Download CHAPTER - 3 BASIC ISSUES IN MONETARISM AND FISCALISM

CHAPTER - 3
BASIC ISSUES IN MONETARISM AND FISCALISM
49
CHAPTER - 3
BASIC ISSUES IN MONETARISM AND FISCALISM
3.1
Introduction:
The present chapter examines the various issues in the debate
between
monetarism
and
fiscalism.
Just
as
monetarism
is
neo-
Fisherianism as restated by Milton Friedman, Brunner and Meltzer and
others, so Keynesianism also restated by Tobin, Warren Smith, Ackely
etc.,
in the form of neo-Keynesianism.
CO
fiscalism
which
is,
of
course
to
Neo-Keynesianism is known as
be
supported
by
the
proper
credit policy.
In reviewing the various issues in the debate, we face the most
important difficulty that there is no agreement even among monetarists
as
to
what
monetarism
is,
when
Thomas
Mayer
sought
to
define
monetarism in 1975, he listed twelve propositions, which in his view,
characterise monetarists and distinguish from Keynesians.
of
a
number of economists
emerged
that
there
to
Mayer's
were several
listing
variants
of
was
The reaction
interesting.
monetarism,
It
one could
label them Chicago (Friedman) monetarism, Brunner-Meltzer monetarism,
International monetarism and so on.
could get some-what different
Even for Chicago monetarism, one
testable propositions from Friedman in
1956 as against Friedman in 1963 or 1967.
concentrate
some
of
the
most
important
However, here we shall
issues,
which
are
most
representative of the respective doctrines.
3.2
Stability of the Economy System:
The view that the economy is inherently stable and that much of
the instability actually experienced since World War II has been the
50
result
of
active
fiscal
and
monetary
intervention,
has
long
been ^
advanced by Friedman and other monetarists.
Keynesians in general,
f 21 ' has described the division,
reject this view.
As
Modigliani'
Keynesians accept,
Theroy:
"TheFundamental Pratical Message
of the General
that a private enterprise economy using an intangible money
needs to be stabilized,
can be stabilized,
and therefore should be
stabilized by appropriate monetary and fiscal policies.
Monetarists by
contrast take the view that there is no serious need to stabilise the
economy, that even if there were a need, it could not be done, for
stabilization policies would be more likely to increase than to decrease
instability
.
The monetarist contention that the economy is inherently stable
does not deny that the economy is subject to fluctuations, but these
fluctuations are attributed primarily to destabilizing variations in the
money supply caused by
the monetary authorities. If that
disturbance is
most
removed,
of the instability
according to this point of view.
will
be
source of
removed,
This leads to the argument long
advanced by Friedman that the money supply should grow at a fixed
rate.
On the other side, the Keynesian rejection of the argument that
the economy is inherently stable is not an acceptance of the opposite
argument that the economy is explosively unstable.
that it is subject to frequent,
variability
of
investment
The argument is
erratic shocks due primarily to the
spending
and
that
these
shocks
are
sufficiently strong to produce business cycles of significant amplitude.
To
reduce
the
damage
that
accompanies
such
fluctuations
requires
appropriate counter cyclical monetary and fiscal policies, according to
51
t£e Keynesian point of view.
From both points of view, counter cyclical monetary and fiscal
policies
will
affect
output,
employment
and
prices.
The critical
difference is that monetarists believe that attempts to make things
better through policy actions more often than not end up making them
worse,
where-as Keynesians believe just the opposite.
monetarists
Therefore, to
there is no active role for stabilization policy and to
Keynesian there is,
this
two-way division has been given a third
dimension in recent years by the rational expectationists who take the
issue with both the Keynesian and monetarist views.
3.3
Views of the Rational Expectations;
A number of economists
T.J.
Sargent,
N.
economists reject
Wallace,
the
have supported this theory including
R.E.
Keynesian
Lucas Jr,
position
R.J.
that
Barro etc.,
monetary
these
policy,
if
appropriate to the condition, can have a beneficial effect on output and
employment;
policy,
they also reject
if inappropriate to
the monetarist
the conditions,
effect on output and employment.
monetary
policy
employment.
has
negligible
position that
can have a detrimental
Rational expectationists maintain that
systematic
effect
affects
produced.
on
output
and
And this is not only true in the longrun, as is generally
accepted by all, but also in the quite short run.
supply
monetary
prices
of
goods,
not
the
total
Varying the money
quantity
of
goods
This being the case, activists monetary policies designed
to stimulate the economy are unlikely to do anything but raise the rate
of inflation
(3)
52
These
economists
are
referred
to
as
rational
expectationistS
because their attack on the proposition that there is a role for
stabilization policy is based on the application of the concept of
rational expectations to the area of macro economic policy.
The idea
of rational expectations is, in short, that households and firms form
their expectations of the future magnitudes of economic variables like
the
price
income.
level,
This
gross
national . products
includes
whatever
and
disposable personal
information
they
have on
what
government fiscal and monetary policies will be in the future because
a rational person recognises that these policies will tend to affect
the values of economic variables.
approach to the explanation
expectations,
In constrast,
the conventional
of the way households and firms fomulate
so called adaptive expectations,
makes
the expected
magnitude of these economic variables equal to a weighted average of
their present and past values.
Therefore, the expected values so
determined do not allow for the influence of all the information that
national households and firms take into account in formulating their
expectations. 14')
Consequently,
in
broad
terms
because
the
public's
current
spending, saving, investing and other economic decisions, are affected
by their expectations of what is going to happen in the uncertain
future and because their expectations of this depend in part on their
expectations
of
what
macro-economic
policy
public's current decisions are what they are,
is
going
in part,
what it expects macro-economic policy will be.
to
be,
the
because of
Accordingly, any
widely expected policy action for example, a slower rate of monetary
53
growth will have little effect
would
have
public.
been
already
However,
cause the public
on
taken
the publics behaviour because i,t
into
account
and
acted
on
by
the
any unexpected policy action will for this reason
to
change its
current
behaviour.
