Monetary Trends in The United States and The United Kingdom: A Review Article

American Economic Association

Monetary Trends in The United States and The United Kingdom: A Review ArticleMonetary Trends in The United States and The United Kingdom: Their Relation to Income,Prices, and Interest Rates, 1867-1975. by Milton Friedman; Anna J. SchwartzReview by: Thomas MayerJournal of Economic Literature, Vol. 20, No. 4 (Dec., 1982), pp. 1528-1539Published by: American Economic AssociationStable URL: http://www.jstor.org/stable/2724831 .

Accessed: 24/06/2014 22:30

Your use of the JSTOR archive indicates your acceptance of the Terms & Conditions of Use, available at .http://www.jstor.org/page/info/about/policies/terms.jsp

.JSTOR is a not-for-profit service that helps scholars, researchers, and students discover, use, and build upon a wide range ofcontent in a trusted digital archive. We use information technology and tools to increase productivity and facilitate new formsof scholarship. For more information about JSTOR, please contact [email protected].

.

American Economic Association is collaborating with JSTOR to digitize, preserve and extend access to Journalof Economic Literature.

http://www.jstor.org

This content downloaded from 185.2.32.14 on Tue, 24 Jun 2014 22:30:11 PMAll use subject to JSTOR Terms and Conditions

http://www.jstor.org/action/showPublisher?publisherCode=aea

http://www.jstor.org/stable/2724831?origin=JSTOR-pdf

http://www.jstor.org/page/info/about/policies/terms.jsp


Journal of Economic Literature Vol. XX (December 1982), pp. 1528-1539

Monetary Trends in the United States and the United Kingdom:

A Review Article

By THOMAS MAYER

University of California, Davis

I am indebted for helpful comments to Alan Blinder, Thomas Cargill, Charles Goodhart, Edward Gramlich, David Laidler, Peter Lindert, Ray- mond Lombra, Allan Meltzer, Alan Olmstead, Steven Sheffrin, and to students in my monetary economics course. None of them is responsible for remaining errors.

MILTON FRIEDMAN AND ANNA SCHWARTZ (F-S) have finally published their long

awaited book on velocity, money and income. It is overwhelming, both in its sweep and in the mass of material presented. The authors have not economized on effort; all nooks and crannies of the data are explored. It is that rarity in economics-a true work of scholarship.

Although its basic analysis is straightforward and simple, the book is inordinately complex and hard reading because of the multitude of detail that F-S investigated over the decades that they worked on it. In ploughing through it most readers will probably wish that F-S had not described their explorations of all the by- ways. Yet one can understand their decision to present it all. Obviously, anything they write on this topic will be subjected to searching crit- icism, and that provides an incentive to present all the evidence on all possible interpreta- tions of the data. The mass of detail is certainly

not due to the failure of the authors to digest their material, but to their being so compre- hensive.

Unfortunately, this comprehensiveness will reduce the book's impact. It will be bought by many, but read completely by few. It will not appear as often as it deserves on graduate reading lists. If F-S would publish a slim paper- back version of this book, hewing to the main line of their argument, this would greatly increase its impact.

A complaint that the book is written in a way that makes it hard to follow the main line of the argument, will surely surprise readers who have been impressed by F-S' superb abil- ity to organize evidence without obscuring the elegant simplicity of their vision. This book is different. Friedman is known to all of us as an applied theorist, policy adviser and political thinker. But he has still another string to his bow. He is also someone to whom the profession is greatly indebted for gathering and com- piling data along traditional National Bureau lines, the prime instance being his and Anna Schwartz' development of time series on the money stock. To associate Friedman's name with the National Bureau's traditional "mea- surement without theory" may seem bizarre

* Monetary Trends in the United States and the United Kingdom: Their Relation to Income, Prices, and Interest Rates, 1867-1975. By MILTON FRIED- MAN AND ANNA J. SCHWARTZ. Chicago, IL: U. of Chicago Press for the National Bureau, 1982. Pp. xxxi, 664. $48.00. ISBN 0-226-26409-2.

1528



Mayer: On Friedman and Schwartz' Monetary Trends 1529

since Friedman has rightly insisted on the ne- cessity of theory. But it is the same Friedman who in 1950 highly praised our profession's preeminent fact-gatherer, W. C. Mitchell, writ- ing:

The ultimate goal of science in any field is a theory-an integrated 'explanation' of observed phenomena that can be used to make valid pre- dictions about phenomena not yet observed. Many kinds of work can contribute to this ultimate goal and are essential for its attainment: the collection of observations about the phenomena in question; the organization and ar- rangement of observations and the extraction of empirical generalizations from them ... [1950, p. 465].

Similarly, Anna Schwartz has been at the Na- tional Bureau for almost all her professional life and is immersed in its tradition of massive fact-gathering.

The handling of the data is meticulous. Such tender loving care of the data is foreign to mod- ern economics with its great emphasis on appli- cation of advanced techniques to any set of numbers almost regardless of their meaning. By contrast, F-S eschew the use of elaborate techniques. Not even Durbin-Watson statistics are given and no adjustments are made for serial correlation. This is a weakness of their work, perhaps a serious weakness. But given the choice of the two approaches, I prefer the old world craftsmanship with which they treat their data to the latest "miracles of space age technology" abounding in so many papers that pay no attention to the weaknesses of the data.

