonetary impulses to gail) insight into the money—spending relalion.

When the existing money stock (however defined)either exceeds or falls short of the quantity demanded,wealih and/ui’ relative prices change and this sets off1)0th substitution and wealth effects, as indicated inthe a000mpallyrng diagram) The changes in relative

*11w author acknowledges the hdpful comments on earlierdrafts of George Kaufman, Thomas Mayer, John Pippenger,Robert Rasehe, Wililam Rawson, C~aik Warburton, andWilliam Yohe. They are blameless for remaining errors.

~The ‘correct” definition of money and the determinants ofmoney demand and suppiy firnetions are matters closely re-lated to. but beyond the scope of the presetit article. Anotherhrnitation is that because of the large number of authors sur-veyed, only the briefest of summaries can be given here, insome cases, this results Ui considerable oversimplification ofcomplex analyses.

Substitution and wealth effeets are treated here as essentiallyequivalent to substthition and income effects of generally-

prices typically involve changes in the rates of returnon real capital and financial assets as well as changesin the prices of goods and services. Ways in whichchanges hi wealth may influence spending includemovements in leal cash balances and changes in themarket value of equities.

There remains eo~siderab1edisagreement about therelative importance of these factors in the transmis-sion of monetary inpulses. This is not surprising, giventhe history of the relative price and wealth relations.Keynes, as ~veI1as prominent economists who pre-ceded him, was ambiguous on the subject. This articlefirst traces the early development of these two factorsand then analyzes more recent work in each area.

HISTORICAL BACKGROUND

Among the better early efforts to explain themoney~spendinglinkages were those of Irving Fisherand Knut Wicksell. Writing around the turn of thecelltury, they both maintained a short-run view of thetransmission process which was dominated by interestrate movements and a long-run view in which the keyrole was played by changes in real cash balances( Money

Price Level

Fisher and Wicksell

Fisher, like other neoclassical writers, determinedthat output was at its full-employment level in thelong run. In the short (or transitional) run, however,business cycies occurred in Fisher’s time, as ~vell as inother penods before and shice. Consequently, macro~economic’ analysts have continued to attempt exp~a—nations of this phenomenon. Fisher’s view of thebusiness cycle depended strongly on “sticky” interestrates.-’

accepted price theory. Although monetary-induced changesin relative prices or changes in wealth may genorato bothsui,stituUon and wealth effects, the relative price change hasoften been associated more with substitution effects and thewealth change more with wealth effeets; we will follow thatpractice.

2Sce especially Fisher’s Chapter 4, “Disturbance of Equationand of Purchasing Power During Transition PeiioW, inFisher [25]. In later years, Fisher [24] associated severeswings of the business cycle with changes in debt activity.

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The Monetary Transmission Process

This relative price effect (via interest rates) was setoff by an increase in the money stock relative to the

quantity of money demanded. The nominal moneysupply may he assumed to have increased due to arise in the gold stock ~md, consequently, bank re-serves. With the additioiml assumption that outputand velocity were fixed initially, a rise in the commod-itv price level was expected to be associated with themoney supply increase. Because Fisher assumed thatthe commodity pi-ice rise preceded the increase in in-terest rates, with interest costs being viewed as a sig-nificant component of firms’ operating costs, the rise inthe price kvel produced an increase in firms’ profits.

A continued increase in demand deposits (throughbusiness investment loan demand) relative to cur-rency i-esulted in yet further ii~creasesin prices andprofits. Eventhally. however, excess reserves wouldrun out, the interest rate would become “unstuck” andwould rise even faster than commodity prices. Withthe rise in firms’ costs of operation, there would occura decline in profits arid investment and a sharp in~crease in banki-uptcies. The downward phase of thecycle was reversed when excess reserves again roseand the interest rate had fallen accordingly.

Wicksell’s well-known “cumulative proee~s” alsocaptured cyclical movements of the economy largelythrough interest rate changes. Some initial disturb-ance, such as an innovation or technological break-through would foster an increase in the desire to

invest at the prevailing interest rate. The demand forloanable funds wouid then rise as would the “normal”or “natural” rate of interest, the rate “at which thedemand for loan capital and the supply of savingsexactly agree” (Wickseil [89], p. 193). If, however,the banking community failed to realize that invest-ment demand had risen, they would maintain thesame market rate of interest through increases in theflIOflC~supply which, given the usual classical assump-tions, would result in commodity price rises.

Note that at this point the money supply has risen,observed interest rates have been kept iow in relationto the normal rate, and business spending has beenthe component of aggregate demand which has in-creased. After some period of time, the banks’ reserveposition deteriorates and monetary growth is curbed.The market rate of interest rises to the level of theilatural rate, an action which ]eads to the eliminalionof excess aggregate demand and price level increases.

In the above short-run dynamic analyses, bothFisher and Wicksell relied on the relative pricemechanism inherent in a money-interest rates-invest-ment framework. However, in their approach to thedetermination of Iong~runequilibrium, interest ratesand investment were replaced by a treatment of therole of real cash balances.

Fisher’s real balance explanatioll began with an as-sumed doubling of the money supply:

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Suppose, for a moment, that a doubling in the cur-rency in circulation should not at once raise prices,but should halve the velocities instead; such a resultwould evidently upset for each indiv~duaI the ad-justment which he had made of cash on hand. Pricesbeing unchanged, he now has double the amountof money and deposits which his convenience hadtaught him to keep oil hand.3

With the apparent increase in wealth, everyonetries to reduce their cash balances by purchasinggoods and services, according to Fisher. Because ve-locity (V) and output (Q) in the equation of ex-change MV = PQ ai-e determined to be fixed in thelong run, a doubling of the money supply (M) cannotgenerate any increased holdings of goods and services,hut must result in a doubling of the price level (P).

Wicksell also saw real balances as the adjustingvariable on the return path to restoring long-run equi-libritim after the economy had been disturbed by anexogenous shock.

Now let us suppose that for some reason or othercommodity prices rise while the stock 0f moneyremains unchanged, or that the stock of money isdiminished while prices remain temporarily un-changed. The cash balances will gradually appear tohe too sinai? in relation to the new level of prices . -

I therefore seek to enlarge my balance. This can onivbe done neglecting for the present the possibilityof borrowing, etc. thi-cmgh a reduction in my de-mand for goods and services, or through an increasein the supply of my own commodity ... or throughboth together.4

The reduction in demand and/or increase in supplywill cause commodity prices to fall until they havereached their equilibrium level. Neither Wicksell norFisher mentioned the money-rnterest rates-investmentspending channel of monetary influence in their anal-yses of movements to long-run equilibrium. Both fo-cused on changes in real cash balances withoutexplaining in detail the substitutlim and wealth proc-esses involved. Although their long-run vs. short-runanalyses were similar in many respects, Fisher wasprobably more noted for his long-mn quantity theoryviews and Wicksell more for his short-run cumulativeprocess.

Keynes

Like Wicksell aild Fisher, Keynes’ position on themonetary transmission mechanism was somewhat

~Fisher [25], p. 153.‘Wicksdl, [901, pp. 39-40. Wicksell’s treatment of the realbalance effect is considered superior to Fisher’s because theformer avoided the trap of dichotomizing the determinationof rehtive prices and the absolute price level. See Patinkin[63].

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Keynes’ substitution effect, which was a part ofa relatively early portfolio choice model, stressedthe money-interest rates-investment spending channel.Did Keynes think changes in the rate of growth of themoney supply affected interest rates? There seems tobe little doubt that he did. The principal evidence tothe contrary may be fow~din the following passagefrom The General Thconj of Employment InterestLind Money:

There is the possibility, for the reasons discussedabove, that, after the rate of interest has fallen to acertain level, liquidity-preference may become vir-tually absolute in the sense that ~dmost everyoneprefers cash to holding a debt which yields so io\v arate of interest. In this event th0 monetary ai~thoritywcmld have lost effective control over the rate ofinterest. But whilst this limiting case might becomepractically important in future, I know of no exam-ple of it hitherto. Indeed, owing to the unwillingnessof most monetary authorities to deal boldly in debtsof long term, there has not been much opportunityfor a test. Moreover, if such a situation were toarise, ft would mean that the public authority its&fcould borrow through the banking system on anirnlimited scale at a nominal [very low] rate ofinterest.5

Note that after raising the possibility that a “liquiditytrap” situation could conceivably arise in the future,Keynes immediately disavowed its existdilce underconditions (the low employment, low interest rate pe-Hod of the 1930s) in which Keynesian analysis sug-gesteci it would likely occur.