Thus the policy
action will be effective in modifying the public's current behaviour
as the policy-makers intended, only if it comes as a surprise to the
public.
According
to
rational expectationists,
a similar impediment to
the effectiveness of counter cyclical fiscal policy is faced.
Because
the public has learnt from experience, there will be tax cuts and/or
increases in government spending in the event of an economic downturn
or slow down.
such
Signs of such a development create expectations of
counter - cyclical
action.
As
the
public
acts
on
these
expectations, the timing of their actions need not provide the desired
stabilizing effect.
The
major tenet of the rational expectationists is that activist
macro-economic policy
cannot
systematically succeed in affecting the
economy's employment and output levels.
To affect these levels, the
authorities must alter policy unexpectedly, but a continuing policy of
this kind must lead to uncertainty by the public as to what policy
will be.
uncertain,
particular
As the publics' expectations of policy action become more
the policy makers have no
way
of knowing whether any
action they take will surprise the public andtherefore be
effective or whether that action has already been taken into account
by the public and will therefore be ineffective.
to
know i*rhat
public
reaction
will
follow
from
Without being able
any
policy step it
54
takes, the policy makers are bound to be in a state of confusion as
to what the appropriate policy at any time should be.
Policy making
becomes
the
dice-shooting.
expectationist
argument,
Therefore
it
is
futile
according
to
try
to
to
affect
rational
output
and
r 5)
employment through activist monetary and fiscal policies.'
Although the rational expectationists have raised some new and
interesting
policy
the
activist
questions
majority
policy
is
concerning
view
not
the
among
feasibility
economists
powerless.
The
so
of
counter-cyclical
far
likelihood
remains
that
that
counter
cyclical monetary and fiscal policies will be abandoned in the near
future is slight,
barring the development of a much stronger case
than has so far been presented by the monetrists and the rational
expectationists.
As
long as
we continue to use counter cyclical
policies, all of the pratical questions faced by policy makers will
remain. ^
3.4- Transmission Mechanism:
The transmission mechanism spells out the channels by which
changes in money supply influence nominal GNP, the price level and
the ouput.
The
income-expenditure
theory
of
the
Fiscalists
adopts
a
particular transmission mechanism to analyse the effects of a change
in the money stock
(or its growth rate)
on the real economy. It
assumes that money change will affect output or prices only through
its effect on a set of conventional yields on the market interest rate
of a small group of financial assets, such as government or corporate
55
bonds.
effect
A given change in the money stock
on
analysis.
change
in
these
The
interest
interest
investment
rates
given
rate changes
spending,
the
by
will have a calculable
the
liquidity
are then used
induced
effects
preference
to derive the
on
income and
consumption^ etc. ^7 ^
The size of the increase in national income depends on the size
of the multiplier.
The whole process can be illustrated using the
45° line diagram. (Fig 3.1).^
2
I2]
Y
Fig 3.1
National
Income
56
In response to increase in the money supply (M) the rate of
interest reduces by r.
Investment increases from 1^ to
following the reduction in the rate of interest (r).
increase in national income from
(by I)
This causes an
to Y2 (by Y)
conversely a
reduction in real income with reduction in investment caused by rise
in the rate of interest.
The Keynesian view, how money affects
economic activity is also shown by a simple flow diagram. (Fig 3.2)
AM
6?
------- »
£1
------ »
■
Fig 3.2 The Keynesian transmission mechanism
Within the transmission mechanism for money to be important,
the following conditions must be satisfied:
1.
Demand for money should relatively be less elastic to interest
rates.
If not so the effect of money supply changes on rates of
interest will be offset by the interest responsiveness of the demand
for money.
2.
Investment should fairly be responsive to changes in the rate of
interest.
Keynesian information bearing on the transmission of monetary
impulses is contained in the slope properties of the IS-LM function.
In this model, money substitutes only for bonds and not for existing
assets or output.
In Keynesian income-expenditure models, real capital goods do
not appear as an asset in the portfolio because they are assumed to
be
a
perfect
substitute
for
long
term
bonds.
Omr\Cj
to
this
57
assumption,
bonds
is
the
not
direct
substitution
explicity
relationship
recognised.
between
Several
misinterpret this Keynesian position
economists
this mis-interpretation has in turn led
(close)
and
seem
to
implying that money is a direct
substitute for financial assets but not for real assets.
money is a good
money
A reaction to
to the recent argument that
substitute not only for bonds but also for
real assets and that monetary policy operates directly in a framework
in
which
assets.
real
assets
are
explicity
introduced
along
with
other
O)
Monetarists,
following
transmission mechanism
the quantity
based
on
theory,
do not
accept the
the liquidity preference theory of
interest rate for several reasons.
1.
They
suggest
expenditures,
physical
that
prices
assets,
an
and
and
increase
a
wide
need
not
in
money
variety
be
of
may
directly
implicit
restricted
to
a
affect
yields
small
on
set
of
conventional yields on financial assets.
2.
They
view
the
demand
for
money
as determining
the desired
quantity of real balance and not the level of interest rates.
3.
And,
authorities
variable
most
can
and
fundamental,
change
thereby
the
bring
they
stock
reject
of real
about
a
the
notion
balances -
permanent
that
the
an endogenous
change
in
interest
rates.™
IS-LM framework has been subjected to attack in recent years.
1.
IS-LM model does not take into account money creation aspect
deficit.
However,
it
was
Carl
Christ
who
drew
attention to
of
the
58
governments budget constraint-government expenditure not financed hy
taxes or by borrowing from the public must be financed by borrowing
from
the
banking
system.
