monetarism

MS Salma Shaheen

• Monetarism is an economic school of thought

that stresses the primary importance of the

money supply in determining nominal GDP

and the price level.

• Monetarism is a theoretical challenge to

Keynesian economics that increased in

importance and popularity in the late 1960s

and 1970s.

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Characteristics of Monetarism

1. The theoretical foundation is the Quantity Theory of Money.

2. The economy and financial markets are inherently stable.

3. The Fed should be bound to fixed rules in conducting monetary policy.

4. Fiscal Policy is often bad policy. A small role for government is good.

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• Monetarism is very closely allied with the classical school of thought.

• An extension of classical theory

• which was developed in the 1960s and 1970s

• Try to explain a new economic phenomenon -stagflation .

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• Much of the Monetarists' work revolved around the

• Role of expectations in determining inflation, Development of the expectations-augmented Phillips Curve .

• Milton Friedman is considered the father of modern monetarism.

•Late 1960s developing macro instability:Persistent BOT deficit

Inflation edging up

BOP crisis and devaluation 1967.

•Response of government of 1970-4:•‘Free market’ policies

•But these go wrong.

•In particular, intensified the inflationary pressures.

• The challenge to the traditional Keynesian theory

strengthened during the years of stagflation

following the 1973 and 1979 oil shocks.

• Keynesian theory had no appropriate policy responses

to the supply shocks.

• Inflation was high and rising through the 1970s and

Friedman argued convincingly that the high rates of

inflation were due to rapid increases in the money

supply.

• He argued that the economy may be complicated, but

stabilization policy does not have to be.

• The key to good policy was to control the supply of

money.

•Monetarist critique:

•‘Monetarists’’ known as Friedman, Chicago school

•Criticised view that monetary policy is relatively unimportant / secondary / ‘accommodating’ role only, i.e. the Keynesian view that:

–ΔM → Δr → Δi, BUT this effect quite weak:

Flattish LM

Steep IS / I r-inelastic

•Called for more debate on monetary policy / ‘money matters’.

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The Effects of Money Supply Changes on the Real Economy

Keynesian View Monetarist View

IS LM1 LM2

ISLM1

LM2

? Y Y

rr

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The Effects of Fiscal Changeson the Real Economy

Keynesian View Monetarist View

IS1 LM

IS1

LM

?Y Y

rrIS2

IS2

• Characteristics of Monetarism

• Monetarism is a mixture of theoretical ideas, philosophical beliefs, and policy prescriptions. Here we list the most important ideas and policy implications and explain them below. The theoretical foundation is the Quantity Theory of Money.

• The economy is inherently stable. Markets work well when left to themselves. Government intervention can often times destabilize things more than they help. Laissez faire is often the best advice.

• The Fed should be bound to fixed rules in

conducting monetary policy.

• They should not have discretion in conducting

policy because they could make the economy

worse off.

• Fiscal Policy is often bad policy. A small role

for government is good.

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Monetarism

• The monetarist analysis of the economy places emphasis on the velocity of money, or the number of times a dollar bill changes hands, on average, during a year; the ratio of nominal GDP to the stock of money (M):

VGDP

M

orV

P Y

M

M V P Y GDP P Y since

then,

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The Quantity Theory of Money

• The quantity theory of money is a theory based on the identityM x V = P x Y and the assumption that the velocity of money (V) is constant (or virtually constant). Then, the theory can be written as the following equality:

M V P Y

Friedman’s restatement of QTM.

Keynesianism made simplifying assumption:

M and B the only two assets affecting money demand.

i.e. Bonds the only alternative to holding M.

Friedman: No -- other assets apart from bonds also need to be

taken into account, e.g.

residential and other property

consumer-durables

equities, etc.

These are also held as alternatives to money.

Cambridge:

MD = kPY

k is factor of proportionality / ‘Marshallian’ or

‘Cambridge’ k.

Reformulates QTM as theory of money demand.

Keynes:

MD = k(r).PY

Not compatible with QTM.

k not constant – cyclical fluctuations, etc.

Friedman:

MD = k(rB, r1 . . . rn).PY

rB: return on bonds

r1 . . . rn : rates of return (explicit or implicit) on

other assets besides bonds. These net out → k = k

i.e. Restatement of QTM.

Neutrality of money – LR / SR distinction:

‘Old’ QTM:

ΔM → ΔP only, with ΔY = 0.

i.e. ΔP / ΔM = 1.

Friedman: M is neutral in LR, as in old QTM:

i.e. ΔLRP / ΔM = 1.

