...against fictions and other tall tales

Thursday 30 April 2020

The Keynesian-Monetarist debates and reverse causation (or how Keynesians destroyed monetarism using only logic)

Traditional monetarist theory held that changes in the money stock are the best indicator of monetary influence on the economy, and that these influences have a significant impact on the course of economic activity over the business cycle.

The idea that "money matters" in this sense is not new. In many ways, monetarism's basic premise dates back to the beginning of political economy as a discipline. However, in the 1950s, the idea gained prominence when a number of "money supply theorists", as they were called back then, began producing studies and charts that appeared to lend support to the view that changes in the money supply had a predominant role in causing fluctuations in (nominal) income and output.

Initially, (neo-)Keynesian economists -- who as a result of their reading of events of both the onset of and recovery from the Great Depression viewed income (output) as determined largely by aggregate demand or the spending of firms, government and household spending -- were not phased. At first, Keynesians responded by saying that their preferred theoretical approach, the Hicks-Hansen IS-LM model, already recognized the role of money in affecting economic activity via the LM curve.* However, these Keynesians also argued that, while money does have a role in driving economic activity, it was of secondary importance, behind consumer and investment spending.**

Also, while Keynesians admitted that fluctuations in the money supply can affect economic activity, they also argued that the seemingly causal relationship between money and output portrayed in monetarist studies could partly be explained by changes in the public's demand for money, the propensity to hold financial assets in the form of money.

The debate intensified when Milton Friedman and other monetarists produced studies (seemingly) showing the empirical importance of money over spending and investment in explaining output fluctuations. In order to show that fluctuations in the money supply cause fluctuations in output, monetarists had to demonstrate that the demand for money was stable (to support their view regarding the predominant role of the money supply in affecting economic activity), and that fluctuations in aggregate demand were a weak source of fluctuations in income.

With respect to the stability of the demand for money, Keynesians argued that the demand for money was not stable (i.e., as a stable function of interest rates, expected inflation, wealth and other variables), nor predictable (thus countering the monetarist view that the predictability in the demand for money would enable the monetary authority to expand or contract the money supply to offset any predicted changes in money demand). The neo-Keynesian view was later proven right when the stability in money demand collapsed in the 1970s and 1980s in the US.

As for the monetarist claim that money supply fluctuations outperformed the traditional Keynesian drivers such as investment and other forms of spending in explaining output fluctuations, which figured most prominently in Friedman's "A Monetary History of the United States", neo-Keynesians responded in several ways.

First, Keynesian critics proposed that the apparent causal relationship stemming from money to income (and economic activity overall) might be a fallacious case of post hoc ergo propter hoc (i.e., what comes before must therefore be the cause), or at the very least, a statistical illusion caused by the fact that investment is recorded in national income accounts in periods subsequent to monetary aggregates, which capture the same transaction but at an earlier stage when investors first come to the money market.

Also, Keynesians challenged the methodological approach used by Friedman and other monetarists to support their claim that the money supply is the key variable explaining fluctuations in output. Most importantly, Keynesian critics suggested that Friedman's approach in the "Monetary History" of assuming an exogenous money supply under the full control of the monetary authority and completely independent from the influence of other economic variables, was unrealistic and overstated the influence of money on economic activity.

Over 50 years ago, neo-Keynesian economists John Kareken and Robert Solow, using simple logic, pointed out the fatal flaw in the monetarist assumption of the exogeneity of the money supply:
The unrealiability of this line of argument is suggested by the following reducio ad absurdum. Imagine an economy buffeted by all kinds of cyclical forces, endogenous and exogenous. Suppose that by heroic, and perhaps even cyclical variation in the money stock and its rate of change, the Federal Reserve manages deftly to counter all disturbing impulses and to stabilize the level of economic activity absolutely. Then an observer following the Friedman method would see peaks and troughs in monetary changes accompanied by a steady level of economic activity. He would presumably conclude that monetary policy has no effects at all, which would be precisely the opposite of the truth.
Karaken and Solow in this example were not suggesting that the money stock was endogenous in the sense that the money supply was negatively correlated with aggregate spending shocks. Rather, they were suggesting that abstracting from the actual behavior of the central bank as Friedman did could result in flawed conclusions about the magnitude of monetary policy's impact on the economy.***

