Monetary-disequilibrium Theory - History of The Concept

History of The Concept

Leland Yeager's (1968) understanding of the monetary disequilibrium theory begins with fundamental properties of money.

Money is the generally accepted medium of exchange is one among the most important properties. The other two properties that Yeager emphasized are that the demand for money is a demand to hold real money balances and that the acquisition of money has a "routinenss" to it that distinguishes it from other goods. He actually made effective use of the cash balance approach to the demand for money. When we combine these two properties we get a distinction between actual and desired money balances. The differences between individuals' actual and desired holdings of money are the proximal causes of them affecting the level of spending in the macroeconomy. These differences between actual and desired money balances appear economy-wide when we have inflation or deflation.

It presents an alternative to the real business cycle model and the quantity theory of money considered only a long-run theory of the price level. While it is widely agreed in economics that monetary policy can influence real activity in the economy, real-business-cycle theory ignores these effects. The theory also addresses the effects of monetary policy on real sectors of the economy, that is, on the quantity and composition of output.

Monetary-disequilibrium theory states that output, not (or not only) prices and wages, fluctuate with a change in the money supply. To that degree, prices are represented as sticky. It is this “monetary disequilibrium,” that, the theory contends, affects the economy in real terms. Thus, changes in the money supply will result first in a change of output in the same direction, as distinct from merely a change in prices. Consequently, an increase in the money supply will induce workers and businesses to supply more, without being fooled into doing so. In a situation where the money supply contracts, businesses will respond by laying off workers. In this way, the theory accounts for involuntary unemployment. The disequilibrium between the supply and demand for money exists as long as nominal supply does not adjust automatically to meet the nominal demand. 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.Now, if the demand for real balances change either the nominal money supply or price level can adjust the monetary equilibrium in the long run as seen from the figure. From the definition of monetary-disequilibrium movements in the demand for money are responded to the changes in the real money supply through adjustments in the nominal money supply as seen from the movement fro point O to A in the figure and not the price level (movement from O to A' in the figure).

The demand for money means demand to hold real cash balances. If the money supply is increased to an amount beyond which the public desires to hold (from MS to MS'), this is interpreted as a movement from O to A, as illustrated in our figure. With the increase in supply of money, people find themselves with larger money balances than they wish to hold and thus reside temporarily at point A. If we assume that there has been no change in the demand for money, these excesses will be spent on goods, services or financial assets thereby increasing their prices, leading to a movement from point A to new equilibrium point B. The increase in the aggregate price level (P* < P') is associated with excess supplies of money which reflects these individual increases. The price level continues to rise with the increase in spending of the excess money balances and eventually reaches point B where the higher nominal supply of money is held at higher price (1/P', where P' > P*). In the long run any supply of money is a equilibrium supply. The long-run movement from equilibrium O to B is shown in the figure.