ECONOMIA E POLITICA MONETARIA (Prof. Elisabetta De Antoni) Aa 2011-2012

INTRODUCTORY LECTUREPREMISE....................................................................................................................................................................................1

I) ENGLISH VERSION........................................................................................................ 3 B. SNOWDON, H. VANE, P. WYNARCZYK:.....................................................................3 A MODERN GUIDE TO MACROECONOMICS:.................................................................3 AN INTRODUCTION TO COMPETING SCHOOLS OF THOUGHT...................................3 EDWARD ELGAR, 1994....................................................................................................3 II) ITALIAN VERSION........................................................................................................3 ETAS, 1998 ....................................................................................................................... 31. THE OLD' CLASSICAL (PRE-KEYNESIAN) MODEL...............................................................................................4 The Existence of Full Employment Equilibrium.................................................................................................................35 2. The Keynesian revolution...................................................................................................................................................42 3. The demand for money.......................................................................................................................................................70 Krugmans description of the crisis.......................................................................................................................................88 Neoclassical Synthesis (1937-1965)........................................................................................................................................97 Monetarism.............................................................................................................................................................................138 the balance of payments........................................................................................................................................................161 new classical (macro) economics..........................................................................................................................................181

PREMISEIN THE LAST THREE DECADES: the financial system has grown faster than the real economy (transactions, incomes distributed.) The leader industrialized country (US) has accumulated unprecedented levels of indebtedness (households, government, whole country).

Thanks to liberalisation, financial techniques and innovations have become more and more unscrupulous and opaque. THE RESULT was an overall increase in financial fragility: the symptoms of a "disaster foretold" were before everybody's eyes. This instability clashed with the dogmas of the mainstream: The free market is stable. Financial markets are efficient. There was NO REASON TO WORRY!!!!!!! We had even entered a new era - the Great Moderationin which the trade cycle and inflation had been definitely bridled. THE CRISIS The world economy has been recently swept by one of the biggest financial crises within the memory of man with devastating effects on the real economy. This obliges us to rethink on the evolution of macroeconomic theory its future perspectives. THE COURSE The course will analyze the role of money and finance in the economy according to the main macroeconomic schools of thought. MAIN QUESTIONS: Why money (a simple piece of paper) is that important? Why finance (a simple way of transferring funds from savers to investors) is that important? Are money and finance a source of stability/instability? The recent financial turmoil confirms the importance of these questions. From the concrete point of view, the course will focus on both the sides of the money market, analyzing the theories of the demand for money and more generally of portfolio allocation the theories of the supply of money (the role of the central bank, of the financial system, of monetary policy). REQUIREMENTS English courses are usually choosen by foreign students.

In the past, many Erasmus students coming from other Faculties (Law, Political Sciences, Engineering.). To be accessible to everybody, the course requires: basic macroeconomics basic mathematics. TEXTBOOK (CHAPTERS 1-7) The textbook is available (also in the University Library) both in English and in Italian. I) ENGLISH VERSION B. SNOWDON, H. VANE, P. WYNARCZYK: A Modern Guide to Macroeconomics: An Introduction to Competing Schools of Thought Edward Elgar, 1994. II) ITALIAN VERSION B. SNOWDON, H. VANE, P. WYNARCZYK: Guida alla macroeconomia. Scuole di pensiero a confronto Etas, 1998 FURTHER MATERIAL Lectures notes/further references will be made available/specified on Comunit on line at the end of each week. EXAMS The course implies written exams. Questions will be in English. Answers can be either in English or in Italian. The student will be able to choose between two kinds of examination. THE SIMPLIFIED EXAMINATION will be mainly based on the textbook will carry a mark of up to a maximum of 25/30. THE EXTENDED EXAMINATION will be based on the textbook plus lecture notes will carry a mark of up to a maximum of 30/30 cum laude. NB Through ESSE3 (if not possible, by e-mail or during the lectures) students have to inform the teacher at least a week in advance if they intend to sit for the exam and for which kind of exam : the number of questionnaires that have to be prepared for the exam depends on the number of students involved. QUESTIONNAIRES will contain about ten questions concerning the different parts of the course/chapters of the book. questions will be of the following kind: What happens to the variable X if money supply increases according to this author/school of thought? Why? Explain and comment. .(5/10 rows for the answer)

What are the effects of a given fiscal/monetary measure according to this and that author/school of thought? Compare the two cases and comment. .(5/10 rows for the answer)LECTURES

Monday 5-7 pm/Room 1A; Wednesday 3-4 pm/Room 2B

1. THE OLD' CLASSICAL (PRE-KEYNESIAN) MODELEnglish not revised Keynes regarded as classical the economists who preceded him, i.e.: -the Classics (Smith, Ricardo)-the Neoclassics (Marshall, Pigou). From a macroeconomic point of view, these pre-Keynesian economists generally placed complete faith in the market mechanism.

As we shall see, this faith has always dominated the field, up to nowadays. The recent financial turmoil, however, casts doubts on the effectiveness of market mechanisms. (Hopefully, textbook will be rewritten!!!) Main Presuppositions of the OC Model 1. Agents are rational; they: -have perfect knowledge; -are able to find their possibility frontier (the set of available options); -choose the optimal option, the one which maximizes their target 2. Markets are perfectly competitive; -there are many small agents with no market power -i. e. unable to affect market prices and quantities; -for competitive agents individually considered, prices are given.3.Prices are perfectly flexible; they instantaneously clear all the markets.

Main Markets 1.Labor market 2.Goods market 3.Money market Every market implies 1. A demand curve D 2. A supply curve S 3. An adjustment mechanism towards equilibrium E

P

D E

S

Q

OCs LABOUR MARKET We shall start with the OC demand for labour. THE OCS DEMAND CURVE FOR LABOUR This curve derives from the production function. The production function gives the maximum amount of output (Y) that can be produced out of any given amount of factor inputs (K,L). Y=A Y(K,L) where: Y is the output level. A is the total factor productivity: --it mirrors technology and input organization --by assumption, in the short run is given and equal to 1. K is the capital stock. --by assumption, in the short run is given. L is the employment level. As we have jus seen, in the short-run A e K are given (underlined) by assumption. The short-run production function thus becomes a relationship between output Y and employment L: if firms want to increase Y, they have to increase L. Thus, the short-run production function can then be represented as follows:

Y

Y=Y(K,L)

Y1 Y0

L0

L1

L

The first derivative of the production function tells us by how much output Y rises if there is a unitary increase in L.

Y/LIt thus measures the productivity of the additional/marginal worker. It is consequently named marginal product of labour. Y/L=MPL Analogous considerations obviously hold for the marginal product of capital. Y/K=MPK Let us now analyze the properties of MPL and MPK. The basic assumptions underlying the production function are the following: -its first derivatives are positive Y/L=MPL>0 Y/K=MPK>0 -its second derivatives are negative MPL/L0 -on the right of Ld0 are not profitable: MPLMPK and thus 0 I=I(r) with I/rG-T+I This excess of savings implies an excess demand for bonds EDB. S-[G-T+I]=EDB The bond price pb will increase and consequently the interest rate r will fall.pb r By aligning the demand and the supply of financial flows, the interest rate clears: -the goods market, -financial markets The aforementioned coincidence between goods and financial markets equilibrium focuses exclusively on financial flows. The underlying assumption is that financial stocks are in equilibrium: people are perfectly happy about the stock of money and bonds inherited from the past. Stocks equilibrium does not interfere with flow equilibrium. This assumption, as we shall see, is all but granted. A DIGRESSION ABOUT FISCAL POLICY

What happens if the government increases government expenditure G (and government deficit G-T)?The increase in G-T implies higher issues of government bonds.

The rise in the supply of new bonds G-T + I(r) causes fall in the bond price and an increase in the rate of interest. From equilibrium point 0 we move to equilibrium point 1 below.

G-T + I(r)=Bs

S(r)= Bd

r1

1 0

r0

S0=G0-T0+I0

S1=G1-T0+I1

The following figure shows the fiscal expansion (the same story) in terms of Ys=Yd. The increase in G raises aggregate demand, moving the Yd curve to the right. The issue of new government bonds raises the interest rate. This reduces private demand (C&I) along the new Yd curve.In the end Yd goes back to its initial full employment level Ys=Yfe,

the only one compatible with the aggregate supply Yfe and thus with goods market equilibrium.Ys r Yd1=C(r)+I(r)+G1 1 Y 0=C(r)+I(r)+G0 0d

Yd= C(r) + I(r) G=Yd

Yfe

Y

Let us compare the old (0) and the new (1) equilibrium. Equilibrium Ys comes from the labour market: it remains at its full employment level Yfe. Equilibrium Yd=C+I+G has thus to remain too at its full employment level Yfe. The new government expenditure G has to crowd out an equal amount of (C+I).

It does this trough the rise in the interest rate provoked by the issue of new government bonds.

