Theory of Monetary Gluts

Money Handshake

Monetary disequilibrium theory is a topic that I’ve struggled with for quite some time. Some time over a year ago, I also wrote a critique of it — a critique that, as I now realize, completely missed the mark. One problem is that I think that monetary disequilibrium is difficult to conceptualize; the emphasis on the money aspect of the problem may detract from how this affects the “real” economy, and it may be more fruitful to frame monetary disequilibrium within the framework of economic calculation. This may also save some people from thinking that all money or money substitute growth has the same effect on the real economy, and thus to realize that money (or money substitute) issued under different conditions will alter the structure of production in different ways.

It should be emphasized that while the “general theory” of Keynes finds a basis in monetary disequilibrium, Keynes’ theory goes in a significantly different direction. Roger Garrison makes the same point in his book, Time and Money (p.126): in The General Theory, the driving force of the business cycle is Keynes’ theory of interest, which helps the author reach the conclusion that the rate of interest on loanable funds will be higher than the profitability of investment. What alters the structure of interest rates is not an increase in the demand for money per sé, but the role of liquidity preference in helping the individual make a choice between alternative financial assets. What’s important is to acknowledge that we aren’t dealing with a “Keynesian notion” or something of that ilk — although, that something is “Keynesian” shouldn’t be just grounds on which to discard it —, but a concept that has colored the work of a broad array of monetary theorists. It, in other words, enjoys wide applicability, and is at the root of most theories of the business cycle — including, even if this may strike a chord with some, the Mises–Hayek theory of business cycles.

The way I’m about to illustrate the theory may also diverge with how others have done it. For example, in the opening paragraphs to Clark Warburton’s 1981 piece on the history of thought he draws our attention to an early theorist who emphasized the importance of maintaining a stable level of output prices: I think this is the wrong way to think about the topic. In large part, I think many theorists that adopted the idea were driven to infer theoretical relationships from highly aggregated data, such that, for instance, the large changes in the money stock associated with industrial fluctuations is blamed entirely on changes in the demand for money. In typical Austrian fashion, I also think this approach is flawed. But, we shouldn’t allow the fact that others may have taken the concept too far, or deduced it from inadequate premises, to cause us to completely dismiss the idea.

The best way to conceptualize monetary disequilibrium is to think about it in terms of exchange and calculation (Leland Yeager puts it in these terms, to an extent, in his essay “The Significance of Monetary Equilibrium,” which can be found in the collection of essays The Fluttering Veil). Before doing that, however, we ought to establish what causes monetary disequilibrium. The straightforward answer: an inelastic currency system unable to cope with changes in the demand for money. The adverse consequences of monetary disequilibrium are different depending on the direction of the divergence. A decrease in the demand for money, otherwise known as a fall in desired cash balances, calls for a fall in the amount of money transacting against goods. In a competitive financial market, a fall in the demand for money will lead to excess notes circulating back to their banks of origin, which will not be able to re-loan these notes out (due to an increase in the volume of redemption — what banking theorists call the “adverse clearings mechanism”). Any system that allows a sustained excess supply of money will cause the malinvestment described by the Mises–Hayek theory. If there is an excess demand for money, or a shortage, the consequences are, in a sense, the opposite. This is the side of the phenomenon of monetary disequilibrium this post will focus on and try to illustrate.

The following two graphs are meant to help conceptualize the problems which result from an inelastic currency — the term “inelastic” here refers to a currency not flexible enough to cope with changes in the underlying preferences which guide market activity. I thought that an IS–LM model may be more pertinent, since it deals directly with the demand for money and other financial assets, but aggregate supply and aggregate demand (AS–AD) are more widely known and it helps see things within the context of changes in the price level. The abscissa (x-axis) shows output, but it’s useful to instead think in terms of exchange; imagine, for the purposes of this post, that output also refers to the exchange of output. The two graphs below illustrate two different ways the market can deal with upward changes in the demand for money,

