ECON 272

Monetarists

(sometimes known as the Chicago School of Economics - or the neo-Quantity Theory of Money model)

Leader:  Milton Friedman (Nobel Prize in Economics - 1976)

Probably the most famous book:  A Monetary History of the United States:  1867-1960, written with Anna Jacobson Schwartz - published in 1963.

Monetarism attracted significant support during the 1960s, 70s and early 80s, when the economy experienced high rates of unemployment and inflation.  Remember this was after the Phillip's Curve (1950s) theory (which was Keynesian) - that unemployment could be "cured" with inflation.

The challenge to the traditional Keynesian theory strengthened during the years of stagflation in the 1970s. Keynesian theory had no appropriate policy responses to stagflation. 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.

Remember that the early Keynesians emphasized fiscal policy over monetary policy (due to the liquidity trap).  But after the influence of the monetarists, Keynesians began paying more attention to monetary policy as a tool.

Basic Ideas (they brought the Classical School of economics back to the forefront - at least some of it):

1.        Both short-run and long-run oriented

2.       Markets are basically self-correcting and stable.  Keynesian economics overstates the amount of macroeconomic instability in the economy.  In particular, Friedman argued, that the economy will ordinarily be at potential real GDP.

3.       Focus is on money and inflation rather than unemployment because of similar arguments the Classical economists gave (quantity theory of money).  Although they agree with Keynes that money wages will not always adjust
    quickly.

4.       Government intervention can often times destabilize things more than they help.  In fact, most instability is caused by changes in the money supply.

The Depression - argued that Keynes was wrong:

The most fluctuations in real output were caused by fluctuations in the money supply rather than by fluctuations in consumption or investment spending.  Friedman and Schwartz (in their book) argued that the severity of the Great Depression was caused by the Federal Reserve's allowing the quantity of money in the economy to fall by more than 25 percent between 1929 and 1933.

Argue that the Quantity Theory of Money is correct (Keynes was wrong).  More specific evidence they use includes:

In other words:  Between 1929 and 1933 real GNP decreased 29.6% and nominal GNP decreased 46.0% and the aggregate price level decreased. At the same time M1 decreased 26.5% and M2 (M1 + bank deposits) decreased 33.3%.

Generally, therefore MV = PQ (quantity theory of money) holds (M decreased and so did PQ).

The Quantity Theory of Money Revisited:

Remember the Classical school gave us an early version.  Then in the early twentieth century - Irving Fisher (Yale economist - also famous in finance) - formalized the connection between money and prices by using the quantity equation:

M x V = P x Y

M =

V =

P =

Y = real output

He defined velocity as:  "the average number of times each dollar of the money supply is used to purchase goods and services included in GDP."

So he rewrote the equation - V = P x Y/M  (just divided both sides by M to solve for V)

Solving for velocity:  So for example - if real output (the actual amount of production) in the economy = 10 widgets.  Each widget cost $10 (when sold and counted in GDP).  Then nominal Y or GDP = $100 (10 x $10). Remember, this is the amount calculated in GDP - calculated when a good is sold (traded).  Divide that by the money supply (number of dollars in the economy).  Let's say there are 30 dollars in the economy - then $100/30 =3.33.  Each of those 30 dollars was used 3.33 times in order for those 10 widgets to be traded.

He also, following the Classical school - said velocity was pretty constant.  That it depended upon:

1. how often people get paid

2. how often people do their grocery shopping

3. how often businesses mail bills

4. and other factors that do not change very often

Whether this is true or not is an empirical question.

 

The Quantity Theory Explanation of Inflation

Remember - the whole point of the quantity theory for the Classical school was to show the relationship between the money supply and prices.  This is what the Monetarists want to do too.

So the equation was changed to include growth rates:

Growth rate of the M + Growth rate of V (basically saying that if the money grows by 10% - and then each dollar is used 10% more times - that would mean this side of the equation would = 20%)

= Growth rate of P (or inflation rate) + Growth rate of Y (the pie)

Note the + signs, not the x signs.  Changing to growth rates only makes sense if these are added, not multiplied.

So the inflation rate = Growth rate of the money supply + Growth rate of velocity - Growth rate of real output.

And if V is constant = it's growth rate is always zero.

So therefore:  Inflation rate = Growth rate of the money supply - Growth rate of real output.