Regarding the second part of the money-interestrates-investment channel, there is considerable evi-dence that Keynes thought investment to be quiteresponsive to inteiest rate changes (Leijonhufvud[53], pp. 157-185) However, the interest sensifivityof investment was restricted in the main to long-termrates, which changed only siowiy.

There are a number of wealth effects to be found inThe General Theory which relate to either price-in-duced changes in wealth (changes in wealth associ-ated with changes in the absolute price level) or in-terest-inthwed movements in wealth (changes inwealth associated with changes in yields). Of thebasic price-induced and interest-induced wealth ef-fects, it has been alleged that “Keynes stated both

5Keynes [51], p. 207. Bracketed expression supplied.

ambiguous. Somefound little or noprice effects whilehaving advanced a

critics have contended that herole for either wealth or relauveothers have credited Keynes withsignificant role for both.

FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974

parts of the wealth effect, emphasized their impor-tance, and then let wealth slip through his fingers byhis failure to build it into his analysis.” (Pesek andSaving [64], p. 21). This criticism is unjustified to theextent that those parts of Keynes’ analyses which sub-sequently enjoyed sustained popularity are riot neces-sarily those parts favored by Keynes. For example,the “liquidity trap” was not an intrinsic part of Keynes’analysis (he denied its occurrence); yet it becameclosely associated with his name as one of his majorcontnbutions.

It is easy to see how Keynes’ wealth effects wereoverlooked by those analysts quick to interpret andpopularize his basic theory, Keynes brought up theprice-induced wealth effect and minimized its signi-ficance in the same passage: “It is, therefore, on theeffect of a falling wage- and price-level on the de~rnand for money that those who believe in the self-adjusting quality of the economic system must rest theweight of their argument; though I am not aware thatthey have done so. If the quantity of money is itselfa function of the wage- and price-level [a variant ofthe real bills doctrine], there is indeed, nothing tohope ill this direction,”6

Keynes endorsed interest-induced wealth effectsmore vigorously, but made it clear that even thesewere of secondary importance. As a man well ac-quainted with the stock market and windfall gainsand losses, he thought interest-induced “windfall ef-fects” had only a minor influence on spending habits.

For if a man is enjoying a windfall increment inthe value of his capital, it is natura] that his motivestowards curreiit spending should he strengthened,even though in terms of income his capital is worthno more than before; . . - Apart from this, the mail’conclusion suggested by experiern~eis, J think, thatthe short—period influence oi the rate of interestis secondary and relatively unimportant, except, per-haps, where unusually large changes are in question.7

There is, however, sufflejeilt question about Keynes’view of wealth effects, which appear frequenfly inThe General Theory, to spark a continuing debate.8

What Keynes actually meant is less significant than hisfailure to give either monetary-induced substitutionor wealth effects a leading part in his attack againstorthodox, classical theory. By vacillating on the im-

UKeynes [51], p. 206. Bracketed expression supplied.7Keynes [51], p. 94.

8See Keynes [51], pp. 92-93, 319. Among the participantsin the Keynes wealth effect debate have been Ackley [1],Patinkin [63], Pesek and Saving [641, and Leijonhufvud[53].

portance of the two major channels of monetary in-fluence, Keynes in effect was inviting his interpretersto close off the channels completely.

THE RELATIVE PRICE RELATION

The most frequently cited of the relative price rela-tions, money-interest rates1nvestrnent, obviously con-sists of a money-interest rates channel and an interestrates-investment channel, Closure of either of thesechannels would eliminate a basic route through whichmolley is presumed to affect spending. This route wasvirtually sealed off by early interpreters of Keynes(among others) and not re-opened for about a quarterof a centuiy.

Closet! and Re~Openod

The initial part of the money-interest rates-invest-ment channel was attacked indirectly through innu-endo rather than directly either by overpoweringtheory or evidence. Although Keynes repeatedlystressed the importance of the money-interest rateslinkage, J. R. Hicks, the chief architect of the IS-LM“Keynesian” framework, failed to pass along Keynes’emphasis. In Flicks’ [44] relatively brief arlicle whichbecame the most popular condensed version ofKeynes, Flicks focused on the liquidity trap as one ofKeynes’ major contributions upsetfing neoclassicaltheory. Nowhere did he indicate that Keynes was un-aware of any such situation actually having occurred.The adoption of such slogans as “yo~ican’t push on astring,” or “you can lead a horse to water, but youcailt make him dñnk” provided popular support forHicks’ interpretation of Keynes’ view of the money-interest rates ehaimel in periods of economic slack.

Empirical studies of the late 1930s were the maininstrument employed to seal off the interest rates-investment channel. Researchers in England and theUnited States published results of surveys in whichbusinessmen were questioned about the importanceof the interest rate in their investment decisions.0 A~‘astmajority indicated that interest rates had little orno effect on their decisions to invest. These studieswere cited prominently by Alvin Hansen [39] in his1938 American Economic Association presidential ad-dress as evidence of the impotence of monetary pol-icy. Moreover, as Samuelson recently noted, “. . pea-

9See Henderson [42], Meade and Andrews [57], and Ebersole [211.For a humorous criticism of the survey approach, see Eisner[22j, pp. 29-40. A more recent example of the survey approachis found in Crockett, Friend, and Shavell [181.

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pie like Sir John Hicks said that as far as short-terminvestme~ilis concerned, interest is of no consequenceas a cost; and as far as long-term investment is con-cerned, uncertainty is so great that it completelyswamps interest, which leaves you with oniy a mini-sonic of intermediate investment that is intereste1astic,”~°

The eventual re-birth of the relative price channeldid mt occur until well into the 195Os, although theseeds were planted kng before. The emergence ofportfolio choice models in the 1950s and 1960s usheredin, among other channels, the old money-interestrates4nvestrnent route.

Much of the literature dealing with portfolio choicemodels has been associated with money demandstudies, Portfolio choice theory, however, provides therationale for the holding of any asset in one’s portfolio,including molley. Instead of focusillg on the individ-ual’s or finn’s income statement which deals withflows, portfolio choice analysis stresses the stock rela-tionships which are found on the asset and liabilitysides of the balance sheet. The basic assumptions arethat: (1) other things equal, everyone eqintes themarginal rate of return on each asset hi the portfolio —

allowing for risk (in terms of variaiice of return andexclusive of price level movements), costs of acquiringinformation and of conducting transactions; and (2)an increase in the supply of any asset (on a macrolevel) will lower the price of that asset relative to allothers. The increased supply of the asset leads todiminishing marginal returns per unit of the asset,thereby motivating the wealth holder to attempt tosubstitute or exchange some of the asset whose pricehas fallen for some of those whose price has not.

Changes in relative prices are a consequence ofwealth holders’ efforts to restore equilibrium to theirportfolio — that is, equate all marginal rates of re-turn. The initial disturbance, a change in the stock ofany asset, may produce a chain of substitution effectsas wealth holders react to changing asset yields.

Although certain types of money have a zero nomi-nal rate of retnrn by law, money continues to be heldin the portfolio for at least two reasons. First, as op-posed to equities, for example (which may carry sub-stantial risk along with a relatively high mean rate ofreturn), money holding is less risky. Second, moneyeconomizes on the use of real resources in the gather-ing of information and in the conduct of transactions.An implication of this latter characteristic is that

°Sawueison [70], p. 41.

money is held to bridge the gap between incomereceipts arni expenditures.”

Which assets, besides money, are included in theportfolio? Much of the controversy surrounding theportfolio choice framework has centered on the an-swer to this question. The early portfolio choicemodels greatly limited the range of assets and ratesof rethrn. Pigou [65] sketched a rough money-capita]model, while Keynes [51] added government andprivate debt to the menu. By assuming perfect sub-stitutability between capital and boilds, Keynes hadonly the yield differential between money and oneother asset (he chose bonds) to explain. Patinkin’smodel [63] was similar to Keynes’ in terms of assetsincluded and yields explained.