monetary disequilibrium adjustment as-ad

I apologize if the above two graphs are not as clear as they should be, but the leftward shift in the demand curve, ceteris paribus, implies a reduction in output (O), from Ō (“optimal” output, associated with “full” employment) to, say, Ot. If we equate output with exchange, then we’d think about it in terms of a reduction in the total volume of trade. What is the causal process which leads to this decline in trade? The money supply is defined as the sum of all individual cash balances: ΣM = Md1 + Md2 + Md3…; for our purposes, ΣM = x. Suppose that a sufficient number of individuals increase their demand for cash balances, given current prices, such that the total demand for money rises to y. In order to do this, they acquire money by trading their own output, but it means that they themselves won’t trade that money for other individuals’ output. As a result, these others won’t be able to fulfill their own cash balance preference — thus, the justification for the term “shortage of money” (represented arithmetically by y – x). Given the nature of how money is acquired — you must trade for it —, it also follows that there will be a reduction in the volume of exchange.

There are two overarching methods by which the market can solve a shortage of money (excess demand, or excess demand for money, are two terms which mean the same thing). One is typically associated with “natural” adjustments and the other with interventionism, but I think this is erroneous — the market process can deal with disorder through a variety of channels. The graph to the left represents what is usually considered the “natural” solution, which deals primarily with price adjustments. The leftward shift in the AD curve represents the fall in the volume of trade, which is restored by a rightward shift in the AS curve. This latter shift represents adjustments in the constellation of prices, where prices fall (including those of the factors of production) and the supply schedule represents the new relationship between the price of output and the costs of production (the prices of inputs). Causally, a reduction in prices will lead to people reducing their desired cash balances (because money buys more), restoring the demand for money to its former level (defined above as ‘x’). There are, however, impediments to this type of adjustment: sticky prices.

What are sticky prices? When economists say things like “prices are rigid downwards” they don’t mean to imply a literal interpretation: it’s a metaphor. It means that there may be reasons that price setters don’t change prices at all, or don’t change them in a way that would equilibrate prices. It also refers to the fact that price changes occur over time, and that during this time changes in the demand for money can have adverse consequences that can be remedied through alternative processes. A lot of price rigidity is attributable to “artificial” relationships, implying interventionism (see W.H. Hutt’s The Theory of Idle Resources [see also my review of Hutt’s book]). But, while interventionism may exacerbate imperfections, we shouldn’t take away from this that all imperfection is rooted in the “artificial.” There may be a wide variety of reasons why prices don’t adjust: efficiency wage theory has some explanatory power, or maybe the profitability of some sectors impede sufficient changes in the prices of the factors of production.

The second general solution to excess demand for money is to change the supply of money. Arithmetically, if ΣM is currently ‘x’ and desired cash balances aggregate to ‘y,’ then this would entail increasing the money supply until ΣM is equal to ‘y.’ Putting it in terms of exchange, imagine that banks supply money through the loanable funds market (i.e. lending). Those who are looking to increase their cash balances, as above established, must sell their output, therefore they can sell their goods to those who have borrowed (who, presumably, have a desire to spend what they’ve borrowed). This allows all individuals in the division of labor to fulfill their desired cash balances and it maintains the volume of exchange.

The problem of monetary disequilibrium can be framed in the parlance of the theory of economic calculation. On one side I’ve brought up the theory’s relationship with Austrian business cycle theory, but the discussion so far has suggested that excess demand for money affects economic calculation differently. In Microfoundations and Macroeconomics (pp. 71–82), Steven Horwitz puts both in the context of the Austrian business cycle, but I don’t think this is correct (especially the emphasis on the interest rate and deviations between the “natural” and market rates). Instead, if we look at the division of labor as a network of exchanges, where prices allow for rational economic calculation (see Ludwig von Mises’ Socialism and Human Action), then a breakdown in the volume of exchanges may prevent the allocation of resources. Incidentally, this change in my conceptualization of the problem helps unearth my error in the above linked piece on prices and the demand for money. I interpreted the objective of monetary equilibrium as the restoration of output prices, in a way analogous to a means of avoiding having to deal with the allocation of economic goods. But, restoring equilibrium should be thought of as neutral to resource allocation in the sense of not purposefully favoring one expenditure over another. Money isn’t neutral, but in this case money helps maintain an allocation of resources neutral in respect to a given set of underlying preferences.

