Major Isuue in Monetary Economics

Major Issues in Monetary Economics
Author(s): Harry G. Johnson

Source: Oxford Economic Papers, New Series, Vol. 26, No. 2 (Jul., 1974), pp. 212-225
Published by: Oxford University Press
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MAJOR ISSUES IN MONETARY ECONOMICS
By HARRY G. JOHNSON
I. Introduction
THE purpose of this paper is to survey the major issues in monetary
economics,witha view to discerningthemostfruitfullinesof futuretheore-
tical and empiricalresearch. This is a useful point in time at which to
undertakesuch a survey,forboth a negative and a positive reason. The
negative reason is that the upsurge of the monetaristcounter-revolution,
whichbegan some years ago in the United States on the basis ofthe proven
failureof Keynesian fiscalpolicy to controlinflation,and which promised
to revitalize the whole field of monetary economics in this and other
countriespreviouslydominated by Keynesianism, has subsided into dis-
array due to the failure of monetarism,as understood by the public, to
deliver policies effectivein controllinginflationeffectivelyand without
prolongedand relativelylarge-scale unemployment. (It should be noted
that the leading monetaristsnever promised such easy success, but the
public neverthelesswas led to expect it; meanwhile, 'monetarism' has
learned fromthe experience a great deal about the importanceof price-
expectations,lags, and micro-economicmarketfunctioning, while 'Keynes-
ianism' has largely retreated into a desperate appeal for rescue to the
sociologistsand a reiterationof the need for an incomes policy-despite
itshistoricallyamplyprovenfutility-to controlthe key monetaryvariable
that is leftundeterminedin the Keynesian model.) The positive reason is
the arrival of a new generationof monetaryeconomists,come too lately
and fromtoo diverseoriginsto be partisansofratherthan learnersfromthe
Keynesian revolutionand the monetaristcounter-revolution, and equipped
with requisite mathematicaland statistical tools to forwardthe scientific
evolution of monetaryeconomics.
There is thereforea challenge to be met, and a scientificallyuseful
responsepossible. But thereare dangersthat the opportunitywillbe wasted
by distractionof effortto activities of peripheralscientificvalue. Apart
fromthe fact that the collapse of the established internationalmonetary
systemover the past two years has tended to concentrateattentionon the
short-runpolicy problems of international crisis, there are three major
reasons for concernabout the presentstate of monetaryeconomics.
First,thereis a noticeabletendencyfortherelicsoftheKeynesian revolu-
tion and theircontemporarydisciplesto attemptto forceanyone seriously
interestedin the influenceof moneyand of monetarypolicy into the mould
of the largelyfictitious'classical orthodoxy' against which the Keynesian

H. G. JOHNSON 213
revolutionwas directed,so as to permittheir dismissal, scientificallyand
in this countrymore importantpolitically,by scornfullabelling as 'mone-
tarists'. When scientificissues are burkedby name-calling,and particularly
when the name-callingis designed to enlist popular political sentimentin
the suppressionof freescientificinquiry,the result is necessarilypseudo-
scientificsterility.'
Second, there has been an evident upsurge of interestin discussion of
'what Keynes really meant', a tendency which usually indicates that a
fieldof studyhas lost its way and is searchingforclues as to how to proceed
by re-examiningthe works of the master forhithertoneglectedideas and
insights. It is, however, necessary to be careful in disentanglingsuch
indicators fromthe results of the stimulus provided by major works of
exegesis, synthesis,and history of thought. Apart from the prolonged
controversystirredup by the GeneralTheoryitself,the last flurryofexegeti-
cal interestwas stirredup by the publication of Patinkin's Money,Interest
and Prices, a work which primarilymade a major contributionto the
development of monetarytheoryin its contemporaryform. The current
wave is a somewhat delayed reaction to Leijonhufvud's Of Keynesian
Economics and The Economics of Keynes, whose lasting contributionwill
probably prove to have been to call attentionto the importantnew work
of the Universityof California,Los Angeles,school on the micro-dynamics
of labour and goods markets; and a gradually emergingreaction to the
recent publication of the Royal Economic Society's edition of Keynes's
Collected VForks,particularlythe two volumes surroundingthe General
Theoryedited by Donald Moggridge,though the results so far have been
largely reminiscencesof ancient battles and old comrades, and a few
articles related to the editing which for one reason or another do not
significantlyilluminate Keynes's place in the historical development of
monetarytheory. Nevertheless,there are signs of a certain gropingfor
ideas in the entrailsof Keynes's literarycadaver, thoughin part this may
be interpretedas an understandable effortof the second post-Keynesian
generationto come to gripswiththe historyofits subject.
Third,thereare seriousdangersthat monetaryeconomicswillbe diverted
by the inherentlimitationsof the elaborate technologiesit has developed
into concentrationon second-rate but solvable problems and into cere-
monially impressive but scientificallyunproductive solutions of trivial
problemsor artificiallycreated pseudo-problems. On the one hand, there
1 Lest this paragraph be considered inconsistentwith a remark in the preceding one,
I should explain that my objection to the recommendationand implementationof incomes
policies is not that it necessarily flows from Keynes's work as an economist, but that it
attempts to solve a problemleftunansweredby Keynes's theoreticalmodel (the determina-
tion of the level of money wages in the longer run) by brute political forcerather than by
the application ofeconomic science.

