Transcript Introduction to Macroeconomics

Chapter 17
Monetarism
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Monetarism
• Monetarism is an economic school of thought
that stresses the primary importance of the
money supply in determining nominal GDP
and the price level.
• The "Founding Father" of Monetarism is
economist Milton Friedman.
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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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The Equation of Exchange
• The equation of exchange (a tautology) is the
building block for monetarist theory.
MxV=PxY
M = money supply
V = velocity
P = price level
Y = real GDP
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The Quantity Theory of Money: The
Short Run
• Monetarists make a seemingly innocuous
assumption that velocity is stable in the short
run, or
MxV=PxY
where V implies that velocity is fixed in the short run.
• Any change in M1 will impact P × Y (nominal
GDP). Changes in the money supply are the
dominant forces that change nominal GDP.
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The Quantity Theory of Money: The
Long Run
• Monetarists believe that the economy is always
near or quickly approaching full employment
because markets work well.
• In the long run, output will be equal to
potential output, YP.
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The Quantity Theory of Money: The
Long Run
• In the long run, the quantity theory of money
becomes:
• 'M' and 'P' are the only variables in this
equation that change in the long run.
• In the long run, changes in the money supply
only cause inflation.
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The Rules vs. Discretion Debate
• Monetarists argue that control of the money
supply (and, hence, inflation) should not be left
to the discretion of central bankers.
• They propose a 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.
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The Rules vs. Discretion Debate
• Keynesians advocate giving central bankers
discretion.
• They attribute little significance to the Quantity
Theory of Money because they believe that
velocity is unstable.
• Keynesians also argue that the economy is
subject to periodic instability, so it is dangerous
to take discretionary power away from the
central bank.
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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 fiscal policy could be beneficial,
monetary policy can do the job better.
• Automatic stabilizers are sufficient sources of
fiscal policy.
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Empirical Evidence of Monetarism
• The suppositions of monetarism depend
crucially on
– the stability of velocity
– the efficiency of markets
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Empirical Evidence of Monetarism
Velocity
9.0
1970-2003
•Recent evidence
suggests that
velocity has been
unstable and
unpredictable since
the 1980s.
8.0
7.0
6.0
5.0
4.0
2003
2000
1997
1994
1991
1988
1985
1982
1979
1976
1973
1970
3.0
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Money and Nominal GDP
Growth of M1 and Nominal GDP
16.0
11.0
(1971-2003)
GDP
M1
6.0
1.0
•The lack of
correlation
between M1 and
nominal GDP
also depicts the
instability of
velocity.
-4.0
1971 1975 1979 1983 1987 1991 1995 1999 2003
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Why did velocity become unstable?
• Most economists think the breakdown was
primarily the result of changes in banking rules
and other financial innovations.
– In the 1980s, interest-earning checking accounts
altered the demand for money and further blurred
the line between transaction and savings accounts.
– Also, money markets, mutual funds and other
financial assets became substitutes for traditional
bank deposits.
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Keynesians vs. Monetarists
• Keynesians and Monetarists fought head-tohead in the 1970s.
• Most economists conclude that Keynesians
won the war, but Monetarists won many
battles.
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Keynesians vs. Monetarists:
Key Differences
TABLE 1
Monetarists
Tie monetary policy to rules
Keynesians
Give 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.
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