Friedman and Schwartz on James Tobin

Nick Rowe and I, with some valuable commentary from Bill Woolsey, Mike Sproul and Scott Sumner, and perhaps others whom I am not now remembering, have been having an intermittent and (I hope) friendly argument for the past six months or so about the “hot potato” theory of money to which Nick subscribes, and which I deny, at least when it comes to privately produced bank money as opposed to government issued “fiat” money. Our differences were put on display once again in the discussion following my previous post on endogenous money. As I have mentioned many times, my view of how banks operate is derived from one of the best papers I have ever read, James Tobin’s classic 1963 paper “Commercial Banks as Creators of Money,” a paper that in my estimation would, on its own, have amply entitled Tobin to be awarded the Nobel Prize. If you haven’t read the paper, you should not deny yourself that pleasure and profit any longer.

A few months ago, I stumbled across the PDF version of one of the relatively obscure follow-up volumes to the Monetary History of the US that Friedman and Schwartz wrote: Monetary Statistics of the US: Estimates, Sources, Methods. Part one of the book is an extended discussion about the definition of money, presenting various historical definitions of money and approaches to defining money. I think that I read parts of it when I was in graduate school, perhaps when I took Ben Klein’s graduate class monetary theory. As one might expect, Friedman and Schwartz spent a lot of time on discussing a priori versus pragmatic or empirical definitions of money, arguing that definitions based on concepts like “the essential properties of the medium of exchange” (title of a paper written by Leland Yeager) inevitably lead to dead ends, preferring instead definitions, like M2, that turn out to be empirically useful, even if only for a certain period of time, under a certain set of monetary institutions and practices. In rereading a number of sections of part one, I was repeatedly struck by how good and insightful an economist Friedman was. Since I am far from being an unqualified admirer of Friedman’s, it was good to be reminded again that despite his faults, he was a true master of the subject.

At any rate, on pp. 123-24, there is a discussion of definitions based on a concept of “market equilibrium.”

Gramley and Chase, in a highly formal analysis of monetary adjustments in the shortest of short periods (Marshall’s market equilibrium contrasted with his short-run and long-run equilibriua), discuss the definition of money only incidentally. Yet their analysis qualifies for consideration along with the analyses of Pesek and Saving, Newlyn, and Yeager because, like the others, Gramley and Chase believe that far-reaching substantive conclusions about monetary analysis can be derived from rather simple abstract considerations and like, Newlyn and Yeager, they put great stress on whether the decisions of the public can or do affect monetary totals. That “the stock of money” is “an exogenous variable set by central bank policy,” they regard as one of the “time-honored doctrines of traditional monetary analysis.” They contrast this “more conventional view” with the “new view” that “open market operations alter the stock of money balances if, and only if, they alter the quantity of money demanded by the public.

In a footnote to this passage, Friedman and Schwartz add the following comment (p. 124).

In this respect [Gramley and Chase] follow James Tobin, “Commercial Banks as Creators of ‘Money.'” . . . Tobin presents a lucid exposition of commercial banks as financial intermediaries with which we agree fully and which we find most illuminating. His analysis, like that of Pesek and Saving, Newlyn, and Yeager, and as we shall note, Gramley and Chase, demonstrates that emphasis on supply considerations leads to a distinction between high-powered money and other assets but not between any broader total and other assets. Unlike Gramley and Chase, Tobin explicitly eschews drawing any far-reaching conclusions for policy and analysis from his quantitative analysis.

Then on p. 135, Friedman and Schwartz in a critical discussion of the New View, of which Tobin’s paper was a key contribution, observed:

This approach is an appropriate theoretical counterpart to an analysis of changes in income and expenditure along Keynesian lines. That analysis takes the price level as an institutional datum and therefore minimizes the distinction between nominal and real magnitudes. It takes interest rates as essentially the only market variable that reconciles the structure of assets supplied with the structure demanded.

In a footnote to this passage, Friedman and Schwartz add this comment.

