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nently to their cash balances. Equilibrium between the supply of and demand
for money will not be restored until spending, prices and income have increased
sufficiently to make people desire cash balances totaling the entire expanded
money supply.
Empirical evidence of moneys influence on spending, income and prices
appears not only in the everyday decisions of people and business firms but
also in historical events, in experience covering centuries in time and spanning
the globe in space (Friedman, 1959a [1969], p. 136). The role of money in
classic hyperinflations and severe deflations is unmistakable. Even in prisonerof-war camps during World War II, increases and decreases in the quantity of
cigarettes, which served as money, resulted in effects described by the quantity
theory (Radford, 1945; recall Chapter 2, pages 256).
Brunner coined the term monetarism and expressed the core of the doctrine
in three propositions (1968, p. 9):
First, monetary impulses are a major factor accounting for variations in output,
employment and prices. Second, movements in the money stock are the most reliable
measure of the thrust of monetary impulses. Third, the behavior of the monetary
authorities dominates movements in the money stock over business cycles.

Brunner cites empirical support for these hypotheses in the research of

Brunner and Meltzer, Cagan (1965), and Friedman and Schwartz (1963). Clark
Warburton really belongs on the list (many of his articles, dating from 1945, are
collected in his book of 1966), and much work done since Brunner wrote in
1968 has further supported monetarist propositions.
Monetarism has often been identified with several other beliefs. However,
we prefer to focus on Brunners original propositions, which accord with the
monetary-disequilibrium hypothesis set forth and documented by Clark
Warburton.

THE MONETARY TRANSMISSION MECHANISM:

ELABORATION OF THE WICKSELL PROCESS
We are concerned here with the question of how changes in the money supply
affect nominal income, postponing until Chapters 6, 7 and 8 the question of
how changes in nominal income are split between changes in prices and changes
in output. A change in the money supply can affect spending and income both
directly and indirectly through the Wicksell Process. In what follows we assume
three types of goods: (1) money; (2) newly produced commodities, interpreted
to include services and labor and (3) nonmoney assets, physical as well as
financial. We also suppose the money supply decreases. In the direct channel

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of the Wicksell Process, people and firms try to restore what they consider
deficient money holdings by straightaway decreasing their demand for commodities. The indirect channel operates when people and firms try to restore
their deficient money holdings by selling assets, thereby raising interest rates
and lowering asset prices, and when people and firms decrease their demand
for commodities in response to the increased rates (rather than directly in
response to the perceived deficiency of cash balances). Mishkin (1995, pp. 310)
surveys the main types of monetary transmission mechanisms found in the
literature. None portray changes in the money supply as affecting aggregate
demand and income through the direct channel of the Wicksell Process. The
Federal Reserve Bank of St Louis Review of May/June 1995, devoted entirely
to the channels of monetary policy, also ignores the direct channel. Similarly,
the Federal Reserve Bank of New York Economic Policy Review (May 2002)
presents the proceedings of its conference on financial innovation and monetary
transmission. The overview or survey article (Kuttner and Mosser, 2002,
pp. 1526) does not mention the direct channel even while supposedly
presenting all the major channels of monetary transmission found in the
literature. It does, however, speak of a monetarist channel, which focuses on
changes in relative asset prices. The authors also recognize an exchange rate
channel and the empirical difficulties of pinning it down.
We acknowledge that several subchannels exist through which monetary
policy can affect nominal income, as these publications illustrate. We choose,
however, to focus on the two channels of the Wicksell Process. Besides these
channels, a complete presentation of the Wicksell Process recognizes two other
effects of each channel besides the one Patinkin (1965) emphasizes in discussing
his real-balance effect, also known as the wealth effect or Pigou effect. Real
money balances form part of their holders wealth, and a decrease in them,
other things being equal, makes their holders less eager to buy commodities
and nonmoney assets. This is true, anyway, of so-called outside money, money
not matched by private debt. Prime examples are commodity money and
government fiat money. Inside money has less claim to being counted as part
of private sector net wealth, since it is matched by private debt. The prime
example is banknotes and deposits created in connection with loans to private
borrowers.8 Although the Pigou effect was originally thought of as working
through price deflation (Pigou, 1943, 1947; Haberler 1952), later writers
including Patinkin broadened the concept to cover as well a change in the real
money supply brought about through a change in the nominal money supply or
increase in prices.
Patinkin does not describe two other effects of the Wicksell Process not
explicitly, anyway. A second might be called the Cambridge effect, referring
to Cambridge k, the inverse of desired velocity (see pages 911 above). The
idea, though not the name, comes from Sir Dennis Robertson (1963,

