# The Development and Evolution of Monetary Theory and Public Policy by Kenneth Kurihara: A Critical Analysis and Evaluation

## Monetary Theory and Public Policy by Kenneth Kurihara: A Review

Monetary theory and public policy are two interrelated fields of economics that deal with the role and effects of money in the economy. Money is not only a medium of exchange, but also a store of value, a unit of account, and a standard of deferred payment. Money affects various aspects of economic activity, such as consumption, investment, production, employment, inflation, interest rates, exchange rates, and balance of payments. Monetary policy is the use of instruments such as money supply, interest rates, or exchange rates by the central bank or the government to influence economic outcomes. Monetary policy can have different objectives, such as price stability, full employment, economic growth, or external equilibrium.

## monetarytheoryandpublicpolicykennethkuriharapdf52

One of the classic books on monetary theory and public policy is Monetary Theory and Public Policy by Kenneth Kurihara, published in 1950. Kurihara was a Japanese-American economist who taught at Yale University and Columbia University. He was also a consultant to various international organizations, such as the United Nations, the International Monetary Fund, and the World Bank. His book is a comprehensive and systematic exposition of the development and evolution of monetary theory from the classical to the post-Keynesian schools. It also provides a critical analysis and evaluation of various monetary policies in light of theoretical frameworks and empirical evidence.

In this article, I will review Kurihara's book by summarizing its main themes and arguments, evaluating its strengths and weaknesses, comparing it with other works in the field, and discussing its relevance and applicability to contemporary issues. I will also provide some recommendations and suggestions for further reading for those who are interested in learning more about monetary theory and public policy.

## Summary of the book

Kurihara's book consists of four chapters, each covering a major school or stage of monetary theory. The first chapter introduces the nature and scope of monetary theory, the second chapter reviews the classical theory of money and prices, the third chapter examines the Keynesian theory of money and income, and the fourth chapter explores the post-Keynesian developments in monetary theory.

### Chapter 1: The Nature and Scope of Monetary Theory

In this chapter, Kurihara defines money and its functions, discusses the quantity theory of money and its criticisms, and explains the role of money in economic analysis. He argues that money is not a neutral factor, but rather a dynamic and influential force that affects the behavior of economic agents and the performance of the economy.

#### The definition and functions of money

Kurihara defines money as anything that is generally accepted as a medium of exchange. He distinguishes between commodity money, such as gold or silver, and fiat money, such as paper currency or bank deposits, which have no intrinsic value but are backed by legal tender or public confidence. He also distinguishes between narrow money, such as currency and demand deposits, and broad money, which includes other liquid assets, such as savings deposits, time deposits, or money market funds.

Kurihara identifies four functions of money: (1) medium of exchange, which facilitates transactions and reduces transaction costs; (2) store of value, which allows people to save and defer consumption; (3) unit of account, which provides a common measure and standard of value; and (4) standard of deferred payment, which enables people to borrow and lend. He notes that these functions are interrelated and interdependent, and that the effectiveness of money depends on its stability and acceptability.

#### The quantity theory of money and its criticisms

Kurihara presents the quantity theory of money as one of the oldest and most influential theories in monetary economics. The quantity theory of money states that the general level of prices is proportional to the quantity of money in circulation, assuming that the velocity of money (the number of times a unit of money changes hands in a given period) and the real output (the quantity of goods and services produced in a given period) are constant or stable. The quantity theory of money can be expressed by the equation of exchange: MV = PT, where M is the quantity of money, V is the velocity of money, P is the general price level, and T is the real output.

Kurihara explains that the quantity theory of money implies that changes in the quantity of money cause changes in the price level, and that monetary policy can control inflation or deflation by regulating the growth rate of money supply. He also discusses some criticisms and modifications of the quantity theory of money, such as: (1) the instability and endogeneity of the velocity of money; (2) the distinction between nominal income (PT) and real income (T); (3) the effects of changes in the demand for money on interest rates and output; (4) the role of expectations and uncertainty in influencing monetary behavior; and (5) the existence of non-monetary factors that affect prices and output.

#### The role of money in economic analysis

Kurihara argues that money plays an important role in economic analysis, both in microeconomics and macroeconomics. He contends that money affects the allocation of resources, the distribution of income, and the determination of equilibrium in various markets. He also asserts that money influences the aggregate demand, the aggregate supply, and the equilibrium level of income and employment in the economy. He claims that money is not a neutral factor that only affects nominal variables, such as prices or wages, but also a real factor that affects real variables, such as output or employment. He maintains that monetary theory should not be separated from general economic theory, but rather integrated with it.

### Chapter 2: The Classical Theory of Money and Prices

In this chapter, Kurihara reviews the classical theory of money and prices, which dominated monetary economics until the 1930s. The classical theory of money and prices is based on two assumptions: (1) the classical dichotomy, which states that real variables are determined by real factors independently of nominal variables; and (2) the neutrality of money, which states that changes in the quantity of money only affect nominal variables proportionally without affecting real variables. Kurihara discusses three main approaches within the classical theory: (1) the equation of exchange approach; (2) the Fisher effect approach; and (3) the Cambridge cash-balance approach.

