Chopter4 Say's Law

The Quantity Theory of Money

assical
Velocity and the demand for money
Some determinants of velocity
onetary and
Exceptions to the quantity theory
mployment and Production
Wages, Prices, Employment,
Theory Aggregate supply of labor
labor market
Aggregate demand for labor and
equilibrium
The relation of money wages to the price level
Graphical and algebraic representation:
I. Traditional classical assumptions
II. Some nontraditional assumptions
A pricing function instead of a demand-for-labor

function

Rigid Wages and Monetary Policy in the

Classical Model

two quite
Modern macroeconomic analysis constitutes a marriage of
the other classical:
diverse approaches: one commonly called Keynesian,
latter an accumulation and
the former the product of the 1930s, the
and a half.
refinement of ideas developed during the previous century
General
Actually, J. M. Keynes' own ideas, as set forth his revolutionary
in

Theory of Employment, Interest and Money (1935), incorporated many

Ideas borrowed directly from classical theory, as well as modifications of
classical ideas which he developed to replace the originals. Keynes recog-
nized the need to integrate that which was new and original in his
vision of
the world with the theoretical ideas that he had inherited.
have
Subsequent analysis and reflection have shown that Keynes may
exaggerated the conflict between his own approach and those that pre-
Ceded it. It is now rather more clear than it was at first that Keynes' ideas
relate to a special case of a more general theory, which also embraces much
O1 the classical ideas (although the Keynesian special case might be pre-
CIsely that which closely corresponds to the economic world of today!). In
any case, the conflict between Keynesian and classical elements is now seen
less clear-cut than it was once regarded. The macroeconomic theories
a
now most
widely accepted among economists and taught to their students
COnstitute a marriage of Keynesian and classical elements-sometimes
ESCTibed as a
Keynesian-classical synthests.
Nevertheless, for purposes of presentation of this synthesis, it has
Cned to the writer (as to many others) useful to present separately, and
heir starkest form, the basic elements of (a somewhat modernized
versio
On of) the classical theory without any Keynesian admixtures. Then
assical Macroeconomics

this is contrasted with

simple, purely Keynesian model, which
a
only the uniquely
Keynesian contributions. Only thereafter we
two sets of clements can be fitted
together. The alternative-to a
develop the synthesis right from the beginning-is judged, at e
writers of textbooks, to be less
leas
productive of
understanding tha
procedure followed here of doing first one, then the
other, foll
their attempted merger.
This procedure also permits us to consider one by one, and in
leisurely and thorough fashion, a number of theoretical and an
problems that arise with respect to both the Keynesian and classi
tems, as well as in any
synthesis of their elements. Almost all imn.
building blocks any eclectic or synthetic macroeconomic model ar
of
expounded as they first come up in developing either the pure clasi
the simple Keynesian model. For this reason the
reader (and his instr
are warned not to
skip blithely over the treatment of either model or

way to the synthesis. To do so would leave a considerable

numh
puzzles unexplained.
There is an
important reason, besides expository convenience
presenting the classical and
Keynesian elements separately. We have
modern macroeconomics a
marriage" of two diverse
approa
however, the marriage is not always
perfectly happy. There clearly re
elements of incompatibility between the
partners, and these are e
bated by friends on each side who still have
not fully
and continue to disparage the other accepted the u

partner. The reader will have at

background for understanding many of the recurring controversia
macroeconomic theory (and policy), if he sees
approaches as a coherent whole. clearly each o
Gradually, perhaps, as some quarrels have been resolved, ant
remaining disagreements brought into better perspective, the
Keynesian marriage begins to seem more stable. Still, the main thingclaa
holds the partners together has
been, and remains, the fact that neithe
really survive alone. The simple Keynesian theory lacks
any the
wages, prices, money, and interest rates, and a
classical writers said about these is still significant part of w
regarded as largely correc
relevant. The classical theory, as it stood even in
lacks an explicit theory of 1930, almost comp
"aggregate demand," which Keynes
supplied.
By the classical economics we here mean
the
basically English
tion it existed (and
as
developed) between the
principal works of
Smith (7The Wealth of Nations, 1776) and Alfred
Marshall (Princ
Economics, 1890). (Others prefer to extend the term to include
stream of Anglo-American economics
the
through 1930. No matter.
cularly if one considers English economics as it existed in 1890, 0
well conclude that no macroeconomics
really existed yet--class
otherwise. And, although macroeconomic questions received c r e "

inc
 a lMonetary a n d Employment Theory 85

ian
allcntion
1890 and 1930, the birth of a full-fledged macro-
between
clearly came only with Keynes. Nevertheless, a fairly coherent
omics clcarl
onomics
in the classical tradition, and it
aerocconomics is at least implicit
reached the surface. However, making this classical
ma

ionally even
acrocconomics complete and explicit has been mainly the work of
mac

post-Keynesian writers.
of economics microeconomic in charac-
The main body classical was

ter lt dealt with

the determination of (relative) prices for and quantities of
individual goods and services, the determination of (relative) incomes to
of production, and the determination of (relative) prices
individual factors
of classes of assets,
real and financial. Its principal explicit macroeconomic
subject was the
determination of the money price level, which, however,
was believed
to have essentially no significance for relative prices and
incomes.