Yfe = C(r)+I(r)+GIf output is at its full employment (its maximum) level government expenditure inevitably crowds out an equivalent amount of private expenditure. Crowding out is:

-real (the constraint is full employment output) -total or complete (each euro of public expenditure crowds out a euro of private expenditure)MONEY MARKET

The fulcrum of the OCs money market is the famous Quantity Theory of Money. There are two versions of it. i) Fisher's version F ISHER ' SIDENTITY OF EXCHANGES

In the real world, goods are exchanged against money.

---Money is a medium of exchange. ---Money is an input in transactions. However, we can say more on this issue! Individual goods are exchanged against an equivalent amount of money. The value of individual goods is equal to the amount of money paid for them.

cigarettes

1

P=4

Let us write this equivalence at the aggregate level. The value of the goods exchanged in the economic system is approximately equal to nominal income PY. The value of the money exchanged does NOT coincide with the existing quantity of money M. In any given period, every coin/banknote flows from hand to hand. In the example below, -I buy 4 euros of cigarettes -the tobacconist buys 4 euros of bread.

4

4

I

Tobacconist

Baker

If money does 2 rounds (finances 2 transactions) in a period, 4 euros of money finance 8 euros of transactions. M times 2 = value of transactions PY Generalizing, let us assume that money does V (rather then two) roundsM times V=value of transactions PY We thus come to the Fisher's identity of exchange: MV=PY

V is the of circulation of money, equal to the value of transactions per unit of money (in our previous example=2) V=PY/M THE QUANTITY THEORY OF MONEY

If we introduce the following assumptions: i) M is exogenously determined by the central Bank ii) V is a given institutional constant iii) Y is given at its full employment levelwe get the quantity theory of money When V and Y are given, an exogenous increase in M turns into an increase in P. MV=PY Let us divide both the terms by P, transforming the previous equation in real terms: M = (1) Y

P

V

The right hand side Y/V is given by the real sector. In equilibrium, also the left hand side has thus to be equal to Y/V. If this is true, increases in M cause equi-proportional increases in P, leaving the real quantity of money M/P unchanged at Y/V. If M doubles, the price level P too doubles. More generally: %M=%P Remember that labour market equilibrium gives W/Pfe. If money supply and the price level P doubles, the money wage W also doubles, leaving the real wage at its equilibrium level W/Pfe. %P=%W THE NEUTRALITY OF MONEY The important implications of the quantity theory of money are the following: i) any given percentage variation in money supply M implies an equi-proportional variation in nominal variables (P and W). %M=%P=%W ii) the real variables (W/P, Lfe, Yfe, C, I, r, M/P..) are all invariant to the quantity of money M. Money supply M does not affect them. iii) This means that money is -neutral, it only affects the nominal scale of the economy leaving real variables unchanged -a veil, that covers the real variables without affecting them. iv) Inflation is a monetary phenomenon. If prices rise too much, this means that money supply rises too much. The responsibility for inflation pertains to the central bank! v) The central bank controls M but not M/P, which in equilibrium is equal to Y/V!

ii) The Cambridge version (Marshall and Pigou)Money is not an input in transactions Money is a particular good necessary to finance the purchases of all the other goods. As every other good, money will then have its own market, with

-a demand curve -a supply curve -an equilibrium condition

THE DEMAND CURVE FOR MONEY Let us start from Fisher's equation of exchange: MV=PYBy isolating M we get M=1 PY V If we put l/V=k the result is M=k PY This equation can be interpreted as a demand for money function:

Md=k PY Money is necessary to finance transactions. The transactions demand for money Md is then a multiple k of the value of transactions which take place in the economic system PY.THE SUPPLY OF MONEY The assumption is that the supply of money is exogenously given Ms=M

MONEY MARKET EQUILIBRIUMThe equilibrium condition of the money market is: M=k PY

If we adopt the following usual assumptions: i) M is exogenously determined by the central Banck ii) K=1/V is a given institutional constant iii) Y is given at its full employment levelonly P can clear the money market. MV=PY This leads to the Quantity Theory of Money. An increase in money supply M turns into an equi-proportional increase in nominal expenditure PY. Since real output Y is given, the result is an equi-proportional increase in P. M =k PY The same story can be told below in real terms The real demand for money (k Y) is given by the real sector. Equilibrium real supply M/P has also to be equal to k Y. Variations in the nominal quantity of money M only determine equi-proportional variations in the price level P. M =k Y P

Money is again -neutral, it only affects the nominal scale of the economy leaving real variables unchanged -a veil, that covers the real variables without affecting them. The Fisher's and the Cambridge versions of the quantity theory are perfectly equivalent. The difference is that money -in the first case is only an input in transactions; -in the second case is a good, with its own market.

Graphical representation of the money marketThe equilibrium condition of the money market in real terms is: M/P=k Y where: --the left hand side is the supply of real money balances M/P. --the right hand side is the demand for real money balances kY which grows with real transactions and thus with real income Y. The money market equilibrium condition is shown by a straight line in the Y,M/P space.M/P M/P=kY

Y

As real income Y grows, the transactions real demand for money M/Pd=kY also grows. In equilibrium the real money supply M/Ps=M/P has to grow by the same amount. Y M/Pd=kY M/P As known, P is the variable that clears the money market. The increase in M/P is thus due to the fall in the price level P. If we want to buy more goods Y with a given money supply M, the price level P has to fall. Y M/Pd=kY M/PP Let us now connect the money market with the rest of the economic system.

According to the Old Classics, real income Y --comes from the labour market --is given at its full employment level Yfe The demand for real money balances is then kYfe. Given M, the price level will have to be such that (M/P)e = kYfe

M/P

M/P=kY

M/Pe

Yfe

Y

MONETARY POLICY What happens if the central bank increases the nominal supply of money M? Given the full employment level of income Yfe, from initial equilibrium point 0 we move to disequilibrium point 1. At the full employment level of income, money supply now exceeds the demand. M > kYfe P

M/P M M/Pe

1 M/P=kY

0

Yfe

Y

The excess supply of money ESM=M/P-kYfe will be used to purchase goods. Since the supply of goods Yfe is given at its full employment level, the higher demand for goods will only raise prices. The increase in P will decrease M/P, reabsorbing the excess supply of money. From point 1 we shall go back to point 0.

M/P M

1 P M/P=kY

M/Pe

0

Yfe

Y

The equilibrium value of M/P -is equal to kYfe -is given by the real sector. Variations in the money supply M only determine equi-proportional variations in the nominal variables (P and W, given W/Pfe) %M=%P=%W According to the quantity theory of money: -money is neutral, -money is a veil. Inflation is a monetary phenomenon. The increase in the price level P reflects the increase in money supply M. The responsible for inflation is the central bank. The Central Bank controls M but not M/P It is unable to affect the real sector. It can only affect the price level.OLD CLASSICAL MODEL: AN OVERALL SUMMARY

The following figure starts from the bottom and summarizes what we have said up to now. Make sure that you know what variable clears each market and why. Notice that the figure below only concerns real variables; by assumption they are independent of nominal variables M,P,W(this independence is defined OC dichotomy). The nominal scale of the economy (M,P,W) only depends on the level of money supply M. Fiscal and monetary policies are ineffective: remember why. M/P=kYM/Pfe

Yd(r) rfe

Ysfe

Labour market Ld(W/P) =Ls(W/P) gives W/Pfe & Lfe Clearing variable W. Production function Ys=Ys(K,L) gives Yfe Clearing variable Ys. Goods market Ysfe=Yd(r) gives r Clearing variable r. Money market M/P=KY gives P&W Clearing variable P.

Yfe

Yfe

Money mkt YYfe

Goods mkt Yfe

45

45

Yfe

Lfe

Yfe

product. fct Ld W/Pfe Ls

Lfe

labour Mkt

OLD CLASSICS AND UNEMPLOYMENT

According to historical evidence, labour market equilibrium is an exception. The real world is generally characterized by

the excess supply of labour (involuntary unemployment). Some people would like to work at the existing real wage. They, however, do not succeed in finding a job. In order to explain the existence of involuntary unemployment, Old Classics had to introduce imperfections. Specifically, they introduced money wage rigidities. Let us then assume that the nominal wage W -rather than being endogenously determined by labour demand and supply -is exogenously given (at a higher than equilibrium level) by the government/trade unions.Ld curve =MPL curve Ls curve

The real wage rises from W/Pfe to W/P0. Only workers with MPL> W/P0.are profitable for firms. Firms demand for labour falls to L0.Employment falls to L0.

