On Passive Money

Author(s): Julio H. G. Olivera

Source: Journal of Political Economy, Vol. 78, No. 4, Part 2: Key Problems of Economic Policy
in Latin America (Jul. - Aug., 1970), pp. 805-814
Published by: The University of Chicago Press
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On Passive Money

Julio H. G. Olivera
Universityof BuenosAires

I
There are two ways in which the quantity of money may be included in a
general equilibrium system: as a datum, whose value is fixed exogenously,
or as an unknown, whose value is determined by the equilibrium system
itself. Let them be called active money and passive money, respectively.
Current monetary theory uses the first approach. The Ricardo-WalrasKeynes tradition in general equilibrium models is clearly of the activemoney variety. This is also true of the more contemporary versions, such
as Patinkin's well-known system (1965).' Apart from the main stream of
thought, however, a number of analyses exist which imply passive money.
The gold-standard model, as it is usually expounded, belongs to this
class. The price of gold in terms of money is given, while the stock of
money is endogenously determined by the set of equilibrium conditions.
The form in which the quantity of money adapts to its equilibrium level
differs according to the institutional mechanism: Convergence is assured
through monetization and demonetization of gold in the pure goldcurrency system, and through convertibility of notes into gold and vice
versa in the gold-standard system with paper money. In either case, the
money supply is allowed to conform to its equilibrium volume. This kind
of monetary system, in which the money price of a certain product or
commodity is a datum and the quantity of money a dependent magnitude,
may be denoted in general as a commodity standard.
I am indebted to Professors Martin J. Bailey, Geoffrey Maynard, Don Patinkin,
and Henry C. Wallich. and to my colleague Rolf Mantel for interestingcomments.
' Gurley and Shaw, whose analysis also belongs to this class, define expressively
what I call active money: "The nominal stock of money is an adventitious datum
cast into the structureof the model" (1960, p. 35).
805

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JOURNAL OF POLITICALECONOMY

Another type of situation which implies passive money is the labor

standard, as described by Hicks (1955, p. 391) in the following passage:
In the new world which began after 1931 the problem of wages is
bound to have a distinctly different character from that which it
had in the older time. Since 1931, wages questions have been
closely associated with monetary questions; it is even true that
the general level of wages has become a monetary question. So
long as wages were being determined within a given monetary
framework, there was some sense in saying that there was an
"equilibrium wage," a wage that was in line with the monetary
conditions that were laid down from outside. But the world we
now live in is one in which the monetary system has become
relatively elastic, so that it can accommodate itself to changes in
wages, rather than the other way about.
In this context, the price of labor is exogenously fixed, whereas money
is a variable whose quantum is established by the economic system.
There is a third type of passive-money model, which (for symmetry, and
in the absence of a better term) we may label the credit standard. Under
this system the interest rate is exogenous, and the money supply endogenous. It is assumed, for example, that the banks set the money-rate of
interest autonomously, while the money supply is one of the economic
variables determined by the market. A model of this structure is clearly
involved in Wicksell's famous analysis on the fluctuations of the price
level (1898, esp. chap. 9). But certain rudiments of it can also be traced in
some notions of the old Banking School, in the English controversy about
the modus operandi of the bank rate, and in the American discussion on
monetary policy during the period of the Treasury-FederalReserve accord.
Today the chief motivation for passive-money hypotheses stems from
inflation theory. The labor standard underlies nearly all cost-inflation
models. Structural inflation analyses, on the other hand, presuppose the
existence of some commodity standard; they view the main strand of
causation as running from the price level to the quantity of money, rather
than in the opposite way.2 Occasionally credit-standard arguments are
combined with cost- or structural-inflation theses.3 Thus the assumption
of passive money, under one form or another, pervades a large part of
the current work on inflation. It is a peculiarity of the present state of
economic thought that, while monetary theory continues to be based on
the principle of active money, inflation theory tends more and more to
rest on the idea of passive money.
On this I may perhapsbe allowed to refer the readerto my previous paper (1964).
Tooke (1844, p. 123) provides an early example of a cost-inflation model based on
the credit standard.
2

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807

PASSIVE MONEY

Active-moneymodelsof generalequilibriumhavereceivedconsiderable
attention.Theirdeterminateness,
comparativestatic behavior,and stability propertieshave been exploredat length. In markedcontrast,passivemoney models of general equilibriumhave not even been formulated
explicitly.We are, at best, only vaguely awareof the bearingand latent
implicationsof passivemoneyfor the economicsystem.If the hypothesis
of passive money is to be properlyassessed, such implicationsshould
be carefullybroughtout. There is no ground to overlook or minimize
their significance.Consequently,the ensuingsectionswill be devoted to
a study of the passive-moneyequilibrium,includingan attemptto comparethe essentialpoints with the doctrineof activemoney.
II

