Download Economic Schools of Thought – Monetarism

Economic Schools of Thought – Monetarism Overview
Explaining Macroeconomic Scenarios
Mr. Stewart’s AP Macroeconomics Class
Spring Semester 2014
Definition of 'Monetarism'
A set of views based on the belief that inflation depends on how much money the
government prints. It is closely associated with Milton Friedman, who argued, based on the
quantity theory of money, that the government should keep the money supply fairly steady,
expanding it slightly each year mainly to allow for the natural growth of the economy.
Credit: http://www.investopedia.com/terms/m/monetarism.asp
Monetarism is a macroeconomic school of thought that emphasizes (1) long-run
monetary neutrality, (2) short-run monetary non-neutrality, (3) the distinction
between real and nominal INTEREST RATES, and (4) the role of monetary aggregates in
policy analysis. It is particularly associated with the writings of MILTON FRIEDMAN,
Anna Schwartz, Karl Brunner, and Allan Meltzer, with early contributors outside the
United States including David Laidler, Michael Parkin, and Alan Walters. Some
journalists—especially in the United Kingdom—have used the term to refer to
doctrinal support of free-market positions more generally, but that usage is
inappropriate; many free-market advocates would not dream of describing
themselves as monetarists.
An economy possesses basic long-run monetary neutrality if an exogenous increase of Z percent in its stock
of money would ultimately be followed, after all adjustments have taken place, by a Z percent increase in
the general price level, with no effects on real variables (e.g., consumption, output, relative prices of
individual commodities). While most economists believe that long-run neutrality is a feature of actual
market economies, at least approximately, no other group of macroeconomists emphasizes this proposition
as strongly as do monetarists. Also, some would object that, in practice, actual central banks almost never
conduct policy so as to involve exogenous changes in the MONEY SUPPLY. This objection is correct
factually but irrelevant: the crucial matter is whether the supply and demand choices of households and
businesses reflect concern only for the underlying quantities of goods and services that are consumed and
produced. If they do, then the economy will have the property of long-run neutrality, and thus the abovedescribed reaction to a hypothetical change in the money supply would occur.1 Other neutrality concepts,
including the natural-rate hypothesis, are mentioned below.
Short-run monetary non-neutrality obtains, in an economy with long-run monetary neutrality, if the price
adjustments to a change in money take place only gradually, so that there are temporary effects on real
output (GDP) and employment. Most economists consider this property realistic, but an important school of
macroeconomists, the so-called real business cycle proponents, denies it.
Continuing with our list, real interest rates are ordinary (“nominal”) interest rates adjusted to take account
of expected INFLATION, as rational, optimizing people would do when they make trade-offs between present
and future. As long ago as the very early 1800s, British banker and economist Henry Thornton recognized
the distinction between real and nominal interest rates, and American economist IRVING FISHER
emphasized it in the early 1900s. However, the distinction was often neglected in macroeconomic analysis
until monetarists began insisting on its importance during the 1950s. Many Keynesians did not disagree in
principle, but in practice their models often did not recognize the distinction and/or they judged the
“tightness” of MONETARY POLICY by the prevailing level of nominal interest rates. All monetarists
emphasized the undesirability of combating inflation by nonmonetary means, such as wage and PRICE
CONTROLS or guidelines, because these would create market distortions. They stressed, in other words, that
ongoing inflation is fundamentally monetary in nature, a viewpoint foreign to most Keynesians of the time.
Finally, the original monetarists all emphasized the role of monetary aggregates—such as M1, M2, and the
monetary base—in monetary policy analysis, but details differed between Friedman and Schwartz, on the
one hand, and Brunner and Meltzer, on the other. Friedman’s striking and famous recommendation was
that, irrespective of current macroeconomic conditions, the stock of money should be made to grow “month
by month, and indeed, so far as possible, day by day, at an annual rate of X per cent, where X is some
number between 3 and 5.”2 Brunner and Meltzer also favored monetary policy rules but recognized the
attractiveness of activist rules that relate money growth rates to prevailing economic conditions. Also, they
typically concentrated on the monetary base, adjusted to reflect changes in reserve requirements, whereas
Friedman was more concerned with M2 or M1 and, indeed, sought major changes in banking legislation,
such as 100 percent reserve requirements on deposits, designed to make the chosen aggregate precisely
controllable.
