x

Acknowledgements

Yeager, L.B. (1968), Essential properties of the medium of exchange, Kyklos,

21 (1), 4569, permission granted by Helbing & Lichtenhahn Verlag AG.
Yeager, L.B. (1973), The Keynesian diversion, Western Economic Journal,
June, 15063, material is reproduced by permission of the Western Economic
Association.
Yeager, L.B. (1976), International Monetary Relations Theory History and
Policy, 2nd edition, New York: Harper & Row, permission granted by
Pearson Education, Inc.
Yeager, L.B. (1978), What are banks?, Atlantic Economic Journal, December,
114, permission granted by the Atlantic Economic Journal.
Yeager, L.B. (1979), Capital paradoxes and the concept of waiting, in Mario
J. Rizzo (ed.), Time, Uncertainty and Disequilibrium: Exploration of Austrian
Themes, Lexington, MA: Lexington Books, pp. 187214, permission granted
by Mario J. Rizzo.
Yeager, L.B. and associates (1981), Experiences with Stopping Inflation,
Washington, D.C.: American Enterprise Institute for Public Policy Research,
permission granted by publisher.
Yeager, L.B. (1982), Individual and overall viewpoints in monetary theory,
in Israel M. Kirzner (ed.), Method, Process, and Austrian Economics: Essays
in Honor of Ludwig von Mises, Lexington, MA: Lexington Books,
pp. 22546, permission granted by Israel M. Kirzner.
Yeager, L.B. (1986), The significance of monetary disequilibrium, Cato
Journal, Fall, 36999, permission granted by the Cato Journal.
Yeager, L.B. and A.A. Rabin (1997), Monetary aspects of Walrass Law and
the stock-flow problem, Atlantic Economic Journal, March, 1836,
permission granted by the Atlantic Economic Journal.
Several of the above articles are reprinted in Yeager, L.B. (1997), The Fluttering
Veil: Essays on Monetary Disequilibrium, edited and with an introduction by
George Selgin, Indianapolis: Liberty Fund.

1. Money in macroeconomics:
frameworks of analysis
TWO APPROACHES TO MACROECONOMICS
SPENDING AND GOODS-AGAINST-GOODS
Monetary (or money/macro) theory investigates the services and disorders of
money and the relations between money, production, employment and the level
of prices. We define money narrowly as media of exchange, including
currency and all transaction deposits. Reasons for this definition will become
clear as we move through the book. In addition to this narrow money, broad
money includes nearmoneys that do not circulate in payments. Examples
include certificates of deposit, time deposits, and in some contexts, treasury
bills and commercial paper.
Two approaches tackle the central questions of macroeconomics. One we
call the spending approach. A second, the goods-against-goods (or Says Law)
approach, goes further back to the fundamentals of production and the exchange
of goods against goods. These two approaches reconcile. No issue arises of a
right one versus a wrong one. The spending approach is potentially misleading,
however, unless grounded in the fundamentals of production and exchange.
Admittedly one can raise objections to the concept of total spending.
According to Hutt (1979, Chapter 11), spending is an ex post notion, a money
measure of exchanges accomplished, and so cannot be a determinant of nominal
income or prices or anything else. (Other things being equal, the higher the
prices at which a given volume of exchanges is measured, the greater the
spending observed.) This, however, is not the meaning we adopt. We stick
closer to the ordinary dictionary meaning, according to which it makes sense
to say that someone has gone on a spending spree. Total spending is the same
as what is commonly called aggregate demand for goods and services,
expressed in money or nominal terms. Usually we mean spending on final
output or nominal income. Spending that includes transactions in intermediate
goods and services is much larger.
Concern with total spending, though misleading by itself, becomes more
meaningful if linked to a disaggregated view of market transactions. Fundamentally, behind the veil of money, goods and services exchange against other
1

Monetary theory

goods and services. The key question of macroeconomics boils down to how
well or how poorly the market process facilitates these exchanges by coordinating the decentralized decisions of millions of people, making use of the
specialized knowledge each possesses with respect to his own situation, and
transmitting appropriate signals and incentives. A sufficiently disaggregated
analysis considers how imbalance between desired and actual quantities of
money can frustrate exchanges and discourage production, how such imbalance
can arise, how appropriate price adjustments could cure or forestall it, and what
circumstances impede the curative price adjustments.
It is not enough to consider how prices affect the demand for and supply of
goods and services. It is also necessary to consider the processes whereby
people determine prices and adjust them, readily or sluggishly, to clear markets
under changed conditions. One price whose decentralized and piecemeal manner
of determination requires special attention is the purchasing power of the money
unit, the reciprocal of some sort of average price level. It is hardly a price in the
ordinary, straightforward sense. Nevertheless, the relation between it and the
nominal quantity of money in existence has much to do with the adequacy of
total spending and with the economys macroeconomic performance.

