The Quantity Theory in the Cambridge Marshallian Tradition in the Late 1800s

In what follows I give a brief overview of Alfred Marshall’s development of the quantity theory in the late 1800s on the basis of the discussion in Laidler (1991).

In Classical Political Economy, the long-run value of gold money was thought to be determined by the cost of production of gold (Laidler 1991: 51). It was only in the short-run that the quantity theory was used to explain the value of money and hence the price level (Laidler 1991: 51).

Curiously, the quantity theory of money was deployed by bimetallists and opponents of the gold standard in the 1873 to 1896 period (Laidler 1991: 50). This use of the quantity theory by bimetallists actually caused the quantity theory to be brought into some disrepute in this period, and advocates of the gold standard and sound money started to look on it with some suspicion (Laidler 1991: 52).

Alfred Marshall actually sketched an early version of the Cambridge Cash Balance Equation in an unpublished paper of 1871 called “Money” (Marshall 1975 [1871]), and later in his paper “Remedies for Fluctuations in General Prices” (Marshall 1887), and in his testimony before the British “Royal Commission on the Value of Gold and Silver” (1888–1889) and the Indian Currency Committee (1899) (Laidler 1991: 53). Hence before the early 20th century Marshall’s teachings on the quantity theory were mainly oral (Laidler 1991: 53). Marshall did, however, publish his views late in life in his book Money, Credit and Commerce (1923).

We can set out the published sources of the early Marshallian quantity theory tradition, as follows (in chronological order):

Marshall, Alfred. 1975 [1871]. “Money,” in J. K. Whitaker (ed.), The Early Economic Writings of Alfred Marshall, 1867–1890. Macmillan for the Royal Economic Society, London.

Marshall, A. 1887. “Remedies for Fluctuations in General Prices,” Contemporary Review 51: 357–375.

Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888.

Keynes, J. M. 1911. Review of The Purchasing Power of Money: Its Determination and Relation to Credit, Interest, and Crisis by Irving Fisher, Economic Journal 21.83: 393–398.

Pigou, Arthur Cecil. 1912. Wealth and Welfare. Macmillan, London.

Pigou, A. C. 1917. “The Value of Money,” The Quarterly Journal of Economics 32.1: 38–65.

Marshall, A. 1923. Money, Credit and Commerce. Macmillan, London.

Marshall’s 1871 paper “Money” was a basic statement of his teaching right down to 1906 (Laidler 1991: 56).

Marshall inherited the quantity theory from Classical economics, and in particular from John Stuart Mill’s writings (Laidler 1991: 54). But Marshall introduced the stock demand for money into consideration as a determinant of money’s value, and downgraded the importance of commodity money’s cost of production as a factor determining its value (Laidler 1991: 54–55).

In explaining the price level, a greater emphasis was put on variations in the demand for currency by the Marshallians (Laidler 1991: 56).

Marshall also understood the limitations of the ceteris paribus assumption in the quantity theory and thought that factors other than money supply changes were probably more influential in causing price level changes:

[sc. Question:] 9629. To pass now to the question which has been raised of the dependence of prices upon the quantity
of the currency, what observations have you to make? …

[sc. Marshall’s answer:] I accept the common doctrine that prices generally rise, other things being equal, in proportion to the volume of the metals which are used as currency. I think that changes in the other things which are taken as equal are very often, perhaps generally, more important than the changes in the volumes of the precious metals.A question was asked by the Commission some time ago as to the dependence of prices upon the amount of the precious metal which was used as the standard of value. I object to make any such distinction. I believe that the shillings and half-crowns in circulation have just the same effect upon prices as they would have if they were legal tender; I believe that four half-crowns affect prices exactly in the same way as a half sovereign does. But putting that aside, I think that we have not the statistics, and that we shall not, in this generation, be able to get the statistics which would enable us to trace any statistical connexion between the amount of the precious metals, or, as I would prefer to say, between the amount of currency and the average level of prices; because, supposing that the volume of the currency remains the same, the height of average prices may yet vary in consequence of several causes. The first of these is a change in the volume of things on sale, and with regard to that no doubt we have fairly good statistics. The second is an increase or diminution in the average number of times each of these things changes hands during the year, and with regard to that we have no statistics whatever; indeed, there has never been any attempt to obtain statistics on the subject. The third cause is the average number of times that each coin or each element of the currency changes hands during the year; on that subject also there are no statistics. The last cause is the proportion which purchases otherwise than by currency bear to purchases by means of currency; on that subject I think we have no statistics which are in the least trustworthy, although, of course, a great many people have given guesses of more or less value. It seems to me that it is an insufficient account to say that average prices depend on the amount of the currency combined with the amount of credit. For without any change in the amount of the currency the average level of prices might be altered, not only by a change in the proportion of credit to other means of purchasing, but also by any other change in the methods of business, as for instance the growth of intermediaries.”
Alfred Marshall’s testimony, Minutes of Evidence taken before the Royal Commission on Gold and Silver. Forty-third Day, 19th December 1887 in Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888. p. 2.