What I find more disappointing than the ab- sence of the latest techniques is that F-S deal only with some of the components of the quantity theory dispute. In 1963 they gave us a pre- view of exciting work on the applicability of the quantity theory to business cycles, dealing with such issues as the direction of causation. Readers expecting a resolution of these issues will be disappointed. In the Preface, F-S tell us that because the material on trends took so long to write, they had to abandon the in- tended book on cycles. Instead, the present book focuses on the functional stability of velocity and the amazingly close correlation between money and income over the long run. But can one blame Friedman and Schwartz for giving an exhaustive discussion of some as-

pects of a problem rather than a less thorough treatment of all?

Since the mass of detail makes this book hard reading, I will provide a reader's guide by going over each chapter, picking out a few salient points, and then discussing qualifications and problems. Inevitably this will provide an insufficient appreciation of the book's contents, because, given the limited space, only a few high- lights can be presented, and many fascinating findings, such as their results on purchasing power parity, have to be ignored.

I.

Friedman and Schwartz start with a ten page summary of their major findings. Someone who intends to read only part of the book can use this summary to select what parts to read. Chapter 1, consisting of three pages, provides a further summary.

Chapter 2 will, in large part, be already familiar to many readers since it is a revised version of Friedman's A Theoretical Framework for Monetary Analysis (1971). Here again we are given the brilliantly clear version of the quantity theory that is such a boon to teachers of undergraduate courses, as well as an exposi- tion of Keynes' theory that insists that Keynes took absolute liquidity preference (i.e. the liquidity trap) as the standard case. This strikes me as utterly unconvincing and perhaps the best one can say about it is that, given Keynes' treatment of "classical" economics in the Gen- eral Theory, his spirit cannot complain if he is treated the same way. In the earlier publica- tion Friedman presented "a simple common model," pointed out that there is one equation too few, and then solved the problem by adding the assumption, to me at least unconvinc- ingly defended, that the expected real rate of interest is constant (or that the gap between the expected real rate and the growth rate of output can be treated as a constant). This makes changes in the nominal rate a function only of changes in the inflation premium, and hence of the past inflation rate, which, in turn, depends on previous money growth rates. It follows that velocity which is, of course, a function of the interest rate and income, depends ultimately on the money growth rate, which thus emerges as the factor driving nominal in-



1530 Journal of Economic Literature, Vol. XX (December 1982)

come. This analysis is not reproduced in the new book, which is all to the good because the assumption that the expected (after tax) real rate is constant is hard to accept. However, F-S do not disavow the previous analysis. On the contrary, we are told that "this chapter supplements, rather than replaces, others of our writings on issues in monetary theory" (pp. 16-17).

The simple theory that now takes the place of the one presented in the Theoretical Frame- work is that changes in nominal income are a function of the excess supply of money. The authors point out that this "implicitly allows for the forces emphasized by Keynes, shifts in investment and other autonomous expendi- tures through the effect of such changes on Ms and Md" (p. 63). This is certainly true, but it does not mean that Keynesians will find the F-S framework useful. A theory is more than a related set of deductive propositions; it is, among other things, a research strategy, and an agenda for research. To be useful and interesting it must, therefore, deal with "interesting" questions (a matter of "scientific taste") and focus on those variables that are empiri- cally important for these questions. It must be set up so that one can deal simply and directly with these particular variables. A focus on the excess supply of money does this for the quantity theory, but not for the Keynesian theory. Hence, whether F-S' approach is an interesting and useful way to proceed, and not merely true, depends upon an empirical issue. This issue is not just the stability of the money demand function because this function includes interest rates and real income. If shifts in the IS curve bring about large and erratic changes in interest rates, which then have a substantial effect on the demand for money, these autonomous changes have to be analyzed-as they are in the Keynesian system. In this case F-S' focus on the supply and demand for money is insufficient. Fortunately F-S take account of this, and in subsequent chapters take up not just the demand function for money, but also the extent to which changes in income are the result of changes in money, as well as the behavior of interest rates.

One problem with the quantity theory is that to predict the change in nominal income that results from a given change in the money stock

one must know the breakdown of the nominal income change between prices and real income-unless by good luck the income elasticity of demand for money just happens to be unity. (Laidler, 1978, pp. 161-62.) For example, suppose that the real income elasticity of demand for money is 0.5, that the money stock rises by 10 percent and that prices are constant. Keeping interest rates constant then requires a 20 percent rise in real and nominal income to equate the supply and demand for money. By contrast, if all the rise of nominal income is in prices, then nominal income has to rise only 10 percent to make the public willing to hold the 10 percent additional money. Since the elasticity of the demand for money with respect to prices is unity, it is only in the special case in which the real income elasticity of demand for money is also unity, that it does not matter whether it is real income or prices that rise. Fortunately, F-S find that the real income elasticity of demand for money (using old M2) is close to unity, 1.1 in the US and is 0.9 in the UK, so that their prediction of changes in nominal income is accurate even if one makes a substantial error in estimating the breakdown between changes in real income and in prices.

Although F-S discuss why the growth rate of income initially overshoots the equilibrium determined by the money growth rate, and take up some growth model considerations, their discussion of the transmission process is less detailed than the sketch they presented in 1963. Some readers will therefore complain that they are watching a magic show. But this objection can easily be overdone. The basic mechanism inside the black box is familiar to every economist; if there is excess supply of an item, such as money, its price falls. All the same, it would have been useful had F-S given some detail. This would probably have helped with the problem of determining causation and with such questions as the variability of the lag in monetary policy. But to anyone willing to accept elementary microtheory the black box is not entirely opaque.