A major change in the approach to the number ofassets ~mdyields to he examined occurred in the early1960s. Tohin [77], Brunner and Meltzer [9], andFriedman [28] all expanded the portfolio menu, butin varying degrees)2 The differing approaches ofthese contemporary monetary economists ~vi11be ex-amined ill some detail.

Three Views on the Relative Price Relation

Tobin ([77], p. 36) suggested that “a minimal pro-gram for a theory of the capital account” should in-clude six assets — all of which, except the capitalstock, are financial assets — and six yields. The num-ber of assets is only slightly greater than the earliermodels, but a substantial step toward reality is takenwith the elimination of Keynes’ perfect substitutabilityassumption. The choice of assets is closely restrictedto facilitate “purchasing definiteness iii results at therisk of errors of aggregation” (Tobin [77], p. 28), Ifincreases in the money supply happen to reduce thesupply price of capital — the rate which wealth hold-ers require in order to hold in their portfolios thecurrent capital stock below its marginal productiv-ity, the capital stock will rise, This is the sole linkage

t1To pursue further these distirn~tions would require a de-tailed analysis of mOiiey demand, a project much beyondthe scope of this article. The interested reader may wishto consult Pigou [65], Hicks [43], Tobin [77] and Brtrnner—Meltzer [101.

‘2Cagan [13} also introduced a sketchy portfolio choice sce-nario. More reeeiillv, he focused on money—interest rateinfluences [14].

The relative price meehamsm was also employed byWarburton as early as 1946 to explain the transmissionprocess. ~‘In practice the effects of a change in demand oriii suppiy, either of a specific commodity or of money ( cir-culating medium), are felt, first in some particular part ofthe economy and spread from that part to the rest of theeconomy through the medium of price differentials createdat each stage of adjustment>’ Warburton [88], p. 85.

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between the financial and real sectors. The “if” is nec~essary because the increase in the supply of moneywhich kwers the price of money relative to other

assets may simply result in an increased demandfor financial assets, rather than for the capital stock(real assets

One infers from Tobin that an increase in the stockof any of the financial assets in the macro portfolio is

about as likely to stimulate investment expendituresas is money) In this view it is unclear as to whether

an increase in the money stock can lower the supplyprice of capital directly without setting off a chain ofsubstitution effects ranging all through the spectrumof assets with different shades of risk-i-eturn charac-teristics. It is apparent from Tobin’s comparative

statie framework, however, that no feedback from thereal to the financial sector occurs,

The types of real capital which are affected by

portfolio shuffling are delineated closely by Brunner-Meltzer [9], although the number of assets and rele-vant yields in the macro portfolio ‘are not. They clas-sify three types of capital according to the relation

between asset prices and output prices — languagesomewhat comparable with Tobin’s supply price ofcapital and marginal productiv~ty.14

Increases in real capital occur as (not “if”) a rise inthe stock of base money lowers the relative price ofbase money ai~dthat of its close substitutes, resultingin an increasec1 demand for other assets, those assetsbeing dominated by real capital. “The increase in theprice of financial assets simuitanernisly raises realcapital’s market value relative to the capital stock’sreplacement costs and increases the desired stock rela-

tive to the actual stock.” (Brunner [5], p. 612). Realcapital is defined to exclude consumer nondurablegoods and services.1~ UtAike Tobin (with regard tohis comparative static models), Brunner and Meltzer([9], p. 379) view the monetary transmission mech-anism as having important feedback effects.

‘~Theview that financial or liquid assets other than money(Mi) can about as likely ailed the real sector, is advocatedmore stnmgly by the Radcliffe Committee [17], Gurleyand Shaw [37], and Gramley and Chase [35], in whatbecame known as the New View” (from Tobin [78]).

i-lFrjedrnan’s [28] terminology is prices of services and pricesof sources as explained in the excerpt from Friedman in theright-hand column of this page. A parallel semantic issue isTobiri’s preference for the term “demand debt”, Friedmanfor ‘high—powered money, and Bnuiner—Meltzer for “basemoney’.

15Brunner added the general thought that ‘The wealth, in-come, and relative price effects rnvolvecl in the wholetransmission process also tend to raise demai~d for non-durable goods.” Brunner [5], p. 612.

NOVEMBER 1974

Friedman [28], in his portfolio choice-relative price

analysis, is less formal than either Tobin or Brunuer-Meltzer in that he attempts no classification of types

of real capital, portfolio assets, or relevant yields.Friedman acknowledges that an increase in themoney supply affects the portfolio of the financialsector first, bift the subsequent increase in demandmay be as likely reflected next in consumer nond~ira-bles as in any areas of real capital. Possible scenariosare outlined by Friedman in several places.16 Ini-tially, the prices of sources are raised relaUve to theprices of services, thereby inducing investment andconsumer expenditures.

The key feature of this process is that it tends toraise the prices of sources of both producer andconsumer services relative to the prices of the serv-ices themselves; for example, to raise the prices ofhouses relative to the rents of dwelling units, or thecost of purchasing a car relative to the cost of rent-ing one. It therefore encourages the production ofsuch smtrees (this is the stimulus to liwesUnent’conceived broadly as inch cling a nmch wider rangeof items than are ordinarIly included in that teim)

and, at the same time, the direct acquisition ofservices rather than of the source (this is the stimu-li’s to consumption relative to savings ) But thesereactions in their u nil tend to raise the prices ofservices relative to the prices of soijrces, that is, toundo the initial eflects on interest rates [broadlydefined]. The final result may he a rise in expendi~tures in all directions without any char~gein interestat all.’7

A Comparison of Three Views

The Friedman, Tobin, and Brunner-Meltzer viewsof the monetary substitution effect are distinguishedby a number of points of agreement and disagree-ment. The three views are coincident in the following:(1) the total response of the financial sector to achange in the money supply occurs before the totalresponse of the real sector; (2) money as a medium ofexchange is of less significance than money as an assetwith regard to the portfolio choice transmission mech-anism; (3) changes in rates of return or yields on realor financial assets are the key e1emei~tsin the trans-

mission process.

To a large extent, the differences in the three viewsare due not so much to contradictory theories, but

~°Friedman [28], Friedman-Meiselrnan [33], Friedman-Schwartz [34]. Other attempts at pinothg down the openmarket purchase-bank reserves-interest rates, etc., channelscan be found in Cagan [13], Davis [191, and Ettir~ [231.

l7Friedman [28], p. 462. Bracketed expression supplied. Thelatter part of this quote represents one of Friedman’s inter-pretaticrns of the feedback effect.

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rather shades of emphasis among similar approaches.Because Tobin insists on a formal separation of thecapital account (stocks) from the production and in~come account (flows), he is led to highlight differentaspects of the portfolio choice process than Friedmanand Brunner-Meltzer.18

Tobin gives the impression that portfolio choiceanalysis adds little to the Keynesian (not Keynes’)view of money-interest rates-investment. Given a con-sumption function dependent on income, but notwealth or relative prices, consumption can be affectedby monetary actions only after investment via thestandard Keynesian multiplier. In his portfolio choiceanalysis, the potential end result of the shu~ingofportfolios is a change in real capital;10 feedback ef-fects from the real to the financial sector do not fitinto Tobin’s capital account approach. Tobin specific-ally draws attention to the insignificance of money’smedium of exchange property vis a vis its zero nomi-nal rate of return in his portfolio analysis and gener-ally denigrates money’s “uniqueness”. Changes inmoney may set off a chain of portfolio reverberationswhich results in a change in desired real capital, or itmay not.

Friedman’s avoidance of formal, structural modelswhich specify any unique monetary transmissionprocess has probably contributed significantly to thecharge that monetarists’ views of how money worksare locked in a “black box”.2° Friedman’s informaltracing of possible monetary channels, ~stresses thepoint that consumer spending is as likely to be the realsector component first to respond to monetary acionsas is investment spending, Although changes in yieldsare the key to portfolio adjustments, “These effectscan be described as operaling on ‘interest rates,’ if amore cosmopolitan interpretation of ‘interest rates’ isadopted than the usual one which refers to a smallrange of marketable securities” (Friedman [28],p. 462).

