; FOUR THE QUANTITY THEORY AND GENERAL EQUILIBRIUM ANALYS For centuries the major propositions concerning the manner in which money affected the economy constituted the body of thought known as the Quantity Theory of Money. In Chapter 6 we shall show that this body of thought was highly complex and meant different things to different writers, but students since the days of Keynes have come to think of the Quantity Theory as the simple proposition that: An exogenous change in the supply of money causes a proportionate ange in the absolute price level. This was, indeed, an oft-repeated refrain in the writings of many Quantity Theorists. In this chapter, we shall consider this proposition, known as the Crude Quantity Theory, to be the Quantity Theory If the money supply affects the absolute prize level, the money prices of re must be some connection between the money supply and the r goods. In this chapter we consicer one of the problems of building a theoretical model that contains some connection between money and the goods markets. This problem, pointed up by Patinkin (1965), relates to the difficulty of integrating the Quantity Theory with Walrasian general equilibrium theory. As we shall see here and in Chapter 5, Patinkin’s work offers us a solution for the problem that remains within the Walrasian framework. In Chapter 14 we shall see that recent work argues that a more fundamental solution to the problem of modeling a monetary economy requires us to abandon the Walrasian framework48 QUANTITY THEORY TRADITION In this chapter we begin by outlining the Quantity Theory and Walrasian general equilibrium theory separately (Sections 4.1 and 4.2); in Section 4.3 we show that in their unmodified forms there is an inconsistency between them, and in Section 4.4 we demonstrate that if they are modified by the inclusioa of the real balance effect, the inconsistency is removed. 4.1 A SIMPLE VERSION OF THE QUANTITY THEORY The Quantity Theory of Money was the dominant macroeconomic theory before the widespread adoption of Keynesian ideas in the 1930s and 1940s, But it is inaccurate to describe it as one theory. Quantity Theorists dealt with questions such as the determinants of the absolute price level, the deter- minants of interest rates, the theory of the supply of money, and the theory of the demand for money. And the fact that Quantity Theorists themselves were in dispute on all these matters further indicates that we should not think of the Quantity Theory but, instead, of 2 Quantity Theory paradigm, framework, or school of thought within which different writers dealt with various questions and frequently came to different conclusions. As noted earlier, however, it is frequently thought that the Quantity Theory consists of the single proposition that the absolute price level is determined by the supply of nominal money balances. This proposition, called the Crude Quantity Theory, is the only version with which we are concerned in this chapter. Two alternative equations are commonly used to express this, theory. The first, the Cambridge Equation, is written as: MS = kpy whereas the second, the Fisher Equation, is written as MSV Without worrying about the meaning of all the variables, we can immediately see how these equations express the idea of the Crude Quantity Theory. In the Cambridge Equation, if k and y are constants, then a change in the nominal money supply, M%, must iead to a proportionate change in the absolute price level, p. A doubling of one leads to a doubling of the other if the equality is to hold. The same principle holds in the Fisher Equation. If V and y are constant, a change in MS must involve an equiproportionate change in p. The Crude Quantity Theory is a theory of the absolute price level. Now consider the Cambridge Equation in more detail. It is, in fact, @ reduced form equation derived from a system of three equations. The first isa demand function for nominal money balances: THE QUANTITY THEORY. The second is a supply function: Mt The third is the equilibrium conditio ‘money must equal the planned sup ‘The Cambridge Equation is deri the right-hand side and the ep equilibrium condition. The Crude the equilibrium absolute price The interesting points al and supply functions. The latte is exogenously determined—it not determined by the borne in mind that this ass Quantity Theorists.) The the private sector plans to (real income, y, multi nominal money balances, 2, and if individuals and income in the form of ‘The two specific and k, the pi balances, are both frequently attributed at its full-employm income equals ni assumption would level, an ‘growth, this assumption of k's transactions i (Chapters 9 and an individual's ‘Suppose arr Walrasian 43 we them nok ory and hey betw iby the inclus JoRY foeconomic theory fe 1930s and 1940s. Theorists dealt with i level, the deter: rand the the: its themselves were tuld not think of the fem, framework, or h various questions that the Quantity Jlute price level is tproposition, called h we are concerned Ised to express this We can immediately Quantity Theory. In Ma change in the fale change in the bling of the other if Bher Equation. 1f Foportionate change Ee Price level. ail It is, in fact, a fitons. The frst ie stisa THE QUANTITY THEORY AND GENERAL EOUILIBRI NALYSIS. 49 The second is a supply function: MS a MS The third is the equilibrium condition stating that the planned demand for money must equal the planned supply in equilibrium: MS =M The Cambrid the right-hand si ‘quation is derived by substituting the demand function into and the supply function into the left-hand side of the equilibrium condition. The Crude Quantity Theory is, therefore, a theory of the equilibriua ute price level The interesting points about the Cambriége Equation concern the demand and supply functions. The latter represents the idea that the supply of money is exogenously determined—it is fixed by the government, for example—and it is not determined by the activities of the private sector. (But it should be borne in mind that this assumption was by no means generally adopted by Quantity Theorists.) The demand function for money represents the idea that the private sector plans to hold a given proportion, k, of its nominal income (real income, y, multiplied by the absolute price level, p) in the form of nominal money balances. If aggregate real income is 100. if the price level is 2, and if individuals and firms plan to hold an average 0.5 of their nominal income in the form of money balances, then the demand for money is 100, The two specific features of the demand function are that y, real income, and k, the proportionate relation between nominal income and desired money balances, are both assumed constant. The assumption of y's constancy is frequently attributed to the idea that real national output was assumed to be at its full-employment level, its maximum attainable level. Since national income equals national output by definition (as we explain in Chapter 8), this assumption would imply that real national income was at its full-employment level, and in a stationary economy with no technical progress ot population growth, this would imply that real natioxal income was constant. The assumption of k's constancy stems from the assumption that the pattern of transactions in the economy is constant. The significance of this assumption will be explored when we consider Keynes's demand function for money (Chapters 9 and 10), but its relevance can be understood now by considering an individual's money holdings. Suppose a certain man receives a nominal salary of 200 per month in the form of a cash receipt at the beginning of the month, and he spends it by spending an equal amount at each moment of the month until his cash balances are zero at the end of the month. His average cash balances over the month will be $100, and the relationship between cash balances and nominal income, MIpy, or k, will be 100/200, or 0.5. Now suppose that instead of receiving a monthly salary of $200, he receives two wage payments per month of $100 each so that he still receives $200 per month, His expenditure, we80 QUANTITY THEORY TRADITION assume, is the same as in the previous example, but it must now take the form of running down his cash balances from $100 to zero in the first half of the month and from $100 to zero in the