Transcript Intermediate Macroeconomics - College Of Business and

Orthodox
Monetarism
Intermediate Macroeconomics
ECON-305 Spring 2013
Professor Dalton
Boise State University
Purposes
Trace the historical development of
modern Monetarism beginning in the
1950s
1.
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2.
Demand for money
Impact of changes in money supply
Augmented Phillips Curve
Monetary approach to Balance of Payments
and Exchange Rates
Summarize the central distinguishing
beliefs of Monetarism
Origins of Quantity Theory

Quantity theory of money has been
called “the oldest surviving theory in
economics” (Blaug)
Many trace it to Locke’s Some
Considerations of the Consequences of
the Lowering Of Interest and Raising the
Value of Money (1692)
 Copernicus’s Monetae cudendae ratio
(1526) is sometimes afforded the honor
 Hume’s Of Money is probably earliest
“modern” statement
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Origins of Quantity Theory
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Martin de Azpilcueta Navarrus
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Comentario resolutoio de usuras (1556)
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first unambiguous statement of quantity theory of
money - defines money’s value as its purchasing
power, whose value is determined by demand and
supply of money
attributed (12 years before Bodin) the price inflation
of the mid-16th century to the influx of silver and
gold
developed purchasing-power parity theory of
exchange rates advanced by colleague Domingo de
Soto (1494-1560)
Pre-Keynesian Monetary
Theory
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Oldest variant is Monetary equilibrium
theory
Cambridge k approach
Fisher’s equation of exchange
What is the “quantity theory”?
Confusion with the proportionality
theorem (∆M/M = ∆P/P)
 Demand and supply theory of monetary
value
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Quantity Theory in IS-LM
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MV = PY
In underemployment conditions V is
highly unstable and passively adapts
to independent changes in M or PY
Liquidity trap
 Interest-inelastic investment
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Money demand is unstable and
unpredictable
Milton Friedman
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Milton Friedman (1912-2006)
Friedman sought to
reestablish what he
viewed as the
Chicago monetary
tradition
Series of influential
papers and books
Popularization of
free market
economics
Friedman’s Contributions
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“The Quantity Theory of Money: A
Restatement” (1956)
“The Supply of Money and Changes in Prices
and Output” (1958)
“The Demand for Money: Some Theoretical
and Empirical Results” (1959)
A Monetary History of the United States,
1867-1960 (with Anna Schwartz) (1963)
Friedman’s Contributions
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“The Relative Stability of Monetary Velocity
and the Investment Multiplier in the United
States, 1897-1958” (with David Meiselman)
(1963)
“Interest Rates and the Demand for Money”
(1966)
“The Role of Monetary Policy” (1968)
“A Theoretical Framework for Monetary
Analysis” (1970)
“Inflation and Unemployment” (1977)
QTM - Money Demand Theory
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“The Quantity Theory of Money: A
Restatement” (1956)
Money is demanded because it yields a
flow of services
Money demand dependent upon
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Wealth constraint; Return on money
relative to other assets; and, Tastes
In equilibrium, wealth is allocated to
equalize marginal return on assets
QTM - Money Demand Theory
Md/P = f (rm, rDG, rb, re, þe, h, Yp, u)
where rm = return on money,
rDG = return on durable goods,
rb = return on bonds, re = return on equities,
þe = expected inflation rate,
h = ratio of income from non-human to human
wealth (capital),
Yp = permanent income, and u = tastes.
Individuals reallocate wealth whenever
marginal returns across assets not equal.
Portfolio Adjustment Process
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Open market purchase of bonds increases
Ms
Reducing the return on holding money (rm)
Money exchanged for financial and real
assets
Increasing price of equities, price of bonds,
price of durable goods (Pe, Pb, PDG)
Returns on equities, bonds and durable
goods fall (re, rb, rDG) and return on money
rises (rm) until equality restored
Portfolio Adjustment Process
Conclusions:
1.
2.
Broader range of assets and
associated expenditures are affected
by ∆MS (not just bonds as in Keynes
and IS-LM)
Stronger, more direct effect on AD
due to ∆MS than predicted by Keynes
and IS-LM
Money and ∆Nominal Income
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Real Money demand changes in stable
and predictable ways
V is predictable and stable
Empirical evidence:
Friedman (1959) argued that ∆r do not
change Md/P.
 Friedman (1966) recanted
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No evidence for either liquidity trap or
vertical LM curve
Money and ∆Nominal Income
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Up to early 1970s money demand was
stable (predictable)
Financial innovation of the late 1970s
and early 1980s breakdown the
stability of Md/P
Relationship between M1 and PY
 Regulation Q of Federal Reserve
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Clear differentiation between money and notmoney
Money and ∆Nominal Income
Greenspan:
“We don’t
know what
money is,
anymore.”
