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and Ricardo who formulated independently one from others the theory of differential rent. These works ware a sort of reaction to committees appointed by Parliament to report on the recent fall in grain prices and the extension of cultivation to less fertile and less accessible land during the years of the Napoleonic Wars which, by drastically reducing the imports of food supplies, had provoked a substantial increase in the price of cereals, in particular corn; the prices of manufacturing goods, on the other hand, had increased less rapidly than agricultural products and wages. In 1816, at the end of a long period of war, the landowners managed to convince Parliament to approve the famous new Corn Laws; tariffs were fixed at such a high level that corn, the foreign prices of which were much lower than the internal ones, could not enter the country at all. Then the protectionist barriers allowed the maintenance of high land rents to the detriment of profits, given the rigidity of real wages.

The opposition of manufacturers was strong because this prevented English industry from taking advantage of its higher level of productivity with respect to its European competitors. At the climax of the debate on the Corn Laws, the underlying explanation in these works lay in the phenomenon of diminishing returns: “in the progress of the improvement of cultivation the raising of rude produce becomes progressively more expensive” as West said (quoted in Blaug, p. 75-76), that is to say: each additional quantity of work will yield a diminished return. This idea is supposed to be applicable only to agriculture, such that the price is regulated by the least favourable circumstance under which the production is carried on. Therefore, the rent is the excess of the product over the outlays of the marginal farmer for capital and labour.

3. 3. The Ricardian system

In the Ricardian system, economic growth is frequently viewed as if all demographic adjustments depend on the fact that the stock of capital is not yet optimally adjusted to the labour force and the supply of available land. So the rate of profit varies with the strength of diminishing returns; In the Essay on the Influence of a Low Price of Corn on the Profits of Stock (1815), Ricardo did use corn as a measure for aggregating the heterogeneous inputs of agriculture on the assumption that all prices rise and fall with corn prices, and he also employed arithmetical examples in which all inputs and outputs of both agriculture and

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manufacturing are expressed in terms of corn. In normal circumstances, a change in the terms of trade between corn and cloth will alter real wages and hence will upset the proposition that the profits of the farmer regulate the profits of all other trades.

The reasoning with which Ricardo tried to demonstrate the necessity for the abolition of the Corn Laws is as follows: Given the limited amount of land suitable for cultivation, if corn imports are impeded, this will force the national agriculture to increase its production by intensifying investment in agriculture, thus increasing the rent share in the national income and diminishing the profit share. This slows capital accumulation, as most of the savings necessary to finance investment come from profits. In fact, the landowners, who also earn very high incomes, do not save because the accumulation of wealth is not among their aspirations; on the other hand, the workers who earn subsistence wages, do not save because they have nothing to save. However Ricardo admitted that technical innovations, by increasing the productivity of labour, could also induce increases in profits, he believed that such affects would only be temporary and would reactivate the catastrophic effects of decreasing returns.

It was only in The Principles of Political Economy and Taxation (1817) that Ricardo first took up the question of value theory. His central purpose is to determine the laws which regulate the distribution of the produce of industry. He did emphasis the quantitative importance of labour inputs and in particular their strategic role in bringing about changes in relative prices over time, the approximate ratios in which goods exchanged are quantitatively influenced more by relative labour costs than by, say, relative interest charges. Therefore, labour costs do dominate total costs in almost all industries (physical man-hours as a rough-and-ready yardstick for explaining changes in relative prices).

When the rate of profit is positive, the price of a commodity is influenced not merely by the amount of labour required to produce it but also by the length of time for which that labour is embodied in production. The price of a good in the long run is equal to its wage cost plus a profit margin on the capital advanced. If one worker produces one bushel of wheat in one year and two workers one yard of cloth in one year, the relative price of the two goods is equal to the ratio of the amounts of labour required to produce each of them, cloth will be twice as expensive as

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wheat. More precisely, Ricardo assumed that the purchasing power of money over all goods and services, as measured by the average level of prices in the economy, is constant and hence that distribution is a matter of dividing a given real national product among landlords, capitalists and labourers. The value of a commodity, therefore, is determined by the variable inputs applied on land and distribution is, in the first instance, a problem of dividing a product between labour and capital. The fact that capital-labour ratios differ among industries means that any change in money wage rates or the rate of profit necessarily alters the structure of prices and therefore the value of the product.

