Transcript Lecture 8b Monetarism and the quantity theory of money

PRINCIPLES OF MACROECONOMICS
LECTURE 8B
MONETARISM AND DEMAND FOR MONEY
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.
Characteristics of Monetarism
1.
2.
3.
4.
The theoretical foundation is the Quantity Theory
of Money.
The economy and financial markets are inherently
stable.
The Fed should be bound to fixed rules in
conducting monetary policy.
Fiscal Policy is often bad policy. A small role for
government is good.
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
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.
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.
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.
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.
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.
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.
Empirical Evidence of Monetarism

The suppositions of monetarism depend crucially on
 the
stability of velocity
 the efficiency of markets
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
Money and Nominal GDP
Growth of M1 and Nominal GDP
16.0
11.0
(1971-2003)
GDP
M1
6.0
1.0
-4.0
1971 1975 1979 1983 1987 1991 1995 1999 2003
The lack of
correlation
between M1
and nominal
GDP also
depicts the
instability of
velocity.

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.
Keynesians vs. Monetarists


Keynesians and Monetarists fought head-to-head in
the 1970s.
Most economists conclude that Keynesians won the
war, but Monetarists won many battles.
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.