Patinkins monetary theory

165

represents individual experiments: it shows how desired cash balances depend

on the inverse of the price level, the total of actual nominal cash balances being
one of the magnitudes held constant.

PATINKIN ON CLASSICAL INTEREST RATE THEORY

Patinkin argues that classical and neoclassical writers held that the interest rate
is invariant with respect to changes in the money supply under the conditions
necessary for the quantity theory to hold. They recognized, for example, that
the increase in the money supply would have to be distributed among people
in proportion to their initial holdings (Patinkin, 1965; pp. 45, 164, 371). They
understood the interdependence among markets. An increase in the money
supply would cause an increase in the demand for commodities and bonds,
temporarily depressing the interest rate. As the price level increased so would
the demand for loans (supply of bonds), causing the interest rate to return to its
initial equilibrium level. (Pages above discuss this process in detail.)
Patinkin (1965, p. 371) mentions that these writers recognized one exception,
forced savings, that involves distribution effects. In this case, a rise in the
money supply accrues mainly to entrepreneurs, who increase investment in
capital goods. The resulting rise in the price level causes the necessary decrease
in consumption, that is, forced savings. Furthermore, the increased capital
stock lowers its marginal productivity and hence depresses the equilibrium rate
of interest.
Patinkin (1965, pp. 3712) argues that since classical and neoclassical writers
recognized the foregoing exception, they probably would have acknowledged
that a change in liquidity preference or open-market operations could also alter
the equilibrium rate. However, he (1965, p. 380) suggests that the following
hypothesis would represent their views:
Variations in the average long-term rate of interest...have originated primarily in technological changes which have affected the marginal productivity of capital, and in
time-preference changes which have affected the desire to save; they have not
originated primarily or even significantly in changes in the quantity of money or
shifts in liquidity preference.

Figure 5.6 shows how an increase in thrift can lower the equilibrium rate,
while Figure 5.10 illustrates how an increase in the productivity of capital can
raise it. Figures 5.7, 5.8, and 5.9 illuminate the different ways a change in
liquidity preference can affect the equilibrium rate of interest. An open-market
purchase by the monetary authority would increase the relative scarcity of
bonds, raising their price and lowering the interest rate.

166

Monetary theory

Chapter 10 views the interest rate, broadly interpreted, as primarily a real

phenomenon. Building on the discussions in Chapter 2, it focuses on the interdependence of markets and the mutual determination of the rate.

MONEY, BARTER AND NEUTRALITY

Patinkin (1965, p. 75) argues that mere conversion of a barter economy to one
with money would not affect the real general equilibrium; introduction of money
would be neutral neutral in the sense of leaving all realities, all quantities
and relative prices, the same as they would otherwise be. Patinkin conceives of
a barter economy as the limiting position of a money economy whose nominal
quantity of money is made smaller and smaller. The equilibrium values of
relative prices and the interest rate remain unchanged as the quantity of money
approaches zero as a limit. Patinkin argues that we can get as close as we want
to a barter economy while preserving the neutrality of money. Yet he senses a
flaw in his own argument: as the nominal quantity of money approaches zero,
so does the price level, leaving the real quantity of money unchanged. Thus the
limiting position that we have defined as a barter economy is one in which there
exists the same real quantity of money as in a money economy!
Actually, the difference between the two economies is no mere quantitative
one concerning levels of prices and sizes of money supplies; the difference is
the momentous qualitative one of whether money exists and functions at all.
Patinkins contention is a curious slip in an otherwise impressive work of
sustained analysis.5 If we take seriously the tremendous services of money
reviewed in Chapter 2, we cannot suppose neutrality with respect to moneys
very existence.
We can conceive of moneys being neutral, leaving the real equilibrium
unaffected, with regard to its nominal quantity; that is what the strict quantity
theory maintains. In this case, a one-time increase in the nominal money supply
could come by way of donations to holders in proportion to their existing
holdings. This proportionality would avoid the distribution effects whose
absence strict neutrality presupposes. Even in the absence of such proportionality, the distribution effects associated with a one-shot change in money
would tend, relative to other influences, to become vanishingly small over
time, as argued by Archibald and Lipsey (1958). In the long run, neutrality
would still hold.
Less plausible is neutrality with respect to moneys nominal growth rate.
Different growth rates entail different rates of rise (or fall) of prices, different
costs (or rewards) of holding real money balances, and different total real
quantities of money in existence. By the principle of general interdependence,
different real money supplies entail different real sizes of other magnitudes