Brunner-Meltzer tread a path between Tobin andFriedman in their methodological approach to port-

18”Treatment of the capital account separately from the proSductioi~arid income account of the economy is only a firststep, a simplification to be justified by convenience ratherthan realism” (Tobin [811, p. 15). It appears, however, thatTobin’s efforts at moving toward greater realism (Tobin[8-4]) are h~hibitedby the “General Equilibrium Approach”(Tobin [81]).

19J~ an informal analysis Tobin added consumer durables tothe list of “storable am’ durable” goods —~ or real capital —

influenced in the monetary transmission process. See Tobin[SO].

20Friedrnan’s formal model [30], [31] sheds little light onspecific monetary transmission linkages,

folio analysis. Like Tobin, they attempt to organizethe pattern of response of the real sector to monetaryimpulses and eventually constnict a formal model(Brurrner”Meltzer [12]). They also emphasize the sig-nificance of real capital in the process with only minorreferences to such spending components as consumernondurable goods and services.

Like Friedman, Brunner-Meltzer do not attach If”considerations to the money-real sector linkage, nor dothey stress long substitution chains relating moneyand other financial assets. Their view is also similarto Friedman’s in that they: (1) emphasize financialsector~rea1 sector feedbacks; (2) do not denigratemoney as an indicator of monetary actions; and (3)stress relative prices, of which yields on securities areonly a part. Brunner points out that “Every change inrelative prices of assets (that is, durables) with differ-ent temporal yield streams involves also a change insuitably defined interest rates.”21

in their money demand theory, Brunner-Meltzer[10] dwell on the medium of exchange property ofmoney, but this property does not appear specificallyin their formal model [12] of the transmission mech-anism. Relative prices in the 1972 model take theform of asset (illeluding securities) prices and outputprices, but no distinction is made between investmentand consumer goods prices. Finally, in spite of theircriticism of IS-LM models which reflect a “Keynesian”approach to the transmission mechanism, they grantthat if changes in the stock of government debt werepresumed to have no effect on wealth, “our modelcould be pressed into the standard, ISWM frame-work” (Brunner-Meltzer [11], p. 953).

In summation, these three approaches to tracingmonetary inipulses are probably not as different asthey at first appear. Once the semantic issues are putaside and the preferences for formal vs. informalmodels are understood, the Tobin, Brunner-Meltzer,Friedman approaches to the relative price channelsof monetary influence are quite similar. It remains tobe resolved, however, if more is to be gained byTobin’s admittedly heroic abstractions from reality,Friedman’s apparent presumption that the channelsare too complex to be captured in any economic

2lflrunner [8], p. 27. FIe adds that “The general role ofinterest rates does not distinguish therefore between theKeynesian and non-Keynesian posiUons. The crucial differ-ence occurs in the range of the interest rates recognized tooperate in the proeess. The Keynesian position restricts thisrange to a narrow class of financial assets, whereas the rela-tive price theory inckdes interest rates over the wholespectrum of assets and liabilities occurring in balance—sheetsof households and firms” (Briinner [8], p. 27).

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model, or Brunner~Me1tzer’sapproach somewhere be-tween these two in terms of answering the q~eslionsof the academic fraternity and the general public ofhow money works.

Other Developments in theRelative Price Relation

Two extensions of the relative price relation which,although out of the mainstream of monetary trans-mission research, merit elaboration are (1) credit ra-tioning and (2) the overshoot, or feedback, phenome-non. The former involves the allocation of resourcesby price and nonprice criteria, and the latter is aconsequence of the dynamic adjus&nent of the eco-nomy to a monetary shock.

Credit Rationing — So long as the price mechanismfunctions in an open market with complete factor andproduct homogeneity, resources (including credit)are rationed by price. In so-called “imperfect” mar-kets, however, non-price discriminatory practicesabound. Among borrowers who are the same in everyrespect b~~tone, net worth for example, lenders mayadvance one borrower credit at an X percent rate andanother borrower zero credit at any interest rate. Atleast, that is one implication of the term “credit ra-tioning”. As used here, “global” credit rationing is de-fined to indicate a reduction in (the rate of) totalspending due to a rise in the non-observed interestprice of loans.

Traditionally, “local” credit rationing has been asso-ciated with the behavior of commercial banks in ex-tending loans in a period of “tight credit”. Argumentsfor commercial bank credit rationing were advancedin 1951 by Robert Roosa [68]. He asserted that inperiods of falling security prices (rising interest rates),bankers prefer to pass over relatively more lucrativecommercial loans and continue to hold on to theirsecurities in order to avoid a recorded capital loss.Moreover, Roosa contended that banks preferred tohold securities as a means of countering the uncer~tainty fostered by the monetary authorities duringcritical, high-interest rate periods.

Paul Sarnuelson [69] objected to this analysis onthe grounds that it did not conform to the usual tenetsof profit-maximizing behavior of the flu-rn. He arguedthat the ustrnl way of rafioning anything in “shortsupply” was to allow a higher price to do the ration-ing. Samuelson would not agree that over any otherthan a very brief period, bankers would hold theirassets in relatively low-yielding securities, while ra-tioning a set volume of loans at a fixed interest rate.

Subsequently, additional arguments were employedto buttress the credit rationing view.22 One of thesewas that default risk increased relatively more forloans than for securities in tight credit periods. An-other was that the banking industry is oligopolisticand is better off to restrict the volume of loans ratherthan lend out to the point required by the compe~-tive market solution.

Legal interest ceilings have been invoked more re-cently ii~explanations of the working of credit ration-ing. The basic idea is that a financial institution mightbe perfectly willing to lend to a borrower at X percentin accord with such cdteria as size of loan, defaultrisk, and compensating balance requirements, but ifusury or other laws set a ceiling at Y percent whichhappens to be below X percent, the prospectiveborrower will not obtain the loan. Tie may be able toobtain fimds from some other source, such as from alending facility in a state whose ceiling is higher, orfrom an effectively iinregulated private individual.There are, however, considerable costs of informationinvolved in addition to the higher interest costs whichmay cause the potential borrower to drop out (that is,he rationed out) of the funds market.

Interest ceilings also affect the flows of funds intofinancial and i~onfinancia1 iflstituth)ns, When marketinterest rates rise above rates payable (consideringlipñdity, nsk, maturity, and tax factors) by savingsinstitutions and state and local governments, many’savers put their funds into less regulated securiliesunirkets. The bypassed institutions accordh~g1y cutback their lending activities. Whether the re-channel-ing of credit results in a reduction of total spending,however, is another matter — one which is rarelytreated in the credit rationing literature.

One study, for example, found that Regulation Qceilings encouraged savers to bypass commercialbanks in certain tight credit situations, allegedy forc-ing commercial banks to curtail credit extensions.23

Since bank credit is only one component of totalcredit, it cannot be assumed that a reduction in totalcredit or total spending could be attributed to theworkings of Regulation Q. According to the authorsof the study, the reduction of credit available to com-mercial bank customers “would presumably occur tothe benefit of customers of other intermediaries

~Lindbeck [55], Hodgrnari [47], and Kane [50] are amongthose who have substaitially advanced the credit rationingliterature.

2~Federa1Reserve Regulation Q places a eeiling on interestrates payable by member banks on time and savings accounts.

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FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974

and/or of those firms uble to raise funds directly inthe rnarket.”24

If it is presumed that credit rationing at one insti-tution is not offset by increased loan activity eIse~where, then “global” credit rationing, which is accom-panied by a slowiiig in the rate of total spending,occurs. Because all observed interest rates do not nec-essarily capture a i-ise in the relative price of creditas represented by greater information and transac-tions costs (which are assumed to include such costsas increased compensating balances), interest ratechanges alone would not give a complete picture ofthe effectiveness of monetary actions. In certain tightcredit situations, interest rates rise to slow downspending. But after some point at which interest yieldsare confronted by legal rate ceilings, interest rateswould not give a correct pictme of the true cost ofcredit. An important implication of this analysis is thatinterest rates likely emit inconsistent signals with re-spect to monetary influences on spending via relativeprice changes.

