orthodox monetarism

Orthodox Orthodox MonetarismMonetarismIntermediate MacroeconomicsIntermediate Macroeconomics

ECON-305 Spring 2013ECON-305 Spring 2013Professor DaltonProfessor Dalton

Boise State UniversityBoise State University

PurposesPurposes1.1. Trace the historical development of Trace the historical development of

modern Monetarism beginning in the modern Monetarism beginning in the 1950s1950s

Demand for moneyDemand for money Impact of changes in money supplyImpact of changes in money supply Augmented Phillips CurveAugmented Phillips Curve Monetary approach to Balance of Payments Monetary approach to Balance of Payments

and Exchange Ratesand Exchange Rates2.2. Summarize the central distinguishing Summarize the central distinguishing

beliefs of Monetarismbeliefs of Monetarism

Origins of Quantity Origins of Quantity TheoryTheory

Quantity theory of money has been called Quantity theory of money has been called “the oldest surviving theory in economics” “the oldest surviving theory in economics” (Blaug)(Blaug) Many trace it to Locke’s Many trace it to Locke’s Some Considerations Some Considerations

of the Consequences of the Lowering Of of the Consequences of the Lowering Of Interest and Raising the Value of MoneyInterest and Raising the Value of Money (1692)(1692)

Copernicus’s Copernicus’s Monetae cudendae ratio Monetae cudendae ratio (1526) (1526) is sometimes afforded the honoris sometimes afforded the honor

Hume’s Hume’s Of Money Of Money is probably earliest is probably earliest “modern” statement“modern” statement

Origins of Quantity Origins of Quantity TheoryTheory

Martin de Azpilcueta NavarrusMartin de Azpilcueta Navarrus Comentario resolutoio de usurasComentario resolutoio de usuras (1556) (1556)

first unambiguous statement of quantity theory of first unambiguous statement of quantity theory of money - defines money’s value as its purchasing money - defines money’s value as its purchasing power, whose value is determined by demand and power, whose value is determined by demand and supply of moneysupply of money

attributed (12 years before Bodin) the price attributed (12 years before Bodin) the price inflation of the mid-16th century to the influx of inflation of the mid-16th century to the influx of silver and goldsilver and gold

developed purchasing-power parity theory of developed purchasing-power parity theory of exchange rates advanced by colleague Domingo de exchange rates advanced by colleague Domingo de Soto (1494-1560)Soto (1494-1560)

Pre-Keynesian Monetary Pre-Keynesian Monetary TheoryTheory

Oldest variant is Monetary equilibrium Oldest variant is Monetary equilibrium theorytheory

Cambridge k approachCambridge k approach Fisher’s equation of exchangeFisher’s equation of exchange What is the “quantity theory”?What is the “quantity theory”?

Confusion with the proportionality theorem Confusion with the proportionality theorem (∆M/M = ∆P/P)(∆M/M = ∆P/P)

Demand and supply theory of monetary Demand and supply theory of monetary valuevalue

Quantity Theory in IS-LMQuantity Theory in IS-LM MV = PYMV = PY In underemployment conditions V is In underemployment conditions V is

highly unstable and passively adapts highly unstable and passively adapts to independent changes in M or PYto independent changes in M or PY Liquidity trapLiquidity trap Interest-inelastic investmentInterest-inelastic investment

Money demand is unstable and Money demand is unstable and unpredictableunpredictable

Milton FriedmanMilton Friedman Friedman sought to Friedman sought to

reestablish what he reestablish what he viewed as the viewed as the Chicago monetary Chicago monetary traditiontradition

Series of influential Series of influential papers and bookspapers and books

Popularization of Popularization of free market free market economicseconomics

Milton Friedman (1912-2006)

Friedman’s ContributionsFriedman’s Contributions ““The Quantity Theory of Money: A The Quantity Theory of Money: A

Restatement” (1956)Restatement” (1956) ““The Supply of Money and Changes in The Supply of Money and Changes in

Prices and Output” (1958)Prices and Output” (1958) ““The Demand for Money: Some Theoretical The Demand for Money: Some Theoretical

and Empirical Results” (1959)and Empirical Results” (1959) A Monetary History of the United States, A Monetary History of the United States,

1867-1960 1867-1960 (with Anna Schwartz) (1963)(with Anna Schwartz) (1963)

Friedman’s ContributionsFriedman’s Contributions ““The Relative Stability of Monetary Velocity The Relative Stability of Monetary Velocity

and the Investment Multiplier in the United and the Investment Multiplier in the United States, 1897-1958” (with David Meiselman) States, 1897-1958” (with David Meiselman) (1963)(1963)

““Interest Rates and the Demand for Money” Interest Rates and the Demand for Money” (1966)(1966)

