Lesson 12: Monetary Theory and Policy

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Lesson 12 Monetary Theory and Policy

• In this lesson we will develop a framework for
  understanding and evaluating monetary policy. We
  will place this in the context of the history of
  economic thought. We will learn about the
  Classical economists, Keynesian economics,
  Monetarism and other approaches.
• Suggested Reading
• RSU Chapter 22, 23, 26, 28, 29.
• You might also find the following paper of mine
  helpful Inflation, Common Fallacies and Real
  Issues, Graduate School of Business
  Administration, University of the Witwatersrand
  Fact and Opinion Papers, No. 3, (Second Edition,
  1978). (You may download it from
  http//www.utdallas.edu/plewin/FOpaper.pdf)
• What Remains of Monetarism? R. W. Hafer Economic
  Review, Federal Reserve Bank of Atlanta Vol. 86,
  No. 4, Fourth Quarter 2001 (available at
  http//www.frbatlanta.org/filelegacydocs/hafer.pdf
  )

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Schools of Economic Thought
The Classical Economists (The Quantity Theory
Tradition) Pre-Smith Adam Smith (1776) David
Hume David RicardoJames Mill John Stuart Mill
The Austrian School (1871) Carl
Menger Böhm-Bawerk Wieser Mises Hayek Modern
Austrians Kirzner, Lachmann Boettke, Horwitz,
Roger Garrison, Lewin
The Neoclassical Revolution (1871)
Karl Marx
Alfred Marshall Cambridge school Irving Fisher
- America Pigou Keynes
The Keynesian Revolution Samuelson, Solow, Tobin
The Chicago School (approx. 1952 1990)
Monetarism Milton Friedman
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Classical Economics and the Role of Money

• The ascendancy of laissez faire ideas Says
  Law and the monetary dichotomy
• Links in the chain Fed ? M ? the Economy
• M ? GDP
• define Q GDP/P, where P is the (current weight)
  GDP deflator. M ? PQ.
• MV PQ the equation of exchange Fisher
• M kPQ the Cambridge cash balance equation
  Marshall.
• gM gk gP gQ Monetary growth inflation
  economic growth (changes in holdings of money)
  Question what is the relationship between gP and
  gQ?
• If M and Q are approximately constant we have the
  Quantity Theory of Money.
• M ?P or gM gP

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Crisis and Disillusionment The Economics of
Keynes and Keynesian Economics

• The prosperous 1920s in the U.S. and the
  struggles in the U.K.
• Keynes, the man and his experiences
• The presumptions of Harvey Road
• Scholar, student, civil servant
• 1914 The Economic Consequences of the Peace
• Top of Cambridge, top of the world
• 1930 A Treatise on Money (1930)
• 1936 The General Theory (1936)
• The U.S.and the New Deal Keynes comes to
  America
• Keynesian economics the market system needs
  help from the government.

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The Keynesian Message

• Consumption (savings), Investment and Money
  (interest rates).
• A law of Consumption, the paradox of thrift and
  the danger of stagnation
• Investment drives the economy, but its so
  unreliable because it depends so much on
  expectations
• A new theory of interest rates, its supply and
  demand for money, not loanable funds, its all
  about a preference for liquidity and expectations
  (again) of interest rates
• transactions, precautionary, speculative motives
• It all adds up to a story of dangerous potential
  instability, the story of Ruritania and the
  wicked witch.
• So youve gotta have the government pay for
  something, anything dig some holes and fill
  them up again.

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• The Keynesian System in Brief the Static
  Version 

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The Keynesian Cross
E  
CIG  
E  
G  
CI  
I  
a I G
C  
a I

•  

B  
Slope c
a
a
Q  
0  
S  
IG  
Q  
0  
B  
-a
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Derivation of the Multiplier

• Issues
• The difference between statics and dynamics
• Are there forces that offset the multiplier?
  for example taxation
• What happens at full employment?
• The method of government financing ?G ?Taxes
  ?Debt ?Money

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The Phillips Curve
gP
A Keynesian Tradeoff between Inflation and
Unemployment
Unemployment rate
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The Keynesian determination of interest rates
i
Ms3
Ms2
Ms1
Liquidity trap
i1
i2
Md LP
M
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The Monetarist Counterrevolution

• Resistance at the University of Chicago
• Milton Friedman and Studies in the Quantity
  Theory of Money
• Milton Friedman and A Theory of the Consumption
  Function
• Milton Friedman and Anna Schwartz A Monetary
  History of the U.S. (1971).
• Presidential address and the stagflation of the
  1970s The Role of Monetary Policy Nobel
  Prize
• It should not attempt the impossible
• It is impossible to control the real rate of
  interest
• It is impossible to permanently reduce the rate
  of unemployment (NRH)
• It should do only what is possible and desirable
• It should control the supply of money to achieve
  predictable price stability (minimum inflation or
  deflation).
• The only way this can be done is through a
  constant monetary growth rate this is
  Monetarism. Its like driving a boat with a
  faulty rudder across a lake
• Monetarism in the spotlight

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Alternative Theoretical Explanations

• Keynesianism in retreat whats the
  alternative?!! gP and gQ are not alternatives
• 1. A monetary disequilibrium theory (Leland
  Yeager) Monetarism enriched.
• 2. A model of rational expectations
• 3. The Austrian Model of the Business Cycle
  (Hayek bounces back Nobel prize in 1974).
• An increase in Consumption may plausibly imply a
  reduction in Investment.
• Investment is an aspect of the Capital Structure
  (the structure of production) of the economy. If
  interest rates are wrong, the production
  structure may be wrong.
• Misallocation requires costly and difficult
  reallocation.
• Which one maybe a combination of 1 and 3.

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But why did Monetarism fail?

• Look at what's gone from Monetarism and what it
  never had in the first place.
• Gone since the early 1980s is a stable velocity
  of money.
• Gone in recent times is any consensus about just
  which monetary aggregate counts.
• Gone is the ability of the Federal Reserve
  actually to hit a money growth target.
• Gone is the possibility of even articulating a
  "monetary rule," let alone actually following
  one.
• So whats left?
• A strong sense that indeed money does matter.
• Central banking is more art than science
• A question can the market help?

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Whats left of the Phillips Curve?
gP
Unemployment rate
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Summing up Aggregate Supply and Demand
Classicism Monetarism, RE, Austrianism
AS
P
Short run/Long run
P2
P1
Keynesianism
AD2
AD1
Q
0
Q2
Q1
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• The ideas of economists and political
  philosophers, both when they are right and when
  they are wrong, are more powerful than is
  commonly understood. Indeed the world is ruled by
  little else.Practical men who believe
  themselves to be quite exempt from any
  intellectual influences are usually the slaves of
  some defunct economist. Madmen in authority, who
  hear voices in the air, are distilling their
  frenzy from some academic scribbler of a few
  years back.
• John Maynard Keynes.