(Tangentially, it may help to get a better idea of what I have in mind if I spell out my differences with professor Horwitz. The Mises–Hayek theory of industrial fluctuations holds that changes in the money supply, given certain conditions, will lead to a pattern of expenditure which doesn’t correspond to the ratio of capital to consumer goods; i.e. an allocation of resource that doesn’t reflect underlying preferences, viz. time preference. Fiduciary expansion – fiduciary referring to fiduciary media, or money substitute unbacked by outside, or base, money – is usually biased towards the purchase of capital goods, meaning that changes in the supply of money may cause a lengthening and/or widening of the structure of production. If the money being used by entrepreneurs to draw resources to earlier stages of production is unbacked by savings then these investment projects are unsustainable. An excess demand for money doesn’t, on its own, influence the time structure of production. Rather, it only may imply a reduction in resource allocation period.)

Doesn’t the Mises–Hayek theory of the business cycle warn us that increases in the money supply will change the structure of production in such a way that it doesn’t accurately reflect the ratio of savings to consumption? As I allude to above, this should be associated with an excess supply of money, rather than any change in the supply of money. I believe that changes in the supply of money that correspond to changes in the demand for money will respect societal time preference. Assume that we’re in a situation where those who increase their demand for money abstain only from consumption. This is analogous to an increase in savings (deferment of present consumption to some, perhaps undefined [or loosely defined], point in the future), and fiduciary expansion will change the structure of production in accordance with a rise in savings (abstracting away from the further complication of the advent of consumer credit).

What if those who increase their cash balances instead abstain from the purchase of capital goods? Supposing that we start in a position of equilibrium, that withheld expenditure must also represent savings — any capital an entrepreneur has to invest in physical production must be financed out of savings. As such, fiduciary media lent in response represents that same physical stock of savings. It’s tantamount to providing the purchasing power to somebody who can replace that previous individual in the production process. While changes in the demand for money may not directly signal changes in time preference, changes in the money stock that respond to changes in money demand respect the underlying time preference of society. (By way of contrast, excess money may draw from a stock of consumer goods as a means of supporting net investment, therefore denying a consumer that same good — thus explaining why Austrians predict that the malinvestment will show itself when the shortage of consumer goods becomes evident.)

None of this, on its own, must necessarily lead one to conclude that only the government can help when problems of excess demand for money arise. There are many ways that government can try to replicate (or putatively improve upon) market processes that accomplish similar ends. The critique that government cannot accomplish these ends without disrupting the market process holds, including for the case of monetary disequilibrium — taking a page out of Ronald Coase’s “The Problem of Social Cost,” the imperfections that arise out of intervention may be even worse than the imperfections the interventions were meant to solve! This is an admittedly shallow disqualification of the role of government (I deal with one aspect of the problem in much more depth in my Mises Daily, “Government Spending is Bad Economics“). This post is already long as it is, but my reasoning revolves around the general fact that the state is simply not as versatile as the market, largely because of the scope of action is much more heterogenous in the latter (and more prone to trial-and-error).

Also, none of this discussion touches on how much “explanatory power” the theory of monetary disequilibrium has (i.e. how applicable it is). As an Austrian, I think most non-Austrians ascribe to it much more explanatory power than it deserves. I also think that it explains only one facet of a problem that may present itself in complex form. Take the business cycle: if we agree that the business cycle is caused by severe intertemporal discoordination, then problems associated with an increase in the demand for money may be secondary. Imagine that a swath of malinvestment is revealed and the pricing process is thrown into chaos, leading to a fluctuation in output and exchange. This may induce people to increase their cash balances, perhaps as a result of heightened uncertainty. How much, then, does the theory of monetary disequilibrium explain? It may be the case that explains very little, or it explains a relatively unimportant area of the issue. It may also interact with other phenomena in ways that invalidate much of the above analysis, and in ways that call for different responses.

