CFA Institute

Friedman and the Flat TireAuthor(s): Alf MarshallSource: Financial Analysts Journal, Vol. 27, No. 2 (Mar. - Apr., 1971), pp. 8-10Published by: CFA InstituteStable URL: http://www.jstor.org/stable/4470783 .

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AND THE

FLAT TIRE

.. . ...... a dynamic explanation of the link between monetary policy and the level of economic activity

by ALF MARSHALL

QO NE of the striking features of the monetarist position typified by Milton Friedman's de- bates with the fiscalists' is the apparent

inconsistency between the long view and the short view. In the long run, monetarists maintain, changes in monetary policy are manifested only in price level effects: in the short run, on the other hand, they can have a profound effect on demand, hence on the level of economic activity. The mone- tarists need a "transmission mechanism" that reconciles their long and short run views.2

Although this description of monetarists' short and long run views is drastically oversimplified, there is an important case in which the views cited are mutually consistent. This paper is primarily concerned with that case.3 Later on, however, it considers some of the exceptions to this description.

The monetarists have also stressed the distinc- tion between the real and nominal rates of interest. Yields on money-fixed claims reflect the nominal rate of interest, which includes an allowance for inflationary expectations. In inflationary times like the present the gap between the nominal rate and the real rate is large. The monetarist's view is that in the short run monetary policy has an important effect on the real rate and little, if any, effect on the difference between the real and nominal rates; in the long run the effect is entirely on inflationary expectations, hence the difference between the real and nominal rates, and not at all on the real rate.

There is a simple physical analogy that resolves the apparent contradiction between the monetar- ists' long and short range views, while providing a dynamic explanation of the link between monetary policy and the level of economic activity. It is the flat tire.

The consequence of a puncture is ordinarily assumed to be a flat tire. More precisely, however, a flat tire is the long run consequence of a punc- ture. The short run consequence of a puncture is rapidly escaping air. In the short run, air escapes rapidly but flattening of the tire is scarcely percep- tible. In the long run the tire becomes flat, but air ceases to escape. This is not a very troublesome paradox: the ultimately flat tire is the cumulative

Without implicating him in any way, the author would like to acknowledge the constructive criticism of Professor David I. Fand. Dr. Fand is Professor of Economics at Wayne State University and has served as a consultant to the Board of Governors of the Federal Reserve. 1. Notes appear at end of article.

8 FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1971

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consequence of escaping air: on the other hand, it is precisely the fact that the tire is not yet flat which in the early stages causes air to continue to escape. The dynamics of a flat tire are scarcely worth be- laboring: yet they parallel almost exactly the dy- namic consequences of changes in monetary policy.

Consider what happens when the central bank injects more nominal dollars into the economy than transactors want to hold. Because wages and prices change only gradually there is initially no cumulative effect on prices, and the increase in the real value of the transactor's cash holdings will be strictly proportional to the increase in the nominal value. Because the real return on holding cash is independent of the nominal quantity held, however, depending primarily on transactors' real wealth and the level of economic activity, there is an in- crease in the real value of the money stock relative to the convenience services provided by that stock. Thus one immediate consequence of an increase in the nominal stock of money is a sudden decline in the real rate of return on holding cash. The price of claims on the existing stock of capital goods rises as transactors attempt to reestablish the de- sired balance in their portfolios between such claims and money. In response to the resulting demand pressure, marginally efficient plant and workers are p-ressed into service: prices and wages begin to rise.

As noted above, the short run effects of an in- crease in the money stock are a decline in the real interest rate and an increase in the level of business activity (delayed only by the time required for banks to lend and businessmen to change produc- tion levels). As price and wage increases begin to accumulate, however, the real value of the money stock declines, and the demand pressure generated by the initial increase begins to abate. Prices con- tinue to rise until the pressure ceases. The pressure ceases when the real money stock no longer ex- ceeds what transactors want to hold. There is then no further pressure for continuing price increases. Although use of marginal plant and workers is dis- continued, the cumulative effect on the subsequent price level of any wage increases in the interim will be permanent. Henceforth, the effect of the original increase in the money stock will be seen entirely in

the level of wages and prices and not at all in the level of economic activity.

At this point the analogy with the flat tire is obvious: it is the fact that the tire is not yet flat which causes air to continue to escaple in the case we are considering: it is the fact that price in- creases have not yet completely offset the initial increase in the nominal stock of money which maintains demand pressure, hence causes prices to continue to increase.