Overshoot Effect — The “overshoot effect” is analo-gous to the previously-mentioned feedback effect, inwhich the real sector reacts hack upoH the financialsector, with the onginal disturbance having comefrom the financial sector. Although the overshoot mayoccur by way of relative price or wealth influences,the vast majority of the hteratllre on this topic iscouched in a relative price framework. The term“overshoot” is indicative of the tendency of the initialadjustment of such economic vanables as interestrates and income to exceed the steady-state kvels.Friedman is often identified as the current leadingadvocate of this thesis, hut the argument has its rootsin studies by Fisher, Wicksell, Keynes, and Tooke.25

Friedman [28], [29], [33~pointed otit in severalplaces that changes in the money supply and interestrates are inversely related for oniy a short period. Arise in the money supply, for example, is associatedwith a fall in interest rates initially. After some periodof time, the fall in interest rates will have slimulatedspending and the demand for credit. The rise in the

demand for credit will tend to reverse the initial fallin interest rates. If spending is continually stimulated,demand pressures will force up the price level andprice anticipations which, in t~irn,add upward pres-s~resto interest yields.

The extent to which interest rates overshoot theirequilibrium value is dependent on many factors, in-cluding initial conditions and the duration and degreeof monetary stimulus. It should be noted that the risein the price level lowers the real value of monetaryassets. At the higher price level, the quantity of moneydemanded is less in real terms. Also, the rate of in-crease of the money supply tends to slow automati-cally due to “feedback effects through the monetarymechanism” (Friedman and Schwartz [34], p. 562).Thus, prices, interest rates, money, and general eco-nomic activity are all subject to the overshootphenomenon.

Similar dynamic analysis has been offered by Brun-ner-Meltzer. Through changes in wealth and relath’eprices, they postulate that monetary impulses alter themagnitude of and rate of return on the capital stock.“Variations in the stock of real capital, of income ex-pected from human wealth, or the yield expected fromreal capital affect the allocation pattern of financialassets, trigger the interest rnechathsm, and generate afeedback to the asset prices of real capital.” Thus,monetary impulses not oniy affect the real processesb~treal impulses feed back to financial processes.”26

Brunner also noted the role of price anlicipations inthe feedback process and postulated that withoutcontinuing morley growth acceTeration, initial outputand employment gains would be offset over lime.27

Tobin’s basic comparative static framework revealedno role for the overshoot effect. On at least two occa-sions (Tobin [82], [84]), however, lie engaged indynamic analysis. On both occasions he pointed outthat initial disturbances in the real sector which affectthe money supply (endogenity of money) are a plau-sible explanation of observed money-income relation-ships. in one instance ( Tobin and Brainard [84],p. 119), lie noted that an exogenous change in bankreserves would produce an adjustment path of theyield on real capital which overshoots and oscillates.

20Brunner—Meltzer [9], p. 379.

27Bruoner [71, p. 13. Friedman ([29], p. 10) made the samepoint regarding monetary acceleration via a comparison ofthe market unemployment rate—natural unemployment ratewith the market interest rate-natural interest rate.

The feedback effects noted in the formal Brurnier-Meltzermodel [12] are started by an initial dLsturbance in the out-put market, and thus are not quite comparable to earlieranalysis.

~Jaffee and Modigliani [49], pp. 871-72. Although Jaffeeand Modigliani suggest that credit rationing of commercialbanks is offset by increased loan aetivity in other areas, thereverse does not necessarily hold. The FRB-MiT model,with which Modigliani has been closely associated, finds acredit rationing effect through non-commercial bank savingsinstitutions not offset by increased commercial bank activity.See deLeeuw and Gramheh [20].

25Sce Fisher [25], Wicksdll [89] (natural interest rate vs.market interest rate), Keynes [511 (the Gibson paradox),and Tooke [86] (the Ricardo-Tooke Conundrum).

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FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974

Even the standard IS-LM framework can be al-tered so as to give interest rate and income over-shoots.28 It can be shown that differences in the ad-j~istmentpattern of investment to interest rates andmoney demand to interest rates are capable of pro-ducing interest rate and income overshoots. If invest-ment is dependent at all on the current interest rate,a sharp drop in interest rates can cause investment toexpand and income to rise; if money demand is afunction of income, there ensues a rise in money cle-mand which reacts hack on interest rates.

It is possible to conjecture fairly complicated reac-tion patterns to relative price changes, even withoutsuch complications as an accelerator effect, or changesin the absolute price level. Even working within asimple analytical framework, it would be difficult forpolicymakers to attempt to stahiTize incomes or inter-est rates if they did not know whether the adjustmentpaths were monotonic or cyclical. Considerable empiri-cal verification of the overshoot or cyclical process inthe “real” economy has been provided.29

THE WEALTH RELATION

The monetary channel of influence which operatesthrough changes in wealth is best approached byexamii~ation of the linkages between wealth andconsumption. Although the substitution effect, in someversions, is seen to work through consumer spendingas well as investment, the wealth effect has beentypically limited to the consumer sector. One (lefini-tion of nonhuman money wealth is

WNH PK + D +

Monetary factors affect each of these components of

nonhuman money wealth in varying degrees.

~8See Laidler [52], Smith [73], Thimer [74] and Tucker[87].

29See Silber [72] and Christ’s ([161, pp. 444-45) revie\v oflarge econometric models.

Real human wealth, vie, is determined by thepresent value of one’s expected lifetime income, aconcept related to permanent income or even dispos~able income (with the appropriate lags), but not di-rectly related to monetary actions. Real consumption(c) is assumed to be a function of both types ofwealth as described by

WNHc = e(wn

The human wealth concept forms the typical Keyne-sian element in the consumption function. The ida-lion between nonhuman wealth (divided by the pricelevel), and consumption is probably less wellaccepted.

Because the arguments for the D and 9 elements

of the wealth effect are closely intertwined, they willhe discussed together as “Real Balance Effects”. ThePlC section follows under the heading “Equity Effects”.

Real Balance Effects

As mentioned earlier, Keynes discussed several dif-ferent real balance effects, but made little use of themin his general framework. Ironically, it was the workof a prornindilt Ke3mesian interpreter which sparkedrenewed interest in real cash balances. Pigou, whogenerally receives the lion’s share of the credit forreviving real cash balances,3°was disturbed by AlvinHansen’s stagnation thesis.

Flansen [40] charged that even with flexible pricesand wages, a perpetual state of less than full employ-ment could we]! be the natural resting place for theeconomy. Such neoclassical economists as Pigou werewilling to concede that an assumption of inflexibleprices and wages could be consistent with the thesisof a less than full employment state, but only giventhis important assumption. Pigon demonstrated thatthe rise in real cash balances associated with a fallingprice level and unchanged money stock would in-crease consumer spending, reduce saving, and therebypennit the rate of interest to rise above some assumed“liquidity trap” level.

By associating consumption with real cash balances,Pigou drove a wedge into the small opening left formonetary policy by the Keynesians of the late 1930s.Because consumption comprises a much larger per-centage of total spending than business fixed invest-

30Pigou [66]. See also Haberler [38] aiid Scitovszky [71].

Page 17

where

P pflce of real capitalK stock of capital ( EK ~—market value of equity)D monetary base p1~sfraction of bank debt not

counted in PKGrit government debt (one dollar multiplied by the

number of securities outstanding, each of whichis assumed to be a consol)

= market interest rate market value of out-

standing debt),

FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974

ment, the potential for monetary policy to affect totalspending was greatly expanded. Pigou and others whofonnulated real cash balance theories in the early1940s did not claim much empirical significance forthis effect. Their c(JncCrll was only to show that it wastheoretically plausible for the economy to return tofull emp1oymet~tunder the assumption of price andwage flexibility. They did not take up Keynes’ wind-fall effect or any other aspect of the monetary wealtheffect. Thus, their concern was limited to the “D”portion of the nonhuman wealth definition, with therelevant debt typically taken to he the governmentsdemand debt (or monetary base).

