Lecture 1: Theories of the Influence of Money on Prices

Hayek uses the first lecture in Prices and Production to lay out what he sees as the developmental trajectory of monetary theory, as well as an introduction to the advances he proposes to make in subsequent lectures. He identifies four stages of theory, the last of which is said to be in its infancy in 1931, when Hayek wrote the lectures.

The first stage is more or less what most people know of as the quantity theory of money. Hayek has two primary critiques of this approach: it is analytically problematic, and even if it weren't problematic it is practically useless. I think Hayek errs on both of these points (which is not to say that I disagree with him that monetary theory could be developed beyond the quantity theory). First, Hayek suggests that "none of these magnitudes as such ever exerts an influence on the decisions of individuals; yet it is on the assumption of a knowledge of the decisions of individuals that the main propositions of non-monetary theory are based". In this sense, Hayek sees a divorce between monetary theory and what we would know as microeconomics. He continues, "if, therefore, monetary theory still attempts to establish causal relations between aggregates or general averages, this means that monetary theory lags behind the development of economics in general. In fact, neither aggregates nor averages do act upon one another, and it will never be possible to establish necessary connections of cause and effect between them as we can between individual phenomena".

Towards the end of his discussion of the first stage, Hayek writes that "you are all sufficiently familiar with this type of theory to supply these [examples] for yourselves and to correct any exaggerations which I may have committed", and so I'll take him up on this and correct some exaggerations. What Hayek appears to miss here is that the quantity theory is useful not as a behavioral law or a statement of causal relations, but simply as a statement of accounting. If you take all the prices charged in an economy and add them up, and then take all the instances that a particular piece of money in the economy was spent and add all those up, the two sums have to be equal to each other. This is a definitional constraint on the system. Think of it as analogous to the "conservation of energy" in physics. On its own, the conservation of energy doesn't tell you anything about cause and effect, and it doesn't tell you about the dynamics of a particular system. Its power is in parameterizing the system so that when action does occur as the effect of some other cause, that action is forced to conform to the conservation of energy, and so the conservation of energy is a useful principle in understanding how cause and effect play out in physical systems. The same is true of the quantity theory of money. Hayek fundamentally misunderstands the very purpose of these theories if he thinks they imply some sort of causal relationship.

The second thing that Hayek critiques about this first stage is his claim that anything that the quantity theory can tell us is relatively useless. He writes "for none of these magnitudes as such ever exerts an influence on the decisions of individuals; yet it is on the assumption of the knowledge of individuals that the main proposition of non-monetary economic theory are based". This seems odd. The various problems associated with inflation and deflation are very well understood, and were most definitely understood when Hayek wrote these lectures. Fisher had not yet written his famous article on debt-deflation theory, but I don't think anyone has claimed that these ideas were especially original to Fisher. Keynes wrote extensively on the differential impact of inflation and deflation in 1923, and I know Hayek read that book. Debt-deflation, the differential impact of deflation on quits and layoffs, the differential impact on the distribution of wealth and the implications for demand, etc., can't be investigated by asking "what does the price do in this particular market - how do relative prices change?". These things can only be investigated by asking "what happens to the general price level?". So on both counts, I think Hayek is quite misguided in his critique of the "first stage" of monetary theory, although he's certainly right that there is more to be said.

The second stage Hayek identifies is the attempt by Locke, Montanari, Cantillon, and others to trace the path through which an increase in the money supply affects prices. The modern equivalent is something like the "monetary transmission mechanism", which has been so central to Ben Bernanke's own research (back when he did research!). He has a few other things on his plate right now, but even now this transmission mechanism problem has played a substantial role in how he has handled his tenure as Fed chairman relative to Greenspan. I was very interested in this section of Hayek's lecture to see some vague allusions to a long-run vs. short-run Phillip's Curve relationship: "Hume, however, makes it clear that, in his opinion, "it is only in this interval or intermediate situation, between the acquisition of money and the rise of prices, that the increasing quantity of gold and silver is favourable to industry".

