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Once upon a time, in a land far, far away called the Kingdom of Adaptive Expectations, there lived a family called the Palmers. There was Mr. Palmer, Mrs. Palmer and their two adorable little daughters, Farah and Sarah. Mr. Palmer was an honest and hardworking man. Everyday, he tended his sheep and went fishing, so that his family could eat good food. And what good and delicious food indeed they had! - for Mrs. Palmer was a very, very clever cook. Every morning, Mrs. Palmer would take Farah and Sarah to school, the Imperial School of Economics. After school, they would come home and play in the garden, while their mother, Mrs. Palmer, baked cakes and bread. Indeed, they were all very, very happy. One day, Farah came home from school excited. "Daddy, Daddy!" she cried, as she jumped into her father's lap. "Guess what I learnt in school today?" "What dear?" asked Mr. Palmer. "I learnt all about monetary neutrality!" "Monetary neutrality? What in this blessed Kingdom is that?" "Well..." Farah began, as she pulled an intelligent look, "...my teacher says that monetary neutrality means that you cannot revive an ailing economy by stimulating growth in either total bank lending or the monetary base. Money-supply growth cannot lead to output growth in the long-run. Money is neutral in other words." Mr. Palmer laughed. He didn't believe Farah. "And just what happens to the money, then?" he asked, as if to make fun her. "My teacher says it would only lead to higher inflation." Hearing this, Mr. Palmer laughed again and said, "Come, come now, Farah. You mustn't believe everything your teacher tells you, you know." "But it's true!" Farah protested. "Come on, now. Go play with your sister. Daddy's got to take the sheep home from the fields. It will be dark soon and it will get cold." Farah went away feeling rather sad. That weekend, as they always do on weekends, the Palmers went into town to buy provisions. In those days, there were no clocks or watches. So, every hour, Mr. Reuters, the town crier, will cry out from the top of the city walls, telling everyone what the time was. Sometimes, he will also tell them the Kingdom's latest happenings. That day, as the Palmers passed under the western gate, they heard Mr. Reuters shout, "Three hours past noon! King expands money-supply by 25.87%! Short-term interest rates fall by forty-three basis points!" Everybody in the streets who heard the announcement was very happy of the news. They were very happy because a money-supply expansion would mean more money for them, they thought. With everyone having more money, everybody is richer. Lower short-term interest rates would also mean lower costs of borrowing, higher investment and hence faster economic growth. "Long live the King! Long live the King!" they cried. And because some of them were so happy, they began to drink and dance in the streets. Soon, they were joined in by other men and women; and it was not long before there was merriment everywhere. Mr. and Mrs. Palmer and Sarah were very happy too. They too joined in the dancing. "This is the best day of my life!" said Mrs. Palmer. But Farah was frightened. She remembered her teachers words: "Always remember:" he said, "Money is neutral in the long-run." She knew that a money-supply expansion would only lead to higher inflation and she became very, very worried. Very soon, autumn turned to winter; and winter to spring. One fine morning, while Farah and Sarah were both picking flowers in the nearby meadow, they heard their father calling out to them. And so they ran home as quickly as they could. When they reached the cottage, they found Mr. Palmer smiling very broadly. He looked very, very happy indeed. "Sit down, all of you. I've got very good news." he announced. Slowly, he put his hand inside the pocket of his cloak and pulled out a bundle of cash. And what a bundle it was! - larger than any of them had ever seen before. "Gosh!" gasped Mrs. Palmer. "Where from did you get all that money?" "Why? Don't you know? People are buying more wool. Everybody is richer now because the King expanded money-supply last year." "Oh! ...I told you that was the most wonderful day of my life." replied Mrs. Palmer. "What are you going to do with the money, Daddy?" asked Sarah. She was very happy too. Mr. Palmer paused to think for a moment. "I know!" he said finally. "I'll keep half of the money to buy more sheep to expand wool production; and with the other half, we can buy all the things we've always wanted. Come on! - let's go into town and celebrate." But Farah did not want to go. She was not happy and did not feel like celebrating. She tried again to explain the monetary-neutrality proposition to her father, but Mr. Palmer was too busy changing into his best clothes to listen. "Come on, Farah." said Mr. Palmer sternly. "You're coming too." When in town, the Palmers stopped by the city fountain to rest. "I've always wanted a new pair of shoes." said Mr. Palmer all of a sudden. And so he got up and went to a nearby shoe shop and came out wearing the handsomest pair of shoes they had ever seen. "I've always wanted new curtains for the house." said Mrs. Palmer. And so Mr. Palmer gave her the money to buy a new pair of curtains. Soon, she returned with the prettiest pair of lace curtains they had ever seen. "This is the best day of my life indeed!" said Mrs. Palmer. "I've always wanted that doll-house." said Sarah. And so Mr. Palmer gave her the money to buy the doll-house she always wanted. Soon, she returned with a huge doll-house, complete with fixtures and fittings that resembled those fit for a stately manor. "What do you want, Farah?" asked Mr. Palmer when he saw that Farah was quiet all along. "I want cash." she declared. "Yes, but what do you want to do with that cash?" Farah did not answer, but Mr. Palmer gave her the cash anyway. She went away for some time and came back later with nothing in her hands. "What have you done with the money, Farah?" asked Mrs. Palmer. But Farah would not answer. They all asked her again and again and again, but she still would not say. And so finally they let her be. Soon, spring turned into summer; and summer into autumn once again. By then, Mr. Palmer had already bought twenty new sheep from a nearby farm. They were a bit dearer than usual. "Everybody's buying sheep these days." explained the farmer. But Mr. Palmer was not deterred. He was confident that with the demand for wool increased, the twenty new sheep made