Chapters 3 and 4 deal with the data. All the variables, except interest rates, are expressed in logs because this reduces heteroscedasticity, and also because we are interested in rates of change. A more critical decision relates to the




time span over which the variables are measured. Friedman and Schwartz transform their yearly data into cycle phase averages, thus treating each expansion or contraction as a single observation. For the US the mean length is 2.7 years for the expansion phase, and 1.7 years for the contraction phase. The corresponding UK figures are 3.4 years and 2.1 years. Obviously, these averages hide much diversity, but in the NBER tradition F-S treat each phase as a single unit of analysis, though they do weight each one by its length. They use these cycle phases because their interest is in "long-period movements" which requires "freeing the data as far as possible from the effects of shorter term movements we call business cycles" (p. 73). They recognize that it is often useful to eliminate trends from the data, and hence they provide levels of the data and an alternative treatment that is similar to first differencing. Since first differencing increases the significance of data errors, they calculate (by least square regressions) the rates of change over triplets of (overlapping) phases, and use these rates of change as their units of analysis. Thus their "first differences" refer to periods running from one expansion phase to the next expansion phase, or from one contraction to the next contraction. The average duration of these periods is 4 years for the US and 5.6 years for the UK.

Although F-S' decision to focus on long run behavior and ignore cycles fits in well with their previous work, and with their advocacy of a money growth rate rule (Meltzer, 1965) some readers will be disappointed by this, be- lieving that by partially eliminating cycles from their analysis, F-S have brushed aside an interesting and important problem. Nowadays few will be surprised that the quantity theory holds over the long run. What is much more controversial, and hence more interesting, is whether changes in money growth are responsible for most cyclical turning points, and whether changes in nominal income reflect changes in money growth within the cycle. If one takes a long enough time span for erratic shifts in "animal spirits" to wash out, even post- Keynesians might accept the quantity theory. The erratic movements which F-S are at pains to eliminate are precisely what is of interest to others, particularly those concerned with

countercyclical policy. Their findings are, therefore, consistent with a world in which Keynesian models have a large role to play.

What F-S are doing here is probably seen best in the following context. At one time it was widely believed that the quantity theory was based on the assumption of a very low or zero interest elasticity of demand for money. Friedman's (1959) money demand function was frequently interpreted this way, though it was not what Friedman had actually said. Similarly some economists interpreted the St. Louis equation as based on a vertical LM curve, rather than on a shift of the LM curve. Friedman (1966, 1968) then showed that the quantity theory does not require such an assumption, that it is based instead on the proposition that prices are flexible enough, so that when the money stock increases the real interest rate declines only for a short time, and soon returns to its previous level. The real issue is, therefore, not the interest elasticity of demand for money, but how long is the short run in which prices, and hence nominal in- comae, have not yet fully adapted to the change in the money stock. Keynesians usually argue that the short run is long enough so that it encompasses most of the interesting macroeco- nomic problems, while quantity theorists deny this. What F-S do in this book is to try to show that this short run is less than four years for the US and less than 5.6 years for the UK. Some readers may find this to be most surprising, and others to be just what they always expected.

In Chapter 4 F-S describe their data. (At this time, when training in formal econometrics has unfortunately crowded out other training in quantitative methods, every graduate stu- dent should be required to read this chapter to learn that one does not just pick up the first available series from the data source.) The money stock data cover 1867-1975 for the US and 1871-1975 for the UK. Not surprisingly the money series used is (old) M2, with US data for the years prior to 1947 coming from F-S' (1970) book. The US income (and implicit price deflator series) are NNP. The observed data are, of course, the money supply rather than the quantity of money demanded. But since they are dealing with phase averages, F-S' assumption that the public is always on its money




demand curve seems plausible. For US interest rates F-S use commercial paper rates and call money rates as well as yields of high grade corporate bonds and high grade industrials. (Their British data, discussed in the companion article by Charles Goodhart, cover comparable series.)

About a quarter of the chapter is devoted to a complex adjustment of the price series for the underreporting of prices during periods of price control. Given the substantial debate that has taken place over whether price con- trols were effective, probably not all readers will go along with F-S' adjustment. Fortunately this does not matter because in subsequent chapters F-S usually provide separate results for war periods and for peacetime. In an ap- pendix F-S present their actual data, a practice as commendable as it is unusual.'

II.

Chapters 5-8 can be treated as a single unit concerned mainly with the behavior of velocity and nominal income. A central feature of these chapters is the emphasis on comparing the monetary experiences of the US and the UK. The great similarity that F-S find provides theorists with an interesting fact to be explained.2 But, at least to me, F-S' extensive discussion of this seems excessive. Chapter 5 is essentially descriptive and focuses on the difference between velocity behavior in the US and the UK. Until 1905 income velocity was much higher in the United States, and F-S plau- sibly attribute this to a lower degree of financial sophistication, by which they mean essentially that the US economy was less monetized, that is a greater share of US than of UK output was for own use rather than for sale. Hence, in place of their earlier belief that the income elasticity of demand for money in the US is about 1.8, they now attribute the secular de- cline in velocity mainly to increased monetiza-

tion. Once one adjusts for this, the behavior of velocity in the two countries is extraordinarily similar. Within each country too, there is great similarity between the rates of change of money and of income.

