Monetary Velocity and Monetary Policy: A Rejoinder

Monetary Velocity and Monetary Policy: A RejoinderAuthor(s): James TobinSource: The Review of Economics and Statistics, Vol. 30, No. 4 (Nov., 1948), pp. 314-317Published by: The MIT PressStable URL: http://www.jstor.org/stable/1927376 .

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3I4 THE REVIEW OF ECONOMICS AND STATISTICS

have some influence on the volume of debt. One of the highly unsatisfactory aspects of the operation of the banking system in the past has been the degree to which this has been the situation. Looking toward the future, it would appear to be good public policy for the quantity of money and the quantity of debt to move in opposite directions.

At any rate, monetary control does not com- prise the inducement of changes in the volume of debt - a large part of which is not held by the banking system. Monetary control com- prises the inducement of changes in the volume

of assets of the banking system, of which the major portion but not the whole consists of debt of governments, business enterprises, and individuals. Good monetary policy - the kind which is a prerequisite for continuous full employment without price inflation - is a policy which permits and induces the assets of the banking system (in excess of capital funds and nonmonetary liabilities) to expand at a reason- able rate independent of the volume of debt. Existing techniques of monetary policy are ample for achievement of this independence.

A REJOINDER James Tobin

THE relevant broad facts of United States monetary experience since the first world

war can be summarized as follows: i. The quantity of money, however defined,

has been larger in the late I930's and in the I940's than in the I920'S.

2. The velocity of money, however it is measured, has been lower throughout the I930's

and I940's than in the preceding decade. 3. Interest rates have been lower in the

I930's and I940's than in the I920'S.

4. The low levels of velocity and of interest rates have proved not to be merely depression phenomena; they have continued in a period of full employment and of incomes greatly ex- ceeding those of the I920'S.

Dr. Warburton interprets these phenomena the increase in money supply, the decline in

velocity, and the lowering of interest rates- as the results of three unrelated secular trends. The alternative interpretation which I suggested is that these phenomena are interrelated; Keynesian theory provides an explanation of why an increase in the money supply, a lowering of interest rates, and a reduction in money velocity should occur together.

To illustrate the consistency of this interpretation with the facts, I presented the statistical record graphically in a manner suggested by Keynes' exposition of liquidity-preference. Dr. Warburton contends that my results depend on the particular data used and that the use of

what he considers more pertinent data would not confirm the consistency of the Keynesian interpretation with the facts. Specifically, he objects to (i) exclusion of time deposits from the quantity of money, (2) use of bank debits rather than some variant of national income as an index of the transactions demand for cash, and (3) use of the short-term interest rate in- stead of a long-term rate. "Had Mr. Tobin chosen the data relevant to his examination of the Keynesian hypothesis," he says, "and se- lected circuit velocity in I929 as a base from which to measure 'idle' money in other years, he would have obtained a vastly different set of estimates, and would have found that these estimates bear little relationship to the rate of interest."

The results of the experiment which Dr. Warburton suggests are presented in Chart i,

which is based on his own data for payments for final products and for the quantity of money held by business and individuals. "Idle" balances are computed by subtracting from actual balances in any year the quotient of aggregate payments in that year by I929 circuit velocity. "Idle" balances so computed are plotted against the long-term rate of interest. Contrary to Dr. Warburton's assertion, the results are not markedly different from those presented in my original article.

Chart 2 plots the results of the same calculation excluding time deposits, and further refutes



MONETARY VELOCITY AND MONETARY POLICY 3I5

CHART i. -AVERAGE "IDLE BALANCES," INCLUDING

TIME DEPOSITS, AND THE LONG-TERM RATE OF

INTEREST, I9I9-45

U.S. Bond Yields (%) 6

*20 5 - .21

*19 23. .22

4 2405 3

26'%29 3

27" 28 .30 34 31s33

3 37. * .35 36 038

39" .40 2 341 042 o43 44 -

45-.