3. 4. Ricardo on foreign trade

Ricardo was virtually the first economists to advocate a separate theory of international trade. Adam Smith thought that trade took place only when countries had an absolute advantage in one good. For example, if England produces a unit of cloth with 100 hours of labour and a unit of wine with 90 hours of labour and Portugal a unit of cloth with 90 hours of labour and a unit of wine with 100 hours of labour, therefore, England has an absolute advantage in wine and Portugal an absolute advantage in cloth, these two countries would find it profitable to import the good which could be obtained in exchange for exports at less cost than their home production would entail. In developing this idea from a critical statement, Ricardo established the comparative advantage theory. Suppose that England produces the cloth at 100 hours and the wine at 120 hours of labour and Portugal produces the same goods, respectively, at 90 and 80 hours. A priori, England has no absolute advantage in terms of labour value of these two goods. But Ricardo said that Portugal had a comparative advantage in wine since the cost difference for wine is relatively greater that that for cloth: 120/80 > 100/90. What have to be compared are not costs but ratios of costs, that is, alternative costs.

Ricardo realised that if Portugal had an absolute advantage in both wine and cloth but a greater relative advantage in wine, foreign trade with England is only possible if money wage rates in Portugal are higher than in England. If the hourly wage rate in terms of gold is the same, Portugal will not import cloth since every Portuguese consumer can then get cloth more cheaply from domestic suppliers. England would therefore have to ship gold to Portugal to pay for wine imports until hourly gold wages (and prices) in Portugal rose enough to make it

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profitable for Portuguese consumers to import English cloth. In general, then, the low-cost country has the higher hourly gold wage and hence a higher money price for similar goods. Hume’s ‘natural distribution of specie’ therefore not only works to balance each country’s exports and imports but also results in such relative price levels between countries as to induce each country to produce goods in which it has a comparative advantage. Relative price levels between countries are determined by differences in the cost of obtaining gold: the greater the efficiency of labour in the export industries of a country possessing no gold mines and the less the expense of conveying gold, the lower will be the cost of obtaining precious metals and the higher will be the level of average wages and prices relative to countries exporting gold bullion. An overall disadvantage in productivity in a particular country relative to the rest of the world need not prevent her from participating in international trade, there is always a rate of exchange that would permit her to export those goods in which she had the least comparative disadvantage, while importing those in which she had the greatest disadvantage.

4. Say and Mill

4. 1. Say’s law

In an economy with an advanced division of labour, the means available to anyone for acquiring goods and services are the power to produce equivalent goods and services. Production increases not only the supply of goods but, by virtue of the requisite cost payments to the production factors, also creates the demand to purchase these goods. This is the core of Say’s Law of Markets: while it is possible for a particular good to be produced in excess relative to all other goods, it is impossible for all goods to be produced in relative excess. That is the impossibility of a general overproduction in the economy.

Jean-Baptiste Say’s Traité d’économie politique (1817) presents major developments on this topic. Assume that there are n goods in a closed economy. If we select any one of the n goods to be a ‘numéraire’ by setting its price identically equal to unity and expressing all other prices in terms of it, there will be n-1 exchange ratios or relative prices to be determined. In an economy in which only accounting money is used –the medium of exchange being an arbitrary commodity

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like any otherthe total value of all goods demanded is always identically equal to the total value of all goods supplied. Summing over all the n goods (commodities plus money) demanded and supplied, this identity can be written as:

This identity (called Walras Law) simply states the logical impossibility of oversupply of all goods in a barter economy where money is only accounting money. However, as soon as we have one good, acting not only as a medium of exchange but also as a store of value, the amount demanded of the n-1 commodities will be equal to the total value of the n-1 commodities supplied only if the demand for money (Dn) is equal to the supply of money (Sn). We can therefore write:

if and only if Dn=Sn. This follows from the fact that the total demand for money is equal to the value of all commodities offered in exchange for money:

n 1

Dn=p1S1+p2S2+…+pn-1Sn-1= pi Si . i 1

And the total supply of money is equal to the value of all commodities demanded with money:

n 1

Sn=p1D1+p2D2+…+pn-1Dn-1= pi Di . i 1

During a specified time period, any difference between the demand and the supply of commodities must reveal itself as a positive or negative excess flow demand for money. An excess supply of all commodities, ESi (or of money, ESn), means an excess demand for money, EDn (or of all commodities, EDi), then:

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The excess demand for money means that economic agents want to add to their stock of cash balances in the current period and this they can do only by demanding fewer goods than are being supplied. To assert the logical impossibility of general overproduction in a monetary economy is equivalent to asserting that EDn≡0. People hold the amount of money in existence in the form of cash balances and never want to alter these balances by financing a purchase out of them or by using the proceeds from a sale to add to them.