W/P0 W/Pfe

0E

The system moves from point E to point 0.Ld0=L0Lfe Ls0L*

Involuntarily unemployment (the excess supply of labour) now is Ls0-L0>0

Firms have no convenience to hire those who are involuntary unemployed. The real wage is too high: in their case W/P0>MPL THE OLD CLASSICAL MODEL WITH GIVEN WAGES If employment L falls in the labour market below, according to the production function aggregate supply Ys too falls. This leads to an increase in the interest rate in the goods market (Yd has to fall) and to the increase in the price level in the money market (kY and M/P fall).Yd(r) M/P=kYM/Pfe=kYfe

Ys00

Ysfe

r0 0 rfe

Labour market W W/P Ld L Production function L Ys

M/P0=kY0

Y0

Yfe

Y0

Yfe

Money market

Goods market

Goods market Ys r Yd Money market Y kY =M/P P

Yfe Y045

Yfe Y0

Yfe Y045

Y0

Yfe

L0

Lfe

production function Ld WP0 W/Pfe

Y0

Yfe

0

Ls

To sum up, we have stagflation, i.e. stagnation (L, Y, C I) plus inflation (P) involuntary unemployment L0Lfe

labour market L 0=L0 Lfed

REMEDIES AGAINST INVOLUNTARY UNEMPLOYMENT

FISCAL POLICY Let us assume a fiscal expansion (00): G=G-T=Bs In financial markets: pb & r In the goods markets, aggregate demand falls: r C(r) &I(r) Yd(r) Equilibrium income Y returns to its initial level Y0: output levels beyond Y0 are not profitable. At the end, government expenditure only crowds out private expenditure. Y0=C(r)+I(r)+G There are no benefits in terms of employment and income! Activity levels beyond L0&Y0 are not profitable according to the labour market.

Yd1(r)r1 1 Yd0(r)

Ys C&I 0 0 G

r0

Ys=Y0

MONETARY POLICY Let us assume a monetary expansion (00): M & M/P Disequilibrium point 0 implies: ESM=EDG Output Y is given from the labour market: the EDG turns into a higher price level: P The real money supply falls to the initial level M/P Money is neutral. The central bank can affect M but not M/P. Again, no benefits in terms of employment and output! Activity levels beyond L0&Y0 are not profitable according to the labour market.

M/P1

0

M/P= k Y

M/P0=kY0

0

Y0

Ld

W/P0 W/Pfe

0

WAGE FLEXIBILITY Involuntary unemployment Ls0-L0 implies L ESL The money wage W becomes flexible. The real wage falls from W/P0 to W/Pfe, W/P Firms demand for labour increases. Employment and output rise. Ld L&Y We reach the full employment equilibrium.s

Ld0=L0

Lfe

Ls0

L*

Involuntary unemployment is due to an excessive cost of labour. Firms do not hire (and do not produce) more workers since labour is too expensive. Wage flexibility is the only weapon against involuntary unemployment!

THE PRE-KEYNESIAN CONCEPTION OF THE ECONOMY

The pillars of the pre-Keynesian approach are the following: Perfect rationality: Perfect competition: Perfect price flexibility: Markets are simultaneously in equilibrium. Everybody buys (sells) the optimal quantity. There is no individual incentive to change. In this idealistic Olympus the real sector spontaneously goes to its general (full employment) equilibrium. there is no need for economic policy.

economic policies may even be dangerous, better not to intervene government expenditure only crowds out private expenditure money supply only affects the price level Rigidities/imperfections The real world is not that perfect. If the system does not reach its general (fe) equilibrium, it is precisely because of these imperfections (wage rigidity). The main task of economic policy authorities is to remove them.Theoretical developments Modern versions of general equilibrium theory are much more complex: inter-temporal, dynamic, stochastic The underlying vision, however, remains the one presented above. Concrete developments This is precisely the vision that inspired the European Monetary Union: the European Central Bank is responsible for inflation (link money/prices) National Government Budgets have to be balanced (no crowding out) The labour market flexibility and the increase in the skill/productivity of labour are the only remedies against unemployment.

MACROECONOMIC EQUILIBRIUM: ITS EXISTENCE, UNIQUENESS, STABILITYITS

Let us reconsider the under-employment equilibrium situation represented by points 0 in the goods market (right upper panel) and in the labour market (lowest panel). The goods market is in equilibrium (Ys0=Yd), the labour market is not. The excess supply of labour can be defined involuntary unemployment.

M/P=kY

Yd(r) r0

Ys00

M/P0=kY0

0

Y0

Yfe

Y0 Goods market

At the ongoing W/P0, some workers would like to work, but cannot find a firm available to hire them.

Money market

Y0

Y0

Y045

Y0

L0 production function

Y0

WP0

Ld 0Efe

Ls

According to the OCs, this situation presupposes constraints on market mechanisms: minimum money wages W imposed by trade unions or governments.

labour market Ld0=L0

Let us then remove the obstacles! Let us liberalise the labour market!M/P=kY M/Pfe=kYfe M/P0=kY0Efe

Yd(r) r0 rfe

Ys00

Ysfe

0

Efe

Y0

Yfe

Y0

Yfe

Money market

Goods market

Yfe Y045

Yfe Y0

Yfe Y045

If money wages W become flexible: -the excess supply of labour will push W downwards -the system will reach its f.e. equilibrium.

Y0

Yfe

L0

Lfe

production function

Y0

Yfe

WP0 W/Pfe

Ld 0Efe

Ls

labour market L =L0d 0

Lfe

Old Classics (the standard) macroeconomic theory assumes that full employment equilibrium: exists is unique is stable. As we shall see, these three assumptions are not necessarily true.

The Existence of Full Employment EquilibriumAccording to the OCs, goods market equilibrium can be specified in the following alternative ways. First formulation: Y=C+I+GAggregate supply Ysfe is equal to aggregate demand Yd.

Second formulation: S=I+G-TThe deficiencies of expenditure (S) are equal to the excesses of expenditure I+G-T.

r

Yd

Ysferfe

G-T + I

S (Yfe)

rfe

Yfe

Y

Sfe=G-T+I

Both the formulations assume that full employment equilibrium exists. Paul Krugman, 2008 Nobel Prize, questions this assumption.2 In his view, we can frequently face the following situation. First formulation: Y=C+I+Gr

Second formulation: S=I+G-Tr

Yd

Ysfe

I+G-T

S(Yfe)

Yfe

Y

S, I+G-T

For positive interest rates r>0, there is no interception between the relevant curves. This means that full employment equilibrium does not exist. Specifically, according to Krugman, at any interest rate r0: the corresponding level of aggregate demand Yd0 will determine output Y0S (i.e when Yd=C+I>Ys=C+S) Y falls when S>I (i.e. when Yd=C+I0 Money yields 0, bonds yield e>0. Wealth is entirely held in bonds: Md=0, Bd=W ii) r=rc e=0 Money yields 0, bonds yield e=0. M and B are totally indifferent. iii) ru*) L=L*; u=u* E L =L ; g =0 W/P* with falling money wages (gwL ; g >0 There is excess demand for labour EDL (Ld>Ls). La Lb L* Money wages W consequently rise. The Ph.C associates the low unempl. rate (ua0 with rising money wages (gw>0). E gw=0 Point E ua ub u* There is labour market equilibrium (Ld=Ls). PhC gwtY0. Let us assume that the financing of the initial government deficit DF 0=G0-tY0=W* considered as a whole has expansionary wealth effects. The consequent increase in income Y and in tax revenues tY will end with reabsorbing the initial government deficit. The system will thus reach the stable medium-run equilibrium point 1, with no government deficit, with no creation of wealth and wealth effects and with a stable equilibrium income level Y1.

G,T G0

T=tY 1 G0

T0=

Y0

Y1

As we have just seen, the stability of the system requires a balanced government budget: DF=G-tY=W*=0 In the medium-run, income Y has to generate a fiscal revenue tY equal to the given government expenditure G. The expression for medium-run equilibrium income thus becomes: Y=G/t The medium-run effect of government expenditure on equilibrium income consequently is Y/G = 1/t>0 The conclusion is that: government expenditure G has an expansionary effect on equilibrium income; this expansionary effect depends on the tax rate t: with a higher t, the income level needed in order to reabsorb the government deficit is lower; this expansionary effect does not depend on the way (M or B) in which it is financed: the effectiveness of fiscal policy does not require the support of monetary authorities.14 Orthodox Keynesians went even further. In the expression for the government deficit, let us introduce interest payments (iB), where i is the nominal interest rate and B is the stock of pre-existing government bonds. DF=G + iB - tY=W* G-tY is the primary deficit iB are interest payments on previously issued government bonds. The medium run equilibrium condition becomes: DF=G + iB - tY=W*=0 The expression for medium-run equilibrium income consequently becomes: Y=(G + iB)/t The medium-run effect on income of government expenditure thus becomes: Y/G= (1+ i B/G)/t>0 The conclusion is the following.14

In order to focus on wealth effects, the exposition deliberately ignores the supply side of the money market. Let us now extend the analysis. Financial wealth generally stimulates the demand both for money and for bonds. In the case of monetary financing, the increase in money supply thus implies an equal increase in financial wealth that only partially turns into an increase in the demand for money. This means that the increase in money supply prevails over the increase in the demand considered in the text. The overall result is a downward shift of the LM curve that strengthens the expansionary effects of government expenditure. Medium run equilibrium income remains the one considered in the text. The novelty is that, in case of monetary financing, stability is granted and does not need ad hoc assumptions.

