The need for quantitative knowledge of economic reactions

In dealing with questions of economic policy it is necessary to form some judgement about the magnitudes and time-forms of the responses of individuals or groups of individuals to changes in certain of the conditions confronting them. We may take as an example the problems facing a government which is pursuing a policy of keeping employment at the highest level consistent with the maintenance of free convertibility, at a fixed rate of exchange, between its own currency and that of another major country, it being the policy of the other country to keep its own employment at the highest level consistent with the maintenance of stable product prices.

Let us assume that some change, say an increase in the desire of home firms to invest in new capital equipment, leads to an increase in production and in the demand for factors of production, and that as a result factor prices begin to rise more rapidly than the secular rise in productivity, so that product prices rise. Because of the higher home demand and rising costs and prices, imports will gradually rise and exports decline, the consequent deficit in the balance of payments being met by drawing upon reserves of foreign currency. The government will take action to correct the adverse balance of payments by reducing home demand, either through a reduction in its own expenditure or, more likely, by increasing taxes, or reducing the quantity of money and raising interest rates, in order to induce private individuals and firms to reduce their expenditure.