Don Patinkin took up the discussion of real cashbalances in the post-war period31 He also ignoredthe hflerest-induced wealth effects and focused ontheoretical rather than empirical considerations. Patin-kin’s chief contribution to the chani~e1sof influencecontroversy was to spell o~itthe hiterplay between thepositive real cash balance effect and the negative realcash balance effect which combine to produce propor-tionality between money and prices (the “quantitytheory>’) between periods of short-run equilibrium32

Prominent among those disputing the usefulness ofthe real cash balance approach have been Flicks andHansen, who also downgraded the monetary relativeprice channel. 1-Tansen’s [41] criticism of the real bal-ance effect was limited to a short note in which heagreed that the effect could theoretically bring a haltto a downturn. but could not generate the spendingrequired to attain full employment.

Hicks devoted more effort to wealth considerations,as demonstrated by the important role of wealth inhis landmark book, Value and Capital [45]. However,neither in Value and Capital nor subsequently did heattach much significance to a monetary weallh effect,Flicks omitted real balance effects in Valne and Capi-tal and only thirty years later did he find any use forthe concept at all.33 The dominailt channel of mone-

3tPatinkin [63]. Patinkin’s first articles on real cash balancesappeared in the late 1940s.

~2Thepositive real balance effect associates the demand forreal ba1arn~es (positively) with money and the negativereal balance effect associates the demand for real bal-ances (inversely) with prices. The demand for goods isrelated to one’s holding of real cash balances.

a3

Leijonhufvjd noted Hicks’ lack of consideration for eitherprice-induced or interest-ind~~cedwealth effects h~ Valueand Capital. “It is interesting to note that the first edition ofVa/tie and Capital did not take the real balance effect intoaccount. In the second editioi~, Hicks responded to thecritieisms of Lange and Mosak on that issue by admitting:‘I ~vas too much in love with the simplification which comesfrom assuming that income-effects [Pigou effects] ca~eeIout when they appear on both sides of the market’ (p. 334).

Page 18

tary infimmee, so long as no liquidity frap exists, wasthrough his portfolio choice-relative price route.

Exactly what should he included in the “D” portionof the real balance wealth definition has been thesubject of debate in more recent years. In most cases,private debt typically is assumed to cancel out. I-low-ever, Pesek and Saving [64] maintained that becauseno interest is paid for demand deposits, wealth(which accrues to hank stockholders) increases inproportion to demand deposits. Thus, they wouldcount both inside money (demand deposits) and out-side money (monetary base) in net private wealth,contrary to the traditional view which counts onlyoutside money. To include all inside money as wealth,however, would likely result in some double counling.

If the inside money benefits to banks are capitalizedin the value of the banks’ stock, as are the typicalgains to nonbai~kfirms, the same inside money wouldhe found in the “D” portion and the “PlC” portion ofthe wealth equation. To the extent that demand de-posit gains are not capitalized instantaneously, thereshould be some allowance made for the addifion ofinside money to net wealth, The effect on spendingwould be through additional outlays by bankstockholders.

What about government securities (G) held by thep~ibIic?Do these represent private wealth? They onlyrepresent private wealth to the extent that the publicdoes not anticipate offsettmg future tax increases to

eliminate such debt. The term in the wealth

equation may have some effect on spending thro~igh:(1) changes in the magnitude of G; (2) changes inthe composition of C; and (3) changes in r.

One source of controversy concerning changes inwealth has been the relation between G and D. Thetwo have frequently been summed (interest-bearingdebt plus non-interest hearing debt) in empirical andtheoretical investigations of the effects of “liquidity”on the economy. If it can be assumed that C and Dare good substitutes, their composition is of less con-

While this did not lead him to reconsider also the assmuip-tion that the wealth effects of interest changes cancel, itmay \veil be that the same remark applies also to thisproblem.” (Leijonhiifvud [53], p. 275).

Hicks eventually took note of the real cash balance ver-sion of the wealth effect in a review of the first edifion ofPatinkin’s book. Hicks missed the point initially that a rise inreal cash balances stimulates spending, as he later admittedin his Critical Essays ([46], p. 52). In 1967 he recognizedthe existence of a ‘liquidity pressure effect’ — but thoughtit had merit only in restraining an expanding economy.This concept, of course, is a variation on the monetary pol-icy ‘can’t push on a string” thesis.

FEDERAL RtSERVE SANK OF ST LOUIS NOV!MBEA 1074

cern than their sum.3 Early empirical investigationsof wealth effects pllblished shortly after the accumiña-tion of much government debt in World \Var II oftentested the real balance effect as the sum of G and~ Many found a strong relation between liquidwealth and consumption. If this can be called a directchannel, a more indirect route, via interest rates. hasbeen envisioned by others.

lobin [79] emphasized aggregate monetary wealthand its compositnm with respect to the effect on in-terest rates. Not oniy does an increase in monetarywealth relative to real assets lower the supply price ofcapital and thereby induce investh~ent, but an in-crease in short-term government debt relathe to long-tei-m debt (110 change in aggregate deht) may achievethe same result. These actions are closer to fiscal poi-icy or debt management policy than to what is nor-mally labeled monetary pohey.

To the extent that monetary actions affect theyields on government debt, there is~~~ninterest-inì-duced monetary wealth effect on consumption. If ex-pansive monetary actions lower the “r” component of

~proportionateIy more than “G” in the wealth defini-

tion, nonhuman money wealth rises, as does (undertypical assumptions) consumption. Of course, a mone-tary overshoot effect would reverse the fall in interestrates and subseqiwntly ~vork in the opposite directionon consumer expenditures. Also, if the rise in the priceof securities (fall in interest rates), induces thosewealth holders who have not yet purchased securitiesto pay a higher price for their securities, this particu~-lar group may curtail their outlays for consumergoods.36

HProponents of the “New View” also add non—government,non-bank liabilities, such as savings and loan shares, to thetotal. See Brunner [6].

The Radcliffe Committee [171 found a role for money toaffect spending if it added to total liquidity, to includefunds made available by non—bank financial institutions.John Gurley noted that the Committee “believes thatchanges in these [interest] rates have had little direct effecton spending; and it does not think that there is any direct,close connection between the money .suppiy and spending.But while money is shoved out of the house through thefront door, for all to see, it does make its reappearancesurreptitiously through the back door as a part of generalliquidity: and the most important source of liquidity is thelarge group of financial institutions.” Gurley [36], p. 685Bracketed expression supplied.

35See Patinkin’s empirical chapter [63]. Lerner [54] theo-rized that continued growth of government debt, as inWorld War II, would eventually induce sufficient con-sumer expenditures as to eliminate any excess of savings overinvestment at full—employment income, lie did not attemptan empirical test, however.

34See Leijonhufvud ([53], pp. 241-42) for a discussion ofthis effect. Lawrence Klein, who recognized the potentialof interest-induced changes in wealth to affect consumption

As far as the real-balance effect, especially that partwhich pertains to “D” is concerned, there is little in-dication that Tobin Brunller—Meltzer, or Friedmanenvision monetary influences as having much impactthrough this channel.37 In at least two cases, however,these leading monetary economists have found a strongrole for the money-equity channel. Their views on themoney-equity route will be discussed after mention ofsome of the earlier proponents of this channel.

.Equity Effect

How can monetary actions affect the market valueof equity, “PK”? One aUS\VCr was provided by LloydMetzler, who re-opened the equity channel in 1951which had been described earlier by Keynes. Metzler[58] was probably the first economist whose formalmodel inclilded the investment-borrowing costs than-nel and both aspects of the wealth channel — realcash balances and private equities38 Metzler, how-ever, made the unusual assumption that the FederalReserve increases the money stock through purchasesof privately held common stock.

An increase in the money stock (in the Metzlermodel), given full employment, results in a propor-tional increase in prices and this no change in con-sumption with real balances remaining constant. TheFederal Reserve’s purchase of common stock lowersnet private wealth (the volume of securities in privatehands falls) and consequently, consumer spendii~g.The fall in consumer expenditures is accompanied bya rise in saving, a fall in the rate of interest, and theconseqi~entincrease ill capital intensity. Criticism ofMetzler’s model centered on his unusual assumptions,which, among other results, gave a negative associa-tion between monetary growth and consumerspending.

The more orthodox conjecture, that monetarygrowth, the market valuation of equities, and con-

inversely, related to the author recently that an inverse rela—lion is more likely in the depression state, such as the 1930s.than today.

