Monetary Theory: ECO 285 – Macroeconomics – Dr. D. Foster Monetarists vs. Keynes

Friedman and the Monetarist View We can imagine a “market” for money… --money demand depends on income (mostly) and on interest rates (slightly) --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. Note MS≡MD.

Money and Aggregate Demand Equation of exchangeEquation of exchange:  An accounting identity: Quantity theory of moneyQuantity theory of money:  People hold money for transactions purposes.  Velocity (V) is constant, or, at least, stable.  Real output (Q) is constant at full employment.  Therefore, changes in M will only change P. Aggregate Demand for output (AD) can be derived from the demand for money. M s * V = P * Q

The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply  MS and that increases AD.  MS and that decreases AD. AD 1 P Q or R-GDP AS 1 P1P1 Shifts in AD can only change the price level and not real output (nor employment). “Inflation is always, and everywhere, a monetary phenomenon.” -Milton Friedman

Velocity of M1:

Velocity of M2:

Velocity of MZM:

Monetarist vs. Keynesian Monetarist vs. Keynesian What are the initial causes of a recession? The Fed as source.Lack of “animal spirits.” How fast can the economy recover? Very fast. Not very fast. Gov’t as source of disruption.Market instability. Markets are quite robust. May have long-term unemployment problem. How does monetary policy help? It has a direct effect on consumer spending. Works through effects on investment spending. Very powerful. Likely ineffective. “Pushing on a string.”

Monetarist vs. Keynesian Monetarist vs. Keynesian Should the government aid in the recovery from recession? No. Yes. Use rules.Use discretion. Monetary rules will provide the necessary effect. Fiscal policies, especially gov’t spending are best. What about increase both government spending and taxes, to maintain a balanced budget?

Keynesian vs. Monetarist Short Run Aggregate Supply The AS is flat in the Keynesian view and steep according to the Monetarists. So, a decrease in the AD will have different consequences in the two theories. AS - Keynes AD 1 P Q or R-GDP AS LR P1P1 Q* AS - Monetarist AD 2

i1i1 i MS 1 M* Money MD M MD K MS 2 MS 3 Keynesian vs. Monetarist in the “market” for money An alternative way to see what is happening to interest rates. Market rate of interest (i) is determined by MS and MD. Let the Fed determine MS. Keynesian MD Monetarist MD Keynesian MD is more “interest sensitive” than is the Monetarist MD. It takes a small ∆i to get a large ∆MD. It takes a large ∆i to get small ∆MD.

Miscellaneous issues concerning the Business Cycle  Persistent inflation & inflationary expectations.  Can we eliminate inflation by  AS (short run)?  To eliminate inflation we need to ↓AD.  Keynes and the “paradox of thrift.”  Current problems and policy questions.

Persistent inflation & inflationary expectations The Fed tries to reduce unemployment and increase output by  MS. This  AD. AD 1 P Q or R-GDP P1P1 AS 1 AD 2 Q* P3P3 AS 2 AS 3 AD 2 AS 4 P2P2 AS 5 P4P4 With a lag, the AS will decrease so all we see is  P. The Fed keeps trying, but now no lag in  AS. If the Fed stops inflationary expectations will continue to  AS, now  Q.

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 controlsWage & price controls Tax-based Incomes policies (TIPs)Tax-based Incomes policies (TIPs) Supply-side incentives to boost output.Supply-side incentives to boost output. Remove barriers that keep wages/prices from falling.Remove barriers that keep wages/prices from falling.

To eliminate inflation we must  AD  But, we’ll have to contend with inflationary expectations. How? Gradualism approachGradualism approach Going cold turkeyGoing cold turkey IndexingIndexing Wages, mortgage interest rates, taxes …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.

Keynes & the Paradox of Thrift Savings role in the economy is negative! Why? Because income is determined by spending. So, if we increase our saving (overall) that means we are decreasing our consumption spending. This will decrease income/employment/production. And, there is a multiplier effect. As income falls, so to does savings!!!As income falls, so to does savings!!! Why does this happen? In Keynesian model, saving isn’t automatically channeled into investment.

Current Problems & Policy Questions AD Q = Real GDP P1P1 Prices Q*Q* AS LR AS SR AD ’ Q’Q’ P2P2 Decreased AD sends us into recession.Decreased AD sends us into recession. AD ’’ P3P3 AD ’’’ Fed expands the MS to stimulate economic growth. Doesn’t work.Fed expands the MS to stimulate economic growth. Doesn’t work. Eventually, there’s an overreaction.Eventually, there’s an overreaction. Sharply rising AD leads to high levels of inflation.Sharply rising AD leads to high levels of inflation. Is Obama a Keynesian?

Monetary Theory: ECO 285 – Macroeconomics – Dr. D. Foster Monetarists vs. Keynes