214 MAJOR ISSUES IN MONETARY ECONOMICS
is no conceivable technologicallimitto the elaboration of ever-larger'big
models', and only the elastic constraintof financialsupport fromfounda-
tions and governmentsto restrain progressiveelephantiasis. But a big
model is only as strongstatisticallyas its weakest equation and intellec-
tually as its least qualifiedresearchassistant; and the forecastingforwhich
such models are chieflyused is inevitablydependent on the judgement of
those who feed in the assumptions fromwhich the model grinds out its
results.' On the other hand, mathematical economics generates its own
criteriaof problem-evaluation,problem-solving,and style of communica-
tion of results-criteria not purely coincidentallyentailing an offensive
degree of intellectualsnobbishnessand elitism-which do not necessarily
promotethe progressof economic science. Since mathematicaleconomics
can easily generate its own mathematical problems but must derive its
economicproblemsfromoutside by application of a social sense and judge-
ment that mathematicianstraditionallylack, it is unlikely to furnisha
reliable guide to the exercise of discriminationbetween significantand
trivialproblems.
To regardthese threetendenciesas dangersis, of course,to take a stand
on a particular methodology of economics, a methodology which it is
perhaps riskyto describe as being related in a broad way to Friedman's
positive economics. The essential basis of that methodologyis the view
that the purpose of economics as a social science is to arrive at a set of
principlesforunderstandingand interpretingthe economy that are both
scientifically'robust' and sufficientlysimple to be communicable to
successive generationsof students and to policy-makersand the general
public-not to establish a politically coerced consensus on a package of
national economic policies,2or a traditionof exegetical scholarshipbased
on recognizedgreat texts of the past in parallel with the classics and the
humanities,or a hierarchyof eminencetested by technicalvirtuosity. On
that basis, despite the tendenciesreferredto, thereare significantpossibili-
ties of importantbreakthroughsin monetaryeconomicsin the foreseeable
future. The issues that give rise to these possibilitiesare categorized for
purposes of discussion as the foundations of monetary theory and the
integrationofmonetaryand value theory,the optimumquantityof money
1 The use made of the National Institute's model has clearly been stronglyinfluencedby
its masters' Oxford-Keynesian belief in the overridingimportance of full employmentand
economic growth as policy objectives and the political possibility of implementingan
effectiveincomes policy.
2 Oxford, the locus of presentation of this paper, is traditionallyfamous as being the
home of lost causes. In economicssince the 1930s, Oxfordhas been famous forits consistent
espousal of internationalcommodityagreementsto solve the problemsof the less developed
countries,an increase in the price of gold to solve the international monetary problem,
and an incomespolicy to solve the problem of inflation. It is a tributeto Oxford's position
in British society that these causes have never been completelypolitically lost.

H. G. JOHNSON 215
and related issues, and the internationalmonetary system, though the
second at least of these descriptionsis admittedlymisleadingwith respect
to the topics included.
II. The foundations of monetary theory and the integration of