Government expenditure has again an expansionary effect on equilibrium income. This expansionary effect keeps depending on the tax rate t: in the presence of a higher t, the income level needed to reabsorb the government deficit is lower. This time, however, the way in which the deficit is financed is no more irrelevant. Bond financing (B/G>0) now becomes more expansionary than money financing (B/G=0). In the case of bond financing, the rise in equilibrium income and in tax revenues has to offset not only the initial increase in G but also the increase in interest payments iB. Comments The debate on the wealth effects of government deficit seems to represent an example of bounded rationality in economic theory: a myopic over-evaluation of the present. The conclusions on wealth effects derive from the assumption that the economic system is stable. In the 1950s and 1960s, this assumption was relatively plausible. Industrialized economies performed well; government deficits and debts were contained. According to nowadays experience, however, stability is not that granted. Industrialized countries are currently experiencing the worst crisis after the Great Depression. At the beginning, instability was endogenously generated by the financial sphere of the private sector. Subsequently, however, it has also affected public finances. In order to offset the dramatic consequences of the crisis, many countries have reached unprecedented levels of government deficit and debt. In the case of the weakest countries like Greek, Spain and Italy, the financial systems availability to buy government bonds has decreased. The bond-financing of their government deficits and the refinancing of their government debts are getting more and more expensive. This is the origin of the ongoing spread problem. An analogous example of bounded rationality in economic theory is offered by the recent pre-crisis experience. The nineties were goods years for the US economy. The industrial application of the ICT fuelled a period of sustained not-inflationary growth. The profession (the Chairman of the FED, Ben Bernanke, included) claimed that we had inaugurated a new era - the Great Moderation in which economic fluctuation would have been contained and under control. In a 2000 article, Blanchard (chief economist of the IMF) proudly wondered: What do we know about macroeconomics that Fisher and Wicksell did not? Slogans are often dangerous. Some years later, we face the opposite question: What did Fisher and Wicksell know about macroeconomics that we have forgotten? Bonds are promises to pay concerning interest payments as well as the repayment of the principal. Bonds will be considered as assets (as component of wealth) only insofar as these promises are credible. If the government has to represent a reliable debtor, its deficit and debt have not to be perceived as excessive and uncontrollable. This leads us to the problem of the sustainability of government debt. The sustainability of government debt As we have seen, in a static economy the medium-run stability of the system requires: a constant stock of bonds a zero government deficit. G + rB - tY= B=0

Let us now move to a growing economy. If income Y grows, the stock of bonds B too may grow. The problem is that the ratio B/Y has not to rise. Such a rise might undermine the confidence on government bonds of financial markets. Let us consider the government budget in nominal terms and in discrete time. By assumption, T=G. DFt = (G-T) + i Bt-1= i Bt-1=Bt = Bt - Bt-1 where: G=T are given nominal variables i is the given nominal interest rate Bt-1 is the stock of government debt at the end of the previous period Bt is the stock of government debt at the end of the current period According to the previous expression, government debt self-feeds itself (si autoalimenta). The existing stock of government bonds (Bt-1) generates interest payments (iBt-1) which imply new bond issues, thus increasing the stock of government debt (Bt). Every euro of todays debt implies (1+i) euros of tomorrows debt. The growth rate (g) of government debt (B) is thus equal to the interest rate (i). Government debt self-feeds itself, growing at a rate equal to the interest rate. gb=i15 The growth rate of nominal income gPY is given by the inflation rate gP plus the growth rate of real income gY. gpy=gp +gy The government debt sustainability condition requires that the growth rate of government bonds is not greater than the growth rate of income. Such a condition can be thus formulated in two alternative ways: in nominal terms, the nominal interest rate i has to be lower than, or equal to, the growth rate of nominal income. i < gp +gy in real terms, the real interest rate r=i-gp has to be lower than, or equal to, the growth rate of real income gy. r (= i - gp) < gy This means that government debt sustainability also depends: on the availability of financial markets to buy government bonds (via interest rate) on monetary policy (again, via interest rate) on the growth rate of the economy (via real income) Specifically, the sustainability problem can be accentuated:15

If government deficit is not balanced, government debt grows more rapidly at the beginning but at the end its growth rate tends to be equal to the interest rate. Dividing the expression for the deficit by Bt-1, we get gb = Bt - Bt-1= ( G-T ) + i Bt-1 Bt-1 In the presence of a bond financed government deficit, B automatically grows with the passing of time and consequently the ratio G-T/ Bt-1 tends to zero. The growth rate of government debt consequently tends to g b=i; independently of the given level of the initial deficit.

by a crisis of confidence in government bonds by a restrictive monetary stance by a low growth rate of the economy The afore-mentioned sustainability condition: is often mentioned in the economic policy debate (newspapers, television and so on). is particularly relevant for Italy, given its high government debt/GDP ratio The condition, however, is only a rule of thumb. It is based on crucial simplifying assumptions, for instance: that the interest rate is given, independently of G-T that the real growth rate gy is given, independently of G-T. that the inflation rate gp is given, independently of G-T. To analyze the problem properly, we should develop a model. The results, however, would then depend on the specification of the model itself. The historical experience of the last decades shows that government debt sustainability can represent a problem. Public finance is not as stable as Orthodox Keynesians thought.NEOCLASSICAL OBJECTION TO THE EFFECTIVENESS OF FISCAL POLICY

We shall refer to Barro 1974: Are government bond net wealth? Barros different perspective Orthodox Keynesians considered bonds as financial assets of the private sector. However, government bonds also represent debts of the state! In the future, these debts will have to be repaid by new taxes. The anticipation of these future taxes has depressive effects on consumption As a result, government expenditure may become totally ineffective: it may end with crowding out private consumption. Barros basic assumptions: there is perfect coordination, prices clear all the markets; income is always at its full employment level; there is perfect knowledge, agents know the future. (In such a perfect world, however, any policy seems destined to be ineffective!) The consumer plans her/his consumption for the whole life. Life is composed by two periods: the present (period 0) and the future (period 1). Todays and tomorrows decisions are strictly interconnected. If the consumer saves sacrificing todays consumption (CYd), she/he will inevitably have to consume less tomorrow in order to repay her/his debt. Present and future are connected by the consumer inter-temporal budget constraint, which requires the equality between: the present value of consumption PVC the present value of disposable income PVYd PVC=PVYd

Specifically C0 + C1 = Y0 + Y1 - T0 - T1 (1+r) (1+r) (1+r)1 today Analogously, 1 today (1+r) This means that: 1 today (1+r) is equivalent to (1+r) tomorrow is equivalent to 1 tomorrow is the present (actual) value of 1 tomorrow

By isolating C1 on the right hand side, the inter-temporal budget constraint becomes a sort of consumption frontier. Given the capitalized (the future) value of disposable income [], a higher C0 today implies a lower C1 tomorrow. C1 = [Y0 (1+r)+Y1-T0 (1+r)-T1] - (1+r) C0 The intertemporal budget constraint is shown by the downward sloping line in the figure. The optimal solution is point O, where the budget constraint is tangent to the highest indifference curve. In the figure, the utility function is such that the consumer prefers a stable consumption path. The solution thus is: C0=C1=C

C1

O C1

45

C0M

*= LM0

C0

Point A below shows the given income levels in the two periods (Y0,Y1). Without financial system, our consumer would have had to choose point A, on a lower indifference curve (corresponding to a lower utility level). Specifically, she/he would have been forced to choose: a higher current consumption C0=Y0 in period 0 a lower future consumption C1=Y1 in period 1

0

C1

O C1 S0(1+r) Y1 S0 C0 Y0 C0 A

In the presence of the financial system, by contrast, our consumer can reach the optimal solution (point O) (corresponding to a higher utility level) and stabilize her/his consumption (C0=C1=C) as desired. Specifically, in period 0 she/he can consume only C0=C and save Y0-C0=S0 in period 1 she/he can rise her/his consumption from Y1 to C0=C=Y1+(1+r) S0. What about fiscal policy? As known, the consumers inter-temporal budget constraint is: PVC=PVYd i.e. C0 + C1 = Y0 + Y1 - T0 - T1 (1+r) (1+r) (1+r) Analogously, the governments inter-temporal budget constraint requires that the present value of government expenditure (PVG) is equal to the present value of taxes (PVT). PVG=PVT i.e. G0 + G1 = T0 + T1 (1+r) (1+r) Today, the government may run a bond financed deficit G0-T0=B0. Tomorrow, however, it will have to repay its debt (1+r)B0=(1+r) (G0-T0) by running a corresponding surplus T1-G1. T1-G1=(1+r)B0=(1+r) (G0-T0) By substituting the governments into the consumers budget constraint, we get C0 + C1 = Y0 + Y1 - G0 - G1 (1+r) (1+r) (1+r) First implication; the tax and bond financing of G are perfectly equivalent

