RDP 1978-01: Two Essays in Monetary Economics 3. The Dynamics of Adjustment: A Simple One-Sector Model
September 1978
A possibly more important channel for the influence of monetary disturbances is what should perhaps be called the disequilibrium real balance effect recently emphasised in balance of payments analysis[7]. Consider the very simple model illustrated in Figure 1. This is the model used by Archibald and Lipsey (1958) to illustrate the transitory nature of monetary disequilibrium in the Patinkin Model.[8]
This is a model with one asset (money) and one good and illustrates the choices made by an individual who cannot influence goods prices or a small open economy which cannot influence prices in the world economy. In this model the consumer uses his stock of money to smooth the path of consumption over time as illustrated in figure 1 by consideration of the implications of a temporary reduction in income (the classic example being a crop failure). The consumer maintains expenditure above the temporarily lower level of income and money balances are run down in order to make up the part of the gap between production and normal consumption. In the next period, when income has returned to normal, consumption will again be less than income because money balances are below their optimal value. Assuming no further real disturbances, the original equilibrium position at point A will eventually be restored. This example illustrates the role of money as a buffer stock in an uncertain world, not unrelated to the traditional concept of the precautionary motive for holding money[9], since money balances have enabled the impact of a real disturbance to be spread over a number of periods. To anticipate a later point, “money” rather than “assets in general” may be particularly important because money exchanges directly for all other assets and goods.
In this model and in similar more general models, it also follows that if the consumption path is maintained in the face of a more permanent real disturbance – such as a reduction in crop yields caused by a new plant disease[10] – the fall in money balances will signal the need to reduce consumption (the dynamic path in this case is illustrated in Figure 2). In this case the first period solution is the same as in the case of the temporary income reduction, and real balances are again run down to maintain consumption of C1. In the second period, however, in contrast to case one, the consumer notes that income is still at its new lower level, and chooses a still lower level of consumption. The final equilibrium has consumption equal to the new lower level of income, and real balances also reduced, in line with the reduced income level.
The latter point can be generalised to a model in which both prices and quantities are set by individuals with important monompoly powers in the short run. In such models, which following Arrow's (1959) seminal contribution which many see as capturing a crucial feature of the economic system, prices and quantities are influenced importantly in the short run by their past history through expectation-generating mechanisms. Accumulation and decumulation of money balances will signal the need to adjust expectations, and therefore the prices and quantities proximately controlled by the relevant economic agent, a point developed at some length by Laidler (1974). An essential feature of this type of analysis is its attempt to come to grips with disequilibrium phenomena, although the word disequilibrium should not be read as implying that economic agents are off profit or welfare maximizing paths. Rather, it is assumed that economic agents are constrained by available information and in particular that it may well be optimal to allow money balances to diverge from the levels that would be held if the system was in a full long run equilibrium with all variables at their steady state values. If adjustment proceeds in this way, the gap between actual and desired money balances will occur in equations representing decisions about other economic variables; and the resulting adjustments in markets influenced by monetary disequilibrium will themselves tend to indirectly eliminate the monetary imbalance. The resulting dynamic analysis is in strong contrast to much standard monetarist analysis which assumes that markets – and in particular the money market – clear very rapidly; it is also in contrast to much conventional analysis which merely assumes that partial adjustment mechanisms are pervasive and adds the lagged dependent to each behavioural equation.
Empirically, there is considerable support for the influence of adaptive expectations mechanisms of various types on price adjustment, but much less work has been done exploring the possible effects of monetary disequilibrium on price and quantity adjustment. Some forthcoming empirical results provide considerable support for the importance of such effects, however, and in view of their unfamiliarity it is perhaps worth discussing them briefly here.[11] The suggestion that the gap between desired and actual money balances importantly influences aggregate expenditure seems particularly robust. Thus Jonson (1975) finds a powerful and significant disequilibrium real balance effect on British expenditure over the past century. Other work has replicated this result with quarterly post-war data. Knight and Wymer (1975) include a disequilibrium real balance effect in the consumption function of a U.K. model and Jonson, Moses and Wymer (1976) find an equally strong effect on Australian consumption. In retrospect, the standard results with wealth (or liquid assets) in the consumption function can be interpreted as the reduced form of a consumption function incorporating a disequilibrium asset effect, although some of the coefficients in such models need to be reinterpreted if this approach is accepted. Whether the relevant asset is money or a broader aggregate, and whether such an asset disequilibrium effect (or a vector of them) should appear in a large proportion of equations in models of the economic system, is an important question which is discussed further below.