monetaryand value theory
The question of the reasons forthe existenceand use of moneyis funda-
mental to monetarytheory,not merelyin the sense of understandingwhy
we live in a monetaryeconomyand the study of moneyis an essential part
of economics,but also to the understandingof how and in what respects
a monetaryeconomy differsfroma barter economy and how monetary
changes, particularlymonetarypolicy changes, affectits operation. Yet,
forreasons to be discussed below and associated withthe fact that Keyne-
sian economicsconvertedmoneyinto a real variable and monetaryfactors
into real factorsinfluencingthe economy, monetarytheoristshave until
very recentlybeen contentmerelyto assume the existenceof money as an
asset alternativeto otherassets and to conduct theiranalysis on this basis.
Only in the past fiveyears or so have economictheoristsbegun to attempt
to explain the presence of money in economic terms,and to work out the
implicationsboth formonetarytheoryand forvalue theory. The attempt
has taken two main and not entirelydivergentlines: exploration of the
micro-economicsof labour and product marketsin the context of macro-
economic problems of unemploymentand inflation,employingthe con-
cepts of informationas an economic good, transaction and search costs
pioneered at the Universityof California,Los Angeles, an attempt which
has yielded very valuable insightsbut still leaves the bridgesfrommicro-
economics to macro-economicsand from partial to general equilibrium
analysis ratherill-defined;'and the attemptto incorporateuncertaintyand
transactions costs into the elaborate formal apparatus of mathematical
general equilibrium theory, with results not amenable to evaluation in
terms of theirrelevance to workaday economics.2
The formerapproach seems to me more usefulthan the latter,precisely
because it remains dependent on acute observation of the contemporary
monetaryeconomy of experience,whereas the latter is concernedto pro-
ceed in correct mathematical style from obvious axioms to universal
1 For a lucid briefaccount and critique see David Laidler, 'Information,money and the
macroeconomics of inflation',University of Manchester Faculty of Economic and Social
Studies S.S.R.C. Research Programme on Inflation: Its Causes, Consequences and Cures,
Discussion Paper 7306, which draws substantially on the work of Brunner and Meltzer.
I have found this paper extremelyuseful in the preparation of my own discussion of the
subject.
2 For a recent survey,distinguishedby its arrogant disclaimerof practical relevance, see
the paper by F. H. Hahn 'On the foundationofmonetarytheory' (chapter 13, pp. 230-42 in
M. Parkin (ed.), Essays on ModernEconomics,Longmans, London, 1973).

propositions. This attempt seems to me to be fundamentallymistaken,
because the use of moneyis not universalin eitherspace or time. In con-
temporaryeconomics,the concepts of the household and the firmare em-
ployed preciselyto hive offthose activitiesof societywithinwhichmoney
is not an organizinginstrumentfromthe activitiesin whichit is; and ifthe
activities of non-profitinstitutions (Boulding's 'grants economy') and
more importantlyof governmentare accorded proper recognition,there
is a relativelylarge proportionof economic activity in the organization of
whichmoneyplays no, or only an inessential,part. Moreover,both econo-
mic historyand observation of contemporary'less developed' countries
suggeststhat reliance on the use of money foreconomicorganizationis an
unusual and possibly transitoryform of social organization, so that the
problem may well be to explain its use in spite of its disadvantages,
ratherthan the advantages of its use.
In other words, the most useful approach to the problem at its most
fundamentallevel may well consist of an economic-history-cum-sociology
model of the development of the use of money, on the lines of Sir John
Hicks's A Theoryof Economic History,rather than of a maximization-
subject-to-constraintmodel of a monetary economy on the lines of the
same author's Value and Capital. Such a theorywould startfroma demo-
graphicallyand economically small static economy using primitivetech-
nology, in which all the problems of barter beloved of the older-style
textbookwriters especially the double coincidenceofwants,and the prob-
lem ofsynchronizationofdeliveriesofindivisiblegoods-would be absorbed
by the infinityof time and the certaintyof assessmentof personal credit
in a small timeless community:credit would be necessary to efficiencyof
production,but money would be unnecessaryand absent. Money would
begin to emerge with trade with foreigners,its emergencebeing further
forced by the logistical requirementsof war against foreignersrequiring
obtainingsupplies in the field,and with technical change. Initially money
would have to be 'full-bodied' commodity money with 'intrinsic' (i.e.
generally acknowledged) value, to overcome personal distrust between
transactors,and only graduallywould acceptabilitybecome divorcedfrom
intrinsicvalue in definingmoney and paper promises substitute forthe
commodity. The demand for money would tend to grow with increasing
uncertainty,change, and personal mobility-factors recognizedin the use
of such variables as degree of urbanizationand proportionof population in
the armedforcesin long-rundemand-for-money studies. At the same time,
credit would come to depend less on personal probity and more on the
ability to findmoney if necessary-which would give rise to the typical
confusionbetween 'money' and 'credit' in amateur monetarytheorizing
and the pronouncementsof commercial and central bankers, and the