It is instructive that economists who adopt this general view write as if the monetary authorities could determine the real and not merely the nominal quantity of high-powered money. For example, William C. Brainard and James Tobin in setting up a financial model to illustrate pitfalls in the building of such models use “the replacement value of . . . physical assets . . . as the numeraire of the system,” yet regard “the supply of reserves” as “one of the quantities the central bank directly controls (“Pitfalls in Financial Model-Building,” AER, May 1968, pp. 101-02). If the nominal level of prices is regarded as an endogenous variable, this is clearly wrong. Hence the writers must be assuming this nominal level of prices to be fixed outsider their system. Keynes’ “wage unit” serves the same role in his analysis and leads him and his followers also to treat the monetary authorities as directly controlling real and not nominal variables.

But there is no logical necessity that requires the New View so elegantly formulated by Tobin to be deployed within a Keynesian framework rather than in a non-Keynesian framework in which some monetary aggregate, like the stock of currency or the monetary base, rather than M1 or M2, is what determines the price level. The stock of currency (or the monetary base) can function as the hot potato that determines (in conjunction with all the other variables affecting the demand for currency or the monetary base) the price level. Denying that bank money is a hot potato doesn’t require you to treat the price level “as an institutional datum.” Friedman, almost, but not quite, figured that one out.


19 Responses to “Friedman and Schwartz on James Tobin”

  1. 1 Tas von Gleichen April 16, 2012 at 12:34 am

    Can’t wait to start the must read in this article!


  2. 2 Bill Woolsey April 16, 2012 at 3:46 am

    As a practical matter, excess supplies of outside currency generate excess supplies of bank money. Most of the spending in the economy is with bank money. The spending on output results in higher output prices. This reduces the real quantity of both bank money and currency, clearing up the excess supply of both.

    The process by which the price level changes involves an excess supply of bank money and a “hot potato” effect for the bank money.

    Suppose there is an excess supply of outside currency. Even if it is spent on goods and services immediately, those selling the goods deposit the currency in banks. The excess supply of money from the point of view of the public is now in the form of bank deposits. Do the banks immediately pay higher interest rates so that people are willing to hold those additional deposits? Quite the contrary. Immediately, banks purchase short term bonds or lend overnight, lowering money market rates. If anything, banks lower the interest rates paid on deposits along with loan rates. Does this excess supply of money cause a shortage of outside currency? No, because currency was in excess supply before. Instead, the excess supply of money is divided between currency and deposits according to the preferences of those using the money. Actual holdings are divided in shares relative to demands and the actual holdings equals the excess supply.

    As already explained, the market forces generate a perverse change in the interest rate on deposits.

    Again, everything is cleared up with a higher price level, reducing the real supply or, in other words, raising the nominal demand, of both forms of money.

    If deposit and loan rates were decreased as part of the process, then this would create an excess supply of bank money as the price level rises and if the quantity of outside currency remains fixed (at perhaps a new higher level or an unchanged level if the disturbance was reduced currency demand,) then the banks must raise the interest rates on deposits to avoid a currency drain.

    In equilibrium, the banks adjust the interest rates they charge and pay according to competitive forces (or imperfectly competitive ones.) That they promise to pay an outside currency dollar on demand forces them to limit their issue to the amount demanded, as influenced by the interest rates paid.

    But the process by which monetary disequilibrium is corrected, particularly if it starts with the outside money, involves the bank money.

    If you think about arrangements where the medium of account is not used as money, like Fama’s steel ingot’s, it is even more obvious that it is only through the bank money (or the accounting system of exchange,) that prices of other goods and services are forced to adjust to clear the market for the medium of account.

    Only with a Walrasian Auctioneer can excess supplies of outside currency, or steel ingots, result in a change in the price level while the interest rates paid on bank money as well as the interest rates on loans, maintain equilibrium in those markets too.

    Think about the process in disequilibrium, not the conditions that must hold in various equilibriums.


  3. 3 Michał Gamrot April 16, 2012 at 4:06 am

    @Bill Woolsey
    I’m not familiar with Fama’s steel inglot exaple. Could you please tell me where it comes from?


  4. 4 Max April 16, 2012 at 4:46 am

    Tobin’s article has a strange statement that “printing press money” can’t be extinguished except by fiscal policy. The correct statement is that total government liabilities (including bonds) are determined by fiscal policy. Money (bank reserves and currency) is created and extinguished by the central bank independent of the budget.

