The Quantity Theory and the Income Expenditure Theory in an Open Economy: Canada, 1926–1958

Abstract

Post-war balance of payments problems are partly the results of policy applications of the “modern view” of the balancing mechanism of international trade theory. Derived from the Keynesian income-expenditure theory of income determination, the “modern view” relegates the role of the stock of money to a secondary place in determining national income. It asserts that control of the stock of money through monetary policy is incapable of significantly, or dependably, influencing the circular flow of income and thereby the balance of payments. One reason for this view is the conviction that monetary velocity behaves in an erratic and unpredictable manner. In contrast, pre-Keynesian theory attributed a central role to the stock of money, and so to monetary policy, in the balancing mechanism of international trade. It contained an explicit acceptance of the quantity theory of money which argues, among other things, that monetary velocity does behave in a predictable manner. The usefulness of the modern view of the balancing mechanism of international trade turns partly on the relative stability and behaviour of monetary velocity on the one hand and of the Keynesian investment multiplier on the other. In all countries, but particularly in those that are sensitive to external disturbances, the balancing mechanism of international trade is an issue of vital concern for public policy. The purpose of this paper is to examine the relative stability and behaviour of monetary velocity and of the investment multiplier in an open economy that is subject to external disturbances and in which international trade plays a relatively important role in aggregate output and income. The article deals with the Canadian economy during the period 1926–58.

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