H. G. JOHNSON 217
extensionof the term'money' by economiststo includeformsof creditthat
became sufficiently money-like.But therewould be economicincentivesto
economize on the use of money,by methods made feasible by advancing
technology,throughthe developmentof 'impersonal' methodsof assessing
and certifyingpersonal credit-worthiness, the credit card and the charge
account being the obvious modern counterpartof the earlier 'letter of
credit' and the personal account at the local shopkeeper's. It is quite
conceivablethat withthe advance ofcomputertechnologythe use ofmoney
as we know it mightvirtuallydisappear-witness the sciencefictiontale in
whichthe spaceman alightson a strangeplanet and presseshis thumb-print
on a plate in the door ofthe nearestbordelloto obtain his night'slodging-
though it will probably never disappear completely because there will
always be some types of transactionsthat people will wish to keep secret
(thougheven that last refugeof privacy could be destroyedwith sufficient
miniaturizationof electronicequipment).
It may be remarkedbeforeproceedingthat the question of the reasons
forthe existenceofmoney,in the morespecificformofthereasonswhysome
creditinstrumentbecomes generallyacceptable as a medium of exchange
and storeofvalue, is of special practical interestat the presenttime in two
contexts,both concernedwith internationalmoney. One is the effortto
establish a common European currency;the other is the objective of re-
formingthe internationalmonetarysystemby re-constitutingsome form
of Special Drawing Rights as an effectiveinternationalreserve money.
Thus far, all internationallyused moneys-gold and silver, sterlingand
dollars-have evolved naturallyout oflocally or nationallyprivatelyuseful
moneys(thoughit should be noted that the replacementofgold by national
paper money in domestic circulations,in the case of both the United
Kingdom and the United States, was in its finaldefinitivestage forcedby
legislationintended to conserve gold for internationalreserve use). It is
now the intentionto set up such an internationalmoney artificially,by
internationalagreementand cooperation. So far as the use of such money
by central banks is concerned, its establishmentis obviously perfectly
feasible given the fact that central banks earn plenty of profitsand are
underno obligationto maximize profits(i.e. avoid unnecessarylosses); but
it is generally agreed among experts that to be effectiveinternationally
usable money must be used privately as well, the minimumrequirement
being its use as a unit of account and standard for deferredpayments in
private credittransactions,and cultivatingthe developmentof private use
of it will raise a numberof problemsalready familiarfromexistingtheory
and research on the welfareeconomics of banking regulation.
To turnfromthe reasonsforthe existenceofmoneyto the problemofthe
integrationof monetaryand value theory,this seemed to have been solved

to professionalsatisfactionby the classical propositionsthat the demand
for money is a demand for real and not nominal balances and that this
demand is related to income, wealth, and other variables, until classical
monetary theory was challenged by Keynes's General Theory on the
groundsthat a monetaryeconomyis fundamentallydifferent froma barter
economy-though the groundsrestated in contemporaryterms mightbe
better expressed as being that the short-runbehaviour of a monetary
economyis not captured by the classical formulationof monetarytheory
(whichwas designedprimarilyto clear moneyout ofthe way ofreal analysis
in termsofwants,technology,and resourceconstraints). Keynes's General
Theory,however,provided neitheran integrationof monetaryand value
theorynor a satisfactoryanalysis ofthe influenceofmoneyon the economy
in the shortrun. Instead, throughthe assumptionofa givenlevel ofmoney
wages, it transformednominal moneyinto real balances and identifiedthe
moneyand real rates of interest,so that monetaryinfluencesaffectedreal
choice-theoreticvariables. This remains the distinguishingfeatureof the
Keynesian tradition in contrast to the neo-quantity-theorytradition,as
exemplifiedparticularlyby the theoreticalwork of the 'Yale School'.
Patinkin's integration of monetary and value theory in his Money,
Interestand Prices, which began paradoxically as a Keynes-based attack
on orthodox quantity theory,went to the opposite extreme,and restored
the classical mechanism of achieving monetary equilibrium through
adjustment of the money price level of the output of a fixed quantum of
productive resources while, throughits static formulation,retainingthe
Keynesian identityofmoneyand real rates ofreturn. Patinkin's workwas
based on the generalequilibriumsystemof Hicks's Value and Capital, and
involved an apparently simplifyingerrorof the same kind as Hicks had
made in treatingsaving as just another commodityin the utilityfunction,
by enteringmoney-a stock-into a utilityfunctionthe other arguments
ofwhichwereflows.' It did, however,serveto clarifyin a definitivefashion
the logical structureofneoclassical monetarytheoryand the circumstances
and context within which money could be regarded as merely throwing
a veil over the workingsof the real (barter) system.
On the otherhand, as Robert Clowerdeservescreditforemphasizing,the
resultsof modellingthe role of moneyin this way are to deprive money of
any distinguishingfunctionin the exchange economy: nominal money is
just a commoditywitha particularset ofcharacteristicsexchangingagainst
other commoditieswith other characteristicson indistinguishableterms,
instead of a unique object obtained by the sale of goods solely for the
1 'Error' is perhaps the wrong word, since the amounts of commodities available per
period can be regarded as initial stocks forthat period, and with sufficiently
careful use of
language the analysis can be kept economically consistent.