#### The equation of exchange approach

Kurihara explains that the equation of exchange approach is derived from the quantity theory of money. It states that MV = PT, where M is the quantity of money, V is the velocity of money, P is the general price level, and T is the real output. It implies that changes in the quantity of money cause proportional changes in the price level, assuming that the velocity of money the real output are constant or stable. It also implies that monetary policy can control inflation or deflation by regulating the growth rate of money supply. Kurihara points out some limitations and criticisms of the equation of exchange approach, such as: (1) the lack of a causal explanation of how changes in money supply affect prices and output; (2) the neglect of the role of interest rates and the demand for money in determining the velocity of money; (3) the disregard of the effects of changes in prices and output on the quantity of money; and (4) the oversimplification of the structure and dynamics of the economy.

#### The Fisher effect approach

Kurihara describes the Fisher effect approach as an extension and refinement of the equation of exchange approach. It is named after Irving Fisher, an American economist who developed it in his book The Theory of Interest in 1930. The Fisher effect approach states that i = r + π, where i is the nominal interest rate, r is the real interest rate, and π is the expected inflation rate. It implies that changes in the quantity of money cause changes in the expected inflation rate, which in turn cause changes in the nominal interest rate. It also implies that monetary policy can affect the real interest rate only temporarily, as the expected inflation rate adjusts to restore the equilibrium real interest rate. Kurihara discusses some implications and applications of the Fisher effect approach, such as: (1) the distinction between nominal and real variables; (2) the role of expectations and uncertainty in determining interest rates and prices; (3) the analysis of international capital flows and exchange rates; and (4) the evaluation of alternative monetary policies.

#### The Cambridge cash-balance approach

Kurihara presents the Cambridge cash-balance approach as an alternative and complementary perspective to the equation of exchange approach. It is named after a group of British economists who developed it at Cambridge University in the early 20th century, such as Alfred Marshall, Arthur Pigou, and John Maynard Keynes. The Cambridge cash-balance approach states that M = kPY, where M is the quantity of money, k is the fraction of nominal income that people hold as money, P is the general price level, and Y is the real income. It implies that changes in the quantity of money cause changes in the price level, assuming that the fraction of nominal income that people hold as money the real income are constant or stable. It also implies that monetary policy can control inflation or deflation by regulating the growth rate of money supply. Kurihara highlights some advantages and contributions of the Cambridge cash-balance approach, such as: (1) the introduction of the concept of the demand for money as a function of nominal income; (2) the recognition of the role of interest rates and other factors in influencing the demand for money; (3) the incorporation of the real balance effect, which states that changes in the price level affect the real value of money holdings and thus affect consumption and output; and (4) the foundation for the development of the Keynesian theory of money and income.

### Chapter 3: The Keynesian Theory of Money and Income

In this chapter, Kurihara examines the Keynesian theory of money and income, which emerged in the 1930s as a response and challenge to the classical theory. The Keynesian theory of money and income is based on two assumptions: (1) the existence of involuntary unemployment, which means that there are workers who are willing to work at the prevailing wage rate but cannot find jobs; and (2) the prevalence of sticky prices and wages, which means that prices and wages do not adjust quickly or fully to changes in demand or supply. Kurihara discusses three main components of the Keynesian theory: (1) the liquidity preference theory and the demand for money; (2) the income-expenditure approach and the multiplier effect; and (3) the IS-LM model and the interaction of money and output markets.

#### The liquidity preference theory and the demand for money

Kurihara explains that the liquidity preference theory is developed by John Maynard Keynes in his book The General Theory of Employment, Interest and Money in 1936. It is a theory of the demand for money that states that people hold money for three motives: (1) transaction motive, which is related to their income and spending needs; (2) precautionary motive, which is related to their uncertainty and precautionary needs; and (3) speculative motive, which is related to their expectations and investment opportunities. The liquidity preference theory implies that the demand for money depends on the level of income and the rate of interest. It also implies that there is a negative relationship between the rate of interest and the quantity of money demanded, holding income constant.

Kurihara illustrates how the liquidity preference theory determines the equilibrium rate of interest in the money market. He shows that the equilibrium rate of interest is the rate that equates the supply of money, which is assumed to be fixed by the central bank, with the demand for money, which depends on income and interest rates. He also shows how changes in the supply of money or the demand for money cause changes in the equilibrium rate of interest. He notes that the liquidity preference theory implies that monetary policy can affect interest rates by changing the supply of money, but it may not affect output or employment if interest rates are too low or too high to stimulate investment.

