Monetarism Notes Econ 102 Mr. Smitka Winter 2003

Prime Minister Kakuei Tanaka, 1972 田中角栄 列島改造計画 Plan to Rebuild the Japanese Archipelago –Slowdown ca encouraged fiscal policy –Tanaka started in the construction industry, used that to raise campaign funds for faction / political party 1971 ¥/$ appreciation: end of “Bretton Woods” –huge inflow of dollars, bought to lessen forex shift but boosted money supply / lowered interest rates Sum: both stimulative MP and stimulative FP –Double-digit inflation by 1973

Oil Crisis October 6, 1973 Yom Kippur War –OPEC already more active –Boom not just in Japan but also US, Europe I worked overtime, 7 days / week, at UAW wages … Demand made cartel discipline moot –Oil prices quadrupled Japan imported 99 + % of oil Huge boost in inflation Inflation jumped to 25% –Panic buying: shoppers trampled to death buying TP

Bank of Japan reaction April % --> 5% May % July 19736% August 19737% December 19739% April 1975Began lowering

Analytic issues Time lags –Recognition –Implementation –Impact Time consistency –Short-run versus long-run Structural issues –Institutional change renders historical relationships (model parameters) misleading

Monetarist models MP = ? … what should be goals? MV  PY … an identity: true by definition –M is money stock –V is velocity, ability of a given amount of money to support economic activity –P is price level, Y real GDP So PY is nominal GDP Can this framework be used?

MV  PY IF velocity “V” is stable AND the link between nominal and real GDP is predictable THEN can tie changes in money supply to changes in “P” – that is, inflation But in fact –V is noisy and shifts with institutional change –PY is not easy to decompose

Sample arithmetic MV  PY…to use, add growth rates –M plus 5% V ±2% since volatile / large error component –Then PY can range from +7% to +3% Real Y avg +2% but can fall as much as -1% –[increase can be more short-run, coming out of recession] –So P can range from: 7% - (-1%) = 8% 3% - 2% = 1% Monetarist framework offers little insight under “normal” growth rates of US and post-1973 Japan

Sample arithmentic #2 M = +25% V ±2% as before –Then PY can range from 27% to 22% –Even with real Y = +5% inflation is high –But oil crisis ---> Y = -2% [or worse!] So inflation 24% ≈ 29% High “M” growth is indicative of problems

Other aspects FP side effects –Implications of lifetime consumption model MP side effects –Do you really want low investment to persist? –Are big swings in forex rates desirable? International side effects –How to respond to exogenous forex shifts?

Calulation Nominal change x = new value is (1 + x) times old Ditto inflation π ==> new value is (1 + π) old Hence the net change is: 1+x=1 + x - π (+ error term) 1+π Hence real change ≈ x - π This approximation is accurate when x & π are single-digit