H. G. JOHNSON 219
purpose of later exchange for other goods, whose role is to organize and
co-ordinatethe production and consumption activities of the economy.
However, Clower's attempt to give formalrepresentationto this unique
propertyby splittingthe goods and factor markets,or the activities of
households as consumersand as factor-suppliers, and subsequent workon
the same lines exemplifiedby a well-knownrecent article by Barro and
Grossman,1seem to me to be signpostspointingdown a dead-end street,
because they attemptto solve a problemin the basic structureofthe model
by tinkeringwith the model without re-examiningthe structure. It is
necessaryto go back to Patinkin as a starting-point;and this is what the
mathematical general equilibrium theoristspreviously referredto have
been tryingto do in theirown way, thoughas already mentionedtheirway
is a far cry indeed frompracticallyrelevant economic theory.
The same issue has come to the forein a moremundane way as the result
of the rise of 'monetarism' and the failureof the Keynesian approach to
providesatisfactoryanswers,oreven clues to answers,to the policyproblem
of inflation,in the formof the question of how an increase in aggregate
monetarydemandgetsdividedbetweenan increasein pricesand an increase
in output. Friedman's attemptto formulatethe answerin termsof a 'third
equation' alternativeto the Keynesian exogenous fixityof prices and the
quantity theory's exogenous fixityof prices has produced a well-known
controversyin The JournalofPolitical Economy.2In my judgement,both
the initial articles and the subsequent controversyare extremely dis-
appointing. Friedman's formulationtook monetarytheory virtually all
the way back to Modigliani's classic 1944 article, and the controversy
descended quickly fromthe scientificissue into a genteel slangingmatch
between Keynesians and monetarists.
A farmoreinterestingdevelopment,in my view,is the trendtowardsthe
application of 'the new micro-economics'ofinformation, search,and trans-
action costs to the macro-economicsphere,in which contextmoneyprices
uniquely summarizeinformationabout marketsand inflationand deflation
and falsifyand distortthisinformationand evoke disequilibriumbehaviour
on the part of demanders and suppliers. As Laidler points out,3 this
1 Robert J. Barro and Herschel I. Grossman, 'A general disequilibriummodel of income
and employment',The AmericanEconomicReview,vol. lxi, No. 1 (Mar. 1971), pp. 82-93.
2 M. Friedman, 'A theoreticalframeworkfor monetary analysis', J.P.E., vol. 78, no. 2
(Mar./Apr.1970), pp. 193-238 and 'A monetarytheoryof nominal income', J.P.E., vol. 79,
no. 2 (Mar./Apr.1972), pp. 232-7, and the J.P.E. Special Issue on MonetaryTheory,vol. 80,
no. 5 (Sept./Oct. 1972), pp. 837-950, containing Karl Brunner and Allan H. Meltzer,
'Friedman's monetary theory', James Tobin, 'Friedman's theoretical framework',Paul
Davidson, 'A Keynesian view of Friedman's theoreticalframeworkformonetaryanalysis',
Don Patinkin, 'Friedman on the quantity theory and Keynesian economics', and Milton
Friedman, 'Comments on the critics'.
3 For reference,see p. 215, n. 1. Laidler is somewhat unfair to 'the Chicago School',
however,since the oral traditioncontinuesto flourishwhile the master is oratingelsewhere,