Role of the Money Supply
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“The Supply of Money and Changes in
Prices and Output” (1958)
Compared rates of monetary growth with
cycle turning points
 Peaks (troughs) of monetary growth
(∆M/M) preceded peaks (troughs) of cycle
by 16 (12) months
 Suggestive of monetary influences
 Problem of causality
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Role of the Money Supply
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A Monetary History of the United States,
1867-1960 (with Anna Schwartz) (1963)
 Rate of monetary growth slower during
contractions than expansions
 Negative monetary growth always
associated with major contractions
 Historical evidence of independent policy
changes producing changes in monetary
growth
 Great Depression consequence of
monetary restriction
Role of the Money Supply
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“The Relative Stability of Monetary Velocity
and the Investment Multiplier in the United
States, 1897-1958” (with David Meiselman)
(1963)
 Compared monetary and Keynesian
approaches
 ∆C = f(∆Ms) versus ∆C = g(∆I)
 Money equation explained more variation
in C, except for Great Depression
 Poorly conceived
Theoretical Framework
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“A Theoretical Framework for
Monetary Analysis” (1970)
Until this paper, no explicit formal
monetarist model
 Friedman intended to show that “the
basic differences…are empirical, not
theoretical”
 Model was IS-LM without Keynesian
extremes, without wage rigidity, and with
Pigou and real balance effects
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Monetarism in mid-1960s
1. Monetary growth predominant factor
in explaining nominal income growth.
2. Stable real money demand means
economic instability is due to
fluctuations in monetary growth
induced by monetary authorities.
3. Authorities can control Ms, when they
do so, path of nominal income is
different than if Ms were endogenous.
Monetarism in mid-1960s
4. Lag between changes in money
supply and changes in nominal
income is long and variable;
discretionary monetary policy is
destabilizing.
5. Money supply should grow at a fixed
rate of real output growth to stabilize
prices.
The 2nd Stage: Phillips Curve
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Monetary growth is the predominant
determinant of nominal income
growth and Md is stable and
predictable.
MV = PY
How are changes in Ms divided
between P and Y?
Augmented Phillips Curve
Augmented Phillips Curve
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Friedman, “The Role of Monetary
Policy,” AER (1968)
Edmund Phelps, “Phillips Curves,
Expectations of Inflation and Optimal
Unemployment over Time,” Economica
(Aug. 1967)
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The original Phillips Curve relationship is
misspecified; correcting the
misspecification gives a new
understanding of the economy.
Augmented Phillips Curve
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Original Specification: dW = f(U)
Although W is set in negotiations between
employees and employers, both are really
interested in w = (W/P).
 Inflation (dP) affects w over the contract
period.
 Inflationary expectations (dPe) therefore
affect (dW)
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Phillips Curve should be specified as
dW = f(U) + dPe.
Augmented Phillips Curve
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dW
PC (dPe2)
PC (dPe1)
5.5%
PC
(dPe
U
0)
Introducing
inflationary
expectations (dPe)
means that rather
than one PC there
exists a set of
Phillips Curves, one
for each dPe (where
dPe0 < dPe1 < dPe2).
Augmented Phillips Curve
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LRPC
dW
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PC (dPe2)
PC (dPe1)
5.5%
PC
(dPe
U
0)
There exists a short-run,
but NOT a long-run
tradeoff between
unemployment and
inflation.
As inflationary
expectations adjust to
the actual inflation rate,
unemployment returns
to its natural, full
employment, level.
The SR-LR Phillips Curve
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With zero productivity growth, in equilibrium, dW =
dP = dPe.
An increase in aggregate demand increases prices,
increasing nominal wages. Workers misinterpret
the higher nominal wages as higher real wages,
given their inflationary expectations, so they
increase the quantity of labor they supply.
Firms, however, see real wages fall, and are willing
to increase employment, reducing unemployment.
As workers come to realize that their real wage has
fallen, they reduce their labor supply, demanding
even higher money wages, reducing employment
and increasing unemployment.
A Graphical Presentation
SL (Pe1)
LRPC
dW
W
W2
W1
W0
SL (Pe0)
C
B
A
DL (P1)
C
B
A
4%
5.5%
DL (P0)
PC (dPe1)
PC
(dPe
U
0)
Lf L1
L
Augmented Phillips Curve
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In the short-run, changes in the money
supply are non-neutral. In the longrun, once expectations have adjusted,
changes in the money supply become
neutral.