It maybe well to approachour subjectfromthe familiarsettingof a closed

productioneconomy,freefrommoneyillusion.All goods will be classified
into four sets: laborservices,commodities,bonds,and money.Exchangeratioswill be heldconstantwithineach set so that the respectivecategories
may be handledas singlecompositegoods. Investment,althoughpositive,
will be supposedto makeonly a triflingadditionto the realcapitalstock.4
Expectationswill be assumed to be stationary,with the elasticity of
expectationsequal to unity. We shall abstractfrom distributioneffects,
both in regardto incomeand assets.
Upon the hypothesisthat the budgetconstraintis strictlyoperativefor
each consumer,the system will be in generalequilibriumif any subset
of threeamongthe fouraggregatemarketsare balanced.We maytherefore
specifythe equilibriumrelationsas follows:
T(s/p) = 0,

(1)

E(s/p, M/p, i) = 0,

(2)

D(M/p, i) = 0,

(3)

whereT, E, and D mean excess demandin the marketsfor labor, commodities,and money, respectively;s denotes the money-wagerate, i the
interest rate, p the money price of commodities,and M the nominal
quantityof money. Since this systemis a widelyknown analyticaldevice
(Patinkin1965),5 let us pass directlyto the applicationswhichconcernus
here.
4 This is the usual assumption in short-period monetary models; see, however,
Mundell (1965).
5 The model above, however, is given solely in terms of the net demand functions,
whereas Patinkin specifies the properties of the supply and demand functions separately. Thus the model with which we propose to deal is actually more general than
Patinkin's.

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JOURNAL OF POLITICALECONOMY

The case of active money stands out quite obviously from the basic
structure: Given M, the group of equations determines s,p, and i. The labor
standard is derived from the same framework by interchanging the roles of
s and M, so that s becomes a datum and M an unknown. Therefore, given
the value of s, the three equations determinethe levels of M, p, and i. If p,
instead of s, is fixed from outside, we get the commodity standard, with the
system telling the values of M, s, and i. Each of these models-active
money, the labor standard, and the commodity standard-is thus consistent with equilibrium.
This condition is easily seen to fail under the credit-standard model.
Here it is the money price of bonds, and consequently the rate of interest,
which acts as a datum, the unknowns being p, s, and M. But since the
latter come into the equilibrium system solely through their ratios, the
model so generated is inconsistent in general. It contains three independent
relations, equations (1)-(3), to determine two unknowns (Mip and sip).
In the light of this, it is hardly surprising that the credit standard had
always been enveloped by a margin of ambiguity. Tooke and Wicksell,
for example, drew mutually contradictory inferences from much the same
theoretical axioms.
To obtain determinateness, it is necessary to relax any one of the
equilibriumconditions. There are two main possibilities from the economic
standpoint. One is to drop the full-employment condition (which is precisely what Tooke did), which leads to a quasiequilibrium system of
Keynesian style. The other is to transform the money-market equation
into an identity, essentially in the vein of Say's Identity (this, it seems clear,
was Wicksell's procedure).6 Either way, the model ceases to be overdetermined. However only the real system becomes determinate-the
equilibrium values of Mlp and s/p are compatible with an infinite number
of monetary equilibria.

mI
Space forbids a closer examination of these issues, but what has been
said is perhaps sufficient to bring out the central points. Let us now direct
our attention to the effects of contingencies tending to produce change.
Our frame of reference will again be the equilibrium system, equations
(1)-(3), with the appropriate monetary specification. We shall utilize the
method of comparative theory which has been long familiar in analytical
economics. A small variation in one parameter will be supposed to come
about. The corresponding total derivatives of the excess demand functions
must all be zero, for we are relating two equilibrium states with one another.
6 Wicksell's theory implies that the money market keeps continually balanced
(Keynes 1958, p. 198).

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809

PASSIVEMONEY

This gives a new system of equations which determinesthe induced changes

in the equilibrium values.
In order to get definite results about the directions of change on the
basis solely of qualitative information referring to the excess demand
functions, we shall use Samuelson's Conjugate Pairs Theorem (Samuelson
1955, chap. 3; Archibald 1965). We assume accordingly that the parameter
shift affects only one of the excess demand functions in the model. As
for the characteristics of these functions, we shall ascribe to them the
"normal" properties
T' < O, E81, > O, Em/P> 0, Ei < O, DMP < 0, and Di < 0.

(4)

As customary, the suffixdesignates the independent variable with respect to

which the partial derivation is performed.
The analysis will have to be confined to the determinate systems, as
singled out by the previous argument. Hence, for purposes of comparison, we may start with the case of active money. Regarding this model,
the displacement of equilibrium brought about by short-runtypical changes
may be summarized as follows.
IA. Change in thepropensity to save.-Let it be represented by a corresponding change in some parameter a. The list of variations in the equilibrium data-hereafter denoted as the shift vector-is
Ta = ?

