Posted by: Dirk | May 6, 2019

Keynes on the quantity theory and techniques of recovery (letter to FDR)

Here is an excerpt of JMK’s letter to FDR from 1933:

The other set of fallacies, of which I fear the influence, arises out of a crude economic doctrine commonly known as the quantity theory of money. Rising output and rising incomes will suffer a set-back sooner or later if the quantity of money is rigidly fixed. Some people seem to infer from this that output and income can be raised by increasing the quantity of money. But this is like trying to get fat by buying a larger belt. In the United States to-day your belt is plenty big enough for your belly. It is a most misleading thing to stress the quantity of money, which is only a limiting factor, rather than the volume of expenditure, which is the operative factor.

The relation between output and money is a statistical one, which means… not much. Here is a graph from FRED to show M1 and GDP growth for the US:


The blue line is the growth of M1 in percent, the red line real GDP growth (also in percent). Of course, one could also use M2, M3 or monetary base to create the figure, but the result is the same. Correlation is not very high, and it is doubtful that anything can be said in terms of causation. Obviously, spending money does something to GDP, but M1 is a stock and “spending money” a flow. Attributed to Keynes is the sentence that “there are many slips between the cup and the lip”, and it is most proper in this case. The upwards change in the stock of money (M1) does not automatically translate into more purchases and hence more production. Things are more complicated.

In his letter, JMK continues with a discussion of the “techniques of recovery”. I’ve written a working paper in which I translate his “techniques” into my macroeconomic model, which fits nicely. You can download the working paper here.

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