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ROBERT M. SOLOW

Introduction: The Tobin Approach to Monetary

Economics
My wife and I met Jim and Betty Tobin for the first time
in Cambridge, probably in a year like 1947 or 1948, but that was not really
the beginning of our friendship. Jim must have finished his Ph.D. thesis by then,
and would soon decamp for Yale, neither the first nor the last in a series of humongous
Harvard blunders. I was just beginning my graduate work, having come back from
the war still an undergraduate. I am pretty sure I had not then read Tobins 1941
Note on the Money Wage Problem. That was, as I later realized, an interesting
excursion into Keynesian economics, interesting even now, I mean. But Tobin had
learned about Keynes purely by accident, when he was an undergraduate. Later
undergraduates like me were protected against that virus.
After I went on to teach at MIT, I knew about Tobin of course. I read his papers
on consumer demand, because I was teaching econometrics and looking for good
examples of it. He published A Dynamic Aggregative Model at just the time
when I was working on economic growth, so I recognized a master hand. Jim has
said that it was his favorite paper. And of course I read Liquidity Preference
as Behavior Toward Risk in 1958. The Review of Economic Studies was the preferred
journal in those days for eager young middlebrow theorists. Not only was it interesting, it came out only three times a year with a mere handful of articles per issue.
If I sound nostalgic for that pace, it is because I am.
Then John Kennedy was elected President in 1960. One night in December of
that year, after 11 oclock, my wife and I were already asleep (we had three little
kids) when the telephone rang. When I picked it up I found myself talking to Walter
Heller, Kermit Gordon, and Jim Tobin, who had already been named as the Chairman
and Members of the new Council of Economic Advisers to take office in January.
I remember my first question was: What are you guys doing up this late? (It
should have been a warning about Walters work habits.) They wanted me to come
to Washington and join the Council staff. I said Id think about it, went back to
bed, told my wife what it was all about, and commented Why would I want
Journal of Money, Credit, and Banking, Vol. 36, No. 4 (August 2004)
Copyright 2004 by The Ohio State University

658 : MONEY, CREDIT, AND BANKING

to interrupt my teaching and abandon my research? Better a hole in the head. She
replied, in words that actually changed my life: For the last 4 years Ive been
listening to you complain about Eisenhowers economic policies. Why dont you
put your money where your mouth is? I couldnt think of a good answer. So I
checked with my department and called back the next day to say OK, its a deal.
Our family arrived in Washington in January 1961.
That was the real beginning of a long and close friendship with Jim Tobin that
lasted until his death in 2002. I honestly dont think that the Council of Economic
Advisers ever againor earliercame close to being what it was in those first
Kennedy years, especially in macroeconomics. Walter Heller hit it off with Kennedy,
and was able to communicate with him, to explain what we had found out, and to
find out what Kennedy wanted to know. I was not an unqualified admirer of Kennedy,
but he was a dream for an economist to work for; he read memos, and he wanted
to understand. Walter was the first, and probably the last Chairman who made sure that
each memo he sent to the President credited the person who had actually done the
work or written it. It was not unknown for a staff member, like Art Okun or me, to
get a phone call from Kennedy: Ive been reading this memo, and theres this stuff
in the fourth paragraph that I dont understand. Can you explain it to me? Somehow
I doubt that the current Council has that experience.
Jim Tobin was clearly the intellectual leader of the Kennedy Council. There were
regular late night discussions about what to think and what to say about pressing
macro issues. The regular participants were Jim, Art Okun, and me, and occasionally
Ken Arrow, Lloyd Ulman, and younger people like George Perry, Dick Cooper,
Roy Wehrle, Dick Attiyeh, Barbara Berman (as she was then), and Ed Kalachek,
with Walter, Kermit and Joe Pechman often pitching in. Those conversations were
intellectually as good as it gets. They indelibly marked my view of what serious
macroeconomics ought to be (and it may not be yours). Tobins way of combining
rigor and relevance, intelligence and passion, theory and common sense, has stayed
green in my memory for more than 40 years. It would be sad if it were to die out
in the profession; and sometimes, when I pick up a current journal (I am not thinking
of JMCB, by the way), I think that is actually happening, more or less deliberately.
If this conference induces some young macroeconomists to read a few of Tobins
best papers, that would already be a useful service to the future of macroeconomics. (If
you want to look at an overview of Tobins work, there is an excellent and empathetic
survey in the November 2003 Economic Journal by one of his best students, Willem
Buiter, who is currently the Chief Economist of the European Bank for Reconstruction and Development.)
Today the focus is on one particular article, A General Equilibrium Approach
to Monetary Theory, which appeared in the first issue of JMCB. At this hour
of the evening, I am not about to get into the nitty-gritty of equations, unknowns,
and the signs of partial derivatives. But I do want to use the occasion to describe
Tobins way of formulating a model and thinking about it, where he starts and
where he finishes. This approach was not Tobins invention. It was the way your
grandfather might have thought about macro- and monetary economics; Tobin just