And
the
latter,
Christ^^
observed,
involved money creation and will alter the structure of portfolios in
the private sector.
Brunner and Meltzer^125
both
money
and
government debt,
bond-financed
like money,
extended Christ analysis, by analysing
fiscal
policy
in
a
model
in
which
is an imperfect substitute for private
capital. They stressed that policy induced IS curve shifts must also
lead to LM curve shifts except in the special case^ in which changes
in
government
expenditure are matched
by
equal changes in taxes,
even if it is assumed that government interest-bearing-debt is not to
any degree net-wealth.
2.
IS-LM analysis fails to incorporate expected
rate of inflation
and effect of past experience or the position of the aggregate supply
curve.
A Pigouvian modification embodying the real balance effect
implying a shift in the IS function consequent upon the shift in the
LM function has now been introduced.
3.
IS-LM model has also been criticised for its highly aggregated
character.
Structure of
aggregates
close
to
Keynes's
interest has
f 131
been suggested by Leijohnfrud;
He aggregated long term bonds with
real assets and money with short-term financial assets.
The portfolio
distribution between these two assets will then depend upon yield on
bonds equal to yield on real assets on the one hand and yield on
money on the other.
This aggregation does not seem logical as a real asset has an
59
uncertain
running
conjectural,
fixed
yield
and
its
future
capital
value
is
highly
while a bond has a certain nominal running yield and a
maturity value.
The determination of
investment
expenditure
requires explicit recognition of the distribution between real assets
and bonds. (Good-Hart).
4.
Brunner
grounds
that
and
it
Meltzer'
treats
criticised
bonds
and
Money substitutes only for bonds,
And
the
However,
problem
of
professor
Tobin^1*^
real
the
IS-LM
capital
as
model
a
on
the
single asset.
not for existing assets or output.
persistent
unemployment
has
extended
is
not
explained.
the Hicksian
model
to
include substitution between money and real capital.
5.
IS-LM
output
model
only
at
gives
the
the
level
solution
of
full
for
the
price-level and
employment.
The
real
problem
of
persistent unemployment is not explained.
6.
Finally,
the
model
has
not
successfully
confirmed
for
its
predictive ability.
Brunner and Meltzer have sought to correct the deficiency of moneybond
substitution in
the traditional
IS-LM
market for the existing real capital.
the
market
for
money
from
the
substantially
different
analysis.
appealing
Walras
By
to
This enables them to separate
market
implications
frame work by adding a
for
from
Law,
credit
the
they
with
logical
traditional
IS-LM
drop
the
market
for
existing real capital and make explicit the credit and money markets.
In this manner they examine the factors that contribute to the nature
of economic response to monetary and fiscal actions.
suggest
an
enlarged
number
of
considerations
in
Their findings
conditioning
the
60
response
of
the
Futhermore,
economy
according
to
to
monetary,
Brunner
fiscal
and
and
Meltzer,
other
stimuli..
specification
of
interest elasticities (slopes) are neither necessary nor sufficient for
determining the response of aggregate demand output (at a given price
level for such output)
response of
to monetary
aggregate demand to
fiscal actions.
Secondly,
the
monetary impacts need not depend
upon weather effect or interest elasticities of IS and/or LM finally,
government deficit financed by issuing debt raises interest rates and
the
price
of
multipliers
existing
are
real
capital.
conditioned
by
elasticities and wealth effect.
Consequently,
considerations
other
the
than
fiscal
interest
Thus they show that a zero interest
elasticity of money is not necessary in order that fiscal multiplier be
zero as is the usual characterisation of the monetarist school.
Monetarists
money
and
real
process of
assets.
assume a
high
assets.
A change
portfolio substitution
It
is,
however,
not
(17)
degree of substitutability between
in money
supply
directly affects
clear
whether
it
through
the
spending on real
affects
flow
of
expenditure on goods and services of stocks of second hand real
capital
goods
such
as
plants,
equipment,
machinery
and
houses.
Unless the open market operations simultaneously change the public's
net worth or its income-which it doesn not the initial effect of the
operations is not income at all, but on the price of existing assets.
This effect, the substitution effect, is then subsequently transmitted
to the real
sector, and only at
and employment affected.
this stage are the levels of income
61
When the monetary authority purchases treasury
open market,
bills in th§.
it is making more funds available for the public to
purchase a wide variety of financial and real assets.
The pertinent
question is which asset or assets the public will first turn to if the
owners
of
wealth
regard
real
assets
as
a
better
than other financial assets they
substitute
for
treasury
bills
will purchase real
assets.
However, if they think financial assets as better substitutes
for the treasury bills sold by them they would purchase financial
assets first and would turn to equities,
real property and capital
goods only after the prices of these financial assets have gone up
sufficiently.
In this case the substitution effect of the open market
operations on the demand for real assets, other things being equal,
would be negligible.
substitution
The crucial factor is not ceteris paribus, the
relationship
between
money
and
real
assets
but
that
between bills (or any assets that the monetary authority deal with in
the open market) and other assets that are not money.
Indeed if
money and real assets were very good substitutes, the wealth owners
would have less inducement to acquire real assets as a result of an
open market operation, i.e. public would regard real assets as less
attractive candidates for portfolio diversification, i.e. for reducing
overall risk of the portfolio.
There are two opposing views on
substitutability among all types of assets.
categories of government debt money,
According to Tobin, all
treasury bills and long-term
bonds etc. are good substitutes for one another because
similarity
in the risk characteristics but are poor substitute for equities and
other real capital goods in respect of riskiness.
According to this,
62
open market operations may not be powerful stabilization weapon since
relatively
large changes
in
interest
any given change in equity yields.
rates
are required
to
produce
However, according to Friedman
and Meiselman, there is a high degree of substitubility among various
financial
and
real
assets and
hence change in money
supply
would
have stronger impact than that expected under Tobin's view.