The problem of complexity also feeds into the problems of centralized intervention. It’s very difficult to discern the relevance of different relationships between the data. If Hayek’s work in theoretical psychology is correct (see The Sensory Order) then it may even be impossible to completely understand complex phenomena. Interventions are shaped by the interpretations of policy analysts and policy makers. This is a major reason why the heterogeneity of the market is preferred, as well as its flexibility in responding to trial-and-error (i.e. profit and loss, or economic calculation). Any single action by any given agent on the market may not give hints as to the “macro” significance of the aggregate of these actions, but the theory of spontaneous order and institutional change suggests that these individual actions tend to form “macro” patterns that help smooth the performance of the division of labor. One example is a free banking regime, where banks can help maintain monetary equilibrium by issuing private notes when the volume of adverse clearings fall (see George Selgin’s The Theory of Free Banking).

At the same time, while monetary disequilibrium is oftentimes associated with interventionism, because it’s used to justify certain policies (even some Austrians can advocate these policies on the grounds that they’re “second best” solutions), this should not be reason to reject the underlying theory. While I do talk in terms of “solutions,” this post is meant to explain how increases in the demand for money can affect the market process, and how individuals may enact changes — whether consciously or unconsciously — that alter the market process in such a way that it can smooth out the results of ubiquitous imperfections. The above analysis is meant to be a contribution in positive, rather than normative, economics.

22 thoughts on “Theory of Monetary Gluts

  1. Rob Rawlings

    Nice article. I’m happy to see you now embracing many of the ideas from monetary disequilibrium theory that you rejected in your earlier paper.

    I have a question on:

    “An excess demand for money doesn’t, on its own, influence the time
    structure of production. Rather, it only may imply a reduction in
    resource allocation period.”

    My understanding of how Austrians typically saw the results of an increase in the demand for money unmatched by an increase in the supply of money is as follows:

    – people increase their money stock
    – banks have less money to lend out
    – Interest rate rise
    – The structure of production will shorten “artificially” until prices and interest rates adjust again

    This would happen even if the initial demand for money increase came proportionately from investment and consumption.

    Sounds like you disagree with this. Can you clarify why ?

    1. JCatalan

      Increases in the demand for money should increase the ability for banks to issue new loans. What restrains the issuance of liabilities is the relationship between the liquidity of these liabilities and maturing claims on the banks’ assets. Increases in the demand for money will decrease the number of maturing claims, therefore allow the bank to issue new liabilities. With regards to the rate of interest, I know Horwitz’ position, which is that an increase in the demand for money will lead to a fall in the natural rate of interest — this may or may not happen, but even if it does I don’t think it’d lead to an Austrian business cycle. (Also, Horwitz only thinks this will hold if the supply of money is inelastic.)

      Let’s say that the equilibrium rate is ‘x’ at time t, and an increase in the demand for money follows a change in time preference which pushes the natural rate down to ‘y.’ But, the rate of interest and prices which guided production up to this point correspond to rate ‘x.’ Compare the situation with one where the market rate is pushed down to ‘y’ even though the natural rate is still at ‘x.’ The structure of prices will come to reflect an increase in the volume of credit, and the new low rate of interest, but what sets off the business cycle is the revelation that these prices are false profit signals and that they don’t correspond to the underlying societal preferences. This doesn’t occur if the rate of interest falls from ‘x’ to ‘y,’ but all existing investments were made based on prices corresponding to the rate of interest ‘x.’ There’d still be misallocation, but not a sudden change in the rate of profit; instead of the structure shortening, it just wouldn’t lengthen and widen as much as it could have.

      1. Rob Rawlings

        “Increases in the demand for money should increase the ability for banks to issue new loans”

        I can see how this would happen under free banking where banks can issue new loans against the larger cash balances resulting from the increase demand for money but not under a system with an inelastic money supply (such as 100% reserve) where banks will have access to less reserves to lend out (as people are instead holding them in accounts that prevent them being lent out under full reserve).

