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4.2.2 The quantity theory and changes in money income: empirical evidence

The assertion that there exists a stable functional relationship (behaviour)

between the demand for real balances and a limited number of variables that

determine it lies at the heart of the modern quantity theory of money approach

to macroeconomic analysis. If the demand for money function is

stable, then velocity will also be stable, changing in a predictable manner if

any of the limited number of variables in the demand for money function

should change. Friedman (1968b, p. 434) has postulated the QTM as

the empirical generalisation that changes in desired real balances (in the demand

for money) tend to proceed slowly and gradually or to be the result of events set in

train by prior changes in supply, whereas, in contrast, substantial changes in the

supply of nominal balances can and frequently do occur independently of any

changes in demand. The conclusion is that substantial changes in prices or nominal

income are almost invariably the result of changes in the nominal supply of


In this section we discuss various empirical evidence put forward in support

of the quantity theory of money approach to macroeconomic analysis,

beginning with the demand for money function. Constraints of space preclude

a detailed discussion of the empirical evidence on the demand for

money. Nevertheless two points are worth highlighting. First, although Friedman

(1959) in his early empirical work on the demand for money claimed to

have found that the interest rate was insignificant, virtually all studies undertaken

thereafter have found the interest rate to be an important variable in the

function. Indeed, in a subsequent paper Friedman (1966) acknowledged this.

Buiter (2003a) recounts that Tobin, in his long debate with Friedman, ‘convinced

most of the profession that the demand for money has an economically

and statistically significant interest rate-responsiveness’ (that is, the LM curve

is not perfectly inelastic). This argument was a crucial part of Tobin’s case in

support of discretionary fiscal policy having a role to play in stabilization

policy. Furthermore, in the 1950s and 1960s there also appeared little evidence

that the interest elasticity of the money demand increased as the rate of

interest fell, as the liquidity trap requires. This means that both the extreme

quantity theory and Keynesian cases of vertical and horizontal LM curves,

The orthodox monetarist school 169

respectively, could be ruled out. The static IS–LM model can, however, still

be used to illustrate the quantity theory approach to macroeconomic analysis

if both the real rate of interest and real income are determined by real, not

monetary, forces and the economy automatically tends towards full employment

(see Friedman, 1968a). Second, although the belief in a stable demand

for money function was well supported by empirical evidence up to the early

1970s, since then a number of studies, both in the USA and other economies,

have found evidence of apparent instability of the demand for money. In the

USA, for example, there occurred a marked break in the trend of the velocity

of the narrow monetary aggregate, M1, in the early 1980s and subsequent

breaks in the velocities of the broader monetary aggregates, M2 and M3, in

the early 1990s. A number of possible explanations have been put forward to

explain this apparent instability, including institutional change within the

financial system which took place in the 1970s and 1980s. The reader is

referred to Laidler (1993) for a detailed and very accessible discussion of the

empirical evidence on the demand for money, and the continuing controversy

over the question of the stability of the demand for money function.

Friedman (1958) sought to re-establish an important independent role for

money through a study of time series data comparing rates of monetary

growth with turning points in the level of economic activity for the USA. On

the average of 18 non-war cycles since 1870, he found that peaks (troughs) in

the rate of change of the money supply had preceded peaks (troughs) in the

level of economic activity by an average of 16 (12) months. Friedman concluded

that this provided strong suggestive evidence of an influence running

from money to business. Friedman’s study was subsequently criticized by

Culbertson (1960, 1961) and by Kareken and Solow (1963) on both methodological

and statistical grounds. First, the question was raised as to whether

the timing evidence justified the inference of a causal relationship running

from money to economic activity (see also Kaldor, 1970a; Sims, 1972).

Second, statistical objections to Friedman’s procedure were raised in that he

had not compared like with like. When Kareken and Solow reran the tests

with Friedman’s data using rates of change for both money and economic

activity, they found no uniform lead of monetary changes over changes in the

level of economic activity. Later, the issue of money to income causality was

famously taken up by Tobin (1970), who challenged the reliability of the

timing (leads and lags) evidence accumulated by Friedman and other monetarists.

Using an ‘Ultra Keynesian’ model Tobin demonstrated how the timing

evidence could just as easily be interpreted in support of the Keynesian

position on business cycles and instability. Tobin accused Friedman of falling

foul of the ‘Post Hoc Ergo Propter Hoc’ fallacy. He also went further by

criticizing Friedman for not having an explicit theoretical foundation linking

cause and effect on which to base his monetarist claims. The claim was

frequently made that much of Friedman’s work was ‘measurement without

theory’ and that monetarism remained too much a ‘black box’. As Hoover

(2001a, 2001b) has recently reminded economists, correlation can never prove

causation. This problem of ‘causality in macroeconomics’ has led to, and will

continue to lead to, endless arguments and controversy in empirical macroeconomics

(see also Friedman, 1970b; Davidson and Weintraub, 1973; Romer

and Romer, 1994a, 1994b; Hoover and Perez, 1994; Hammond, 1996).