-5 0 5 10 15 20 25 30 35 "Idle Balances" (billions of dollars)

CHART 2. - AVERAGE "IDLE BALANCES," EXCLUDING

TIME DEPOSITS, AND THE LONG-TERM RATE OF

INTEREST, I9I9-45

US. Bond Yields (%) 6

20 .21

2 092 3J373 23 *0 22

29' !?053 *32 33

36 .39 040 2 041 *42 .43 .44 45o

0 5 10 15 20 25 30 35 40 45 50 "Idle Balances" (billions of dollars)

Dr. Warburton's contention that my results reflected merely the erratic behavior of the bank debits series.

Dr. Warburton claims that, in contrast to the ratio between debits and demand deposits, the "circuit velocity of money . . . shows very little relationship to the rate of interest." He illustrates this claim by the bottom lines of dots in his Charts i and 2. He has unfortunately used the same scale for circuit velocity, which varies between 2.2 and I.2, as for the debits- deposits ratio, which varies between 55 and I5. On Charts 3 and 4, therefore, I plot the same data with a more legible verticle scale.

Charts I-4, which use Dr. Warburton's data, are submitted to show that my results did not depend on the particular series originally used. This is more imnortant than a defense of the

relevance of those series. However, I am not convinced that Dr. Warburton's choices are more suitable, for the following reasons:

(i) Inclusion of time deposits in the quantity of money conceals a phenomenon which the concept of liquidity-preference illuminates. Demand deposits have increased much more

CHART 3. - WARBURTON'S CIRCUIT VELOCITY AND THE

SHORT-TERM RATE OF INTEREST, I9I9-45

Circuit Vel city 2.2 19 *20

2.0 24. .26 *23 *29

925. .21 1.8 2~~~~~~7* *22 .28

*30

.37

1 6 - 936

4O43:3a34 .31

1 4 - *44 *33 .32

.45 1 2

IC0 0 I 2 3 4 5 6 7 8

Rate on prime commercial paper (%)

CHART 4. - WARBURTON'S CIRCUIT VELOCITY AND THE

LONG-TERM RATE OF INTEREST, I9I9-45

Circuit Velocity

2.2 I1

9 20

2.0 26

29. *23 I 4 * 24

27.:2 25 *22 021 1.8 2

*30

.37 1.6 402*41 :36

*4 38 *35*34 .31

1.4 - '44*33 .32

1.2

I .0 I

1 2 3 4 5 6 Yield on U.S. Bonds (%?)



316 THE REVIEW OF ECONOMICS AND STATISTICS

rapidly than time deposits since I929. At the same time the gain from holding time rather than demand accounts has been reduced, even if allowance is made for the former practice of paying interest on demand deposits. It is in conformity with Keynesian theory, therefore, to find that the circular velocity of demand deposits plus currency shows a closer relationship to the rate of interest in the I930's than Dr. Warburton's circular velocity. (Compare my Charts i and 2.)

(2) Neither bank debits nor any variant of national income is entirely appropriate as a measure of the transactions demand for cash. The difficulties arise from what Dr. Warbur- ton, following Copeland, calls transactions "outside the main money circuit," principally transactions in securities. The total dollar value of these transactions is not closely cor- related with income; and "outside" transactions require a smaller ratio of cash holdings than those within the main money circuit. In- come is a faulty index of transactions requirements because it omits the cash requirements for "outside" transactions. The series of bank debits is a faulty measure because it lumps "outside" transactions with those inside the income stream. Dr. Warburton emphasizes the distortions involved in the use of bank debits due to the erratically changing volume of secu- rity speculation. He ignores the fact that my findings are not changed by omission of New York City banks. (See Chart 4 of my original article.) He does not face the fact that his circuit velocity makes no allowance for cash requirements for "outside" transactions, which, as he emphasized, do not move in correspond- ence with income.

(3) The reason for using the short-term rate of interest in an examination of the holdings of demand deposits is that it applies, better than the long-term rate, to assets which are just below currency and demand deposits in the hier- archy of liquidity.