In understanding the reconstructed classical macroeconomics it is

that it emerged from the study of microeconomic
important to remember
that lay behind the microeconomic
questions and to recall the a[sumptions
make those classical assump-
analysis. As we proceed we shall attempt to
tions explicit. For what may have been and
still are perfectly reasonable
could well
and useful assumptions to simplity a microeconomic analysis
turn out to be responsible misleading conclusions when carried over to
for
the macroeconomic sphere. Indeed, we shall later so argue.

SAY'S LAW

One of the few explicitly macroeconomic propositions of classical theory

Was Say's Law of Markets (named after J. B. Say, the French economist,
1767-1832). This theory sprang from the controversy ot the early
nineteenth century over the question: can there exist a general *"over-
production or "glut" in a market system of production and exchange'?
Say's law held that there cannot. Much of macroeconomic theory to date
Cxamines the conditions under which this principle will or will not hold
true
Law is usually summarized supply creates its own demand. If
3ay's as
8ods are produced, there will automatically be a market for them. This
Casily be seen to be true in a barter economy, although its application
s not supposed to be limited to that circumstance. More fully set forth,
a y appears to have had in mind can be expressed in this way: People
n o t for its own sake (indeed, work is unpleasant) but only to obtain
divic services that yield satisfactions. In an economy that practices
division of labor and exchange, one does not obtain most of these goods
OneVCes
and directly (as did Robinson Crusoe) by his own efforts. Rather
ser
one produces gor
anor goods in which one's efficiency is relatively the greatest and
exchanges
"BCS the surplus above one's own use for the products of others. The
Tassical Macrrronomies

very ict of production therefore constitutes the denmand for othe

demand cquivalent to the valuc of the surplus goods each ner
man
How then can there cver be a gcneral
overproduction of good.
man's production (supply) constitutes his demand for
other goode.
the aggregate demand must in some sense
equal the aggregate
Total output may be limited by the fact that, at some
point, f
individual, the satisfactions of a little more leisure will
sacrilice of a little morc of goods that might have been
outwe.
obtained, b but
"unemployment" will be "voluntary," not "involuntary."
It is necessary clearly to distinguish this theory from the defini
identity among national product, national income and total expend.
The identity exists at any level of income,
output, or spending. What
Law implies is that any increment of
output will generate an equi
increasce in income and inspending. Thus income and product can a
be at
full-employment" level. If they should be at a lower leve.
a
Some resources
unwillingly idle, additional production will generat
equivalent amount of additional income, which will all be
expended i
purchase of the added product. And since no one will be content at less
full employment," additional
production will take place until the
employnent level is reached.
To be sure, Say's Law admitted that individuals might not
direct their corr
production in accordance with one another's wants.
Ther
producing shoe laces might produce more than people want to buy a
price (in terms of other goods) he had assumed would exist befoe
brought his product to market. As a result, the surplus shoe laces buy fe
potatoes and less beer than he had anticipated. There is a demand for
shoe laces, all right, from the
producers of potatoes and beer, who bro.
their surpluses to market to trade for shoe
laces. But it is not the dem.
he had
expected-in that sense, there was a glut of shòe laces.
however, is merely the temporary maladjustment of relative
barter ratios, to which outputs
producers can easily adjust. The shoe-
producer's adjustment will involve either a decision in favor of m
leisure or a decision to produce some other
When Say's Law is framed in terms ofproduct,
more in demand.
a barter
self-evident. But does it also hold true for an economy, it S
case of barter, it is
economy using money?
literally true that one can supply a commodity or Se
to the market only as a
so obvious when
demand for another commodity or service. Itb
goods are sold for money. Can we be sure that the m
received will be inevitably and
promptly and fully spent against
goods? As we shall see in the second
part of this chapter, the mon
theory contemporary with Say's Law did explain in somê detail
ho"
'For an excellent treatnment of Say's Law, see J. A. Ec
Analysis (Oxford University Press, 1954), 615-625.
Schumpeter, History o
 al Mtoncary and Employment Theory 87

of a "veil," behind which everything

Amoney's role was solely that
as if all exchanges took the form
operated in fundamentally the same way
ted in
But this result depends chain of rcasoning and on specific
on a
harter.
the correctness of which might be subject to
assumptions about behavior,is
assumptions

