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David Laidler

David Laidler is a professor of economics at the University ofWestern Ontario and is affiliated with the GD. Howe Institute.This papei the fourth annual Homer Jones Memorial Lecture,was delivered at the Federal Resea’ve Bank of St. Louis onApril 11, 1990.

The Legacy Of The MonetaristControversy

It is not quite true, as one (hostile) commentaryhas asserted, that Monetarism was developed by“Milton Friedman at the Federal Reserve Board(sic) of St. Louis,” but it is nevertheless the casethat the intellectual environment created at thisBank by Homer Jones ensured that the doctrinetook root and flourished here when it was verymuch a minority taste elsewhere.1 And indeed,at least two early and seminal contributions tothe Monetarist controversy, Andersen and Jor-dan (1968) and of course Brunner (1968), whichgave the controversy its label, first appeared inthe Bank’s Review. The Monetarist controversy,therefore, is surely a suitable topic for this lec-ture. Now Monetarism has been much definedand debated over the years, to the point atwhich one may find authority for applying theterm to almost any economic andlor politicaldoctrine one likes, or more probably dislikes.However, it is not so much my purpose here todefine that doctrine in detail yet again, as it isto discuss the consequences for the develop-ment of monetary economics, both in theoryand practice, of the debates to which it gaverise during the 1960s and 1970s.

In this lecture, I shall first of all describe theissues that were at stake at the outset of those

debates. I shall show that although the Mone-tarist policy agenda was very different fromthat of what we might call “Keynesian” ortho-doxy, the positive differences in economic analy-sis which underlay the policy debate were atfirst empirical in nature, raising no fundamentalquestions of economic theory. I shall also show,however, that, whether it was logically necessaryor not, theoretical considerations of profoundimportance did get introduced into the Mone-tarist controversy as it progressed. Althoughthese at first seemed to strengthen the Mone-tarist position, I shall go on to argue that thesevery considerations in the longer run under-mined it, leaving Monetarism without distincttheoretical foundations, and incapable of copingwith the empirical difficulties which it began toencounter from the mid-1970s onward. Further-more, I shall suggest that most, though not all,of those empirical problems stemmed from anattempt by “Keynesian” orthodoxy to adapt Mon-etarist ideas to its own use. Finally, I shall arguethat though the Monetarist controversy was toall intents and purposes over by the early 1980s,the problems which it bequeathed to monetaryeconomics continued to affect theoretical,empirical- and policy-oriented aspects of thesub-discipline into the 1980s, with results which

‘See Gould, Mills and Stewart (1981), p. 26.

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I cannot help but view with considerablediscomfort.

THE MONETARIST CONTR&VERSE IN THE iSOOs

The Monetarist controversy concerned therole played by monetary variables in general,and the quantity of money in particular, in themacroeconomy. Different exponents of Mone-tarism stressed different propositions, but itwould be fair to say that, from the point ofview of the non-academic observer whose mainconcern was the conduct of economic policy,Monetarism involved first a theory of inflation,second a theory of the cycle, and third, as acorollary of these, a recommendation for theconduct of monetary policy. Specifically, infla-tion was said to be explicable in terms of therate of growth of the money supply, and thecycle, or more precisely its turning points, interms of changes in that rate of growth. Fromthese propositions, it immediately seemed tofollow that both inflation and cycles could beavoided by choosing an appropriate rate ofgrowth for the money supply, and binding themonetary authorities to deliver it year in andyear out by imposing upon them some quasi-constitutional rule of conduct, The central itemon the Monetarist policy agenda was thus toeliminate inflation and stabilize the real economyby taking discretionary power away from thecentral bank.2

Whatever position may be taken about itsvalidity, this Monetarist agenda is nowadaystreated as having been (and perhaps as still be-ing) worthy of serious discussion. It was not so25 or 30 years ago. Then, though the Phillipscurve, about which I shall have more to saybelow, was coming onto the scene, the predomi-nant view treated inflation as largely a matterof “cost-push” forces. The cycle was regarded ashaving its roots in investment fluctuations, andsome mixture of wage-price guidelines and fiscalmeasures was thought best able to cope with

the policy problems the two phenomenapresented. Monetary tools had at best a minorrole to play in the conduct of macro policy, andthe relevant variables were, in any event,thought to be not the quantity of money, butthe level and structure of nominal interestrates. In 1960, say, that as yet un-named bodyof doctrine which we now know as Monetarismwas hardly debated for the simple reason that itwas regarded as quite outlandish. This wasstrange indeed, because at that time no funda-mental questions of economic theory separatedproponents of the conventional macroeconomicwisdom of the early 1960s from their Monetaristcritics. Each side in the debate that was tofollow could, and did, derive their views fromspecific quantitative hypotheses about relation-ships embodied in what was, nevertheless, quali-tatively speaking, essentially the same macroeco-nomic model, that staple of the contemporarytextbooks, the Hicks-Hansen IS-LM framework,~

The first stage of the Monetarist controversywas about the empirical nature and stability ofthe demand for money function, or, as it wasthen thought equivalently, the relationship deter-mining money’s velocity of circulation. As earlyas 1956, Friedman had advanced the hypothesisthat the demand for money was a stable func-tion of a few arguments, and by 1959 had pro-duced empirical evidence which seemed toshow that, as far as real money balances wereconcerned, “few” meant “one”: namely, perma-nent real income. The implications of this resultwere startling, because, once fed into the IS-LMframework, they suggested that if the quantityof money was held to an appropriate constantgrowth rate, there would be essentially noscope for shocks originating on the real side ofthe economy, for example, in the investmentcomponent of aggregate demand, to bring aboutany significant fluctuations in nominal income.Nor would there be any role for fiscal measuresto play in influencing that variable, Further-more, a slightly later, but essentially complemen-tary, study by Friedman and Meiselman (1963)

2ln an earlier essay, Laidler (1982), Ch. 1., I analyzed theessential characteristics of Monetarism from an academicperspective, concentrating there on the role of a stable de-mand for money function and the expectations-augmentedPhillips curve in defining the doctrine, As the reader willsee, these relationships play a large part in the followingdiscussion, and I regard this essay as supplementingrather than in any way contradicting this earlier piece.

function, while Friedman (1971) also used it as an ex-pository device. Note, however, that Brunner and Meltzer(e.g., 1976), because of their insistence on the importanceof credit market effects in the generation of the moneysupply, were led to extend this framework to a point atwhich it became sufficiently different in its characteristicsto make it misleading to treat it as simply one more varianton lS-LM.

3Thus Laidler (1969) used this framework to motivate itsdiscussion of the significance of the demand for money

seemed to confirm directly the irrelevance ofvariations in autonomous expenditure, while atthe same time attributing a considerable in-fluence on money income’s behavior to thegrowth rate of the money supply.

The appealing simplicity of these results didnot long survive further empirical investigation.A number of studies soon found a role for inter-est rates to play in influencing velocity, hencere-opening the theoretical possibility of variablesother than money affecting the time path ofmoney income, and the Friedman-Meiselman re-sults were not robust in the face of smallchanges in the way in which the Keynesian con-cepts of autonomous and induced expenditurewere measured.~Nevertheless, from a practicalpoint of view, the modifications to the basicMonetarist position required by these resultswere rather minor. The quantity of money didseem to be an economic variable of potentiallystrategic importance; and real shocks originatingin the private sector, not to mention impulsescoming from fiscal policy, did seem to play apotentially less important role in determiningmoney income’s time path than the conventionalwisdom of about 1960 would have had it. By1967 results such as these were sufficiently wellestablished and widely accepted that it was pos-sible for the present writer to begin work on asupplementary textbook (Laidler, 1969) whichsummarized the empirical evidence on the de-mand for money function, and explicitly inter-preted it in terms of the above-mentioned IS-LMmodel along just such lines as these.

