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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
"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
"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
"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
"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
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
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
"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.
"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
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
"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
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