Park
concluded
that
both
monetarists
and
non-monetarists
appear to support some version of the portfolio adjustment process as
a
framework todescribe the
economy.
the
effects of monetary policy on
the real
The disagreement between them on this process centres on
range of
assets
and
interest
rates
that
should
be considered.
The range of assets and interest rates considered by non-monetarists
is rather limited, whereas monetarists stress a broad range of assets
and the expenditures associates with these assets.
Monetarists
up-till now
money is linked with GNP.
have not sufficiently spelled
out how
Their writings, however, seem to point
out the transmission process as follows:
Money supply —> Rates of Return —Aggregate demand
A
different
change
assets
in
the money
which inturn
supply
affect
affects
aggregate
rates .of
GNP
return
demand.
of
When
aggregate demand changes aggregate spending (GNP) changes.
Monetarists
postulate
that
individuals
allocate
wealth
among
various assets such as consumer durable goods, capital goods, stocks
bonds and money In such a way that the marginal dollar invested in
63
each asset yields the same amount of return.
Returns from assets are
received in the form of services (as in the case of consumer durable
goods),
income
(as
in
the
case
of
investment
in stocks,
bonds,
machine and equipment) and convenience (as in the case of money).
When a Central bank increases the money supply, money assets
of the public will rise.
Assuming the public is at equilibrium as to
the distribution of wealth (implying that the marginal rate of return
of each asset is the same), an increase in money assets will reduce
their marginal rate of return and the rate will fall below the rates
of other assets because they, like other assets, are subject to the
law of diminishing return.
If the marginal rate of return of money
assets is lower than those of other assets, this means that the public
is holding more wealth in money assets, than it would like to hold.
Another way of saying this is that a situation of excess supply of
money assets has developed.
The excess supply of money assets will
increase aggregate demand consequently aggregate spending because it
will induce the public to optimise its position by disposing of these
assets.
The public can dispose of excess money assets by purchasing
consumer durable goods, capital goods, bonds and' stocks.
Purchases
of these assets will cause aggregate spending to rise.
Aggregate
spending will rise directly if consumer durable and capital goods are
bought.
If stocks and bonds are purchased aggregate spending will
also rise, though in an indirect way.
3.3.1.
St. Louis Model:
The St. Louis model is the most popular model of monetarists.
64
The
transmission
process
as
viewed
in
this
model
is
outlined
^ U9)
diagram (3.3 J .
Diagram
(3.3)
effect of monetary policy as viewed in the St.
Louis model.
It shows that policy instruments work through the money supply
and
changes
in
the
money
supply
directly
affect
total
spending.
Changes in total spending affect output directly as well as indirectly,
via the price level.
The price level is inversely related to output.
This is due to the assumption that a change in total spending (^Y^.)
in any given period is equal to a change to a change in the price
level (GNP-price deflator- £pt)
3Xt) that is -
plus a change in output (Real QNP-
65
(iO)
AY, =AP, *AXt OI-AX, -AY, - APt
Total
pressure.
spending
affects
the
price
level
through
the
demand
Other things being equal, an increase in total spending
increases the current demand pressure.
The price level is assumed
to be a function of current and past demand pressure and anticipated
price changes.
An increase in current demand pressure, other things
beina equal, increases the price level.
In
this
model,
output,
prices,
anticipated
prices
and
the
money supply determine the market rate of interest but the market
rate of interest does not exercise any direct role in the determination
of spending, output and prices.
3.4
Proximate Instruments and Targets:
(.20
Friedman
explores three possible facts with respect to
proximate instrument and targets.
1.
Using money market conditions, which means interest rates, both
as a target and also as an instrument.
2.
Using
monetary
aggregates
as
a
target, . but
money
market
conditions or interest rates as an instrument for achieving that target.
3.
Using monetary aggregates as a target and control over
the
monetary base, that is the obligations of the monetary authority, as
the instrument.
Monetarists and Keynesians differ on the use of the money stock
as an indicator or target variable.
the Central
market
The non-monetarists believe that
Bank should formulate its policies in terms of money
variables
and
implement
them
through
operations
on
the
instrument variables.
can,
The monetarists believe that the central bank
and should define its objectives,
and implement its policies in
terms of the money stock.
The large body of theoretical literature on the paramount role
of interest rates is not in dispute.
Most monetarists acknowledge the
role of interest rates in transmission mechanism.
in
a
world
structure,
of
perfect
both
the
knowledge
money
about
stock
and
the
According to Keran,
financial
interest
rates
and
economic
would
give
indentical information about monetary influences on the economy.
It is generally asserted that it is changes in real interest rates
which affect economic activity,
rates are actually
measured
but only changes in nominal interest
and
reported.
The difference between
real and nominal interest rates is the result of the change in prices
which
is
expected
financial instrument.
to
occur
between
now
and
the
maturity of the
Measurement of these expected price changes is
both conceptually and empirically a difficult process, subject to many
errors.
If nominal
inflation
in
the
interest
future,
unchanged or falling.
the
Thus,
rates
real
are arising
interest
because of expected
rate
may
actually
be
to evaluate monetary action in a period
of inflation or deflation by looking at nominal interest rates may be
misleading.
money
stock,
values
of
This problem
does not
arise with measurements of the
because in its most generally used form it is nominal
money
which
influence
nominal
values
of
economic
activity.(23)
Governments historically have imposed ceiling on interest rates.
X
NX
(22
67
When such ceiling exist, interest rates cannot be used as a indicator
of
monetary
influence
on
the
economy.
An
allowed to move with changes in market
and
wrong
information.
Usually
indicator
that
is not
forces can give misleading
when an interest
rate is used
to
measure monetary influence, it is selected from among those which are
not under direct government constraints.
