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A clarification of the excess demand for or excess supply of money.

I. INTRODUCTION

This article focuses on many economists' neglect (and even denial) of monetary disequilibrium. I am convinced that one of the most misunderstood and neglected concepts in all of economics is the notion that money may indeed be in excess supply or excess demand. For example, McCallum |1989, 84~ argues:

Since it does not take long to alter the amount of currency that one holds, either by purchasing interest-bearing bonds or consumption goods, it is reasonable to assume that actual holdings correspond very closely to desired (demanded) holdings for each household. Thus in the aggregate we have

|M.sup.d~ = |M.sup.s~;

that is, the quantity of money demanded equals the quantity supplied.

McCallum then goes on to argue that given the above equality, "there should be no loss in content if we simply use the symbol |Mathematical Expression Omitted~ to denote both |M.sup.d~ and |M.sup.s~." Accordingly, McCallum assumes money demand and money supply coincide. Although his book is about monetary theory, McCallum completely overlooks the importance of monetary disequilibrium.

Dornbusch and Fischer |1990, 137~ also commit this oversight when they argue:

For many purposes it is useful to restrict the dynamics by the reasonable assumption that the money market adjusts very quickly and the goods market adjusts relatively slowly. Since the money market can adjust merely through the buying and selling of bonds, the interest rate adjusts rapidly and the money market effectively is always in equilibrium. Such an assumption implies that we are always on the LM curve: any departure from the equilibrium in the money market is almost instantaneously eliminated by an appropriate change in the interest rate. In disequilibrium, we therefore move along the LM curve....

If one is going to discuss the dynamics of macroeconomic adjustment, then surely one should not disregard monetary disequilibrium. Similarly, other economists, as in Serfaty |1979~, Kaldor |1982~, and Moore |1988~, argue that money can never be in "excess supply."

Much of what this article says has been written elsewhere. While this repetition may be tedious to some, "only by varied iteration can alien conceptions be forced on reluctant minds."(1)

II. MONETARY DISEQUILIBRIUM

By "money" is meant "narrow money," "the medium of exchange" (that is, currency plus demand deposits). Some economists seem to imply that "money demand" and "money supply" are almost conceptually the same, since they are always equal. For example, Kohn |1991, 678~ argues: "Since all of the money in existence must be held by someone, the aggregate demand for money must equal the total amount in existence." One of the critical errors in such assertions is the assumption that newly accepted cash balances are fully demanded. Because of money's role as a medium of exchange, people are always willing to accept newly created money. However, that does not mean that they are actually demanding these additions to their money holdings. Rather, they may try to dispose of these acquired (but excess) money balances with appropriate speed. Yeager |1968, 51-52~ discusses this crucial distinction for a closed economy:

A person accepts money not necessarily because he chooses to continue holding it but precisely because it is the routine intermediary between his sales and his purchases or investments and because he knows he can get rid of it whenever he wants....People's initial unwillingness to hold all newly created actual money would not keep them from accepting it and would not prevent its creation.

Yeager |1968, 50-51~ further elaborates on the process by which these excess money balances eventually become desired:

A holder of unwanted money exchanges it directly for whatever he does want, without first cashing it in for something else. Nothing is more ultimate than money. Instead of going out of existence, unwanted money gets passed around until it ceases to be unwanted. Supply thus creates its own demand (both expressed as nominal, not real, quantities, of course). To say this is not to assert that there is no such thing as a demand function for money or that the function always shifts to keep the quantities demanded and in existence identical. Rather, an initial excess supply of money touches off a process that raises the nominal quantity demanded quite in accordance with the demand function. Initially unwanted cash balances 'burn holes in pockets', with direct or indirect repercussions on the flow of spending in the economy....People's actions to get rid of unwanted money make it ultimately wanted by changing at least two of the arguments in the demand function for money: the money values of wealth and income rise through higher prices or fuller employment and production, and interest rates may move during the adjustment process.

By "demand for money" economists are referring to people's desire to hold money as balances in a portfolio. Equilibrium occurs when the money supply equals the amount of money that people wish to hold in this portfolio. In disequilibrium, money possessed (the money supply) and money demanded for portfolio reasons are not equal. As Yeager's statements argue, an excess supply of money will manifest itself in people's desires to get rid of this excess by increasing their purchases of goods and services (as well as securities), so that an excess demand for goods and services (and securities) results.(2)