approach both calls into question some established concepts like 'the
demand formoney' and resolvesmany puzzles about the variabilityof the
process of transmission of monetary impulses, heretofore'fudged' by
general referencesto time-lagsin the formationof expectations and the
reactions to economic changes. Laidler sees this approach as calling for
a large numberof detailed studies of dynamic processes of adjustment in
differentmarkets,out ofwhicha largerpicturemay be pieced; but it seems
to me that the ultimate goal ought to be a relativelysmall-scaledynamic
general equilibrium model, involving interactions among a handful of
aggregatedsectors-otherwise we shall be back professionallyin the big-
model business, and practicallyin the hunch-and-wisdomtrade.
III. The optimum quantityof money and related issues
The term'the optimumquantityofmoney'is an extremely
misleading
descriptionof a subject that by now constitutesa well-tilledfieldin the
theoreticalliterature.' The problem originates historicallyin a concern
about the optimum behaviour of the price level, on the assumption that
moneyis non-interest-bearing so that deflationofthe pricelevel is the only
way of giving money a positive private yield and so correctingfor the
welfare-distortion created by the private alternative opportunitycost of
an asset that is sociallycostlessto create.Properlyconceivedin termsofthe
contemporarypaper-creditrather than the historical commoditynature
of money, the problem is better approached as one of achieving social
efficiency in the provisionofcreditmoney,that is, as a problemin industrial
organizationand regulationratherthan optimizationof the rate of mone-
tarygrowth(whichwould be irrelevantin the long-runcontextifthe possi-
bility of the 'inflationtax' were removed by socially efficientprovisionof
the moneysupply.) The obvious theoreticalproblemthat this raises is that
of second-best welfare economics, that is, of artificialrestraintson the
achievementof total Pareto efficiency that make partial application of the
and the lesser lights have been workingon the problems Laidler discusses fromwhat may
be a more useful macro-economic point of view. See in particular the important un-
published Ph.D. thesis of Ruben D. Almonacid, 'Nominal income, output and prices in
the short run', University of Chicago, June 1971, and the paper by Larry A. Sjaastad,
forthcomingin the proceedingsof the Wingspread Conference,edited by Robert Z. Aliber.
F
Friedman's essay on the subject (the title essay of his The OptimumQuantityon Money,
London, Macmillan, 1969) is probably the least elegant piece of economic analysis he has
ever written,since it varies uncertainlybetweenpure theoryand roughempiricalestimation,
and only in two pages near the remoteend makes it clear that the whole problem in the form
in which he deals with it arises fromlegal and conventional restrictionson the payment of
intereston money; also, it obligeshim to effecta ratheruneasy and unpersuasivecompromise
between the deflationrule the analysis indicates and the rule of a fixed rate of monetary
expansion he has advocated for so long. Its main contributionto the existingliteratureis
the recognitionthat when money is non-interest-bearing, a liquidity premium attaches to
bonds which makes it necessary to formulatethe rule forachieving the optimum quantity
of money rather carefully,in terms of the money rate of interestrather than the rate of
price deflationas other authors have done.

H. G. JOHNSON 221
Pareto conditionsforfirst-best welfaremaximizationinsufficient to achieve
a welfaremaximumgiventhe assumed constraints.The obvious case is the
difficultyof paying interest on hand-to-hand currency,though this is
likely to be of trivial quantitative significanceexcept under significantly
inflationaryconditions. Other cases, such as the absence of interestpay-
mentson stocks of goods analysed by Perlman' and a varietyof considera-
tions connectedwiththe role of moneyin the economysuggestedby Hahn
in his reviewofFriedman,2have not yet been establishedas logicallyvalid.
More interestingthan the welfareanalytics of money supply, however,
because it necessarilyentersinto the evaluation of such importantpolicy
changes as the move towards greater competitionin banking introduced
by the Bank of England's green paper on Competitionand CreditControl,
is the question of why governmentalregulationof the bankingsystemand
the centralbank's techniquesof monetaryand creditcontroltake the form
they do-which is quite differentfrom what welfare economics would
indicate as desirable. That problemhas appeared earlierand receivedmore
attention in other branches of economic research,notably in the field of
industrialorganizationand regulation,whereit has led to the development
of theoriesof regulationas a joint profit-maximizing arrangementbetween
the centralbank and the commercialbanks at the expense ofthe consumer
and the rest of the financialsystem. An application of this theoryto and
empiricaltest of it against the resultsof the introductionof competitionin
bankingin Canada may be foundin a forthcoming paper by Brian Griffiths.3
The literaturejust described relates to the structureof the system of
money supply,and the researchproblem mentionedto the reasons forthe
formof that structure. A parallel problem is evident with respect to the
control of the money supply by the monetaryauthorityin the nominal
pursuit of the objectives of stabilization policy: why does the monetary
authoritybehave as it does, in contrastto how monetarytheoryindicates
it should behave? Thus far,formalanalysis of this question has concen-
trated on empirical estimation of the central bank's 'reaction function',
which points to the alternative possibilities of differencebetween the
preferencesof the centralbank and social preferencesamong policy objec-
tives, or of differencesbetween the central bank's assumptionsabout the
structureof the economic system and scientificallyvalidated knowledge
of that structure. In my de Vries lectures4I raised the broader question
1 Mori-isPerlman, 'The role ofmoney in an economyand the optimumquantityof money'

Economica,N.S. xxxviii,no. 151 (Aug. 1971), pp. 233-52.
2 Ibid., no. 149 (Feb. 1971), pp. 61-80.
Brian Griffiths,'Competition and regulation in oligopoly banking: the Canadian
experience with the 1967 Bank Act' (unpublished).
4 Harry G. Johnson,Inflationand theMonetaristControversy, Amsterdam: North-Holland
1972.

