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Money Is Important
An important shift in macroeconomics since 1960 has been
in the way economists view the importance of money. In the
1950s there was a sizable contingent of economists who
believed that changes in money stock had little effect on
spending; by the 1980s there was a sizable contingent who
believed that little else mattered. An important reason for
this shift was the realization that both the Great Inflation
and the Great Depression could be explained in terms of
changes in money stock.
The dominant explanation of the Great Inflation, and
perhaps the only explanation that economists consider
reasonable, was that it was the result of excessive money
creation by the German government. There was a tremendous
increase in the amount of money during the period, and the
totals at the end of the inflation are beyond comprehension.
Bresciani Turoni states that on November 15, 1923 the amount
of paper marks had reached 92,800,000,000,000,000,000
marks.1 Phillip Cagan estimates that bank
deposits less cash reserves were
1,959,000,000,000,000,000,000 marks in 1923, but three years
earlier there had been ten zeros less on this
statistic.2 Yet the rapid increase in money was
not as great as the increase in spending. Velocity increased
about ten times from the start of the inflation to its peak
in November, 1923.
If one had told a German in 1923 that his inflation was
caused by too much money, he probably would have replied
that, on the contrary, there was a shortage of money. There
was such a great shortage, in fact, that businesses issued
illegal money called Notgeld or Need Money. (The
German word Not means need, not not.
Phillip Cagan estimates that the amount of this money did
not exceed 192 quintillion marks.) If you would have told
the experts in the Reichsbank that they were issuing too
much money, they would have told you that this could not be
so. The real money stock, or the amount of money divided by
the price level, had fallen.
To evaluate these objections that Germany had too little
money, one must remember the distinction between equilibrium
and adjustment. Most monetary theorists believe that if the
amount of money doubles, price will double in equilibrium.
This means that the real amount of money--the purchasing
power that people hold--will remain constant. But this is
only an equilibrium condition; it does not need to hold in
the adjustment process, and none of the prominent monetary
theorists has held that it will. If the adjustment process
involves inflation, the velocity of money should increase
and real money holdings should decrease. Inflation lessens
the usefulness of money as a store of value, and the more
serious the inflation, the poorer is money as a store of
value. As money becomes a poorer store of value, people
should try to switch into other assets and hold less of
it.
If velocity increases, as monetary theorists say it will
if inflation accelerates, then real money balances must fall
if output remains constant. The mathematics of the equation
of exchange insists on this conclusion. One can see this by
rewriting the equation of exchange in the following
form:
M/P = Q/V.
M/P is the real money stock. If Q was roughly constant
and V increased by ten times, the real money stock must have
been about ten times smaller than it was at the beginning of
German hyperinflation.
Today almost all economists believe that money played
some role in causing the Great Depression, though they
disagree on how big its role was. There was a close
correspondence between the amount of money in circulation
and GNP. However, Peter
Temin argued that the drop in interest rates from 1929
to 1931 indicated that monetary forces were off stage during
this period and may not have had much of a role in the rest
of the story either. Temin supports his interest-rate
argument by noting that prices fell by as much as money did
between 1929 and 1931, so real money did not decline. As a
result, he states that monetary forces could not have caused
the level of income to fall.3
In our discussion of the ISLM model, we argued that the
demand for money should be stated in terms of purchasing
power, or real money. Temin is using this same argument
here. If real money did not change, then the LM curve should
not have shifted. Note that the same logic can be used to
argue that monetary forces did not cause the Great
Inflation. In fact, since real money declined between 1921
and 1923, the LM curve should have shifted to the left,
which suggests that monetary policy in Germany was
restrictive, and rather than causing the inflation, it kept
it from being even worse. A problem with Temin's real-money
argument is that the demand for money (and hence velocity)
should be sensitive to the rate of change in prices. Because
prices were falling between 1929 and 1931, money appeared to
be a better store of value than it had looked a couple of
years earlier. A constant real money will indicate no
changes are originating from the monetary sector only if the
expected rate of change in
price level remains constant.
1. The Economics of
Inflation: A Study of Currency Depreciation in Post-War
Germany, p. 23.
2. "The Monetary Dynamics of
Hyperinflation", in Studies in the Quantity Theory of
Money, Milton Friedman, editor (University of Chicago
Press, 1956), pp 101, 104.
3. Temin, Did Monetary
Forces Cause the Great Depression, p. 170.
Copyright
Robert Schenk
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