““The Role of Monetary Policy” (1968)The Role of Monetary Policy” (1968) ““A Theoretical Framework for Monetary A Theoretical Framework for Monetary

Analysis” (1970)Analysis” (1970) ““Inflation and Unemployment” (1977)Inflation and Unemployment” (1977)

QTM - Money Demand TheoryQTM - Money Demand Theory ““The Quantity Theory of Money: A The Quantity Theory of Money: A

Restatement” (1956)Restatement” (1956) Money is demanded because it yields Money is demanded because it yields

a flow of servicesa flow of services Money demand dependent uponMoney demand dependent upon

Wealth constraint; Return on money Wealth constraint; Return on money relative to other assets; and, Tastesrelative to other assets; and, Tastes

In equilibrium, wealth is allocated to In equilibrium, wealth is allocated to equalize marginal return on assetsequalize marginal return on assets

QTM - Money Demand TheoryQTM - Money Demand TheoryMMdd/P = f (r/P = f (rmm, r, rDGDG, r, rbb, r, ree, þ, þee, h, Y, h, Ypp, u), u)

where rwhere rmm = return on money, = return on money, rrDGDG = return on durable goods, = return on durable goods, rrb b = return on bonds, r= return on bonds, ree = return on equities, = return on equities,

þþee = expected inflation rate, = expected inflation rate, h = ratio of income from non-human to human h = ratio of income from non-human to human wealth (capital),wealth (capital), YYpp = permanent income, and u = tastes. = permanent income, and u = tastes.

Individuals reallocate wealth whenever marginal Individuals reallocate wealth whenever marginal returns across assets not equal.returns across assets not equal.

Portfolio Adjustment Portfolio Adjustment ProcessProcess

Open market purchase of bonds increases Open market purchase of bonds increases MMss

Reducing the return on holding money (rReducing the return on holding money (rmm)) Money exchanged for financial and real Money exchanged for financial and real

assetsassets Increasing price of equities, price of bonds, Increasing price of equities, price of bonds,

price of durable goods (Pprice of durable goods (Pee, P, Pbb, P, PDGDG)) Returns on equities, bonds and durable Returns on equities, bonds and durable

goods fall (rgoods fall (ree, r, rbb, r, rDGDG) and return on money ) and return on money rises (rrises (rmm) until equality restored) until equality restored

Portfolio Adjustment Portfolio Adjustment ProcessProcess

Conclusions:Conclusions:

1.1. Broader range of assets and Broader range of assets and associated expenditures are affected associated expenditures are affected by ∆Mby ∆MSS (not just bonds as in Keynes (not just bonds as in Keynes and IS-LM)and IS-LM)

2.2. Stronger, more direct effect on AD Stronger, more direct effect on AD due to ∆Mdue to ∆MSS than predicted by Keynes than predicted by Keynes and IS-LMand IS-LM

Money and ∆Nominal IncomeMoney and ∆Nominal Income Real Money demand changes in stable Real Money demand changes in stable

and predictable waysand predictable ways V is predictable and stableV is predictable and stable Empirical evidence:Empirical evidence:

Friedman (1959) argued that ∆r do not Friedman (1959) argued that ∆r do not change Mchange Mdd/P./P.

Friedman (1966) recantedFriedman (1966) recanted No evidence for either liquidity trap or No evidence for either liquidity trap or

vertical LM curvevertical LM curve

Money and ∆Nominal IncomeMoney and ∆Nominal Income Up to early 1970s money demand Up to early 1970s money demand

was stable (predictable)was stable (predictable) Financial innovation of the late 1970s Financial innovation of the late 1970s

and early 1980s breakdown the and early 1980s breakdown the stability of Mstability of Mdd/P/P Relationship between M1 and PYRelationship between M1 and PY Regulation Q of Federal ReserveRegulation Q of Federal Reserve

Clear differentiation between money and Clear differentiation between money and not-moneynot-money

Money and ∆Nominal IncomeMoney and ∆Nominal Income

Greenspan: Greenspan: “We don’t “We don’t know what know what money is, money is, anymore.”anymore.”

Role of the Money Role of the Money SupplySupply

““The Supply of Money and Changes The Supply of Money and Changes in Prices and Output” (1958)in Prices and Output” (1958) Compared rates of monetary growth Compared rates of monetary growth

with cycle turning pointswith cycle turning points Peaks (troughs) of monetary growth Peaks (troughs) of monetary growth

(∆M/M) preceded peaks (troughs) of (∆M/M) preceded peaks (troughs) of cycle by 16 (12) monthscycle by 16 (12) months

Suggestive of monetary influencesSuggestive of monetary influences Problem of causalityProblem of causality