challenge, and,
in any casc, surely not obvious.
form of Say's Law was also framed in terms of
The elementary
ane-person or family
firms, each producing final products. These producing
units owned their own land and capital and used it, along
and consuming and
with their own
(rather than hired) labor, to produce final goods
or family units that
in turn were sold to other one-person
services. These true that Say's Law holds as
directly consumed them.But is
it necessarily who
an economy
where production is organized by entrepreneurs,
well for some or the larger
for a wage, perhaps buy from other firms
hire workers the firm, and sell their
of the services of capital and land used by
part but to other firms to
services not only to ultimate consumers,
products and
still other products?
use in producing
The price, wage, and employment theory
contemporary with Say's
existence of separate
to explain how and why the
Law was believed for the
intermediate products and materials, and
markets for labor, for all
to assure the full employment of
services of capital and land operated free and com-
as all such markets were
factors of production, so long
was why the supply of goods
and services-which created its
petitive. This
be the maximum supply which was
equivalent demand-must always the full use of all the labor,
permitted (given the existing technology) by But, once
owners wished to provide.
capital, and land services that their of this
challenge either the assumptions or the reasoning
again, we can
not obvious.
argument. And the result is surely
formulation of Say's Law also paid
The elementary and self-evident market in
no attention to the phenomena
of saving and investment. The
with each other was presumably
which Say's producer-consumers bartered
a market for consumer goods only, and
each participant was presumably
consumer goods. At least there was no
spending his entire real income for or that
some might wish to save,
discussion of the possibilities either that
facilities with which they
others might desire to add to the capital
also developed a theory about
produced. To be sure, classical economics
the next chapter) which seemed
Saving and investment (to be taken up in
conclusions are not obvious.
COnsIstent with Say's Law; but, again, its
for Say's Law in a real-world
Thus, to understand the entire basis
in which most people sell labor
cOnony-which uses money, not barter; need
which people save and invest-we
VICes, not final products; and in each of which turns out to be
a whole range of classical ideas,
0kat
formulations we will present long post
Cmplex. In most cases, the The first of these basic
.B.Say; indeed, some postdate J. M. Keynes.
lassical deas is the "quantity theory of money.
Classical Macroeconomics

THE QUANTITY THEORY OF MONEY

The quantity theory asserts that money determines only the price le.
evel
real output. The root idea of the quantity theory is that no rational.
holds money idle. for it produces nothing and yields no satisfaper
Kather.people promptly use all the cash they receive trom the sale ofof th
tacti
goods or services to buy other goods and services. How prompt
s depends on how production is organized. how frequently ine
are paid. and other structural or institutional factors that were judeed
quite independent of the quantity of money or the level of price
these
assumptions. the how the
theory showed
mines the level of money prices, and in a way which is withoutimpa
quantity of money
the demand or supply of any individual product, and thus cannot a
relative prices nor the absolute quantities of products produced and
Thus it cannot affect aggregate production, either.
Formally, we can state the quantity theory in any of several ways
start with two, closely related formulations of the theory:" the
transacti
form
1) MV = PT

and the income form

2) MC PoY
The symbols have the following meanings, each of which is
fur
explained in the paragraphs that follow:
M =
quantity of money in circulation
V =
"transactions velocity" of money
Pr = average price level of all transactions

T physical volume of transactions

C = "income velocity" (or "circular velocity") of mone

Y real national product

=

Po =
average price level of national product
M is be measured as the total number of
to
monetary units
example, dollars) "in private circulation." Although other meanings
possible, for now, M can be thought of as including only "cash" (bills a
coin), plus bank deposits subject to check. Since all cash and
owned by some business or individual (we do
deposits
not include in the suf
These equations are to be understood as
equilibrium conditions, not as identities. Thal
isdetermined independently of M, P, and T. If V were defined
as PoY/M), then the
(measured) as (P,T)/M
equations are true by definition and therefore devoid of predic
explanatory value. As theories, these equations assert propositions that are capable obene
found untrue, whereas as definitional identities they cannot be.
 and Eiployment Theory 89
al Monetary

aunts held by banks or governments), M is the sum of all of the

those
alances"
idual "bal. of cash and deposits held at any given moment by
dividuals.
businesses and indi As money is "used" in transactions, each par-
slar balance rises or falls; but so long as all transactions are among
ticu.
ndividuals, the total of all balances does not change
businesses and ind
through money's use. Its total amount can, however, be changed in other
waVS. now mainly by means of transactions between businesses or
individuals and banks (including central banks) or governments, the nature
of which we do not need to specify or describe at this time.
Originally, when economists first developed the quantity theory, M
referred to the amount of metallic money in the economy-then the only
kind. Thus, increases in the money supply occurred, for example, through
the mining of gold, or its importation from abroad. Decreases occurred
through conversion of gold into Jewelry, or its export. Later, the quantity
theory was reinterpreted to apply to an economy which used paper or bank
later on, checking accounts). This made an
money (first, bank notes,
important difference. For the supply of paper or bank money can be
controlled with relative ease by government policy. Thus, in modern
economies, where the medium of exchange (money supply) consists essen-
tially of government currency and demand deposits, the quantity theory
may say something useful about the consequences of the government's
"monetary policy'"-the policy which determines changes in the money
supply.
V is expressed as the average number of times per year (or other
period) that units of money are used in any purchase-sale transaction.
Individual units of money may turn over more slowly or rapidly, but, on the
average, a unit of money changes hands V times per year
Pr iS Some price index, which reflects changes in the average of prices
at which transactions occur, appropriately weighted. (If it is an "explicit"
index, it will be used to defiate the money value of all transactions to get
their real volume, T, or, if T should be measured otherwise, P'r Will bean
,mplicit defiator," obtained by dividing the money value of transactions
by T.)
iS the real or physical total volume of money-using transactions
in
Er the total of all payments or of all receipts, corrected for changes
the samee
which occur during a year (or other period: obviously,
period as for V).
k e V, is expressed as the average number of times per year (or
Cr period) that units of money are used: but not in just any purehase-
C is
Saction,rather, only in a purchase-sale of final products.
An alternative version expresses C the average number of times that units of money
as
are
used not in
only purchase-sale
Iransact purclhasingfinalgoods, but in payinginincomes;
that is, it counts

prOductive services. However, a simple economy, with only consumption

put inand alternative version does,
EOvernment, nincome and product are equal. This
however, imply government,
ply Po as
Po * a price index of factor services, rather than otf goods.
Yassical Macrorconomic s

obviously less than V in that it ignores all turnovers of

ma
purchase-salc of intermediate goods or productive services. ey
Y is real national
product, expressed per year (or other perit
period as for
) , while Po is the national product
deflator
obviously the moncy value of the national
product (and it is a me
indifference whether Po is an explicit or implicit index).
Consider, now, cquation (1). Why must MV=P;T? Simply
the product on cach side of the cquals sign is the same; it is
the.
value of total transactions during
some specified period. On the left
measured by multiplying the number of units of
money times the a
number of times per period each unit is used in a
it is measured by
transaction; on the.
multiplying the physical quantity
of transactions b
price level.
We assume that V is always constant at its
maximum feasible
since no one ever holds an idle balance-that
is, never holds a single un
money longer than he needs to. This maximnum level for V
minimum period for which units of (reflectin
money must be held) depend
structural and institutional factors unrelated to T,
Pr, or M, which we
analyze shortly. Given a constant V, MV is, of course, proportional
Look now at the other side of the
equation. Assuming that price
perfectly flexible, T can always be at the maximum level permitted
technology and the willingness to work of the community. At any by
time this maximum level of T can be taken as
constant. Hence Pr mu
proportional to M: increase M by 10 percent and Pr must rise b
percent.
One reason why the
"transactions" form of the
(equation 1) has fallen out of use is that there existsquantity the
no accept
measurement of the physical volume of transactions
(which is inde:
conceptually fuzzy variable) nor of the price level of total transactions
the other hand, Y can
clearly be identified as real GNP, and Po
GNP deflator: Thus we turn to
equation (2) (dropping the
no
longer necessary to distinguish an index of final output subscript
of transaction prices). prices from
Why does MC PY? Again, because both are alternate
=

for the money value of the national expres

product during a given
left, this is measured by multiplying the number of units of period.
money oby
average number of times per period each unit is used to buy final
pay incomes); on the right, it is measured by multiplying the
outp
ph
quantity of final output by its price level. Reasons that make V consta
its maximum level make C constant as
well, if we add the plau
assumption that, at any particular time, the volume of transactions
output is some constant fraction of the volume of total transactions.
if money stays in all balances only the
necessary minimum period o
and if the number of intermediate balances the
average dollar musduct
through in making a complete circuit from one purchase of final prou
 Fmployment Theory 91
M o n e a r y
and Er
al
su
Cs
smaller than V. Again,
d,
nother is fixcd, C will be a constant-of course
Y can be taken always to be at its
suming compet; petition and flexible prices,
7ssu proportional to M.
therefore
imum level, and P the notion that no
either equation ( ) or (2) is clearly
m a x n

root idea of
some (slowing
businessholds "idle" money. He holds
c o n s u m e r or but only
otherwise be an infinite velocity of circulation),
iawn what would between his discrete lumps of
there is imperfect coincidence
hecause hold money by
his discrete lumps of outpayment. People
inpavment and
little, and for as short a time, as they
can.
necessity. but they hold as or (2) is also clearly that of
second root idea of either equation (1)
A than
Additional money bids up prices-rather
fiexible,competitive prices.
volume of output or transactions-because output
increasing the physical How do we know
maximum amount.
were already at their
or transactions unable to sell all
Because if they had not been, someone,
that they were? and prices
would have offered his supply at a lower price,
that he wished, reached its max-
output had
would have fallen-output expanding-until idea just
imum. (We shall see,
in the third part of this chapter, that the
and somewhat qualified, in a society in
summarized needs to be expanded,
sells goods.)
which sell their services to a business which in turn
people

