This paper analyzes the interaction between the real and monetary sectors via the balance-of-payments adjustment mechanism. An explicit theoretical model is developed and its coefficients are estimated (using two-stage least squares) for the United States during the period 18791914. The model is then synthesized to evaluate the views of Phillip Cagan, Milton Friedman and Anna Schwartz on one hand, and Jeff rey Williamson, Robert Mundell, and Moses Abramovitz on the other. The period 1879-1914 in American economic history is of particular interest as it provides an excellent testing ground for theories pertaining to balance of payments and money supply. In this era the U.S. economy developed rapidly under a gold standard regime with little direct government intervention. There are conflicting interpretations of the events of this period with regard to the interaction between the monetary and real sectors. Cagan and Friedman and Schwartz regard the variations in the money supply as independent of the changes in the real sector. Their view can be best summed up in the following passage from Friedman and Schwartz:

The optimal rate of monetary expansion is derived for the case when the government resorts to deficit financing to finance its development expenditure. It is argued that, while higher rates of monetary expansion increase investment and contribute to future consumption, the consequent inflation imposes welfare costs by reducing the level of real balances held by the public. A theoretical framework is developed and its empirical implications considered by deriving the optimal rate of monetary expansion which maximizes the discounted flow of total consumption--material consumption minus the disutility of holding suboptimal levels of real balances--over time.

The optimal rate of monetary expansion is derived for the case when the government resorts to deficit financing to finance its development expenditure. It is argued that, while higher rates of monetary expansion increase investment and contribute to future consumption, the consequent inflation imposes welfare costs by reducing the level of real balances held by the public. A theoretical framework is developed and its empirical implications considered by deriving the optimal rate of monetary expansion which maximizes the discounted flow of total consumption--material consumption minus the disutility of holding suboptimal levels of real balances--over time.