Now the reader will be well aware that ourearlier confidence in the empirical stability ofthe demand for money function has not beenentirely justified by subsequent experience. I willtake up this matter below. For the moment it ismore important to concentrate upon anotheranomaly in this aspect of the Monetarist contro-versy, namely that empirical evidence on thestability of the demand for money function,though relevant to Monetarist propositionsabout the causative role of money vis I vis bothinflation and the cycle, and hence also to pro-posals to tie down monetary policy by way of agrowth rate rule, stops far short of establishingthem. Thus, if monetary elements in the genera-

tion of inflation on the one hand, and the cycleon the other, are to be discussed coherently, onerequires more than a link between the time pathof money and money income. One also needs atheory of how fluctuations in money income aredivided up between its price level and real in-come components. Moreover, a stable demandfor money function is quite compatible with theexistence of cost-push inflation and a cyclewhose origins lie in the private sector of theeconomy, provided only that institutional ar-rangements are such as to render the supply ofmoney as an essentially passive variable.

Empirical evidence about the stability of thedemand for money function, that is to say, gotMonetarist analysis taken seriously enough forit to become controversial, but it could not inand of itself guarantee its victory in a debatewhich rather centered on the two issues raisedabove. The first issue became known as theproblem of Friedman’s “missing equation,” anddebate about it overlapped heavily with discus-sions of the “Philips curve,” otherwise knownas the “inflation-unemployment trade off.” As tothe second, it was addressed by such workersas Philip Cagan (1965), and Brunner and Meltzer(e.g., 1964, 1976) who opposed their findings tothe then “new view” of money propounded byJames Tobin (eg., 1969) and his associates. Itwill be helpful to discuss these two aspects ofwhat we might term the second stage of theMonetarist controversy in turn.

The problem of decomposing variations inmoney income into their real and price levelcomponents was a longstanding one in macroeco-nomics, dating back at least to Hicks’ original(1937) formulation of the IS-LM framework as amodel of the determination of money income.Though subsequent developments of this systemreinterpreted it as dealing with real income,that still left prices unexplained. Here, the usualsolution was to have them determined by thebehavior of the money wage, and as I have al-ready noted, to treat the latter variable as beingdriven by exogenous “cost-push” factors. How-ever, this is not the whole story, for “demand-pull” explanations of inflation also had their ad-herents, and the Phillips (1958) curve relatingthe rate of money wage inflation inversely to

4Among early papers finding a significant interest elasticityof demand for money were Meltzer (1963) and Laidler(1966). Both Ando and Modigliani (1965) and De Pranoand Mayer (1965) showed that fairly small changes in thedefinition of “autonomous” expenditure led to rather large

effects on the assessment of its influence on aggregatedemand. Strangely enough, at this stage of the Monetaristcontroversy, questions about vagueness in the definition ofmoney were not raised.

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the level of unemployment soon came to beseen as a device for synthesizing these twopoints of view. Wage inflation, according to thePhillips curve was proximately caused by an ex-cess demand for labor, for which variable theunemployment rate was a proxy. Such excessdemand could either result from “pull” forcesshifting the labor demand curve, or “push” in-fluences shifting the supply curve. In eithercase, however, price inflation would be deter-mined by the difference between wage inflationand labor productivity growth. Hence thereseemed to exist a structural inverse trade-offbetween inflation and unemployment, or equiva-lently a positive relationship between the levelof real output and inflation.~

From the point of view of microeconomics,the above analysis was fatally flawed, beingbased on a theory which had the supply and de-mand for labor determine the money, ratherthan the real, wage, and it was not long beforePhelps (1967) and Friedman (1968) indepen-dently pointed this out. The latter, moreover,brought his critique into the center of the Mon-etarist controversy, by noting, first that the or-thodox Phillips curve predicted that an inflation-ary monetary policy could generate permanentgains in real income, and second, that when itsunderpinnings were corrected to take accountof the money wage-real wage distinction, theinflation-unemployment trade-off was reducedto a temporary phenomenon at most. Hence, akey ingredient of the theory which yielded thecharacteristic Monetarist propositions aboutmoney growth affecting only prices in the longrun but quantities too, in the short run, wascreated after the empirical observations uponwhich those propositions were based had beenpublished, and turned out to be a theory not ofmoney, but of labor market behavior. It seemedto be, moreover, in its original form, a modifica-tion of a device borrowed from one branch ofthe orthodoxy to which Monetarism was oppos-ed. As a practical matter, rather than replace itwith some alternative equation, the Phelps-Friedman critique of the Phillips curve simplyadded the expected inflation rate to the relation-ship’s right-hand side, with a coefficient ofunity.

As with Monetarist propositions about the de-mand for money function, then, questions raisedby the Monetarist “correction” to the Phillipscurve seemed to be inherently empirical. Eitherthe labor force was immune to money ilusionin the long run, so that there was no permanentinflation-unemployment trade-off, or it was not,in which case such a permanent trade-off ex-isted. This question generated much empiricalwork in the late 1960s and early 1970s, and it isa fair generalization that as more and more evi-dence was added by the passage of time, themore the work in question came to support theMonetarist position- Evidence from the 1950sand early 1960s was compatible with the ex-

istence of an inflation-unemployment trade-off,but the experience of higher inflation ratesfrom the mid-1960s onward made this hypothe-sis harder and harder to support.6 Once again,though, there was no reason why this resultcould not be incorporated into the frameworkof a suitably extended IS-LM model. However,two factors militated against so simple and har-monious an outcome to this stage of the Mone-tarist controversy.

To begin with, the original Phelps-Friedmancritique of the Phillips curve had been advancedon theoretical grounds, and before empiricalevidence seemed to require economists to changetheir notions about labor market behavior.When confronted with a choice between what

empirical evidence seemed to show, and whatelementary economic theory required to be thecase, Phelps and Friedman had chosen the lat-ter. Ex-post, they were vindicated by empiricalevidence, and this vindication served notice onmacroeconomists that they would be wise to paymore attention to the microeconomic foundationsof their empirical generalizations than had typi-cally been the case up until then. Second, Fried-man’s version of the critique had been accom-panied by a brief account of labor market be-havior, part of which was quite incompatiblewith the then conventional interpretation ofreal income and employment fluctuations asmanifestations of variations in excess demand inthe economy.

Phillips’ original analysis was much elaborated by Lipsey(1960), but responsibility for explicitly treating the Phillipscurve as a structural relationship constraining policychoice probably rests with Samuelson and Solow (1960).

6The relevant empirical literature was voluminous, but issurveyed by Laidler and Parkin (1975).