Keran*25*
has
shown
institutional contexts,
that
in
(24)
a
wide range of historical and
the money stock is a reliable and predictable
indicator of monetary influence, and that interest rates are not.
the
reason for this difference in results stems largely from the fact that
it apparently take more knowledge about the workings of the economic
system to evaluate the impact of the money stock.
There are atleast
five possible factors responsible for this:
1.
The
markets
reported
which
interest
transmit
rates
monetary
do
not
cover
influences
to
all
the
the
rest
financial
of
the
economy.
2.
The data reported
are of nominal
interest
rates,
while it is
real interest rates which affect economic activity.
3.
It is difficult to distinguish changes in interest rates which are
induced
by
demand
pressures of
the
public
from
those caused
by
Central Bank actions.
4.
Uncertainty
about
the demand
for commodities relative to the
demand for money increases the uncertainty of the relation of interest
rates to economic acitivity.
5.
Government
interest
rate
ceilings
in
some
markets
induce
arbitrage flows which distort the movements of interest rates in other
markets.
68
Selecting the appropriate aggregate as an indicator requires
that several issues be addressed.
The first issue concerns the
controllability of a given monetary aggregate. In other words, given
a change in monetary actions, which aggregate will respond to change
in a predictable manner?
A second issue concerns the predictability
of the movements in the indicator and economic acitivity i.e., how
well the monetary aggregate explains movements in nominal GNP, a
measure of economic activity.
Finally,
there is the important
question of the proposed indicators exogeneity with respect to the
economic variables that policy makers are attempting to influence.
Friedman and Mieselman by regressing nominal GNP on various
measures of money concluded that M3 (currency, demand and time
deposits) was the preferable definition.
Anderson and Jordan (26) have pointed out that the monetary
base is under the direct control of the Federal Reserve System.
It
may be changed by monetary managers in a predictable manner and
such changes have an important influence on output, employment and
prices.
These
considerations lead to the conclusion that monetary
base is an important magnitude for those interested in monetary
management.
r 271
Friedman and Schwartz1
have established the stability of
M2 for the U.S.A. and the U.K. over the period 1867-1975.
Recently
demonstrated
Friedman^®^,
that
it
is
has
simply
not
stated:
"Experience
feasible
for
the
has
monetary
authority to use interest rates as either a target or as an effective
69
instrument.
Were it feasible for the Federal Reserve to adopt and
achieve a target interest rate, it is inconceivable that the prime
rate would ever have risen to over 20 percent.
In principle, given
sufficient knowledge about
market behaviour, it is possible to use
money
to
market
instruments
achieve
monetary
aggregate
targets,
however experience has demonstrated that monetary authorities are in
practice unable to achieve in this way the degree of control over
monetary
aggregates
that
seems
hypothetically
possible.
Hence,
there is now wide agreement that the appropriate short-run facts are
to express a target in terms of monetary aggregates,
and to use
control of the bases or components of the base as an instrument to
achieve the target.
Friedman proclaims that, set a target path for several years
ahead for a single aggregate, for example, M2> or the base, it is
less
important
which
aggregate
is
choosen
than
that
a
single
aggregate be designated as the target.
3.5
Inflation -Unemployment Trade-off;
The phill/ps curve has evolved through several stages since its
empirical investigation of the U.K. wage behaviour by Philips in
f 29)
1958.
Lipsey
extended the Phillips curve. In his version, the
rate of change of wage in a single labour market was positively
related to the excess demand for labour, and the unemployment rate
was negatively related to the excess demand for labour.
If markets
were aggregated and added the assumption that the price level was
marked up over the wage rate by a relatively stable proportion, one
obtained a negative relationship between the rate of inflation and the
70
rate of unemployment.
It
by
coincidence^ this
negatively
sloping
Phillips curve crossed the zero-inflation point (on the vertical axis)
at an unemployment rate (on the horizontal axis) generally regarded
as
'Full'
full
or
'Optimal'
employment
,
no policy problem arose .
and price
stabilitywere not
If however,
compatiable, policy­
makers were forced to choose among a set of second best points along
the Phillips curve.
This was the first stage of trade-off where the
hypothesis was that there is a stable negative relation between the
level of unemployment and the rate of change of prices.
Keyneisan economists view
the Phillips
curve,
atleast in
the
relative short-term, as sloping downward because of wage and price
rigidities
in
assumption
the
economies.
that
the wage
This
bargain is
is
the
heritage
nominal
in
of
Keynes's
character.
Thus
descretionary monetary and fiscal policy can be effectively used to
affect
This
aggregate
justifies
stabilise
the
demand
the
level
and,
usefulness
therefore
of
of economic
the
level
descretionary
activity
of
real
economic
output.
policy
to
in response to exogenous
stocks to the economic system.
Friedman's labour-market analysis differed from Lipseys in its
explicit
assumption that both the demand for and supply of labour
depended on the
the
nominal
wage
real wagerather than on the nominal wage.
was
evaluated
product price by employers and
in
terms
of
the
Since
current actual
in terms of the expected average
consumer price level by workers, employment could increase only as
long as the expected price level lagged behind the actual level.
In
equilibrium the expected and the actual price level were equal, and
71
so in equilibrium only one level of employment and output was
possible.
Friedman called the associated unemployment rate, given
population, techonology and labour-force participation as the natural
rate of unemployment. (31)
3.6
Natural Rate of Unemployment Hypothesis:
This hypothesis developed by Phelps (1967,1970) and Friedman
(1968) distinguished between the short-run and long-run effects of
unanticipated changes in aggregate nominal demand. (32)
There
is
no
stable
trade-off between
inflation
and
unemployment; there is a
'natural rate of unemployment' which is
consistent
forces
with
the
real
and
with
accurate perceptions,
unemployment can be kept below that level only by accelerating
deflation.
