bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

98 MONETARY ECONOMICS
money plays in an economy. Rather, the monetary sector is merely added
on to an already-existing real sector and does not modify it in any way.
We noted in 2.2, however, that Irving Fisher’s approach was more complex
than this suggests since he distinguished between transactions related
to national income and those related to financial transactions:
MV = P YY + P F F ...5.3
where Y and F are income and financial transactions respectively. If we
accept this, and still require T to be exogenous and entirely unrelated to M,
we must assume, as we did in the first of our simple models in Section 2.2,
that financial transactions only take place in the pursuit of real ends. That
is, there are no purely financial transactions — a difficult assumption to
maintain even in the 18th century and clearly impossible amidst the speculative
behaviour in modern financial markets. This distinction has largely
been ignored since Fisher’s time. Indeed, most textbook versions of
Fisher’s statement have replaced T with y, excluding the financial sector
from consideration.
A further complexity arises if we pay attention to the precise meaning of
M. M was initially limited to currency (in modern terms, the monetary base
or high-powered money) but was later extended to include bank deposits:
MV C C + MV D D =
PT
...5.4
where the subscripts C and D indicate currency and bank deposits respectively.
M C is the monetary base. V C and V D are assumed to have different
values and so variations in M C/M D lead to changes in P. As long as M C/M
is constant (people hold a constant proportion of their money holdings in the
form of currency), the extension to bank deposits does not change the result.
Although this formulation allows us to consider the possibility of a change
in M undesired by the authorities, even if they were totally in control of M C,
the Quantity Theory has not been used as a vehicle for the examination of
the relationship between the monetary base and the money stock.
According to Fisher, an increase in M C caused prices to rise and hence the
real interest rates to fall. This led to an increase in demand for bank loans
and an increase in M D. Nominal interest rates were pushed up until the real
rate of interest returned to its initial level.
Although V is usually written as a constant, it is affected by changes in
the financial system, in particular by changes in the form in which income
is received and payments are made. Thus, V changes over time (and is dif-