Some Major Problems in Monetary Theory

This 1961 American Economic Association Papers and Proceedings essay by Karl Brunner argues that evaluating monetary policy’s effectiveness requires separately and rigorously assessing two distinct theoretical links: how policy actions (open-market operations, reserve requirements, the discount rate) affect monetary aggregates (“money supply theory”), and how monetary aggregates in turn affect income and prices (“money demand theory” combined with aggregate demand theory) — and that casual empirical patterns commonly invoked in policy debates fail to discriminate between rival hypotheses about either link. Brunner outlines a money-supply theory in which the money stock, bank credit, and interest rates are jointly determined in the bank credit market, and reports that partial-correlation estimates across differently-situated sample periods put the “monetary multiplier” (money stock’s response to the monetary base) in the range of 1.5 to 3.5, with the base identified as the single most important determinant of the money stock — explicitly rejecting the UK’s Radcliffe Report’s claim that the money supply was “evidently uncontrolled.” On the demand side, Brunner confirms the basic Keynesian interest-and-income specification but argues Milton Friedman’s permanent-income-based demand function better explains the secular and cyclical behavior of velocity, and reports his own modified versions (adding an interest-rate term) estimated on 1919-1959 annual data, finding significantly negative interest elasticities (around -0.22 to -0.30) dominated by a substantially larger permanent-income elasticity. The essay’s central substantive claim is a “portfolio adjustment” balance-sheet transmission mechanism — monetary policy works because money-stock changes alter the public’s whole balance sheet, triggering asset substitution across the full range of assets and liabilities (not just money versus bonds), which spills over into demand for newly produced goods and assets — and Brunner marshals four types of observational evidence (money-financed deficits and inflation, delayed post-control price adjustment, cross-sectional asset-holding patterns, and aggregate-demand equation fit) as consistent with this view.

Karl Brunner | Macro Paper Warehouse

Some Major Problems in Monetary Theory