37’Like Friedmari (1970, pp. 206-7) we believe that therea~-ba1aneeeffect is one of several explanations of long—runchai~gesin the IS curve. We agree, also, that the short—runmiportance of the real—balance effect is small &rnugh toneglect in most develcpecl economies where real balancesare a small part of wealth. In our analysis the size of thetraditional real—balance effect depends on the proportion ofmoney to total nonltuniaii wealth, a factor that is less than.05 for the United States” ( Bronner and Meltzer [11],p 847).

~Tinbergen provi led the first empirical test of an equities—consumption relation. Dividing cons~imption into that byincome earners and non-workers, he found that “a fall incapital gains had already caused a decline in consumptionbetween 1928 and 1929” (Tinbergen [75], p. 78).

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FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974

sumer spending are all positively related, has bedgiven theoretical and empirical support by FrancoModigliani. Modigliani [59], [60] advaticed formaltheoretical models in 1944 and 1963. He recognized arole for wealth-consumpt1on influences in his revisedmodel of the economy (called the “rnid-50s” model)which he acknowledged had been omitted from the1944 model. His new consumption equabon was

where

CC(X,~,r.[~~2

X = real income

= Modigliani’s life-cycle aggregate labor income

variabl&9

r = the rate of return on (or cost of) capital

12 = the net worth of the private sector.p

The two latter monetary-related terms, the borrowingcost variable and the wealth variable, appeared inmuch the same form in the FRB-MIT model of thelater 1960s, a model with which Mochghalli has beenclosely identified.

The money-equities-consumption channel in theFRB-MIT model hinges on the substitutability ofbonds and stocks. If an increase in demand for, say,Treasury securities, by the Federal Reserve results inlower yields and higher prices for these securities,other investors could ~vc1Ibe discouraged from pur-chasing the now higher-priced Treasury securities, butsecurities whose price was not initially affected bythe Federal Reserve action. To the extent that de-mand is shifted to equities from Treasury securitiesbecause of their higher price, there is a rise in com-mon stock prices, which is reflected in a rise in PK.

The higher equity prices represent capital gains toequity owners. The wealth effect portion of this proc-ess is the inducement to spend on the part of equityowrn~rsbecause of their increased net worth. Over asixteen-quarter period, the equity channel represents45 percent of the enlire monetary influence on totalspending in the FRB-MIT model.4°

39ModiglianiBrnmberg [621 in 1954 related consumption toone’s expected income over his life span. The discountedvalue of ‘permanent” income is human wealth, or = w.Nefther Modigham~Bruniberg nor Friedman [27] relatedmonetary-ii~duced nonhuman wealth to consumption at thisearly stage.

WdeLeeuw and Gramlich [20], p. 487. Other simulations byModigliamof the FRB-MIT model indicate an even strongerequities eflect when alternate forms of the money—equities—consumption equations are run. Modigliani [61], however,did not accept these as realistic.

It is not likely that Friedman would credit any sortof monetary-induced nonhuman wealth effect as hav-ing that much influence on spending. The relaliveprice channel dominates his discussion of the channelsof monetary influence ir~numerous articles (Friedman[28], [33], [34]). In more recent studies in whichFriedman developed a formal economic model, heomitted wealth from the consumption function, using

oniy C/p = f(I, r).41 One indication that nonhuman

wealth is of some significance in his view of thetransmission process emerged in a recent article inwhich he attempted to delineate initial and subse-quent shifts in the IS-LM apparatus.42

Until recently, Tobin apparently shared Friedman’slack of enthusiasm for monetary-induced wealth effectson consumption. His omission of wealth influellees onconsumption may be found in his informal models ofthe early 1960s as well as his more detailed models ofthe late 1960s.43 It is not so mllch that Tobin denied awealth effect, rather that he preferred to keep stockand flow variables separate. Thus, consumption (andsaving) were functions of flow variables specificallyincome — and not wealth, a stock concept. “The pro-pensity to consume may depend upon interest rates,hut it does not depend directly on the exisfing mix ofasset supplies or on the rates at which these suppliesare growing.”41

In a significant departure from most of his previousstudies, Tobin [85] stressed the importance of wealtheffects in an article co-authored with Dolde in 1971.They considered the “two major recognized channelsof monetary influence on consumption: (A) changesin wealth and in interest rates, (B) changes in liquid-ity constraints.”45 They recognized the historical sig-

~1Friedrnan recognized the inadequacy of the above con-sumption function ([30] p. 223) and ([311, p. 331) “ina hill statement” ([30j, p. 223), because it excludedwealth, but he stated he was attempting to stick to Key-nesian short-period analysis. In a much earlier study, Fried~man [261 endorsed the real balance effect more vigorously.

~2Fdedman ([321, p. 916) (liscussed shifts in IS-LM curves(first_round effects vs. subsequent effects) in a manner con-sistent with the view that wealth influences subsequentshifts. Friedman did not mention “wealth” but Blinder-Solow [2] interpreted his discussion in that context.

~3See Tobin’s early models [77], [78] and later models[81], [84]. He did mention monetary influences o’~saving!consumption in “Money, Capital, and Other Stores of Value[77], and gave the relation somewhat more prominence inthe earlier “Rejative Ineome, Absolute Income, and Saving[76].

1’Tobin [811, p. 16.4~Tobin-Do1de [85], p. 100. Tobin’s comments concerning

the volatility of the marginal propensity to consume, espe-cially with respect to the 1968 tax surcharge, provide a

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nificance of the Pigou effect, but wealth changes intheir study were associated with capital gains (equityeffect). Their liquidity effect referred to the cost ofconverting nonliquici assets to liquid form in a worldof imperfect capital markets. The level of the penaltyrate of interest (a relative price) inhibits or encour-ages conversion of nonliquid to liquid assets.

Using a Modig1iani~Brurnberglife-cycle model, theyconcluded that wealth (equity values), interest rates,

and the liqudity constraint all have important influ-ences on consumer spending. Their model was basi-cally a reduced form, in that they did not provide thelinkages between monetary policy actions and mone-tary effects.

Bmnner and Meltzer have long included a promi-nent role for wealth effects in their view of the mone-tary ti-ansrnission process. “PK” is the component ofnonhuman wealth mentioned most favorably in theiranalysis. For example, in discussing the chain ofevents following an injection of base money, Brunner-Meltzer noted that “the resulting rise in the marketvalue of the public’s (nonhuman) wealth raises thedesired stock of capital III and the desired rate ofreal consumption.”46 They further stated that relativeprice effects also operate to increase real consumptionfollowing the expansive monetary action.

At a later date Brunner again stressed the impor-tance of “PK” relative to the real balance effect in thetransmission process. “The dominant portion of thewealth adjustment induced by a monetary impulseoccurs beyond a real balance effect and depend.s oi~the relative price change of existing real capita]. Themonetarist analysis of the trai~smissionmechallism de-termines that this portion of the total wealth effectthoroughly swamps the real balance or even the finan-cial asset effects,”47

Real balances are included, however, in Brrninerand Meltzer’s [12J formal model. Total spending

ohe as to why he chose to include wealth in the coflsump~tion funetjon. Now if it had been true that the income—How theory of consumption ‘vas a resounding success, andthat its indications were being borne out all the time, thenwe wouldn’t need to go into the wealth theory or the life—eyele theory and all that. We wouldn’t need to seek afundamental theory about why savings ratios are what theyare and how they relate to various parameters. But we allknow that the cash income theory is not a resounding sue-cess.” Tobin [83], p. 159.

46Brunner and Meltzer [91, p. 377. Capital III refers primarilyto certain types of consumer durable goods. Exampks of theother two types of capital delineated by Bruoner and Melt—zer are maehiriery and equipment (Type I) arid houses(Type II).

47Brunnor [7], p. 5.

which includes consumer spending) in that model isinfluenced by, amollg other factors, nonhuman wealth.Their nonhuman wealth variables include real capital,the monetary base, the stock of government debt, andthe value of commercial banks monopoly position ex-cluded from real capital (Pesek and 5av h~geffect).

