Origin of the Idea

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19.1 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 (1851-1926), 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.

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Photograph courtesy of: (c)Corbis # BUS2016;

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19.2 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.

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19.3 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.

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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.

Photograph courtesy of: (c)AP Photo/Charles Bennett

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19.4 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).