Laidler notes that Marshall and the Cambridge Marshallians eventually de-emphasised and abandoned the velocity of circulation concept as an important concept in the quantity theory (Laidler 1991: 59). Instead, the important concept was the money people choose to hold as a stock (Laidler 1991: 59), or the cash balance which would become the variable k in the Cambridge Cash Balance Equation.

BIBLIOGRAPHY
Final Report of the Royal Commission Appointed to Inquire into the Recent Changes in the Relative Values of the Precious Metals; With Minutes of Evidence and Appendixes. Eyre and Spottiswoode, London, 1888.
https://archive.org/details/cu31924030184745

Keynes, J. M. 1911. Review of The Purchasing Power of Money: Its Determination and Relation to Credit, Interest, and Crisis by Irving Fisher, Economic Journal 21.83: 393–398.

Laidler, David E. W. 1991. The Golden Age of the Quantity Theory: The Development of Neoclassical Monetary Economics 1870–1914. Harvester Wheatsheaf, New York and London.

Marshall, A. 1887. “Remedies for Fluctuations in General Prices,” Contemporary Review 51: 357–375.

Marshall, A. 1923. Money, Credit and Commerce. Macmillan, London.

Marshall, Alfred. 1975. The Early Economic Writings of Alfred Marshall, 1867–1890 (ed. by J. K. Whitaker). Macmillan for the Royal Economic Society, London.

Marshall, Alfred. 1975 [1871]. “Money,” in J. K. Whitaker (ed.), The Early Economic Writings of Alfred Marshall, 1867–1890. Macmillan for the Royal Economic Society, London.

Pigou, Arthur Cecil. 1912. Wealth and Welfare. Macmillan, London.

Pigou, Arthur Cecil. 1917. “The Value of Money,” The Quarterly Journal of Economics 32.1: 38–65.

“In the Long Run we are all Dead”: What Did Keynes Mean by That?

So Niall Ferguson made a fool of himself in recent remarks about Keynes. Ferguson’s comments are not a new charge: the egregious and laughable Austrian Hans-Hermann Hoppe put his foot in his mouth and said virtually the same thing as well some years ago.

Apart from the fact that Keynes appears to have been bisexual, not exclusively homosexual, and apparently lived as a normal married man who was romantically and sexually attracted to his wife Lydia Lopokova after his marriage, the various other ideas dragged up by Ferguson are wrong on so many levels.

The most important issue is, quite simply, Keynes was not indifferent to the long run at all. Ferguson, Hoppe, and a long line of other idiots hostile to Keynes do not know what they are talking about.

All the controversy comes from Keynes’s assertion that “in the long run we are all dead.” This is a statement lifted from Keynes’s A Tract on Monetary Reform (1923) that is often taken out of context and misunderstood, as Matias Vernengo argues here.

When Keynes wrote A Tract on Monetary Reform, he was still a believer in the truth of the quantity theory of money, and stated that its “correspondence with fact is not open to question” (Keynes 1923: 74). Keynes even thought that

“… money as such has no utility except what is derived from its exchange-value, that is to say from the utility of the things which it can buy” (Keynes 1923: 75).

Keynes then proceeded to defend the quantity theory and the direct relation “between the quantity of cash … and the level of prices” (Keynes 1923: 78). So Keynes was not even a “Keynesian” when he wrote these words.

In his discussion of the quantity theory in A Tract on Monetary Reform, Keynes uses the following equation:

n = p(k + rk′),

where
n = quantity of money, or currency notes or other forms of cash in public circulation;
p = the index number of the cost of living;
k = consumption units of cash on hand;
k′ = money people want to be available in banks in the form of their demand deposits or checking accounts;
r = cash reserves of the banks.

In this version, Keynes thinks that as long as k, k′ and r remain unchanged, if n rises, then p will rise too (Keynes 1923: 77).

Both k and k′ appear to be roughly the equivalent of k_d in the Cambridge Cash Balance equation (see Appendix below).

Shortly after this discussion comes the famous passage:

“The error often made by careless adherents of the Quantity Theory, which may partly explain why it is not universally accepted, is as follows. Every one admits that the habits of the public in the use of money and of banking facilities and the practices of the banks in respect of their reserves change from time to time as the result of obvious developments. These habits and practices are a reflection of changes in economic and social organisation. But the theory has often been expounded on the further assumption that a mere change in the quantity of the currency cannot affect k, r, and k′, — that is to say, in mathematical parlance that n is an independent variable in relation to these quantities. It would follow from this that an arbitrary doubling of n, since this in itself is assumed not to affect k, r, and k′, must have the effect of raising p to double what it would have been otherwise. The Quantity Theory is often stated in this, or a similar, form.