Tsiang |1977, 331n~ offers the following alternative interpretation: "To spend money to buy goods is the normal way to make use of the essential function of money as the medium of exchange. It is not just an act to get rid of an excess supply of money." Tsiang's statement is true in the sense that each day some people spend money, while others accept it. Money may not be in excess supply in the aggregate even though people are engaging in transactions with it. But then, no excess demand for goods would exist either. That is, if the goods market and the money market were in equilibrium, that is not to deny that money would be continuously changing hands. The significant point though of this section (and of Yeager's comments) is that if people were attempting to increase their purchases so that an excess demand for goods existed, then money would indeed be in excess supply. It is conceivable that the excess demand for goods would also partially be matched by an excess supply of bonds. However, it would not be matched solely by an excess supply of bonds. For the interest rate adjusts fairly rapidly to equilibrate the bond market (see next section). On the other hand, money has no unique price of its own. Monetary disequilibrium would not show up on any particular "money market." Instead, an excess supply of money would express itself in quite general eagerness in buying things. Its pressures would be obscurely diffused over myriads of individual markets and prices. This very diffusion would render any correction sluggish.(3)

More specifically, there are two further reasons why monetary disequilibrium would persist. First, prices and wages are "sticky," so that automatic market forces, working alone, would correct a monetary disequilibrium only slowly.(4) Second, excess money holdings are not immediately spent. People would accept money that they did not desire to hold in the long run at the initial price level because money balances act as a "buffer stock."(5) According to the buffer-stock literature, an individual's quantity of money demanded "does not refer to an amount of money which an agent will want to hold at each and every moment, but rather to an amount which he will want to hold on average over some time interval... |that is to say, it denotes~ the average or target value of an inventory, of a buffer stock, of cash balances."(6) Moreover, holders of money would sooner or later take action if they saw their balances diverging markedly and persistently from desired ranges or average levels, as in Miller and Orr |1966~. Thus, an excess inventory of money would be worked off over time.

The foregoing analysis has some bearing on the issue of the need empirically for a lagged dependent variable in the short-run aggregate demand-for-money function. The existence of portfolio adjustment costs is often given as the basis for the inclusion of that variable. However, both Laidler |1982; (1984) 1990~ and Lane |1990~ challenge that reasoning. While portfolio adjustment costs may make sense in the "individual-experiment," they produce no observable consequences in the "market-experiment," to use Patinkin's |1965~ terminology.(7) On the other hand, Laidler |1982, 56, 63~ argues that the lagged dependent variable is empirically needed because it reflects monetary disequilibrium.

Laidler |1990, 60~ also argues that the collapse of the empirical stability of the short-run demand-for-money function starting in the mid-1970s stemmed from "the inability of simple single equation distributed lag techniques to come to grips with the dynamic complexities involved in the transmission mechanism of monetary policy."(8) (We might add that institutional change was also a source of instability in empirical demand-for-money functions.)

III. THE INTEREST RATE AND MONETARY DISEQUILIBRIUM

Some economists might object to the foregoing analysis of monetary disequilibrium. They might argue as in Boyes |1992, 96~ that "the interest rate changes... until the quantity of money demanded equals the quantity supplied." Indeed, Boyes |1992, 108~ even argues that "the level of interest rates is determined in the money market by the demand for and supply of money."

The question of what determines the interest rate brings to mind the old debate over liquidity-preference and loanable-funds theories of the interest rate. Rabin and Yeager |1982, 19~ argue: "General equilibrium does not prevail, of course, unless the interest rate (along with all other variables) is at a level where not only desired lending and borrowing but also desired and actual stocks of money are equal. Outside of general equilibrium, however, it is not necessarily true that upward pressure on the interest rate corresponds to an excess demand for money and downward pressure corresponds to an excess supply of money." An example illustrates a conflict between the two theories. Suppose money and bonds are in excess demand, and commodities are in excess supply. The liquidity-preference theory, which focuses on the demand for and supply of money, indicates upward pressure on the interest rate. On the other hand, the loanable-funds theory, which focuses on the loan or bond market, indicates downward pressure. The excess demand for bonds should indeed raise their price and thus depress their yield or rate of interest. Rabin and Yeager |1982, 19~ elaborate: "As partial-equilibrium theories, the liquidity-preference and loanable-funds theories of the interest rate are not equivalent, and the latter is preferable. Lutz (1968, p. 184), among others, has pointed out that 'the immediate cause of a price change has to be sought in changes of supply or demand in the market of the good in question and not in other markets.'"(9)

Although the interest rate is determined directly in the bond or loan market, this does not deny that changes in the money supply can affect the interest rate. But they do so through pressures working in the bond or loan market (that is, by affecting the demand for or supply of bonds). Moreover, changes in the interest rate do not eliminate immediately an excess supply of or demand for money.(10)