    In my view the quantity of money required to support an economy is zero. Transacting in terms of money doesn’t require that anyone hold money, not even a little. Money can be an investment, and it can be a medium of exchange, but those roles aren’t essential.

    The central bank can vary its interest rate without changing the quantity of money. See: “Monetary Policy in a World Without Money”,


  5. 5 Nick Rowe April 16, 2012 at 5:20 am

    David: Yes, this is definitely a friendly (and useful) argument.

    I found this quote from F&S p 124 (my italics):

    “The “more conventional view” nonetheless—and correctly
    treats the quantity of money (defined more broadly than highpowered
    ) as, for all practical purposes, “an exogenous variable
    set by central bank policy” because it accepts the empirical hypothesis
    that a change in high-powered money will produce private reactions that
    will rapidly alter the quantity of money demanded by the public
    in a
    predictable way. Far from incorporating a “new view” in any substantive
    , the Gramley-Chase analysis involves the elaborate spelling out of
    one minor component of the adjustment process envisaged by the “more
    conventional view”—the component that consists of the initial readjustment
    of portfolios abstracting both from subsequent portfolio readjustments
    and from any effects of the initial and subsequent readjustments
    on spending for current services or on the production of capital goods,
    or on incomes and prices.”

    I confess I find F&S less than easy to interpret on this question. The first two bits in italics seem to support the hotpotato view. The third goes the other way. The fourth seems to be back to hot potato!

    David Laidler has a useful thought experiment on this. Suppose, just suppose, that the demand to hold money (both base and deposits) were perfectly interest-inelastic, and that income and prices were slow to adjust (treat them as temporarily fixed, if you like). Would it be possible for central banks and commercial banks to increase the stock of money? Hot potato people would say ‘yes”. The New View would say “no”.


  6. 6 Lee Kelly April 16, 2012 at 6:35 am

    I haven’t read Commercial Banks as Creators of Money, but I have read Leland Yeager’s critique of Tobin and his so-called New View, What are Banks?. It’s a 1978 paper from the Atlantic Economic Journal and is included in Part Two of Yeager’s The Fluttering Veil. Yeager seems about on the mark to me, so how is he wrong?


  7. 7 Nick Rowe April 16, 2012 at 6:54 am

    I forgot to add: my own views are as much if not more a result of David Laidler as well as Yeager. David has been a strong proponent of the disequilibrium money or “buffer stock money” view. “People accept new money not necessarily because they want to hold it but because they want to spend it on something else” (not an exact quote) is one of his favourite sayings.

    How much David’s views on this question were in turn influenced by Milton Friedman’s, I cannot say.


  8. 8 Mike Sproul April 16, 2012 at 7:18 am

    David: The key difference between us on this issue is that you accept the existence of fiat money. I think it is an imaginary concept like phlogiston, ether, caloric, etc. Economists observe that we can’t get gold for our Federal Reserve Notes, and conclude that those notes are unbacked. The truth is that FRN’s are backed but inconvertible. Old note-issuing banks used to suspend all forms of convertibility every weekend, and resume on Monday. Over the weekend, people recognized that the bank’s assets were still there it its vault, but that convertibility had been suspended for two days. Nobody called those notes fiat money. Now, what if the suspension were extended to 30 days or 30 years? The currency is still backed but inconvertible, but as years go by, more people will fall for the fallacy that the notes are unbacked, even when the bank’s assets are plainly listed on its balance sheet.

    Just think how much this view cleans up the theory of money. You don’t have one set of rules governing government-issued money and another for privately-issued money. The value of all types of money is determined by its issuer’s assets, just like for stocks and bonds. The “What is money?” question disappears. People just recognize that FRN’s are the liability of the Fed, Wells Fargo checking account dollars are the liability of Wells Fargo, Credit card dollars are the liability of the credit card company, etc.

    One more thing: I like your discussion of endogenous money, but I don’t like the term “endogenous money”. Too many big words. I like the term “derivative money”. This emphasizes, for example, that checking account dollars and credit card dollars are a CLAIM to a FRN. I’d guess that you would then call the FRN’s base money, but I’d say that FRN’s are themselves derivative money, since they are a claim on the Fed’s assets.