So this theory predicts:

  1. If the money supply grows at a faster rate than real GDP, there will be inflation (as we have learned).
  2. If the money supply grows at a slower rate than real GDP, there will be deflation (as we have learned).
  3. If the money supply grows at the same rate as real GDP, the price level will be stable, and there will be neither inflation or deflation (as we have learned).

However - it turns out Irving was wrong about velocity.

http://research.stlouisfed.org/fred2/series/M1V

However, Monetarism today relies on the predictability of velocity rather than absolute stability, so in the 1970s one could make a case for the short-run quantity theory (velocity was more predictable - not too volatile).  However, the 1980s and 1990s have not been kind to Monetarist assumptions. Velocity was highly unstable with unpredictable periods of increases and declines. In such an environment, the link between the money supply and nominal GDP broke down and the usefulness of the quantity theory of money came into question. Many economists who were convinced by Friedman and Monetarism in the 1970s abandoned this approach in the mid- to late-1980s. The empirical relationship had simply broken down. Why?

Most economists think the breakdown was primarily the result of changes in banking rules and other financial innovations. In the 1980s banks were allowed to offer interest-earning checking accounts and many people chose to hold their wealth in the form of M1 (cash, checking accounts, traveler's checks).

Monetarists and Keynesians alike closely watch the behavior of velocity. If velocity should become more stable in the future, there is no reason that monetarism could not make a resurgence. The Federal Reserve would be thrilled to have an indicator that predicts economic activity so accurately.

So therefore, predictions of the quantity theory don't hold every year.  But still, most economists agree that the quantity theory provides useful insight into the long-run relationship between the money supply and inflation:  In the long run, inflation results from the money supply growing at a faster rate than the pie!

Keynesian vs. Monetarist difference in Monetary Policy:

Monetarists have always said that the FED should target the money supply - not interest rates.  Friedman said that interest rates were a function of the money supply, not the other way around.  Keynesians tend to want to target interest rates (easy or tight credit).

 

Aggregate Demand Theory:

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, supply of dollars increases, the exchange rate between the dollar and some foreign currencies changes - the dollar depreciates (know what this means), this depreciation stimulates U.S. net exports and thereby increases the quantity of goods and services demanded.

GRAPH:

 

 

Policy recommendations:

Discretionary policy of any kind (both monetary policy or fiscal policy) is not good.  It causes market participants to shift their expectations, increases uncertainty, and thereby causes erratic shifts in the market.

So they advocate:  Fixed Rule Monetary Policy or a Money Growth Rule  (increase the Money supply as GDP or Q increases, thereby assuring stable prices).  The FED has typically focused more on controlling interest rates than on controlling the money supply.  They should stop doing this and have a plan for increasing the quantity of money at a fixed rate.  Friedman believed that adopting a monetary growth rule would reduce fluctuations in real GDP, employment, and inflation.

They also advocate a balanced budget (believe in crowding out), deregulation (to provide greater flexibility of wages and prices), and basically no fiscal policy (except perhaps tax cuts -- but to decrease the size of government mainly.)

They argue that government policy in general has destabilizing effects - lags and increasing uncertainty (the market on its own is OK, it is government that causes the problems). 

Conclusion:  Back to Laissez Faire.

Summary of Keynesians vs. Monetarists

Keynesians and Monetarists fought head-to-head in the 1970s.  Because of the healthy debate, Keynesians are more convinced of the importance of the money supply and monetary policy, especially over the long run. They are more acutely aware of the long-term threat to price stability that rapid money growth can bring.

However, Keynesians are also now more likely to use monetary policy as well as fiscal policy.  But target interest rates (or unemployment) instead of the money supply.

Despite the convergence, important differences remain between the two schools of thought:

Although differences remain, the debate between Keynesians and Monetarists cooled considerably in the 1990s. Many Monetarists now emphasize the longer-run relationship between M growth and nominal GDP growth. In fact the "new" school of thought called the "Market Monetarists" has recently emerged.  These economists follow Friedman - but they want the Fed to target nominal income instead of the money supply per se.  They are generally in favor of QE3 because they say the money supply hasn't changed much since 2008 and therefore, money is too tight.  Increasing the money supply will increase nominal income - thereby increase spending, etc.

Although Keynesians do not stress the importance of money growth as much as Monetarists, the focus on the long run is much less controversial. The short-run, however, is a another story!!