Much confusion in the literature likely stems from the failure to distinguish between the demand for money and the demand for credit. For example, when people go to the bank in order to borrow money newly created by the banking system, they are demanding loans (or credit), not necessarily money to hold.(11) That is, with this newly accepted money they may now increase their stream of expenditures on goods and services. In this way, an excess supply of money and an excess demand for goods and services will have been created as a by-product of this credit market activity. Only after prices and incomes have risen sufficiently (to increase money demand) would monetary equilibrium again prevail.(12)

IV. AN INCREASE IN THE MONEY SUPPLY THROUGH OPEN-MARKET PURCHASES BY THE CENTRAL BANK

When the central bank increases the money supply in a closed economy through open-market purchases, people willingly accept money. Yet an excess supply of money can result, along with an excess demand for goods and services and securities. In this manner, monetary policy may have inflationary consequences. But someone may object to the above line of reasoning. They may claim that people sold the bonds to the government because they demanded more money. Our reply is that people are generally willing to sell bonds to whoever offers an attractive purchase price. However, when the central bank is the buyer, the money supply rises, creating an excess supply of money. (The increase in the money supply would be all demanded if the lower interest rate which results cleared both the bond market and the "money market" without any repercussions in the goods market. On the other hand, if the initial decrease in the interest rate equilibrated only the bond market |as argued above~, then the fall in the interest rate would be accompanied by an excess demand for goods and an excess supply of money.)

Some economists may further object to the above line of reasoning; they may insist that the fall in the interest rate equilibrates money demand and money supply. But if the demand for goods then increases because of the lower interest rate, what matches the excess demand for goods? The answer, of course, is an excess supply of money.

Dornbusch and Fischer |1990, 140~ provide an example of a complete misunderstanding of the above line of argument:

Consider...the adjustment process to the monetary expansion....By our assumption that the assets markets adjust rapidly, we move immediately to point |E.sub.1~, where the money market clears, and where the public is willing to hold the larger real quantity of money because the interest rate has declined sufficiently. At point |E.sub.1~, however, there is an excess demand for goods. The decline in the interest rate, given the initial income level |Y.sub.0~, has raised aggregate demand and is causing inventories to run down. In response, output expands and we start moving up the LM|Prime~ schedule.

Dornbusch and Fischer |1990, 125~ are assuming that: "When the money market is in equilibrium..., the bond market, too, is in equilibrium...." Their analysis winds up with monetary expansion producing an excess demand for goods unmatched by an excess supply of anything else, thus violating Walras's Law.(13)

Part of the confusion likely stems from their reliance on the IS-LM framework, which portrays only two markets--for goods and money. For example, Dornbusch and Fischer |1990, 131~ go on to state, after repeating the last assertion quoted above, that "the LM curve is, therefore, also the schedule of combinations of interest rates and levels of income such that the bond market is in equilibrium." This statement is wrong. Through the use of Walras's Law, the IS-LM framework can correctly focus on just the two markets. But implicitly underlying this framework is a bonds-equilibrium curve which passes through the intersection of the IS and LM curves. Johnson |1972, 13~ does indeed draw such a curve in an IS and LM diagram.

V. CONCLUSION: LM VS. BB

The preceding section argues that some authors incorrectly contend that the LM curve is also a bonds-equilibrium curve.(14) Other authors avoid this error by just focusing on the goods and money markets. We shall be charitable here and assume that these authors are aware of the separate bonds-equilibrium curve (BB curve) implicitly underlying the IS-LM model. In the full diagram, as portrayed in Figure 1, when the money supply increases, the LM curve shifts downward to the right and the BB curve shifts downward.(15) A key question then boils down to: During the adjustment to a new equilibrium, does the economy move along the new LM curve or along the new BB curve--that is, if we must insist on a movement along one of these shifted curves?

In Figure 1, an increase in the money supply results in a shift of L|M.sub.1~ and B|B.sub.1~ to L|M.sub.2~ and B|B.sub.2~. The economy moves from the old equilibrium, point A, to the new equilibrium, point E. Those authors who maintain that money demand equals the money supply during the adjustment process are therefore implying that adjustment occurs along L|M.sub.2~, from point B to point E, as in Branson |1989, 69-70~. On the other hand, this article argues that adjustment would occur along B|B.sub.2~, from point C to point E. For a bond market does exist whose price (which is inversely related to the interest rate) moves fairly rapidly to clear that market. Yet, as we have argued, no "money market" exists with a single price which would clear that market. Hence, in Figure 1 the economy at point C would be off both the LM and IS curves, reflecting the excess supply of money and the excess demand for goods.