        “With regards to the rate of interest, I know Horwitz’ position, which is
        that an increase in the demand for money will lead to a fall in the
        natural rate of interest”

        I don’t see how an an increase in the demand for money will change the natural rate. In the short run at least won’t it (with an inelastic money) cause the market rate to rise since the supply of loanable funds got smaller ?

      2. Dan(DD5)

        Steve Horwitz also subscribes to the pure theory of interest according to his own book. In the past at least, he has maintained that time preference is time neutral. Selgin also maintains this fact. I have provided you with his own quotes here in the past. On the other hand, it is true that Steve Horwitz does give the impression in his book that a rise in demand for money is equivalent to a rise in voluntary savings, i.e., a fall in time preference. It is sort of taken for granted that a rise in cash holdings is equivalent to a rise in “loanable funds”

        The question is this:

        How are these two seemingly contradicting statements combine together to form a logically valid argument? And don’t tell me (again) that a rise in cash holdings can result in a lower time preference because you just assume that consumers increase their cash holdings by lowering by consuming less. I can just as well ASSUME that they achieve the same cash balance by investing less and making no changes in their consumption.

      3. JCatalan

        @b50fed300ab5d91bbd3d0b59ab55e10a:disqus : Yea, that’s one of the criticisms of full reserve banking. Also, I agree with you (as I write in the post) that changes in the demand for money don’t necessarily reflect time preference. But, it doesn’t necessarily lead to a smaller pool of loanable funds. It could actually lead to a larger pool of loanable funds if cash is held in checking deposits.

        @dan_dd5:disqus : I do talk about that in the post (and we’ve discussed it in the past), and it doesn’t rely on the assumption that a rise in cash balances implies a fall in time preference.

        1. Dan(DD5)

          So what constitutes loanable funds according to you?

          If time preference has not changed, or even worse, it has risen, but cash holdings increase in the form of checking deposits, then what do banks do now? Well, according to the “free banking” doctrine, banks will loan them out to meet demand for their notes. M will rise by issuing fiduciary media to offset a decline in V. This is MET 101!

          1. JCatalan

            An increase in preferred cash balances can be causally linked to a decrease in the expected maturity of savings, but banks will have to deal with a decrease in savings when these mature (i.e. when notes begin to reflux in greater volume). But, something is savings whether you plan to maintain that stock of savings for the next two days or for the next five years. A rise in the demand for money can’t be causally linked to an increase in consumption, since consumption requires expenditure.

            Regarding loanable funds, banks decide what constitutes loanable funds based on capital constraints.

          2. Dan(DD5)

            You’ve managed to complicate relatively simple concepts. I’m not even sure I understand what you’re trying to say.

            First, I clearly didn’t link any change in cash balance to a rise or fall in time preference. I said it is time neutral. So what does this mean:

            ” A rise in the demand for money can’t be causally linked to an increase in consumption, since consumption requires expenditure.”

            What does “link” mean in this context. Does it necessarily imply causation, or are you just talking about achieving one by doing the other. The latter does not require any causal link. For example, one can increase his cash balance by one of 3 ways:

            1. Defer spending on both present goods and future goods so that the end result leaves the proportion between the two unchanged, thus, interest rate is unchanged.

            2. Defer spending on present goods, indicating a fall in time preference occurring together with a rise in demand for money.

            3. Defer spending on future goods, indicating a rise in time preference occurring together with a rise in demand for money.

            That demand for money is time neutral does not imply that time preference does not change also at the same time, as evident by #2 and #3.

            I don’t know why you must complicate things with concepts such as “maturity of savings” or appeal to modern savings instruments (not you in this particular case) in order to show that money in the bank always amounts to basically loanable funds. It obviously does not. A rise in cash balance reveals nothing about changes in time preference. Banks increasing M by issuing loans to offset V distort the interest rate. While this is most evident in #3, it also occurs in #2 and in #1.