#### The income-expenditure approach and the multiplier effect

the goods market. It is based on the principle of effective demand, which states that the level of output and employment in the economy is determined by the aggregate demand for goods and services, not by the aggregate supply. The income-expenditure approach implies that there can be a gap between the actual output and the potential output of the economy, resulting in underemployment or overemployment. Kurihara discusses two main concepts of the income-expenditure approach: (1) the consumption function and the saving function; and (2) the investment function and the marginal efficiency of capital.

#### The consumption function and the saving function

Kurihara explains that the consumption function is a relationship between consumption and income that states that consumption depends on income. He presents the Keynesian consumption function as C = a + bY, where C is consumption, a is autonomous consumption, b is the marginal propensity to consume, and Y is income. He notes that autonomous consumption is the amount of consumption that does not depend on income, such as basic needs or habits. He also notes that the marginal propensity to consume is the fraction of additional income that is spent on consumption, which is assumed to be positive and less than one.

Kurihara derives the saving function from the consumption function by subtracting consumption from income. He presents the Keynesian saving function as S = -a + (1-b)Y, where S is saving, -a is autonomous dissaving, and 1-b is the marginal propensity to save. He notes that autonomous dissaving is the amount of saving that does not depend on income, which can be negative if consumption exceeds income. He also notes that the marginal propensity to save is the fraction of additional income that is saved, which is assumed to be positive and less than one.

#### The investment function and the marginal efficiency of capital

Kurihara describes the investment function as a relationship between investment and interest rates that states that investment depends on interest rates. He presents the Keynesian investment function as I = f(r), where I is investment and r is the rate of interest. He notes that the investment function is a downward-sloping curve, which implies that there is a negative relationship between investment and interest rates. He also notes that the investment function depends on other factors, such as expectations, profitability, technology, or capacity utilization.

Kurihara explains that the marginal efficiency of capital is a concept that measures the expected rate of return on an investment project. It is defined as the discount rate that equates the present value of future net revenues from an investment project with its current cost. It implies that an investment project will be undertaken if its marginal efficiency of capital exceeds the rate of interest. It also implies that there can be fluctuations in investment due to changes in expectations or uncertainty about future net revenues.

#### The multiplier effect

the income-expenditure approach. He shows that the equilibrium level of income and output in the goods market is determined by the equality of aggregate demand and aggregate supply. He defines aggregate demand as the sum of consumption and investment, and aggregate supply as the total output of the economy. He presents the equilibrium condition as Y = C + I, where Y is income and output, C is consumption, and I is investment. He notes that both consumption and investment depend on income and interest rates, as explained by the consumption function and the investment function.

Kurihara demonstrates how a change in autonomous spending, such as an increase in autonomous consumption or autonomous investment, causes a change in equilibrium income and output that is larger than the initial change in spending. He explains that this is because an increase in autonomous spending increases income, which in turn increases consumption, which further increases income, and so on. He calculates the multiplier as the ratio of the change in equilibrium income to the change in autonomous spending. He presents the multiplier formula as k = 1/(1-b), where k is the multiplier and b is the marginal propensity to consume. He notes that the multiplier is positive and greater than one, which means that a small change in autonomous spending can have a large impact on income and output.

### The IS-LM model and the interaction of money and output markets

Kurihara introduces the IS-LM model as a synthesis and extension of the liquidity preference theory and the income-expenditure approach. It is a model that depicts the simultaneous equilibrium of the money market and the goods market in a two-dimensional diagram. It was developed by John Hicks and Alvin Hansen in 1937 as an interpretation and simplification of Keynes's General Theory. Kurihara discusses two main curves of the IS-LM model: (1) the IS curve; and (2) the LM curve.

#### The IS curve

Kurihara explains that the IS curve represents the combinations of interest rates and income levels that ensure equilibrium in the goods market. It is derived from the income-expenditure approach by substituting the consumption function and the investment function into the equilibrium condition of Y = C + I. It can be expressed as Y = a + bY - brM/P + f(r), where M is the quantity of money, P is the price level, and the other variables are as defined before. It implies that for a given level of money supply and price level, there is a negative relationship between interest rates and income levels in the goods market.

Kurihara illustrates how to draw and shift the IS curve in the IS-LM diagram. He shows that the IS curve is a downward-sloping curve, which reflects the inverse relationship between interest rates and income levels in the goods market. He also shows how changes in autonomous spending or fiscal policy can shift the IS curve to the right or to the left. For example, an increase in autonomous consumption or autonomous investment, or an increase in government spending or a decrease in taxes, can increase aggregate demand and shift the IS curve to the right.

#### The LM curve

the money market. It is derived from the liquidity preference theory by substituting the consumption function into the demand for money function. It can be expressed as M/P = a + bY - cr, where c is the sensitivity of the demand for money to interest rates, and the other variables are as defined before. It implies that for a given level of money supply and price level, there is a positive relationship between interest rates and income levels in the money market.

Kurihara illustrates how to draw and shift the LM curve in the IS-LM diagram. He shows that the LM curve is an upward-sloping curve, which reflects the direct relationship between interest rates and income levels in the mon