Also, this line of reasoning suggested that the statistically significant relationship (correlation) between money and output highlighted by the monetarists should not be understood as implying that changes in the supply of money cause changes in income. Instead, this objection suggested the possibility that the observed relationship could just as well be the consequence of reverse causality, that is, that spending shocks, by affecting money demand and generating pressure on the interest rate, led to accommodating changes in the supply of reserves provided by the Fed during that period, and ultimately resulted in changes in the money supply.

Having then demolished the Friedman assumption of an exogenous money supply, neo-Keynesians in the 1960s thus allowed for the possibility that the relationship between money and economic activity could be the result of actions from the public, as they respond to current economic conditions, and that these actions from the public could have such a significant influence on observed movements in the money stock that one could not tell the direction of causality between money and economic activity simply by looking at measurements of monetary aggregates and income.

For a few years later, a lively debate on reverse causation followed between monetarists and the economic staff of the St. Louis Federal Reserve Bank on one side and neo-Keynesians and staff economists of the Federal Reserve Board on the other. Empirically, a breakthrough in favor of the reverse causation argument occurred in 1973 when two staff economists of the Federal Reserve Board, Raymond Lombra and Raymond Torto, demonstrated in a paper entitled "Federal Reserve Defensive Behavior and the Reverse Causation Argument" that during the 1953-1968 period the supply and demand for money was interdependent and that this interdependence provided an avenue for the reverse influence of the business cycle on money.

In doing so, Lombra and Torto confirmed the endogeneity of the monetary base and money supply resulting from the Fed's offsetting and accommodating actions whenever it sought to stabilize conditions in the money market by pegging the level of short-term interest rates over the short-run:
If the demand for money is, in part, a function of the level of economic activity and the supply of money has been at least partially demand determined, then the money stock is endogenous whether or not the Fed has the power to control it
However, the conclusions by Lombra and Torto were eclipsed by the conclusions of a paper published one year earlier by Christopher Sims utilizing newly developed statistical techniques which contended that the hypothesis of unidirectional causality running from money to income could not be rejected. Of course, monetarists, in their attempt to support their case, cited this work with approval since it appeared to support the monetarist assumption of an exogenous money supply.

In 1982, Sims published another paper recognizing that his earlier work and work based on it was open to serious question. This paper along with Lombra and Torto's paper should have demolished the monetarist case from the start. Unfortunately, such an attack was not enough to stop the monetarist ascendancy that was gathering support within and outside the economics profession (such as the St.Louis Federal Reserve Bank) in the 1970 and 80s.

Today, we know that this monetarist view influenced later New Keynesians (not older New Keynesians like Stiglitz, Akerlof and Blinder). Some Post Keynesians adhere to reverse causation in their monetary economics.

* The LM curve had been relegated to the background (as a supporting role) during the war years and early post-war years when interest rates were pegged as a result of the Treasury-Fed accord

** The main changes through which the real money supply affects the economy are: the real balance effect, the portfolio effect, and money as a medium of exchange effect.

*** More specifically, by assigning total control over the money supply to the central bank in their model, Friedman and other monetarists were effectively dismissing the potential influence of both the banking system and the real economy in influencing the money supply.


  1. Hey, its been awhile. Glad you are back and hope you keep it up.

    1. I'll give it my best. Thanks for the message.

  2. Jos Laliberté6 May 2020 at 03:59

    Great stuff Circuit and welcome back! Always a pleasure to read your text. Recent experience since financial crisis has definietly debunked the monetarist view.

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