Velocity and the Demand for Money

The versions of the quantity theory that we have just discussed (equations
with which
1or 2) the concept of velocity-the average frequency
use

units of money are used. However, the theory can

be--and usually is-
relormulated in somewhat different terminology. Ignoring the
a
"transactions" formulation as nonoperational, we replace the "income (or

circular) velocity" formulation by

Ma = nPY

fraction of PY
where Ma is the demand for money, and m is that (constant)
which, in the aggregate, members of the community (businesses as well as
Consumers) desire to hold in the form of money balances; and

M Ma

(3) M = mPY
C M is (as before) the supply of money. Equation (3) says that all the

uthat exists must be in someone's balance, and, in equilibrium, it

e a w i l i n g l y held. lt should be obvious that m = 1 / C . It is theretore
lcar that whateve
he
the size whatever factors determined the size of C must also determine
m. However, whereas the formulation in terms of C directed
assical Macrocconomics

attention toward the institutional and structural factors

whiçh ina
frequency of money paynentswhich operate
the
ue
straints onon beha
as constraints
formulation in terms of directs attention to the
m
which intlucnce
people to hold money. Both sets of factors factors or al
factors or
important in thinking about the basic tors are
are obv
phenomenon involved.
Formulation (3) explicitly differentiates between the
money balances by members of the community and the dema
balances which in the aggregate they supplmany
makes it easier to understand that the
actually hold. Thereby, perh
quantity theory equation exna
an
equilibrium condition. Any absence of equality between
people in fact hold and those that they want to hold would the bal al
system was in disequilibrium. People would then be mean th
that
or increase the attempting
money they held by buying more or selling less
to r
or the reverse. This action
could not change the amount of than
actually held, nor could it change the production of monev
it would tend to goods and services
bring the system into equilibrium through altering
the
demand-supply balance for goods, and thus the
price level. Suppose
at some level of PY, people find themselves
desire to hold. They holding more money than
immediately
more goods. Because Y is at its
try to get rid of the excess, by bu
but they can bid up the
maximum, they cannot really buy m
price level of what is available, and will
do so until PY is high
enough to make them willing to hold the contin money
they in fact have.
A parallel
expression of the
(velocity) formulation (equation 2)equilibrium
condition in the pre
actual value of C and an implies differentiating betwee:
equilibrium value of
PoY as the equilibrium condition. In thatC-say Ce--and
sta
MCE =

case, while CE migh

constant, actual C could vary over time,
Actually, as we shall later see, still moreindicating absence of equilibr.
quantity theory treat m (or sophisticated versions ot
of M (or CE) does
CE)
as an economic variable, so that vard
not, in itself, necessarily signify
The strict
quantity theory, either in formulation disequilibrium
makes m or Cp a constant, (2) or (3), howe
and it is important to understand the basis
this view. It is,
essentially, that no rational person wishes to hold any
money, or hold it any longer, than he
absolutely needs to. And
needs to hold at any
given time depends on the time patternwha o
(expected) receipts and payments in money, given that
expects his money balance to be zero as often as he wishes
of payments and possible during his C)
receipts. A recurring minimum cash balance ol
means that
money is merely a medium of exchange, not wanted for
sake. It means that the demand for i
money is strictly proportional to m
incomeat the Jowest possible
proportion, or that
highest possible rate. To see what determines thisvelocity is constant
lowest possible pi
tional or highest possible rate
minants of velocity.
requires some elaboration of the det"
 Employment 1heory 93
!Monetary and

NN :0
Time ("days")
40
FIGURE4-1

Determinants of Velocity
Some
time of the money balance of an individual
behavior over
Consider the look somewhat like
economy. His balance might
member of a money-using
4-1. At time point 0, this individual receives money
the diagram in Figure for productive services. Just
of $100, presumably in payment
in the amount $100. His
to this receipt, his balance had been zero. Now it becomes
prior
20 time units ("days") later. The particular
next receipt of $100 will come
in this diagram has our individual spending
one
balance pattern assumed
his balance to zero just before
twentieth of this money each day, reducing
could equally well assume some other balance
his next pay period. We essential
one that is concave upward-without altering the
pattern-say,
principle described.
balance that varies from $100
We can say that our individual holds a
to 0. On the average, he holds $50 (in
the straight-line case). This average
balance ($50) is equal to one half his income ($100),
if we state his incomne
a ""yearly" rate, and there
are
as per pay period. If we state his income as

four pay periods in a "year," his average balance

is one eighth of his
Income. (Since income is a flow, and money
balance a stock concept, the
on the time unit used to
S1Ze of
any ratio between them must depend
matter of indifference,
express the income flow. This unit is obviously a
unit for reckoning.)
CXCept for the convenience and custom of the annual
reason for
his individual holds no money for its own sake. His only
and outpayments
nolding it at all is to bridge a gap in time between receipts
o funds. Yet we find him, in fact, holding money, and doing so quite