In 1963, Friedman and Schwartz (1963) presented more persuasive evidence

to support the monetarist belief that changes in the stock of money

play a largely independent role in cyclical fluctuations. In their influential

study of the Monetary History of the United States, 1867–1960, they found

that, while the stock of money had tended to rise during both cyclical expansions

and contractions, the rate of growth of the money supply had been

slower during contractions than during expansions in the level of economic

activity. Within the period examined, the only times when there was an

appreciable absolute fall in the money stock were also the six periods of

major economic contraction identified: 1873–9, 1893–4, 1907–8, 1920–21,

1929–33 and 1937–8. Furthermore, from studying the historical circumstances

underlying the changes that occurred in the money supply during

these major recessions, Friedman and Schwartz argued that the factors producing

monetary contraction were mainly independent of contemporary or

prior changes in money income and prices. In other words, monetary changes

were seen as the cause, rather than the consequence, of major recessions. For

example, Friedman and Schwartz argued that the absolute decline in the

money stock which took place during both 1920–21 and 1937–8 was a

consequence of highly restrictive policy actions undertaken by the Federal

Reserve System: for example, reserve requirements were doubled in 1936

and early 1937. These actions were themselves followed by sharp declines in

the money stock, which were in turn followed by a period of severe economic


Even more controversial was the reinterpretation of the Great Depression

as demonstrating the potency of monetary change and monetary policy. Friedman

and Schwartz argued that an initial mild decline in the money stock from

1929 to 1930 was converted into a sharp decline by a wave of bank failures

which started in late 1930 (see also Bernanke, 1983). Bank failures produced

an increase in both the currency-to-deposit ratio, owing to the public’s loss of

faith in the banks’ ability to redeem their deposits, and the reserve-to-deposit

ratio, owing to the banks’ loss of faith in the public’s willingness to maintain

their deposits with them. In Friedman and Schwartz’s view, the consequent

decline in the money stock was further intensified by the Federal Reserve

System’s restrictive action of raising the discount rate in October 1931,

which in turn led to further bank failures. In this interpretation the depression

The orthodox monetarist school 171

only became great as a consequence of the failure of the Federal Reserve to

prevent the dramatic decline in the money stock – between October 1929 and

June 1933, the money stock fell by about a third. By adopting alternative

policies the Federal Reserve System, they argued, could have prevented the

banking collapse and the resulting fall in the money stock and severe economic

contraction. Friedman and Schwartz further justified their view that

changes in the stock of money play a largely independent role in cyclical

fluctuations from the evidence that cyclical movements in money had much

the same relationship (both in timing and amplitude) as cyclical movements

in business activity, even under substantially different monetary arrangements

that had prevailed in the USA over the period 1867–1960 (for further

discussion of these issues, see Temin, 1976; Romer and Romer, 1989; Romer,

1992; Hammond, 1996).

A more intense exchange was triggered by the publication of the study

undertaken by Friedman and Meiselman (1963) for the Commission on Money

and Credit. Although the ensuing Friedman–Meiselman debate occupied

economists for a lengthy period of time, the debate itself is now generally

regarded as largely only of interest to students of the history of economic

thought. In brief, Friedman and Meiselman attempted to estimate how much

of the variation in consumption (a proxy variable for income) could be

explained by changes in (i) the money supply, in line with the quantity theory

approach, and (ii) autonomous expenditure (investment), in line with Keynesian

analysis. Using two test equations (one using money and the other autonomous

expenditure as the independent variable) for US data over the period

1897–1958, they found that, apart from one sub-period dominated by the

Great Depression, the money equation gave much the better explanation.

These results were subsequently challenged, most notably by De Prano and

Mayer (1965) and Ando and Modigliani (1965), who showed that a change in

the definition of autonomous expenditure improved the performance of the

autonomous expenditure equation.

On reflection it is fair to say that these tests were ill devised to discriminate

between the quantity theory of money and the Keynesian view, so that they

failed to establish whether it was changes in the supply of money or autonomous

expenditure that were causing changes in income. This can be illustrated

by reference to the IS–LM model for a closed economy. In general, within

the Hicksian IS–LM framework, monetary and fiscal multipliers each depend

on both the consumption function and the liquidity preference function.

Equally good results can be obtained using the two equations when income

determination is either purely classical or Keynesian. The classical case is

illustrated in Figure 4.2, where the demand for money is independent of the

rate of interest. The economy is initially in equilibrium at a less than full

employment income level of Y0 and a rate of interest r0, that is, the intersec172

Figure 4.2 The classical case

Figure 4.3 The Keynesian case

The orthodox monetarist school 173

tion of LM0 and IS. An increase in the money supply (which shifts the LM

curve from LM0 to LM1) would result in a lower rate of interest (r1) and a

higher level of income (Y1). As the interest rate falls, investment expenditure

is stimulated, which in turn, through the multiplier, affects consumption and

income. In the classical case, empirical studies would uncover a stable relationship

between autonomous expenditure and the level of income, even

though the direction of causation would run from money to income.

The Keynesian case is illustrated in Figure 4.3. The economy is initially in

equilibrium at an income level of Y0 and a rate of interest of r*, that is, the

intersection of IS0 and LM0. Following an expansionary real impulse (which

shifts the IS curve outwards to the right, from IS0 to IS1), the authorities could

stabilize the interest rate at r* by expanding the money supply (shifting the LM

curve downwards to the right, from LM0 to LM1). In the Keynesian case,

empirical studies would uncover a stable relationship between the money supply

and the level of income, even though in this particular case the direction of

causation would run from income to money. In conclusion, what the Friedman–

Meiselman tests appeared to demonstrate was that (i) the marginal propensity

to consume had been relatively stable and (ii) contrary to the extreme Keynesian

view, the economy had not been in a liquidity or investment trap because if it

had the tests would not have found such good fits for the money equation.