A Monetary History of the United States, 1867-A Monetary History of the United States, 1867-1960 1960 (with Anna Schwartz) (1963)(with Anna Schwartz) (1963) Rate of monetary growth slower during Rate of monetary growth slower during

contractions than expansionscontractions than expansions Negative monetary growth always Negative monetary growth always

associated with major contractionsassociated with major contractions Historical evidence of independent policy Historical evidence of independent policy

changes producing changes in monetary changes producing changes in monetary growthgrowth

Great Depression consequence of monetary Great Depression consequence of monetary restrictionrestriction


““The Relative Stability of Monetary Velocity The Relative Stability of Monetary Velocity and the Investment Multiplier in the United and the Investment Multiplier in the United States, 1897-1958” (with David Meiselman) States, 1897-1958” (with David Meiselman) (1963)(1963) Compared monetary and Keynesian Compared monetary and Keynesian

approachesapproaches ∆∆C = f(∆MC = f(∆Mss) versus ∆C = g(∆I)) versus ∆C = g(∆I) Money equation explained more variation Money equation explained more variation

in C, except for Great Depressionin C, except for Great Depression Poorly conceivedPoorly conceived

Theoretical FrameworkTheoretical Framework ““A Theoretical Framework for Monetary A Theoretical Framework for Monetary

Analysis” (1970)Analysis” (1970) Until this paper, no explicit formal Until this paper, no explicit formal

monetarist modelmonetarist model Friedman intended to show that “the basic Friedman intended to show that “the basic

differences…are empirical, not theoretical”differences…are empirical, not theoretical” Model was IS-LM without Keynesian Model was IS-LM without Keynesian

extremes, without wage rigidity, and with extremes, without wage rigidity, and with Pigou and real balance effectsPigou and real balance effects

Monetarism in mid-1960sMonetarism in mid-1960s1.1. Monetary growth predominant factor in Monetary growth predominant factor in

explaining nominal income growth.explaining nominal income growth.2.2. Stable real money demand means Stable real money demand means

economic instability is due to economic instability is due to fluctuations in monetary growth fluctuations in monetary growth induced by monetary authorities.induced by monetary authorities.

3.3. Authorities can control MAuthorities can control Mss, when they , when they do so, path of nominal income is do so, path of nominal income is different than if Ms were endogenous.different than if Ms were endogenous.

Monetarism in mid-1960sMonetarism in mid-1960s4.4. Lag between changes in money Lag between changes in money

supply and changes in nominal supply and changes in nominal income is long and variable; income is long and variable; discretionary monetary policy is discretionary monetary policy is destabilizing.destabilizing.

5.5. Money supply should grow at a fixed Money supply should grow at a fixed rate of real output growth to rate of real output growth to stabilize prices.stabilize prices.

The 2The 2ndnd Stage: Phillips Stage: Phillips CurveCurve

Monetary growth is the predominant Monetary growth is the predominant determinant of nominal income determinant of nominal income growth and Mgrowth and Mdd is stable and is stable and predictable.predictable.

MV = PYMV = PY How are changes in MHow are changes in Mss divided divided

between P and Y?between P and Y? Augmented Phillips CurveAugmented Phillips Curve

Augmented Phillips Augmented Phillips CurveCurve

Friedman, “The Role of Monetary Friedman, “The Role of Monetary Policy,” Policy,” AERAER (1968) (1968)

Edmund Phelps, “Phillips Curves, Edmund Phelps, “Phillips Curves, Expectations of Inflation and Optimal Expectations of Inflation and Optimal Unemployment over Time,” Unemployment over Time,” EconomicaEconomica (Aug. 1967)(Aug. 1967) The original Phillips Curve relationship is The original Phillips Curve relationship is

misspecified; correcting the misspecification misspecified; correcting the misspecification gives a new understanding of the economy.gives a new understanding of the economy.


Original Specification: dW = f(U)Original Specification: dW = f(U) Although W is set in negotiations between Although W is set in negotiations between

employees and employers, both are really employees and employers, both are really interested in w = (W/P).interested in w = (W/P).

Inflation (dP) affects w over the contract Inflation (dP) affects w over the contract period.period.

Inflationary expectations (dPInflationary expectations (dPee) therefore ) therefore affect (dW)affect (dW)

Phillips Curve should be specified as dW Phillips Curve should be specified as dW = f(U) + dP= f(U) + dPee..


Introducing Introducing inflationary inflationary expectations (dPexpectations (dPee) ) means that rather means that rather than one PC there than one PC there exists a set of exists a set of Phillips Curves, one Phillips Curves, one for each dPfor each dPe e (where (where dPdPee

00 < dP < dPee1 1 < dP< dPee

22).).PC (dPe0)

dW

U5.5%

PC (dPe1)

PC (dPe2)


There exists a short-There exists a short-run, but NOT a long-run run, but NOT a long-run tradeoff between tradeoff between unemployment and unemployment and inflation.inflation.