Chapter 6 then presents an econometric analysis of velocity. The authors first point out that the much maligned naive quantity theory is "an impressive first approximation." Thus, for peacetime years, taking money as exogenous, 62 percent of the variance of changes in income in the US (and 69 percent in the UK) are explained by changes in the money growth rate alone. (Remember however that these growth rates are measured for periods averaging 4 years for the US and 5.6 years for the UK.)

In going beyond the simple quantity theory and fitting a money demand function F-S do not follow the parade ground drill of deducing the relevant variables from a utility function, and then using them all in a regression. In- stead, they follow a sequential procedure of adding intuitively obvious variables one at a time, arguing that this provides greater insight. But given the fact that the results one obtains in this way are likely to depend on the rather arbitrary order in which the variables are intro- duced, it is doubtful that the insight gained is worth the extra pages required.

The first factor F-S consider is the growing financial sophistication of the US for which they adjust the US money stock. To do this they argued that the US had essentially caught up with the UK's financial sophistication by 1904, and assumed that this process had pro- ceeded at a constant percentage rate since 1867. They therefore multiplied the US money stock each year until 1904 by a constantly de- creasing stepup factor. This adjustment is important since it accounts for almost three quar- ters of the total variance of velocity in the whole period F-S cover, even though the adjustment itself applies to only 30 percent of the period. They prefer their adjustment of the data to the alternative of using a dummy variable in the regression because the dummy might pick up effects due to other variables. But their prior adjustment of the money stock data really amounts to using a dummy variable and giving it first crack at explaining the data, which might result in an understatement of the income elasticity. Besides, Michael Bordo

1 In checking F-S found an error that had crept into their data, but was not large enough to require a revision of all the work based on these data. They should be commended not only for including this footnote, but also for checking their data, something which I suspect recently-trained economists usually do not do.

2 As F-S point out this similarity implies that any explanation of the behavior of velocity on grounds specific to just one of the countries has to be rejected.




and Lars Jonung (1981) have handled the adjustment for increasing financial sophistication more elegantly by using proxy variables.

Friedman and Schwartz then introduce two dummy variables. One takes account of the increased demand for liquidity due to the Great Depression and to WWII, and the other is for the postwar readjustment of velocity after WWI and WWII. Surprisingly, these two effects were about equally strong in both countries.

The next variable F-S consider is the cost of holding money, i.e. both long and short-term rates, and the latter turns out to dominate the former. The elasticities measured at the mean are between -.1 and -.4 in various regressions. (Perhaps this will finally lay to rest the notion that the Chicago quantity theory is based on the assumption of a completely interest inelastic money demand function.) Then, F-S add the yield on money. They assume that banks have no monopoly power and pay a fully competitive rate of return on deposits. This is questionable because the value of free ser- vices to depositors is (at least in periods of moderate tax rates) less than their cost to banks.

Physical capital and equities are also substitutes for money holdings. Hence F-S add a measure of the yield on capital to their money demand function. Since for households with moderate incomes consumer durables, and for owners of small firms physical capital, may well be closer money substitutes than are bonds or commercial paper, this makes a great deal of sense. However, their proxy variable for the yield on physical assets is questionable. They use the rate of growth of nominal income on the argument that since income is the yield on capital times the stock of capital, with the capital stock being fairly stable, fluctuations in income must mirror mainly fluctuations in yield. But this is questionable. If "capital" is interpreted to mean only nonhuman capital, then it is open to the objections that with about two-thirds of income being labor income, fluctuations in income growth may be a better measure of the marginal product of labor than of capital. If "capital" is interpreted to include human capital this problem disappears, but then there is the problem that human capital is not a good money substitute. Friedman and Schwartz justify their proxy by saying that it is close to the Christensen-Jorgensen direct es-

timates of the yield on capital since 1929, but then why not use that series from 1929 on? The fact that the growth rate of income per- forms well in the regressions is also not persua- sive since it may be picking up some other effects, such as demand for money as a buffer stock when income changes.

Friedman and Schwartz then use all of these variables in a single set of regressions.3 Despite the fact that one would expect a high correlation of data averaged for cycle phases, the goodness of fit is impressive. The functions fit both the US and UK extremely well; combining the data for both countries into a single regression, R2 is .9889 for levels and .72 for rates of change. For the US and the UK separately the corresponding R2s are respectively .994 and .997 for levels, and .807 and .616 for rates of change. The regression coefficients for the two countries are remarkably similar, though F-S seem almost embarrassed to find that the income elasticity is somewhat different, 1.15 for the US and .88 for the UK. But this difference seems fairly minor. Since studies of demand for various consumer goods in the two countries show large differences (Arthur Gold- berger and Theodore Gamaletsos, 1970; Hen- drik Houthakker 1965; Constantino Lluch and Alan Powell, 1975),4 it is surprising that F-S' regression results are so similar for the two countries. But "surprising" is not a synonym for wrong. I can detect no bias that accounts for F-S' remarkable result.