Formal economic models now routinely includewealth and/or substitution effects cm consumption.48

Few, if any, of the ernpiricaIIy-oriei~ted, structuralmodels permit all the wealth effects on consumptiofldescribed above. For example, the FRE-MIT mode](Board of Governors [3]) has an equities effect butno real balance effect; the \Vliarton Mark III model(McCarthy [56]) has a real balance effect but noequities effect. Only when model builders make al-lowance for all possible monetary effects are so-calledstructurally rich models as likely to reflect as sigmfi-cant a rnoney~spending impact as reduced formmodels. There is, of corn-se, a good possibility that yetundiscovered wealth, relative price, and even mone-tary income effects will be fotrnd in the monetarycharniels of the future.

SUMMARY

This article surveyed the rehthve price and wealthchanges set in motion when the quantity of moneysupplied changes relative to money demanded. Rela-tive price ~md wealth changes were viewed as majorelements of the molletary transmission mechanismaround the turn of the century (in rudimentary fash-ion) and in recent years, hut in much of the inter-vening period their role was subjected to considerable

question.

Fisher and Wicksell favored one approach in whichwealth was the dominant monetary force ai~danotherin which relative prices were of more significance.Keynes amplified 1)0th views, but his major interpret-ers were not SO inclined. It is, in fact, ironic thatJ. R. Hicks, who fomiulated the IS-LM interpretationof Keynes, downgraded both monetary wealth andrelative price influences, despite his pioneering re-search into basic wealth [45] and portfolio choicefields [43],

Real balance wealth effects were revived by Pigou,PatinkiH, and others while Metzler re-formulated theequity wealth effect. Tobin, Brunner-Meltzer, andFriedman advanced the poi-tfolio choice-relative priceeffect in the early 196Os, and with the exception of

48See, for example, Christ [15] and Rasehe [67].

Page 21

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These hardly exhaust all the ways in which mone-tary impulses affect spei~ding.For example, an incomeeffect occurs when the Treasury draws clown its bankbalances to purchase goods and services. A decline inTreasury deposits relative to demand deposits in-creases the money supply (other things equal) andincome.

AIternative~y, a rise in the money supply may beassociated with a change in relative prices and nochange in wealth. For example, a fall in currencyrelative to demand deposits increases the molley sup-ply and lowers bank loan rates, but there is no rise

in real balances — if defined oniy as outside money— and no change in Government debt.

Thus, depending on how the money supply iscaused to change relative to money demand, soniceffects on spending are set in motion, but not neces-sarily all. Moreover, the fact that initial conditions, tomelude all relative prices, are never the same suggeststhat under one set of circumstances initial monetary

effects may be on, say, conslimer durable goods ex-pendithres, and under another set, state and localgovernment purchases. To follow explicitly the chan-nels of monetary influence whenever there occurs a

change in the quantity of money supplied relative tothe quantity demanded, one would have to know asa minimum the cause of the change in the moneysupply, all re1eva~trelative prices, and the impact of

other exogenous events on spending units. Add to thisthe effect of feedback forces, both relalive price andwealth, and it becomes less surprising that the con-tents of the monetary black box have been difficult tounravel.

The complexity of the forces at work, however,does not mean that one should despair of forecastingthe effect of molletary iiilluences on total spendingand rely on (presumably) more elementary tools toguide economic activity. The effects of other policyactions are also difficult to trace with certainty49

191t has become clear hi recent years that simply fo,ecastingthe result of fiscal policy effects on total spending requiresmore than reliance on some variation of the deceptivelysimple relafions YC+I+G and C=C(Y—T), These

Friedman, have also highlighted the equity wealtheffect.

Page 23

FEDERAL RESERVE BANK OF ST. LOUIS NOVEMBER 1974

[1] Ackley, Gardner. “The Wealth-Saving Relation-ship.” The Journal of Political Economy 59(1951).

[2] Blinder, Alan S., and Solow, Robert M. “Does Fis-cal Policy Matter?” Journal of Public Economics2(1973).

[3] Board of Governors of the Federal Reserve Sys~ern.Equations In The MIT-PENN-SSRC EconometricModel Of The United States. (1973)

[4] Brown, A. J. “The Liquidity-Preference Schedulesof the London Clearing Banks.” Oxford EconomicPapers 1(1938).

[3] Brunner, Karl. “The Report of The Commission OnMoney and Credit.” The Jcwrnal of Political Econ-omy 69(1961).

[6] ~ “The Role of Money and Monetary Policy.”this Review 50(1968).

[7] ~ “The ‘Monetarist Revoluflon’ in MonetaryTheory.” Wcltwirtshaftliches Archit 105(1970).

[8] ~ “A Survey of Seleeted Issues in MonetaryTheory.” Schwcizerisdw Zeitschrift für Vo/kswirtschaft und Statistik 107(1971).

[9] Brunner, Karl, and Meltzer, Allen H. “The Place ofFinancial Intermediaries In The Transmission ofMonetary Policy.” The American Economic Review53(1963).

[10] ~. “The Uses of Money: Money in the Theoryof an Exchange Economy.” The American Eco-nomic Review 61(1971).

[11] ~ “Friedman’s Monetary Theory.” The Jour-nal of Political Economy 80(1972).

[12] _~. “Money, Debt, and Economic Activity.” TheJournal of Political Economy 80(1972).

[13] Cagan, Philip. “Why Do We Use Money in OpenMarket Operations?” The Journal of Political Econ-omy 66(1958).

[14] . The Channels of Monetary Effects on Inter-est Rates. i’~ewYork: National Bureau of EconomicResearch, 1972.

Page 24

tio~ (C). \Vhat does not appear in these simple relationsate the vector of relative prices, the type of governmentspending invoKed, how the government spending is to befinanced, and whether the tax changes are presumed tohe temporary or pernialactit.

Fiscal policy acLioiis way also influence wealth and inter-est rates in addition to income, the income effect presmoablyberng what is referred W as the direct eflect of fiscal aetionson spending. Although monetary aud fiseat channels of in-fluence are both complex, only monetary actions have typ-ically been viewed as operating within a black box.

p15] Christ, Carl F. “A Model of Monetary and FiscalPolicy Effects on the Money Stock, Price Level,arid Real Output.” Journal of Money, Credit andBanking 1(1969).

[16] . “Econometric Models of the Financial Sec-tor.” Journal of Money, Credit and Banking 3(1971).

[17] Committee on the \Vorking of the Monetary Sys-tem, Report. London~Her Majesty’s Stationary of-fice, 1959.

[18] Crockett, Jean; Friend, Irwin; and Shavell, Henry.“The Impact of Monetary Stringency on BusinessInvestment.” Survey of Current Business 47(1067).

[19] Davis, Richard G. “The Role of the Money Supplyin Business Cycles.” Federal Reserve Bank of NewYork Monthly Review 50(1968).

[20] deLceuw, Frank, and Gramlich, Edward M. “TheChannels of Monetary Policy.” Federal Reserve Bul-letin 55(1969).

[21] Ebersole, J. Franklin. “The Jnfiueiwe of InterestRates Upon Enterpreneurial Decisions in Business—. A Case Study.” Harvard Business Review 17(1939).

[22] Eisner, Robert. “Factors Affecting The Level ofInterest Rates: Part IT.” United States Savings andLoan League. Savings and Residential Financing:1968 Conference Proceedings, 1968.

[23] Ettin, Edward C. “A Qualitative Analysis of theRelationships Between Money and Income.” Welt-wirtschaftliches Archiv 96(1966).

[24] Fisher, Irving. Booms and Depressions: Sonic FirstPrinciples. New York: Adeiphi Company, 1932.

[25] ~. The Purchasing Power of Money: Its De-termination And Relation To Credit Interest AndCrises, rev. ed. New York: Reprints of EconomicClassics, 1063.

[26] Friedman, Milton. “A Monetary and Fiscal Frame-work for Economic Stability.” The American Eco-nomic Review 38(1948).

The likelihood is that all possible channels of mone-tary or other policy adions have not been spelled outcompletely in any one model. There remains muchroom for research which wodd narrow the gap be-tween economic reality and economic models.

relations imply a direct link between government spendingG) and total spending ( Y), and between dis~osab1e in-

come (Y — T), which includes tax changes, and consump-

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