Knowledge that Transforms

The last decade has seen an array of empirical studies for testing possible associations between the stock of money and relevant flow variables, such as consumption and income. These studies originated with the comparison by Milton Friedman and David Meiselman between the relative stability of monetary velocity and the autonomous expenditure multiplier; and they include the comments, criticisms, and further investigations the F-M study has provoked [1], [2], [4], [51. [6], [71, [8], [9]. For good reason, the original studv by Friedman and Meiselman uses consumption rather than income as the dependent variable in estimating the relative stability of velocity and the multiplier [4, pp. 175-76]. While a persistently high relationship between the stock of money and consumption is found, the Quantity Theory of Money nonetheless hypothesizes more generally that the stock of money is a major factor in the determination of total money expenditures.' A brief supplementary test is included in the F-M study using income as the dependent variable. However, no explicit examination of gross private domestic investment as a dependent spending variable is undertaken. Net private domestic investment is included in the F-M definition of autonomous expenditures for testing the stability of the multiplier. Since consumption correlates better with the money stock than does total expenditure-income, Friedman and Meiselman c clude:

This paper is written in reply to the contributions by Willem H. Buiter and Jonathan Eaton, Alan Deardorff, and Norman C. Miller which appeared in the September 1981 issue of this Review as comments on my 1978 article. I propose to deal mainly with the issues raised by Buiter and Eaton, Deardorff, and Miller in his Section IV, as the point of departure of the first two sets of authors and Miller in the section noted is essentially the same. Miller, in his Sections II and III, however, takes a different view, arguing that the Keynesian models I criticized were meant to be nonequilibrium constructions in important respects. If this is the case, my remarks would have been inappropriate, since they were made specifically in the context of models in which all markets are supposed to clear. I personally do not think that Miller's basic premise in these two sections is correct, but readers will of course make their own judgements. The papers on the whole contend rightly that it is my Propositions 2 and 3, concerning the inconsistency and incompleteness of the Keynesian models under fixed-exchange rates, which are the crucial ones. The other two propositions may be easily accommodated by introducing wealth into the demand functions of the models (as is clear from the choice of words in those two statements). Proposition 2 asserted that models which require the demand for money to equal the domestic supply in each country force the balance of payments to vanish, which contradicts the values given by their defining equations. The commentators argue that this is incorrect because I did not properly consider the exchange-market-intervening activities of the authorities. Proposition 3 stated that neither bond market clears in Keynesian models because Walras' Law permits the exclusion of only one market-equilibrium equation. Again, there is unanimity of approach, although not of results, in the three papers. Each of them attempts to utilize a balance-of-payments equation to make the system determinate. My reply to these positions is the following. The authors' argument against Proposition 2 assumes that the monetary authorities are able to sterilize exactly and simultaneously all balance-of-payments flows. This is, of course, patently false empirically. It requires the ability of the monetary authorities to predict precisely what the aggregate equilibrium currency flows will be if it steps in to totally offset them. This involves knowledge of a completely different order than that conventionally assumed in general equilibrium models. It is as if the Walrasian auctioneer were first, as usual, to call out his prices to all agents. But then, in an aside, each exchange authority is informed of the total sum of its residents' demands and supplies of foreign exchange, so that, in the same marketing period, it can formulate a response to exactly counterbalance their plans. This is not the way the world works. Exchange authorities, lacking omniscience, sterilize currency flows after they have taken place, and the possibility that the market period may be reasonably short does not alter this fact. The difference, moreover, is not one of theoretical hairsplitting, since the two alternative sterilization assumptions do give different results. In addition, if the simultaneous sterilization interpretation is made for the Keynesian models, they can only deal with the case in *London School of Economics. I would like to thank Howard Petith and Kyoung Mihn for helpful comments on a previous draft of this paper.

The question of whether controls on the importation of foreign oil into the United States should take the form of tariffs or quotas has been a topic of recent public debate and investigation bv econonmists. Under static competitive conditions it is well known that equivalent tariffs and quotas can be constrtucted. Hence in this context, there is no choice to be mlade on economic efficiency grounds.' Hlowever, in a recent isstue of this Review, George Hay poinlts out that the actual market for oil in the United States differs fromii the required textbook conditions for equivalence. Under the U.S. oil import program which prevailed until recentl-, each refiner's quota for inmport of foreign oil is a positive function of his refinery input. Since import tickets are allocated free of charge, rather than auctioned, the form of the quota lowers the marginal cost of domestic refiners. Hay goes on to show that when combined with other static competitive assumptions, this quota mechanismi could generate greater consumer benefits in terms of lower prices than would an equivalent tariff (equivalent in the sense that the same percentage of imports is admitted).2 Hay expresses a preference for tariffs in a real world context and warns that his analysis of the price effects of the U.S. oil quota system holds only under very restrictive conditions. However, he does not address what is perhaps an even more important deviation of the domestic oil industry from the standard textbook model: crude oil production in the United States was limited in the major producing states by regulatory commissions that practiced market demand prorationing under the old oil quota program. Under this system, an-y price set by the industry is ratified by the commissions by limiting production to a level that will not result in the accumulation of undesired inventories.' We are not addressing the issue of the level of price in the oil industry in this paper. Rather, we wish to review the effects of tariffs and quotas on resource allocation, an issue which Hay omits from his analysis; and, for this purpose we make use of the simple model of a profit-maximizing monopolv as a characterization of the domestic oil industry. The assumption of profit maximiza-

In a recent article in this Review, Benjamin Klein derived a particular form for the demand for money function and presented econometric estimates of that specific function for the period 1880-1970. He also included estimates of a simpler linear functional form for the same period. In comparing the two, Klein concluded it is therefore not unambiguously clear which functional specification is superior (p. 941). In this comment I show that Klein's functional form is equivalent to the linear form with a single linear constraint imposed upon the coefficients. Such a constraint can be tested with a standard F-ratio test. I perform that test and conclude that in fact Klein's specification can be rejected in favor of the simpler linear form.' Klein's functional form is

In the 1950's and 1960's a strong dollar standard existed; under fixed exchange rates the monetary policies of most nations were governed by the stable monetary policy of the United States. In the 1970's, the dollar standard was reduced to a weak form where industrial (but not less-developed) countries float their exchange rates to secure more domestic monetary independence, but the financial processes underlying international trade itself remain dollar based. What are the elements of the weak dollar standard necessary for world trade to remain largely monetized and multilateral? How can nations avoid a relapse to the bilateralism and barter that characterized the 1930's? I shall consider first, necessary restraints on foreign exchange intervention and reserve holdings by central banks of industrial economies other than the United States; and second, the proper American monetary policy for reconciling the weakened international role of the dollar with domestic monetary stability.

In reforming the system of pegged exchange rates, one matter of concern is the distribution of the burden of adjustment between revaluatioins anid devaluations. The same amount of adjustment cain be accomplished wvith various revaluationidevaluat ioni combinations, but changing the combination has several effects. One imp)ortant elfect was noted in a report by the Internlational Monetary Fund: