Download Lecture IV Monetarism

Lecture IV Monetarism and Milton Friedman
Attack on Keynesianism
• The first major challenge to Keynesian ideas came
from members of the so-called monetarist school
that believed that the principal source of economic
instability was monetary fluctuations
• In this regard, monetarists not only challenged
Keynesian ideas but the classical model as well,
which believed that money was neutral and that the
economy was fundamentally stable with occasional,
brief deviations from full-employment equilibrium
• In this one respect, Keynesians and monetarists
see eye to eye; beyond that, there is little on which
the two agree
Monetary Economics and James Tobin
• Monetarism is distinct from monetary
economics, which deals more generally with the
effects of changes in the money supply on real
and nominal economic variables
• The “father” of monetary theory is James Tobin
of Yale University
• Despite his belief in the power of money in the
economy, Tobin was and still remains a leading
Keynesian and believes that discretionary fiscal
policy is the most efficient way to deal with
recessions and depressions.
Milton Friedman
• By contrast, Milton Friedman, perhaps the most
influential economist in the second half of the 20th
century, believes that money, and only money, is
the source of all major economic swings
• His most convincing evidence of this proposition
lies in his Monetary History of the United
States,1867-1960, which he co-authored with Anna
Schwartz
• In the Monetary History, Friedman and Schwartz
show how every major economic expansion and
contraction was accompanied by a corresponding
expansion or contraction, respectively, of the U. S.
money supply
The Fed and the Great Depression
• While this is not proof that these monetary changes
caused the swings in the economy, it does provide
evidence that these episodes could not have occurred
without the corresponding monetary swings
• Thus, the monetary authority, had it acted countercyclically rather than pro-cyclically, might have avoided
these episodes
• For a long time many economists have blamed the Fed
for its weak response to the financial crisis in not
providing enough liquidity to the market in 1930
• Some claim that had Benjamin Strong not died in 1928,
the Great Depression might have been avoided; we’ll
never know
• Strong was the former Chairman of the Federal Reserve
Bank of New York and most influential member of the Fed
Friedman and Schwartz on
the Great Depression
The following is from Snowdon and Vane
Even more controversial was the reinterpretation of the Great Depression
as demonstrating the potency of monetary change and monetary policy.
Friedman and Schwartz argued than an initial mild decline in the money
stock from 1929 to 1930 was converted into a sharp decline in a wave of
bank failures which started in late 1930. Bank failures produced an
increase in both the currency-to-deposit ratio, owing to the public’s loss
of faith in the banks’ ability to redeem their deposits, and the reserve-todeposit ratio, owing to the banks’ loss in faith to the public’s willingness to
maintain their deposits with them. … the consequent decline in the
money stock was further intensified by the Federal Reserve System’s
restrictive action of raising the discount rate in October 1931, which in
turn led to further bank failures.
Quantity Theory of Money
• The starting point of monetary economics and
monetarism is the quantity theory of money and
its equation of exchange MV = PY, where M is
the nominal money supply, usually defined as
broadly as possible to include all money that can
be used easily in market transactions
• P is the “aggregate” price level, where P is the
price of whatever Y measures
• Y is final output of goods and services, or GDP
• V is the “velocity” of money; this needs to be
defined so as to be the velocity of money in
carrying out the transactions define by Y
More on money velocity
• Irving Fisher, in order to simplify defining V, used the
equation MV = PT, where transactions include all
transactions, for final and intermediate product
• A natural definition of V, therefore, is V = PY/M
• A tenet of monetarism is the stability of V
• On this point Tobin disagrees with monetarists
• Like Keynes, Tobin believes that V may be very unstable
over the business cycle, increasing during periods of an
over-heated economy and contracting during contractions;
that is, V is very pro-cyclical
• Only through aggressive action can the monetary authority
maintain monetary stability
• Recent economic events have demonstrated just how
unstable money velocity can be
• This fact alone has diminished the influence of the purest
form of monetarism
The monetarist argument against
Keynesianism
• Friedman was always very wary of the
intrusiveness of government into economic
affairs and argued vehemently for economic
freedom and his 1990 Free to Choose: A
Personal Statement speaks of his libertarian
views
• In addition to his concerns about the loss of
economic freedom, Friedman also felt the
discretionary fiscal policy suffered severe
effectiveness constraints due to a variety of lags,
which he call recognition, action, and effect lags
Recognition Lag
• The first is the recognition lag; it often is not until months
into a recession, for example, that policy makers are
even aware of the problem and many more months until
its magnitude can be determined
• For example the National Bureau of Economic
Research, which dates the stages of the business cycle,
requires two quarters (not months), of negative real GDP
growth before declaring a recession; it’s often not until a
year into a recession that one is declared
• Revisions of macroeconomic data can be substantial
and occur for months after the quarter of interest
• The most recent U. S. recession was declared over as of
June 2009; this determination was announced in
September 2010!