-a tax financed government expenditure G0 implies T0=G0 taxes today. -a bond financed government expenditure G0 implies T1=G0(1+r) taxes tomorrow, -the present value of taxation is the same in both the cases (PVT=G0). This leads us to the famous Ricardian equivalence theorem: bonds are not wealth, they are future taxes. Tax financing and bond financing are perfectly equivalent. Second implication: government expenditure crowds out private consumption We have seen that a new government expenditure G0, however financed, raises the present value of taxation by G0. From the consumers point of view, it thus implies an equivalent fall in the present value of her/his disposable income an equivalent fall in the present value of her/his consumption. Government expenditure crowds out an equal amount of private consumption. Third implication: a bond financed government expenditure stimulates current saving In the case of a new government expenditure G0 financed by bonds, the new taxes T1=G0(1+r) will be collected tomorrow, when government bonds will have to be repaid. The consumer has to save more in order to be able to pay these new future taxes. Comments: Barros results obviously depend on his initial assumptions; first of all, the assumption of a full-employment income Y which by itself implies the ineffectiveness of government expenditure. 3rd extension: the long-run IS-LM model According to the OKS, in the long-run money wages and prices become perfectly flexible. The labour market reaches its equilibrium; outputs Y goes to its full employment level Yfe. The long-run aggregate supply curve LRAS is a vertical line at Yfe. Let us analyze the long-run working of the IS-LM model.LRAS IS E

LMe(M/Pfe)

rfe, rfe

Yfe

The long-run equilibrium of the real sector is given by the intersection IS/LRAS Yfe, rfe The LM curve is passive: its position (i.e. M/P) has to adapt itself to the intersection IS/LRAS. M/Pfe=L(Yfe, rfe) This adaptation is based on the price level P, at the given level of M M Pfe (& Wfe)

There is dichotomy. Real equilibrium does not depend on the nominal scale of the economy

rIS

LRAS

The labour mkt gives the LRAS curve and output Yfe.LMe(M/Pe)

The goods mkt (IS curve) gives rfe, the interest rate at which Yd(r)=Ysfe. (a real variable). The money mkt gives M/Pfe. Given Yfe&rfe, M/Pfed and consequently M/Pfes are given. Point E represents a real equilibrium (Yfe, rfe, M/Pfe) independent of the nominal scale of the economy (M, P, W).

E

Yfe

Monetary policy is ineffective: money is neutral. Money supply M does not affect M/P; it only determines the price level P (and money wages W). The figure below shows the case of a monetary expansion. LRAS From 0 to 0: monetary expansion r LM0 IS M M/P r (LM) I&Yd (on the IS curve) Point 0: excess demand for goods Yd0>Yfe 0 Adjustment mechanism: P M/P LM1 Point 0: we go back to the initial position.0 -The LM is passive: its position has to adapt itself to the ISASLR intersection. -Equilibrium real money balances M/Pfe (the LM position) is consequenly given by the real sector. -An increase in M creates an equi-proportional increase in P.

Yfe

Yd0

Fiscal policy too is ineffective Let us assume a bond financed increase in government expenditure.r IS0 IS1 LRAS 1 LM(M0/P1) LM(M0/P0) 0 Point 0: initial equilibrium. Point 0: G Yd (IS): excess demand for goods Yd0>Yfe Adjustment mechanism: P M/P r (LM) Point 1; new equilibrium at Yfe again. Equilibrium income does not change The crowding out of I is -total -real (the constraint is Y=Yfe)

0

Yfe

INFLATIONARY EXPECTATIONS Before we have considered a non inflationary regime, with once and for all changes in M and P. Let us now move to an inflationary regime with: rising money and prices gM=gP>0 an expected inflation rate equal to the effective one gPe=gP >0 Expected inflation introduces the distinction between the nominal (i) and the real (r) interest rate: i=r+gPe According to the IS-LM model, the wealth holder has the choice between money and bonds. Inflation decreases the real value of both of them (M/P&B/P).

The cost of money holdings (i=r+gPe) is given by the real interest rate on bonds (r) plus the expected loss in purchasing power due to inflation. The traditional LM curve will thus be defined in terms of the nominal interest rate i. The new LM* curve in the figure (in r= i- gPe) gives the real interest rate r. The vertical distance between the two curves is obviously equal to expected inflation gPe.i,r LM (in i) LM* (in r=i-gPe) gPe

Y

For investors, what matters is the real interest rate r. Inflation reduces the real value of loans. It thus represents a gain for firms who borrow in order to invest. The real cost of borrowing is thus r= i- gPe For the IS curve, what matters is the LM* curve (in r). The equilibrium real interest rate (rfe) is given by the interception LRAS/IS. The relevant LM curve (the LM*) has to intersect that point (via fluctuations in P). Point R thus represents the equilibrium of the real sector (Yfe, rfe). Point N represents the equilibrium of the monetary sector (ife=rfe+gPe).LRAS ife rfe

LM gPe

(in i= r+ gPe) LM* (in r)

N

R

IS Yfe

The figure below analyzes the full employment effects of inflation. In the initial situation of monetary stability where gP=gPe=0 the nominal interest rate coincides with the real one (i0=r0) the LM0 (in i) curve coincides with the LM0* (in r) the real and the nominal equilibrium of the system coincide with point R0 Let us move to an inflationary regime where gM=gP=gPe>0 real equilibrium remains at R0 the real interest rate remains at r0 the LM0* curve (in r) coincides with the initial one. the LM curve (in i) moves upwards to LM1 the nominal equilibrium of the system moves to N1 the nominal interest rate i raises by an amount equal to expected inflation (i1=r0+ gPe)

LRAS N1

LM1 gPe

(in i)

i1 i0=r0 =

R0=N0

IS0 Yfe

Adjustment mechanism Inflationary expectations initially imply a corresponding fall in the real interest rate (r) at any given nominal interest rate (i). The LM* curve (in r) falls below the unchanged LM curve (in i). This has expansionary effects on investment and aggregate demand (on the unchanged IS curve). Since output is already at full-employment, however, the higher demand will only increase the price level P. The consequent fall in M/P will raise the nominal and the real interest rates. The LM* curve (in r) and the LM curve (in i) will both shift upwards, At the end, the real interest rate (r) will go back to its initial level. The only effect of inflation will be an equivalent increase in the nominal interest rate (i) in the figure.16.LRAS N1 R0=N0 0 IS0 Yfe LM1 LM0= LM*0=LM0=LM*1 LM*0

i1 i0=r0 =

Who cares about the increase in the nominal interest rate? To answer, let un focus on the money market. Inflation decreases the purchasing power of money. Expected inflation gPe consequently raises the cost of holding money (i). The demand for money L thus falls in favour of the demand for goods. The excess demand for goods raises the price level P. The real supply of money M/P consequently falls, aligning itself to the lower demand. Money market equilibrium moves from point 0 to point 1. M = L(i, Yfe) P

16

Looking at the LM1, however, this reflects a rise in the price level P and a fall in M/P. We shall come back to this below.

M/Ps1 i1 r1=r0=i0 1 gPe 0

M/Ps0

Inflation tax

M/Pd

M/P1

M/P0

The conclusion is that inflation implies an inflation tax, with tax rate gPe and tax base M/P1. As a consequence of this tax, real money balances M/P fall from M/P0 to M/P1. Since money is wealth, this is the welfare loss due to inflation. Conclusion In a regime of flexible money wages and prices: Money is neutral Changes in the level of money supply M imply equi-proportional changes in the level of P, leaving M/P and all the other real variables unchanged. The level of M does not really matter. Money is not super-neutral Changes in the growth rate of money supply M imply an inflation tax on money holdings that in turn decreases M/P. Real money balances M/P are real wealth, this is thus a real welfare cost. The growth rate of M really matters. LEIJONHUFVUDS HETERODOX VIEWS ABOUT INFLATION The empirical value of the inflation tax is negligible. Thus, according to neoclassical theory, anticipated inflation has no relevant real costs. Nominal variables grow at the same rate as M, real variables remain (essentially) the same. The real world however, is radically different. In a 1995 book, Leijonhufvud and Heymann analyze the experience of high inflation in Argentina. Inflation implied a great contraction in economic activity (not only a negligible inflation tax). How to explain this?? Leijonhufvuds and Heymanns answer is the following. Under an inflationary regime, uncertainty increases. The result is that: agents and economic policy authorities loose the ability to forecast the future. They have no idea about future costs, future price levels, future profits, future interest rates, and so on. Between the phone call and her/his arrival, the taxi driver has already increased the price. When uncertainty is so high, economic decisions become more difficult to take. medium and long-term contracts disappear. -in financial markets, the segments beyond twelve months disappear; only very short-term assets are exchanged. -in the real sector, investments drastically fall. All of this entails heavy depressive repercussions on the real economy.