of why governments,in spite of theirdeclarationsof intentionto the con-
trary,have pursuedmacro-economicpoliciesthat have permittedthe 'secu-
lar inflation'of our times to occur,and produced explanatory hypotheses
which included dismissal of the obvious explanation of sheer ignorance
of monetary cause and inflationaryeffect. In his review of the book,
Karl Brunner' has argued 'that the role of ignorance has probablynot
been sufficientlyexplored for this problem', ignorance including both
governmentalignoranceand ignoranceofthe public exploitable by govern-
ment. The subject is certainlyworthfurtherexploration in terms of the
economic theory of politics, because both 'secular inflation' and 'the
political cycle' have become common-place encapsulations of regular
characteristicsof the behaviour of the contemporaryeconomic system.
Further reflectionon the problem suggests to me that greater attention
mightusefullybe paid to the biological and social characteristicsof the
human individual,in the practical sense that the individual's world-viewis
formedat an age much earlierthan that at whichhe assumes responsibility
forimportantsocial decision-taking,and that the periodforwhichhe exer-
cises this responsibilityis itselfrelativelyshort-five or ten years at most,
which makes it plausible to dispute the contentionthat a governmentcan
only get away with perversemanagementpolicies forat most one or two
business cycles,and helps to explain why we in Britain are still stuck with
the interwarbeliefin fullemploymentas the sine qua non of social welfare.
IV. The internationalmonetarysystem

Followingthe traditionset by Keynes's GeneralTheory,and as a natural
and understandable corollaryof the fact that most of the new work in
monetaryeconomics, both 'Keynesian' and 'quantity' theory,has been
generatedin the United States in the period since the Second World War,
both 'pure' monetarytheoryand its application to economic policy have
been largely developed, implicitlyor explicitly,on the assumption of a
closed economy. And where the facts of openness to internationalin-
fluences have been recognized, in policy-theorizingand policy-making,
theyhave generallybeen accommodated by a mixtureofreal analysisbased
on the assumption of autonomy of national price levels and employing
elasticitiesof internationaldemand, and monetaryanalysis extendingthe
theoryofportfolioadjustment. The increasinglyclose integrationof world
marketsin manufacturesas a resultof successive rounds of negotiationof
reciprocalnon-discriminatory tariffreductionson manufacturedgoods, and
of world capital markets with the restorationof currencyconvertibility
after 1958, however,have made the closed economy assumption less and
less tenable as a general principle,while the 'secular inflation'of the past
1 The Journal ofEconomic Literature,vol. xi, no. 1 (Mar. 1973) pp. 113-15.

H. G. JOHNSON 223
fiveyears or so has made it decreasinglyplausible to considerdomesticprice
levels as autonomouslydeterminedby domesticeconomicforcesand infla-
tion as a national problem-coincidentally presentin all major countries
simultaneously-to be dealt with by national policy measuressuch as in-
come policy. It has becomeincreasinglyclear that monetarytheoryand the
theoryof macroeconomicpolicy mustbe extendedto make the openness of
the typical national economya centraland not a peripheralfeatureof the
analysis.
The distinctionbetween an open and a closed economy in monetary
analysis is fundamental. It correspondsto Patinkin's distinctionsbetween
individual and marketexperimentsand betweenceterisparibus and mutatis
mutandisassumptions;but wherePatinkin's objective, in parallel withthe
usual textbook development of value theory,was to move fromthe be-
haviour of the individual in the market system faced with parametric
prices and perfectlyelastic demands and supplies at those prices, the
currentproblem in monetarytheoryis to move in the reverse direction,
fromthe national economy as a closed marketsystemto the nation as an
individual actor in an approximatelyparametricworld economic system.
In terms of basic monetarytheory,in a closed economy the real balances
the public desiresto hold are securedby adjustingthe pricelevel up or down
to make an exogenouslygiven total of nominal money balances equal in
purchasingpowerto the quantity desired; in an open economy,in abstrac-
tion, the desired real balances are achieved by the import or export of
nominal money balances through the over-all balance of payments, the
money price level being fixed by world monetary behaviour and para-
metric to the individual country. Among other importantimplications,
this means that the national monetaryauthoritycontrols,not the money
supply, but the supply of domestic credit,the residual money demanded
being supplied by the country'sholdingsof internationreserves,and that
is all it controls(at the level of abstractionof the long run), since pricesare
determinedin worldmarkets,the only qualificationbeingthat the authori-
ties can change the nominal domestic currencyprice level relative to the
foreignprice level by changingthe exchange rate.
A new approach to balance-of-paymentstheoryand policy on these lines
has been developingin recentyears,1largelyinspiredby the theoreticaland
policy writingsof R. A. Mundell on the internationalmonetarysystem.
Thus far,the new approach has been largelyconfinedto the elaboration of
the pure equilibriumtheory,with some mathematical dynamics applica-
tions-and has been criticized for this emphasis by both Brunner and
1 See my Inflationand theMonetaristControversy,op. cit., and 'The monetaryapproach
to balance-of-paymentstheory', Chapter 11, pp. 206-23, in M. B. Connolly and A. K.
Swoboda (eds.), InternationalTrade and Money (London: Allen & Unwin, 1972), reprinted
as chapter 9 in my FurtherEssays in MonetaryEconomics (London: Allen & Unwin, 1973).