          3. JCatalan

            #3 is wrong: deferring expenditure on future goods does not indicate, or imply, a rise in time preference, if the goal of the agent is to increase her cash balances. A rise in time preference implies expenditure on present goods. By increasing one’s cash balances this agent is deferring from spending in general — it’s an investment in a financial asset that is expected to bring a reward over time. In other words, it’s an act of saving, and if cash balances are increased at the expense of other savings instruments then it simply indicates a change in liquidity preference.

            You write,

            That demand for money is time neutral does not imply that time preference does not change also at the same time.

            Absolutely, but these have different effects which impact banks’ balance sheets. You accuse me of “complicated relatively simple concepts,” but you’re not embracing the complexity of the problem!

  2. Current

    I mostly agree with what you say above. It’s good to see you take a more positive view of monetary disequilibrium theory.

    I’ve been thinking about this a lot recently, there are lots of loose ends to tie up. For example, how do the “narrow” market interest rates such as those on bonds and account relate to the broader rate of profit which is incorporated in share earning and other investments. The weakness of lots of Keynesian thought is that it only tackles the narrow rate, the weakness of the early marginalists like Bohm-Bawerk is that their theories are really about the broader rates.

    Also, how does liquidity preference connect with time preference? Two people may have very different time preference, and therefore split their wealth quite differently between saving and consumption. But, those two people may increase their money holding in quite a similar way if uncertainty rises. Both may allocate more of their pot of savings to money and less to other investments. This indicates that liquidity preference only changes the overall magnitude of saving when for some of the population it’s necessary for them to hold on to money rather than spend it on consumption.

    1. JCatalan

      I agree that the basic Austrian literature may be too broad and Keynesian literature too narrow in the discussion on interest rate theory, but I don’t know either of it well enough to comment for sure. It seems to me that the task is to see how individual rates of interest are determined, and how all of this relates in the market process (especially how savings are allocated in an economy with multiple avenues of lending). Personally, this should be done sacrificing detail, because one of the problems is that the number of interest bearing assets increases as economic complexity increases, so we just need general principles of the determination of interest and then how the structure of rates interplays with the allocation of savings.

      Keynes thought that two factors determine the rate of interest: time preference and liquidity preference. Money may be a suitable asset during periods of increased uncertainty because of how liquid it is. But, what liquidity preference determines in how individuals save. I see liquidity preference as one of a multitude of forces which affect the market rate of interest, where greater liquidity is met with lower rates of interest on the asset (it’s a trade off). There’s a good book that compares the pure time preference theory with Keynes’ liquidity preference theory called Keynes’ General Theory of Interest, by Fiona Maclachlan, but I haven’t found the opportunity to read it yet.

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  4. Dan(DD5)

    Cont from below:

    “#3 is wrong: deferring expenditure on future goods does not indicate, or imply, a rise in time preference, if the goal of the agent is to increase her cash balances.”

    Where did the “IF” come from? Not from #3.

    If ONLY liquidity preference is changing then the cash holdings are increased by deferring spending of both future and present goods so that the end result leaves the ratio between them unchanged – This leaves the structure unchanged. Interest rate remains the same, and prices have adjusted proportionally. This is basically scenario #1.

    What you are claiming or implying now is quite absurd but indeed it is what you must do in order to keep your theory intact.

    You are saying that I cannot defer spending on future goods only, as if future goods were not real goods or as if there is something almost mythical about them, for surely you wound not argue this about present goods. Future goods are means to ends just like consumption goods, the latter simply being more “immediate” or further down the structure.

    If my initial spending pattern between present and future is 30-70. people can increase their cash holdings by tapping either the 30 only, 70 only, or both (in what ever proportions they want). they don’t have to keep the structure the same when their liquidity preference is changing. I can also change my time preference in either direction. So yes, I can increase my cash holdings to $10 by spending only $60 on future goods but still maintain spending of $30 on present goods. There is no law that says I can’t! That’s a new 30-60 structure. A 1/2 ratio vs 3/7 ratio before. That’s a shorter less roundabout structure, that’s higher interest rate, and that’s $10 in my pocket. call it investment of whatever you want ( I won’t even disagree), but it got there by a process of “dissavings” in terms of the structure!

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