second half of the month (after receiving his second wage payment, that is). His average cash balance at any moment of time will be $50, but his monthly nominal income is, as before, $200. In consequence, the ratio M®py, or k, is now 50/200, or 0.25. From this reasoning, therefore, it can be seen that k depends upon the pattern of income receipts and expenditure; for the economy as a whole, k will increase if there is, for example, 2 general move away from weekly wage payments to monthly salary payments. The constancy of k, therefore, stems from an assumption that the transactions pattern is constant, and that it alone determines the desired level of k. The Fisher Equation is identical in form to the Cambridge Equation. The variable V is the velocity of money, or the speed with which a unit of nominal money balances circulates. It is defined as the reciprocal of k, and therefore the constancy of V can be justified on the same grounds as the constancy of k The fact that velocity is the reciprocal of the proportion k can be seen by dividing both sides of the Fisher Equation by V and comparing the resulting equation with the Cambridge Equation. On a less formal level, it can be appreciated from the following reasoning. We saw above that k declines if, with a given income per period, the pattern of income payments changes in such a way that smaller lump sums of cash are handled as wage. payments. Instead of $200 of cash being necessary to finance income payments, only $100 of cash is required. Therefore a smaller stock of cash supports the same value of transactions per month, but each unit of cash—each $1 note— has to do more work or, in other words, has to circulate faster. The velocity of money is therefore inversely related to the proportion of nominal income held as cash balances: as k falls, V rises. 4.2 WALRASIAN GENERAL EQUILIBRIUM MODELS Although in Chapter 1 we briefly discussed some aspects of Walrasian general equilibrium models, we must now consider them more explicitly. In this section, we examine the main features of such a model as applied to an exchange economy, one where there is no production, We shall assume that time can be divided into distinct market days and that we confine ourselves to examining one such day. At the beginning of the day, all individuals are in possession of their own bundle of goods, their endowment. They are then able to enter the market and trade goods with other individuals in an attempt to maximize their own utility. The market is conducted in such a manner that no trades actually occur unless they are negotiated at a set of relative prices that equilibrates the market. An equil 1m set of relative prices is one at which the individuals are willing to trade so that the total of such trades causes no excess demand or supply for any THE QUANTITY THEORY AND GENERAL EQUILIBRIUM) good. Before proceeding, it is necessary to be clear, first, on how occurs and, second, on precisely what is meant by excess demand The Walrasian process by which the equilibrium relative reached is known as 1d/dnnement (often translated as "groping", that the market is overseen by an auctioneer whose task isto eall relative prices for the m goods. Individuals then indicate how good they wish to buy and sell at these relative prices. These desip. made by the individual participants in such a way as to maximi at the given set of prices. They can be considered as contracts, conditional contracts that will be torn up if the auctioneer: of prices called, there is in aggregate an excess supply of s excess demand for others. A situation like that can easily arise. Suppose that apples with which individuals are endowed at the start of society's total endowment of oranges, but that the auction prices in which the price of apples relative to other goo lower than that of oranges. It is easy to imagine that demand for apples that the demand wil demand for oranges that there will be an excess of excess demands and supplies of that nature, the call out a new set of relative prices, following the prices of goods for which there was formerly the prices of those which were in excess supply relative prices may again result in excess dem goods (although the pattern will be different set of prices), and again the individuals will a new set of prices will be called. It cf assumptions this process wi which the aggregate excess demand and st is the equilibrium set of prices; contracts and trades occur. Walras’ Law Now let us be more precise excess supply. For individual ay is the difference between her pl the good she already owns ( If her planned demand, Xe then her excess demand, *1 supply. Excess supply therefe latter takes a negative$200. In From this se if there nonthly f nominal therefore 2 resulting it can be hanges in payments, ents, only the same e— has to elocity of THE QUANTITY THEORY AND GENERAL EQUILIBRIUM ANALYSIS §1 good. Before proceeding, it is necessary to be clear, first, on how this process occurs and, second, on precisely what is meant by excess demand and supply The Walrasian process by which the equilibrium relative price set is reached is kno that the market is overseen by an auctioneer whose task is to call out a set of relative prices for the n goods. Individuals then indicate how much of each good they wish to buy and sell at these made by the individual as {dtdnnement (often translated as “groping"), The idea is clative prices. These desired deals are ize their utility considered as contracts but only as conditional contracts that will be torn up if the auctioneer finds that at the set of prices called, there is in ager joods and an excess demand for others. A situation like that can easily arise. Suppose that the total number of apples with which individuals are endowed at the start of the day is similar to society's total endowment of oranges, but that the auctioneer calls out a set of prices in which the price of apples relative to other goods is considerably lower than that of oranges. It is easy to imagine that there will be such a high mand for apples that the demand will exceed the supply and such a low demand for oranges that there will be an excess supply. Observing a pattern of excess demands and supplies of that nature, the auctioneer is supposed to call out a new set of relative prices, following the rule that in the new set, the prices of goods for which there was formerly excess demand are raised and the prices of those which were in excess supply are lowered. This new set of relative prices may again result in excess demands and supplies for some goods (although the pattern will be different from that obtained under the first set of prices), and again the individuals will hav ts and @ new set of prices will be called. It can be shown that under certain assumptions this process will eventually lead of relative prices at which the aggregate excess demand and supply for each good is zero. That set is the equilibrium set of prices; contracts agreed to on the basis of it are honored ticipants in such a way as to maxi at the given set of prices. They can b to cncel their contr Walras’ Law Now let us be more precise about the meanings of excess demand and excess supply. For individual a, for example, the for a good x, is the difference between her planned demand for the good and the supply of the good she already owns (which, in this model, she received in her endowment at the beginning of the day): FE (4) If her planned demand, xQ, is lower than the given supply in her hands, then her excess demand, x, is negative and we say that she has an excess supply. Excess supply therefore is defined as being excess demand when the latter takes a negative value. If this individual has an excess demand, she tries$2 QUANTITY THEORY TRADITION to buy good x; if she has an excess supply, she tries to sell it. Aggregate excess demand or supply for good x, is defined simply by summing the sxcess demands and supplies of all individuals, so that if the number of individuals is 1, we have aggregate excess demand for good x, expressed as: To simplify notation we shall write these aggregate variables as ? (42) Thus, if society's total endowment of good x, at the beginning of the market day is 8? and ifthe total amount that individuals wish to own or consume, x”, is greater than 2 at the particular set of relative prices called by’ the