Lecture Notes -- Monetarism

Chapter Seventeen: Lecture Notes -- Monetarism

Characteristics of Monetarism
The Quantity Theory of Money: The Short-Run
The Quantity Theory of Money: The Long-Run
The Rules vs. Discretion Debate
Fiscal Policy
Empirical Evidence of Monetarism
Keynesians vs. Monetarists
Useful Web Resources

Monetarism is an economic school of thought that stresses the primary importance of the money supply.

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. Monetarism is a theoretical challenge to Keynesian economics that increased in importance and popularity in the late 1960s and 1970s. In fact, the tide was so strong that in 1979 the Federal Reserve switched its operating strategy more in line with Monetarist theory, though they subsequently abandoned the strategy in 1982 for a number of reasons.

The challenge to the traditional Keynesian theory strengthened during the years of stagflation following the 1973 and 1979 oil shocks. Keynesian theory had no appropriate policy responses to the supply shocks. 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.

The theoretical foundation of Monetarism is the Quantity Theory of Money.

Characteristics of Monetarism

Monetarism is a mixture of theoretical ideas, philosophical beliefs, and policy prescriptions. Here we list the most important ideas and policy implications and explain them below.

The theoretical foundation is the Quantity Theory of Money.
The economy is inherently stable. Markets work well when left to themselves. Government intervention can often times destabilize things more than they help. Laissez faire is often the best advice.
The Fed should be bound to fixed rules in conducting monetary policy. They should not have discretion in conducting policy because they could make the economy worse off.
Fiscal Policy is often bad policy. A small role for government is good.

Velocity is the average number of times that the dollar turns over in a given year on the purchase of final goods and services.

By assuming that velocity is stable, we transform the equation of exchange into the quantity theory of money.

The Quantity Theory of Money: The Short-Run

We begin with the equation of exchange. This is the building block for monetarist theory. It says that

M × V = P × Y
where M is the quantity of M1, V is velocity of M1, or the average number of times that the dollar turns over in a given year on the purchase of final goods and services, P is the price level, and Y is real output.

As defined, the equation of exchange is always true. Keynesians, Monetarists and all other economists accept this equation as valid. The controversy arises because Monetarists make a seemingly innocuous assumption that velocity is stable in the short run. Let us take that assumption to its extreme and assume that velocity is fixed in the short run. The equation of exchange is rewritten as

where

implies that velocity is fixed in the short run. By making this simple assumption, we have transformed the equation of exchange into the Quantity Theory of Money. This equation tells us that any change in M1 will impact P × Y. Changes in the money supply are the dominant forces that change nominal GDP (P × Y). It is not surprising, therefore, that monetarists view control of the money supply as the key variable in stabilizing the economy.

Monetarists argue that, in the long run, changes in the money supply only cause inflation.

The Quantity Theory of Money: The Long-Run

Because monetarists believe that markets are stable and work well, they believe that the economy is always near or quickly approaching full employment. Even if the economy is not at full employment, the danger of GDP deviating substantially from its potential level is small. So in the long-run, the economy will be at Y_P. The Quantity Theory of Money in the long-run becomes:

Notice that 'M' and 'P' are the only variables in this equation that change in the long run. The implication is that changes in the money supply will only impact the price level, P. In the long run, changes in the money supply only cause inflation. This conclusion explains Friedman's famous quote "Inflation is always and everywhere a monetary phenomenon." Another implication is that the rate of growth of the money supply will equal the rate of growth of the price level (or inflation) in the long-run. If the money supply grows by five percent per year, the inflation rate will be about five percent per year.

Monetarists prefer to take away the discretion of central bankers by forcing them to follow the money growth rule: Monetary policymakers should 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

Because monetarists believe that the money supply is the primary determinant of nominal GDP in the short run, and of the price level in the long run, they think that control of the money supply should not be left to the discretion of central bankers. Monetarists believe in a set of "rules" that the Federal Reserve must follow. In particular, Monetarists prefer the 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. If the economy is expected to grow at 2 percent in a given year, the Fed should allow the money supply to increase by 2 percent. Monetarists wish to take much of the discretionary power out of the hands of the Fed so they cannot destabilize the economy.

Keynesians balk at this proposed money growth rule. Keynesians believe that velocity is inherently unstable and they do not believe that markets adjust quickly to return to potential output. Therefore, Keynesians attach little or no significance to the Quantity Theory of Money. Because the economy is subject to deep swings and periodic instability, it is dangerous to take discretionary power away from the Fed. The Fed should have some leeway or "discretion" in conducting policy. So far, Keynesians have won this debate. There has not been serious talk in some time of tying the Fed to a fixed money growth rule.

Monetarists believe that fiscal policy is not helpful. Where it could be beneficial, monetary policy could do the job better.

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 it could be beneficial, monetary policy could do the job better. Excessive government intervention only interferes in the workings of free markets and can lead to bloated bureaucracies, unnecessary social programs, and large deficits. Automatic stabilizers are sufficient to stabilize the economy.

The debate between Monetarists and Keynesians hinges on the stability of velocity and the efficiency of markets.

Velocity has been unstable and unpredictable since the early 1980s.

Empirical Evidence of Monetarism

Which school of thought is right, Keynesians or Monetarists? The answer hinges on the two assumptions described above: the stability of velocity and the efficiency of markets. We address the first of these two assumptions here. The figure titled "Velocity" plots velocity of M1 from 1970 to 2003. In the 1970s velocity was not stable, but at least it was increasing at a fairly constant rate.

Monetarism 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. 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. In short, the distinction between checking and savings accounts partially eroded. Moreover, many people found that money markets, mutual funds and other assets were better alternatives to traditional bank deposits. Hence, the relationship between money and economic performance changed. The figure titled "Growth of M1 and Nominal GDP" illustrates the lack of correlation between money growth and nominal GDP growth since the mid-1980s. 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.

Most economists conclude that Keynesians won the war, but Monetarists won many battles.

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. 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. Keynesians are also now more likely to prefer monetary policy to fiscal policy.

TABLE 1

Monetarists Keynesians

Tie monetary policy to rules Give policymakers discretion.

Fiscal policy is not useful. Fiscal policy may be useful.

AS curve has a steep slope.
Economy is inherently stable. Economy can be unstable.
AS curve can be flat.

Despite the convergence, substantial differences remain between the two bodies of thought. We summarize the more important differences here and in Table 1.

Keynesians argue that the Fed should use discretion in conducting monetary policy, while Monetarists advocate a long-run money growth rule.
Keynesians still view fiscal policy as potentially important. Monetarists are less convinced of the usefulness of fiscal policy.
As a general rule, Keynesians believe that the Aggregate Supply curve is more horizontal than vertical in the short run so stabilization policy can have big impacts on output and employment. Because Monetarists believe that the economy is inherently stable, they tend to view the Aggregate Supply curve as more vertical so discretionary stabilization policy is not as important.

Although differences remain, the debate between Keynesians and Monetarists cooled considerably in the 1990s. Monetarists could no longer defend a simple relationship between M1 and nominal GDP. Many Monetarists now emphasize the longer-run relationship between M2 growth and nominal GDP growth. Although Keynesians do not stress the importance of money growth as much as Monetarists, the focus on the long run is much less controversial.

Useful Web Resources

Read what economist Alan Meltzer has to say on Monetarism in The Concise Encyclopedia of Economics.
Read this article entitled The Rise and Fall of a Policy Rule: Monetarism at the St. Louis Fed,1968-1986 regarding the role that the Federal Reserve Bank of St. Louis played in promoting and researching monetarism.
In this Atlanta Fed publication, economist Rick Hafer asks What remains of Monetarism?