Friedman’s constant-money-growth rule, rather than other equally fundamental aspects of monetarism,
attracted the most attention, thereby detracting from the understanding and appreciation of monetarism. In
particular, this led to the comparative neglect of Friedman’s crucial “accelerationist” or “natural-rate”
hypothesis, according to which there is no long-run trade-off between inflation and UNEMPLOYMENT; that
is, the long-run PHILLIPS CURVE is vertical. The no-trade-off view was also promoted by Brunner and
Meltzer. Accordingly, it might be argued that the two fundamental monetarist propositions are (1) that
cyclical movements in nominal income are primarily attributable to movements in the stock of money, and,
(2) that there is no permanent trade-off between unemployment and inflation. Together, these lead to
monetarist style policy positions.
Monetarism’s rise to intellectual prominence began with writings on basic monetary theory by Friedman
and other University of Chicago economists during the 1950s, writings that were influential because of
their adherence to fundamental neoclassical principles. The most outstanding in this series was Friedman’s
presidential address to the American Economic Association in 1967, published in 1968 as “The Role of
Monetary Policy.” In this paper Friedman developed the natural-rate hypothesis (which he had clearly
stated two years earlier) and used it as a pillar in the argument for a constant-growth-rate rule for monetary
policy. Almost simultaneously, Edmund Phelps, who was not a monetarist, developed a similar no-trade-off
theory, and, within a few years, events in the world economy apparently provided dramatic empirical
support.
In the late 1970s and early 1980s, after a decade of increasing influence, monetarism’s reputation began to
decline for three main reasons. One was the growing belief, based on plausible interpretations of
experience, that money demand is in practice highly “unstable,” shifting significantly and unpredictably
from one quarter to the next. The second was the rise of RATIONAL EXPECTATIONS economics, which split
analysts antagonistic to Keynesian activism into distinct camps. (A majority of monetarists themselves
soon embraced the rational expectations hypothesis.) The third was the Federal Reserve’s famous
“monetarist experiment” of 1979–1982. The latter episode warrants an extended discussion.
During the 1970s, inflation rose in the United States, as well as in many other industrial nations, to levels
unprecedented on a multiyear basis during periods of relative peace. This occurred as a consequence of
various “shocks”—oil price increases, the Vietnam War, and especially the 1971–1973 demise of the
Bretton Woods system of fixed exchange rates (itself caused largely by the failure of the United States to
maintain the gold value of the dollar). This demise left central bankers with a major new responsibility;
namely, to provide a nominal anchor for national fiat currencies to replace the GOLD STANDARD. The
Federal Reserve announced several times during the 1970s that it intended to bring inflation under control,
but various attempts were unsuccessful. Then, on October 6, 1979, the Fed, under Paul Volcker’s
chairmanship, announced and put into effect a new attempt involving drastically revised operating
procedures that had some prominent features in common with monetarist recommendations. In particular,
the Fed would try to hit specified monthly targets for the growth rate of M1, with operating procedures that
emphasized control over a narrow and controllable monetary aggregate, non-borrowed reserves (i.e., bank
reserves minus borrowings from the Fed). The M1 targets were intended to bring inflation down from
double-digit levels to unspecified but much lower values.
In retrospect, the events that occurred from October 1979 to September 1982 are widely viewed as the
crucial beginning of a necessary and successful attack on inflation that led, eventually, to the worldwide
low-inflation environment of the 1990s. At the time, however, the “experiment” seemed anything but
successful to many Americans. Short-term interest rates jumped dramatically in late 1979 under the
tightened conditions, and 1980 witnessed a major fall in output in one quarter followed by a major jump in
the next, due primarily to the imposition, and then removal, of credit controls. Finally, in 1981 and into the
middle of 1982, a sustained period of monetary stringency brought about the deepest recession since the
GREAT DEPRESSION of the 1930s and began to bring inflation down, more rapidly than many economists
anticipated, toward acceptable values. Some relevant statistics, designed to put the episode in perspective,
are reported in Table 1. Throughout the entire episode, moreover, both interest rates and money growth
rates were highly variable. To be specific, the standard deviation of monthly percentage growth rates of M1
increased from 3.73 (for the previous three years) to 8.22 for the period from October 1979 to September
1982, while the standard deviation of monthly percentage changes in the federal funds rate jumped from
2.86 to 23.1 (annualized units).
Table 1 Selected Statistics, 1960–1999, percentages (average or changes)
Year or
Average
Over
CPI
Inflation
Dec.–Dec.