E, < ? .

(5)

-Da = 0

The alteration in the propensity to save is assumed to occur entirely at the

expense (or to the benefit) of the bond market. The response vectorwhich is deduced by the method described above-is

[ds/da<

01

dp/da <01.

di/da <

(6)

The results carry the opposite sign in the case of a variation of the propensity to invest.
lB. Change in liquiditypreference.-It will be symbolized by a corresponding change of the parameter A. The shift vector is taken to be
TA = ?

Ex = ?

[DE > ]

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(7)

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JOURNAL OF POLITICALECONOMY

Again, the change in liquidity preference is assumed to take place at the

cost (or to the benefit) of the bond market. The response vector is

<0
Eds/dA
dp/dA <01.

(8)

di/dA> o
IC. Change in the money supply.-A glance at the equilibrium system
suffices to show that, given a variation of M, equilibrium is reestablished
through an equiproportional change of p and s, with i remaining constant.
This is the well-known derivation of the Quantity Theory as a proposition
in comparative statics.
So much for the case of active money. Let us now focus on the behavior
of the labor standard under the same hypothetical changes.
2A. Change in the propensity to save.-The
response vector is found to be

shift vector is (5). The

dpld =
dMIda> 0

(9)

di/da < 0
With a reversal of signs, the foregoing vector is applicable to any variation
of the propensity to invest.
2B. Changein liquiditypreference.-The shift vector is (7). The response
vector is now
dp/d = O
dM/dA

(10)

>0]

di/dA> o
2C. Change in s.-Obviously, equilibrium is restored through an equiproportional adjustment of p and M, with i unaltered. We are thus led
to a kind of converse statement of the Quantity Theory.
Finally, let us envisage the effects of the same types of disturbance in a
commodity-standard system.
3A. Change in the propensity to save.-The shift vector is again (5). The
response vector is
ds/da = 01
dM/da >

di/da < 0

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(11)

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PASSIVEMONEY

As in the preceding cases, the negative of this vector describes the response
to a shift in the propensity to invest.
3B. Change in liquiditypreference.-With (7) as shift vector, the effect
on equilibrium is
E

ds/dA =

0]

dM/dA > 0
di/dA >

(12)

oJ

3C. Change in p.-It is intuitive that the new equilibrium is attained

by means of an equiproportional variation in M and s, with i unaltered.
We arrive again at a converse form of the Quantity Theory.7

IV
These results are far from anomalous, but still their scope would be narrow
if equilibrium were not stable. Let us therefore turn to the dynamics of the
subject. We shall concentrate attention on the so-called asymptotic stability
the tendency of a perturbed system to return, over time, to the equilibrium state. Only small perturbations will be considered. Proceeding in
the usual fashion, we shall approximate the dynamic system through
adjustment laws which are linear in the deviations from equilibrium.
Our knowledge about the respective coefficients will be limited to their
signs. If such information suffices to indicate stability of the dynamic
process, we shall say that the system is qualitatively stable.8 If stability
cannot be determined without specifying the numerical values of the
parameters, we shall say that the system is qualitatively nonstable. If the
data about the signs preclude the stability of the system, we shall refer to
it as qualitatively unstable.
A word now on the criterion of stability. Since we must operate with
characteristic equations of the third degree, a convenient shortcut to the
investigation of stability is provided by one of the rules of Lienard and
Chipart (Gantmacher 1960, p. 220). Namely, given the characteristic
polynomial X3 + a x2 + a2x + a3, a necessary and sufficient condition
that all its roots have negative real parts is
a,,

a3

> 0; a1a2 > a3.

(13)

7 The symmetry, however, is only mechanical; the spirit of the genuine Quantity
Theory involves active money (Friedman 1956, esp. pp. 16-17).
8
Sign stable, in the terminology of Quirk and Ruppert (1965).

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JOURNAL OF POLITICALECONOMY

8I2

Having set forth these premises, let us briefly sketch their application
to the matter in hand. In the active-money case, the adjustment laws are
normally
hl > 0,
ds/dt = hiTL(slp),
dp/dt = jiEL(s/p, Mo/p, i),

jl > 0,

di/dt = kDL(MoIp, i),

k, > 0.