He be described as having a "demand for

ralionally'" and "willingly". can
Oney equal to one eighth his *"annual" income. (If the descending phase
balance would be less, and
sDalance were concave upward, his average
his demand for money a smaller fraction of his income.) We çall this
that he holds money only to
dnda transaction demand, indicating
make necessary transactions.
is a second way in which we can describe our man's money-
ICre
holding behavio
E Dehavior. It is to say that the average dollar he
10 days. Some dollars are
receives is held for
held for 1, 2, 3, 18, 19, and 20 days. But the
averay
of lar istheheld
hi adnce, 10 days. (If we had assumed a curvilinear time path
average period would be less.) Alternatively we can say
Classical Macroeconomics

that the average dollar he receives IS

passed along (turns over
Since 10 days is half his income
period, and there are four snein
per year, we can say that the average dollar he receives is uch
turned
rate equivalent to
eight times per year. This is its (partial) velocit o
ed
It should be obvious that to describe his demand for ty
moneya
one
eighth his annual income or to describe the velocity of hias eq
receipts as eight times per year are merely alternate ways of ev
single phenomenon. Likewise, it should be clear that we can useores
time period and get different numerical results. (For an
sometimes convenient to think of the
example
payment period as our time
so, his demand for money is half his income, and the
is two.)
velocity of his.
m
To complete the picture on this matter of money use (or
holding) in society we need to expand our example. Suppose that m
4-1 represents the total balance Fi
position of all income recipients in
economy. Let us suppose that all wages, salaries, interests, and
paid out to individuals on the same day. They receive, in the prof
$100 of income on days 0, 20, 40, and so on. Where does the aggre
from, and where does it go when they release it? Assume all
money
busine
organized in one giant firm (and that there is no government). The par.
of the business balance is
obviously a mirror image of that of inc
recipients. Figure 4-2 shows this relationship between the balanc:
business and that of consumers. As the
are reduced to zero as incomes are
figure is drawn, business bala.
paid out on day 0. Thereafter
consumer balances shrink, business balances
grow. By day 20, when
sumers are out of
money, business has accumulated, through sale
consumers, exactly enough to pay the incomes then due, and the
sequE
is repeated thereafter.
Now our business also has a money balance, the average size of wi.
is also $50. This balance also turns over
eight times per year. The tota
Money Ba lance
Si00F

S50

20 40
Time

S100

S50

20 40 Time FIGURE 4-2

 95
Employment
Theory
and
Monetary
Cessthal
dollar of this sum is always
is carly $100. Every forth
It bounces back and
moncy n ulation
circ ul
business or of
consumers.

alance
bal of individuals to
in the services from
either sales of productive
ween them mediating from business to individuals.
busincss, a n d ;sales of goods
betwco

business plus consumers

on the part of
"demand for money Since the annual
1he total " t r a n s a c t i o n s demand."
This is all a be
$100. demand for money can
ic obviously is $400, the
this economy The total
hatal income in income or product.
fourth of a year's
as one demand for money
described are$800 per year, so the
fransactions in this
economy
total transactions.
described as equal to one eighth of a year's
transactions
can also be is to say that the
these relationships
of describing the
Another way times year. Or we can say that
is eight per
velocity of
this money the average dollar
this is four times per year:
money
income velocity of an income
business,
recipient, through
from
circuits per year
makes four
an income recipient
again.
and back to had the shrinkage of consumers' balances
noted that
It should also be business balances would
have
was concave upward,
followed a path which demand
convexupward. The smaller average
grown by
a path which was offset by a larger
c o n s u m e r s would
have been precisely
for money by turnover by c o n s u m e r s
offset by a
demand business; the faster
by there is no
either circumstance, however,
average
business. In
slower turnover by business and c o n s u m e r s .
zero both for
Minimum balances are
idle money. real economies. All
to reflect more closely
We can adapt this picture income payment is
coincide. The period for
income payment dates do not in one giant
incomes. Business is not organized
not the same for all types of them-
intermediate transactions among
firm, but in separate firms having these
transactions balances. All of
selves, each one holding necessary
Even the
without alteration of principle.
complications can be incorporated business
in existing assets, and that
fact that people save and lend, and deal in.
can also be brought
not only from sale but from borrowing
gets money
be so easily handled: particularly, per-
Other problems, however, cannot conditions, but of certainty
naps, the assumption not only of stationary
future of More of these things
payments.
regarding timing and
the amount