The natural rate of unemployment is not a numerical'
constant but depends on 'real' as opposed to monetary factors-the
effectiveness of the labour market,
monopoly,
the extent of competition or
the barriers or encouragements to working in various
occupations and so on.
r 331
'
Two policy implications stem from the natural rate and the
accelerationist propositions.
First, the authorities can either peg
unemployment or stabilise inflation but not both.
If they peg
unemployment, they will ultimately lose control of inflation since the
latter eventually accelerates when employment is held below its
natural level.
Alternatively, if they stabilize the inflation rate,
they will lose control of unemployment since the latter will return to its
72
natural level at any steady rate ot inflation.
original
Phillips
hypothesis,
they
cannot
Thus, contrary to the
peg unemployment at any
constant rate of inflation.
The
next
stage
of
tf.e
Phillips
curve
analysis
statistical testing of the natural rate hypothesis.
involved
These tests led
to criticism of the adaptive-expectations or error-learning model of
inflationary expectations and thus helped to
prepare the way for
the
expectations
introduction
of
the
alternative
rational
idea
to
. . (34)
Phillips curve analysis.
The recent development in the Phillips curve analysis is that
it
is
positively
sloped.
The
phenomenon
of
simultaneous
inflation and high unemployment is termed as ''Stagflation".
high
It is
observed that since the early 1970's the U.S.A. and several other
countries
have
unemployment
observed
suffered
at
the
inflation
same
rime
and
or
unusually
high
"Stagflation".
levels
Futher
it
of
is
that along with stagflation is the decline of productivity
or economic growth.
Recently,
(35)
Friedman and Schwartz1
curve for the economies of the U.S.A.
Phillips
curve
rejected
by
without
their
data.
a
price
have tested the Phillips
and the U.K.
expectations
The output/capacity
significant for Britain, is not siouficant
variable
The simple
is
strongly
variable is clearly
for the U.S.A. and even has
the wrong sign for the U.S.A. if the interwar period is excluded:
"at most, the calculations show only a trace of a simple
Phillips
curve effect". Then Friedman-.Schwartj test a more complex Phillips
73
curve
that
has
lagged
price
term
to
take account
of
expectations, and
a money growth rate term to take account
Fisher's
of
version
Phillips
curve
relation.
This
price
of Irving
more complex
version, while it does not improve the fit, does yield one important
and surprising conclusion.
In so far as there is a Phillips curve at
all its slope is positive.
3.7
* Crowding-Out1 Effect:
Government spending financed by taxes or borrowing from saving
of the general public may reduce other spending to such an extend
that there will be little, if any, net increase in total spending-this
is referred
to as
the
'Crowding-out'
of private expenditures by
fiscal actions.
Fiscal policy provides additional spending in a world of sparce
spending opportunities.
finance
in
finance.
a
world
But it does not provide a new source of
where spending
is
constrained
by
sources of
The government expenditures are financed in debt markets in
competition with private expenditures.
The case least favourable to
fiscal policy is that in which the additional government-borrowing
simply
crowds
out
greater) volume of
f 1
expenditures.
1
of
the
market
borrowing
that
an equal
would
(or conceivably even
have
financed
private
The Keynesian position is that any fiscal action irrespective of
mode
of
financing
will
have
significant
effect
on
GNP.
The
Keynesians do not deny the rise of the rate of interest and admit
that deficit financed
by money creation is more expansionary than
74
increased government spending financed by taxation.
do not admit complete offsetting.
with dual effect.
their
demand
holdings
However, they
Higher interest rates are invested
They discourage private investment and reduce
for
speculative
balances,
thus
releasing
idle
for meeting the transactions demand for money.
cash
To the
extent the velocity of circulation increased there is a fiscal impact
on aggregate demand.
The
current
'
debate
on
economic
stabilisation
policy
actions
focuses on the impact of the method of financing government spending.
It has led to increased analysis of the government budget constraint.
This
constraint
specifies
that
the
total
flow
of
government
expenditures must equal the total flow of financing from all sources.
The total flow of financing includes taxes, net government borrowing
from the public and the net amount of new money issued.
deficits
method
Budgetary
or surpluses alter the size of the public debt,
of
financing
such
and the
deficits or disposing of such surpluses
affects the composition of private wealth.
Hence, any discussion of
the effects of fiscal policy actions should distinguish the different
modes
of
financial
budgetary
deficits
or disposing of
budgetary
sul pluses.
Recently
Arestis
f 391
has
investigated
empirically
whether
government spending financed by either taxation or borrowing from the
public
is mainly a resource transfer from the private sector to the
government
with
little net
effect
on
total
spending.
The study
concentrates on the U.K. economy for which a structural model is
constructed, as constrasted to the St. Louis Model, properly estimated
75
and then simulated.
budget
constraint
This model includes the so-called government
which enables one to clearly distinguish among
different ways of financing deficits.
The 'crowding-out'
question is
then examined through the derivation of 'dynamic multipliers' which
register the impact of government expenditure- financed in a number
of ways on the level of national income.
The major conclusions of
the study are: First, it is very important to spell out clearly how
government expenditures are financed.
bias
in
the
derived
dynamic
Failure to do so introduces a
multipliers.
Second,
government
expenditure crowds out private expenditure only in the case that it
is tax financed, but even then only when taxes are on expenditure
and they are of the autonomous type.
case,
there
assertion.
is
no
'crowind-out',
In the crucial bond-financed
contrary
to
the
Monetarist
(4®)
The above discussion clearly shows that the issue of impact of
fiscal actions on economic activity reduces to the analysis of impact
of the different sources of financing the government spendings.
3.8
Speed or Size of Response to a Monetary Action:
Controversy also exists between Keynesians and Monetarists as to
how quickly and how much GNP responds to a change in the money
supply.
