Transcript Lesson 12: Monetary Theory and Policy

Lesson 12: Monetary Theory and Policy
• In this lesson we will develop a framework for
understanding and evaluating monetary policy. We will
place this in the context of the history of economic thought.
We will learn about the Classical economists, Keynesian
economics, Monetarism and other approaches.
Suggested Reading:
• RSU Chapter 22, 23, 26, 28, 29.
• You might also find the following paper of mine helpful –
“Inflation, Common Fallacies and Real Issues,” Graduate School of
Business Administration, University of the Witwatersrand Fact and
Opinion Papers, No. 3, (Second Edition, 1978).
(You may download it from
http://www.utdallas.edu/~plewin/F&Opaper.pdf)
• What Remains of Monetarism? R. W. Hafer Economic Review, Federal
Reserve Bank of Atlanta Vol. 86, No. 4, Fourth Quarter 2001
(available at: http://www.frbatlanta.org/filelegacydocs/hafer.pdf)
Schools of Economic Thought
The Classical Economists
(The Quantity Theory Tradition)
Pre-Smith
Adam Smith (1776); David Hume
David Ricardo
James Mill
John Stuart Mill
Karl Marx
The Neoclassical Revolution
(1871)
Alfred Marshall – Cambridge
school
Irving Fisher - America
Pigou; Keynes
The Keynesian Revolution
Samuelson, Solow, Tobin
The Chicago School
(approx. 1952 –
1990) Monetarism
Milton Friedman
The Austrian School
(1871)
Carl Menger
Böhm-Bawerk; Wieser
Mises
Hayek
Modern Austrians
Kirzner, Lachmann
Boettke, Horwitz, Roger
Garrison, Lewin
Classical Economics and the Role of Money
• The ascendancy of laissez faire ideas –
Say’s Law and the monetary dichotomy
• Links in the chain Fed  M  the Economy
• M  GDP;
– define Q = GDP/P, where P is the (current weight) GDP
deflator. M  PQ.
– MV = PQ – the equation of exchange –Fisher;
– M = kPQ – the Cambridge cash balance equation –
Marshall.
• gM = gk + gP + gQ; Monetary growth = inflation + economic
growth (+changes in holdings of money); Question: what is the
relationship between gP and gQ?
• If M and Q are approximately constant we have the
Quantity Theory of Money.
• M P or gM = gP
Crisis and Disillusionment:
The Economics of Keynes and Keynesian Economics
• The prosperous 1920’s in the U.S. and the struggles
in the U.K.
• Keynes, the man and his experiences
–
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The presumptions of Harvey Road
Scholar, student, civil servant
1914 The Economic Consequences of the Peace
Top of Cambridge, top of the world
1930 A Treatise on Money (1930)
1936 The General Theory (1936)
The U.S.and the New Deal – Keynes comes to America
• Keynesian economics – the market system needs
help from the government.
The Keynesian Message
• Consumption (savings), Investment and Money (interest
rates).
– A law of Consumption, the paradox of thrift and the danger of
stagnation
– Investment drives the economy, but its so unreliable because it
depends so much on expectations
– A “new’ theory of interest rates, its supply and demand for
money, not loanable funds, its all about a preference for liquidity
and expectations (again) of interest rates
• transactions, precautionary, speculative motives
• It all adds up to a story of dangerous potential instability,
the story of Ruritania and the wicked witch.
• So you’ve gotta have the government pay for something,
anything – dig some holes and fill them up again.
The Keynesian System in Brief – the Static Version
1.Q = C+I+G
2.C = a+cQtheconsumptionfunction
3.I = I(i,r); r=mei, the marginal efficiency of investment
4.i = i(M s ,M d ); M d = LP, liquidity preference,
M s = M s (determined by theFed?)
5.r = r(PY, SP); prospective yield and supply price
6.G = G
Substitute 2. and 3. into 1.
 1 
Q=(a+cQ)+I+GorQ= 
 [a+I+G]
 c 
 1 1 


= the multiplicand, autonomous expenditure
 = the multiplier;[a+I+G]
 c 
 1C is induced expenditure
E
The Keynesian Cross
C+I+G
E
G
I
a +I +G
•
C+I
C
a +I
B
Slope = c
a
a
0
Q
S
I+G
0
-a
B’
Q
Derivation of the Multiplier
For any increase in G, G;
Q = G + cG + c 2 G + ... + c n G
= G(1+c+c2 +...+c n )
 1 
(1+c+c 2 +...+c n ) 
 as n 
 1 c 
 1 
Sothemultiplieris

 1 c 
Issues:
• The difference between statics and dynamics
• Are there forces that offset the multiplier? – for example taxation
• What happens at full employment?
• The method of government financing G = Taxes + Debt + Money
The Phillip’s Curve
gP
A Keynesian Tradeoff between Inflation and Unemployment
Unemployment rate
The Keynesian determination of interest rates
i
Ms1
Ms2
Ms3
Liquidity trap
i1
i2
Md = LP
M
The Monetarist Counterrevolution
• Resistance at the University of Chicago
• Milton Friedman and Studies in the Quantity Theory of
Money
• Milton Friedman and A Theory of the Consumption Function
• Milton Friedman and Anna Schwartz A Monetary History of
the U.S. (1971).
• Presidential address and the stagflation of the 1970’s – The
Role of Monetary Policy – Nobel Prize
– It should not attempt the impossible
• It is impossible to control the real rate of interest
• It is impossible to permanently reduce the rate of unemployment (NRH)
– It should do only what is possible and desirable
• It should control the supply of money to achieve predictable price
stability (minimum inflation or deflation).
• The only way this can be done is through a constant monetary growth
rate – this is Monetarism. It’s like driving a boat with a faulty rudder
across a lake
• Monetarism in the spotlight
Alternative Theoretical Explanations
• Keynesianism in retreat – what’s the
alternative?!! gP and gQ are not alternatives
– 1. A monetary disequilibrium theory (Leland Yeager)
– Monetarism enriched.
– 2. A model of rational expectations
– 3. The Austrian Model of the Business Cycle (Hayek
bounces back – Nobel prize in 1974).
• An increase in Consumption may plausibly imply a reduction
in Investment.
• Investment is an aspect of the Capital Structure (the structure
of production) of the economy. If interest rates are wrong, the
production structure may be wrong.
• Misallocation requires costly and difficult reallocation.
• Which one – maybe a combination of 1 and 3.
But why did Monetarism fail?
– Look at what's gone from Monetarism and what it
never had in the first place.
• Gone since the early 1980s is a stable velocity of money.
• Gone in recent times is any consensus about just which
monetary aggregate counts.
• Gone is the ability of the Federal Reserve actually to hit a
money growth target.
• Gone is the possibility of even articulating a "monetary
rule," let alone actually following one.
– So what’s left?
• A strong sense that indeed “money does matter.”
• Central banking is more art than science
• A question: can the market help?
What’s left of the Phillips Curve?
gP
Unemployment rate
Summing up: Aggregate Supply and Demand
P
Classicism: Monetarism, RE,
Austrianism
AS
Short run/Long run
P2
P1
Keynesianism
AD2
AD1
0
Q1
Q2
Q
The ideas of economists and political
philosophers, both when they are right and when
they are wrong, are more powerful than is
commonly understood. Indeed the world is ruled
by little else.
Practical men who believe themselves to be quite
exempt from any intellectual influences are
usually the slaves of some defunct economist.
Madmen in authority, who hear voices in the air,
are distilling their frenzy from some academic
scribbler of a few years back.
John Maynard Keynes.