Classical Monetary Theory

Classical Monetary Theory

Insofar as pure theory is concerned, most of the ground in monetary econom­ics was broken in the eighteenth century. The nineteenth century had little more to do than adopt the monetary theory of Cantillon and Hume, which it did, sometimes adding more confusion than light.

Perhaps the best summary statement of the period's monetary thought was the Bullion Report of 1810. In the opening years of the nineteenth century the move to an inconvertible paper currency saw only a slight increase in the cir­culation of British bank notes and little change in exchange rates. But begin­ning in 1808 the increase in note issue began to make itself felt as prices climbed steadily and exchange rates fell. Certain sectors of the public ex­pressed their concern, and early in 1810 Francis Horner, a member of Parlia­ment, proposed in the House of Commons that a committee be appointed to investigate the high price of bullion. A number of witnesses were called to tes­tify, after which a report, drawn up largely by Horner, William Huskisson, and Henry Thornton, was delivered to the House in June. It was not debated until the following year, however, when its conclusions were rejected.

The Bullion Report was the first official argument against discretionary monetary policy. It maintained that an excessive amount of note issue influ­enced the value of paper money and attributed the high price of bullion (infla­tion) to this cause. Somewhat paradoxically, the report maintained that the reigning British monetary problems were not occasioned by a lack of public confidence in paper money, although this was a widely held belief among the public. The committee's position in this regard may have been staked by Thornton, who had taken a similar position in his book published in 1802, An Enquiry into the Nature and Effects of the Paper Credit of Great Britain. By the time they reached the end of the report, however, the committee had prac­tically reversed itself, for it concluded that the return to convertibility was the only way to "effectively restore general confidence in the value of the circu­lating medium of the kingdom" (Cannan, The Paper Pound, p. 70).

The Bullion Report served as a pretext for David Ricardo's early pamphlets on monetary matters, which were published as commentaries on the report. In 1809, Ricardo published his "Treatise on the Price of Bullion," and in 1816, his "Proposals for an Economical and Secure Cur­rency." In both works Ricardo reaffirmed the quantity theory of money and advocated a return to convertibility. The concept of quantity completely dom­inated Ricardo's monetary theory. He maintained that both declines and rises in the price level are regulated by changes in the quantity of money. The idea of money as a store of value seems not to have occurred to him. He makes no mention of the demand for money. Money is defined in the narrowest terms as a mere regulator of value. Ricardo either rejected or ignored the idea of money as a link between the present and the future by virtue of its imperishability and scarcity. His view of credit was also overly restrictive. For example, he did not think of checks as instruments of circulation (as Cantillon did) but as a means of economizing on the use of money. Since he did not regard checks as currency instruments, therefore they could not affect prices. Taken together, Ricardo's ideas on money had the effect of changing the quantity theory of money into the Ricardian theory of money. His formulation was so one-sided and restrictive that it led many later economists to regard with suspicion any theory of money or prices in which quantity plays a part.

One curiosum remains to be covered on this topic. Found among Ricardo's papers after his death and published in 1823 was his Plan of a National Bank, which furthered the notion that paper money is an efficient substitute for me­tallic money because it requires fewer resources to maintain. All that is nec­essary is to fix the quantity of paper money once and for all. Ricardo devised a plan for this whereby the state would be granted the monopoly issue of paper money and would only be able to issue new notes against a backing of new gold from abroad. An element of currency elasticity was introduced, however, by allowing the central bank to engage in open-market operations: it would buy government securities when it desired to increase the quantity of money and sell them when it desired to decrease the quantity of money. These pur­chases and sales were to be determined by changes in the exchange rate, which would reflect the relation between the value of paper money and its me­tallic counterpart. Thus it can be seen that the idea of such operations, while sometimes regarded as the height of modernism, is in fact very old. Moreover, it seems but a brief step from recognizing the legitimacy of such operations under a gold standard to the idea of a fully managed, fiat currency.

John Stuart Mill (see Chapter 8), who represented classical economics at the height of its influence, also accepted the quantity theory but added quali­fications to it, some of which served to correct the Ricardian excesses. For one thing, Mill recognized (as did Cantillon and Hume) that the rigid conclu­sions of the quantity theory were based on the assumption of an equi-proportionate distribution of new money relative to initial money holdings. Any other distribution would upset the strict proportionality between money and prices. Further, he believed that the strict quantity theory held only for metallic money and that:

When credit comes into play as a means of purchasing, distinct from money in hand, we shall hereafter find that the connection between prices and the amount of circu­lating medium is much less direct and intimate, and that such connection as does exist no longer admits of so simple a mode of expression (Principles of Political Economy, p. 495).

Finally, Mill recognized that an increase in bank credit under conditions of full employment could drive the interest rate down.

By far the brightest light among the classical monetary theorists was Henry Thornton, the British banker and member of Parliament mentioned above in connection with the Bullion Report of 1810. Thornton made two important contributions to monetary theory: (1) the distinction between the natural rate of interest and the bank (loan) rate of interest and (2) the doctrine of "forced saving."

Regarding the first principle, Thornton correctly pointed out that the rate of return on invested capital (determined by thrift and productivity) regulates the bank interest rate on loans. If the bank rate is below the former, competition for business loans will drive the bank rate up; if the bank rate is above the former, the demand for bank loans will dry up, forcing banks to lower rates in order to make loans. Therefore, the question of determining the optimum quantity of bank loans depends on a comparison of the rate of return on capital (Thornton called this the "natural" rate) and the interest rate on bank loans. If investment and savings are determined by the real forces of thrift and productivity, then only a change in one or the other of these forces will shift the schedules depicted in Figure 1. In this model, SS' represents the supply of savings as a function of the interest rate. Likewise, II' represents the demand for investable funds also as a function of the interest rate. The intersection of SS' and II' determines the natural rate (r). In monetary equilibrium, the loan rate (i) will be equal to the natural rate. But if monetary equilibrium is dis­turbed by an increase in paper money, the interest rate on bank loans will be driven down, say to i' (because of an increase in loanable funds). At the same time, SS' and II' would remain unchanged unless there was a change in the real factors of thrift and productivity, which would not be induced by a purely monetary phenomenon such as an increase in paper money.


Thus a gap would be created between the natural rate and the loan rate, and this gap would give rise to an insatiable demand for loans. The ensuing infla­tionary pressure would be eliminated only when the loan rate was again raised to its former level at r. In the process, however, prices would have climbed to a higher level. In this way, the quantity theory is vindicated: An increase in money leads to higher prices but no (long-run) change in the real interest rate.

Thornton's second contribution—the doctrine of forced saving—recognized that an increase in money brings about an increase in capital as well as an in­crease in prices. This would be the case as long as part of the new money went to entrepreneurs. If entrepreneurs converted this new money into capital, then output effects (forced capital accumulation) would accompany the higher prices associated with the increase in money; hence money would not be strictly neutral, as Hume maintained. In addition, Thornton suggested the pos­sibility that an increase in bank notes under conditions of general unemploy­ment would lead to an increase in output and employment rather than an in­crease in prices. Clearly, Thornton affirmed the neutrality of money only as a long-run proposition, and then only under certain circumstances.