ROBERT M. SOLOW : 659

happened to be a master of it. I fear that it may soon be extinct, like some obscure
Melanesian language whose native speakers are dying off. Since I think it may
actually be more productive of useful knowledge than the current fashion, I would
be sad to see it sunk without a trace. So I will just remind you.
The first thing you will notice about A General Equilibrium Approach is that its
basic building blocks are net-asset-demand functions, which determine the fraction of
total wealth parked in each specified asset as a function of the rates of return
on the various assets, plus the ratio of income to wealth (to allow for necessities
and luxuries among assets, and to connect up with current flows) and also any
unspecified predetermined variables that make sense in context. The signs of the
various partial derivatives are discussed in common-sense terms. There are no
optimizing consumers who maximize the expected present discounted values of
infinite utility streams, no Euler equations.
So where are the microfoundations? The answer is that they are embedded in
those common-sense restrictions on partial derivatives. The usual homogeneity
postulates and the adding-up conditions imposed by budget constraints are also built
into Tobins specification. You know, there is something a little ludicrous in the
belief that microfoundations for macroeconomics were invented some time in
the 1970s. If you read Keyness General Theory or Pigous Employment and Equilibrium (or many lesser works) you will see that they are full of informal microfoundations. Every author tries to make his behavioral assumptions plausible by talking
about the way that groups of ordinary economic agents might be expected to act.
(I mention Pigou here only to make it clear that this issue has nothing to do with
the apocalyptic struggle between Keynes and the Classics. But you can recall
Keyness argument that the marginal propensity to consume should be between zero
and one, or his discussion about whether the marginal efficiency of investment
should be sensitive to current output or should depend primarily on the state of
long-term expectations. Those are microfoundations.)
If you were skeptical about any of his specifications, Tobin would have welcomed
your comments. There would be no objection if you were to frame your dissenting
opinion by writing down one of those optimizing models and showing that its
implications contradicted Tobins specification. But of course you would have to
defend your specification, Euler equation and all. I will come to that in a moment.
The other big difference you will notice between Tobins approach and todays
fashion is the absence of a representative agent. That personage is not needed with
the common-sense approach to microfoundations. One can take it for granted that
agents are heterogeneous, because they are. They differ in their preferences, their
expectations, their access to information, their beliefs about the way the economy
works, and their notions of proper behavior in the economic sphere. The economists responsibility is to choose those asset-demand functions (or whatever) in
such a way that they leave adequate scope for the market consequences of the
heterogeneities that happen to exist. That cannot be done exactly; it would be much
too hard. All one can do is to try to make proper allowance, accept criticism, and
respect the data.