auctioneer, there will be an aggregate excess demand for good x, at that set of prices. Having defined the excess demand and supply for commodities, w= can immediately state one principle that is central to Walrasian general equili. Pru models, the principle known as Walras’ Law. There are competing interpretations of this principle, but for the present we shall state xi = yD Walras’ Law is the proposition that the sum of the excess demands and Supplies over all markets aust identically equal zero In other words, if, ata particular set of relative prices, there is an aggregate excess demand in some markets, there must be an excess supply in at least Ge other market of a magnitude such that the sum of excess supplies equals the sum of excess demands. Using money prices to value excess demands sad Supplies, and assuming that there are (n+ 1) markets, Walras’ Law cay be stated formally as the identity: 43) It can also be expressed in an equivalent but more illuminating form. If the sum of excess demands in n markets (for example, the n goods markets) is Positive, then there is an excess supply in the (n + i)st market (for example, the money market) equal in value to the sum of excess demands in the int markets: DE pat? 44) or since the money price of money, ps. is unity, this becomes: x=) 3 pat? as) if the (m+ 1)st market is the money market. Thus, the excess demand for | THE QUANTITY THEORY AND GENERAL EQUIL) money is, according to Walras’ Law, equal to the sum of supplies in all other markets Walras’ Law plays a significant role in monetary econ, encounter it again in Chapters 12 and 16, For the momen note that it is not a postulate that is arbitrarily inserted Prium models as a convenient way to link the money a Instead: it follows from the fact that individuals are at onstraint in their market transactions.’ An individual whan endowment of n goods and money. In nominal ter is Div Defi, + Xana (Where Linen isthe stock Otay with which the individual enters the market). The Budget a statement that the individual cannot, through greater value of goods and money than the initial e individuals cannot hold goods into the next period, they each may consume less goods and hold more the end of the market, the value of the total of the of the initial endowment. Assuming that rational cannot avoid this equality between initial endox of goods and final holdings of money balances, demand for goods and money does not exceed ‘Their demand is Dt-1 yt! + x2.ne and the i | PR + Law BE If we sum this individual budget constraint it in the same form but without the a sl Ea pal from both sides and remember tion 4.3 (or its derivatives, Eqs. 4.4 and from the individuals’ budget constrair "That Walras’ Law can be derived ‘but under some highly special as ddemonsirated inthe content of Cassel "The budget constraint and the form appropriate to an economy. suppose that individuals ean borrow fend of the market. It would no initial endowments. Nevertheless. borrowing, the constraint would the set of borrowing involves the purchase of a bond). We cover (+2) markets—the ‘would state thatthe value of the excess supplies inthe in equilibrium, any excesso sell it. Aggregate y summing the excess ginning of the market prices called by the F good x, at that set of Irasian general equili There are competing shall stat Sess supply in at least excess supplies equals te excess demands and Walras’ Law can be (43) uminating form. If the en goods markets) is t market (for example, demands in the first (4.4) becomes: 4) he excess demand for yy money is, according to W. supplies in all other markets, alras’ Law plays a significant role ir monetary economics, and ual to the sum of the nominal excess encounter it again in Chapters 12 and 16. For the mom at, it is important to note that it is not a postulate that is arbitrarily inserted into general equili brium models as a convenient way to link the money and goods market Instead, it follows from the fact that individuals are subject to a budget constraint in their market transactions.’ An individual @ enters the mark with an endowment of m goods and money, In nominal terms, this endowment is S01 pla + Klewrna [where £n-+1hq is the stock of nominal money balances with which the individual enters the market]. The budget constraint is simply statement that the individual cannot, through market trading, obtain a reater value of goods and money than the initial endowment. Assuming that individuals cannot hold goods into the next period, this means that although each may consume less goods and hold more money (or vic versa) at the end of the market, the value of the total of the two must equal the value of the initial endowment. Assuming that rational individuals know that they annot avoid this equality between initial endowments and their consumption of goods and final holdings of money balances, they will ensure that their own id for goods and money does not exceed their own initial endowment. Their demand is 37.1 px2+ x2... and the implied equality is Sn If we sum this individual budget constraint over all individuals, we may write it in the same form but without the @ subscript. If we then subtract #/,,1) and Zi-1 pi from both sides and remember that x7 = xP}, we obtain Equa- tion 4.3 (or its derivatives, Eqs. 4.4 and 4.5). Thus, Walras’ Law is derived from the individuals’ budget constraint + Baw = Dp +s "That Walras’ Law can be derived ut under some highly special essumptior lemonstrated in the context of Ca 1m the individual's budget constrains is generally he derivation will ot be possible, This except 2s work by Patnkin (1965, Note #). get constraint and the expression for Walras’ Law considered here are form appropriate to an economy where the individual trades only in goods and money. But suppose that individuals can borrow (and lend) so that they may have debts outstanding atthe dof the market. It would no longer be the case chat their demands are constrained by thei Nevertheless, if we alter the budget const borrowing, the constraint would stl hold and Wala" Law would remain count of this points that the act of borrowing involves the supply of a bond ix exchange for money (end lending involves the purchase of a bond). We should therefore amend the budget constraint and Walras’ Law to over (n+ 2) matkets—the markets for goods, money, nd bonds. In such a case, Walras" Law would state that the value of the excess demand in any one market equals the valve of the um of the excess supplies inthe remaining (n + 1) markets for example, all the markets for goods are in equilibrium, y excess demand for money must be matched by an excess supply of bondsS4 QUANTITY THEORY TRADITION The Homogeneity Postulate In addition to Walras’ Law, a principle that is frequently employed in general equilibrium models is one known as the Homogeneity Postulate. This is simply stated as the proposition that: ‘The demands and excess demands in the n goods markets will not change in Tesponse to a change in the absolute price level alone. ‘This principle can best be understood if we write out the demand and excess demand functions for goods explicit Consider the aggregate demand for good x. Applying utility theory to a barter model--one where money's only function is as x Unit of Account since it does not act as Medium of Exchange or Store of Value—we obtain particular demand functions for goods, The special feature of these demand functions is that the only variables upon which demand depends are the relative prices of goods and the real value of income. We can write the set of felative prices for the m goods as (plPs PalPs.»~»DIPs.+~»Palf) where p is the absolute price level (p =5 @n). We can write the real value of an indiviual’s income in this model of a single day's exchange economy as the wrominal value of the individual’ initial endowment af goods divided by the Stvolute price level For the aggregate of individuals, we can in general simply sum their incomes and write 37.) (p/p)S}. We can therefore wte the agare- fate demand function for good 3, 2s paa(? p apa f(P Bes Bh, We can also write the ageregate excess demand function for good x, 2s the aggregate demand for it less the agarezate of each individuals ini endowment of good (46) x “7 ‘These demand and excess demand functions incorporate the principle of the Homogeneity Postulate, A change in the absolute price level alone will, according to Equations 4.6 and 4.7, cause no change in the quantity demanded or the excess demand for good x, This follows because the meaning of the phrase “a change in the absolute price level alone” specifically implies that relative prices remain unchanged. In other words, each of the money prices (Pis-++sPo+++yPq) must change in the same proportion as the absolute price level. Thus, (pup, polp,-.