Chapter 17 Parks Econ124 Monetarism © OnlineTexts.com p. ‹#› Econweb.com

Monetarism Monetarism is an economic school of thought that stresses the primary importance of the money supply in determining nominal GDP and the price level. The "Founding Father" of Monetarism is economist Milton Friedman. © OnlineTexts.com p. ‹#› Econweb.com

Characteristics of Monetarism The theoretical foundation is the Quantity Theory of Money. The economy and financial markets are inherently stable. The Fed should be bound to fixed rules in conducting monetary policy. Fiscal Policy is often bad policy. A small role for government is good. © OnlineTexts.com p. ‹#› Econweb.com

The Equation of Exchange The equation of exchange (a tautology) is the building block for monetarist theory. M x V = P x Y M = money supply P = price level V = velocity Y = real GDP © OnlineTexts.com p. ‹#› Econweb.com

The Quantity Theory of Money: The Short Run Monetarists make a seemingly innocuous assumption that velocity is stable in the short run, or M x V = P x Y where V implies that velocity is fixed in the short run. Any change in M1 will impact P × Y (nominal GDP). Changes in the money supply are the dominant forces that change nominal GDP. © OnlineTexts.com p. ‹#› Econweb.com

The Quantity Theory of Money: The Long Run Monetarists believe that the economy is always near or quickly approaching full employment because markets work well. In the long run, output will be equal to potential output, YP. © OnlineTexts.com p. ‹#› Econweb.com

The Quantity Theory of Money: The Long Run In the long run, the quantity theory of money becomes: 'M' and 'P' are the only variables in this equation that change in the long run. In the long run, changes in the money supply only cause inflation. © OnlineTexts.com p. ‹#› Econweb.com

The Rules vs. Discretion Debate Monetarists argue that control of the money supply (and, hence, inflation) should not be left to the discretion of central bankers. They propose a money-growth rule: The Fed should be required to target the growth rate of money such that it equals the growth rate of real GDP, leaving the price level unchanged. © OnlineTexts.com p. ‹#› Econweb.com

The Rules vs. Discretion Debate Keynesians advocate giving central bankers discretion. They attribute little significance to the Quantity Theory of Money because they believe that velocity is unstable. Keynesians also argue that the economy is subject to periodic instability, so it is dangerous to take discretionary power away from the central bank. © OnlineTexts.com p. ‹#› Econweb.com

Fiscal Policy Because Monetarists dislike big government and tend to trust free markets, they do not like government intervention and believe that fiscal policy is not helpful. Where fiscal policy could be beneficial, monetary policy can do the job better BUT will probably not (Friedman). Automatic stabilizers are sufficient sources of fiscal policy. © OnlineTexts.com p. ‹#› Econweb.com

Empirical Evidence of Monetarism The suppositions of monetarism depend crucially on the stability of velocity the efficiency of markets © OnlineTexts.com p. ‹#› Econweb.com

Empirical Evidence of Monetarism Recent evidence suggests that velocity has been unstable and unpredictable since the 1980s. © OnlineTexts.com p. ‹#› Econweb.com

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Money and Nominal GDP The lack of correlation between M1 and nominal GDP also depicts the instability of velocity. © OnlineTexts.com p. ‹#› Econweb.com

Why did velocity become unstable? Most economists think the breakdown was primarily the result of changes in banking rules and other financial innovations. In the 1980s, interest-earning checking accounts altered the demand for money and further blurred the line between transaction and savings accounts. Also, money markets, mutual funds and other financial assets became substitutes for traditional bank deposits. © OnlineTexts.com p. ‹#› Econweb.com

Keynesians vs. Monetarists Keynesians and Monetarists fought head-to-head in the 1970s. Most economists conclude that Keynesians won the war, but Monetarists won many battles. © OnlineTexts.com p. ‹#› Econweb.com

Keynesians vs. Monetarists: Key Differences TABLE 1 Monetarists Keynesians Tie monetary policy to rules Give policymakers discretion. Fiscal policy is not useful. Fiscal policy may be useful. AS curve has a steep slope. Economy can be unstable. Economy is inherently stable. AS curve can be flat. © OnlineTexts.com p. ‹#› Econweb.com

Taylor rule Stanford economist John Taylor created Taylor’s rule as a tool to manage monetary policy research has shown that Taylor’s rule provides an accurate prediction of the proper course of monetary policy © OnlineTexts.com p. ‹#› Econweb.com

πt* is the desired rate of inflation, where it is the short-term nominal interest rate, πt is the inflation rate measured by the GDP deflator, πt* is the desired rate of inflation, rt* is the assumed equilibrium real interest rate, yt is the logarithm of real GDP, and is the logarithm of potential output aπ and ay should be positive = .5 © OnlineTexts.com p. ‹#› Econweb.com

Taylor rules offer a simple and transparent framework with which to organize the discussion of systematic monetary policy. Their adoption as a tool for policy discussions has facilitated a welcome convergence between monetary policy practice and monetary policy research and proved an important advance for both positive and normative analysis. © OnlineTexts.com p. ‹#› Econweb.com

In short, the rule proposes a high interest rate when “inflation is above its target rate and when the economy is above its full employment level.” Similarly, the rule proposes a low interest rate when inflation is below its target and the economy is below its full employment level (current situation). The dilemma takes place when inflation is above its target and the economy is below full employment or inflation is below its target but the economy is above full employment. © OnlineTexts.com p. ‹#› Econweb.com

Alas, the Taylor rule depends on picking the target inflation rate, the equilibrium real rate of interest, and estimating the full employment GDP. It also requires picking the coefficients. © OnlineTexts.com p. ‹#› Econweb.com