660 : MONEY, CREDIT, AND BANKING

It would cut no ice with Tobin or with me to say that the only respectable
microfoundations are those deduced from a model with agents who optimize fully,
conditional on the usual things. That is just jive talk unless you can make a
good case that real agents can carry out a decent approximation to the suggested
optimization, and that the agents in the optimizing model have been endowed with
preferences, information, beliefs, and physical constraints that could reasonably be
imputed to real consumers, workers, and managers. And on top of it all, some reason
would have to be given why a reasonable person should believe that a model with
one agent or identical agents could possibly give a decent representation of a world
in which agents differ among themselves in all those ways I just talked about, not
to mention that some of them are big and others small. (An argument about robustness
would be acceptable but I dont recall one ever being made and such an argument
would be intrinsically very unlikely to succeed if it were tried.)
Nor do I think there is any salvation for the current fashion in an appeal to
empirical success. (I should be careful about what I describe as the current fashion.
I took a quick look at the latest issue of the Journal of Money, Credit, and Banking,
and discovered that only a few of the articles exhibited the telltale symptom of
doing their theory by introducing a representative agent who maximizes an infinite
sum of discounted future utilities. But when I inspected the latest issue of the Journal
of Monetary Economics, I found that a clear majority of the articles that could
do it did it. A couple of them were straightforward data analysis, and offered no
opportunity for this particular excess.) My view is that the standard empirical test of
a representative agent optimizing modelwhich is to calibrate it and check that
it can reproduce a few low-order moments of the datais a test with very little power
against plausible alternatives. The hurdle is set far too low. And in the meanwhile,
casual observation and the much more rigorous findings of behavioral economics
tell us that the world of the fashionable model is very different from the world we
are trying to give an account of. Tobins asset-demand functions and informal
restrictions offer at least a decent shot at giving the world an even break.
In short, it is not the general appeal to microfoundations that Tobin would
have rejected in 1968 or 2002; it is rather the extraordinarily limiting and implausible
microfoundations that the literature seems to be willing to accept. One could even
question whether a representative-agent model qualifies as microfoundation at all.
I realize that some fashionistas are in fact working to extend the standard model to
allow for heterogeneous agents and various frictions and non-standard behavior
patterns. More power to them.
Suppose we move from methodology to substance. There is a lot in A General
Equilibrium Approach to admire; and much of it has made its way into the literature
of monetary-macro-economics. Tobin was of course a Keynesian; he later described
himself as an Old Keynesian, not New, not Neo, not Post. But he was evidently
aware that the standard Keynesian emphasis on current flows needed to be completed
by an analysis that explicitly linked flows and stocks. This paper, along with the
earlier Money, Capital, and Other Stores of Value, are steps along the way.

ROBERT M. SOLOW : 661

A contemporary reader will immediately notice the appearance of q in its standard

meaning as the ratio of the equity-market price of a unit of real capital to its cost
of production. There is no fanfare about it: q had first seen the light of day in a
paper by Bill Brainard and Tobin in the May 1968 Papers and Proceedings number
of the AER, less than a year earlier. Given the vagaries of journal-editing and
printing, no issue arises about priority; it is clear what was being talked about in
New Haven. The point is that a role for q emerges quite naturally in A General
Equilibrium Approach. Tobin needs an expression for real wealth in a model with
one produced good and two assets (money and real capital). Money holdings have
to be deflated by the price of the composite good, p. The other component of
wealth, the ownership of real capital, is the market value of the existing capital
stock deflated by p, and that is obviously qK. In this paper, q is usually taken as
endogenous in the short run.
There is no explicit q-theory of investment in this paper, but Tobin is clear that
a higher value of q is favorable for effective demand, so he surely had its relation
with investment in mind. Whats more, in the two-asset money-and-capital model,
he shows how the financial sector can be reduced to a single equation in q and Y
that plays the role of an LM-curve; and he intersects it with a schematic IS curve that
is not specified in detail, to show how comparative-static results for this shortrun model can be obtained. He also considers a long-run equilibrium interpretation
in which q must equal 1. But the point to remember is that this is a model in which
stock effects play an equal role with flows, with q doing a lot of the work.
In summary, says Tobin, ...(T)he principal way in which financial policies affect
aggregate demand is by changing the valuations of physical assets relative to
their replacement costs. Monetary policies can accomplish such changes, but other
exogenous events can too.... There is no reason to think that the impact will be
captured in any single exogenous or intermediate variable, whether it is a monetary
stock or a market interest rate. Ill drink to that.
It could also be said that this paper (along with other, almost simultaneous,
articles) gets at what these days is called the credit channel or bank-lending
channel. A third model in the paper introduces a banking system and two related
assets, deposits and bank loans, and invites the natural comparative statics to explicate
the effects of policy measures on aggregate demand, generally mediated through q.
The neat thing, of course, it that it does this in an explicit general-equilibrium way.
The last point of substance that I want to mention is perhaps more philosophical
than practical, but it too reflects the general equilibrium approach. Tobin asks: what
distinguishes money from other assets in this way of looking at the economy? Why
is the exchange of money for other government debt expansionary? His answer is
that it has nothing to do with the conventional properties of money; the key is that
money has a legally or institutionally fixed interest rate. That rate is usually taken
to be zero, but it could be some other number. What matters is that it is exogenously
fixed, and not determined in a market. I will quote Tobins words at length; he was,
after all, the most lucid macroeconomist ever. When the supply of any asset
is increased, the structure of rates of return on this and other assets must change in