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Conventionally enough by the standards ofthe 1960s Friedman described the early stagesof the economy’s response to a monetary expan-sion in the following terms.7

- -.much or most of the rise in income will take theform of an increase in output and employmentrather than in prices. People have been expectingprices to be stable, and prices and wages have beenset for some time in the future on that basis. It takestime for people to adjust to a new state of demand.Producers will tend to react to the intitial expansionin aggregate demand by increasing output, employeesby working longer hours, and the unemployed bytaking jobs now offered at former nominal wages.This much is pretty standard doctrine. (p. 103, myitalics)

However, Friedman immediately went on toelaborate this account of the mechanisms thatbrought about short-term fluctuations in incomeand employment:

Because the selling prices of products typically res-pond to an unanticipated increase in nominal de-mand faster than prices of factors of production, realwages received have gone down—though real wagesanticipated by employees went up, since employeesimplicitly evaluated the wages offered at the earlierprice level. Indeed, the simultaneous fall ex-post inreal wages to employers and rise er-ante in realwages to employees is what enabled employment toincrease. (pp. 103-04)

Unemployment fluctuations in the conventionalview of the Phillips curve had been treated asmanifestations of variations in the pressure ex-erted by excess demand in goods and labormarkets characterized by less-than-perfect priceflexibility, and hence likely to be operating outof equilibrium in the wake of any shock to ag-gregate demand. The first passage quoted aboveis quite compatible with this view. In the secondpassage quoted, however, employment fluctua-tions are explicitly pictured as arising from vol-untary decisions taken in response to pricechanges and, in the case of the suppliers oflabor, on the basis of faulty expectations whichwould in due course be corrected.

Thus Friedman’s critique of the Phillips curvepotentially involved much more than the addi-tion of an extra variable to the right-hand sideof an equation. It also pointed toward a funda-mental reinterpretation of the labor marketbehavior underlying it. Viewed with hindsight,it provides as an unmistakable sketch of themicrofoundations of the short-run aggregate

supply curve which was to become the centralanalytic device of New-classical economics. Aswe shall see below, this device would in duecourse, and quite paradoxically, not strengthenbut thoroughly undermine the very Monetaristexplanation of the business cycle to which Fried-man’s analysis of inflation-unemployment inter-action was particularly addressed.

The analysis of inflation-unemployment inter-action was by no means the only area in which,during the 1950s and 1960s, macroeconomistswere seeking to strengthen the microeconomicfoundations of their analysis. A whole set ofquestions concerning the determination of themoney supply, and the mechanisms wherebymonetary changes might interact with aggregatedemand in the economy, were also addressed insuch terms, both by adherents of the conven-tional Keynesian macroeconomic wisdom of thetime, and by Monetarists. Here as elsewhere,the contentious issues were more empirical thantheoretical. As Harry Johnson noted as early as1962, there was no debate in principle between,say, Brunner and Meltzer on the one hand andJames Tobin on the other about the basic natureof the linkages between the monetary and realsectors of the economy- Both saw these as in-volving disturbances to the structure of the port-folios of the banking system and the non-bankpublic generating changes in the relative ratesof return on various assets, financial and real,which would in turn provoke attempts on thepart of agents to restore equilibrium by way ofsales and purchases of various assets, Both sidesalso agreed that financial institutions and thenon-bank public alike should be analyzed asmaximizing agents.

What defined the Monetarist position herewas not its general approach, but rather a setof specific hypotheses about the quantitativenature of the responses in question. First, as faras the non-bank public was concerned, Mone-tarists took a broad view of the array of assetswhose rates of return were relevant to what wemight term the transmission mechanism of mon-etary policy. Specifically, they argued that mone-tary policy would have effects not just on ratesof return borne by financial assets, but also onthe implicit rates of return yielded by producerand consumer durables. Hence they saw its ef-fects as being both more pervasive, and quanti-

references here and elsewhere to quotations from his workare to this source unless otherwise noted.

‘Friedman’s (1969) Optimum Quantity of Money reprintsmany of his seminal contributions, and the page

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tatively more significant too, than did proponentsof the Tobinesque “new view.” Furthermore,while not denying that disturbances originatingin the private sector of the economy would im-pinge upon the behavior of financial institu-tions, so that the quantity of money was un-doubtedly in this sense an endogenously deter-mined variable, they nevertheless strongly re-sisted the idea that the endogeneity in questionalso involved that variable being passivelydemand-determined, even when the monetaryauthorities used short-term interest rates astheir policy instrument.

Such an outcome was logically possible, to besure. If interest rate changes disturbed only themargin between financial assets (let us call thembonds) and money, then a reduction, say, in in-terest rates would lead to the public simply of-fering bonds to the banks in exchange for mon-ey with no further consequences. However, con-sistent with their broad view of the range ofassets relevant to the transmission mechanism,Brunner and Meltzer argued that the principalmargin likely to be disturbed by a change in in-terest rates was that between bonds andphysical capital, including consumer durables.The public would sell bonds to the banks, ofcourse, but as part of a process of replacingthose bonds with physical capital. Furthermore,and crucially, this would be only a first-roundeffect, for the sale of bonds to the banks wouldbe in exchange for newly created money whichwould have to be accommodated in the port-folios of the non-bank public. Since the bankshad presumably changed interest rates for areason in the first instance, the possibility oftheir simply acquiescing in the destruction ofnewly created cash by the public dischargingdebts to them could be discounted. Hence, fur-ther substitution effects, changes in aggregatedemand, and ultimately in the price level, wouldbe set in motion.

Monetarists’ theoretical position vis-â-vis thebehavior of the quantity of money in circula-tion, then, may be described succinctly as fol-lows. Rather than being a passive demand-deter-mined variable, money also had a separate sup-ply function which was derivable from analysisof the interaction of banks and the public in themarket for bank credit. In turn, the quantity of

credit which banks were willing to grant, aswell as the terms on which they would make itavailable, were both subject to a strong (thoughnot unique) influence flowing from the quantityof reserves which the central bank made avail-able to them. The quantity of money was an en-dogenous variable, certainly, arising from acomplex set of interacting portfolio choices, butit was nevertheless controllable by themonetary authorities. This theoretical position,moreover, was supported by a good deal of em-pirical evidence, some yielded by formaleconometric studies, and some by less-formalhistorical work to the effect that the behaviorof bank reserves, or more precisely of the quan-tity of high-powered money, was the principaldeterminant of the quantity of money in circula-tion and that variations in the ratio of high-powered money to the money supply propercould be modeled as the outcome of systematicmaximizing portfolio choices.8

THE SUBVERSION OF MON&TARISM BY NEW~CLASS1CALECONOMICS

In the previous section of this essay, I havedescribed the main elements of Monetarist doc-trine, and have tried to show that they were allreasonably well-developed in the academicliterature by the end of the 1960s. However, ittook the inflationary experience of the early1970s, particularly in the United States andBritain, to draw popular attention to that doc-trine by providing, during its early stages, some-thing as close to a controlled experiment as oneever gets in economics. In both countries, mone-tary expansion preceded an inflation which theauthorities attributed to cost-push forces andattempted to control with wage-price controlprograms, and in both countries those programsfailed. Though the OPEC-led energy price in-creases of 1973 contaminated the later stages ofthe experiment by introducing an extraneouscost-side impetus to the upward progress ofprices, the early 1970s was nevertheless the lasttime that wage-price controls were deployed asan alternative to monetary restraint in an anti-inflation policy. Moreover, the fact that the high

Perhaps the best known of early econometric studies ofthe money supply function is Brunner and Meltzer (1964).The standard historical study is that of Cagan (1965).Brunner’s (1968) St. Louis Review piece contains perhaps

his single best exposition of the Monetarist position on thegeneration of the money supply, and of the characteristicsdistinguishing it from the Tobinesque “new view.”