Monetarism(English to be revised) The Monetarist School flourished from mid-1950s to mid-1960s. This school represented the neoclassical component of the Synthesis. Its aim was to restate the pre-Keynesian Quantity Theory of Money. Milton Friedman was the leader of the Monetarist School; he got the 1976 Nobel Prize. The following presentation of his contribution will focus on the two issues raised by the Synthesis: the nature of aggregate demand the role of aggregate demand.THE NATURE OF AGGREGATE DEMAND

Basic Questions Is aggregate demand mainly a real or a monetary phenomenon? Do shocks mainly come from the real or from the monetary sector? To be more effective is fiscal or monetary policy? Orthodox Keynesians answered that: aggregate demand is a real phenomenon; the basic equation for Y is the expression below of the Keynesian multiplier; income fluctuations are mainly due to real disturbances: expectations, and thus the investment component of autonomous expenditure A, are highly volatile. fiscal policy is the most efficient weapon for the control of A and consequently of economic activity. Y = [A - d i] Monetarists objected that aggregate demand is a monetary phenomenon; the basic equation for Y is the one at the basis of the Quantity Theory; monetary shocks are the main source of fluctuations in nominal income; monetary policy is the most efficient weapon for the control of economic activity. (M) V = (PY) The crucial role assigned to money explains the label Monetarism In order to present the monetarist view about the nature of aggregate demand, we shall start with: Friedman (1956), The Quantity Theory of Money: a Restatement. This article was published in the same year as the 1st edition of Patinkins book, which completed the Synthesis. As the title claims, its aim was to restate the Quantity Theory of Money. The IS-LM model adopted by Orthodox Keynesians focused on the allocation of financial wealth between money and bonds. Friedman extends the concept of wealth; in his view, wealth W* includes all what yields

future income streams either in monetary or in non monetary terms. The main components of wealth - and the corresponding income streams - are shown in the following table. AssetsMoney M Bonds B Equities E Durable goods G Human capital H

Pecuniary or not pecuniary income streamsTransactions, precautionary and speculative non-pecuniary services, whose amount depends on the purchasing power of the stock of money (ceteris paribus, on P) Nominal interest payments, in percentage equal to the nominal interest rate on bonds rb Dividends d (a share of firms real profits which in percentage ensure a real return re ) plus expected inflation gep (an expected capital gain on real assets) Non pecuniary services (car, washing machine, flat). Their value is expected to rise with expected inflation gep Labor incomes, corresponding to a percentage return h on human capital H.

ReturnsP rb re+gep gep h

On this basis, Friedman deduces that the nominal demand for money Md is: a demand for real money balances M/P, i.e. a positive function of P; a negative function of the rates of return on non-monetary assets; a positive function of nominal wealth W*. Md=f(P, rb, re+gep, gep, h, W*) As we have seen, wealth has the property of yielding future incomes streams (pecuniary or not) If we multiply nominal wealth W* by the average interest rate r, we get the average future nominal income stream. Friedman defines it as permanent nominal income Ynp. Ynp=r W* Without explanations, Friedman then assumes that current income is equal to permanent income. The superscript p thus disappears. Yn=r W* This means that W*= Yn /r The equation for the nominal demand for money then becomes: Md=f(P, rb, re+gep, gep, h, Yn/r) This function can be further simplified: the twofold negative effect of gep can be unified. the average interest rate in Yn/r can be removed; its role is captured by individual rates of return. Md=f(P, rb, re, gep, h, Yn) Finally, we have to consider that what is relevant is the amount of money in real terms M/P. If nominal variables (P and PY) double, the nominal demand for money Md too doubles. 2Md=f(2P, rb, re, gep, h, 2Yn) More generally, if P and PY grow by , Md too has to grow by . Md=f(P, rb, re, gep, h, Yn) Given nominal income Yn =PY, by setting

=1/Yn =1/PY we get (1/PY) Md= f(1/Y, rb, re, gep, h, 1) This means that Md= f(1/Y, rb, re, gep, h, 1) PY In equilibrium, Md is equal to the exogenously given money supply M. The money market equilibrium condition consequently becomes: M= f(1/Y, rb, re, gep, h, 1) PY Friedman highlights that everybody (even Keynes himself) would agree on this result. What is then the distinguishing feature of Monetarism? According to Friedman, Monetarism is characterized by the following assumptions: the supply of money M is exogenous the f() function behaves like a constant. This can be due to many reasons: -the variables inside f() come from the real sector and are consequently given for the monetary sector; -the variables on which f(..) depends do not vary with time by a significant amount; -the variables on which f(..) depends vary with time, but their effects on f(...) offset each other. -f(..) has a very low sensitivity to its determinants: more generally, f(..) is a stable and predictable function of a limited number of variables. Under these assumptions: nominal income PY becomes a stable and predictable function of the given money supply M; put otherwise, nominal income is a monetary phenomenon; economic fluctuations reflect nominal shocks; money supply is the best control weapon. PY = f(1/Y, rb, re, gep, h, 1)-1 M When money supply M increases, the excess supply of money will turn into a demand for alternative assets. Partly through the fall in interest rates and partly (as we shall see, above all) through wealth effects, this will stimulate the value of expenditure on goods and services. M PY To sum up, Monetarism (the modern Quantity Theory proposed by Friedman) is essentially a monetary theory of nominal income. It is the equation above (not the expression for the Keynesian multiplier) that we have to estimate in order to explain and to forecast the time behaviour of nominal income. With regard to the debate animating the Synthesis, Friedman (1956) proudly adds that Monetarism represents THE general theory: Old Classics took real income Y as given at its full employment level;. Keynes (according to the mainstream interpretation) took money wages W and thus P as given; Monetarism focuses on nominal income PY, without introducing ad hoc assumptions in order to distinguish between real income Y and prices P. In his (1958) article, The supply of money and changes in prices and output, Friedman claims

that the relationships between M and PY is strongly confirmed by econometric evidence. Money and nominal income have a very similar cyclical behavior. The peaks (troughs) in the money cycle, however, anticipate the peaks (troughs) in the nominal income cycle. This confirms that causality runs from money M to nominal income PY: nominal income is a monetary phenomenon. M PYM, PY

M PY

peaks troughs

time

The debate between Friedman and Tobin In a 1970 article entitled Money and income: post hoc ergo propter hoc, James Tobin - leader of the Orthodox Keynesian School - objected that: post hoc does not mean propter hoc put otherwise, afterwards does not mean as a consequence of. Firms have generally to get bank credit before investing, and bank credit in turn stimulates money supply. The expansion in bank credit and in money supply thus anticipates the expansion of expenditure and income. Nevertheless, it is a consequence of the higher propensity to spend. More generally - according to Tobin - money supply M is endogenous.17 The existing amount of money depends on the behavior of the economy. As a consequence, it is outside the control of the central bank. Let us see why. As mediums of payment, we use: currency CU (coins and banknotes in our pockets) bank deposits D. Money supply can be consequently defined as: M = CU + D According to the budget constraint of the banking system, bank deposits D are equal to bank reserves RE plus bank credit CR. D = RE + CR By substituting above, we get that: M=CU+RE+CR By definition, the coins and banknotes issued by the central bank17

According to Tobins (1963) article entitled Commercial banks as creators of money, however, the distinction between banks and the other financial intermediaries in not sharp. For a recent debate on this issue, see the web site uneasy money.

represent the monetary base or the high powered money (H), which in its turn is held partly by the non bank public (as currency CU) and partly by banks (as bank reserves RE). H=CU+RE The result is that M=H+CR Money supply has thus two components: the high powered money - or monetary base H, which is issued by the central bank bank credit CR, created by the banking system by buying bonds (promises of payment) or by granting loans. To conclude, the banking system too creates money. When you get a credit from a bank, you exchange a promise of payment (a non monetary asset) against banknotes or deposits (a monetary asset). Thanks to bank credit, the quantity of money available to the non-bank public rises. In Friedmans view, the most important component of money supply is the high powered money or monetary base H issued by the Central Bank. Bank credit (and thus the whole money supply) can be considered as a multiple of H. 18 The control of H by the central bank consequently ensures the control of the whole M. The supply of money is exogenously determined by monetary authorities. In the relationship between money and nominal income, causality thus runs from the former to the latter. M PY According to Tobin, by contrast, the main component of money supply is represented by bank credit. This variable is determined by banks and by their customers, not by the monetary authorities.19 This means that bank credit and money supply are endogenously determined by the economic system. In the relationship between money and nominal income, causality runs from the latter to the former. PY CRd CRs M=H+CR To conclude, Tobins objection to Friedman is that: the quantity theory equation explains money supply M, not income Y. income is determined by the Keynesian multiplier (1/1-c) and by autonomous expenditure A.18