-.Pip.--->Palp) remains unchanged and Stu (pip)€!, the real value of initial endowments, remains unchanged. Since nothing on the right-hand side of the equations changes as a result of a change in the absolute price level alone, the demand and excess demand variables on the left-hand side remain unchanged % ‘THE QUANTITY THEORY AND GENERAL F Xe 5 Nia Figure 4-1 There are two points that should be clarified co Postulate. The first is that it is not an unusual prin result in the utility analysis encountered in microee individual a's choice, in a two-good economy, betv %, Figure 4.1 illustrates the indifference map, dividual’s utility function, and the budget line AB budget constraint. The point of tangency, E!, betw: indifference curve determines the utility-maximiz x8" and xf". If the slope or intercept of the budge! for x; and x, changes. The slope depends only ot goods, (pi/p)), and its intercept depends only ¢ individual's income or endowment, (pip)#&+(P/t relative prices and the real value of the individuals ‘or her demands for goods in this model. | ‘The second point concerns the derivation Postulate. It is derived from the mathematical function, which we will find useful later in this ) is said to be homogeneous of variable y when, and only when, it has the by some number A, the dependent vari other words, the function is homo independent variable y if we can write Xo, Yu and zp represent particular Ie homogeneous of the first degree proportionate change in x; a do double. Since A'= A, such a €ase function has the convenient Pi x= yf(ly2)- If the funetion is a change in y causes m0, follows from the mathematical y, AM 4 From this we can se the idea that the dematPostulate. This will not change in mand and excess tility theory to a of Account sine alue—we obtain of these demand depends are th n write the set of pulp) where p is eal value of an economy as the Is divided by the in general simply 46) mm for good x; as adividual’s initial ¢ the principle of evel alone will, uuantity demanded fe meaning of the cally implies that ne money prices as the absolute and anchangs unchanged. Since result of a change nand variables on Figure 4-1 There are two points that should be clarified concerning the Homogeneity Postulate. The first is that it is not an unusual principle; it is a commonplace sult in the utility analysis encountered in microeconomics courses. Consider dividual a's choice, in a two-good ‘onomy, retween the two goods, x; and x, Figure 41 illustrates the indifference map, which represents the in: dividuals utility function, and the budget line AB, which represents budget constraint. The point of tangency, E', between this bu: indifference curve determines the utility-maximizing demand for x; and x, at x2" and x2" If the slope or intercept af the buiger line changes dx; changes. The slope depends only on the relative price of the (Pip)), and its intercept depends only on the real value of the individual's income or endowment, ((p/p)%,+(p/p)33.). Therefore, only the relative prices and the real value of the individual's endowment determine his, or her demands for goods in this mod The second point concerns the derivation of the t ulate. It is derived from the mathematicel concept of a homogen function, which we will find useful later in this chapter. A function such as x= f(9.2) is said to be homogeneous of degree q with respect to, say ariable y when, and only when, it has the property that when y is multiplied by some number A, the dependent variable x changes by the factor A In other words, the function is homogeneous of degree q with respect to the independent variable y if we can write the function as A‘xa = f(Ays, 20). where X, Yo, and z9 represent particular levels of the variables. If the function wei homogeneous of the first degree in y, then a c in y would cause proportionate change in x; a doubling of y, fer example, would cause x to double. Since A'=A, such a cas function has the conv ft line and an the demand m Homogeneity can be written as Ax) = f(Aye, that x =/( n also be written as /(1, 2). If the function is homogeneous of degree zero in y, it implies that a change in y causes no ch (Ayo, 20). This ti that A raised to the power zero is equal to follows from the mathé unity, A°= 1 From this we can ee why we can express as the Homogeneity Postulate the idea that the demand and excess demand in the goods markets are no!56 QUANTITY THEORY TRADITION ‘THE QUANTITY THEORY AND GBI functions of money prices and the absolute price level but are functions of Equations 4.8 and 4.9 give us (n+ 1) equations relative prices. The full name of the Homogeneity Postulate should be the” variables, the relative prices (pilp,....pJp, “postulate that the demand and excess demand functions for goods are The question now is whether this number gf homogeneous of degree zero in money prices and the absolute price level.” A etermine these relative prices and, if so, doubling of all money prices (and therefore of the absolute price level—a determine other variables. To answer this, itm multiplication of (pi... Pis---»Px) and p by 4 = 2—would cause no change general rule (the exceptions to which need not eo in x? or x?®, as can be seen from Equations 4.6 and 47. n linearly independent equations to determine m rule, it appears at first sight as though we have fo determine the n dependent variables. Ho Indeterminacy of the Price Level Law enables us to reduce the number of Walras’ Law, together with the excess demand equations for goods that we are left with n independent equations which, ike Equation 4.7, have the Homogeneity Postulate as a property, gives Equation 4.4, the expression for Walsiil us the basic elements of simple Walrasian general equilibrium models. If, in good barter economy: addition, we note that equilibrium in any market requires the excess demand 3 in that market to be zero, we are able to proceed to consider the model in full. pax = Tn doing so, we wish to demonstrate a particular point: A It is evident from this equation that the exe The m goods markets by themselves cannot determine the absolute price indeed, for any individual market that level, p, or the money prices (Pj,-.-.Py.-- ,) but can determine only the left-hand side) is completely determined as n relative prices (p\/P.-.-» iPr: PaP). plied by =1) of the excess demands in d the validity of Walras* Law, otly (01) In order to demonstrate this point, we shall apply the Walrasian general ae linearly independent equations. We equilibrium model to @ world where there is no money market. Money is used tions [Eq. 49 plus (n=) from Eq, only as a Unit of Account, so the relative prices (pilp... Px!P) are the ratios variables, the m relative prices (PilPs «<1 of the goods' individual money prices to the absolute price level, but since there In this model, therefore, we cam det is no money commodity or credit money no individual can own money balances. however, determine the n money In the absence of money balances, the model consists of the m goods markets (ie--sPas+++DmP) for, as a result 0 without any money market. This’ assumption is equivalent to assuming the dependent equations, which are insu existence of barter. ables. The absolute price level is The equilibrium conditions for the m goods markets are that excess demand prices, (pl/p's....!lP's.