Keynesians claim that the lag between changes in the money
supply and GNP is quite long.
They argue it on the ground that
investment and consumption expenditures which is affected by interest
rates are responsive to long-term rather than short-term interest
rates, e.g. plant and equipment expenditures respond to corporate bond
76
rates and stock prices, housing responds to mortgage rates, consumer
durable goods respond to consumer credit rate, construction of state
and
local government responds to state and local government
rates.
It takes
longer for long-term
bond
interest rates to change in
response to a change in the money supply.
After interest rates are
changed, it takes time before firms order and purchase capital goods,
however alter their house purchases, and local and state government
float bonds for construction projects.
Monetarists,
on
the
other
hand
claim that
the lag
changes in the money supply and GNP is quite short.
between
They argue
their case on the ground that a change in the money supply, in many
cases, has a direct impact, on aggregate spending.
the
An increase in
money supply increases the excess money balances of individuals.
A rise in
excess money balances reduces the rate of return of money
assets relative to other assets are omitted in the reduced form;
Likelyhood of variations in the variables, (unborrowed reserves,
free reserves or interest rate) used for control purposes by monetary
authorities, thus making M, an endogenous variable.
Use
of
policy
variables
included
in
the
reduced
form
for
assumption of
the
economic stabilisation.
According
to
Schwartz
f 41)
,
the
underlying
exercise of Modigliani and Ando is that structural models provide
some kind of standard against which to measure reduced forms.
the very short -comings
in structural models.
Yet
alleged for reduced forms may also inherent
The problems of omitted exogenous
variables
77
Again endogeneity of M, in the structural model mak£S
biased
in
quantity
reduced
of
money
determinants of
form.
According
can
treated
be
to
monetarists,
the estimates
the nominal
as an exogenous variable,
the
which are largely independent of such as endogenous
variable as nominal income.
However, nominal quantity of money may
be an endogenous variable from
a different
point of view.
The
variables treated as exogenous in one sector may be determined in
another sector by variables other than those regarded as endogenous
in first sector.
policy
The
third source of bias attributed to use of fiscal
for stabilisation is. individuals seeking to dispose of their
excess balances may spend a portion of them
on goods and services
which will directly enhance aggregate spending.
With regard to the size of response, monetarists believe that
monetary influences have a strong impact on the GNP. Keynesians, on
the other hand, believe that they have a weak impact on GNP.
3.9
Methodological Approaches of the Respective Schools:
Associated with the issue of the monetarism versus fiscalism is
the
choice
supported
of
appropriate
methodology.
their propositions with
The
reduced
form
monetarists
equations.
have
The
Keynesians, on the other hand, have relied upon the structural model
approach
to
the
estimation
and
testing
of
relationship
regarding
economic impact of policy variables.
(42)
According to Modigliani and Ando1
reduced form gives highly
biased estimates of true structural relations.
key sources of the bias as-
Modigliani gives the
78
the presence of correlation between policy variables included 4n
the reduced form regression and other policy and exogenous variables
which affect money income but purposes assumes success of fiscal
policy.
However,
there does not seem to be any justification for
such an assumption.
Cartson^43* points out that the structural and reduced forms are
not
competing
methodologies.
If
the model
builder is useful in
forcasting and simulating economic experience, then a structural form
may be most appropriate.
On the other hand, if the model builder
is interested in policy recommendations or evaluations, a theoretical
interpretation
of
parameters
is
required,
then,
reduced
form
is
better.
Wilber^44^
commenting
on
the
methodological
issues
monetarists and Keynesian point out the following
problem.
1.
standard
Contrary
to
the
logical
proposition
of
empirical tests seldom will resolve theoretical dispute.
between
economics,
This is true
because there are insurmountable testing problems like the choice of
proper definition of money.
Monetarists cannot* agree even among
themselves on this issue (while Friedman has, of course argued that
the
definitional
problems
issues
plague
the
can
be
settled
empirical
empirically).
speicification
of
The
the
same
Keynesian
theoretical concept of autonomous expenditure.
2.
There
is
problem
of
proper
leads
and
lags
in
econometric
testing.
3.
The third difficulty is the problem of distinguishing cause from
79
effect in the test, e.g. does causation runs from M (money supply) to
Y (nominal income) to B (induced expenditure) as the monetarists say,
or A (Autonomous expenditure) to y to M as Keynesians maintain.
4.
Finally,
the
methods
of
collecting
and
constructing empirical
data are not reliable.
3.10 Conclusion ;
These are some of the major issues on which the debate between
monetarism and fiscalism is going on.
This part of the analysis of
the debate helps immensely for the formulation of the 'reconciliation'
between the two schools of thought.
References;
1.
Laliwala, J.V.
"Monetarism
versus Keynesianism"
(ed), "Monetarism versus Keynesianism
Implications"
2.
-
in R.K.
Sinha
The Debate and Its Policy
Deep and Deep Publications, New Delhi, 1985, P. 37
Modigliani,
F.,
Forsake Stabilisation
"The
Monetarist
Policies?",
Controversy
American Economic
on
Should
Review,
We
March,
1977, P. 1.
3.
Shapiro,
Edward
"Macro Economic Analysis" V Edition,
Publications, New Delhi, 1984, P. 598.
4.
Ibid P. 599.
5.
Ibid P. 600.
6.
Ibid P. 600.
Golgotia
80
7.
Teigen, R.L. “A Critical Look at Monetarist
Reserve Bank of St. Louis Review, Vol. 51,
Economics" Federal
No. 1, Jan. 1972, PP.
10-25.
8.
Gian Kaur, "Monetarism Versus Keynesianism in India", Himalaya
Publishing House, Bombay, 1988, P. 14.
9.
Johar,
Economics,
R.S.
PSE
and
Mathareo,
G.K.