662 : MONEY, CREDIT, AND BANKING

a way that induces the public to hold the new supply. When the assets own rate
can rise, a large part of the necessary adjustment can occur in this way. But if
the own rate is fixed, the whole adjustment must take place through reductions in
other rates or increases in prices of other assets....(A)n n -asset economy will provide
no more than n1 independent market-clearing equations. If the rate of return on
one asset, money, is fixed, then the market rate of return on capital can, indeed
must, be among the n1 rates to be determined. This enables the monetary authority
to force the market return on physical capital to diverge from its technological
marginal efficiencyor, what is the same thing, to force the market evaluation of
existing capital to diverge from its reproduction cost. By creating these divergences,
the monetary authority can affect the current rate of production and accumulation
of capital assets. This is the manner in which the monetary authority can affect
aggregate demand in the short run.
I suspect that this thought also has something to do with Goodharts Law: one
of the problems associated with expanding the definition of the money supply
beyond the monetary base is that things with market-determined interest rates get
swept into the expanded money supply. Apart from the difficulty of control
brought about by financial engineering, the relation to the economy is attenuated.
That is Tobins story about monetary policy in the short run. How the short run
eases into the long run is a difficult matter, not only mathematically but conceptually.
Tobin never took care of it in a satisfactory way, though he was at least aware of
the problem, and nibbled away at it. The chance that it will be settled by versions
of the Ramsey model seems to me to be orders of magnitude smaller than the chance
that the Red Sox will beat the Cubs in the 2004 World Series. At least those of us
who root for the Red Sox know in our hearts that we are kidding ourselves.
The paper by Andres, Lopez-Salido, and Nelson in this volume is precisely
intended to co-opt Tobins 1969 paper into the fashionable modeling style. I want
to say a word about it from the perspective I have been advancing. In fact I want to
say two things about it, one favorable and one skeptical.
On the favorable side, it is obviously a skillfully carried out exercise in its
tradition. As I said earlier, I am much in favor of those who like toor feel they
mustmodel in the fashionable dynamic, optimizing, representative-agent style,
but use their ingenuity to introduce behavioral elementseven if in artificial ways
that can bring the model response closer to what one sees in real economies. That
is a good thing; and I read the paper as a step in that direction.
On the skeptical side, now: suppose I ask what is accomplished by doing this
exercise rather than starting with Tobins asset-demand functions. (Of course the
1969 paper doesnt talk about goods and labor markets, etc. Its scope is much
narrower than the paper by Andres et al. Imagine Tobin completed by a real sector
in his own style.) To estimate a Tobin model, you would have to choose specifications
and impose constraints in an ad hoc common-sense manner. Estimates would of
course depend on those specifications. The alternative is to provide estimates that
also depend on specifications, but different specifications tailored to a preference
for forward-looking optimization but limited by unrealistic specifications that you

ROBERT M. SOLOW : 663

wouldnt make unless you had to: ignoring heterogeneity (except in trivial ways),
ignoring bounded rationality, ignoring capital accumulation (!), allowing only special
classes of asset preferences. What reason is there to believe that those specifications
are any better, or not significantly worse than, some reasonable-looking asset-demand
functions? I do not see any such reason, once simple consistency conditions are
imposed. Maybe a simple analogy without any ideological baggage will make the
point. Suppose you wanted to estimate a downward p-sloping demand curve for
apples. Would any reasonable, pragmatic person insist on a demand curve that would
emerge from a single representative apple-buyer maximizing within a narrow class
of utility functions? Why?
I realize that an occasion like this is bound to call forth an excess of piety. Since
Jim Tobin was a close and admired friend, I am no doubt especially vulnerable to
that tendency. So perhaps I should say explicitly that I am perfectly aware that
money-and-macro did not end with A General Equilibrium Approach, or even
with Tobins later papers and books. He had his problems with short-run wage and
price dynamics, as do we all even now. He was perhaps not serious enough about
the role of expectations, or about the game-aspects of economic policy. You could
argue, though I would probably not go along, that he might profitably have made
more use of the intertemporal optimizing model as a sort of benchmark. And so
on. I have been trying to get across the notion that A General Equilibrium Approach
was a useful paper because it opened up a line of research that was in fact followed
by some readers of JMCB, but was soon overtaken in the professionat least in
the journals, if not in practiceby a less plausible, less promising way of doing
monetary macroeconomics. If you are looking for an excess of piety, thats where
to look.