Empirical Studies
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dW = f(U) + ßdPe ; assume zero productivity
growth
dP = dW; dP = f(U) + ßdPe ; equilibium, dP = dPe
dP – ßdP = f(U); dP (1–ß) = f(U)
dP = f(U)/(1-ß)
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ß = 1; vertical PC
0 < ß < 1; neg PC but less favorable
0 = ß; LRPC and SRPC identical
No clear-cut evidence
Theoretical case overwhelming
Policy Implications
1. Adaptive (Error-learning) expectations
imply that U < UN occurs only because
of unexpected inflation.
2. Attempts to maintain U < UN only
leads to accelerating inflation.
3. Combatting inflation involves outputunemployment costs (U > UN ) and the
greater is monetary contraction the
greater the costs.
Policy Implications
4. Fixed Rate of Monetary Growth
a) Steady monetary growth rate will
lead economy to settle at UN.
b) Rule removes greatest source of
instability.
c) Discretionary policy destabilizing
due to long and variable lags.
d) Because UN not known, policy
should not aim at U*.
Policy Implications
5. Permanent reductions in U can only
come through removing output and
labor restrictions.
a) Incentives to work (welfare reform).
b) Flexible wages.
c) Labor mobility.
d) Enterprise privatization.
3rd Stage: Money and BOP
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Monetarism and the Balance of Payments
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Approach made monetarist analysis relevant to
open economies
Fixed Exchange Rates
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Currencies are defined as fixed quantities of
foreign currencies
Monetary authorities in each country hold
reserves of foreign currency (international
reserves) to stabilize value of domestic currency
relative to foreign currency.
Monetary Approach BOP
Fixed Exchange Rates
 Key assumptions
Md/P stable function of limited variables
 In long run, Y and L tend to YN and LN
 In long run, monetary authorities can’t
neutralize monetary impact of BOP
surpluses or deficits
 Arbitrage ensures that prices tend to be
equalized
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Monetary Approach BOP
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Harry Johnson, “The Monetary Approach to
Balance of Payments Theory” (1972)
 Three Assumptions: Y = YN; law of one
price holds in commodity and financial
markets; domestic prices and interest
rates are pegged to world levels
 Md = P* f(Y,r); Ms = D + R, where D equals
domestic credit and R equals
international reserves
 Md = D + R
BOP Analytics
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What are the effects of increasing domestic
credit?
Increase D means Ms > Md
Individuals rid excess balances by buying
foreign goods
Generates BOP deficit
Authorities sell foreign currency for
domestic currency to cover BOP deficit
R falls, Ms falls until BOP deficit eliminated
∆D = ∆R
BOP Analytical Dynamics
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A country experiences persistent BOP
deficits and continued loss of
international reserves when domestic
credit growth (∆D/D) exceeds
domestic money demand growth
(∆Md/Md) due to real income growth
Policy Implications
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There exists automatic adjustments to
correct BOP disequilibria
Discretionary monetary policy is selfdefeating
Domestic monetary expansion in small
open economy has no effect on dP, r, or
dY (only foreign reserves)
In large open economy, domestic
moentary expansion increases world dP
Monetary Approach BOP
Flexible Exchange Rates
 Frenkel and Johnson, The Economics of
Exchange Rates, (1978)
With perfectly flexible exchange rates,
exchange rates adjust to clear market so
that BOP = 0
 Implies no ∆ in R
 Implies ∆D only source of ∆Ms
 Therefore, ∆D change ∆Ms and change
exchange rates and domestic prices
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BOP Analytics
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What are the effects of increasing domestic
credit?
Increase D means Ms > Md
Individuals rid excess balances by buying
foreign goods
Excess supply of domestic currency in
foreign exchange markets reduces value of
domestic currency
Depreciation in currency raises domestic
prices, increasing Md and money market
equilibrium is restored
BOP Analytical Dynamics
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ε = g(Ms, Y)
∆ε = h(∆Ms, ∆Y)
Depreciating exchange rate occurs
when domestic monetary growth
is faster than domestic real
income growth
Orhtodox Monetarism
1. Monetary growth predominant
factor in explaining nominal
income growth.
2. Economy inherently stable and
erratic monetary growth is primary
source of economic instability.
3. No long-run tradeoff between
inflation and unemployment.
Orthodox Monetarism
4. Prices and BOP are essentially
monetary phenomena.
5. Monetary policy should be guided
by a rule; fiscal policy should be
constrained to traditional roles of
distribution and allocation.