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inflation of the 1970s was combined with anobvious deterioration in real economic perfor-mance, rather than an improvement, ensuredthat Monetarist ideas about the absence of along-run inflation-unemployment trade-off quick-ly became conventional wisdom,

At the very time at which Monetarist ideaswere gaining popular acceptance, however, theiracademic foundations began to shift dangerous-ly as New-classical economics was developed. Ihave suggested elsewhere that the work ofRobert E. Lucas, Thomas Sargent, Neil Wallaceand Robert Barro is more usefully treated asseparate and distinct from Monetarism, and forwhat I still regard as good reasons.9 However,this was and remains, something of a minorityviewpoint; and the fact remains that the twocentral characteristics of New-classical econom-ics, namely the interpretation of the Phillipscurve as a reflection of an aggregate supply rela-tionship, and the rational expectations hypothe-sis, were quickly adopted by leading Monetarists.This was unfortunate, because as the Monetaristcontroversy moved into the 1970s and 1980s, itincreasingly became, as a matter of fact, a con-troversy about New-classical economics. The ma-jority of economists failed to distinguish betweenMonetarism and New-classical economics, andaccepted James Tobin’s characterization of New-classical economics as Monetarism Mark 11.10When New-classical economics was academicallydiscredited, so too was Monetarism in general,leading to what, as I shall argue in the final sec-tion of this paper, is a dangerous gap in thestructure of contemporary monetary economics.

I have already noted that Friedman’s 1968analysis of the inflation-unemployment trade-offrelied on two incompatible theories of labormarket behavior. In the passages quoted earlier,we had quantities moving instead of wages andprices, which had already been set and hencewere unable immediately to change; and wealso had quantities moving in response to asym-metrically perceived money-price changes. Wehad, in short, both an informal account of theeffects of wage and price stickiness which was,as Friedman said, “pretty standard doctrine” inthe macroeconomics of the 1960s; but we also

had an unmistakable sketch of an aggregate sup-ply curve interpretation of the short-run Phillipscurve in which money-wage and price flexibilitywas of the essence,

There is little point in speculating about theextent to which Friedman was aware of the ten-sions inherent in his analysis in 1968; but it isinteresting to note that, at that time, he charac-terized Phillips’ work as “. - containing a basicdefect—the failure to distinguish between nomi-nal wages and real wages (p. 102, Friedman’sitalics) whereas in 1975 he referred not only tothis point, but also attributed to Phillips an er-ror in having “..taken the level of employment[instead of the rate of change of prices] as theindependent variable. - “ in the relationship. By1975 Friedman clearly was aware that there wasa choice to be made concerning the microeco-nomic underpinnings of the Phillips curve andhad explicitly rejected that which hinged on in-terpreting the unemployment rate as a proxyvariable for some excess demand for labor con-cept. Brunner and Meltzer made a similar choiceconcerning the modeling of the linkages betweenoutput and price-level variations in designingthe basic framework which they and their asso-ciates used to analyze the inflationary processin a number of countries in the mid- 1970s.Like Friedman too, they chose to model expecta-tions as being formed not adaptively but, follow-ing Lucas and Sargent and Wallace, rationally,as the inflation forecast of the “true model” ofthe economy under analysis.”

These developments seemed at the time to bein no sense revolutionary. I have already re-marked that the Phelps-Friedman critique of thePhillips curve initially involved using simple mi-croeconomic analysis to mount a theoretical at-tack on what at the time seemed like an hypothe-sis well-supported by empirical evidence; and inthe event, microeconomic principles proved asounder guide than what turned out to be somemisleadingly special observations. To show thatprice-output interaction could be derived from asupply and demand apparatus without resort topurely empirical generalizations about pricestickiness, and to show that the analysis in ques-

9This argument is developed in some detail in Laidler(1982), Ch. 1.

lOThis characterization of Tobin’s is developed and defend-ed by him in Tobin (1981), in a paper prepared for thesame conference as the above mentioned Laidler (1982).Ch. 1.

11The relevant work here is contained in Brunner andMeltzer, eds. (1978). Note that the details of their formula-tion of the aggregate supply curve, with output’s rate ofchange rather than level playing a major role, set it apartfrom the standard Lucas (e.g., 1973) formulation. Thesematters, discussed by McCallum (1978), are not central tothe matter under discussion here.

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tion was compatible with agents making use of“all available” information in a utility maximiz-ing fashion, simply seemed to be making evenmore secure the microeconomic foundations ofa particular piece of macroeconomics, and henceto be rendering it less prone to excessivedependence on theoretically unsupported em-pirical observations of a type that had provedso misleading in the recent past.

Also, and crucially, New-classical macroeconom-ics still seemed to yield Monetarist implications,namely that inflation in the long run was a mon-etary phenomenon, and that, in the short run,so was the cycle. To be sure, it broadened themenu of monetary rules that would enable thecycle to be avoided to any that the general pub-lic could understand and therefore use as a basisfor expectations formation, but a constantgrowth rate rule was still a particularly simple,and therefore viable, item on the menu in ques-tion, and it was of course a particularly appro-priate choice if price stability in the long runwas added to the elimination of the cycle as aproper goal for monetary policy.

Even in the mid-1970s, it should have beenapparent that the attempt to underpin the Mone-tarist position with New-classical foundationswas dangerous. As early as 1958, Friedman hadsuggested that monetary policy affected theeconomy with a “long and variable” time lag.The evidence with which he supported this sug-gestion identified a change in monetary policyas a change in the rate of growth of the quanti-ty of money in the economy; and it showed thatdownturns in that rate of growth occurred onaverage 16 months before the correspondingupper turning point of the cycle, while upturnsin money growth led cyclical troughs by abouttwelve months, Furthermore, as Friedman(1987) was later to note more explicitly, the ef-fect of changed money growth on nominalincome’2

- typically shows up first in output and hardly at allin prices. If the rate of monetary growth increasesor decreases, the rate of growth of nominal incomeand also of physical output tends to increase or de-crease about six to nine months later, but the rate ofprice rise is affected very little. the effect on pricescomes some 12 to tB months later...(p. 17)

In 1963, Friedman and Schwartz had presenteda more elaborate analysis of money’s role ingenerating the cycle, in the course of whichthey explained the length of the time lags in-volved in terms that amounted to an informalsketch of a dynamic version of the Monetaristversion of the transmission mechanism whichBrunner and Meltzer were also expounding atthe time.

The central element in the transmission mecha-nism.--is the concept of cyclical fluctuations as theoutcome of balance sheet adjustments, as the effectson flows of adjustments between desired and actualstocks. It is this interconnection of stocks and flowsthat stretches the effects of shocks out in time, pro-duces a diffusion over different economic categories,and gives rise to cyclical reaction mechanisms. Thestocks serve as buffers or shock absorbers of initialchanges in rates of flow, by expanding or contractingfrom their “normal” or “natural” or “desired” state,and then slowly alter other flows as holders try toregain that state. (p234)

The empirical evidence referred to here, andparticularly that part of it dealing with the tim-ing of output responses relative to those inprices, and an explanation of that evidence interms of a transmission mechanism involvingportfolio disequilibria working themselves slow-ly out over real historical time are quite incom-patible with New-classical analysis. Since boththe evidence in question and the above explana-tion of it were available and well establishedbefore the development of New-classical ideas,the incompatibility in question ought to haveprevented those ideas from being adopted as abasis for Monetarist propositions, but it did not.Whether this was because the problem was notfully appreciated at the time, or because thatshift in methodological priorities away from em-pirical evidence and toward “sound” theoreticalfoundations upon which I have already com-mented caused those who were aware of it toopt for the latter is hard to say. I suspect that astrong element of the latter consideration musthave been at work, though, since the inconsisten-cy in question is hardly subtie)’

To begin with, the price flexibility postulate ofNew-classical economics creates problems for the

“The reader’s attention is drawn to the recent (1987) vin-tage of this statement. I have not been able to find soclearcut and concise an exposition of the point in Fried-man’s earlier work, though I believe that the basic messagecontained in the passage quoted here can be distilled fromthe evidence presented in Friedman (1969), Chs. 10-12.

