POLICY IMPLICATIONS OF A FLOW-OF-FUNDS MODEL.

A financial system in a modern market economy has two basic functions: the facilitation of transactions among economic units, and the allocation of savings among alternative investments and investors. The former has been associated with money as a medium of exchange and with the short-term money markets, and the latter with the capital markets. Traditional monetary theory emphasized the transactions function in focusing upon the demand and supply of money as the primary analytical framework for examining the role of financial variables in the economic system. The basis for this point of view was the classical quantity theory of the monetary mechanism. Money as a medium of exchange was given heavy emphasis in a theory which specified a rigid relationship between total transactions and the demand for money balances--a relationship which could not be altered by other factors endogenous to the economic system. Under these circumstances, any change in the supply of money balances was fully reflected in a proportionate change in the demand for nominal output. There was little interest in, or need to refer to, the market for other financial assets. The present model differs in that it is concerned with the demand and supply of bonds rather than the demand and supply of money balances. This allows us to undertake a degree of disaggregation by asset and sector that is not feasible within the framework of the market for money balances, Such a model is theoretically and empirically equivalent to the "money models" unless there are significant departures from the hypothesis underlying the homogenization of different types of marketable securities. Specifically, it is our view that observed differences in the cyclical movement of market interest rates are affected by the relative quantities of the individual securities outstanding. [ABSTRACT FROM AUTHOR]