"Some
Issues
in
Monetary
Economic Analyst, Vol. 1 No. 1, June 1980, P. 143.
10.
Teigen (1972), Op. cit P. 18.
11.
Christ, Carl "Fiscal and Monetary Policies and the Government
Budget Restraint" American Economic Review, Vol. 69, No.4, September
1969, P - 526-38.
12.
Brunner, Karl and Meltzer^ A.H. "An Aggregate Theory for a Closed.
£conomy" in "Monetarism"
Stein} J.
(ed)
North Holland Publishers,
Oxford 1976, PP. 151-158.
13.
Leijonhufrud^ A., "Money
Transmission Mechanism".
and
Money
Journal
Income,
An Essay on
of Monetary Economics,
No.
the
4,
1978, P. 151-91.
14.
See in Gian^Kaur (1988) Op. cit P. 17.
15.
Brunner,
Karl,
and
Meltzer^
A.H.,
"Mr.
Hicks
and
the
Monetarists." Econometrica, Vol. 40, Feb., 1973, P. 44-59.
16.
Tobin
James, , "Inflation
and
Unemployment"
American
Economic
Review, Vol. 52, No.l, March 1972, P. 1-18.
17.
Johar and Matharoo^ (1980) Op.cit P. 144.
18.
Park,
Yung
Chul,
"Some Current
Issues on the Transimission
Process of Monetary Policy" IMF Staff Papers, Vol. 19^ No.
1972, PP.31-36
March
81
19.
Anderson, Leonell.C. and Carlson, Keith.M., "A Monetarist Model
for Economic Stabilization,"
Review:
Federal Reserve Bank of St.
Louis, April 1970, PP. 9-10.
20.
Ibid P.G.
21.
Friedman, Milton "Monetary Trends in the United States and the
United Kingdom:
Their Relation to Income Price and Interest Rates"
Chicago Press for the National Bureau, ChicagOj 1982, PP. 100-101.
22.
Keran, Michael.W. "Monetary and Fiscal
Influences on Economic
Activity: The Foreign Experience" Federal Reserve Bank of St. Louis
Review, Vol. 52, No.2, Feb. 1970 P. 14.
23.
Ibid PP. 14-15
24.
Ibid P. 16.
25.
Friedman,
Milton and Meiselman, David
"The Relative Stability
of Monetary Velocity and the Investment Multiplier in the United
States, 1897-1958, Stabilization Policies".
Commission on
Money and
Credit^ Prentice Hall, Englewood cliffs, New Jersy, 1963, PP. 165-268
in Gian, Kaur (1988) Op. cit PP. 20-21.
26.
Anderson,
Leonell.C. and Jordan, Jerry
L. "The Monetary Base
Explanation and Analytical Use". Federal Reserve • Bank of St. Louis
Review, Vol. 50 No. 8, 1975, P. 7-11.
27.
Friedman, Milton and Sctwart^, Anna.J.
United States and the United Kingdom.
"Monetary Trends in the
Their ,, Relation of Income,
Price and Interest Rates," Chicago Press for the National Bureau,
Chicago, 1982, in Gian, Kaur (1988) Op. cit P. 22.
28.
Friedman,
Milton,
"Monetary
Policy:
Theory
and
Practice".
Journal of Money, Credit and Banking, Vol. 14, No. 1 Feb. 1982, P.
98-118.
82
29.
Lipsey
R.G.
"The Relationship Between Unemployment
Rate of Change of Money Wage Rates in the United Kindom_,
A Further Analysis".
and
the
1862-1957,
Economics, vol. 27, Feb 1969 PP. 1-32 in Gian,
Kaur (1988) Op. cit. P. 28.
30.
Ibid P. 29.
31.
Gordon,
Robert
J.,
"Recent
Inflation and Unemployment",
Development
in
the
Theory
Journal of Monetary Economics,
of
No. 2,
1976 P. 191.
32.
Gian Kaur (1988) Op. cit.
33.
Friedman,
Milton. Nobel
Lecture "Inflation and
Unemployment",
Journal of Political Economy, Vol. 85, No. 3, June 1977-PP. 457-59.
34.
Gian, Kaur. (19*88) Op. cit P. 30.
35.
Friedman and Schwartz,(1982) Op. cit P. 445.
36.
Culbertson,
John M.
"Macro Economic Theory and Stabilization
Policy", Macgraw Hill Book Company, New York 1968, P. 463.
37.
Friedman,
Milton
"Money
and
Economic
Development,
"Praeger
Publishers Ltd., New York 1973, P. 29.
38.
Choudhary,(1976) P. 408 See in Gian Kaur (1988) Op. cit P. 24.
39.
Arestis, P. "The Crowding -Out of Private Expenditure by Fiscal
Actions, An Empirical Investigation", Public Finance, Vol. 34, No. 1,
1979, PP. 36-48.
40.
Ibid P. 46-47.
41.
Schwartz,
"Monetarism"
Anna
edited
J.
by
"Comments
Stein,
on
Jerome.
Modigliani
and
North Holland
Ando"
in
Publishing
Company, Oxford, 1976 P. 43-49.
42.
Modigliani, F. and Ando, Albert. "Impact of Fiscal Actions on
Aggregate
Income
and
the
Monetarist
Controversy;
Theory
and
83
Evidence in "Monetarism” Edited by Stein (1976) Op. cit P. 17-42.
43.
Carlson,
Keith
M.
"Monetary
and
Fiscal
Actions
in
Macro
Economic Models" Federal Reserve Bank of St. Louis, Vol. 56, No. 1
Jan. 1975, P. 13.
44.
Wilber,
Selection:
Charles
K.,
"Empirical
Verification
The Keynesian-Monetarist Debate".
Issues, Vol. 13 No. 4 December 1979, P. 973-82.
and
Theory
Journal of Economic