Download Origin of the Idea

Origin of the Idea
22.1 Monetarism
22.2 Equation of Exchange
22.3 Rational Expectations Theory
22.4 Efficiency Wages
22.1 Monetarism
As indicated in the text, monetarism descended from classical economics. Today it is not
seen so much as a distinct school of economic thought, but as a subset of neoclassical
economics. As the name suggests, monetarists focused on the role of money in the
economy. Earlier economists saw money as a veil that must be pulled aside to see the real
economy. Monetarists helped demonstrate that monetary changes have real impacts,
and are not merely a cover for economic activity.
Some of the better-known monetarists were Swedish economist Knut Wicksell (18511926), Yale professor Irving Fisher (1867-1947), British Treasury official Ralph George
Hawtrey (1879-1975), and University of Chicago professor Milton Friedman (b. 1912).
Perhaps the earliest monetarist, though typically not remembered as such, was
philosopher John Locke (1632-1704). Known more for his political philosophies, Locke
argued that the price level is determined by the quantity of money in circulation, given a
fixed quantity of real output and velocity of money. Today referred to as the quantity
theory of money, Locke's contribution is part of the foundation of monetarism.
22.2 Equation of Exchange
Irving Fisher (1867-1947) developed the equation of exchange within his quantity theory
of money. Fisher used the quantity theory of money and equation of exchange to argue
that "one of the normal effects of an increase in the quantity of money is an exactly
proportional increase in the general level of prices."(1) In other words, the only effect of
an easy money policy would be to cause inflation.
Fisher's equation of exchange is a bit more complex than the version that appears in the
text. Specifically, when looking at the quantity and velocity of money, Fisher separated
currency (M) and its velocity (V) from checkable deposits (M') and their velocity (V'). This
leaves Fisher's equation of exchange as:
MV + M'V' = PT
Fisher used T (for "Trade") instead of Q to represent the physical volume of goods and
services produced. As explained in the text, monetarists believe that velocity is stable, an
idea that originated with Fisher:
No reason has been, or, so far as apparent, can be assigned, to show why the velocity of
circulation of money, or deposits, should be different, when the quantity of money, or
deposits, is great, from what it is when the quantity is small.(2)
Even if velocity is stable, it is possible, at least in mathematical terms, that an increase in
the money supply could increase real output. Considering this possibility, Fisher responds
as follows:
An inflation of the currency cannot increase the product of farms and factories, nor the
speed of freight trains or ships. The stream of business depends on natural resources and
technical conditions, not on the quantity of money.(3)
Thus with velocity assumed constant and the quantity of money unable to affect real
output, Fisher concludes that a monetary expansion will only yield increases in the price
level.
It should be noted that philosophers John Locke (1632-1704) and David Hume (1711-1776)
articulated notions of the quantity theory of money some 200 years before Fisher would
formalize the theory.
Irving Fisher, The Purchasing Power of Money (New York: Macmillan, 1911), p. 157.
Fisher, p. 154.
Fisher, p. 155-156.
22.3 Rational Expectations Theory
Milton Friedman of the Chicago school of economics (also known as new classical
economics) argues that people adapt their expectations (about inflation, for example) as
new events occur. One of the theoretical implications, as explained in the text, is that in
the long run the Phillips curve is vertical. Another University of Chicago economist,
Robert Lucas, along with economists Thomas Sargent and Neil Wallace, extended
Friedman's analysis, formulating the theory of rational expectations. Lucas, in his Studies
in Business-Cycle Theory, argues that economic participants process economic
information so effectively that they can predict and respond to policy changes before
they have an effect, allowing them to act in a manner that negates the policy change.
Lucas won the Nobel Prize in 1995 for his work on rational expectations, but had to split
the almost $1 million prize with his ex-wife, as stipulated in their divorce agreement.
22.4 Efficiency Wages
The notion that higher wages promote greater productivity - efficiency wages - appears
often in the history of economic thought. Although not credited with developing the
term, Adam Smith (11723-1790) was one of the first to articulate the idea. Robert Owen
(1771-1858), owner of the New Lanark spinning mills in Scotland, attempted to put the
idea into practice. Owen, who owned and ran the mills from 1800-1820, also established
the model community of New Lanark. Operating during the industrial revolution, a period
in which wages were pushed to subsistence, Owen paid his workers significantly more
than the prevailing wages of the time, and his mills were both productive and profitable.
Several economists developed formal theories of efficiency wages. These theories are
summarized by George Akerlof and Janet Yellen, eds., in their book, Efficiency Wage
Models of the Labor Market (Cambridge: Cambridge University Press, 1986).