Finding a money demand function that fits such a long period for two countries so well is an extraordinary achievement. But the rose has some thorns. One is that no adjustment for autocorrelation has been made (and we are not given the D-W statistics) although such an adjustment can make a major difference in a money demand function (Bordo and Jonung 1981, p. 110).5 Second, F-S do not compare their function with others. It could be that another function, say one, using nonhuman

3 However they combine the yield on other assets and the yield on money into a single variable.

4Perhaps the explanation is that for commodity demand the differences shown for the UK and the US are due to sampling errors. Moreover, F-S' data are cycle phase averages.

5However, F-S may be justified in not adjusting for serial correlation if the structure generating the residuals is not stationary (Cukierman and Meltzer, 1981).




wealth, fits even better.6 Moreover, to say that the money demand function is "stable" requires a basis for comparison, such as the stability of the main Keynesian relationships over the same period. Third, F-S' high R2 is not quite as surprising as may seem at first. Few economists would doubt that in the long run there is a high correlation between money and nominal income. An even F-S' rates-of-change regressions are fairly long run since each rate of change is measured over a period that averages four years for the US and 5.6 for the UK, so that most of the cyclical and erratic elements are excluded by design.

Finally, like most money demand functions that have been fitted, the F-S function per- forms much worse for 1973-75 than for the preceding years, at least if one uses yearly data.7 But this "failure" of money demand functions should not be exaggerated. It does not provide a strong argument against use of a monetary target.8

Chapter 7 deals with velocities in the two countries. The authors argue that these two velocities are very similar. (However this similarity is not so pronounced before WWI or after 1960, and some of it is surely due to F-S' adjustment of the US money data prior to 1904.) They explain this similarity by the US and UK being part of a common trading system in which capital flows and interest rates keep prices and interest rates aligned. Hence some important arguments in the money demand functions are similar in the two countries. But, all the same, the close relation between the two velocities is surprising given the difference in the industrial and financial structures. This

chapter, which deals among other things with the effect of one country's 'income and prices on the other country's income and prices, will be of great interest to economic historians and other students of the Atlantic economy. But here, as in some other places, some readers may wish that F-S had given a bigger role to the monetary approach to the balance of payments.

In Chapter 8 F-S discuss the consistency of their empirical findings and their theoretical model presented in Chapter 2. The model is supported in one way; an increase in the money growth rate causes income to over- shoot. However, in another way the model is less fortunate. In its income equation it replaces a traditional variable, assets yields, by previous money growth rates on the argument that these determine asset yields. But the data reject this; the regressions using current and lagged money do worse than those using current money and yields or even just current money. How serious is this? That the regressions using yields do better is not so serious. In the model lagged money enters only because it explains current yields which, in turn, explain the demand for money. Since the relationship between lagged money and yields is stochastic, one can hardly expect lagged money to perform as well as current yields. What is more serious however, is that the regressions using both current and lagged money perform worse than those using just current money. Perhaps all this says is that the adjustment is completed within a cycle phase, but a more troublesome alternative for F-S would be that the higher correlation of income with current money than with current and lagged money is at least in part due to causation running from income to money.

The most interesting result of this chapter is the extraordinarily high correlation between money and income. For regressions of levels that include yields as well as the dummy variables, the lowest R2 shown is .9977, and for rates of change it is .9534. Even when one makes allowance for the fact that the phase averages wash out year-to-year variations this is extraordinary.

While these correlations certainly support the quantity theory, Keynesians can respond along two lines. One is to say that important

6 Unfortunately, no other money demand functions have been fitted for equally long periods. How- ever, Meltzer's (1963) that covers a fifty year span using annual data, has R2's that are close to F-S'.

7 I am indebted to Milton Friedman for providing the relevant data.

8 The average annual error of the F-S money demand function was about 3 percent for 1973-75. While this shows that the LM curve was not stable, the IS curve was perhaps even less predictable. In any case, once one removes the unwarranted assumption of central bank efficiency, the relative stability of the IS and LM curves turns out to be just one issue in the choice of a money stock or interest rate target; the extent to which each of these targets is likely to mislead the central bank may be just as, or more, important (Thomas Mayer, 1982).




developments can take place within the periods that are encompassed in F-S' time units. Second, there is the old issue of causation, which F-S do not discuss much. They argue that income increases can have either positive or negative effects on the money growth rate, depending, for example, on whether exchange rates are fixed or flexible. Moreover, their Mon- etary History of the United States, as well as Phillip Cagan's (1965) companion volume showed that at least for the US changes in the money supply are determined primarily by factors other than changes in current income.9 But they have not denied that some causation also runs from income to money.10

Moreover, the observed changes in both money and income could be due to a third variable. Thus Abramovitz (1973) has developed and tested a model in which swings in the balance of payments generate changes in both income and the money stock. Interactions in which an increase in income, by raising interest rates causes a capital inflow which raise the money growth rate, and hence raise income further, are possible (Patric Hendershott, 1968). Hence, even to someone like myself who agrees with F-S that causation runs mainly from money to income, it seems unfortunate that F-S discuss the direction of causation so little. Although every reader will be bound to respect the excellence of this book's empirical work, I suspect that a considerable number whose priors are anti-quantity theory will reject its quantity theory "message" because of the causation problem.

III.