Laidlerl-though it has produced some as yet unpublishedempiricalwork
by members of the University of Chicago Workshop in International
Economics and influencedthe work of the University of Manchester
ResearchProgrammeon Inflationsupportedby the Social Science Research
Council. The criticismsdirectedat the approach forits neglectof dynamic
disequilibriumbehaviour, the processes of internationaltransmissionof
monetaryimpulses,and other problems familiarto students of domestic
monetarypolicies and phenomenaare certainlyjustifiedby the published
literatureof the approach as it now stands. In exculpation, it may be
argued that the present stage of development of the approach is com-
parable to the situationof closed-economymonetarytheorysome twenty-
fiveyears ago, when theoreticaldebate proceeded virtuallyexclusivelyin
terms of static general equilibrium models with negligible concern for
empiricalapplication and testing,and that some at least of its proponents
recognizethat reality occupies the area between the closed and the open
economytheoreticalassumptions,very much as the problem of how the
effectsof monetary impulses are divided between price and quantity
responsesdefinesthe grey area requiringintensive empirical research in
contemporaryclosed-economymonetaryeconomics. The programmeof
researchinto monetaryaspects ofthe balance ofpaymentsjust inaugurated
at the London School of Economics with the support of the Social Science
Research Council,involving CliffordWymer,Malcolm Knight. Alexander
Swoboda, myself,and our research associates, is intended to pursue this
matterin depth. But anyone else is verywelcometo join in the endeavour.
While the new approach has been emerging,however,the systemoffixed
exchange rates towards which it is orientedhas itselfcollapsed, and does
not look like being quickly restored. This development will obviously
requireadaptationsand modificationsofboththenew 'monetary'approach,
and the more conventional approaches to domestic and international
economicpolicy,whichhave tended to assume a fixedexchange rate as the
normal state of affairs,and changes fromone pegged level to another of
that rate as a policy instrument-albeit an instrumentof last resort.The
experience of a regime of floatingexchange rates since general floating
began in March 1973 also suggeststhe possible need forsubstantialrevision
of the traditionalcase forflexibleexchange rates, inasmuch as rates have
oftenmovedveryrapidlyand forwardmarketshave apparentlynot always
fulfilledtheir expected function. The explanation may well lie in the
uncertaintyto be expected in the aftermathof the breakdown of a fixed
rate system whose parities have become unsustainable, aggravated by
deliberate effortsto generate uncertaintyfor internationalpolitical pur-
poses and by speculation engenderedby the demonstratedinabilityof the
1 See referencescited in p. 215, n. 1, and p. 222, n. 1.

H. G. JOHNSON 225
participating Common Market countries to make the 'snake within a
tunnel' systemwork,and so requireno drasticrewritingofthe basic theory.
But that remainsa subject forresearch. Experience does, however,suggest
that the theory of the foreignexchange market needs to be recast, on
lines parallel to Keynes's treatmentof the determinationof the rate of
investment,in termsof a model in which stock demand and supply (both
influencedheavily by expectations about the future)dominate the deter-
mination of the currentprice and currentflows respond, sluggishly,to
that price.'
V. Concluding observations
The currentsituation in monetary economics offersabundant oppor-
tunitiesforsignificantnew workin the field. The main problemis to keep
controlof our propensitiesto select problemsthat serve mainlyto provide
exercise forour analytical and statistical tools, and to ignore the law of
diminishingreturnsfromconcentratingefforton deeper work on already
recognized and analysed problems. Research is like mining: one should
always be on the look-out formore promisingdeposits of ore, and better
technologyforextractingit.
London School of Economicsand Universityof Chicago

1 I am indebted forthis point to a conversationwith Rudiger Dornbusch.


Major Isuue in Monetary Economics

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Major Issues in Monetary Economics

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II. The foundations of monetary theory and the integration of

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1 Mori-isPerlman, 'The role ofmoney in an economyand the optimumquantityof money'

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IV. The internationalmonetarysystem

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London School of Economicsand Universityof Chicago

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