OUTPUT AND SPENDING

It is convenient to begin with questions that are not fundamental ones. Why
they are not becomes clear later in this chapter. Figure 1.1 charts the growth and
fluctuations over time of a countrys total real income, both actual and potential.
Because of the logarithmic vertical scale, a straight line would represent a
constant growth rate. Total real income is the sum of the physical outputs of
goods and services newly produced in the country (in a year, say). We need
not be precise here about how different things are added up or just which of
the national income and product concepts we mean. Potential (or fullemployment) real income is the total output that could be produced in virtue of
the economys real factors the population or labor force and its size, health
and strength, skills, alertness to opportunities, orientation toward work and riskbearing and other traditions and attitudes; natural resources; the state of
technology; accumulated capital equipment (roads, harbors, buildings, machines
and so forth), as well as the attitudes that influence saving and investment.
Another real factor is the tightness of resource allocation or degree of efficiency
of economic coordination, as influenced in part by legal and other institutions.
The figure shows potential output growing over time as the labor force grows
in size and abilities, technology advances and capital equipment accumulates.
Figure 1.1 is consistent with Friedmans (1964, 1993) plucking model of
business fluctuations. Potential output acts as a ceiling against which actual

Money in macroeconomics

Real income
(logarithmic
scale)

Potential real
income
Actual real
income

Time
Figure 1.1

Growth of real income, actual and potential

output may bump after first being plucked downward by economic forces. An
asymmetry arises: a fall in output below the ceiling is followed by a rise in output
of similar magnitude (that is, back to the ceiling), but a rise in output is not
correlated with the subsequent contraction that occurs.1 In contrast to selfgenerating business cycles, business fluctuations consist of recessions followed
by recoveries. (Chapter 6 and Birch, Rabin and Yeager, 1982, explore the
possible case of output temporarily expanding beyond its full-employment level.)
At least two other versions of Figure 1.1 appear in the literature. According
to De Long (2000, p. 84), new Keynesian economists view business cycles as
fluctuations in actual output around the sustainable long-run trend.2 Advocates
of real business cycle theory argue that the economy is always in equilibrium
and that actual and potential output are equivalent. Output changes in response
to random changes in technology (supply shocks), in which case both actual
and potential output can permanently change (see pages 208209 below).
Whether actual output fully meets the potential determined by real factors or
instead sometimes falls short depends largely on monetary factors. Business
firms produce in hope of selling their output for money, and at a profit. They
will not persist in producing things that they cannot expect to sell profitably.
If total spending falls short of what is necessary to buy the potential output of
a fully employed economy, output will fall short and workers will be
unemployed. It hardly follows, however, that policy should always aim at

Monetary theory

pumping up the quantity of money and the flow of spending. Why that does
not follow is one of the lessons of this book.
The distinction between monetary and real factors is not sharp. Monetary
factors can influence real ones. Depression and unemployment due to too little
money and spending will hold down income, saving and investment, and so
the stock of productive equipment existing thereafter. This is just one example
of how monetary instability can interfere with establishment of market-clearing
prices and wages and so can undermine the coordination of different sectors of
the economy. (We have listed the tightness of coordination among the real
factors.) Conversely, real factors can influence monetary factors. Under a gold
standard, improvements in gold mining will tend to expand the money supply.
Under a passively managed and passively responding money and banking
system, innovations that improve investment prospects will tend to expand the
money supply. Still, the distinction between real and monetary factors, though
fuzzy at the fringes, is useful.
To keep actual output growing over time along with potential output,
spending must be adequate to buy that potential output and to buy the necessary
labor and other inputs. Abstractly considered, any flow of spending would be
adequate no matter how small in dollars if prices (including wages) were flexible
enough. Prices could go down enough the purchasing power of the dollar
could rise enough to make any nominal flow of spending suffice to buy fullemployment output.
Reality though poses difficulties. First, prices and wages do not adjust
instantly to market-clearing levels, and good reasons exist for their stickiness.
Later chapters will examine these reasons. They will show why the term
stickiness, though traditional, labels a complex condition and must not be
taken too literally. Second, prices and wages are not all equally sticky, so a
general decline would distort relative prices and wages during the process, and
these distortions would also hamper transactions. A third difficulty concerns
expectations. As people perceived rigidities gradually dissolving and the price
level sagging, they would postpone purchases and hang onto money and claims
expressed in money to gain from the expected further rise in its purchasing
power. Fourth, price deflation spells a rise in the real burden of existing debt.
The gains of creditors would not fully offset the losses of debtors. Creditors do
not gain from an increase in the apparent real value of their claims if the debtors
go bankrupt and the claims become uncollectible (Fisher, 1933).
As a practical matter then, price flexibility alone cannot be counted on to
maintain full employment. To keep actual real income near its potential level
total spending must be adequate to buy the output of a fully employed economy
at approximately the existing general level of prices and wages. Spending must
grow over time approximately in step with the growth in potential output due
to real factors. History and theory suggest that markets can cope with a slightly