Having dealt with the central issue of the quantity theory, the relation of money to nominal income, F-S devote the last four chapters (9-12) to discussing extensions and implica-

tions. The first of these, Chapter 9, dealing with the breakdown of nominal income changes between prices and output is one of the most interesting and iconoclastic chapters. It makes no concessions to the Lucas-Barro distinction between expected and unexpected changes in money. It also rejects the widely accepted view that the growth rates of prices and output are positively correlated. Much to their surprise, F-S found that a positive relationship showed up only weakly, at least for the US phase averages. Before WWI the correlation is close to zero, and for the post-WWII period it is significantly negative. It is significantly positive only for the interwar period which F-S consider idiosyncratic because of its severe recessions. For Britain the relation is consistently negative, though it is significant only for the period as a whole. They suggest several reasons for this surprising result. One is statistical. The real income series is derived by deflating nominal income, so that an error in the deflator results in an error with the opposite sign in real income. A second reason is that an exogenous shock to output, such as a good harvest raises real income but lowers prices. A third explanation relies on adjustment lags; an expansionary shock first raises output, and subsequently output falls again while prices are rising.

At least for the US one might challenge F-S on a statistical ground. For the pre-WWI period their results differ sharply from those of Abramovitz (1973, Chart 1) which show a strong positive correlation between the growth rates of prices and real GNP. Like F-S Abramo- vitz used data across cycles, though his method of eliminating cycles differs somewhat from F-S'. Since this difference in methods is pre- sumably the cause of the great differences in results, this raises at least some question about the robustness of F-S' results, even though their method is, in principle, the better one. For the postwar period, F-S' negative correlation could reflect a greater lag between changes in output and in the inflation rate which would make their third explanation, just discussed, more important. Hence, F-S' seem- ingly revolutionary findings here may perhaps simply reflect a long lag in the relation of output and prices during the postwar period.

Leaving aside such statistical issues how radi- cal are F-S' findings? In a simple, and by now

9 Additional arguments of F-S are that there are lags in the response of money to income, and the findings of many studies of money supply theory. But the evidence from lead-lag relationships is unre- liable (Friedman, 1970; James Tobin 1970) and the money supply theory studies cited treat the monetary base (or some similar variable) as exogenous. But it is just the base that may respond to income changes.

10 For F-S' discussion of this in a cyclical context see (F-S 1963, pp. 47-55).




quite old fashioned Keynesian view, in which there is no real balance effect to constrain nominal income, the greater the rise in output, the more prices rise since capacity pressures are greater. But in a more sophisticated model in which the real balance effect constrains nominal income, a greater rise in prices generates a greater downward pressure on output via the real balance effect. Hence, while F-S' results reject the simple Keynesian model, they are consistent with a fairly widely accepted more sophisticated model that includes a real balance effect. It is only fair to add, however, that F-S' previous work is a major reason why this model is now fairly widely accepted.

Apart from relating the inflation rate to the growth rate of output, F-S also relate it to the level of output relative to capacity thus testing the Phillips curve. They concede that the Phil- lips curve is usually thought of in a cyclical context while their units of observation average four years for the US and 5.6 years for Britain. The simple Phillips curve without a price expectations variable is strongly rejected by their data. The output/capacity variable is barely significant for Britain, is not significant for the US and even has the wrong sign for the US if the idiosyncratic interwar period is excluded: "at most, the calculations show only a trace of a simple Phillips curve effect" (p. 445). Then F-S test a more complex Phillips curve that has a lagged price term to take account of price expectations, and a money growth rate term to take account of Irving Fisher's version of a Phillips curve relation (Fisher, 1973). This more complex version, while it does not improve the fit, does yield one important and surprising conclusion. Inso- far as there is a Phillips curve at all its slope is positive.

On the whole, F-S found that for Britain monetary changes had little if any effect on output, and while such an effect does show up for the US, this is entirely the result of the idiosyncratic interwar period. Thus, a naive quantity theory seems vindicated. There is no need to separate expected from unexpected money growth; over a period averaging four years for the US and 5.6 years for Britain: neither seems to affect output.

F-S' results should be compared to those of Charles Schultze (1981, p. 553) who also used

phase averages. Like F-S he finds no effect of unemployment on the inflation rate in the pre- war period. But he does find such an effect for the postwar period. (In addition, the change in the unemployment rate is significant in both periods.) And Gordon (1981, p. 585) finds an effect of the capacity ratio on the inflation rate (i.e. a Phillips curve) in annual data for 1892- 1980. Hence F-S' results are sensitive to the way the data are processed.

But let us brush this problem aside, and at least for the sake of the argument, accept F-S' findings. How could they be explained? The authors refer to Friedman's (1977) Nobel Lecture, in which he argued that inflation lowers output growth by creating inefficiencies. But he does not develop the underlying mi- croeconomics sufficiently, and his discussion seems more applicable to high inflation rates than to those that were typical in F-S sample period, at least for the US. But for high inflation rates a recent IMF (1982) study of inflation and growth in non-oil LDC's support F-S.

The next chapter, Chapter 10, accounts for almost one-fifth of the book. The initial theoretical section that sets out the effect of changes in money growth on interest rates is probably familiar to most readers from Friedman's (1968) presidential address. Initially, an increase in the money growth rate lowers interest rates through a Keynesian liquidity effect, but this is then offset by the effects of rising real income and rising prices on the demand for nominal money. Subsequently, as price expectations adapt to the higher inflation rate, nominal rates rise above their previous level.

