Monetary-disequilibrium theory

Leland Yeager's (1968) understanding of the monetary disequilibrium theory begins with fundamental properties of money. Monetary-disequilibrium is a short-run phenomenon as it contains within itself the process by which a new equilibrium is established i.e. through changes in the price level. If the demand for real balances changes, either the nominal money supply or price level can adjust to monetary equilibrium in the long run as seen from the figure. ==Early monetary-equilibrium theory==

Swedish economist Knut Wicksell (1898) was one of the main propagators of the theory. He was primarily concerned with the behavior of the general price level, as influenced by interest rates. As described by Gunnar Myrdal in 1939, the definition given by Wicksell was based on the existence of three conditions. First, among them is the equivalence of the "natural" rate of interest and the money rate of interest. The second condition of monetary equilibrium is equilibrium in the capital market. That is the equivalence between the supply of and demand for savings. Finally, the third condition of monetary-equilibrium concerns equilibrium in the commodity market defined as stable price level. Myrdal however has a different stand all together on this. He does admit the possibility that an increase in savings might decrease the money interest rate thereby increasing the investment but does think this to be a very strong factor and therefore misses the equilibrating function of the interest rates in the capital market. Two important points regarding monetary-equilibrium needs to be stated. First, there is no necessary relationship between monetary and general equilibrium. It is totally compatible with disequilibria in various markets for goods and services. Second, monetary-equilibrium can be seen as a desirable policy goal by monetary regimes. ==Monetary-equilibrium in the Austrian school==

The concept of monetary-equilibrium is basically a European one. Much of the work on this doctrine has been done by Swedish, British and Austrian economists. The whole approach begins with the work of Knut Wicksell in the development of the concepts of natural and market rates of interest. Wicksell believed that if the two rates are equal then the price level will be constant and any difference in the two rates will manifest themselves as changes in the value of money. Wicksell's work had a clear Austrian connection as he relied on Eugen Ritter von Böhm-Bawerk's theory of capital in developing the concepts. The representative of the British monetary-equilibrium approach was mainly Dennis Robertson. Mises relationship to the theory is ambiguous. According to Ludwig von Mises, monetary equilibrium happens first at the individual level. Each actor wants to keep a cash balance on hand for future transactions, say, both planned and contingent. This desired money balance of the individual constitutes his money demand and is based on his subjective valuation of holding money compared to their valuation of obtaining more goods and services. The amount of the money that the individual possess is his supply of money. Individuals will try to equate their desired and actual cash holdings through their spending behavior. ==Synthesis of the Yeager and Austrian theory==

Monetary disequilibrium theory has always been a part of the Austrian monetary theory. Significant features of the monetary-disequilibrium theory except the inclusion of the stable price level have been present in the Austrian theory for a long time. Mostly modern Austrian economists emphasize the effects of inflation more than the harm caused by rapid deflation. This is mainly because inflation is a more immediate problem in the current system and deflation is a result of prior inflation. ==Monetary-equilibrium, loanable funds and interest rates==

In case of loanable funds market, we need to discuss to concepts ex-ante and ex-post. Ex-ante is what people desire, and ex-post is what happens in the market process. In case of market equilibrium what demanders wish to do is exactly equal to what suppliers wish to do. This has been shown in the figure. The equilibrium here is ex-ante. However, it does not guarantee that ex-post will match it especially if entrepreneurs are prevented from finding the price that will bring equilibrium in the market. Let us take the case of price ceiling. At that price quantity demanded will exceed the quantity supplied resulting in an ex-ante disequilibrium. If the market process proceeds in this scenario, we will see that the amount bought equals the amount sold and there is an ex-post equality. This happens because demanders are unable to make their demands effective due to the price ceiling. In loanable funds market equilibrium ex-ante plans of savers and investors match precisely. The monetary equilibrium has implications for the rate of interest as there is a distinction between market rate of interest and natural rate of interest. The market rate of interest is the rate that the banks are actually charging in the loanable funds market while natural rate of interest corresponds to the time preferences of savers and borrowers as expressed in demand-supply presentation for loanable funds (r* in the figure). The monetary system is not a source of disturbance when there is monetary equilibrium but at the time of monetary disequilibrium the system becomes a source of disequilibrium by distorting the sources generated during the process of turning time-preferences into the demand and supply for loanable funds. For ex-ante and ex-post quantities to be equal someone has to lose out. In addition, the adjustment process entails significant social costs. Now, let us suppose there is an excess supply in the market. Banks will create more loanable funds than people's real willingness to save as determined by their time preferences. This will result in a fall in the market rate of interest as banks will try to lure new borrowers with their excess money supply, but the natural rate remains the same as no additional supply of loanable funds have come from the public. ==Monetary equilibrium, classics and Keynes==

The monetary-equilibrium framework is in some ways not at all different from the classical model. The three central theories of the classical school are Say's law, quantity theory of money and the role of interest rates. Say's law (supply creates its own demand) implies that aggregate supply would always be equal to aggregate demand. The argument was that the sales of goods in the market produces the necessary income to buy that supply. This view was a part of the belief in laissez-faire that government intervention is not required to prevent general shortages. Say's law finds its most accurate expression in monetary equilibrium. In monetary-equilibrium, production is truly the source of demand but if there is an excess demand for money this does not happen as some potential productivity has not been translated into effective demand. If there is an excess supply of money then demand comes not only from previous production but also from the possession of the excess supply. The quantity theory of money explained the general price level whereas other microeconomic factors explained relative prices. With relative prices being explained by resources and tastes, the possibilities of shortages excluded by Say's law and quantity theory of money being explained by the price level, the only missing factor was the intertemporal exchange. Example In the simplest model, income Y is made up of either Consumption (C) or Saving (S) while expenditure (Yi) were either on consumption or investment goods. Here, we ignore government and foreign trade. This can be seen from equation 1. Now, if the preferences of the income earners shift towards the future resulting in a fall in C and increase in S as shown in equation 2. In the simple classical model increase in savings cause a fall in the interest rates thereby inducing additional investment expenditure. This increase in Investment (I) implies a fall in (C) on the expenditure side as shown in equation 3. As given Ci= Ce, the increase in investment is equal to the increase in savings and a shift in intertemporal preferences does not disrupt the equality between income and expenditure and also there is no change in income. (Equation4) :1. Yi = Ci + S = Ye= Ce+ I. :2. Yi = C↓+S↑ :3. Ye = Ce↓+I↑ :4. If S = I then Yi = Ye. Thus, we can see that monetary-equilibrium shares a lot with the classical model. ==Problems with monetary-disequilibrium theory==

• According to Yeager, monetary-disequilibrium is a part of the monetarist tradition which states that "money matters the most" which cannot be true as in terms of economic analysis actors matter most. • The static definition of equilibrium at the heart of monetary-disequilibrium theory is flawed as he uses a very neoclassical definition on the macro-economic level i.e. he talks about constant price level. • Yeager does not take into consideration that business cycles start not just with monetary-disequilibrium but happen when that disequilibrium enters the market for loanable funds and produces disequilibrium there, such that the supply of lonable funds exceeds real savings. • As the name suggests the monetary-disequilibrium theory is a strictly monetary explanation of a set of economic phenomenon. It does not take into account the real economic factors like real savings or market processes that influence business cycles. ==Footnotes==