Now ‘in the long run’ this is probably true. If, after the American Civil War, the American dollar had been stabilized and defined by law at 10 per cent below its present value, it would be safe to assume that n and p would now be just 10 per cent greater than they actually are and that the present values of k, r, and k′ would be entirely unaffected. But this long run is a misleading guide to current affairs. In the long run we are all dead. Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is long past the ocean is flat again.” (Keynes 1923: 79–80).

In other words, the famous “in the long run we are all dead” statement was about the long run and short run effects as predicted by the quantity theory, not about deficit spending or Keynesian stimulus.

In essence, Keynes’s passage boils down to the instability of the demand to hold money.

Keynes concluded that the quantity of money and the cash reserves of the banks are “under the direct control (or ought to be) of the central banking authorities” (Keynes 1923: 84).

In contrast, the money that people desire to hold either as (1) cash on hand or (2) in the form of demand deposits or checking accounts changes, and is not under the control of the central bank. The latter “depends on the mood of the public and the business world” (Keynes 1923: 84).

So Keynes concludes:

“The business of stabilising the price level, not merely over long periods but so as also to avoid cyclical fluctuations, consists partly in exercising a stabilising influence over k and k′, and, in so far as this fails or is impracticable, in deliberately varying n and r so as to counterbalance the movement of k and k′.

The usual method of exercising a stabilising influence over k and k′, especially over k′, is that of bank-rate. A tendency of k′ to increase may be somewhat counteracted by lowering the bank-rate, because easy lending diminishes the advantage of keeping a margin for contingencies in cash. Cheap money also operates to counterbalance an increase of k′, because, by encouraging borrowing from the banks, it prevents r from increasing or causes r to diminish. But it is doubtful whether bank-rate by itself is always a powerful enough instrument, and, if we are to achieve stability, we must be prepared to vary n and r on occasion.

Our analysis suggests that the first duty of the central banking and currency authorities is to make sure that they have n and r thoroughly under control. For example, so long as inflationary taxation is in question n will be influenced by other than currency objects and cannot, therefore, be fully under control; moreover, at the other extreme, under a gold standard n is not always under control, because it depends on the unregulated forces which determine the demand and supply of gold throughout the world. Again, without a central banking system r will not be under proper control because it will be determined by the unco-ordinated decisions of numerous different banks.

At the present time in Great Britain r is very completely controlled, and n also, so long as we refrain from inflationary finance on the one hand and from a return to an unregulated gold standard on the other. The second duty of the authorities is therefore worth discussing, namely, the use of their control over n and r to counterbalance changes in k and k′. Even if k and k′ were entirely outside the influence of deliberate policy, which is not in fact the case, nevertheless p could be kept reasonably steady by suitable modifications of the values of n and r.

Old-fashioned advocates of sound money have laid too much emphasis on the need of keeping n and r steady, and have argued as if this policy by itself would produce the right results. So far from this being so, steadiness of n and r, when k and k′ are not steady, is bound to lead to unsteadiness of the price level. Cyclical fluctuations are characterised, not primarily by changes in n or r, but by changes in k and k′. It follows that they can only be cured if we are ready deliberately to increase and decrease n and r, when symptoms of movement are showing in the values of k and k′.” (Keynes 1923: 85–86).

So what we have here is Keynes the quasi-monetarist advocating short-term monetarist solutions to changes in the demand to hold money. To avoid destabilising price level shocks, Keynes argued that the bank rate must be changed.

The neoclassical theory held that in the long run markets would adjust and return to full employment equilibrium in response to shocks, and Keynes seems to have agreed, but – like other Marshallian neoclassicals – argued that short term pain from the destabilising forces of deflation during recessions was unnecessary and monetary interventions should be used to stabilise economies.

Nor was Keynes ignoring the “long run” in his discussion: the whole point, as Matias Vernengo argues, is that “action in the short run facilitates the road towards the fully adjusted equilibrium in the long run.”

Appendix
Keynes’s formulation of the quantity theory is different from the Cambridge Cash Balance equation:

M = k_d PY

where M = quantity of money;
k_d = the demand to hold money per unit of money income;
P = the price level
Y = the volume of all transactions that enter into the value of national income (goods and services).

M and P are causally related, if k_d and Y are constant (Thirlwall 1999).

BIBLIOGRAPHY
Amadeo, Edward J. 1989. Keynes’s Principle of Effective Demand. Edward Elgar, UK and Brookfield, VT.

Keynes, John Maynard. 1923. A Tract on Monetary Reform. Macmillan, London.

Thirlwall, A. P. 1999. “Monetarism,” in P. Anthony O’Hara (ed.), Encyclopedia of Political Economy: L–Z. Routledge, London and New York. 750–753.