Monetary Disequilibrium Theory

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The Monetary Disequilibrium Theory presents an alternative to the more popular and widely coveted Real business cycle model and the quantity theory of money considered as only a long-run theory of the price level. While most economists can agree that monetary policy influences real activity in the economy, the Real business cycle model ignores these effects of monetary policy. By relying primarily on a Keynesian or non-market-clearing approach, the Monetary Disequilibrium Theory addresses the effects of monetary policy on real sectors of the economy.

Monetary Disequilibrium correctly recognizes that prices and wages do not fluctuate with a change in the money supply; rather they are “sticky.” This “monetary disequilibrium” in the short run is the impetus which proponents of the Monetary Disequilibrium Theory contend affects the economy in real terms. Within the Monetary Disequilibrium model changes in the money supply will result first in a change of output, rather than a change in prices. Consequently, an increase in the money supply will induce workers and businesses to supply more, without being fooled into doing so. In a situation where the money supply contracts, workers will be overpaid, and thus businesses will respond by laying off workers. An advantage over the current Real business cycle theory is that through this explanation the Monetary Disequilibrium Theory is able to account for involuntary unemployment.

Despite the Monetary Disequilibrium’s reconciling the effects of monetary policy on real economic factors, it suffers from its own set of inadequacies. An essential drawback to the Monetary Disequilibrium Theory is that higher wages in the short run (caused by a decrease in the money supply) will not change the relative profitability of investments. The Monetary Disequilibrium Theory is also mistaken in claiming that the labor market will clear faster than the production markets, since in depressions the production center will typically rebound first, while unemployment lags behind for a number of quarters (as seen in the last recession). It is these inadequacies which explain why the Monetary Disequilibrium Theory has never enjoyed overwhelming support among economists.

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