later, however.)
We turn now to brief consideration of some of the factors that deter-
ne the amount of money balances necessary to accommodate any parti-
the
income. One of these factors is, clearly,
dr ievel of transactions or in our previous example,
Paynent habits of the community. Suppose that, of income were
$50 paid out
pay period were cut to 10 days. Suppose as in
days instead of $100 cach 20 days Figure 4-3. Exactly the
business sales could
of annual income payments and volume of
VC The demand
De accomplished with half the previous stock of money.
sixteenth of a year's transactions, onlyy
Would now be only one now be
Rnh of a year's income. The income velocity of money would
0, 11s
transactions velocity 16.
Classical Macroeconomics

Money Balance

S100

S50

Time
20

S100
7

$50-

20 40 -Time FIGURE 4-3

The payment habits that are relevant here are not only those re
to frequency of income payment, but also those relating to freque
settlement of bills for goods. Suppose, for example, we introduce c
accounts, which need to be settled only once per year. This obviouslyt:
substantially the need for money. "Trade credit" among firms
business sector operates similarly to reduce the need for money
ness.
b
A related determinant of velocity is the
degree of business integr
If business is vertically integrated, less money is needed than if busin:
vertically disintegrated, each "layer'" holding a necessary balane
discussion of these points the student should consult the
"determinants of velocity" in any standard
sectie
money and banking text
Given the payment habits and the industrial structure of
the
munity, the amount of money needed for transactions obviously de
only on the money volume of these transactions. If our highly sim
economy considered earlier doubled in size-twice as much prou
and real income-twice as much
money would be required to medi
enlarged volume of transactions, assuming the price level remain
same. Aggregate income would double to
$200 per period and s
goods to $200, meaning that a money supply of $200 would be
to make the necessary
payments, with average balances of bus1ne
consumers each now $100 instead of $50 as
before. But if the

A further significant determinant, less often discussed, is the

degree of "overl
ppit

payment dates. See Howard S. Ellis, "Some Fundamentals in the Theory ot

Quarterly Journal of Economics, May 1938, LII, 431-72; reprinted in Readings
Man

Theory (Philadelphia, Pa.: 1951), pp. 89-128.

 and tmloyment 1heory 97
AMometarvr

Iemancd aat $100, it would be impossible to make $200 worth of

perIOd
Half of the goods could not be sold: half of the
Cnis pCr
aN scOuld not be paid. However, because prices were flexible, prices
the doubled volume of goods could
ould
instead fall by 50 percent, and
and the doubled real incomes could then be paid with the
then be sold
stock.
$ T00 money
same
in in the degree of business
payment habits or
Similarly. if changes
oubled the volume of transactions required for the same
integration dou
would reduce incomne velocity, C. by one half.
alume of final output, this
double or prices fall by 50 percent. But given these
Either M must
payment frequency, business inte
-

determined patterns
institutionally of
C or m was constant because rational individuals would
oration, and so on,

hold idle balances. Minimum balances during the payment cycle

never
would always be
zero.

Erceptions to the Quantity Theory

classical writers ruled out the possibility of changes in C
To be sure, not all
or m as the
result of irrational waves of "hoarding" or "dishoarding."
reason-for example, severe uncertainty about
Suppose that for some wished to
possible future political developments-people generally
increase by 10 percent their average stock of money balances, by returning
of the money they
tothe spending stream in some period only 90 percent
to 10 percent of their
had received, acquiring minimum balances equal
The previous real output could, of
previous) money incomes per period.
course, still be sold-but only at a price
level now 10 percent lower than
of
before-even though M had not changed. Assuming perfect fiexibility
prices, the price of every good would fall by 10 percent, and-so longas
no further desire to add to balances appeared-the economy would con
unuc to function at the new 10 percent-lower price
level. with each
less, but which
participant receiving a money income which was 10 percent
it would
WOuld buy the same quantities of goods as before. As it was spent,
provide others with money receipts adequate to purchase
the (now 10
With 10 percent
PETCent lower priced) goods or services which he supplies.
Othe money supply immobilized in idle balances, it was just as it that

money had disappeared.