Fed
Funds
Rate
“Real”
Funds
Rate
M1
Growth
Rate
Adjusted
M1B
Growth
Unemployment
Rate
1960–64
1965–69
1970–74
1975
1976
1977
1978
1979
1980
1981
1982
1983
1984
1985–89
1990–94
1995–99
1.2
3.9
6.7
6.9
4.9
6.7
9.0
13.3
12.5
8.9
3.8
3.8
3.9
3.7
3.5
2.4
2.9
5.4
7.1
5.8
5.0
5.5
7.9
11.2
13.4
16.4
12.3
9.1
10.2
7.8
4.9
5.4
1.7
1.5
0.4
−1.1
0.1
−1.2
−1.1
−2.1
0.9
7.5
8.5
5.3
6.3
4.1
1.4
3.0
2.8
5.0
6.1
4.7
6.7
8.0
8.0
6.9
7.0
6.9
8.7
9.8
5.8
7.7
7.8
−0.4
—
—
—
—
5.8
7.9
7.2
6.8
6.9
2.4
9.0
10.3
5.2
—
—
—
5.7
3.8
5.4
8.5
7.7
7.1
6.1
5.8
7.1
7.6
9.7
9.6
7.5
6.2
6.6
4.9
Sources: Economic Report of the President, 2003, except: Adjusted M1B Growth:
Alfred Broaddus and Marvin Goodfriend, “Base Drift and the Longer Run M1 Growth
Rate: Experience from a Decade of Monetary Targeting,” Federal Reserve Bank of
Richmond Economic Review 70 (November–December 1984), pp. 3–14.
Note: Adjustments to M1 growth rates were made and used by the Fed, at the time,
to take account of estimated distortions brought about by the introduction of NOW
(negotiated order of withdrawal) accounts.
Many critics characterized the “experiment” as a macroeconomic disaster. Some believed, moreover, that it
provided strong and definitive evidence invalidating monetarism—partly by showing how undesirable it
was to have money growth targets and partly in showing how poor are operating procedures for controlling
M1 money growth by means of tight control of a narrow monetary aggregate. Monetarists argued that the
episode was actually not monetarist in its design because growth rates of M1 fluctuated very widely on a
month-to-month basis; the operating procedures in place were, because of lagged reserve requirements,
extremely poorly designed for the control of M1; and the Fed never forswore discretionary responses to
current cyclical conditions. It now seems clear that the Fed’s use of a narrow monetary aggregate for weekto-week control was highly effective in terms of public relations. The reason was that it permitted the Fed
to escape political responsibility for the resulting high and, therefore, unpopular interest rate levels by
claiming that these were simply the consequence of market forces.3 At the same time, by adopting a
putatively monetarist approach, the Fed could at least, even if the episode was a failure, discredit
monetarism and the Fed’s annoying monetarist critics. As matters played out, the episode was soon seen as
a strategic success, despite temporary unhappiness, and monetarism was discredited as well!
What is left today of monetarism? While some disagreement remains, certain things are clear. Interestingly,
most of the changes to Keynesian thinking that early monetarists proposed are accepted today as part of
standard macro/monetary analysis. After all, the main proposed changes were to distinguish carefully
between real and nominal variables, to distinguish between real and nominal interest rates, and to deny the
existence of a long-run trade-off between inflation and unemployment. Also, most research economists
today accept, at least tacitly, the proposition that monetary policy is more potent and useful than FISCAL
POLICY for stabilizing the economy. There is some academic support, and a bit in central bank circles, for
the real-business-cycle suggestion that monetary policy has no important effect on real variables, but this
idea probably has marginal significance. It is hard to believe that the major recession of 1981–1983 in the
United States was not caused largely by the Fed’s deliberate tightening of 1981—a tightening that shows
up in ex-post real interest rates and in M1B growth rates as adjusted by the Fed at the time (Table 1,
column 6) to take account of major institutional changes.
In 2005, most academic specialists in monetary economics would probably describe their orientation as
NEW KEYNESIAN. Also, monetary aggregates currently play a small or nonexistent role in the monetary
policy analysis of academic and central-bank economists. In terms of its underlying scientific rationale,
however, today’s mainstream analysis is much closer to that of the monetarist than the Keynesian position
of, for example, 1956–1978. In addition to the points noted above, current thinking clearly favors policy
rules in contrast to “discretion,” however defined, and stresses the central importance of maintaining
inflation at quite low rates. It is only in its emphasis on monetary aggregates that monetarism is not being
widely espoused and practiced today.
Credit: http://www.econlib.org/library/Enc/Monetarism.html