17 Econweb Monetarism

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OnlineTexts.com p. 1

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 areinherently 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.

M x V = P x Y

M = money supply P = price level

V = velocity 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, orM x V = P x Y

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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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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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 ofreal GDP, leaving the price level unchanged.



The Rules vs. Discretion Debate

Keynesians advocate giving central bankers

discretion.

They attribute little significance to the QuantityTheory of Money because they believe that

velocity is unstable.

Keynesians also argue that the economy issubject 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 fiscalpolicy 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

Recent evidence

suggests thatvelocity has beenunstable andunpredictable sincethe 1980s.

Velocity1970-2003

3.0

4.0

5.0

6.0

7.0

8.0

9.0

1970

1973

1976

1979

1982

1985

1988

1991

1994

1997

2000

2003



Money and Nominal GDP

The lack of

correlation

between M1 and

nominal GDP

also depicts the

instability of

velocity.

Growth of M1 and Nominal GDP(1971-2003)

-4.0

1.0

6.0

11.0

16.0

1971 1975 1979 1983 1987 1991 1995 1999 2003

M1GDP



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 Keynesianswon the war, but Monetarists won many

battles.


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Keynesians vs. Monetarists:

Key Differences

TABLE 1

Monetarists KeynesiansTie monetary policy to rules 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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