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Money Is Important

An important shift in macroeconomics since 1960 has been in the way economists view the importance of money. In the 1950s there was a sizable contingent of economists who believed that changes in money stock had little effect on spending; by the 1980s there was a sizable contingent who believed that little else mattered. An important reason for this shift was the realization that both the Great Inflation and the Great Depression could be explained in terms of changes in money stock.

The dominant explanation of the Great Inflation, and perhaps the only explanation that economists consider reasonable, was that it was the result of excessive money creation by the German government. There was a tremendous increase in the amount of money during the period, and the totals at the end of the inflation are beyond comprehension. Bresciani Turoni states that on November 15, 1923 the amount of paper marks had reached 92,800,000,000,000,000,000 marks.1 Phillip Cagan estimates that bank deposits less cash reserves were 1,959,000,000,000,000,000,000 marks in 1923, but three years earlier there had been ten zeros less on this statistic.2 Yet the rapid increase in money was not as great as the increase in spending. Velocity increased about ten times from the start of the inflation to its peak in November, 1923.

If one had told a German in 1923 that his inflation was caused by too much money, he probably would have replied that, on the contrary, there was a shortage of money. There was such a great shortage, in fact, that businesses issued illegal money called Notgeld or Need Money. (The German word Not means need, not not. Phillip Cagan estimates that the amount of this money did not exceed 192 quintillion marks.) If you would have told the experts in the Reichsbank that they were issuing too much money, they would have told you that this could not be so. The real money stock, or the amount of money divided by the price level, had fallen.

To evaluate these objections that Germany had too little money, one must remember the distinction between equilibrium and adjustment. Most monetary theorists believe that if the amount of money doubles, price will double in equilibrium. This means that the real amount of money--the purchasing power that people hold--will remain constant. But this is only an equilibrium condition; it does not need to hold in the adjustment process, and none of the prominent monetary theorists has held that it will. If the adjustment process involves inflation, the velocity of money should increase and real money holdings should decrease. Inflation lessens the usefulness of money as a store of value, and the more serious the inflation, the poorer is money as a store of value. As money becomes a poorer store of value, people should try to switch into other assets and hold less of it.

If velocity increases, as monetary theorists say it will if inflation accelerates, then real money balances must fall if output remains constant. The mathematics of the equation of exchange insists on this conclusion. One can see this by rewriting the equation of exchange in the following form:

M/P = Q/V.

M/P is the real money stock. If Q was roughly constant and V increased by ten times, the real money stock must have been about ten times smaller than it was at the beginning of German hyperinflation.

Today almost all economists believe that money played some role in causing the Great Depression, though they disagree on how big its role was. There was a close correspondence between the amount of money in circulation and GNP. However, Peter Temin argued that the drop in interest rates from 1929 to 1931 indicated that monetary forces were off stage during this period and may not have had much of a role in the rest of the story either. Temin supports his interest-rate argument by noting that prices fell by as much as money did between 1929 and 1931, so real money did not decline. As a result, he states that monetary forces could not have caused the level of income to fall.3

In our discussion of the ISLM model, we argued that the demand for money should be stated in terms of purchasing power, or real money. Temin is using this same argument here. If real money did not change, then the LM curve should not have shifted. Note that the same logic can be used to argue that monetary forces did not cause the Great Inflation. In fact, since real money declined between 1921 and 1923, the LM curve should have shifted to the left, which suggests that monetary policy in Germany was restrictive, and rather than causing the inflation, it kept it from being even worse. A problem with Temin's real-money argument is that the demand for money (and hence velocity) should be sensitive to the rate of change in prices. Because prices were falling between 1929 and 1931, money appeared to be a better store of value than it had looked a couple of years earlier. A constant real money will indicate no changes are originating from the monetary sector only if the expected rate of change in price level remains constant.

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1. The Economics of Inflation: A Study of Currency Depreciation in Post-War Germany, p. 23.

2. "The Monetary Dynamics of Hyperinflation", in Studies in the Quantity Theory of Money, Milton Friedman, editor (University of Chicago Press, 1956), pp 101, 104.

3. Temin, Did Monetary Forces Cause the Great Depression, p. 170.

Copyright Robert Schenk