bain_y_howells__monetary_economics__policy_and_its_theoretical_basis

instability is compatible with long run stability. Further, long run studies
(which typically use annual observations or temporally averaged data) face
problems because the definitions of many of the variables change over time.
Some elements omitted from the equation because they are assumed constant,
such as payment systems, do change over time. In any case, the distinction
between long run and short-run studies is arbitrary. There is no theoretical
definition of the long run in macroeconomics other than the period
necessary for the economy to return to equilibrium — a definition that is
useless for empirical work.
What can we learn from testing?
One result of these problems is that the standard regression equation used in
demand for money testing makes relatively little use of theory beyond taking
as a starting point the need to include both an income term and an interest
rate term. It is hard, therefore, to argue that it is the theory being tested.
Rather, we start with a view of the world that leads to a belief in a stable
relationship between the demand for money and real income and we seek to
confirm this. Failure to do so does not produce a re-evaluation of the theory
or a change of world view but a determination to change the equation and
try again. A chapter on the testing of the demand for money in a recent
book (Handa, 2000) contains the sub-heading, ‘The desperate search for a
stable money demand function’. This is an accurate description of much
that has gone on. None the less, let us look at the results of all this endeavour.
6.3 Early demand for money studies
TESTING THE DEMAND FOR MONEY 143
Before Keynes’s General Theory, estimates were made of the velocity of
circulation over long periods, with the aim of relating changes in long-run
velocity to institutional changes (fitting in with the classical quantity theory
of money). After the publication of The General Theory, attempts were
made to show a positive relationship between interest rates and velocity
(and thus an inverse relationship between interest rates and the demand for
money). The aim was to demonstrate that an increase in the money stock
would produce a fall in velocity, reducing the impact on nominal income.
Other studies (Tobin, 1947; Bronfenbrenner and Mayer, 1960) sought to
distinguish between idle and active balances and then to relate idle balances
to interest rates, on the assumption that interest rates only influenced idle
balances and had no role to play in the transactions or precautionary