-- PhP) 4 in each of the m markets must be zero: money prices and the absolute price relative prices (pi/p",....PHD™ +1» the numerator of each equation have: set of relative prices and is therefo money prices, and therefore any (48) equilibrium, The commonsense interpretat ‘The excess demand functions in the i on the Homogeneity Postulate. good is a function of relative PH there is initially equilibrium in prices and absolute price levels prices will not disturb equilibr upon which the excess demands d prices, any set of money prides a= (B.. These equations, plus the equation defining p, the absolute price level, completely specify the Walrasian general equilibrium model for the n goods barter economy. The equation defining p is, as we saw in Chapter 2, gabat 49)it are functions of late should be the ns for goods are ate price level.” A ate price level)—a cause no change lations for goods 1s a property, gives rium models. If, in the excess demand sr the model in full the absolute price determine only the Walrasian general ket. Money is used Palp) are the ratios 2vel, but since there wn money balances. re n goods markets nit to assuming the that excess demand (asi solute price level, del for the n goods Chapter 2, 49) ‘quations 4.8 and 4.9 ve us (n +1) equatic variables, the relative prices (p The question now is whether this number of eq determine these relative prices and, if so, wheth s to determine the dependent r tions does enable us to determine other variables, To answer this, ii must be borne in mind that as a eneral rule (the exceptions to which need not cone rn us), We require exactly nr linearly independent equations to determine n variables. In the light of this rule, it appears at first sight as though we have too many equations (n + 1) to determine the n dependent variables. However, the application of Walras’ Ww enables us to redul that we with m independent Equation 4.4, the expression for Walras’ Law, in a form appropriate t good barter economy nd tions. This can be si equations by 0 VS oar (4.10) is evident from this left-hand side) is com plied by -1) 0 the validity of Walras’ Law, only (n —1) of the » equations in Equation 4.8 are linearly independent equations. We therefore have n independent equa tions [Eq. 49 plus (n-1) from Eq. 4.8] to determine the n endogenous iables, the n relative pr PulP) In this model, ther n determine relative prices. We cannot, however, determine the n money prices and the absolute price level +PmP) for, as a result of Walras’ Law, we have only 1 in- dependent equations, which are insufficient to determine these (n + 1) vari ables. The absolute prices, (pilp',....pilp's..-.pilp') is an equilibrium set, a doubling of all money prices and the absolute price level, ceteris paribus, yields the set of p?,..., Pi/p*,.-.,p2/p*). Since both the d or and the numerator of each equation have doubled, this set is the same as the initial um set. Any level of fore any absolute price level, is consistent with market (or, nter on the ation that the excess demand in the d, for any individual market that we may have chosen to ly determined as a linear function (the sum multi- f the excess demands in the cther (n 1) markets. Thus, given ( Pi price level is therefore indeterminate. If the set of relative relative prices (pi omit ve prices and is therefore also an equilib: money prices, and ther equilibrium commonsense interpretation of this conclusion is straightforward. ss demand functions in the markets of this model (Eq. 4.8) are based con the Homogeneity Postulate, They state that the excess demand for each good is a function of relative prices and the endowment of goods alone. If there is initially equilibrium in these goods markets at a given set of money prices and absolute price level, a proportionate change in all these money prices will not disturb equilibrium, since it will not affect the upon which the excess demands depend. Therefore, given equilibrium relative prices, any set of money prices (any absolute price level) is consistent with lative prices58 QUANTITY THEORY TRADITION equilibrium. The Homogeneity Postulate, although it is commonplace and appears quite innocent, yields this strong implication. We shall sce in the next section that the Homogeneity Postulate, together with Walras’ Law, has another strong implication: Its inclusion makes it impossible to extend the Walrasian general equilibrium model from_a barter economy to a monetary economy. 4,3 THE PROBLI DICHOTOMY. ICY AND THE INVALID In the preceding two sections we have examined respectively the Quantity Theory (in its crude form) and a simple Walrasian general ecuilibrium model of a barter economy. Each by itself is unsatisfactory as a model of a monetary economy. The Quantity Theory gives us determination of the absolute price level but says nothing of relative prices; the Walrasian general equilibrium model gives us determination of relative prices but says nothing of the absolute price level. The question we must now face is whether we can have an integrated model of relative prices and the absolute price level. Is it possible to integrate microeconomic price theory with monetary theory? The question was indicated by Lange (1942) but has been pursued by other writers and has received its most complete treatment from Patinkin (1965). An obvious, deceptively simple solution to the problem would be to build a model consisting of the Walrasian general equilibrium model of a barter economy with the Quantity Theory added to it as an equation for the money market. In such a model, it might appear that we can dichotemize the pricing process so that relative prices are determined in the goods markets by the principles of general equilibrium analysis, while the absolute price level is determined in the money market by the Quantity Theory. After all, we saw in Section 4.2 that in a model without a money market, we have sufficient ‘equations to determine relative prices. If we add a money market equation, we will surely then have sufficient equations to determine an extra variable, the absolute price level. This is indeed true, but unfortunately such a model would involve an internal inconsistency, or, in other words, such a di chotomization would be an invalid dichotomy. Patinkin’s proof of this follows. Inconsistency and Invalid Dichotomy AG Bol SB) nm 4.11 ‘THE QUANTITY THEORY AND GENER Se These equations are the same as those that me previous section. In addition, the present mode function modeled according to the Quantity Th M? = kp By subtracting M® from both sides, this eg equilibrium condition in terms of the excess balances: > M*? = kpy — M! Finally, the element that links the money and Law. As we saw in the last section, Walras’ La function for money as a function of the excess ‘A model incorporating the Quantity Theory anc two excess demand functions for money, E because of the inclusion of the I} it mutually inconsistent, The inconsistency arises because each equ In Equation 4.15, the excess demand function degree one in the absolute price level. If all mo example, the excess demands for commodities result of the Homogeneity Postulate having b 4.11. Therefore the x?® terms on the right-ham not alter, but the money prices, ps would all ¢ for nominal money balances, M*°, would dow excess demand function for money yielded as Theory is nonhomogeneous in the absolute Pt cause a change in M*®, but it will not, #eco equation, cause a proportionate change i demand for money (kpy) and not the excess demand equation is therefore degree one; in fact, it is not ho inconsistent with the excess demand Law. is implied by the Homogeneity The inconsistency can equally Well mathematical properties of the ea the money market are in equll level doubles and no exogenous ¥é Because the excess demands for Homogeneity Postulate) the, aa FBeatse in be nex fpwalras’ Law, ha Ppa to extend the eto a mone {EINVALID pectively the Quantit feral equilibrium mode bry as a model of a determination of the {the Walrasian gener Jeices but says nothin face is whether we can [solute price level. Is it monetary theory? The lirsued by other writers finkin (1965), {blem would be to build jum model of a barter Fauation for the money flichotomize the pricin goods markets by the Absolute price level is ids After all, we saw in Ket, we have sufficien Woney market equation, fBiine an extra variable Whately such a model Words, such a di PSB HOOE of this follows. [i elttne its essential BMiations modeled =1 ™ a1 1 4.12) tions are the same as tho: jon. In addition, the pi inction modeled according to the Quan‘ity Theory These ea previous sei that made up the barter model of thi seni model has a money market demand M? = kpy 4.3 By subtracting M° from both sides, this equation can be written as an equilibrium condition in terms of the excess demand for nominal money M* = kpy- M5 =0 (4.14) Finally, the element that links the money and the goods ma Law. As we saw in the