(14)

The subscript o signifies that the variable is regarded as exogenous, and the
superscriptL denotes that the function is approximated by the linear part
of its Taylor series in the neighborhood of equilibrium. This dynamic
system fulfills all the conditions in (13) and is, therefore, qualitatively
stable.9
Let us now take up the hypothesis of passive money. Under the commodity standard, the adaptability of the money supply must replace the
flexibility of the price level. The resulting dynamic system is
dsldt = h2TL(sIpO),

h2 > 0,

dM/dt = i2EL(sIpo,M/po, i),

di/dt = k2DL(Mlpo, i),

(15)

0,
k2 > 0,
<

i2

which also turns out to be qualitatively stable.

For the labor standard we have, finally, the adjustment functions
dM/dt = h3TL(soIp),
dp/dt= j3EL(soIp, M/p, i),
di/dt = k3DL(Mlp, i),

h3 < 0,

(16)

13 > 0,
k3 > 0.

The test for stability exhibits a different pattern in this case. Although a,
and a3 are again positive, the sign of a1a2 - a3 depends on the parameter
values. The system is hence qualitatively nonstable.
This raises the question of how the coefficient of monetary adjustment
affects the stability of equilibrium. Is a high or a low speed of response
of the money supply more likely to promote stability? The result ultimately
turns on the sign of the expression
S-h j3T'
-h3

(k3DMIpEjEi

2M
--i3Es/l

MEs

p2)1 '

(17)

which is the uncertain term in a1a2 - a3, the other terms being necessarily
positive. It is a cumbersome formula, but its import is clear. If the term
(17) is positive, the system is stable, whatever the absolute magnitude of
h3. But if (17) is negative, the chance of stability is greater the smaller h3 is
in absolute value. Hence, on balance, a slowly responsive money supply
8 Incidentally, this proves in a formal manner Patinkin's thesis in chap. 13, secs. 2
and 3 (Patinkin 1965, pp. 316-28).

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PASSIVEMONEY

is more favorable to stability than a highly sensitive one. However, some

degree of sensitivity is required. If h3 = 0, the system becomes qualitatively
unstable, for then a3 = 0.

Our topic is not one to be dealt with exhaustively in a few pages, and it
would not be difficult to amplify or qualify the foregoing argument. But
we hope to have carried the analysis far enough to permit some broad
conclusions. The passive-money economy we have examined is quite regular in behavior, from both the static and the dynamic standpoints, under
the regime of the commodity standard. It is much less "well behaved"
under the labor standard, for although it yields definite comparative
static results, it offers no assurance of stability. And it proves anarchic
under the credit standard-overdetermined in real terms and indeterminate in monetary values.
Parallels of this kind can be drawn only with reference to a specified
equilibrium structure. Needless to say, alternative models may lead to
conclusions which differ from the ones just summarized. We cannot even
exclude the possibility that in other analytical settings the passive-money
economy may behave more regularly, in the above sense, than the activemoney system. So we must be careful not to overassert the particular
results established in the preceding sections. The chief point is rather that
there exists no necessary congruity, either statical or dynamical, between
the active-money type of model and its passive-money "duals." This fact
must be emphasized, more than any special instance of it.
We must not conclude without saying a word about economic growth.
Some of its consequences on passive money, and vice versa, have been
attended to by the theories of inflation cited at the outset of this paper.
But the problem should be subjected to a closer dissection with the
apparatus of modern growth theory. The recent attempts at integrating
the doctrines of money and growth are based on active-money premises,
since they consider the rate of increase in the money supply as given
exogenously. It would be worth while to undertake a similar integration
from the passive-money point of view. In neither case, however, can we
expect to be able to predict the directions of change of the variables with
the aid of qualitative information alone.10
One more matter may be mentioned before closing these remarks.
Active money is not always separated by a sharp line of demarcation from
passive money. Very often they merge together in actual fact. To the extent
10 That is an additional reason in favor of Harberger'sadvice (and practice) of
bringingthe "inflation and growth" controversydown to rigorous empirical analysis
(Harberger1963, 1964).

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JOURNAL OF POLITICALECONOMY

that money prices are downward inflexible, the historically given prices fix
a minimum to the monetary stock. Below this lower bound there is no
general equilibrium solution. But above the passive minimum, insofar as
prices are upward flexible, money becomes active. Price increases may well
happen to be structural-the monetary floor may rise because of autonomous factors uplifting them-but there is room for monetary inflation
above the floor. It would thus seem that a mixed model, in which active
and passive money are amalgamated, would come nearest to the real
course of events.
References
Archibald, G. C. "The Qualitative Content of Maximizing Models." J.P.E.
73 (February 1965): 27-36.
Friedman, Milton. "The Quantity Theory of Money-A Restatement." In
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Gantmacher, F. R. The Theory of Matrices. Translated by K. A. Hirsch.
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Gurley, John G., and Shaw, Edward S. Money in a Theory of Finance. Washington: Brookings Institution, 1960.
Harberger, Arnold C. "Dynamics of Inflation in Chile." In Measurement in
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