This page intentionally left blank MONETARY THEORY AND POLICY FROM HUME AND SMITH TO WICKSELL Th is book provides a comprehensive survey of the major developments in monetary theory and policy from David Hume and Adam Smith to Walter Bagehot and Knut Wicksell. In particular, it seeks to explain why it took so long for a theory of central banking to penetrate mainstream thought. Th e book investigates how major monetary theorists understood the roles of the invisible and visible hands in money, credit, and banking; what they thought about rules and discretion and the role played by commodity-money in their conceptualizations; whether or not they distinguished between the two diff erent roles carried out via the fi nancial system – making payments effi ciently within the exchange process and facil- itating intermediation in the capital market; how they perceived the infl uence of the monetary system on macroeconomic aggregates such as the price level, output, and accumulation of wealth; and fi nally, what they thought about monetary policy. Th e book explores the analytical dimensions in the various monetary theories while emphasizing their policy consequences. Th e book highlights the work of a number of pioneering theoreticians. Among these Henry Th ornton stands out, primarily because of his innovative analysis of the compli- cated phenomena that developed aft er the introduction of an inconvertible monetary system in 1797. A major question addressed by the book is why theoreticians and policy makers were so resistant to his ideas for so many years. Arie Arnon is Associate Professor of Economics at Ben-Gurion University and Head of the Economics and Society Program at Van Leer Jerusalem Institute, Israel. Professor Arnon’s areas of research include the history of economic thought, macroeconomics, and monetary theory. His books include Th omas Tooke: A Pioneer of Monetary Th eory (1991); Th e Palestinian Economy: Between Imposed Integration and Voluntary Separation (1997, coauthored with I. Luski, A. Spivak, and J. Weinblatt); and Th e Open Economy Macromodel: Past, Present, and Future (2002, coedited with W. Young). Professor Arnon has published articles in History of Political Economy, Oxford Economic Papers , the E conomic Journal , and M iddle East Journal . He has served on the editorial boards of the European Journal of the History of Economic Th ought , the Economic Quarterly , and the Journal of Welfare and Social Security Studies . He has held visiting positions at the University of California, Berkeley; Stanford University; the University of Pennsylvania; Th e New School; and the School of Oriental and African Studies, University of London. He has also served as a Senior Economist in the Research Department of the Bank of Israel and as a consultant to the World Bank. Since 2002, Professor Arnon has been the coordinator of the Israeli team in the Aix Group, where experts from the Palestinian Authority, Israel, and the international com- munity discuss various economic aspects of the confl ict and develop scenarios and policy alternatives for a permanent peace settlement. A recent publication of the group is enti- tled Economic Dimensions of a Two-State Agreement between Israel and Palestine (2007). HISTORICAL PERSPECTIVES ON MODERN ECONOMICS General Editor: Craufurd D. Goodwin, Duke University Th is series contains original works that challenge and enlighten historians of economics. For the profession as a whole, it promotes better understanding of the origin and con- tent of modern economics Other books in the series: William J. Barber , D esigns within Disorder: Franklin D. Roosevelt, the Economists, and the Shaping of American Economic Policy, 1933–1945 William J. Barber , From New Era to New Deal: Herbert Hoover, the Economists, and American Economic Policy, 1921–1933 Filippo Cesarano , Monetary Th eory and Bretton Woods: Th e Construction of an International Monetary Order Timothy D avis , R icardo’s Macroeconomics: Money, Trade Cycles, and Growth Jerry Evensky , Adam Smith’s Moral Philosophy: A Historical and Contemporary Perspective on Markets, Law, Ethics, and Culture M. June Flanders , International Monetary Economics, 1870–1960: Between the Classical and the New Classical J. Daniel Hammond , Th eory and Measurement: Causality Issues in Milton Friedman’s Monetary Economics Samuel Hollander , Th e Economics of Karl Marx Lars Jonung (ed.), Th e Stockholm School of Economics Revisited Gerald M. Koot , E nglish Historical Economics, 1870–1926: Th e Rise of Economic History and Mercantilism Kim Kyun , Equilibrium Business Cycle Th eory in Historical Perspective David Laidler , F abricating the Keynesian Revolution: Studies of the Inter-War Literature on Money, the Cycle , and Unemployment Odd Langholm , Th e Legacy of Scholasticism in Economic Th ought: Antecedents of Choice and Power Robert Leonard , V on Neumann, Morgenstern, and the Creation of Game Th eory: From Chess to Social Science, 1900–1960 Harro Maas , William Stanley Jevons and the Making of Modern Economics Philip Mirowski , M ore Heat Th an Light: Economics as Social Physics, Physics as Nature’s Economics Philip Mirowski (ed.), N ature Images in Economic Th ought: “Markets Read in Tooth and Claw” Continued aft er Index Monetary Th eory and Policy from Hume and Smith to Wicksell Money, Credit, and the Economy ARIE ARNON Department of Economics, Ben-Gurion University of the Negev, Beer-Sheva, Israel and Head, Economics and Society Program, Van Leer Jerusalem Institute cambridge university press Cambridge, New York, Melbourne, Madrid, Cape Town, Singapore, São Paulo, Delhi, Dubai, Tokyo, Mexico City Cambridge University Press 32 Avenue of the Americas, New York, NY 10013-2473, USA www.cambridge.org Information on this title: www.cambridge.org /9780521191135 © Arie Arnon 2011 Th is publication is in copyright. Subject to statutory exception and to the provisions of relevant collective licensing agreements, no reproduction of any part may take place without the written permission of Cambridge University Press. First published 2011 Printed in the United States of America A catalog record for this publication is available from the British Library. Library of Congress Cataloging in Publication data Arnon, Arie. Monetary theory and policy from Hume and Smith to Wicksell : money, credit, and the economy / Arie Arnon. p. cm. – (Historical perspectives on modern economics) Includes bibliographical references and index. ISBN 978-0-521-19113-5 (hardback) 1. Monetary policy – History. 2. Banks and banking, Central – History. 3. Economists. I. Title. II. Series. HG230.3.A684 2011 339.5′3–dc22 2010037658 ISBN 978-0-521-19113-5 Hardback Cambridge University Press has no responsibility for the persistence or accuracy of URLs for external or third-party Internet Web sites referred to in this publication and does not guarantee that any content on such Web sites is, or will remain, accurate or appropriate. To Ruth, my greatest love; Yes, more than the history of monetary thought and Peace in the Middle East.