Changes in the Quantity of Money

(i) Changes in the quantity of money primarily affect effective demand through its influence on the interest rate.

If this were the only reaction, the quantitative effect could be derived from the 3 elements:

1. The liquidity-preference curve

This tells us by how much the interest rate will have to fall in order that the new money may be absorbed by willing holders

2. The marginal efficiencies curve

This tells us by how much a given fall in the interest rate will increase investment

3. The investment multiplier

This tells us by how much a given increase in investment will increase effective demand as a whole.

Those 3 elements are themselves partly dependent on the following complicating factors:

2. Since resources are not homogeneous, there will be diminishing, and not constant, returns as employment gradually increases.
3. Since resources are not interchangeable, some commodities will reach a condition of inelastic supply whilst there are still unemployed resources available for the production of other commodities.
4. The wage-unit will tend to rise, before full employment has been reached.
5. The remunerations of the factors entering into marginal cost will not all change in the same proportion.

The liquidity-preference curve depends on how much of the new money is absorbed into the income and industrial circulations.

This depends in turn on how much effective demand increases and how the increase is divided between

• the rise of prices,
• the rise of wages, and
• the volume of output and employment.

The marginal efficiencies curve will partly depend on the effect which the circumstances attendant on the increase in the quantity of money have on expectations of the future monetary prospects.

The multiplier will be influenced by the way in which the new income resulting from the increased effective demand is distributed between different classes of consumers.

Nor, of course, is this list of possible interactions complete. Nevertheless, if we have all the facts before us, we shall have enough simultaneous equations to give us a determinate result. There will be a determinate amount of increase in the quantity of effective demand which, after taking everything into account, will correspond to, and be in equilibrium with, the increase in the quantity of money.

Moreover, it is only in highly exceptional circumstances that an increase in the quantity of money will be associated with a decrease in the quantity of effective demand.

The ratio between the quantity of effective demand and the quantity of money closely corresponds to what is often called the “income-velocity of money”; — except that effective demand corresponds to the income the expectation of which has set production moving, not to the actually realised income, and to gross, not net, income.

But the “income-velocity of money” is, in itself, merely a name which explains nothing. There is no reason to expect that it will be constant. For it depends, as the foregoing discussion has shown, on many complex and variable factors. The use of this term obscures, I think, the real character of the causation, and has led to nothing but confusion.

2. Chapter 4 showed the distinction between diminishing and constant returns partly depends on whether workers are remunerated in strict proportion to their efficiency.

If so, we shall have constant labour-costs (in terms of the wage-unit) when employment increases. But if the wage of a given grade of labourers is uniform irrespective of the efficiency of the individuals, we shall have rising labour-costs, irrespective of the efficiency of the equipment. Moreover, if equipment is non-homogeneous and some part of it involves a greater prime cost per unit of output, we shall have increasing marginal prime costs over and above any increase due to increasing labour-costs.

Hence, in general, supply price will increase as output from a given equipment is increased. Thus increasing output will be associated with rising prices, apart from any change in the wage-unit.

3. Under (2) we have been contemplating the possibility of supply being imperfectly elastic. If there is a perfect balance in the respective quantities of specialised unemployed resources, the point of full employment will be reached for all of them simultaneously.

But, in general, the demand for some services and commodities will reach a level beyond which their supply is, for the time being, perfectly inelastic, whilst in other directions there is still a substantial surplus of resources without employment. Thus as output increases, a series of “bottlenecks” will be successively reached, where the supply of particular commodities ceases to be elastic and their prices have to rise to whatever level is necessary to divert demand into other directions.

It is probable that the general level of prices will not rise very much as output increases, so long as there are available efficient unemployed resources of every type. But as soon as output has increased sufficiently to begin to reach the “bottlenecks”, there is likely to be a sharp rise in the prices of certain commodities.

Under this heading, however, as also under heading (2), the elasticity of supply partly depends on the elapse of time. If we assume a sufficient interval for the quantity of equipment itself to change, the elasticities of supply will be decidedly greater eventually.

Thus, a moderate change in effective demand caused by widespread unemployment may spend itself very little in raising prices and mainly in increasing employment; whilst a larger change, which, being unforeseen, causes some temporary “bottle-necks” to be reached, will spend itself in raising prices, as distinct from employment, to a greater extent at first than subsequently.

4. The wage-unit may tend to rise before full employment has been reached, requires little comment or explanation. Since each group of workers will gain, cet. par., by a rise in its own wages, there is naturally for all groups a pressure in this direction, which entrepreneurs will be more ready to meet when they are doing better business.

For this reason a proportion of any increase in effective demand is likely to be absorbed in satisfying the upward tendency of the wage-unit.

At full employment, money-wages have to rise due to an increasing effective demand in terms of money. This is proportional to inflation. Thus, we have a succession of earlier semi-critical points where an increasing effective demand raises money-wages though not fully proportional to inflation. This is the same in the case of a decreasing effective demand.

Actually, the wage-unit changes non-continuously in terms of money in response to every small change in effective demand. These points of discontinuity are determined by:

• the psychology of the workers and
• the policies of employers and trade unions.

In an open system, where they mean a change relatively to wage-costs elsewhere, and in a trade cycle, where even in a closed system they may mean a change relatively to expected wage-costs in the future, they can be of considerable practical significance.

These points, where a further increase in effective demand in terms of money is liable to cause a discontinuous rise in the wage-unit, might be deemed, from a certain point of view, to be positions of semi-inflation, having some analogy (though a very imperfect one) to the absolute inflation (cf. Section V below) which ensues on an increase in effective demand in circumstances of full employment. They have, moreover, a good deal of historical importance.

But they do not readily lend themselves to theoretical generalisations.

5. Our first simplification consisted in assuming that the remunerations of the various factors entering into marginal cost all change in the same proportion.

But in fact the rates of remuneration of different factors in terms of money will show varying degrees of rigidity and they may also have different elasticities of supply in response to changes in the money-rewards offered. If it were not for this, we could say that the price-level is compounded of two factors, the wage-unit and the quantity of employment.

Perhaps the most important element in marginal cost which is likely to change in a different proportion from the wage-unit, and also to fluctuate within much wider limits, is marginal user cost.

For marginal user cost may increase sharply when employment begins to improve, if (as will probably be the case) the increasing effective demand brings a rapid change in the prevailing expectation as to the date when the replacement of equipment will be necessary.

Whilst it is for many purposes a very useful first approximation to assume that the rewards of all the factors entering into marginal prime-cost change in the same proportion as the wage-unit, it might be better, perhaps, to take a weighted average of the rewards of the factors entering into marginal prime-cost, and call this the cost-unit.

The cost-unit, or, subject to the above approximation, the wage-unit, can thus be regarded as the essential standard of value; and the price-level, given the state of technique and equipment, will depend partly on the cost-unit and partly on the scale of output, increasing, where output increases, more than in proportion to any increase in the cost-unit, in accordance with the principle of diminishing returns in the short period.

We have full employment when output has risen to a level at which the marginal return from a representative unit of the factors of production has fallen to the minimum figure at which a quantity of the factors sufficient to produce this output is available.