  9. 9 Julian Janssen April 16, 2012 at 3:23 pm

    If anyone is interested in my takedown of an article about Sweden’s tax cuts:


  10. 10 JP Koning April 16, 2012 at 7:41 pm

    Bill, I see an alternative. When people return excess currency to banks for deposits, those banks in turn send the currency back in trucks to the Fed for reserve deposits. Banks now have excess reserves so they start to spend them on financial assets, driving up bond prices. But as soon as bond prices rise in secondary markets, primary dealers can conduct arbitrage by purchasing bonds from the Fed (with reserves, which the Fed cancels) and on-selling these bonds at a higher price in the secondary market. This process, a reflux process, almost immediately removes excess reserves so that the price level doesn’t need to change so as to balance the system.


  11. 11 Bill Woolsey April 17, 2012 at 5:10 am


    If you are assuming the Fed is targeting money market rates, then when we get to the step of banks buying money market instruments and driving down the yields, the Open Market Trading desk undertakes open market sales. Those buying the bonds from he Fed have reduced balances in their checking accounts and their banks have reduced reserves. Both the excess supply of bank deposits and reserves are cleared up.

    And yes, currency is deposited in reserve accounts in both the scenario I described (lower currency demand, no change in quantity of base money,) and the one that you seem to have in mind, which was a reduction in the quantity of base money to match the decrease in the demand for currency which was implemented by keeping short term interest rates from falling.


  12. 12 David Glasner April 20, 2012 at 4:08 pm

    Tas, Go for it!

    Bill, Would you say that, under a gold standard, a reduction in the real value of gold, necessarily implies an excess supply of bank money?
    An excess supply of currency increases nominal income and prices and therefore increases the demand for bank deposits, so I don’t agree that there is necessarily any excess supply of bank deposits in the transition. The problem is that more currency has been created and there is no way to get the currency to be held willingly except by increasing nominal income. The demand for and the supply of bank deposits have to adjust to accommodate the increase in the stock of currency that just won’t go away. If it is deposited in banks, banks are stuck with it and they must adjust their balance sheets somehow. Everything else is an adjustment forced by the excess supply of currency. By the way, I don’t deny that it is possible for there to be an excess supply of bank deposits or that an excess supply of bank deposits may cause an increase in spending, I simply say that there is another powerful means of adjusting the quantity of bank deposits supplied to the amount demanded, and that bank deposits once created can also be withdrawn and banks have an incentive to withdraw excess bank deposits from circulation. So our disagreement is not quite as absolute as it appears when we state our theories in their most extreme form.

    Max, I agree (I think) with your revision of Tobin’s statement. I don’t find it strange, just oversimplified. The amount of money needed to support an economy is whatever amount people desire to hold.

    Nick, Thanks for providing the further excerpts from F&S, which I almost included myself, but was too lazy to copy. Like you, I partly agree and partly disagree (and partly don’tunderstand) what they wrote.

    Lee, Well you have given me a topic for another post. Let’s see when I get to it. I have been wanting to do this one for at least 3 months.

    Nick, As you know, I am a bit befuddled that David Laidler is so adamant in rejecting Tobin’s position. I actually think Tobin’s discussion dovetails very nicely with David’s buffer stock notion.

    Sorry that I have been so slow in responding to these comments. I will have to quit for a while and come back to the rest later.


  1. 1 Glasner on “Friedman and Schwartz on James Tobin” « The Market Monetarist Trackback on April 15, 2012 at 11:38 pm
  2. 2 Links for 2012-04-17 | FavStocks Trackback on April 17, 2012 at 12:36 am
  3. 3 Links for 2012-04-17-Economic Issue | Coffee At Joe's Trackback on April 18, 2012 at 5:41 pm
  4. 4 James Tobin Got It Right « Uneasy Money Trackback on May 6, 2012 at 7:11 pm
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  7. 7 Tobin vs. Yeager, my view | Spontaneous Finance Trackback on March 25, 2014 at 3:10 pm

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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