Allied with the usual arguments that excess commodity demand will raise prices, the disequilibrium real balance effect on consumption is sufficient to produce the standard result that monetary expansion first increases output and then, with a further lag, raises prices. It is, however, possible that an excess supply of money has direct spillover effects on price change, in addition to the indirect effect via goods market disequilibrium. Such an effect can be based on the earlier arguments about the role of money as a signalling device or, in addition, can be formalised in terms of rational or at least “sensible” expectations – generating mechanisms, and a strong direct link between monetary disequilibrium and inflation has been detected in the Australian data by Jonson, Moses and Wymer (1976). The approach used involves adding the gap between actual and desired real money balances to a standard price equation with unit labour costs and import prices – these variables representing costs as in mark-up models (e.g. Godley and Nordhaus (1972)) or given an expectations interpretation as in the work of writers with monetarist orientation, for example Parkin (1974a) – and a measure of commodity market disequilibrium. The result suggests that the direct partial equilibrium effect of 10% excess money balances is to raise the annual inflation rate by almost two percentage points (e.g. from 2% to 4%). There are of course many indirect effects – including output effects via consumption which tend to reinforce this direct effect and feedback effects which tend to dampen it – to consider, and the whole system effect cannot be discussed here. In general however, this channel for the effect of excess money balances tends to speed up the price response to monetary disequilibrium relative to models in which the effect is absent. There is some indirect evidence that such an effect has only become important in recent years, in that it is not found in the 90 years of British data analysed by Jonson (1975). At first sight the implied structural change may appear curious, but it must be recalled that the gold standard dominates the inflation experience of much of the past century. In a situation where prices are widely believed to fluctuate about the relatively fixed peg provided by the gold standard, a domestic monetary expansion (for example) will not necessarily signal the desirability of raising prices. According to this line of argument, it is only in relatively recent years, when the Bretton Woods system of adjustable exchange rates and a dollar standard combined with widespread commitment to full employment policies, that it has become rational to expect excessive domestic monetary expansion to signal domestic inflation. In the countries whose monetary policy is on average more expansionary than in the rest of the world – for example, the United Kingdom – the price rises have been validated by exchange rate depreciation. In less inflationary countries, – Germany for example – relatively tight domestic monetary policies have signalled the need for price restraint, which has also been validated by exchange rate policy.
The introduction of disequilibrium real balance effects into aggregate price and quantity equations is based upon the insights of a very simple one good, one asset model. The results can readily be incorporated in standard one sector macro-econometric models, and with some technical modifications to ensure that such models have sensible long run properties, are sufficient to ensure that the models exhibit the “quantity theory” predictions as properties of their steady states. By themselves however the monetary disequilibrium effects do not throw much light on a major fact of recent economic life, the simultaneous rise in inflation and unemployment rates. Conventional analyses have incorporated a variety of tentative explanations for this phenomenon, and in particular, increased uncertainty associated with higher and more variable inflation rates reducing business investment, a tendency for wages to rise at times considerably faster than prices and productivity, perhaps as an over-shooting phenomenon of some kind, and the oil crisis, and such factors are likely to be relevant for understanding in detail the short run dynamics of recent experience. Additional insight into the trade-off debate can however be obtained from consideration of a simple two sector model.
Footnotes
Ando (1974) and Helliwell and Lester (1975) have argued that the MPS model and the RDX2 models – which incorporate the usual mechanisms – more or less replicate the simple monetarist results for closed and open economies respectively. [6]
The clearest early – and neglected – discussion with an empirical orientation is provided by Lydall (1963). I am grateful to G. Harcourt for pointing out this reference. Mishan (1958) should also be mentioned in this context. [7]
The model can be complicated by assuming that
is a function of permanent income (ŷ) and allowing for the possibility that ŷ changes slowly or partially in response to a real disturbance.
[8]
See Brunner and Meltzer (1971) and Darby (1972) for relevant discussions. [9]
Or by cartelization of the oil industry. [10]
Much of this work has been carried out at the International Monetar Research Program at the London School of Economics, and more recently at the Reserve Bank of Australia. Distinguishing features of the econometric methods employed, which have only become operational with the development of a suite of computer programs by C.R. Wymer, are that hypotheses are tested in a manner which allows for all of the simultaneous interactions specified in a structural macroeconomic model, with due allowance for the fact that economic data is discrete while most macroeconomic models are specified to be continuous. [11]