This analysis has a major implication for the Keynesian-quantity theory dispute. If the demand for money is a function of nominal income, the expected inflation rate, and the expected real interest rate, then, if subsequent to an increase in the money stock the expected real interest rate and inflationary expectations are back at their previous levels, then nominal income must have changed enough to raise the demand for money by as much as the supply of money has increased.11 Since, with the

11 See Mayer (1976). However Michael Darby (1975) has pointed out that what is relevant is a wide spectrum of interest rates rather than just the few open market rates for which we have evidence on the relation of changes in money and interest rates.




real interest rate being unchanged, real income must be unchanged too, this implies that all of the increased money has been absorbed by higher prices, so that the simple quantity theory is correct. Hence, the behavior of the interest rate can be used to determine, at least with respect to changes in the money stock, the time period to which Keynesian theory applies.

How do F-S' findings relate to this? They argue that the liquidity and loanable funds effects are offset within a cycle phase by the effect of rising nominal income, thus suggesting a time domain for Keynesian theory of one cycle phase or less. (Is this surprisingly short? Obviously, the answer depends on one's priors.) But when they regress the real interest rate on money growth, the coefficients suggest that an increase in the money growth rate lowers real, as opposed to nominal, interest rates for more than a single cycle phase. They point out that this could be due to their inability to include a sufficient number of lagged terms for money, but that, "more likely, it reflects our inability to allow for many other factors affecting interest rates, which produces a downward bias in the regression coefficients" (p. 587).12

Friedman and Schwartz show that after the mid-1950s, as inflationary expectations took hold, the Fisher effect became more pronounced; nominal rates are now much more responsive to the inflation rate. But this should not be interpreted as validating the view that, within cycle phases, changes in the money growth rate leave the relevant interest rate unchanged, and are, therefore, fully reflected in the growth rate of nominal income-the relevant interest rate is not the expected real rate per se, but the expected after-tax real rate.13 And F-S demonstrate that this rate did not come near to adjusting fully to the inflation rate.

Where does this leave us? The postwar re-

gressions do not support the proposition of rapid adjustment of prices to money because the interest rate "snap-back" that they docu- ment refers only to the before-tax rate. For the earlier period when income taxes were low or nonexistent F-S' regressions show a negative effect of money growth on the real rate as Keynesian theory predicts, though this could be due to the previously discussed statistical problems. Hence, the behavior of interest rates should not be cited as supporting the quantity theory against Keynesianism.

However, the main theme of this chapter is not what was just discussed, but is the Gibson paradox. This is a proposition popularized by Keynes that interest rates are positively correlated with the price level. After an exhaustive investigation F-S conclude that "the alleged relation does not hold over periods witnessing a substantial shift in the price level, but only within briefer periods; . . . markets may have learned their Fisher and so made Gibson obso- lete" (p. 546).

The two major explanations of the Gibson paradox are those of Fisher and of Wicksell- Keynes. The former assumes that inflationary expectations adapt to actual inflation with a substantial lag, so that for much of the period when prices are high, interest rates are still in the process of rising. The Wicksell-Keynes explanation is that a rise in the marginal efficiency of investment raises both prices and interest rates. Friedman and Schwartz conclude that the Fisher explanation is "plausible for the pre-World War I period, somewhat plausible for the interwar period, but not at all plausible for the post-World War II period" (p. 563). They reject the Wicksell-Keynes explanation on two grounds. First neither F-S' proxy for the real yield of capital nor the real yield of nominal assets show the required correlation with the price level. But, as previously discussed, their proxy for the real yield, the growth rate of real income, is open to question. Their second reason is that the growth rates of money depended more on the growth rate of high powered money than on the Wicksel- lian mechanism of banks being willing and able to meet the higher demand for loans as the marginal efficiency of investment rises. But it is at least possible that increases in the marginal efficiency of investment-and hence in

12 Another possible explanation is that the inflation rate was not anticipated. However, F-S use the short rate, and there was probably enough autocorrelation in the inflation rate to allow it to be forecast for such a short period ahead.

13Joe Peek (forthcoming) in explaining the nominal interest rate used expected inflation rates com- bined with an adjustment for taxes and found coefficients well below unity.




interest rates-increased high powered money by generating a gold inflow or a more expansionary monetary policy.

IV.

Chapter 11 is a brief examination of long cycles. By segregating those cycle phases that were affected by wars-and in the US by deep depressions-F-S show that most of the fluctuations we call long cycles are connected with these two phenomena. They argue that this points to a variable generally neglected in the literature on major cycles, the money growth rate. That major cycles are much less pronounced in the UK than in the US fits this inter- pretation well since the UK, due to its sounder banking system, avoided the deep depression cycles of the US.

This analysis is perhaps the liveliest part of the book, because it is not burdened by the baggage of great detail that the other parts of the book carry, but for this very reason it is also more suggestive than conclusive. Thus, the relation between wars, depressions and money growth needs to be developed in detail, and the hypothesis should be compared to others, such as Abramovitz' (1973) or Hyman Min- sky's (1963) that make money endogenous. If major cycles are merely a reflection of wartime spurts in the money growth rate, they are of rather limited interest; if they are also the result of major depressions, then the question whether these depressions are endogenous deserves more discussion. Such an analysis would probably have to make more use of F-S' Mone- tary History than of this book.