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pp. 4434).9 People hold money largely for transactions purposes and are
concerned with the size of their cash balances relative to income and expenditure. A decrease in the relative size of these balances, whether through a
decrease in the nominal quantity of money or a rise in the prices at which income
and expenditure flows are evaluated (or through a rise in real economic activity)
would make people feel that they were holding too little money and so make
them less willing to buy commodities and nonmoney assets and more willing
to sell.
A third effect, the portfolio-balance effect, hinges on peoples concern for the
composition of their asset holdings (both money and nonmoney). The internal
rate of discount (IRD) or marginal rate of time preference also enters into the
analysis, which Chapter 2 discusses at length. Here we briefly review it. Suppose
people start with portfolios they consider satisfactory and then experience a
decrease in moneys share in them, whether through a decrease in the nominal
quantity of money or a general rise of prices. People find that their portfolios
contain relatively too little money. In accordance with the principle of diminishing marginal yield, their MERs on money are now above the MERs on
nonmoney assets and above their IRDs. People set about trying to replenish
their cash balance holdings by buying fewer commodities and nonmoney assets
and by selling more. The operation of this portfolio-balance effect (like the
Cambridge effect, if not the wealth effect) does not seem to hinge on whether
money is of the outside or inside type.
Chapter 2 differentiates the portfolio-balance effect, whereby changes in the
money supply can affect spending and income through both the direct and
indirect channels, from the portfolio-adjustment models found in the literature.
In almost all of these models monetary policy affects spending and income
only indirectly, by changing interest rates and asset prices, including the prices
of existing real (physical) assets relative to the costs of producing them new
(see pages 456 above).
A total of six aspects of the Wicksell Process exist: the direct and indirect
channels, each operating through the wealth, portfolio-balance and Cambridge
effects. In the operations of the direct channel, people try to remedy what they
consider excessive or deficient cash balance holdings by straightaway (directly)
altering their behavior in the markets for commodities. In the operations of the
indirect channel, people try to remedy excessive or deficient cash balances by
altering their behavior in the markets for securities and debt. The resulting
changes in interest rates and credit terms and availability then (indirectly) induce
people to alter their behavior in the market for commodities.
The three effects of the Wicksell Process each operating through the direct
and indirect channels are not distinct, separate components of that process.
They are, as we said, aspects, meaning views or slants on how real cash

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balances affect the demand for commodities. The borderline between direct
and indirect operation of each of the three effects is blurred in reality, yet the
distinction is illuminating. Analogously, we view a statue from several different
angles, obtaining a better appreciation of it than from one angle only. But the
views overlap; they are views of a single reality, the whole statue.10
Both the real-balance effect and its broader version, the Wicksell Process,
pertain to interaction of the demand for money with the actual quantity.11 Just
as individuals try to adjust their cash balances in light of their stocks of other
assets and the prices, incomes and interest rates confronting them, so their
efforts to make these adjustments in the face of a given nominal money supply
affect the intensities of demands and supplies in various markets and so the
prices, incomes and interest rates that result. A focus on influences running
from confrontation between desired and actual cash balances to the economys
macroeconomic variables yields a description of the Wicksell Process or the
real-balance effect, broadly conceived.
The real-balance effect is sometimes said to be a disequilibrium phenomenon
that vanishes in equilibrium. If this remark merely means that economic
variables are in the process of change in consequence of disequilibrium between
desired and actual money holdings only when such a disequilibrium prevails,
well, that is obviously true. The effect makes things happen only outside of
equilibrium. In a less trivial sense the real-balance effect and Wicksell Process
characterize a monetary economy even in equilibrium. People are concerned
about the real sizes of their money holdings and act to maintain them at or
restore them to levels they consider appropriate. Even in the imagined case of
a full general equilibrium, the determinacy and stability of prices depend on
this concern for real holdings confronting the nominal money supply.
The Wicksell Process also affects investment by firms through the direct
channel as firms respond to their money holdings (Miller and Orr, 1966),
although the usual presentation of the real-balance effect focuses narrowly on
consumption. After a monetary contraction, for example, the increased MERs
on money held by firms make the MERs on new factories, machinery and other
capital goods (as well as goods in inventory) look relatively less attractive and
therefore depress investment.
Bernanke (1983) provides a useful insight. During the Great Depression,
financial intermediation was greatly impaired, with severe real effects on the
economy. Well, monetarists recognize that monetary disorder operates through
other channels besides the two of the Wicksell Process, including interference
with the channels of financial intermediation. However, the Wicksell Process
played a major role in the depressions financial crises. Indeed, Brunner and
Meltzer (1988, pp. 4489) argue that the financial crises were endogenous
events, conditional on the monetary propagation mechanism.

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Both the direct and indirect channels of the Wicksell Process operate
regardless of whether the counterpart of money supply contraction on the banks
balance sheets is a smaller volume of business and consumer loans or reduced
holdings of government securities. We do not deny that the details and the
intensity of the effect are influenced by the balance sheet counterparts of the
monetary contraction. Under our current system, the initial impacts of a
tightening of monetary policy may fall largely on bank-credit-dependent
activities. This follows from our particular institutional structure. But it is illegitimate to downplay the importance of the quantity of money by a narrow
focus on initial impact effects (see, for example, the many writings of Milton
Friedman and David Laidler).
We must clarify an important but potentially confusing point. An excess
demand for money following a decrease in the money supply does not imply
that the direct channel of the Wicksell Process is operating. In both channels a
fall in the money supply is met by an excess demand for money and an excess
supply of commodities. However, in the indirect channel the excess demand
for money first shows up as decreased spending on bonds, raising the interest
rate, and thereby depressing the demand for commodities so that an excess
supply of commodities occurs.

THE MONETARISTS BLACK BOX

A charge often levied against monetarists is that they have not adequately
described the process whereby changes in the money supply affect real income
and prices. Monetarists, critics claim, work with a black box, leaving money
to exert its effects in some mysterious way not specified in sectoral and
sequential detail.
Yet the critics have not shown that a detailed or quantitative account of the
transmission mechanism is an appropriate objective. What reason is there to
suppose that the sequence and other details of how a monetary disturbance
affects prices and activity in various sectors of an economy are the same at
different times and places and under different technological and institutional
conditions? The characteristics that different episodes of monetary disequilibrium do have in common, including the nature of obstacles to easy
adjustment of moneys value so as to restore equality between its demand and
supply, may well not amount to anything reasonably described as a detailed
transmission process.
Monetary disequilibrium has widespread and diverse effects. The forces
tending to restore a disturbed monetary equilibrium are diffused over the entire
economic system for reasons already mentioned. If moneys value is out of line
with its quantity, if its desired and actual real quantities diverge, then things