In Monetary Theory and the Trade Cycle, Hayek draws attention to the deficiency of equilibrium theory to explain “why a general disproportionality between supply and demand should arise.” The solution to this problem, Hayek notes, is not to be found by changes originating within the equilibrium construct nor by the methods of equilibrium analysis since “the essential means of explanation in static theory . . . is the assumption that prices supply an automatic mechanism for equilibrating supply and demand.” In resolving the dilemma between equilibrium theory and the disequilibrium associated with business cycles, Hayek argues that it is only the introduction of money that can provide a “new determining cause” capable of explaining “the difference between the course of events described by static theory . . . and the actual course of events.” The introduction of money, Hayek tells us, “does away with the rigid interdependence and self-sufficiency of the ‘closed’ system of equilibrium and makes possible movements which would be excluded from the latter.” . . .
My remarks perhaps come in somewhat sharper relief if we examine Hayek’s discussion of neutral money in the Appendix to Lecture IV of Prices and Production. In general, neutral money is employed by Hayek to describe a monetary economy that has achieved a constellation of relative prices as if money were not present; it would involve an economy fully specifiable by equilibrium theory. In reflecting on the suitability of the neutral money concept as an objective of monetary policy, Hayek says:
. . . the term points, of course, only to a problem, and does not represent a solution. . . . The necessary starting point for any attempt to answer the theoretical problem seems to me to be the recognition of the fact that the identity of demand and supply, which must necessarily exist in the case of barter, ceases to exist as soon as money becomes the intermediary of the exchange transaction. The problem then becomes one of isolating the one-sided effects of money . . . which will appear when, after the division of the barter transaction into separate transactions, one of these takes place without the other complementary transaction. In this sense, demand without corresponding supply, and supply without a corresponding demand, evidently seem to occur. . . .
—William N. Butos, “Hayek and General Equilibrium Analysis,” Southern Economic Journal 52, no. 2 (October 1985): 338.