“Though I do not claim to have understood this matter fullyfrom the outset, I did discuss it in some detail as early as1978 in an essay reprinted as Chapter 4 of Laidler (1982).

Monetarist account of the transmission me-chanism. Slow adjustment of portfolios in thewake of a monetary disturbance is of the veryessence here, and it is usual to explain the slow-ness in question in terms of transactions costs.But if the price level moves freely and instanta-neously to keep markets cleared it also, in theprocess, eliminates portfolio disequilibria quitecostlessly for agents. According to Friedman andSchwartz, excessive money holdings develop be-cause, when money growth increases, the rateof inflation does not respond immediately. Butaccording to New-classical economics it does,and so increased money growth cannot cause atemporary rise in buffer-stocks of money as apreliminary to increased expenditure flows. Theconflict here between traditional Monetarismand New-classical analysis concerns rival theoret-ical constructions. Much more serious is theconflict between theory and evidence whicharises when the New-classical aggregate supplycurve is confronted with the empirical evidenceconcerning the interaction of money, outputand prices over the course of the cycle, evidenceupon which traditional Monetarism laid con-siderable stress.

As is well known, the New-classical aggregatesupply curve explanation of the decompositionof nominal income changes into their real andprice-level components hinges upon the distinc-tion between demand side shocks whose pricelevel effects can be anticipated by agents, andthose that cannot. The word “anticipated” nor-mally means “expected and acted upon,” butsince the New-classical model is one in whichflexible prices always move costlessly and in-stantly to equate supply and demand in all mar-kets, the second phrase is redundant in its con-text. If a price level change is anticipated byagents, there will be no quantity changes associ-ated with it; but if it is not, then the specificmoney-price changes in particular markets thatare associated with it will be misinterpreted asreflecting relative price changes and voluntaryresponses in quantities of goods and servicessupplied will occur. Cyclical fluctuations in realvariables may therefore be interpreted as theconsequence of unanticipated price level changes.The trouble here is that it is hard to see howoutput and employment fluctuations can be re-sponses to price level fluctuations jf they precedethose price level fluctuations; but the empiricalevidence tells us that they do just that.

This inconsistency of the timing of data withthe basic structure of New-classical theory, which

should have led monetarists to reject that theoryfrom the outset, did eventually undermine it. So

long as empirical work was confined to testingthe proposition that output and employmentfluctuations could be modeled as responses to“unanticipated” money, all seemed well. How-ever, Robert J. Barro (1978) noted that the theo-ry in question made specific predictions aboutthe relationship between monetary shocks andprice level changes as well. When he came totest the latter predictions, he found that, inorder to reconcile them with his data, the pricelevel’s response to unanticipated monetary shockshad to be characterized by a rather slow-moving distributed lag process, in an economyin which, however, prices could respond withno lag to anticipated money. Furthermore, hisresults also seemed to require that the aggregatedemand for money display a greater sensitivityto transitory than to permanent changes in in-come, the very opposite result to that impliedby a wide variety of other studies. New-classicalanalysis could be forced to fit the data generatedby the U. S. economy, that is to say, only byway of some extremely implausible subsidiaryassumptions.

Nor did the results of subsequent empiricalwork enhance New-classical economics’ claim tobe taken seriously. Mishkin (1982) repeated Bar-ro’s tests of the irrelevance of anticipatedmonetary shocks for output using more sophisti-cated econometric techniques, and found thatthis resulted in a reversal of the initial results—apparently anticipated monetary changes didhave real effects. Boschen and Grossman (1982)noted that money supply estimates are publishedweekly, and that only the errors in these esti-mates properly can be regarded as constitutingthe unanticipated component of the money sup-ply. They further noted that the latter were im-plausibly small to form the basis of a monetaryexplanation of the cycle, and that output changeswere in fact correlated with monetary changesabout which information had previously beenpublished.

In addition to these problems raised by aca-demic work, of course, there was the experienceof the early 1980s recession, which played thesame role in publicly discrediting New-classicaleconomics, as did the inflation of the 1970s inundermining “Keynesian” theory. New-classicaleconomics discounted the importance of realworld wage and price rigidities, and placed con-siderable faith, therefore, in the public’s will-ingness to react immediately to a well-publicized

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anti-inflation policy based on monetary contrac-tion in such a way as to reduce inflation withoutserious real income and employment conse-quences. The policies in question certainly didreduce inflation, but the recession which accom-panied that reduction was, in some respects, theworst since the 1930s. Moreover, the UnitedKingdom and Canada carried out similar experi-ments at about the same time with similarresults. By the mid-1980s, the New-classical de-velopment of the Monetarist account of the roleof money generating the business cycle wasthus widely recognized to have failed in its en-counter with empirical evidence. This couldhave led to a revival of interest in more tradi-tional Monetarist analysis; but it did not, becausethe very postulate that had established the re-spectability of that analysis in the first place,namely a stable aggregate demand for moneyfunction, had also run into difficulties.

THE KEYNESIAN ADOPTION OFTHE STABLE DEMAND FORMONEY FUNCTION

The early studies of the aggregate demand formoney function, which established Monetarism’srespectability, were carried out using long runsof U-S- data, some stretching back into the 19thcentury. Moreover, the data themselves werehighly time aggregated. Thus Friedman’s (1959)

seminal study covered the years 1869-1956, andused cycle averages of variables in estimating itsbasic equation. One business cycle, that is tosay, lasting on average about four years, provid-ed one observation. Later studies, such as thoseof Meltzer (1963) or Laidler (1966) dealt withessentially the same time period, but used an-nual observations. It was an obvious enough ex-tension of such work to test the hypotheses atstake in it against data drawn from other coun-tries and also against more time disaggregateddata too, and such extension proceeded apace inthe 1960s mainly at the hands of people farmore interested in exploiting new data and com-puting techniques than furthering any par-ticular policy agenda.

At first the hypotheses in question—that thedemand for money varied with some real in-come or wealth measure, some measure of theopportunity cost of holding money, and in pro-

portion to the general price level—displayedremarkable robustness; so much so that, by theearly 1970s, the demand for money functionwas a prime candidate to become the center-piece of stabilization policy, much as had theKeynesian consumption function or the Phillipscurve at earlier times. For the demand for mon-ey function’s full potential for such a use to beexploited by policy makers, detailed knowledgeof the function’s contemporary form was ob-viously needed, and in the early 1970s a remark-ably simple version of the equation seemed tobe able to deal with quarterly U. S. data with ahigh degree of precision. This relationship,nowadays known as the “Goldfeld equation” afterits most careful exponent (Goldfeld, 1973), hadthe long-run average value of money holdingsdetermined by real income and interest rates,but involved the hypothesis that when somedisturbance took money holdings away fromthis long-run average, they would move backtoward it slowly over time, with the speed ofadjustment in question being proportional to thesize of the gap to be closed.’~The Goldfeldequation fitted U. S. data well, appeared to bestable over time, and crucial for policy pur-poses, dealt with data at a relatively low degreeof time aggregation. It did indeed appear to beso policy relevant that, in his Presidential ad-dress to the American Economic Association,Franco Modigliani (1977) argued that it could,and should be used as the basis of an activistmonetary stabilization policy in the Keynesianmold.