function for money as a function of the excess demands for goods: s Wal ast section, Waltas’ Law can yield an excess demand %0 = (1) pul? (4.15) A model incorporating the Quantity Theory and Walras’ Law therefore yields two excess demand functions for money, Equations 4.14 and 4.15. But, because of the inclusion of the Homogeneity Postulate, these equations are ses because each equation has different properties. xcess demand function for money is homogeneous of degree one in the absolute price level. If all money prices were to double, for example, the excess demands for commodities would remain unchanged as a ult of the Homogeneity Po: ated in Equation 4.11. Therefore the x?? terms on the right-hand side of Equation 4.15 would not alter, but the money prices, p,, would all double, and the excess demand for nominal money balances, M*®, would double as a result. However, the ion for money yielded as Equation 4.14 by the Quantity el. A change in p will late having been incorp excess demand funi Theory is nonhomogeneous in the absolute price cause a change in M*®, but it will not, according to the Quantity Theory equation, cause a proportionat in M*®, since it affects only the demand for money (kpy) and not the supply (M®). The Quantity Theory excess demand equation is therefore not homogeneous of degree zero or of degree one; in fact, it is not homogenzous to any degree. It is therefore inconsistent with the excess demand function for money which, via Walras Law, is implied by the Homogeneity Pos‘ulate in the goods market equations. The inconsistency can equally well te expressed without referring to the ematical properties of the equations. Suppose that the goods markets and ine that the absolute price nd no exogenous variable (such as the money supply) changé Because the excess demands for goods depend only on relative prices (the Homogeneity Postulate) the goods markets remain in equilibrium with zero chanj the money market are in equilibrium, Now in level double:60 QUANTITY THEORY TRADITION excess demands. Walras’ Law indicates that since the goods markets have zero excess demand, the remaining market, the money market, also has zero excess demand. The Quantity Theory, however, indicates that this increase in the absolute price level does cause a positive excess demand for money; while the supply of money remains unchanged, the demand for money increases because the Quantity Theory proposes that it deperds on the absolute price level. The Quantity Theory analysis of the money market is) therefore inconsistent with the existence of the Homogeneity Postulate in the goods markets and the existence of Walras’ Law, which links together all the markets, "It is impossible to refute Patinkin’s demonstration that an internal in- consistency exists in any model containing the Quantity Theory, Walras’ Law, Land the Homogeneity Postulate, Nevertheless, his argument generated con- siderable controversy, and several writers, including Valavanis-Vail (1955), have attempted to dispute it. One of the arguments attacking Patinkin has been the idea that there is no inconsistency in the model if we examine the economy at a point of equilibrium. This is, in a sense, true. It comes down to saying that the (n +2) equations of the model (the goods market equations, the price level definition, and the Quantity Theory) include (n +1) in- dependent equations as a result of applying Walras’ Law, and these are sufficient ( determine (7 +1) variables (Ihe m selative prices and the absolute price level) when all excess demands are zero. ‘The point of Patinkin’s argument, however, is that the inconsistency is revealed as soon as we explore the possibility of disequilibrium and non-zero ‘excess demands; such disequilibrium analysis has to be undertaken if we are to consider the determinateness of the absolute price level in a meaningful way. Disequilibrium analysis must be undertaken in order to determine the stability of equilibrium. At an equilibrium point, the inconsistency between the two excess demand functions for money, Equations 4.14 and 4.15, need not greatly concern us, although it continues to be present. It is of little interest because both of them take the value zero in equilibrium. However, as, soon as we consider a change in equilibrium or the disequilibrium forces that bring about equilibrium, their inconsistency prevents analysis even though the number of independent equations matches the number of endogenous vari ables. Suppose, for example, that we analyze whether the absolute price level is determinate by imagining that it diverges from its initial equil brium level and examining what happens to the model. We would find that Equation 4.14 tells us that there will be an excess demand for money, whereas Equation 4.15 tells us that there will not, Say’s Identity We have seen, therefore, that a model containing the Quantity Theory, Walras’ Law, and the Homogeneity Postulate is not an internally consistent model of the determination of relative prices and the absolute price level. We ¥ THE QUANTITY THEORY AND GENERAL B¢ could equally well show that the inconsistency exist the Homogeneity Postulate and include the principh model Say's Identity is a proposition that, like the H commonly found at least implicitly in microeconom ‘The demand for goods as a whole always equals two are identically equal, Equivalently, it can be read as stating that the exc: markets as a whole is identically equal to zero. 1 excess demand for some goods, but this is always bal of other goods. Thus, for an economy with n good: can be written in symbols as: Soxi?mo This expression appears to be very similar to Walras comparing Equation 4.16 with Equation 4.3. The tween the two is that Walras’ Law refers to the aggregated over alll markets—both the goods aud m Say's Identity refers to the sum of excess deman alone. It has the strong implication that there can ne oversupply, whereas Walras’ Law merely implies t ‘20048, it is accompanied by an excess demand for m If we were to build a model containing the Quant and Say's Identity, it would be internally incons including the Homogeneity Postulate is. This can be reasoning: Suppose we are initially at equilibrium an were to double while all exogenous variables rema tence of Say’s Identity would ensure that this cha being an excess demand or supply for the goods mart of excess demands in the n goods markets is, a¢et identically equal to zero (Eq. 4.16). In consequence, the excess demand in the (n+ I)st market is Quantity Theory tells us that the excess demand as a result of the rise in p. There is, therefore, the excess demand function for money deri Walras’ Law and the excess demand func! Theory. The inconsistency in Walrasian general Quantity Theory added can therefore be the Walrasian model to include the Hi Say’s Identity Patinkin was concerned, not onlye goods markets ha could equally well show that the inconsistency exists if we ignore the role of marist aio hat see the Homogeneity Postulate and include the principle of Say’s Identity in the that this increase in model srdemand Kertea cacy Say's Identity is a proposition that, like the Homogeneity Postulate, is Sanat etree commonly found at least implicitly in microeconomic theory. It states t at it depends on the tie money: market 3" ‘The demand for goods as a whole always equals the supply of goods; the reneity Postulate in the two are identically equ » links together all the Equivalently, it can g that the excess demand in the goods mn that an internal in markets as a whole is identic ual to zero. There may be a positive Theory, Walras’ Law excess demand for some goods, but this is always balane 5s supplies uument generated con of other goods. Thus, for an economy with n goods markets, Say's Identity Valavanis-Vail (1955), can be written in symbols as attacking Patinkin has velit we examine the Sonieo 4.16) dart equations, This expression appears to be very similar to Walras’ Law, as can be seen by y) include (n +1) in comparing Equation 4.16 with Equatior 4.3. The important distinction be-” Law, and these are tween the two is that Walras’ Law refers to the sim ef ee one prices andthe absolute areeated over all markets—both the goods and money, markets whee Say’s Identity refers to the sum of excess nands in the goods markets at the inconsiteney ix alone. It has the strong