I agree with Dr. Warburton that the total value of the community's wealth is a variable relevant to the demand for cash balances. The logic of the liquidity-preference argument indicates the likelihood that, other things being equal, the demand for cash will vary directly with the value of the community's accumulated

savings. Keynes' omission of this variable from his formal statement of the liquidity function is explained by the assumption made throughout the General Theory that the stock of capital is constant. The theory concerns a short run in which additions to accumulated savings are insignificant in comparison with the existing stock. Analysis of the demand for money over a longer run should reckon with changes in the total money value of wealth, but in practice a satisfactory series of wealth estimates is not available. It is possible, as Dr. Warburton suggests in footnote ii, that accumulation of wealth may be responsible for a falling trend in circuit velocity independent of the rate of interest. However, this explanation cannot be used for the decline in velocity in the I930's. Because of capital decumulation in the depression and the fall in valuation of existing wealth, the money value of the national wealth was not so large in the late I930's as ten years earlier.1

Dr. Warburton must use some other rationale for his trend in circuit velocity. The rationale should be consistent with evidence which sharply differentiates the period since I929

from the previous forty years: i. Currency plus all deposits grew as a per-

centage of national income from 5I.4 per cent to 64.2 per cent in the 39 years I890-1929. In I940 the percentage had reached 85.3, and in I946, 96. The average geometric rate of increase was in the first period less than o.6 per cent per year, compared with 2.4 per cent since I929.2

2. The income velocity of money, excluding time deposits, showed no downward trend from I899 to I929 but fluctuated about the value of 3.00. In the I930's, however, income velocity fell to 2.00.3

The ambiguities which Dr. Warburton finds in the liquidity-preference analysis of the demand for cash vanish as soon as it is realized that the dependent variable in the "L" func-

1Doane's estimates are 428.I billion dollars in I930 and 388.4 billion in I938. (From J. P. Wernette, Financing Full Employment, Table 4, pp. 36-37.) The National Industrial Conference Board estimate for I938 is below that for any year from I924 through I93I. (Economic Almanac for 1948, p. 3I5.)

2Wernette, op. cit., Table 8, p. 46. My calculation for I 946.

3J. W. Angell, Investment and Butsiness Cycles, Appen- dix II, column (3), pp. 337-38.



MONETARY VELOCITY AND MONETARY POLICY 37

tion is not a ratio, but an absolute amount measurable in dollars. The function can easily be amended to take account of the effects of the stock of wealth and of transactions not tied to income. It then takes the form L =

L(Y, r, W, T) where W is the money value of the community's wealth and T is the annual rate of transactions "outside the main money circuit," in dollars. I turn now to Dr. War- burton's three questions: (i) In speaking of the demand for cash balances, I mean the absolute amount of cash desired. (2) The "L" function is said to be perfectly interest-inelastic

ifDL r if L = o, i.e., if, given the values of W, T, and Y, a change in r has no effect on L. This implies that a change in the interest rate has no direct effect on (a) L/W, (b) L/Y, or (c) L/T. The extreme view which I was discussing is that this partial elasticity is zero for all values of Y, r, W, and T. (3) Under that view, no change in the rate of interest will alter the relative amounts of cash and securities which the public desires to hold. This does not preclude transactions in securities. The term "idle balances" refers to large holdings of cash relative to the values of Y and T.

Dr. Warburton says that he has made no assumption one way or the other concerning the interest-elasticity of the demand for cash balances. It was precisely his failure to make an explicit assumption which I originally criti-

cized. The theoretical issue cannot be dodged by appealing to the secular trends, even if Dr. Warburton's interpretation of the trends is ac- cepted. For Dr. Warburton's policy conclu- sions rest on the belief that at any given time the circuit velocity of money is a constant, in the following sense: its value for any date can be found from its time trend, and this value will hold whatever the interest rate may be on that date. Only such a belief can justify Dr. War- burton's confidence in the efficacy of expand- ing the quantity of money merely by transfer- ring existing assets from the public to the banks. Only such a belief can explain his view of deficit spending as just another method of enlarging the money supply. And this belief depends, as I demonstrated in my original article, on the assumption that the demand for cash balances is independent of the interest rate.

Incidentally, Dr. Warburton misrepresents the General Theory when he attributes to Keynes the view that v (= Y/M) "may be taken as constant for short periods." Keynes considered this to be a tolerable assumption for V (= Y/M1), but not for v. Dr. Warbur- ton distinguishes between v and V in the first part of his paper and then proceeds to ignore the distinction. From this confusion stems his statement that my interpretation of the downward trend in v as related to the interest rate is a departure from Keynes.



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Monetary Velocity and Monetary Policy: A Rejoinder