Another point of view holds that the fiscal approach presented above is misleading because it ignores the part played by monetary factors in determining the level of economic activity. The following discussion presents an alternative model, which, though equally simplistic, suggests that primary reliance be put on monetary policy.

“Money” in what follows may be taken to refer to currency (coins and notes) plus the checking deposit liabilities of commercial banks. For the sake of brevity, the model developed in the preceding section will be referred to as the income model. The naive quantity theory model that will be explained here may be labelled the money model.

The income model dealt with changes in money income in terms of the demand for and supply of output. The money model focusses on the supply of and demand for money. The income model explained the determination of the level of income in terms of relationships between its component flows. The money model emphasizes the relationship between money supply and income. The structure of the income model was based on the distinction between household and business (and government) sectors. In the money model, the distinction is between the banking sector (supplying the money) and the nonbanking sectors (the demanders). The concept of income is the same in both models.

In the money model, the supply of money is treated with the same simplicity that was accorded investment in the income model—as “autonomously” determined, which is to say that it is not affected by other factors: M^s = M̄. This assumes that the central bank is able completely to control the stock of money, which is held at whatever level the bank desires.

The dynamic relationship in the income model was the consumption function. Here it is the money demand function. The amount of money demanded is assumed to vary with income (and, in this naive version of quantity theory, with nothing else). The simplest relationship between income and the demand for money would be: M^d = kY. Here, k is a constant. Since Y is a flow (measured per year) and M^d a stock (the average stock of money over the year), k has the dimension of a “storage period.” If k = 1 4, for example, the equation states that the nonbanking public desires on the average to hold a cash balance that is equal to the total of three months’ income.

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Figure 3: Relation between money demand and income (see text).

Encyclopædia Britannica, Inc.

Since there is a determined amount of money in the system, it can be in equilibrium only when the nonbanking sector is satisfied to hold exactly the amount of money that exists, no more and no less: M^d = M^s. The system represented by these three equations is shown in Figure 3. The determination of income in the system is shown by assuming M^s = $25 million and k = 1 4. The amount of money demanded is equal to supply when income is $100 million. A reduction of the money supply to $20 million will cause income to decline to a level of $80 million per year.

Figure 3 shows what will happen if income temporarily exceeds the figure of $100 million per year. To the right of Ŷ₀, the amount of money demanded exceeds the existing stock of it. The way for an individual to build up his cash balance is to reduce his disbursements below his receipts. But his spending (to the extent that it is spending on final goods at least) is somebody else’s income. A general attempt to build up cash balances cannot succeed—it does not induce an increase in the money supply in this model—because it will result in a decline of income throughout the system. This decline will continue to whatever level is required to make the nonbanking sector bring the amount of money it demands into line with the amount in existence. An excess demand for money is associated with falling income. Similarly, if the amount of money demanded falls short of the amount supplied, an individual may decide to reduce his cash balance by increasing his disbursements—but the money stays in the system; incomes will rise all around. An excess supply of money is associated with rising income.

The stabilization policy that this model suggests is obvious: if the relationship between income and the demand for money is stable, the system can be maintained in equilibrium by keeping the money supply constant or, in a growing economy, by allowing the money stock to grow at roughly the same rate as real output. If the relationship between income and the demand for money is found to shift about over time, the money stock should be made to grow more rapidly in periods of increasing demand for money and more slowly in periods of decreasing demand.

Although the two models seem to have nothing in common—the crucial variables of one do not even appear in the other—their descriptions of what happens during income level movements are not contradictory. Falling income is associated with an excess supply of goods and services in the income model, with an excess demand for money in the money model. Rising income is associated with an excess demand for goods in the first model, with an excess supply of money in the other. Evidently the two models give only partial descriptions of what is going on: one model looks at the process from the “real” side only and the other from the “monetary” side. But an excess demand for goods on one side will be associated with an excess supply of money on the other, and vice versa, so in this respect the two are consistent.

The controversy between the two schools of thought represented by the models has mainly to do with two issues. One issue is which set of policy instruments—fiscal or monetary—provides the best means of stabilizing the economy. The other, more fundamental, issue concerns the causes of income movements. As seen above, changes in investment were the main cause of income movements in the income model; changes in the money stock were the main cause in the money model. Simplistic as the two models are, they embody the conflicting hypotheses of the two contending schools. Income–expenditure theorists attribute the instability of income primarily to events that influence the business sector’s expectations with regard to the profitability of new investment, thus influencing investment. The modern quantity theorists see the irregular time path of the money stock as the most important factor.

The gross features of economic history do not contradict either hypothesis. Private investment has indeed been the most volatile component of Gross National Product. Similarly, the movements of the money stock have conformed to those of money income: rapid inflation has been associated with a rapid growth of the money supply; severe recessions, with a decline in the money supply; and mild recessions, with a slowdown in the growth of the money supply. (“Mild” recessions may be thought of as recessions during which total employment stagnates, and the growth in unemployment, therefore, is largely due to the growth of the labour force.) The controversy has in large measure come to concern the direction of causation: one side maintains that shifts in investment cause income changes and infers that these in turn induce changes in the money stock which go in the same direction; the other side maintains that changes in the size or rate of growth of the money stock cause income changes that in turn will tend to fall most heavily on the investment component of income.

The problem of resolving this controversy is twofold. First, the theoretical issue is less clear-cut than implied above. Each side acknowledges that neither investment nor the money supply is autonomous and that each affects the other. The question has become, therefore, which model is “most nearly true” and which model, consequently, should be regarded as a “first approximation” in guiding stabilization policy.

Second, the empirical methods at the disposal of economists are not yet adequate for settling such issues. Attempts have been made to compare the performance of the two models by testing whether the best predictions of income are obtained by using actual data for “autonomous expenditures” and assuming that consumption will obey the consumption–income relation that has generally obtained in the past or by using actual money stock figures and assuming that money demand will obey the relation to income that has generally obtained in the past. These attempts have bogged down in disagreements on various statistical matters and must be judged inconclusive. They have shown, however, that even with consumption functions and money demand functions that are a good deal more “reasonable” than the naive relationships above, the predictions of both models are too inaccurate for the purposes of stabilization policy.

Each model emphasizes one set of disturbances (“real” or “monetary”, respectively) that will cause income to change. Each gives a partial view of the process of income-level movements. What is needed, therefore, is a third model explaining the linkages between “real” and “monetary” forces that these two simple models leave out.