Patinkins monetary theory

167

also. Yet a far-fetched case is conceivable after all in which neutrality socalled superneutrality would hold even with regard to moneys growth rate.
In that case, continuing increases in the money supply would have to come by
way of donations to holders in proportion to their existing holdings, thereby
just canceling the price-inflation disincentive to the holding of real balances
and also avoiding distribution effects.
We have now considered three imaginable types of neutrality. The third,
superneutrality, presupposes continuing changes in the money supply in an
utterly implausible and pointless manner. The second, the quantity theory
concept, is the most nearly plausible of the three. Yet, as we know, reality does
not strictly satisfy the conditions necessary for the exact quantity theory result.
The first concept, denying any real difference between barter and monetary
economies, is downright wrong.
A barter economy might get stuck away from full employment at disequilibrium relative prices. While the aggregate of excess demands for all goods
and services must be zero, with excess demands in some sectors matching
excess supplies in others, these sectoral imbalances still could entail overall
unemployment. Adjustment of barter prices to market-clearing levels is more
difficult than adjustment of money prices. Money existing in a correct or
adequate quantity could lessen the effects of nonmonetary disorders by
providing a kind of cushion as described on pages 10911 above. On the other
hand, monetary disorder can pose disturbances unknown to a barter economy.

CONCLUSION
According to a broad or loose version of the quantity theory, the money supply,
together with the demand for cash balances, determines the stream of spending
and nominal income. The rigid or strict theory goes on to assert an exact proportionality between the nominal money supply and the price level. Patinkin
explains the conditions necessary for the latter version, conditions not fully met
in reality. Changes in the money supply affect output quantities and relative
prices as well as the price level. The real world exhibits disequilibrium, as
explained in our next chapter, not the general equilibrium of Patinkins book.
Nevertheless, his analysis, especially of the real-balance effect, contributes
greatly to understanding the real world. His diagrammatic apparatus can be
applied and extended in illuminating ways (see pages 21215 below).

NOTES
1. Patinkin departs from his focus on general equilibrium when he discusses involuntary unemployment in Chapters 13 and 14. He distinguishes between output and supply in Chapter 13

168

2.
3.
4.

5.

Monetary theory

(see pages above). In his Introduction to second edition, abridged, Patinkin (1989) further
elaborates on his disequilibrium approach to macroeconomics.
Patinkin avoids explicitly considering labor by assuming enough flexibility of nominal and real
wage rates to keep its market always in equilibrium. We prefer getting rid of a separate labor
market by aggregating labor with commodities, which also include services as mentioned above.
Looking up Mill (1848 [1965], pp. 6538) is well worth the trouble.
In mathematics a function is said to be homogeneous of degree n if multiplying each of its independent variables by a positive constant k makes its value kn times its original value. If f(kx, ky)
= knf(x,y), then the function is homogeneous of nth degree.
Homogeneous functions of degree 1, also called linear homogeneous functions, are familiar
in economics. The standard example is a production function exhibiting constant returns to
scale: an equiproportionate change in the quantities of all inputs changes output in the same
proportion.
A homogeneous function of degree zero has its value unaffected by an equiproportionate
change in its independent variables. A simple example is the identity saying that real income
equals nominal income divided by the price index: doubling both nominal income and prices
leaves real income unchanged. When Patinkin refutes the homogeneity postulate, he refers to
particular zero-degree functions, namely, commodity demand and supply functions having the
supposed property that quantities demanded and supplied are unaffected by an equiproportionate change in money prices given the money supply.
Wonnacott (1958) makes this criticism of Patinkin.

6. Disequilibrium economics (1)

THE MONETARY-DISEQUILIBRIUM HYPOTHESIS
Among theories of macroeconomic fluctuations that accord a major role to
money, at least three rivals have confronted each other. One is orthodox
monetarism the monetary disequilibrium hypothesis, as Warburton has called
it (1966, selection 1, and elsewhere). A second is the so-called Austrian theory
of the business cycle. A third is part of the new classical macroeconomics,
which features two main hypotheses: rational expectations and equilibrium
always (also known as continuous market-clearing or the Walrasian generalequilibrium model). This latter hypothesis consists of two strands: the theory
of misperceptions in which money does have a role to play, and real business
cycle theory. What monetarism offers toward understanding and perhaps
improving the world becomes clearer when one compares it with its rivals.
When monetary disequilibrium occurs, things begin to happen that tend
eventually to restore equilibrium. Instead of adjusting rapidly, however, prices
and wages are sticky, so adjustment in the short run involves quantities rather
than prices alone. Theories emphasizing an infectious failure of markets to clear
have been criticized by adherents of the new classical macroeconomics. Yet a
microeconomic rationale of disequilibrium behavior is available and will be
presented here. It recognizes that most markets are not and cannot be perfectly
competitive. It shares some strands with new Keynesian economics, which we
review in the next section.

NEW KEYNESIAN ECONOMICS

New Keynesian economics contributes to our understanding of why prices and
wages are sticky. It is a response to criticisms lodged by new classical
economists that Keynesian economics lacks rigorous microeconomic foundations because it simply assumes prices and wages are rigid. New Keynesians
address this issue by realistically assuming imperfect competition in their
models. Agents are wage-and-price setters, not takers as in the perfectly competitive model.
No single new Keynesian theory exists. Rather, many compete for attention.
Some new Keynesians even complain about too many theories, as in Blinder
169