The third stage of the development of monetary theory was the link between money and the interest rate. Hayek attributes this insight to many people, including Malthus, Mill, Bentham, etc. - but of course it is found in its most developed form in the hands of Knut Wicksell. Hayek muses that "by a curious irony of fate, Wicksell has become famous, not for his real improvements on the old doctrine, but for... his attempt to establish a rigid connection between the rate of interest and the changes in the general price level." This was interesting to read because I know Wicksell best for his "natural rate of interest" and loanable funds market theory of interest work, and not for whatever this other point is that Hayek is refering to. Clearly, the discipline has recognized in Wicksell as important exactly what Hayek recognized as important in 1931. That's encouraging! In 1931, Hayek felt that Wicksell was being acknowledged for the wrong thing, but now in 2010 we all acknowledge Wicksell for the work that Hayek thought was important.

I have another critique of Hayek here - I think he is far too hard on Wicksell when it comes to equilibrium and the price level. Hayek writes "according to Wicksell, the equilibrium rate of interest was a rate which simultaneously restricted the demand for real capital to the amount of savings available and secured stability of the price level" - taking issue with this position, Hayek counters that "the banks could either keep the demand for real capital within the limits set by the supply of savings, or keep the price level steady; but they cannot perform both functions at once. Except in a society in which there were no additions to the supply of savings, i.e., a stationary society, to keep the money rate of interest at the level of the equilibrium rate would mean that in times of expansion of production the price level would fall." Hayek's analysis here is right, of course, but I think his critique of Wicksell is misguided. Wicksell provides us with a loanable funds market equilibrium, right? The equilibrium position assumes a given demand for and supply of loanable funds. Of course if there is an "expansion of production the price level will fall", as Hayek says - but the whole point is if there is an expansion of production there will be a shift in the demand for loanable funds and there will be a new loanable funds market equilibrium. Imagine if you were describing a market for food and you noted that where supply and demand met you had an equilibrium price where the real price level would be stable. Hayek here is saying "well that doesn't make sense because if you make more bread the price level will fall!". Certainly it will, but that's because the supply curve has shifted. So, just as I would not take his critique of the quantity theory very seriously, I would not take his critique of Wicksell very seriously. There are ways to complicate and add to the loanable funds market, but there's nothing fundamentally wrong with it.

The fourth stage of the development of monetary theory is of course Hayek's turf: the impact of changes in the quantity of money on relative prices, particularly prices of the same good over time. I can't argue with the fact that this is one avenue to develop. I've never accused this version of ABCT of being illogical. Hayek is a little vague on why exactly this is such an important culmination of prior monetary theory. It appears to me to be an interesting side-issue to look into, not a conclusion towards which monetary work was naturally heading. But of course, my bias in this regard is probably obvious. If you asked a group of people reasonably well educated in the history of economic thought "which early twentieth century economist earned his fame for his work bringing monetary economics into mainstream economic theory", the answer would not be Hayek. The answer, in all likelihood, would be Keynes. This is not to say that Keynes invalidates Hayek's work. This was, at it's core, both of their projects. They both sought to make monetary theory relevant for the broader world of economic theory. My feeling is that Hayek took this project down a detour. It is an interesting detour and probably an accurate detour, but a much less significant path than the path that Keynes took. This seems to be the assessment of Hayek and Keynes's peers and descendants as well. Money is important because it is the medium through which demand is translated into effective demand, and the quantity of circulating medium substantially influences the efficacy of demand in stimulating production. I don't want to make this a post about Keynes, but the similarity between their missions was absolutely unmistakable in reading this first lecture.

I guess my lingering question is "why is this the fourth stage, other than because Hayek is writing about it and he wants to put it in the context of earlier stages?" Any answers? Why should I care more about relative prices than about the impact of money on effective demand?

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Other discussions of Hayek's first lecture tied into our reading group (graciously organized by Jonathan Catalan) can be found here, here, and here. Please let me know if I've missed one.