Chapter 21: Learning Objectives What is Monetarism? The Central Role of Expectations: Adaptive vs. Rational Rules vs. Discretion: Time Inconsistency in Policy The Quantity Theory vs. “Real Bills” The Causal Role of Money

Monetarism In the long-run, money is neutral so it has no real economic effects Inflation is a purely monetary phenomenon Business cycles are explained by active monetary policy Money causes inflation and economic activity (in the short-run) not the other way around

The Role of Expectations Adaptive Expectations involve forecasting inflation based on the past history of inflation and past inflation forecast errors: EQUATION 21.1 Rational expectations involves predicting inflation based on available information, usually processed through some formal economic model: EQUATION 21.4 The choice of expectations models influences predictions about the neutrality and potency of monetary policy actions

The Key Equations The Algebra of Adaptive Expectations The Algebra of Rational Expectations

Adaptive Expectations: A Numerical Example Year PtPt Forecast for P t Forecast error

Rules Versus Discretion in Monetary Policy The Phillips Curve suggests a temptation by policy makers to exploit the trade-off between inflation and unemployment

Phillips Curves in the Short Run and the Long Run  3 =  e 3 D e3e3 C u*u* Inflation rate, actual (  ) and expected (  e ) A  1 =  e 1 Long-run Phillips curve Short-run Phillips curves e1e1 B  2 =  e 2 e2e2

Rules Versus Discretion in Monetary Policy As a result, there is thought to be a built-in bias toward more inflation than is desirable. This is called the time inconsistency problem Credibility in monetary policy is central to its success or failure

A New Trade-Off: Taylor’s Rule Variance of Inflation Variance of the output gap B A Strict inflation targeting Flexible inflation targeting Strict output gap targeting

Base Drift Monetary targeting is one way to implement a monetary policy rule and has been used in many countries Revisions of the target, which can be frequent, means that the new target growth rate ins in terms of some new base value, not the original base value when the policy was introduced As a result, the base used to target money growth drifts over time: TABLE 21.2

A Numerical Example of Base Drift YearTargetActualRevised Target Base drift

Theories of Money The Quantity Theory has existed for centuries in one form or another and essentially links changes in the price level to changes in the money supply:MV=Py The link between M and P is clearest if we assume that income and velocity of circulation (Chapter 12) are constant The real bills doctrine is also an old idea recently re- introduced. It suggests that fluctuations in the price level can be determined by looking at the balance sheet of the central bank and how its assets are backed

The Transmission of Monetary Policy The central problem in monetary analysis is understanding how money supply changes are transmitted to the real side of the economy As a result, it is important to consider the transmission mechanism in monetary policy. But which one? Interest rate channel: as in loanable funds theory exchange rate channel: as in interest rate parity asset price channel: as in Tobin’s q credit channel: via banking system portfolio management

Money and Growth Is inflation harmful to economic growth? Inflation leads to costly and wasteful activity but is it significant? The evidence is mixed: FIGURE 21.3

Inflation and Economic Growth

Summary The debate about the role of money centers on how important money supply changes are in explaining economic activity Monetarists place emphasis on fluctuations in the money supply to explain inflation and economic growth There is a temptation for monetary authorities to inflate called the time inconsistency problem The Phillips curve is the principal model used to analyze the role of monetary policy