Action Lag
• Even after the recession has been declared, the
legislature must act on this information
• Even if the legislators agree that action must be
taken, and that’s a big IF, it may still be months
before legislation is drafted, voted on, and finally
signed into law by the executive
• And even then, the time from the authorization of
funds and their final expenditures will be many
months, even years later
• One of the main complaints about the U.S. stimulus
package is how long it took to spend the money;
there’s still some left over almost two years after
passage of the bill
Effect Lag
• Even after funds have been allocated and spent,
the economy requires time for the complete
effects to be felt
• The Keynesian multiplier effect is not
instantaneous but requires time for the
secondary impacts to occur
• By the time the entire process has run its
course, the economy may be well into its
recovery phase, just in time for the fiscal
stimulus to expand the next “bubble”
Effectiveness of Monetary Policy
• By contrast, monetarists see monetary policy as more
direct and able to avoid the action lag
• Inflation data, for example, are available monthly
• The Fed meets about once a month and can take
immediate action through the Federal Reserve Banks to
lower borrowing rates and to purchase government
securities (open-market operations)
• The effect lag is still a problem, probably about the same
as for fiscal policy; Friedman estimated between 9 and
18 months for money to work its way fully into the
economy
• Because of this last problem, monetarists are consistent
in their arguments against the use of discretionary policy,
both fiscal and monetary
The Monetarist Rule
• Friedman argued that since discretionary government
policies to regulate the economy may have adverse effects
because of timing and intensity, the Fed should follow a
constant monetary growth policy
• He settled on a 3% growth in the money supply arguing that
if real GDP growth is in the neighborhood of 2.5% to 3%,
this will maintain stable prices or very moderate inflation
• The Fed has in fact been operating on monetarist principles,
but has often erred in attaining the desired growth rate of
the money supply
• Fed Chairs have frequently admitted that they under or
overestimated the economic stimulus provided
How to target money growth
• The central bank is unable to actually observe the
money supply at any given time
• What it does know is the size of the monetary base or
“high-powered” money it has created
• How the monetary base actually translates into “money”
depends on both banks and the public
• If banks do not lend the reserves (recall F&S on the
increase in the reserve-to-deposit ratio in 1930) for fear
that loans will not be repaid, or if the public desires to
hold more currency, then the money supply may actually
contract despite the good intentions of the Fed
• Today the existence of deposit insurance mitigates the
public’s fear of bank failure, but low interest rates may
still lead to higher currency holdings
Interest rate targeting
• In the absence of direct knowledge of the actual money
supply, the Fed often uses some interest rate target to
assess market liquidity
• Most often it uses the shortest of these rates, and the one
over which the Fed has most control, the Fed Funds rate,
which is the rate at which member banks can borrow
overnight
• The short rates, however, may or may not be in synch with
longer rates, which are more important in investment
decisions
• Today despite considerable “quantitative easing” of money,
long rates have not risen, a signal that the market does not
foresee inflation in the near or distant future
• In any event, interest rate targeting becomes useless at
the lower bound, where we are right now
Other targeting mechanisms
• A relatively new proposal by Lars Svensson and promoted
by Scott Sumner is to target nominal GDP, or NGDP
targeting
• Let’s suppose the central bank wants a 5% growth in PY;
this can be divided any way between money growth and
real output growth
• MV = PY can be written in growth rate terms as m + v = p
+ y, where lower case means growth rate
• So if p + y = 5%, we can have p = 3%, y = 2%, which is
OK
• And if p = 5% and y = 0%, we’re not happy, but at least
we’re not in deflation
• And if we hit deflation and p = -2%, at least y = 7%, and
that’s great!
Rate or level targeting
• One issue that arises in NGDP targeting is whether to
target the growth rate or level of NGDP
• If you target growth at say 5% per year, if you miss by
1%, say p + y = 4%, then next year you again target 5%
• If on the other hand you want the level to attain a target
for each year, the shortfall of one percent the first year
requires a 6% target rate for year 2
• The idea of central bank credibility is greater with level
than with rate targeting as the actions will be even more
expansionary (larger open market purchases) with level
versus rate targeting
Friedman and the Phillips Curve
• One of the tenets of Keynesian economics is the idea of a
tradeoff between unemployment and inflation; Friedman
disagreed with the argument of a permanent and stable
relationship between inflation and unemployment
• He used the idea of adaptive expectations to argue that
over time economic agents would change their behavior
as they incorporated inflation into their perceptions
• For example, if policy makers believe that the current 6%
unemployment rate is unacceptable, they can raise
inflation from 0% to 2% and individuals initially increase
their work effort as wages rise when firms compete to hire
new workers
• As workers see the real wage has not increased, and
maybe even fallen, they quit their jobs (or new workers
decline to work) and the unemployment rate returns to its
original rate
Graphical Natural Rate Hypothesis
p or w
PC2
2%
B
C
0%
A
4%
6%
U
PC1
Initially the unemployment rate falls from 6% at point A to
4% at point B. Then, as perceptions of the inflation rate
are adapted from 0% to 2%, the unemployment rate returns
to its original 6% and a new short-run Phillips curve is
established through point C. An attempt to lower unemplyment
from 6% to 4% by raising the inflation rate, will again be met by
changes in perceived inflation and return to 6%, but at a
higher inflation rate. In the long run unemployment remains
at its "natural rate" of 6%. Any attempt to reduce the inflation
rate will now result in even higher unemployment until agents
come to view the reduced inflation rate as permanent.
Historical reaffirmation
• The U. S. stagflation of the late 1970’s confirmed the idea that
higher inflation rates could not ward off real OPEC oil price
shocks
• And the Volcker recession of the early 1980’s demonstrated
the pain involved in reducing inflationary expectations
• Today, all major central banks accept the idea of inflation
targeting to try to avoid the pain that will eventually occur from
inflation reduction
• Later versions of the natural rate hypothesis actually deny
even a short-run Phillips curve as economic agents become
increasingly aware of the likely actions of plicy makers
• This results in a vertical Phillips curve with unemployment
stuck at the natural rate barring unanticipated demand shocks
• This story will be part of the next lecture on rational
expectation