The business cycle with its alternation of cyclical expansion and contraction is a recurrent feature of the economy. The human misery associated with contractions or recessions manifests a failure of the price system. But what kind of failure? There are two schools of thought. One school, the market-disorder view, which includes the credit-cycle and Keynesian traditions, takes the failure as endemic to a free market system of economic organization. The opposing school, the monetary-disorder (quantity-theory) view, attributes major cyclical instability to interference by central banks with the operation of the price system.

THE ISSUES THAT DIVIDE ECONOMISTS INTO DIFFERENT SCHOOLS

There are two fundamental issues in monetary economics. One issue concerns whether the price level is a real or a monetary phenomenon. Does the price level emerge as an aggregation of dollar prices in individual markets in which those dollar prices are determined by real factors affecting supply and demand particular to those markets? Alternatively, does the price level depend on the monetary arrangements of a country, that is, the way in which the central bank controls money creation?

An alternative formulation of this issue is whether there is a clear distinction between the determination of equilibrium values of nominal and of real variables. How does one give empirical content to the rationality postulate, which states that welfare depends only on real, not nominal, variables? In the quantity-theory tradition, the central bank possesses the power to control nominal variables independently of the behavior of real variables. In particular, it can control the nominal expenditure of the public as the sum of trend growth in real output and a targeted value of inflation.