implication that the1e can never be gluts of goods os uilibrium and non-zero oversupply, whereas Walras’ Law mere'y implies that if there is a slut of undertaken if we are 8004s, itis accompanied by an excess demand for money, 4 level in a meaningful | If we were to build a model containing the Quantity Theory, Walras’ Law. order to determine the and Say's Identity, it would be intermally inconsistent, just as a mode inconsistency betwe including the Homogeneity Postulate is. This can be seen from the following ins 4.14 and 4.15, need easoning: Suppose we are intially at equilibrium and the absolute price level ent. It is of little were to double while all exog jOus variables remain unchanged. The exis- rilibriutn, However, as tence of Say's Identity would ensure that this change in p prevents there eqqil{befum forces that being an excess demand or supply for the goods markets as a whole. The sum nalysis even though the | of excess demands in the m goods markets is, according to Say’s Identit + of endogenous vari- identically equal to zero (Eq, 4.16). In consequence, Walras' Law implies that the absolute price level the excess demand in the (n+ I)st market is also identically zero, But the nitial equilibrium level Quantity Theory tells us that the excess demand for money becomes positive find that Equation 4.14 as.a result of the rise inp. There is, therefore, again an inconsistency between J whereas Equation 4.15 the excess demand function for money derived from the goods markets via Walras’ Law and the excess demand function derived from the Quantity Theory The inconsistency in Walrasian general equilibrium models that h: Quantity Theory added can therefore be demonstrated either by specifying the Quantity Theory the Walrasian model to include the Homogeneity Postulate or as including ‘m internally consistent Say’s Identity solute pride iovet Patinkin was concerned, not only to demons fe the existence of in62 QUANTITY THEORY TRADITION consistency in models of the type we have discussed, but also to argue that inconsistent models such as these are found in the published work of many economists who wrote within the Quantity Theory tradition before the 1930s. Thus, a part of his work is an exercise in the history of economic thought; if his interpretation of the Quantity Theorists’ work is correct, then the exis- tence of an inconsistency in such models is a serious flaw in the quantity theory tradition. There is, however, room for doubt as to whether the Quantity Theorists’ work contains the Quantity Theory, Walras’ Law, and Say’s Identity (or the Homogeneity Postulate). This is a question to which we return in Chapter 6 where we consider in some detail the development of the Quantity Theory. 4.4 THE REAL BALANCE EFFECT Patinkin’s work demonstrates, as seen earlier, that itis impossible to reconcile the established theory of relative price determination (based on the Homo- geneity Postulate or Say's Identity) with the Quantity Theory explanation of the absolute price level. We are therefore left with the question posed at the beginning of the last section: How can we build a model of 2 monetary ‘economy where relative prices and the absolute price level are both deter- minate? ‘One apparent solution would be to drop the Quantity Theory. Then we would have 2 model consisting of the n goods market equations (Eq. 4.8), the equation for the (n + I)st market, the money market, and the equation for the absolute price level (Eq. 4.9). Walras’ Law, the Homogeneity Postulate, and Say’s Identity would still be present. Walras’ Law would determine the relationship between the n goods markets and the money market, the (n+ L)st, and there would be no Quantity Theory equation to contradict the money market equation derived via Walras’ Law. Walras’ Law also enables us to climinate the money market equation as being not an independent equation. We are left with (n+) equations, the n goods market equations, and the definitional equation for the absolute price level. Say's Identity, however, implies that we must eliminate yet one more equation, for it states that one of the n goods market equations is dependent on the remaining (n—1). If the sum of excess demands in (n—1) of the n goods markets is positive, then there must be an equivalent excess supply in the nth market, for otherwise Say’s Identity would not be satisfied. Thus, through the application of both Walras’ Law and Say’s Identity, we have eliminated as dependent equations two of the (n +2) original equations. We are left with just n independent equations, and these are sufficient only to determine the 1 relative prices of ‘goods, There are not sufficient equations to determine the absolute price level. Therefore, it is impossible to avoid the inconsistency between the Quantity Theory, Walras’ Law and Say’s Identity (or the Homogeneity Postulate) by dropping the Quantity Theory. That procedure would lead to the absolute price level's being indeterminate cannot, however, instead, the exeeg the real balance ¢ position that: (O. The difference considered for goods assumed that fore interpret |{also to ara jhed work of many jn before the 1930s conomic thought; if he exis rect, then the faw in the quantity nether the Quantity (and Say’s Identit hapter ye Quantity Theory sible to reconcile possible to fased on the Homo: teory explanation of inestion posed at the del of a monetar evel are both ty Theory. Thei tuations (Eq. 4.8), the the equation for the mneity Postulate, and ould determine the market, the (n + 1)s ontradict the money W also enables us Mependent equation t equations, and the ' Identity, however, tritstates that one of (aining (n 1). If the Fetes positive. in Market, for o} P application of both slependent equations Wiust m independe En relative prices absolute price lev twee " Petween the Quantity Bencity Postula Head to the absolute The Real Balance Etfect An alternative procedure is to amend the model presented in Section 4.3, so that the Homogeneity Postulate and Say’s Identity are abandoned. This rocedure is the one proposed by Patinkin. He demonstrates that a consisten monetary model of relative prices and the absolute price level can be built and that it can comprise both the Quantity Theory and Walras’ Law. I cannot, how comprise the Homogereity Postulate or Say's Identity instead, the excess demand functions for goods and money must incorporate the real balance effect. The real balance effect can be defined as the pro position that The demands for goods (and for real morey balances) are not only functions of relative prices and the endowment of z00ds; they arc also functions of the Thus, the excess demand functions for the markets must be written as n) 4.17) The difference between these excess demand functions and those we have considered previously (Eq. 4.8) is that here the demand and excess demands jor goods depend on the real val assumed that the relationship is positive (2: ‘ore interpret Equation 4.17 as saying that if rela e of money balances, In particular, it is (M°[p)>0). We can the fe prices and the endow ment of goods remain unchanged, an increase (or decrease) in the real value of money balances causes an increase (or decrease) in the demand and excess demand for goods. With the goods market equations written in this form so that they include the real balance effect, the demands and excess demands for good: level. If the stock of nomi unchanged, an increase in the absolute price level will reduce the value of real balances, MfS/p—the real value of $100 in notes declines if th level increases. This decline in real balances causes a fall in goods and also, if the goods markets were initially in equilibrium, an excess supply of goods. Thus, the inclusion of the real balance eff oes affect the demand for £0 pend on yal money balances, M5, is the absolute pri t ensures that a change in the thereby ensuring that the Homogeneity Postulate does not hold in the goods market. The inclusion of th balance effect also ensures that Say's Identity does not hold, for a change in the absolute price level affects the excess demands for all goods, all in the same direction: If the goods markets are initially all in equilibrium, a rise in the absolute price level, causing a fall in real balances, produces excess supply in all goods markets, a position that is inconsistent with Say’s Identity64 