Modigliani’s address in fact appeared after thefirst signs of trouble with the relationship hadappeared. Before dealing with that, however, itis worth reiterating that the progress of the de-mand for money function so briefly dealt withabove was by no means synonymous with theprogress of Monetarism, but rather it involved acomponent of Monetarism being taken over bythe Keynesian opposition. Just as the associationof Monetarist ideas about the cycle with thoseof New-classical economics was to prove de-structive, so too was this association, and oncemore this could have been, but was not, dis-cerned at the time in the light of evidence thenavailable. That the association in question wasindeed being formed was, of course, obviousenough once Modigliani made the existence of a

“Though the relationship in question is now irrevocablyknown as the “Goldfeld Equation,” it was in fact usedbefore him in studies of the demand for money by, among

others, Teigen (1964) and Chow (1966). Goldfeld, be it ex-plicitly noted, did not claim originality for the relationshipin question.

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stable demand for money function an importantpart of the basis of his case for monetary fine-tuning, a policy stance to which Monetarismwas root and branch opposed; and I am nothere claiming otherwise. However, I am alsoclaiming that the equation fitted by Goldfeld,and the interpretation he put upon it, werequite antithetical to earlier Monetarist ideasabout the demand for money function in par-ticular, and the role of money in the economyin general.

To begin with, the demand for money func-tion for which Friedman had initially claimedstability was the “long run” relationship. In 1959he had tested it against cycle average data,among other reasons, in order to abstract fromthe complex interactions among money, output,prices and interest rates that characterized thecycle, and which would tend to obscure theunderlying stability of the relationship in ques-tion. Nor was such a procedure a quirk of oneparticular paper: the empirical work of Fried-man and Schwartz’s Monetary Trends.,., thoughnot published until 1982, was largely completedin the late 1960s and was based upon cyclephase average data. The apparent stability ofdemand for money functions such as Goldfeld’s,which used quarterly data and hence weredominated by within-cycle interactions amongvariables, should have been a source of puzzle-ment to Monetarists, therefore, not ofsatisfaction.

Monetarists should also have seen thatGoldfeld’s interpretation of his equation ranquite counter to their ideas about the transmis-sion mechanism.” He used the money supply asthe dependent variable of his relationship, andtreated it as responding passively, albeit with adistributed lag, to variations in the arguments ofhis demand for money function. It is of thevery essence of the Monetarist view that thereexists a supply function of money that is in-dependent of the demand function, and that theinteraction over time of the money supply, in-come, interest rates and the price level involves

causation running predominantly, though notuniquely, from money to the other variables.Goldfeld’s work on the demand for money, andmany other studies in the same vein, were thusbased implicitly on the “new view” of the moneysupply process discussed above, of which Brun-ner (1968) had been so critical. And indeed, inthe 1970s, as central banks became interested incontrolling the time path of monetary aggre-gates, their procedures involved measuring orforecasting the values of all the right-hand-sidevariables of a Goldfeld-style equation except theinterest rate, and then setting the latter in orderto achieve a value of the quantity of moneydemanded equal to the money supply target.Clearly such a procedure left no room for tak-ing account of the subtle interactions amongmarkets for money, credit and equity that lay atthe heart of the Monetarist view of the matter.

Be that as it may, the stability of the Goldfeldshort-run demand for money function thatought to have puzzled Monetarists did not lastlong. By 1976 he was inviting his readers tosolve “The Case of the Missing Money,” whileby the early 1980s, a number of commentatorswere contemplating an unexplained decline inmoney’s velocity of circulation. i6 Nor were pro-blems with the demand for money function auniquely American phenomenon; Canada andthe United Kingdom too had problems with bad-ly behaved demand for money functions in thesame years; so did Australia and New Zealand alittle later; and this list is far from exhaustive.There is little point here in attempting a surveyof the voluminous literature generated by theseevents, Suffice it to say that a wide variety ofad hoc explanations, often relying upon par-ticular institutional changes were proposed, andoften (not always) proved fragile. The upshotwas that in the eyes of the majority of commen-tators the postulate of a stable aggregate de-mand for money function was discredited, andalong with it the very foundation ofMonetarism.

15The first sign of discomfort about this matter that I canfind in my own writings appears on pp. 143-44 of the se-cond (1977) edition of my Demand for Money, where I referto there being a fallacy of composition involved in pro-ceeding from the individual to the market experiment whenanalyzing adjustment processes in the demand for moneyfunction. Chapter 2 of Laidler (1982) developed my doubtsabout all this in much more detail.

recovery from the 1982 recession. Monetarists should nothave predicted renewed inflation then, because actual andexpected inflation fell dramatically in the precedingdownswing, and hence should have led to an increase inthe demand for real balances which could be met only bya falling price level or a growing nominal money supply.What ought to have been done, and what was done,however, are different matters, and careless Monetaristpredictions at this time did help to discredit the doctrine.‘SAnd this decline in velocity was associated with rapid

money growth failing to produce renewed inflation in the

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Of course this upshot was preposterous. Thestability that Monetarism had from the outsetattributed to the demand for money functionwas long run in nature, and the relationshipsthat collapsed were short-run formulations,espoused by Keynesian economists intent onestablishing a basis for a policy of monetaryfine-tuning. Moreover, those relationships werebased on a view of the money supply processwhich Monetarists had vigorously opposed fromthe earliest stages of the controversy. An alter-native inference to be made from the collapseof the empirical stability of short-run demandfor money functions from the mid-1970s on-ward was that this was the result of theirfailure to model the dynamic relations amongthe quantity of money, interest rates, real in-come and prices as the outcome of the interac-tion of an independent supply of money func-tion with the arguments of the demand func-tion; that the problem stemmed not from in-stability of the latter relationship at all, butfrom the inability of simple single equationdistributed lag techniques to come to grips withthe dynamic complexities involved in thetransmission mechanism of monetary policy.

Those of us who advanced the latter explana-tion, however, did not find much of a sym-pathetic audience, even among Monetarists. Nodoubt this was partly because we did not makeour case as clearly as we might have done. Butit was mainly because the case in question hadas a key component the notion that marketsfailed to clear instantaneously in the mannerdemanded by New-classical economics. Rather, itwas argued that the transmission mechanismworked along the portfolio disequilibrium linessketched by Friedman and Schwartz (1963) inthe passage quoted on page 56- In the wake ofthe success of the Phelps-Friedman critique ofthe Phillips curve, Monetarism had come to at-tach great importance to adhering to “sound”microeconomic foundations, so much so that ithad, as we have seen, become intertwined withNew-classical economics; and New-classical eco-nomics was unable to tolerate such “disequilib-rium” analysis.h7 As has already been noted, thefailure of New-classical business cycle theory inthe early 1980s was widely regarded as a failure

of the Monetarist view of the phenomenon; andwhat I am now arguing is that this same associa-tion with New-classical ideas prevented Mone-tarism from deploying its own earlier analysisof the transmission mechanism as a defenseagainst an attack on another of its key compo-nents. Empirical evidence about the instabilityof the short-run demand for money functionought not to have been interpreted as under-mining Monetarist propositions about the stabili-ty of the long-run relationship, but it was. Bythe early 1980s, the Monetarist controversy wasover, with Monetarism discredited in the eyesof most observers.

