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Monetary Theory:
Monetarists vs. Keynes
ECO 285 – Macroeconomics – Dr. D. Foster
The Market for Money
• An idealized market, to better show ∆MS  ∆i
• MS is determined by the Fed
 We know that isn’t strictly true; it’s just for ease of
exposition.
• What is “money demand” and what does it mean?
 Classical/Monetarist – demand comes from the desire
to buy goods & services.

Depends primarily on income and expected inflation.

Bonds and money are not close substitutes.
 Keynesian – demand comes from desire to buy goods
and from a wealth-maximizing strategy.

Depends primarily on interest rates.

Bonds and money are close substitutes.
The Market for Money
i
An alternative way to see
what is happening to
interest rates.
MS3 MS MS2
1
Market rate of interest (i) is
determined by MS and MD.
Let to
theshow
Fed determine
MS.
Note that this is just a different way
the
same effects … When the Fed wants to MS it must
i1
Keynesian MD is more
buy bonds. This raises the price of bonds,
which
“interest
sensitive” than
interest rates. That is still true, but this
graph
is a MD.
is the
Monetarist
MDM story.
shortcut version of that same
MDK
Money
M*
Keynes & the Portfolio Demand for Money
• There is a speculative demand for money:
 We seek to maximize our wealth over time.
 Our wealth is held in the form of bonds or money.
 Holding money allows us to time bond purchases.
 At “high” interest rates, we expect them to fall …
i.e., bond prices will soon be rising.
Wealth-max. strategy - buy bonds now. MD
 At “low” interest rates, we expect them to rise …
i.e., bond prices will soon be falling.
Wealth-max strategy - sell bonds now. MD
Changes in MS will change i and that will change I.
Friedman and the Monetarist View
Money demand depends on many variables:
Income mostly and not interest rates.
Money supply affects spending directly:
MS – Excess MS - AD - PQ in short run
• The Fed buys bonds,
• Banks have more reserves,
• Banks make more loans,
• Spending goes up across economy.
If velocity is stable … see the equation of exchange.
Money and Aggregate Demand
• Equation of exchange:
 An accounting identity:
• Quantity theory of money:
Ms * V = P * Q
Md = k * P * Q
 People hold money for transactions purposes.
 Velocity (V) is constant, or, at least, stable (=1/k).
 Real output (Q) is constant at full employment.
 Therefore, changes in M will only change P.
• Aggregate Demand for output (AD)
- derived from the demand for money, or
- derived from the wealth effect.
Velocity of M1, M2 and MZM, 1960-2013
QTM & The Aggregate Demand Schedule
AD1=MS/(k*P)
AD = MS/(k * P)
AD2=MS/(k*P)
Q2
Q1
The Money Supply and the Long Run Equilibrium
between Aggregate Demand and Aggregate Supply
P
AS1
MS and that increases AD.
MS and that decreases AD.
Shifts in AD can only change
the price level and not real
output (nor employment).
“Inflation is always, and
everywhere, a monetary
phenomenon.”
P1
-Milton Friedman
AD1
Q or R-GDP
Keynesian vs. Monetarist Short Run Aggregate Supply
P
ASLR
The AS is flat in
the Keynesian
view and steep
according to the
Monetarists.
AS - Monetarist
AS - Keynes
So, a decrease in
the AD will have
different
consequences in
the two theories.
P1
AD1
AD2
Q*
Q or R-GDP
Monetarist
vs.
Keynesian
 How fast can the economy recover from recession?
very fast
not very fast
G source of disruption
Mkt. source of disruption
 What are the initial causes of a recession?
MS
Investment
Fed as source
Lack of “animal spirits”
 Should the gov’t aid in the recover from recession?
No, use rule
Yes, use discretion
Favor monetary policy
Favor fiscal policy
 What is the effect of raising G and raising T?
G dubious effects
G is the key to success
T slows economic growth
T is easily offset by G
Persistent inflation & inflationary expectations
P3
The Fed tries to
reduce unemployment
and increase output by
MS. This AD.
With a lag, the AS
will decrease so all
we see is P.
P2
The Fed keeps trying,
but now no lag in AS.
P
AS4
AS5
AS3
AS2
AS1
P4
P1
AD2
AD2
AD1
Q*
Q or R-GDP
If the Fed stops
inflationary
expectations
will continue to
AS, now Q.
Miscellaneous issues on the Business Cycle
 Can we eliminate inflation by AS (short run)?
No, these policies are “doomed to failure.”
Remember, inflation is a monetary phenomenon,
and caused by shifts in the AD.
So, what are these policies?
• Wage & price controls
• Tax-based Incomes policies (TIPs)
• Supply-side incentives to boost output.
• Remove barriers that keep wages/prices from falling.
Miscellaneous issues on the Business Cycle
 To eliminate inflation we must AD.
But, we’ll have to contend with inflationary expectations.
How?
• Gradualism approach
• Going cold turkey
• Indexing
• Wages, mortgage interest rates, taxes …
 And, what of the role of government?
Increasing share of GDP & growth is slower, recoveries
taking longer. Benefits of G may not be worth the costs.
Current Problems & Policy Questions
Prices
• Decreased AD sends
us into recession.
ASLR
ASSR
• Fed expands the MS
to stimulate economic
growth. Doesn’t work.
P3
AD’’’
P1
• Eventually, there’s an
overreaction.
AD
P2
AD’’
AD’
Q’
Q*
Q = Real GDP
• Sharply rising AD
leads to high levels of
inflation.
Monetary Theory:
Monetarists vs. Keynes
ECO 285 – Macroeconomics – Dr. D. Foster