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 8.0 7.0 6.0 5.0 4.0 3.0 1970-2003

Recent evidence suggests that velocity has been unstable and unpredictable since the 1980s.
1991 1994 1997 2000 2003

1970

1973

1976

1979

1982

1985

1988

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Money and Nominal GDP

Growth of M1 and Nominal GDP
16.0 11.0 6.0 1.0 -4.0 1971 1975 1979 1983 1987 1991 1995 1999 2003 (1971-2003)

GDP

M1

The lack of correlation between M1 and nominal GDP also depicts the instability of velocity.

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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 Keynesians

Tie monetary policy to rules Fiscal policy is not useful. AS curve has a steep slope. Economy is inherently stable.

Give policymakers discretion. Fiscal policy may be useful. Economy can be unstable. AS curve can be flat.

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