Intermediate
Macroeconomics
Topic Five: Monetarism
Mostly From "Monetarism" by Allan Meltzer, The Fortune Encyclopedia of Economics
Major Name: Milton Friedman
(Theoretical Framework for Monetary Analysis, 1970)
Basic
Ideas (they brought the Classical School of economics back to the forefront):
1. Both
short-run and long-run oriented
2.
Markets
are basically self-correcting
3.
Focus
is on money and inflation rather than unemployment because of similar
arguments the Classical economists gave. Although
they agree
with Keynes that money wages will not always adjust quickly.
Reinterpretation of The Depression:
Milton Friedman and Anna Schwartz (Monetary History of the United States 1867-1960 published in 1963) argued that a mild decline in the money stock from 1929 to 1930 was converted into a sharp decline by a wave of bank failures which stared in late 1930.
Bank failures produced an increase in both the currency –to-deposit ratio, owing to the public’s loss of faith in the banks’ ability to redeem their deposits and the reserve reserve-to-deposit ratio, owing to the banks’ loss of faith in the public’s willingness to maintain their deposits with them.
Plus, the FED raised the discount rate in October 1931, which in turn led to further bank failures. So the FED’s failure to prevent that dramatic decline in the money stock further intensified the downturn – turning it into a depression.
Between Oct. 1929 and June 1933, the money stock fell by about a third.
By opting for alternative policies, they argued, could have prevented the depression.
Aggregate
Demand Theory
- But markets are self correcting:
Although the Monetarists are still concerned with Aggregate Demand (like Keynes), they argue that a short run drop in aggregate demand is not a problem to markets (and therefore we do not need government to step in and correct the situation). Why? Because the market will correct itself due to three effects:
Real
Balance (or Wealth) Effect:
If AD drops, prices will drop, the value of money balances (real value)
will increase, and C will increase (bringing AD back up).
Interest
Rate Effect:
If AD drops, prices will drop, the value of money balances (real value)
will increase, S will increase, r will fall, and I will increase (bringing AD
back up). Note the return to the
Classical assumption that there is a link between S and I due to the r.
The
Exchange Rate Effect: If AD
drops, prices will drop, interest rates will fall (see above), U.S. investors
start investing in foreign markets, demand for dollars decreases, the exchange
rate between the dollar and some foreign currencies depreciates, this
depreciation stimulates U.S. net exports and thereby increases the quantity of
goods and services demanded.
The Three Main Propositions:
1. Explain the monetarist's first principal proposition: the association between money growth and inflation.
Sustained money growth in excess of the growth of output produced inflation; to end inflation or produce deflation, money growth must fall below the growth of output.
MV = PQ
Why does money growth cause inflation? An increase in money leads to an increase in spending or demand. When demand increases, but supply (or) output does not, prices will go up.
Graph: MD/MS and AD/AS.
Explain this statement: "money growth in excess of output growth is a necessary but not a sufficient condition for inflation."
There can be money growth without inflation. How?
2. Explain the monetarist's second principal proposition: the relationship between expectations, interest rates and exchange rates.
When inflation is expected to be high, interest rates on the open market are high and the foreign-exchange value of a currency falls relative to more stable currencies.
Nominal interest rate = real rate of interest + the expected rate of inflation.
Also, the value of one currency relative to another, depends upon the supply and demand of that currency. So if the supply of dollars increases (increase in the money supply), it’s price (in terms of another currency) will fall.
Graph: Foreign exchange market (Yen to the $).
What other factors (besides money growth) could influence the relationship between inflation and currency depreciation and why?
There is not a one to one relationship between inflation and currency depreciation.
Examples of other things that affect currency values:
Reason: changes the demand for a currency or the demand/supply of another currency relative to the dollar.
3. Explain the monetarist's third proposition: first (or short run) effects of money growth vs. later (or long run) effects of money growth.
Short Run:
Long Run:
Adaptive Expectations:
Graph: The Phillips Curve (Short run and Long run)
Milton Friedman: The long run effects of discretionary monetary policy by governments is hyper-inflation.
Explain this statement: "Not all recessions are caused by monetary growth, but many are."
The long run can be seen as a recession. Once the government starts inflating, it must continue to do so to avoid a recession. This is how hyper-inflation was born.
Recessions might also be caused by a large shock to the economy, such as 9-11 or a tax increase.
Why are monetarists critical of Keynesian models and their use in policy? What do the monetarists favor (in terms of policy) instead? How do "forecasts" fit in here?
Keynesians want discretionary policy – and use forecasting models to try to “fine-tune” the economy like engineers. Monetarists feel that these models can’t predict the economy and also that discretionary policy causes uncertainty, and lags – both of which cause problems, don’t solve them.
Monetarists prefer fixed rule policies – based on the recent past. So people can plan better.
Meltzer claims there is still skepticism about monetarism. What are his two factors behind this skepticism?
1. FED’s monetarist experiment in the early 80s. The FED decreased the money supply to pull down inflation – but not only did prices fall, but output fell considerably more than thought.
Meltzer says this was probably due to a large increase in the demand for money (or decrease in V).
2. Very different policy agendas. Critics see government policy as action as a way of removing instability caused by unruly private behavior. Monetarists see these policies as the cause of the instability.