THE LEOACY OF THECONTROVERSY

The Monetarist controversy was concernedwith policy, but the issues involved in it did, atthe time, pose questions which defined a fron-tier of academic research in monetary theory.Furthermore, and again at the time, the latest ineconometric techniques were applied to the in-vestigation of the empirical questions which thecontroversy raised. There was nothing specialabout all this. The Keynesian revolution too hadbeen simultaneously about theory, empiricalevidence and policy, and so had virtually everyprevious debate in the history of monetary eco-nomics. The end of the Monetarist controversy,however, ushered in a period during whichmonetary economics began to disintegrate intorelatively self-contained bodies of theoreticalwork on the one hand and empirical policy-re-lated work on the other. Whether this disinte-gration is a temporary or permanent phenome-non, only time will tell.

New-classical economics was underpinned bya strong methodological preference on the partof its exponents for grounding macroeconomictheorizing on explicit microeconomic founda-tions. Such foundations, however, are capableof yielding a wider variety of macro modelsthan the monetary explanations of the businesscycle that lay at the heart of the work of Lucasand Sargent and Wallace - Thus the empiricalfailure of those models did not lead to the aban-

‘7Some of the problem here stemmed from semantics. If“disequilibrium” behavior is read as synonymous with“unplanned” behavior, then it is understandable that aneconomist would not wish to rely on it in constructing aneconomic model. If it means merely behavior incompatiblewith the existence of continuous competitive equilibrium in

all markets, then it is surely more acceptable. The fact re-mains that those of us who used it in the latter sense wereread as using it in the former, and were not sufficientlycareful to explain ourselves. The result was a considerableamount of unconstructive debate and confusion amongMonetarists.

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donment of the methodological agenda whichhad produced them, but merely to an attemptto replace them with an alternative explanationof the cycle with equally well, or even better,defined micro premises. I refer here to thatbody of research known as “real business cycletheory” which is based on a stochastic versionof the New-classical growth model of Meade,Swan and Solow, and attributes cyclical fluctua-tions to exogenous shocks to the aggregate pro-duction function, in much the same way as,over a century ago, Jevons attributed the cycleto fluctuations in agricultural productivityassociated with sunspot activity.

The exponents of real-business cycle theory,though hostile to econometric testing, neverthe-less do not ignore empirical evidence, and havebegun to address the question why, if it is not acausative factor in cyclical fluctuations, thereare nevertheless systematic relations among thequantity of money and other variables. Thevery manner in which the question is posed vir-tually dictates the answer offered, namely thatthe relations in question are the result ofreverse causation running from the cycle tomoney, rather than vice versa. Thus, in what issurely one of the greater ironies in the recenthistory of economics, a research agenda whichis widely regarded as a direct descendant of theMonetarism of the 1960s has ended up adoptinga view of the role of money in the economy di-rectly opposed to that of its intellectual antece-dent, and virtually identical to that of the mostextreme form of “post-Keynesian” economics.”This is no accident, for a view of the worldwhich has markets functioning perfectly andwithout friction leaves no more room for moneyto play an important role than does a view inwhich markets do not function at all.

Though one important group among the aca-demic heirs of Monetarism has thus systematical-ly adopted hypotheses that downgrade the im-portance of monetary phenomena, and has alsoabandoned traditional econometric methods as abasis for empirical research, this does not meanthat econometric work on monetary economicsceased in the early 1980s. On the contrary, adiverse body of contributors, including unrepen-tantly old-fashioned Monetarists, econometri-cians in search of an area in which to try outnew techniques, not to mention economists as-

sociated with central banks in various countrieswhich do, after all, still have to carry out mone-tary policy regardless of the state of academicopinion concerning its importance, have gener-ated an extensive empirical literature on the de-mand for money function during the 1980s. Theliterature in question has been lively and, as Ishall now argue, productive in two lines ofinquiry.

First, questions arising from the fact of in-stitutional change in the monetary sector havebeen examined using both historical and con-temporary data. In both cases, this phenomenonhas been found to be sometimes important. ThusBordo and Jonung (1987), using data going backto the 19th century for five countries, haveshown that the slow decline in velocity whichoccurred largely before the first world warseems to have been associated with the increas-ing degree of monetization of the economies in-volved, and its later rise with the increasing ef-ficiency of monetary exchange. Closer to ourown time, the sharp increase in the velocity ofMl balances in Canada that occurred at theturn of the I 980s has been shown, beyondreasonable doubt, to have been associated withthe simultaneous spread of daily interest check-ing accounts. As to the United States, the workof Barnett (eg., 1990) using Divisia aggregates,provides evidence that various instances offinancial deregulation have produced shifts inthe demand for more conventionally measuredaggregates; while the very fact that it provednecessary not so long ago to redefine those ag-gregates is itself testimony to the importance ofinstitutional developments.

The other line of inquiry to which I referabove has involved the application of far moresophisticated techniques than were previouslyavailable, both to the explicit modeling of theso-called short-run demand for money function,and closely related, to the task of extracting in-formation about the underlying long-run rela-tionship from data with a high degree of timedisaggregation. Here the results have been quitestartling. Short-run dynamics dominate quarter-ly data and have to be modeled with a greatdeal more care than exponents of, say, theGoldfeld equation brought to bear or, given thestate of econometric technique, could have beenexpected to bring to bear, on the task. Never-

181 refer here to King and Plosser (1984) which uses a formof the old “money-income-causes-money” hypothesis to

reconcile monetary phenomena with a productivity-shocktheory of fluctuations in real variables.

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theless, once this is done, stable long-run rela-tionships, very much like those which were firstestimated by Friedman (1959), Meltzer (1963) orLaidler (1966), are after all to be found buriedin those data. This same result emerges withpowerful simplicity from a recent “low-tech”study by Robert E. Lucas (1988), who showsthat data for the last 25 years or so of UnitedStates history are still scattered (albeit widely,and with complex serial correlation) around avelocity function directly derived from Meltzer’s(1963) estimates of the long-run demand formoney. Nor are results of this sort confined tothe United States. Similar conclusions arisewhen British, Canadian or Japanese data areanalyzed.