BUT: ΔM may have SR effect on Y:

ΔM → ΔP, but also ΔSRY > 0.

i.e. ΔSRP / ΔM < 1.

This SR effect gradually unwinds till we have

ΔLRP / ΔM = 1.

Friedman’s Adaptive Expectations Hypothesis / ‘fooling’ model

/ effect of SR changes in MS:

Wage-earners’ expectations of movements in P take time to

adapt.

P↑ and wage-earners underestimate change.

→ they supply more labour than if they had realised how much

their real wage has been eroded by inflation.

Model works symmetrically in reverse / overestimation.

P0

Y*

AD0

Y

P

P’

AD1

Y’

SRAS (Pe = P0)

LRAS

Workers supply more

labour → Y↑ because

they think their real

wage has increased

more than it actually

has.

Friedman’s monetarism:adaptive expectations, and the LR-SR distinction, contd

MS ↑

→ AD ↑

Workers realise they

have overestimated their

real wage and adjust it

over successive time

periods, so they reduce

LS, i.e. AS shifts left.P0

Y*

AD0

AD1

Y

P

Y’

SRAS (Pe = P0)

LRAS (Pe = P)

P1

SRAS (Pe = P1)

Friedman’s monetarism:adaptive expectations, and the LR-SR distinction, contd

(1)

(2)

Eventually Y returns to

Y*

Net result is just

inflation and

instability.

P0

P1

YNR

AD0

AD1

Y

P

SRAS (Pe = P0)

LRAS (Pe = P) SRAS (Pe = P1)

P has risen, and Y falls

back to its original level –

the ‘Natural Rate’.

Y returns to YNR --

net result is ΔP only

Friedman’s monetarism:adaptive expectations, and the LR-SR distinction, contd

‘Natural rate’

‘Old’ classical:

Unique point of equilibrium / self-regulating level.

This is YFE.

Friedman: This is unrealistic.

→ redefined LR sustainable level as ‘natural rate’:

(1) Will always be some unemployment.

At equilibrium / self-sustaining level:

‘natural rate’ – NRU.

(2) NRU is not constant.

Changes with changing labour market conditions.

Expectations-augmented Phillips Curve

• The Phillips Curve showed a trade-off between unemployment and inflation.

• Friedman then put his mind to whether the Phillips Curve could be adapted to show

• why stagflation was occurring,

• Include the role of expectations in the Phillips Curve .

• Hence the name 'expectations-augmented' Phillips Curve.

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• Friedman argued that there were a series of different Phillips Curves for each level of expected inflation.

• Friedman was therefore assuming no 'money illusion'

• The Rules vs. Discretion Debate

• Because monetarists believe that the money supply is the primary determinant of nominal GDP in the short run, and of the price level in the long run, they think that control of the money supply should not be left to the discretion of central bankers.

• Monetarists believe in a set of "rules" that the Federal Reserve must follow. In particular, Monetarists prefer the Money growth rule:

• The Fed should be required to target the growth rate of money such that it equals the growth rate of real GDP, leaving the price level unchanged. If the economy is expected to grow at 2 percent in a given year, the Fed should allow the money supply to increase by 2 percent. Monetarists wish to take much of the discretionary power out of the hands of the Fed so they cannot destabilize the economy.

• Keynesians start at this proposed money growth rule. Keynesians believe that velocity is inherently unstable and they do not believe that markets adjust quickly to return to potential output.

• Therefore, Keynesians attach little or no significance to the Quantity Theory of Money.

• Because the economy is subject to deep swings and periodic instability, it is dangerous to take discretionary power away from the Fed.

• .

• The Fed should have some leeway or

"discretion" in conducting policy.

• So far, Keynesians have won this debate.

There has not been serious talk in some time of

tying the Fed to a fixed money growth rule

• Fiscal Policy

• Because Monetarist dislike big government and tend to trust free markets, they do not like government intervention and believe that fiscal policy is not helpful.

• Where it could be beneficial, monetary policy could do the job better.

• Excessive government intervention only interferes in the workings of free markets and can lead to bloated bureaucracies, unnecessary social programs, and large deficits. Automatic stabilizers are sufficient to stabilize the economy.

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Keynesians vs. Monetarists:Key Differences

Monetarists Keynesians

secure monetary policy to

rulesGive policymakers discretion.

Fiscal policy is not useful. Fiscal policy may be useful.

AS curve has a steep slope. Economy can be unstable.

Economy is inherently stable. AS curve can be flat.