QUANTITY THEORY TRADITION Thus, the existence of the real balance effect in a model implies the nonexistence of the Homogeneity Postulate or Say’s Identity. On the basis of it, we can build a Walrasian model of a monetary economy without encoun- tering an inconsistency, and the problem discussed in the last section can be resolved. Such a model would consist of the Quantity Theory cs the equation of the money market, Walras’ Law (Eq, 4.15) linking the money market and all the goods markets, the n excess demand equations of Equation 4.17 (set to zero to express the goods market equilibrium conditions) to represent the n goods markets, and the equation defining the price level (Za. 4.9). It is important to note, however, that to treat the real balance effect rigorously and to ensure the internal consistency of the model, we can no longer represent the Quantity Theory by Equation 4.14. For, if the demand for goods depends upon real balances, so does the demand for real balances itself, as will be demonstrated in Chapter 5. Thus we can write the demand for nominal balances as and the excess demand as: MP ~ pfaai(y. ‘) =a ‘These can be considered as the Quantity Theory equations of the money market when amended to take specific account of the real balance effect. Consistency and Determinateness First we must examine the model to check that the number of in- dependent equations is sufficient to determine the endogenous variables. There are (n +2) equations of which, by applying Walras’ Law, (n+ 1) are independent. These are exactly sufficient to determine the m relative prices plus the absolute price level, or, what is the same thing, the m money prices (Pi,--+Ph+-+Px) and p, the absolute price level. This, however, is of relatively little interest, since we saw in the last section that the internal consistency of the model is separate from the question of the equality between independent equations and endogenous variables. Our second task, then, is to consider the internal consistency of the model. Again imagine that the model is initially in equilibrium in all markets and that all money prices and the absolute price level double with no other exogenous change. Once again, this will induce an excess demand for nominal money balances in the money market, as described by the Quantity Theory. For internal consistency, this must be accompanied by equivalent excess supply in the n goods markets, for otherwise Walras’ Law would not be satisfied. The real balance effect ensures that this excess supply of goods does occur. For the increase in p reduces the real value of money balances, THE QUANTITY THEORY AND GENERAL, (AT)p), and, as suagested by Equation 4.17, this re (ey arte n goods to decline and a negative Supply) to develop in the goods markets. The rise Fae re ey model, then, throws each market ir way that the excess supply in the goods markets Way that the Gcare consistent with the relation ra ralated by Walras’ Law. It can immediately be abandoned in this model, for the increase in price supply of goods as a whole. PAve lace found, therefore, that the Walrasia real balance effect is internally consistent and do Teel galance Soney prices and the absolute pricy Complete the analysis, however, since a full discus St’ should consider what forces occur in é economy to a new equilibrium. In the preceding See denling in the air, with disequilibrium ir Peer ete anease in money prices and p. This si we make an assumption that is common in eco there is excess demand in a market, the pri t falls when there is excess supply. This, it will be falls when thetValrasian models is assumed to fo aa iereer oF ney prices being higher than in the e in all goods markets and excess de cess suPPnY on ensures that the price of eact a eerie) falls, and, what comes to th eee sccy balances in terms of goods (1/P,0 price level) rises. Thus. the disequilibrium brows money prices and p causes a fall in money pr restored. muat be the case that equiliam se i fallen to their original lev prices and p have al equilibrium with the siven exogenous arb Ss aaeeer fave not changed, the initial levels of vacin hehe equilibrium levels. Thus, the mone level are determinate in this aosel iim : arbitrary rise in (Dis--» Pi ++ Pe | i levels. The real balance initial equiiprioe ye in prices reduces the walt result. An arity jg unchanged. This brings ab money supply Men prices, and therefore real BE ‘overcome only when PRICES, ee rated the internal consiste fe have demonst dete Sacness of a prices) and pOlliEg equally indoning Say’s Identity. ‘We could eal abandoning, $A" Joning the Homogeneiy Ba achieved by ePMqquations (Es, 417) a excess supply ifnodel im e {On the basis of } without encoun n be yas the equation ney market and uation 4.17 (set to io represent the 4 Eq "4 fect rigorously and > longer represent for goods depends itself, as and for nomin: ans of the money balance effect. & number of in: dgenous variables P Law, (n+ 1) are © mt relative price hen money prices 5: however, is of {that the internal M of the equality ‘Onsistency of the fim in all markets ble with no oth iemand for nominal F Quantity Theory Sahivalent excess W Would not be IBely of soods docs Money balan (it*Jp), and, as suggested by Equation 4.17, this reduction for each of the n goods to decline and a negative exce supply) to develop in the goods markets: The rise in the absolute price level in uses the demand demand (an ex this monetary model, then, throws each market into disequilibrium in such a way that the excess supply in the goods markets and excess demand in the money market are consistent with the relationship between the markets postulated by Walras’ Law. It can immediately be seen that Say’s Identity is abandoned in this model, for the increase in prices has brought about excess supply of goods as a whole We have found, therefore, that the Walrasian monetary model with the al balance effect is internally consistent and does have sufficient equations ‘0 determine money prices and the absolute price level. This does not quite complete the analysis, however, since a full dis. p should consi jon of the determinateness .ccur in disequilibrium to bring the uilibrium. In the prececing paragraph, the economy has angling in the air, with disequilibrium in all markets having resulted from the increase in money prices and p. This situation is easily resolved if we make an assumption that is common in economics. Assume that when here is exc arket, the price in that market rises, and that it falls when there is excess supply. This, it wil be recalled, is the rule that the auctioneer of We s is assumed to follow. Now, as a result of p and the m money prices being higher than in the i excess supply in all Our assumption ensures that the price of each good in terms of money Pis-.+4Pq) falls, and, what comes to the same thing, the price of nominal money balances in terms of goods (1 se of the absolute price level) rises. Thus, the disequilibrium trought about by the increase in money prices and p causes a fall in money prices and p until equilibrium is der what forces s demand in a asian mod tial equilibrium, there is ods markets and excess demand in the money market. or the in restored. It must be the case that equilibrium is restored only when the money prices and p have fallen to their original level, for at that level was equilibrium with the given exogenous variables, and since the exogenous variables have not changed, the initial levels of (Piy....Pu +++ Px) and p will again be the equilibrium levels. Thus, the money prices and absolute price level are determinate in this model. Given th arbitrary rise in (p),.-..Ds..++Ps) and p sets up forces that initial equilibrium levels. The real balance effect, in particular, ensures this result. An arbitrary rise in prices reduces the value of real balances, since the money supply M° is unchanged. This brings about disequilibrium, which is overcome only when prices, and therefore real balances, are restored to their initial levels We have demonstrated the internal consistency of this model (and the determinateness of all prices) and pointed out that this is achieved by abandoning Say's Identity. We could equally well note that consistency is achieved by abandoning the Homogeneity Postulate. Since the goods m: xcess demand equations (Eq. 4.17) contain real balances,