Let us assume that the desired amount of CU and RE is a given fraction of bank deposits D, i.e. that CU=cu D, RE=re D, CR=(1-re) D. From H=CU+RE we have that: D=[1/(cu+re)] H Since M=CU+D=(1+cu) D, we can conclude that: M=[(1+cu)/(cu+re)] H The Keynesian multiplier [1/(1-c)] focuses on the interdependence between expenditure and income, coming to the conclusion that in the goods market income Y is a multiple of autonomous expenditure A. The money multiplier [(1+cu)/(cu+re)] focuses on the interdependence between bank deposits and bank credit according to which the monetary based deposited into the banking system comes back to the non-bank public through bank credit and is deposited again. The result is that the stock of money M is a multiple [(1+cu)/(cu+re)] of the monetary base H created by the central bank. In Friedmans view, the parameters cu and re (and consequently the whole money multiplier) can be considered as given. The control of the monetary base H by the central bank consequently ensures the control of the whole supply of money M. According to Tobin, by contrast, cu and re are not given. They reflect the choices of banks and of their customers and consequently depend on the behavior of the economy. 19 The endogenous nature of money is one of the tenets of the Post Keynesian School. This issue is crucial. As we have seen, if money is endogenous, the fall in money wages and prices is unable to lead the system to its full employment equilibrium.

Extending Tobins approach, we may notice that money supply can be endogenous also in the absence (and thus independently) of the banking system, i.e. when M=H. This can happen as a consequence of the strategy adopted by the central bank. Given the demand for money function (L), the monetary authority has two options: it can control the amount of money (M); in this case, money supply is exogenous whilst the rate of interest (i) is endogenously determined by the demand for money. it can control the interest rate (i); in this case, the latter becomes endogenous whilst money supply is endogenously determined by the demand for money.i Md=L(i)PY Ms

Ms

M

The choice between the two intermediate targets (the quantity of money M and the interest rate i) will depend: on their controllability by the central bank; on their ability to affect the final targets (output, prices..) of the central bank.Strategy of the Central Bank Instruments(open market operations)

Intermediate Targets(money supply, interest rates)

Final Targets(expenditure, output, prices.)

Until the 1990s, the strategy of monetary authorities was generally based on the control of money supply. In line with the Quantitative Theory, this was meant to ensure the control of expenditure and prices. With time, however, this strategy proved increasingly impracticable and ineffective. The stock of money proved increasingly difficult to control. The link between money and expenditure (the velocity of circulation) became increasingly unstable and unpredictable. Given the impracticability and the ineffectiveness of the control of money supply, monetary authorities moved to the control of the interest rate. Currently, central banks set the interest rate and offer all the amount of money that the system requires. Put otherwise, the interest rate is exogenous whilst money supply is endogenous. Tthe conduct of modern central banks is usually described by the Taylor rule: it = (rt* + gpt*) + a (gpt - gpt*)+ay (Yt-Yt*) where the asterisked variables represent desired/target values; the non-asterisked variables represent observed/expected values; the coefficients a and ay represent given parameters with positive values.

In the previous equation: the first term on the right-hand side (rt*+gpt*) represents the nominal interest rate desired by the central bank i*, given by the sum of the desired real interest rate rt* plus the desired inflation rate gpt*. the last two terms on the right hand side (gpt - gpt*) and (Yt-Yt*) tell us that, whenever inflation gpt or output Y are higher than desired, the central bank restricts the economy by raising the interest rate i above its target level i*. The following graph compares the actual Fed funds rate with the value generated by the Taylors rule. The Taylor rule seems to be a reasonably good representation of the U.S. monetary policy!! The same holds for many Central Banks of other industrialized countries (EMU, UK..).

Thus, if we consider the experience of nowadays, Tobin was right in highlighting the endogenous nature of money supply.THE DANGEROUS LIAISON BETWEEN MONEY AND INCOME

As we have seen, the demand for money function is the starting point of Monetarism. This function is analyzed in more detail in two famous articles: Friedman 1970, A theoretical framework for monetary analysis Friedman 1971, A monetary theory of nominal income. Following Fisher, Friedman starts with the distinction between the nominal interest rate (i) and the real interest rate (r). As known, the relationship between the two is: i = r + gep By holding money, we have two kinds of costs: the real interest rate on alternative assets (r); the expected fall in moneys purchasing power due to expected inflation (gep) It is thus the nominal interest rate (i = r + gep) which is relevant for the demand for money (L). In a not-inflationary environment in which gep=0, nominal and real interest rates coincide. The money market equilibrium condition can thus be written in the usual way, where r=i is the average interest rate. M=L(i=r) PY In an inflationary environment in which gep>0, however, nominal and real interest rates diverge. Since the demand for money depends on the nominal interest rate,

the money market equilibrium condition becomes: M = L(i=r + gep) PY As an example, let us start with an initial equilibrium where: -money supply M grows at a rate of 6% -nominal income PY grows at a rate of 6% -prices P grow (for instance) at a rate of 3% -real income Y grows at a rate of 3% -expected inflation gep is 3% (in equilibrium expectations are correct) 6% 3% 3% 3% M = L( r + gep) P Y Let us now assume that -the growth rate of money supply raises to 12%. -the real interest rate r does not change We shall reach a new equilibrium where: -money M grows at a rate of 12% -nominal income PY grows at a rate of 12% -prices P grow (for instance) at a rate of 6% -real income Y grows at a rate of 6% -expected inflation (as current inflation) gep is 6% (in equilibrium expectations are correct) 12% 6% 6% 6% M = L( r + gep) P Y In each of the two equilibrium situations, money M and nominal income PY grow at the same rate: first by 6% and then by 12%. In the transition phase, however: -expected inflation gep rises from 3% to 6%. -the nominal interest rate i=r+gep rises -the speculative component of the demand for money L(..) falls -nominal income grows at a rate higher than 12% M = L(r + geP) P Y Friedmans analysis can be represented in the following figure. At time T , the growth rate of money supply exogenously rises from 6% to 12%. In the old and in the new equilibrium, money M and nominal income PY grow at the same rate (firstly 6% and then 12%). The two series, however, do not coincide. In the transition period, as inflationary expectations rise, PY grows faster than M.0

logM, logPY

logPY

Transition geP i L PY

log M12%

6%Old equilibrium

T0 Transition

New equilibrium

Time t

The example considered above implies a regular transition to the new equilibrium. In Friedmans view, however, the monetary sector may also be unstable. The change in the growth rate of M may then imply an explosive reaction in PY.

Log PY Log M, LogPY

Log M

Time t

The cumulative process which leads to the explosive reaction of income is due to the interdependence between gep and L(..). On the one hand, the rise in expected inflation (gep) implies an increase in the nominal interest rate i=r+ gep which reduces the demand for money L. gep i L On the other hand, the decrease in L implies an increase in the demand for goods which fuels actual and thus expected inflation. L gp gep Starting with the monetary nature of aggregate demand, Friedman consequently comes to the conclusion that money: is a powerful weapon for the control of nominal expenditure; but is also so powerful that it can be destabilizing. Friedmans belief is consequently that central banks: should not pursue a short-term perspective, using money as a countercyclical tool for the fine-tuning of economic activity; should instead adopt a long-run perspective, using money to accommodate the growth of real income (gy) without leaving any room to inflation (gp).

Friedmans monetary policy rule consequently is: gm=gy Comments on Friedmans analysis about the nature of AD i) The real interest rate r To simplify, let us consider a not inflationary environment. In terms of the IS-LM model with P given that was used by the Synthesis, the Monetarists framework is the opposite of the Orthodox Keynesians one: -the interest rate (i=r) is given by the real sector (a flat IS curve) -real income is given by the monetary sector (a rigid LM curve)LM

r=i

IS

Y

By assuming that the real interest rate r is given, however, Friedman too introduces an ad hoc assumption. With this, he can no longer present Monetarism as THE general theory. Downsizing its ambitions, he is forced to recognizes that: -Old Classics took real income as given at its full-employment level -Keynes (orthodox interpretation) and Orthodox Keynesians took nominal wages and prices as given -Monetarists take the real interest rate as given. At this stage, Friedman also comes to admit that his ad hoc hypothesis of a given interest rate lacks a convincing theoretical justification. To quote his own words, in the absence of this justification his monetary theory of nominal income resembles the Shakespearean play of Hamlet without its Prince. If Friedman subscribes to the Quantity Theory of Money, however, it is because he firmly believes that (contrary to the money sector) the real sector is stable. -Thanks to the price mechanism, the labour market tends to its equilibrium. -Aggregate supply consequently tends to its full employment level Yfe. -The goods market (the IS curve) gives the interest rate (a real variable) which aligns Yd to Yfe. -The LM curve is passive: it adapts itself to the ASfe-IS intersection through the fluctuations in P. -Equilibrium money balances M/P are given by the ASfe-IS intersection (by the real sector). -Money is neutral: money supply can only affect the price level.