In the foregoing case it is assumed that (1) initial demand conditions are such that an increase in the money stock will cause increased demand pressure, and (2) increased demand pressure ultimately causes money wages to rise. If these assumptions don't fit conditions at the time of an increase in the nominal money stock, the conse- quences will be very different from those discussed above.

There may be initial levels of demand such that an increase in the money stock still leaves demand below the level at which the money wage begins to rise (or below the level at which wages rise faster than productivity). At such levels of demand, there is no cycle of continuing inflation. There will be a long run increase in real value of the money stock, and a long run effect on output and em- ployment.

There may still be one-shot price changes occur- ring as increased demand causes less efficient plant and labor to be pressed into service, lowering the real wage of those already employed. In the ab- sence of wage changes, however, a static equili- brium will be reached in which the original change in nominal money supply would be partially, but not entirely, mitigated.

If, on the other hand, either the increased de- mand for labor or the decline in the real wage con- comitant with these "temporary" price increases encourages labor to bid up nominal wages, prices will continue to rise. Worse still, absent any pro- ductivity improvement, any change in the level of money wages tends to get transmitted quickly into a proportionate increase in prices, leaving labor with. the same real wage as before, and leaving the pressure for higher money wages unresolved. Al- though the precise mechanism by which demand

FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1971 9

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pressure drives up the money wage remains the subject of a very active controversy, it is clear that, whatever the mechanism, inflation will continue until demand pressure subsides.

It has often been argued, however, that below certain levels of demand, changes in the money stock are ineffective in generating additional de- mand pressure. It has also sometimes been argued that below certain levels of demand, open-market action is ineffective in increasing the money stock. Such levels of demand represent one pole on a continuum. The other pole is a level of demand at which the only effect of any increase in the money stock is more inflation.4 The question arises whether there is a happy middle ground somewhere be- tween these poles where appropriate open-market action can (1) increase the money stock, (2) thereby increase demand pressure, and yet (3) not stimulate wage increases. If no such middle ground exists then, in those cases where expansionary monetary policy has any effect on real output the long run effect is primarily a change in wage levels, and any temporary gain in employment must ulti- mately be paid for with a permanent increase in the price level. *

NOTES

1. A monetarist's characterization of a very different view allegedly held by many fiscalists is given in David Fand's paper "Keynesian Monetary Theo- ries, Stabilization Policy, and the Recent Infla- tion," Journal of Money, Credit, and Banking, August 1969. See particularly pages 558-561 and pages 568-571.

2. Fand acknowledges the confusion in some quar- ters, saying ". . . monetarists seem to be advocat- ing two contradictory propositions at the same time: on the one hand, their theoretical analysis

views the nominal money stock as a kind of veil (as in the classical tradition) and stresses real variables as opposed to nominal variables; on the other hand, their historical and applied analysis suggests that movements in the money stock are the key to curbing inflation and to preventing depressions." He also notes that "There is an apparent paradox, striking some as a contradic- tion, between the theoretical proposition that the quantity of nomin.al money will not, substantially, affect any of the real endogenous variables, and a policy recommendation to impose either fixed rules or policy guidelines on monetary growth, in order to stabilize the economy." "A Monetarist Model of the' Monetary Process," Journal of Finance, May, 1970, page 279.

3. This case is described by Fand as follows: ". . . several conditions must be satisfied if the authorities are to print money and succeed in raising real balances permanently. These are: that the economy has a substantial volume of un- used resources; that the price level is stable; and that discrepancies between supply and demand in individual markets are eliminated through quan- tity changes," in his paper "Money, Interest, and Prices" in the Proceedings of the 1.970 Savings and Residential Financing Conference, page 60.

4. The respective poles have been articulated by Fand in Proceedings, page 59: "There are, how- ever, two circumstances in which monetary actions may have a significant impact on some of these real endogenous variables: in an economy where output can easily expand, where the price level is stable, and where market discrepancies are cleared through quantity adjustments rather than price changes, an increase in the money stock may lower the real rate of interest and bring about an increase in real output and employment; at the other extreme, in an economy where output can no longer expand, where markets can only be cleared through price changes, a deceleration in monetary growth may be the key to achieving price stability and lower market rates of interest, even if it does not significantly impact the real endogenous variables in the economy."

"ECONOMISTS are often twitted with being theoretical and out of touch with the facts of industry. Much more unpractical is the attitude of the; average business man, who is familiar with but one small corner of the industrial world, contents himself with the most superficial commonplaces, and knows so little of the essential problems of economics that he is hardly aware even of their existence."

-(F. W. Taussig, Principles of Economics)

10 FINANCIAL ANALYSTS JOURNAL / MARCH-APRIL 1971

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