As yet, this empirical evidence has not at-tracted the academic attention it deserves, large-ly, I suspect, because the treatment of theshort-run dynamics in the studies whichgenerate it has been based more on econometrictechnique than economic theory. Exponents ofthe so-called “buffer-stock” approach to model-ing the demand for money, who have of coursefollowed up the analysis of the transmissionmechanism of Brunner and Meltzer as well asFriedman and Schwartz, have tried to bridgethis gap. They have tended to ground their ex-plicit analysis on rather simple special cases,however, which have not proved empiricallyrobust; and this in turn has led to an identifica-tion of the general approach with those specialcases and a tendency to dismiss prematurely thebroad insight which it yields: namely that thedynamics of what we have learned to call theshort-run demand for money function are notthe property of a structural relationship at all,but rather reflect that complex interaction ofthe quantity of money with other variables towhich the Monetarists of the 1950s and 1960sused to refer as a transmission mechanism sub-ject to long and variable lags.’°

The Monetarist controversy was about theoryand empirical evidence, to be sure, but it wasalso about monetary policy; and here it has leftits strongest mark. To begin with, the idea that

inflation is fundamentally a monetary phenome-non, so outlandish in the 1950s, has by nowbecome something close to conventional wisdom.We nowadays hear very little about cost-pushforces and the need to control them with wageand price guidelines, controls and so on. Closelyrelated, central banks routinely pay attention tothe behavior of monetary aggregates in design-ing their anti-inflation policies. Though evensuch hard-core Monetarists as Brunner andMeltzer (1987) no longer argue that the domi-nant impulse driving the business cycle is alwaysthe quantity of money, neither they, nor thepractitioners of monetary policy, have shownthe slightest sign of taking the productivity shockhypothesis of the real business cycle theoristsseriously.20 Rather, the exclusively monetary inter-pretation of the cycle has been replaced by aneclectic approach in which monetary factorshave an always potentially important, and some-times an actually important, role to play. That iswhy the pursuit of price stability by monetarymeans is tempered by caution concerning theshort-term costs that could be incurred if thepursuit in question was to become too vigorous.And eclecticism about the causes of cyclical in-stability has not been accompanied by a revivalof interest in the use of fiscal policy for stabili-zation purposes—though this probably has asmuch to do with the fiscal deficits that are thelegacy of supply-side economics as with any les-sons learned during the Monetarist controversyitself,

A superficial reading of the above recordmight suggest that, whatever its academic stand-ing, Monetarism is alive and well in policy cir-cles. That it has left a lasting mark in those cir-cles is beyond doubt, but its success on the poli-cy front has been far from complete. Indeed, onone interpretation of the evidence, Monetarism’spartial success here may have been worse thanfailure. The Monetarist agenda, after all, involvedestablishing the importance of the quantity ofmoney as a policy variable as a preliminary stepto removing from the monetary authorities theirdiscretionary control over it; and the record

19For an informal but more complete exposition of thearguments involved here, see Laidler (1987). One of thebetter known pioneering special case empirical formula-tions of the approach is that of Carr and Darby (1981),who refer to it as a “shock-absorber” approach.

20Let it be clear, however, that I do not regard “realbusiness cycle theory” as a total waste of time, and that Ido think it merits policymakers’ attention. Though I find ithard to believe that shocks to technology will turn out to

be the sole or even main source of real world cyclical fluc-tuations, it is nevertheless the case that, from a theoreticalpoint of view, such shocks as do originate in suchphenomena are likely to be welfare improving. Thevaluable message of real business cycle theory, then, isthat we should not take it for granted that stabilizing thecycle is always and everywhere desirable. It might not bein particular instances. That reminder is surely worthhaving.

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shows that only this preliminary step was com-pleted. Monetary policy plays a far more impor-tant role in macroeconomic affairs now than itdid 30 years ago, but those in control of it have,as a result, much more power than previously,not less, as the Monetarist agenda intended.This cannot really be helped, because part ofthe academic legacy of the Monetarist con-troversy has been a greater appreciation of therole of institutional change in influencing veloci-ty’s long-run behavior; but once that role is ad-mitted, the case for tying down monetary policywith rules becomes far more difficult, perhapsimpossible, to make.

All this, though, poses a challenge. If monetarypolicy cannot be tied down by rules, then thenext-best solution is to subject it to the disciplineof constant public scrutiny and criticism. Aca-demic economics has a large role to play here,in providing the intellectual basis for such ac-tivity, but at the moment it is not in good condi-tion to do so. We do have, as I have notedabove, a large and growing body of empiricalwork which points to the long-run stability (notconstancy, note) of money’s velocity, institution-al change notwithstanding. That same body ofwork, however, tells us that the short-run dy-namics of that function are at least as complexas anyone thought they were 30 years ago; andwe are no further forward now than we werethen in understanding just why this is the case.

At the same time, the gap between theoreticalwork on the role of money in the economy, andour empirical knowledge in the area, which wasopened up when the Monetarist controversybecame a debate about New-classical economicsand began to pay more attention to microfoun-dations than to data, still remains. Intellectualvacuums of this sort rarely remain unfilled forlong, but until this one attracts more attentionthan it has to date, the Monetarist controversy’slegacy must be judged to be a distinctly uncom-fortable one. The controversy weakened thelinks between academic research and contem-porary policy which in the past made such re-search a natural source of constraining criticismof the conduct of policy, while simultaneouslyenhancing the discretionary powers of policymakers. ‘I’hat is hardly what its participantsintended.

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Ando, A., and F Modigliani. “The Relative Stability of Mone-tary Velocity and the Investment Multiplier;’ AmericanEconomic Review (September 1965), pp. 693-728.

Barnett, W. A. “Developments in Monetary AggregationTheory[ Journal of Policy Modeling (forthcoming).

Barro, R. J. “Unanticipated Money, Output, and the PriceLevel in the United States’ Journal of Political Economy(August 1978), pp. 549-80.

Bordo, M. D., and L. Jonung. The Long-Run Behavior ofthe Velocity of Circulation: The International Evidence (Cam-bridge University Press, 1987).

Boschen, J. F., and H. I. Grossman. “Tests of EquilibriumMacroeconomics Using Contemporaneous Monetary Data;’Journal of Monetary Economics (November 1982), pp.309-33.

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_______ and _______- “An Aggregative Theory for a ClosedEconomy;’ in J. Stein, ed. Monetarism (Amsterdam: NorthHolland, 1976), pp. 69-103._______ and _______- “Money and the Economy: Issues in

Monetary Analysis;’ The 1987 Raffaele Mattioli Lectures,Carnegie Mellon University, mimeo.

_______ and _______- “The Problem of Inflation;’ in K.Brunner and A. H. Meltzer, eds., The Problem of Inflation,Carnegie-Rochester Conference Series on Public Policy(Vol. 29, 1988), pp. 137-68

Cagan, P. Determinants and Effects of Changes in the Stockof Money, 1875-1960 (Columbia University Press, 1965).

Carr, J., and M. R. Darby. “The Role of Money SupplyShocks in the Short-Run Demand for Money,” Journal ofMonetary Economics (September 1981), pp. 183-99.

Chow, G. “On the Long-Run and Short-Run Demand forMoney” Journal of Political Economy (April 1966),pp. 111-31.

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_______- “The Demand for Money: Some Theoretical andEmpirical Results;’ Journal of Political Economy (August1959), reprinted in Milton Friedman, The Optimum Quantityof Money and Other Essays (Aldine Publishing Co., 1969),pp. 111-39.

_______- “The Role of Monetary Policy;’ American EconomicReview (March 1968), reprinted in Milton Friedman, TheOptimum Quantity of Money and Other Essays (AldinePublishing Co., 1969), pp. 95-110.

______ The Optimum Quantity of Money and Other Essays(Aldine Publishing Co., 1969).

_______- “A Monetary Theory of Nominal Income;’ Journalof Political Economy (MarchlApril 1971), pp. 323-37.

_______- Unemployment versus Inflation? An Evaluation ofthe Phillips Curve (London: Institute of Economic Affairs,1975).

_______• “The Ouantity Theory of Money,” in J. Eatwell,M. Milgate and P Newman, eds. The New Palgrave—A Dic-tionary of Economics (London: Macmillan, 1987).

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