This strong version of Say’s Law is called “Say’s Identity” which states that the money market is always in equilibrium because, regardless of prices, economic agents supply commodities only to use the money received to demand other commodities immediately. This implies that a change in the price level is no way disturbs the relations between commodity markets and the money market.

Translated into the ‘homogeneity postulate’, this means that excess demand functions for commodities depend only on relative prices and not on the absolute price level: the demand functions for commodities are homogeneous of degree zero in money prices. Homogeneous functions have the property that if each of the variables in the function is multiplied by a constant (say, by ), the total function is increased by some power of that constant. We have therefore, with a function as:

f(x, y),: f( x, y)= mf(x, y),

where m is the degree of the homogeneous function. For a function which is homogeneous of degree zero, we have:

f( x, y)= 0f(x, y)= f(x, y).

In a world in which Say’s Identity holds, money is only a ‘veil’ which can be lifted without affecting the analysis of relative prices.

4. 2. Dichotomisation and the quantity theory of money

Say’s Identity, which asserts that the money market is always in equilibrium, leaves the value of money indeterminate. Don Patinkin (Money, Interest, and Prices: An Integration of Monetary and Value Theory, N. Y.: Harper&Row, 1965) said that both the classical and the neoclassical economists consistently dichotomised the pricing process, they determined relative prices in commodity markets and absolute prices in the money market, which necessarily assumes that

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the money stock in the hands of the economic agents remains invariant regardless of prices. But if people do have a demand for nominal money holdings because receipts and payments are not be perfectly synchronised or because of uncertainty about the future, it is a demand that will vary with every change in the value of money or the price level, it is a demand for real balances. The equation which takes into account these facts is called the Cambridge equation:

n 1

Dn=k pi Si =M,

i 1

where k is the proportion of the total supply of goods measured in money that economic agents will want to hold as cash balances and M is the supply of money. The pure quantity theory of money says that the value of money is only determined by the quantity of money in circulation and implies Say’s Identity. The theory may be taken to mean that in equilibrium:

MV=PT or M/P=T/V.

T is the level of transactions, P the price level and V the velocity of circulation of a unit of money. T is supposed to be determined only by real forces, V is seen as a constant, so the price level is entirely determined by the stock of money, say by the supply of money which is given by the government or by the monetary authorities (the central bank).

Therefore, we have a stable demand for active money balances. In these statements, the money is only a medium of exchange, a veil, because relative prices are exclusively determined by real forces, that supply creates its own demand irrespective of the price level and absolute prices always vary in proportion to the quantity of money then depressions cannot be permanent. This proposition has been called Say’s Equality which asserts that an excess supply of goods or an excess demand for money tend to be self-correcting. If demand proves insufficient to sell all goods at cost-covering prices, including the going rate of profit, prices must fall. The purchasing power of nominal cash holdings will rise and everyone will find himself holding excess real balances; there is at such times an excess demand for money. In the effort to reduce the level of individual cash holdings, the demand for commodities increases until the excess supply in commodity markets is eliminated. A zero excess demand for money is an

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equilibrium condition because prices, along with the rate of interest, will continue to fall as long as there is an excess demand for cash. The same argument holds in reverse for a rise in prices owing to a positive excess demand for commodities. This is called the real-balance effect.

In the classical theory, following the Say’s Equality, the market rate of interest is not determined by the quantity of money in circulation but by the same real forces that govern the rate of profit on capital for in equilibrium the two rates are equal. The rate of interest is determined in the loan market. The money rate of interest depends on the demand and supply of loanable funds identified with investment and saving respectively. This is a corollary that a neutral doubling of M will double P, then agents will supply and demand exactly double the value of loanable funds on which the rate of interest depends. When the price level has doubled, the real quantity of money in the economy is the same and so the demand and supply of loans intersect at the same interest rate.

4. 3. John Stuart Mill and Principles of Political Economy (1848)

Mill starts his book by a critique of mercantilism emphasizing the “realness” of economic relations and asserting that money as money satisfies no want. Mill considers the relationship between land and labour as the two original factors of production. Labour is productive of wealth which consists, in his theory, in essence of tools, machines and the skill of labour force. He thinks that labour services expended in acquiring skills or in protecting property are to be considered productive. The profit or the interest must be a reward for the sacrifice or the abstinence of those who can afford to wait for the final product. The rate of capital accumulation is a function of the productive of the labour force employed productively.