The foregoing discussion deliberately avoids the issue of whether an increase in the money supply would also shift the IS curve upward to the right. This issue will be addressed in another article.(16)

1. Spencer |(1897) 1978, vol. 1, 34~.

2. The monetary transmission mechanism or process described above was indeed understood by Wicksell |(1898) 1965, 39-41~, who provided one of the clearest early statements of the connection between an excess demand for or supply of money and adjustments in the demands for and supplies of goods and services. The following are some other economists who also have described this process: Fisher |1920, 153-54~, Keynes |1936, 84-85~, Friedman |(1959), 1969, 141-42~, Friedman and Schwartz |(1963) 1969, 229-34~, and Laidler |(1984) 1990; 1987~.

3. The point that money has no unique price or market of its own has been the theme of several papers by Leland Yeager.

4. Yeager |1986, 376~ is referring specifically to depression, but his comment can be extended to inflationary disequilibrium.

5. Laidler |(1984) 1990, 1987~.

6. Laidler |(1984) 1990, 25-26~. Laidler |1987, 22n~ cites the following contributions to the "buffer-stock" literature: Bordo, Choudri, and Schwartz |1984~, Carr and Darby |1981~, Gordon |1984~, and Greenfield and Yeager |1986~. He also cites in another footnote on the same page Jonson's |1976~ article: "the relationship between the role of money as a buffer stock, and traditional analysis of real-balance effects, is one of the topics explored in Jonson's seminal (1976) paper." A referee has pointed out that Alfred Marshall's unpublished paper on "Money," reprinted in Whitaker |1975, vol. 1, 164-76~, explicitly defines the demand for money as being the average value of an inventory of cash balances which fluctuates over time.

7. Laidler |1982, 48, 56~ and Lane |1990, 478-79~.

8. Laidler |1990, 62~ elaborates: "the dynamics of what we have learned to call the short-run demand for money function are not the property of a structural relationship at all, but rather reflect that complex interaction of the quantity of money with other variables to which the Monetarists of the 1950s and 1960s used to refer as a transmission mechanism subject to long and variable lags."

9. See also Fellner and Somers |1966~.

10. Besides Boyes |1992~, Mankiw |1992, 250-60~ also embraces the liquidity-preference theory. Similarly, Baily and Friedman |1991, 126~ argue that the interest rate is determined in the money market. Mishkin |1992, 118~ not only embraces the liquidity-preference theory, but also argues incorrectly that in a model in which there are two kinds of assets, money and bonds, "the liquidity preference framework... is equivalent to the loanable funds framework."

11. Here we suppose that the banking system is able to create new money because the Federal Reserve has provided it with excess reserves, perhaps through loans at the discount window. The case of open-market purchases by the central bank is considered in the next section.

12. Much of what is said here about money being created as a by-product of credit market activities, and of the importance of distinguishing between the demand for money and that for credit, is to be found in a number of papers by Brunner and Meltzer on the money supply process. One such work is cited below.

13. Froyen |1990, 173-74~ also makes the errors mentioned here. A referee has pointed out that the Dornbusch and Fischer argument that the sum of the excess demand for money plus the excess demand for bonds always equals zero is an "invalid dichotomy" in the sense of Patinkin |1965~. Abel and Bernanke |1992, 128, 401~ also embrace this invalid dichotomy.

14. I would like to thank Richard J. Sweeney for suggesting the discussion of this section.

15. The slope of the BB curve is drawn horizontally. However, there is no clear presumption that this line slopes either upward or downward, although by Walras's Law it slopes less steeply upward than the LM curve or less steeply downward than the IS curve. We do not lose much of importance by assuming that the BB line is horizontal, as in Patinkin |1965, 331-32~. The three curves intersect at a common point, which represents equilibrium.

16. Two types of objections to the arguments presented in this paper might be raised. First, Kaldor |1982, 24, 70~ and Moore |1988, xi~ argue that when the central bank pursues interest-rate targeting, the money supply is demand-determined; hence, in such cases there could never be an excess supply of money. However, Brunner and Meltzer |1976~, Judd and Scadding |1982~, Laidler |1982~, and Greenfield and Yeager |1986~ provide counter-examples to this line of argument. A second type of objection concerns an open economy under fixed exchange rates. The monetary approach to the balance of payments, as associated with Frenkel and Johnson |1976~, asserts that under fixed exchange rates the domestic money supply is demand-determined. The balance of payments acts as an equilibrating mechanism to assure this result. However, Rabin and Yeager |1979; 1982~, Laidler |1982, 60-61~, and Norman C. Miller |in several of his articles~ provide counter-examples to this line of argument.

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