The final chapter is a summing up. (Those who wish to read only the summary parts of this book should, however, also read the con- cluding sections of each chapter.) Its theme is the failure of the Keynesian revolution, and its arguments are the various findings discussed above. While I have raised questions about some of them, the whole is here more than the sum of its parts. Few economists who are not already convinced quantity theorists will emerge from reading this book with completely unchanged priors. While it will achieve few "conversions," in part because it does not provide the cyclical analysis that F-S promised us in their 1963 article, it should generate a

significant shift of view. And besides all this, it is an extraordinary piece of scholarship! This book will surely become a classic, which may be defined as a book future generations will not have to read because their textbooks will have made them familiar with its contents.

REFERENCES

ABRAMOVITZ, MOSES. "The Monetary Side of Long Swings in U.S. Economic Growth." Stanford Uni- versity, CREG Memorandum #146, 1973.

BORDO, MICHAEL AND JONUNG, LARS. "The Long Run Behavior of the Income Velocity of Money in Five Countries, 1870-1975: An Institutional Ap- proach," Econ. Inquiry, Jan. 1981, 19(1), pp. 96- 116.

CAGAN, PHILLIP. Determinants and effects of changes in the stock of money, 1875-1960. NY: Columbia U. Press, 1965.

CUKIERMAN, ALEX AND MELTZER, ALLAN. "What Do Tests of Market Efficiency Show?" Unpub- lished ms., 1981.

DARBY, MICHAEL. "The Financial and Tax Effects of Monetary Policy on Interest Rates," Econ. In- quiry, June 1975, 13(2), pp. 266-76.

FISHER, IRVING. "A Statistical Relation between Un- employment and Price Changes," J. Polit. Econ. Mar.-Apr. 1973, 81(2, Part 2), pp. 496-502.

FRIEDMAN, MILTON.. "Wesley C. Mitchell as an Eco- nomic Theorist," J. Polit. Econ., Dec. 1950, 58(6), pp. 465-93.

. "The Demand for Money: Some Theoretical and Empirical Results," J. Polit. Econ., Aug. 1959, 67(3), pp. 327-51.

. "Interest Rates and the Demand for Money," J. Law Econ., 9, Oct. 1966, pp. 71-85.

. "The Role of Monetary Policy," Amer. Econ. Rev., Mar. 1968, 58(1), pp. 1-17.

. "Comments on Tobin," Quart. J. Econ., May 1970, 84(2), pp. 318-27.

. A theoreticalframework for monetary analysis. NY: Columbia U. Press, 1971.

. "Nobel Lecture: Inflation and Unemploy- ment," J. Polit. Econ., June 1977, 85(3), pp. 451- 72.

AND SCHWARTZ, ANNA. "Money and Business Cycles," Rev. Econ. Statist., Feb. 1963, 45(1, Part 2), pp. 32-64.

AND SCHWARTZ, ANNA. Monetary Statistics of the United States. NY: Columbia U. Press, 1970.

GORDON, ROBERT J. "Comments and Discussion," Brookings Pap. Econ. Act. 1981: 2, pp. 581-88.

GOLDBERGER, ARTHUR AND GAMALETSOS, THEO- DORE. "A Cross-Country Comparison of Consumer Expenditure Patterns," Europ. Econ. Rev., Spring 1970, 1(3), pp. 357-400.

HENDERSHOT, PATRIC. The neutralized money stock: An unbiased measure of Federal Reserve Policy actions. Homewood, IL: Irwin, 1968.

HOUTHAKKER, HENDRIK. "New Evidence on De-




mand Elasticities," Econometrica, Apr. 1965, 33(2), pp. 277-88.

INTERNATIONAL MONETARY FUND. World economic outlook. Washington, DC: 1982.

LAIDLER, DAVID. "Money and Money Income: An Essay on the 'Transmission Mechanism'," J Monet. Econ., Apr. 1978, 4(2), pp. 151-92.

LLUCH, CONSTANTINO AND POWELL, ALAN. "Inter- national Comparisons of Expenditure Patterns," Europ. Econ. Rev., July 1975, 6(3), pp. 275- 303.

MAYER, THOMAS. "The Interest Rate Snap-Back and its Implications for the Keynesian-Quantity The- ory Dispute," Banca Naz. Lavoro Quart. Rev., Sept. 1976, 118, pp. 203-21.

. "Money Stock vs. Interest Rates Targets. Working Paper # 188, U. of Calif., Apr. 1982.

MELTZER, ALLAN. "The Demand for Money: The Evidence from the Time Series," j Polit. Econ., June 1963, 71(3), pp. 219-46.

. "Monetary Theory and Monetary History," Schweiz. Z. Volkswirtsch. Statist., 1965, 101(4), pp. 404-22.

MINSKY, HYMAN. "Can 'It' Happen Again?" Banking and Monetary Studies. Ed.: DEANE CARSON. Homewood IL: Irwin, 1963, pp. 101-11.

PEEK, JOE. "Interest Rates Income Taxes and Antici- pated Inflation," Am. Econ. Rev., forthcoming.

SCHULTZE, CHARLES. "Some Macro Foundations for Micro Theory," Brookings Pap. Econ. Act., 1981: 2, 521-76.

TOBIN, JAMES. "Money and Income: Post Hoc Ergo Propter Hoc," Quart. J. Econ., May 1970, 84(2), pp. 301-17.



Documents

Monetary Trends in The United States and The United Kingdom: A Review Article