1, al some later time, members of the economy should
desire to get rid
t h e idle money previously laid by (again assume all at once, tor
excess ot
plicity), all prices must rise by 11 percent, retlecting the
and
y demand over supply at the lower price level. General hoarding
in ordinary circum-
d n g were not, however, assumed to occur not
Cs.Rational e n had no use for idle money. Therefore, they did
could not dishoard.
Ih C ,and, having not previously hoarded, they
SOurce of price levcl fluctuations was not ordinarily to be found
here.
Classical Macroeconomics

Another aberration sometimes recognized as an

exceptio
quantity theory was the possibility that wages and prices might
t be
porarily rigid especially in the downward direction. It is casyto.
if there occurred a drop in M and velocity remained const..
although the money value of the national product would necessari
proportion to the decline in M, it would be Y, not P, that woult
Real output would fall short of the full-employment level. Likew
might occur if growth in the level of full-employment output w
accompanied by a proportional rise in M. Then, i, for some rea
failed to decline, Y would have to.
In either of these circumstances, a subsequent increase in M
then be more likely to raise real output than the price level. And si
the real world, prices are not as flexible as the quantity theory assume
not surprising that there were times when classical economists ar
advocated deliberate increases in the quantity of money as a me
increasing real output and employment. To be sure, this would
necessary if only wages and prices had been fully fiexible; but they m
always be that flexible. And if unemployment had arisen from a pre
fall in M, or from a rise in Y as the result of greater productivity or a
labor force, it would not even be "inflationary" to increase M-at
"inflation'" were defined as an increase in P.
li
Irrational hoarding-dishoarding and irrational price
rigidity
nevertheless the exceptions that proved the rule. Generally
spe
changes in the price level were only the result of changes in M. Thu
classical economists saw the mining or importation of gold as m
responsible for changes in the price level. Their successors today
described as "monetarists," explain changes in the price level as m.
determined by the "money creation" of central banks (in
the
States, the Federal Reserve System.)
Subsequent developments in monetary theory-which w
explained fully later-have considerably modified this analysis, Wit
nificant consequences both for Say's Law and the
have added other
quantity theory
they of
demand for money in addition
sources a
"transactions demand" contemplated by the quantity theory's assu
that money is used merely as a medium of
exchange. (Existence o
additional sources of demand for money can be described as
"rational" explanation for systematic prov
hoarding and dishoarding.)
tion, they have recognized that even the transactions demand
for m
not simply a
parameter that is given by the socie structure of
instead, that it is an economic variable that needs
explanation ji"
adequate theory. As will be seen, this view holds that the pat tter"

Price rigidity would be irrational because it must have arisen from d e l i b e r a t e che
accept unemployment of labor or capital rather than a wage or price reduction- -which

not have been even a reduction in real wage relative

or
price.
 Monetary and Fmployment Theory

institutions but rather reflectsa

paymer cnts is not uniquely determined by
sed on their relative costs-among many possible payment pat-
relative costs may thus give rise to different patterns of
c h o c e -

ns Changing
different transactions demand for money. One factor, in
ments, and a the rate of interest.
articular. which determines these relative costs is
the velocity of circulation, or the demand for
Thus. it will be argued,
function, in part, of the rate of interest.
money, is a
Here we need merely to be aware
All this will be elaborated below.
a fixed velocity of circulation, we are making the sim-
that. in assuming
olificationwhich the classical economists made.

PRODUCTION
wAGES, PRICES, EMPLOYMENT, AND

that classical macroeconomics maintained that

We saw in the previous part
the value of the national product,
P¥, is determined by the money supply,
is a
of money, aggregate price times quantity
M. With a given stock
at proportionately lower prices. If prices
constant. More can be sold only
this fall in
are flexible, they
will fall whenever there are idle resources;
or accompanies the absorption
of
prices somehow automatically promotes of the physical volume of output. In
these idle resources and an expansion
promotes full
this part, we examine more specifically how price flexibility
for wages, rather than
employment in an economy in which people work
market.
supply final goods directly to the
We simplify this analysis very greatly (as
did the classical writers) by
in all industries and that each
assuming that perfect competition prevails labor and produces final
industry is vertically integrated. It hires only
and natural resources); there
output (using a given stock of capital goods
are no intermediate goods. We further assume that sellers attempt always
to maximize short-run profits. make the
employment and wages are concerned,
we can
far as
S0 labor market, in
Turther assumption that there exists a single, national
seek to hire a single,
Wnich all workers provide and all employers and that the competition
unaierentiated type and quality of labor service,
and of employers for workers thus produces single,
a
Workers forjobs
unitorm wage rate. This implies the absence of effective labor unions (or
sufficient
oyer's associations) that restrict competition. localities,implies
It also
and complete
1ty of labor among firms, industries, andworkers and firms, so that
to all
a o n freely and instantly available in order to hire or retain
Hnpoyers must pay the going (uniform) wageeach can hire all he needs
none needs pay more because
thal wage. yet
CTS,
at th

A can recognize
realistic but still classical theory
the o r e complete and markets for a wide variety of specialized
Ce of separate
ypes partially
type qualities
and qualitio of labor, with only limited mobility of workers among