ASfe

LM(M/P)

r=i

ISYfe

ii) The nominal interest rate According to Orthodox Keynesians, a monetary expansion implies a fall in the nominal interest rate. M i According to Friedman, the opposite happens. A monetary expansion raises actual and thus expected inflation. Given the real interest rate, it consequently raises the nominal interest rate. M i = r+ geP iii) The velocity of circulation V According to the Old Classics, the velocity of circulation was an institutional constant. Real income was at its full employment level. The result was the neutrality of money.. MV=PY According to Keynes, the equilibrium condition of the money market is M=L(i) PY The velocity of circulation is the reciprocal of L(i). 1/L(i)=V(i) This means that V is a positive function of the interest rate i (instead of being a constant). i L(i) V=1/L(i) In the presence of a monetary expansion which lowers the interest rates, the velocity of circulation falls and this mitigates the impact of M over PY To conclude, in Keyness view, V performs an anti-cyclical role. M V(i) = P Y According to Friedman, the equilibrium condition of the money market is M = L(r+gep) YP. On this basis, a monetary expansion: -increases actual and expected inflation; -raises the nominal interest rate i=r+gpe; -implies the fall in L(..) and the increase in V=1/L(..). M gp gpe i L V=1/L The velocity of circulation V accentuates the impact of M over PY Friedmans conclusion is that the role of V is pro-cyclical.

MV=PY iv) The role of monetary policy The high confidence placed in the link from M to PY might suggest that Friedman is favorable to monetary policy. As we have seen, this is absolutely false!!! Money may have explosive effects on nominal income: we have to use it the least possible. Money supply should simply accommodate the real growth of the economy, without giving any room to inflation. Friedmans rule for monetary policy consequently is: gm=gy v) Expectations As we have seen, in the transition period inflationary expectations gradually adapt themselves to their new equilibrium values. With regard to this, Friedman assumed adaptive expectations. Todays expectations gpet are equal to yesterdays expectations gpet-1 adjusted by a fraction P) will imply a negotiated real wage W*/P which is higher then the desired one (W/P)*. Firms (workers) will offer (require) a real wage above their traditional Ld (Ls) curve. W*>(W)* P P An underestimation of the price level (Pe < P), will imply a negotiated real wage W*/P which is lower then the desired one (W/P)*. Firms (workers) will offer (require) a real wage below their traditional Ld (Ls) curve. W* gep=gw* =0%Ls0

W/P0 W/P0

0

W/P falls below W/Pfe L rises above Lfe. Y rises above Yfe u falls below ufe.

Lfe

L0

However, Friedmans short-run is really short-lived: price data are published relatively frequently. With time, workers will then realize their forecasting errors. As a result, they will gradually correct them (adaptive expectations). Specifically, they will ask for higher money (and real) wages W* (W*/P). Their labor supply curve will go back from the Ls0 to the traditional Ls0 curve. The system will move back from short-run equilibrium 0 to long-run equilibrium 1. Employment (unemployment) will go back to its natural level Lfe (ufe). Current and expected nominal variables will now grow at a 10% rate.IMPLICATIONS FOR THE

PHILLIPS CURVE

Following Friedman, we shall distinguish between: the short-run the long-run. FRIEDMANS SHORT-RUN PHILLIPS CURVE As we have seen: what matters in the labour market are real wages W/P; ceteris paribus, desired money wages W*=(W/P)* Pe depend on expected prices Pe; ceteris paribus, the growth rate of money wages (gw) will then reflect expected inflation (gep) On the basis of these premises, Friedman claims that the short-run Phillips curve has to be inflation augmented. Behind the lines, it subtends a given expected rate of inflation gep. gw=f(u) +gep The negative slope of Friedmans short-run Phillips Curve At the given expected rate of inflation gep: the short-run Phillips curve will be downward sloping. there will be a negative relationship between the growth rate of money wages gep and the rate of unemployment u. This result derives from Friedmans analysis of the labour market. As we have seen, when the growth rate of money and prices rises from 0 to 10%: workers do not realize the change (their gep=0) they ask for the same money wage as before (gW=0) they involuntarily ask for lower real wages (gp=10%)

their Ls curve moves rightwards employment and output rise unemployment falls. The relevant short-run Phillips curve implies a 0% expected inflation (gep=0). When actual inflation rises to 10%, there is an inflationary surprise (gp - gep) which stimulates the economy. The higher rate of inflation thus implies a fall in the rate of unemployment u. We move from point 0 to point 1 (the new short-run equilibrium).

gP

SRPC(gep=0) 1 0 ufeu

10%

0

Notice that in Friedman: causality runs from inflation gp to unemployment u. For Keynes and for the OKS, the direction of causality was the opposite: the activity level determined marginal costs and prices. fluctuations in employment and output are supply led. If unemployment is high, it is because labour supply is low. For Keynes and for the OKS, unemployment was due to a low demand for labour. The position of Friedmans short-run Phillips Curve depends on the given expected rate of inflation gep. When u=ufe, we are in general equilibrium. This means that foresight is perfect. At u=u*, expected and current inflation consequently coincide (gp=gep). The inflation rate gp corresponding to ufe along the curve thus gives us the given expected rate of inflation gep. underlying the whole curve.

gp

SRPC(gep=10%)

gp=10%0

ufe

u

Instead of the traditional unique Phillips curve, we shall have a whole set of short-run Phillips curves; each of them implies a given expected rate of inflation gep higher Phillips curves imply higher expected rates of inflation gep

SRPC(gep=30%) SRPC(gep=15%) SRPC(gep=0%) gp=30% gp=15% gp=0%ufe

u

LONG-RUN

PHILLIPS CURVE

As we have seen, according to Friedman, in the long-run: the labour market reaches its full employment equilibrium; unemployment is at its natural/equilibrium rate ufe; the long-run Phillips curve is a vertical line at u=ufe. ; there is perfect foresight: current and expected variables coincide. actual and expected nominal variables grow at the same rate as money supply;

the growth rate of nominal variables does not affect the real sector of the economy.gp LRPC

Initial long-run equilibrium 0 (with gm=0) u=ufe and gm=gp=gep=gw=0 Subsequent long-run equilibrium 1 (with gm=10%) u= ufe and gm=gp=gep=gw=10% Long-run Phillips curve u=ufe

gm=gp=10% gm=gP=0%

1

0

ufe

In the long-run, there is no trade-off between unemployment and inflation!FRIEDMANS

PHILLIPS CURVE AND MONETARY POLICY

MONETARY EXPANSION Let us start from an initial not-inflationary long-run general equilibrium point 0. unemployment is at its natural rate u* nominal variables are stable (gm=gp=gw=0) expectations are correct (gep=0) we are both on the LRPC and on the SRPC corresponding to gep=0

gp

LRPC

SRPC (gep=0%)

0%

0ufe

Let us now assume an expansionary monetary policy. Money supply and prices start rising at 10%. gm = gp=10% New short-run equilibrium. Workers do not realize the change; they keep expecting a stable price level (gep=0%). We shall move leftwards on the corresponding SRPC (gep=0%)

gp

When actual inflation rises to 10%, there is an inflationary surprise (gp - gep) which stimulates the economy.SRPC (gep=0%)

The higher rate of inflation thus implies a fall in the rate of unemployment u. We move from point 0 to point 0(a short-run equil.). Unexpected inflation stimulates economic activity.

10%

0

0%

0ufe

In the short-run, the monetary expansion is effective However, it acts through an inflationary surprise which damages workers inducing them to accept lower wages. Transition to the new long-run equilibrium short-run equilibrium 0 is inevitably temporary: expected inflation is 0% whilst actual inflation is 10%; gradually, workers realize and correct their errors; they consequently ask for a higher money (and real) wage; the short-run Phillips curve moves upwards. New long-run equilibrium We end up at point 1, at the same time: on the LRPC on the new SRPC corresponding to gep=10%. In the new long-run equilibrium 1, actual and expected nominal variables grow by 10%: u= ufe and gm=gp=gep=ga =10%

gp

SRPC(gep=10%)

LRPC

SRPC(gep=0%)

10%

0

1

0%

0 ufe

In the long-run, money is neutral and monetary policy has no real effect. In the short-run, a higher rate of growth in money supply stimulates economic activity. In the long-run, however, the only effect is a higher growth rate in current and expected nominal variables. This is undesirable, since inflation implies the inflation tax. The negative effects of a monetary expansion are accentuated by Friedmans accelerationist hypothesis.

If monetary authorities want to keep u