sensible investment. After all, he assured himself, everybody's expanding production, so it must be the right thing to do. When he came home and told the rest about the price of sheep increasing, Farah became frightened once again. She tried to remind them about the long-run neutrality of money. "That's a sign that inflation is beginning to take off." she said. "At a full-employment level of output, producers cannot increase production anymore because they are already running at maximum output. But with demand still so strong, thanks to the money-supply expansion, they are forced to increase prices to choke off some demand in order to maintain equilibrium between supply and demand." "Oh, come now!" cried Mrs. Palmer. "You shouldn't be so negative-minded." "Farah, what did I tell you about believing everything your teacher says?" said Mr. Palmer. "That's right, Farah." spoke Mrs. Palmer again. "You should be happy that your father is able to afford more sheep. He's only trying to give us all a better life, you know. You could at least be grateful enough not to spread stories about that nonsense they teach you at school." "And besides," added Mr. Palmer, "the King expanded money-supply more than a year ago. If what your teacher says is really correct, surely it would have happened by now!" That night, Farah could not sleep. She cried and cried and cried. She knew that a money-induced expansion in production could not last. She remembered the words of her teacher: "Remember! An expansion in the volume of the money-base and/or credit that is not supported by an increase in savings or capital inflows from another kingdom will itself contain the seeds of a recession." Farah was very frightened of recessions. She had never seen one before, but she knew they were very, very awful. Her teacher told her so. He said that everybody will be sad. Some people would lose their homes, their horses and even their trade. Families would always quarrel and some may even separate, unable to withstand the intensity of the pressures. Farah didn't like being sad. She also didn't want to live elsewhere. She loved the cottage, the meadows around it and all of her father's horses. She did not want him to lose his trade either for she knew he was very happy tending to his sheep. And she also loved her family very, very dearly and didn't want them to live apart. And so she continued to cry and cry and cry. Seasons passed, the cold waxed and waned and pretty soon winter's frost had given way to glorious spring. Spring was also the time to sheer the sheep. Mr. Palmer recalled eagerly the amount of money he could make from his increased wool production, especially when he recalled that the price of wool had increased. When the time was right, he set about the job of sheering. He had so many sheep that he had to work from morn to night. He even had no time to come home for dinner. And so, very often, Farah and Sarah had to bring food out to him. Finally, the day came when all the sheep had been sheered and the wool piled up in their horse cart. "Tomorrow, we'll head into town." said Mr. Palmer to Mrs. Palmer, Farah and Sarah when he came home that night. "Once we're there, we'll stop at the yarn-makers' to sell all my wool and then with the money we can buy more goods." Mrs. Palmer began thinking of buying new furniture for the house; and Sarah dreamed of a nice, big birthday cake. It was, after all, her birthday soon. But Farah said nothing. She was very worried that tomorrow might turn out to be a sad day, rather than the happy one everyone else was hoping to have. The next morning, they set out early. Along the way, they sang songs and played guessing games. They were all very happy. Everyone, that is, apart from Farah. When they reached town, as planned, they went straight to the yarn-makers' to sell the wool. But - alas! - much to the horror of Mr. Palmer, the yarn-maker would not buy his wool. Mr. Palmer tried ever-so-hard to sell his wool, even willing to part with them below cost price. But the yarn-maker shook his head. He bade Mr. Palmer follow him to the back of his factory, where there were heaps and heaps of wool. "The demand for clothes has fallen dramatically, and the tailors are refusing to buy my yarn. I cannot afford to produce anymore yarn, and so I cannot buy your wool." explained the yarn-maker. "But that's impossible!" replied Mr. Palmer in disbelief. "Everybody is wealthier now, thanks to last year's money-supply expansion, are they not?" "That's what we all thought. But now we know that that is no longer the case. I'm sorry, Sir, but I won't buy your wool." Mr. Palmer returned to his family. He did not know how to tell them that he did not have any money at all. How was he going to survive without any money? But no words need he have spoken. For when he returned to his family, he found Mrs. Palmer and Sarah in tears. In the shopping basket, he saw that there was only bread and water. "But what...what happened? Did somebody rob you whilst I was away?" Mr. Palmer asked. "Oh heavens, no!" explained Mrs. Palmer, as she wiped her cheeks. "I went into the grocery store and, much to my anguish, found that the price of every single foodstuff had risen. In fact, they had risen by so much that this was all I could afford to buy." And with that, she burst into tears again. "And I can't have my birthday cake!" said Sarah, and she too burst into tears. At this point, Mr. Palmer became very angry. "Those irresponsible and indiscriminate producers. They are raising prices without bethinking the consequences of their actions for the welfare of their fellow country-folk. They are jealous that everyone else is catching up with them in their riches. Naught are they but traitors to their own kingdom." Just then, however, Farah ran off into the crowds. Much to the amazement of her family, she returned with a bundle of cash. "Farah!" gasped Mrs. Palmer in amazement. "Where have you gotten the money from?" "From Tessa." replied Farah. "Who's Tessa?" asked Mr. Palmer. "Not 'who?', Daddy, but 'what?'. Tessa stands for 'Tax-Exempt Super Savings Account'. I opened one two years ago with the cash you gave me." The rest of the Palmers listened in amazement. Only then did they realise that Farah's actions had saved their lives. "Oh, Farah!" cried Mrs. Palmer. "How can we ever thank you?" "Come now!" replied Farah. "Let's buy those provisions; and Sarah, you can have your birthday cake after all." PART TWO: Farah explains to her family the monetary-neutrality proposition
