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Thursday, December 20, 2012

The Intemperate Discourse Continues

I noted a couple of days ago that the folks on the Society for the History of Economics listserv were having something of an intemperate discussion about Keynes and the clasical economists.  We branch out now into a sideshow about Say's Law, as one of the participants writes:

First, I don't recognize what he calls Mill's "'temporary' deviations from Say's Law" as deviations at all.  The law says there cannot be an overproduction of all goods at the same time. [John Stuart]Mill is simply pointing out that money (cash or currency) is also a good (or commodity).  Thus, should there be an excess demand for money (or insufficient supply) there would be an excess supply of all other goods and a fall in the price level. 

Well, perhaps the potted version of Say's Law ("Supply creates its own demand") says nothing more than that the income generated in production is euqal to the value of the goods produced (which remains a truism of national income accounting).  But that is not what one takes away from a more, um, complete reading of Say's work (have a look at A Treatise on Political Economy, if you're interested). 
Elsewhere, Say argues that a surplus of even one commpdity, and a corresponding shortage of another commodity, cannot exist except very temporarily, because prices will adjust to eliminate both the surplus and the shortage.
Why is this important?  It suggests that all markets return to equilibrium quickly and with no frictions.
Let us return, then, to the argument that being made above--that Mill says that money is also a commodity.  Frankly, I think this is a mis-reading of Mill, as it is surely a mis-reading of Say, who argues that
Money performs but a momentary function in this double exchange; and when the transaction is finally closed, it will always be found, that one kind of commodity has been exchanged for another...(p. 134)
This is a fairly clear statemnt of the conclusion reached by classical economists that money is neutral, that the amount of money in an economy has no effect on the underlying, or "real," economy (money is neutral).  If the amount of money in the economy increases, then the general level of prices inreases--we have inflation.  If the amount of money in the economy decreases, we have deflation.  Because money is valued and used for its function as a medium of exchange, it does not make much sense to take about an "excess demand for money."
What is an "excess demand for money," anyway?  In general there is an excess demand for a good if, at the existing price, people are willing and able to buy more of it that is made available for sale.  So, if there is an "excess demand" for money, peple will be willing and able to buy more money than is available at the existing price.  What does it mean to "buy" money, in this context, and what is the "price" of money?  In a classical explanation of the world, people "buy" money by selling goods for money.  And the "price" of money is the quantity of goods it takes to acquire a given quantity of money.  In the aggregate, the "price" of money is the reciprocal of the general level of prices.
So how do we get an excess demand for money?  Assume that there is a central authority that controls the amount of money.  If that authority reduces the amount of money (the supply curve of money shifts to the left) and the price of money does not rise (which is the same thing as saying that the general level of prices does not fall), there will be an excess demand for money.
(In the diagram above, the excess demand for money is shown by the red line segment.)  Note that, for the excess demand for money to be resolved, the price of money must rise to its new equilibrium level--which is the same as saying that the general level of prices must fall.  Now, Say and Mill and the other classical economists concluded that this increase in the price of money (fall in the general level of prices) would occur quickly, that the excess demand for money would be quickly remedied.  Or, explaining it differently, and using the quantity theory of money as a framework, we would have:
M*v = P*Q

(Where M is the quantity of money supplied, v is the "velocity of money" (roughly, the number of times per time period the "average" unit of money is spent), P is the general level of prices, and Q is an index of the total output of goods.)  Classical economic theory concludes that v is (relatively) constant.  So, if a decrease in M leads immediately to a corresponding decrease in P, the quantity of goods produced will remain constant.  And, hence, money is neutral.  Say believed money is neutral.  Mill believed money is neutral.  That was one of the underlying tenets of the classical system.
But what if the general level of prices does not adjust quickly?  (What if prices are sticky, especially downward?)  Then, with a relatively constant velocity, Q must fall.  Oh, wait.  That's, essentially the argument Keynes made.
(More in a while.)



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