The industry is limited by capital which means that employment cannot be augmented except by capital formation. Another fundamental proposition of Mill is that capital is the result of saving. The capital fund of a firm is the power to purchase labour and the products of other firms over the period during which the firm has no output to sell. If we think of the whole economy as a giant firm, the giant firm must pay workers for their services as they are rendered before the services have ripened into consumers’ goods. To tide itself over this period, the firm must be in possession of a stock of finished consumer goods as well as semi-

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finished producer goods capable of being added to inventories as they are depleted. All these goods represent produced means of production in the sense that they are all in the process of being converted into final output. Therefore, the real capital fund of a society can be defined as the sum total of all produced goods-in-process in the hands of producers, wholesalers and retailers. In this wage fund doctrine, the capital is understood in terms of a time interval between production and consumption.

The theory emphasises the complementarity of capital and labour, in the absence of an increase in the rate of capital accumulation, aggregate wages cannot be permanently raised. The wage rate depends upon the growth of previous investment. The wage fund as the demand for labour is set against the existing supply of labour; the wage rate is said to be determined by dividing the number of workers into the total sum of money available for wage payments.

4. 4. The Currency School-Banking School controversy

For an appreciation of Mill’s position on the question of how to assure price stability, we have to sketch the background of the controversy on the issue of currency regulation. Ricardo had laid down the currency principle: a mixed goldpaper currency should be made to vary in the same way as a purely metallic currency, so that it responds automatically to any inflow or outflow of gold. With the resumption of specie payments in 1821, the question arose whether convertibility as such provided an automatic mechanism to stabilise the currency. The Currency School (Ricardo and Torrens) took its stand on a regulated note issue that would tie the currency to the movement of foreign exchanges. The Bank of England leaned towards the views of the Currency School followed the rule of maintaining a constant ratio of security holdings (loans, investments and discounted paper) to total liabilities. The banking Charter Act of 1844 achieved the same effect by centralising the note issue in the hands of the Bank of England, separated the Issue Department from the Banking Department and left the function of discounting entirely unregulated on the strength of the notion that changes in deposits would follow changes in the note issue. In contrast to this view, the Banking School (Tooke and Fullarton) denied that it was possible ever to over-issue a convertible paper currency in as much as the needs of trade automatically controlled the volume of notes issued. There was no need for

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statutory control of the currency as long as convertibility was maintained. It was argued that the use of bank deposits, bills of exchange and other forms of credit as substitutes for Bank Notes would defeat the Currency School’s efforts to control the money supply through the control of Bank Notes only.

The Currency School wanted to regulate the note issue in order to leave central banking free, while the Banking School balked at the idea of any monetary management whatever. There is a fundamental difference of opinion about the definition of money in the economy. The Currency School asserted that only gold and redeemable notes are money and that their total circulation should be made to reflect the changes in gold supply. Just as Thornton and the Bullion Report had argued earlier that the issues of country banks were substantially governed by Bank of England Notes, so the protagonists of the currency principle argued that, while credit could influence prices just as much as coins and paper money, the superstructure of credit could not for long get out of line with the supply of gold and Bank Notes; the latter were the basic monetary instruments because they were always demanded for final payments in a crisis. Moreover, they held that the low velocity of circulation of bank deposits and bills of exchange rendered these credit instruments a quantitatively unimportant part of the money supply. On the other hand, “the Banking School’s stress on the variety of sources of credit, and their insistence that it was necessary to control near-money as well as money proper, is relevant once again in view of the current debate over the role of financial intermediaries in monetary policy” (Blaug, 1997, p. 195).

The Banking School stated that a mixed currency will expand and contract with the needs of business because a bank’s assets will normally consist of real bills. If banks restrict their loans to self-liquidating commercial paper (to discounting short-term notes based on goods-in-process), the means of payment in the economy will necessarily expand in pace with the volume of goods produced. This real bills doctrine is held in the form of the Law of Reflux: if banks should ignore the policy of real-bills-only and lend on long term or for speculative purposes, the rise in prices would generate an excess issue to flow back to the banks through repayment of loans or conversion into specie.

This Law states therefore that an overexpansion of bank credit cannot produce inflation. In opposition to this Law, the Currency School stated that the

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