As inflationary As inflationary expectations adjust to expectations adjust to the actual inflation the actual inflation rate, unemployment rate, unemployment returns to its natural, returns to its natural, full employment, level.full employment, level.

dW

PC (dPe0)U5.5%

PC (dPe1)

PC (dPe2)

LRPC

The SR-LR Phillips CurveThe SR-LR Phillips Curve With zero productivity growth, in equilibrium, dW = dP With zero productivity growth, in equilibrium, dW = dP

= dP= dPee.. An increase in aggregate demand increases prices, An increase in aggregate demand increases prices,

increasing nominal wages. Workers misinterpret the increasing nominal wages. Workers misinterpret the higher nominal wages as higher real wages, given higher nominal wages as higher real wages, given their inflationary expectations, so they increase the their inflationary expectations, so they increase the quantity of labor they supply.quantity of labor they supply.

Firms, however, see real wages fall, and are willing to Firms, however, see real wages fall, and are willing to increase employment, reducing unemployment. increase employment, reducing unemployment.

As workers come to realize that their real wage has As workers come to realize that their real wage has fallen, they reduce their labor supply, demanding fallen, they reduce their labor supply, demanding even higher money wages, reducing employment and even higher money wages, reducing employment and increasing unemployment.increasing unemployment.

A Graphical PresentationA Graphical Presentation

PC (dPe0)U5.5%

PC (dPe1)

LRPCdW W

L

DL (P0)

SL (Pe0)

A

A

Lf

B

DL (P1)

L1

W0

W1

B

4%

SL (Pe1)

CW2

C


In the short-run, changes in the In the short-run, changes in the money supply are non-neutral. In the money supply are non-neutral. In the long-run, once expectations have long-run, once expectations have adjusted, changes in the money adjusted, changes in the money supply become neutral.supply become neutral.

Empirical StudiesEmpirical Studies dW = f(U) + ßdPdW = f(U) + ßdPe e ; assume zero productivity ; assume zero productivity

growthgrowth dP = dW; dP = f(U) + ßdPdP = dW; dP = f(U) + ßdPe e ; equilibium, dP = dP; equilibium, dP = dPee

dP – ßdP = f(U); dP (1–ß) = f(U)dP – ßdP = f(U); dP (1–ß) = f(U) dP = f(U)/(1-ß)dP = f(U)/(1-ß)

ß = 1; vertical PCß = 1; vertical PC 0 < ß < 1; neg PC but less favorable0 < ß < 1; neg PC but less favorable 0 = ß; LRPC and SRPC identical0 = ß; LRPC and SRPC identical

No clear-cut evidenceNo clear-cut evidence Theoretical case overwhelmingTheoretical case overwhelming

Policy ImplicationsPolicy Implications1.1. Adaptive (Error-learning) expectations Adaptive (Error-learning) expectations

imply that U < Uimply that U < UNN occurs only because occurs only because of unexpected inflation.of unexpected inflation.

2.2. Attempts to maintain U < UAttempts to maintain U < UNN only leads only leads to accelerating inflation.to accelerating inflation.

3.3. Combatting inflation involves output-Combatting inflation involves output-unemployment costs (U > Uunemployment costs (U > UNN ) and the ) and the greater is monetary contraction the greater is monetary contraction the greater the costs.greater the costs.

Policy ImplicationsPolicy Implications4.4. Fixed Rate of Monetary GrowthFixed Rate of Monetary Growth

a)a) Steady monetary growth rate will Steady monetary growth rate will lead economy to settle at Ulead economy to settle at UNN..b) Rule removes greatest source of b) Rule removes greatest source of instability.instability.c) Discretionary policy destabilizing due c) Discretionary policy destabilizing due to long and variable lags.to long and variable lags.d) Because Ud) Because UNN not known, policy should not known, policy should notnot aim at U*. aim at U*.

Policy ImplicationsPolicy Implications5.5. Permanent reductions in U can only Permanent reductions in U can only

come through removing output and come through removing output and labor restrictions.labor restrictions.a)a) Incentives to work (welfare Incentives to work (welfare reform).reform).b) Flexible wages.b) Flexible wages.c) Labor mobility.c) Labor mobility.d) Enterprise privatization.d) Enterprise privatization.

3rd Stage: Money and 3rd Stage: Money and BOPBOP

Monetarism and the Balance of PaymentsMonetarism and the Balance of Payments Approach made monetarist analysis relevant to Approach made monetarist analysis relevant to

open economiesopen economies Fixed Exchange RatesFixed Exchange Rates

Currencies are defined as fixed quantities of Currencies are defined as fixed quantities of foreign currenciesforeign currencies

Monetary authorities in each country hold Monetary authorities in each country hold reserves of foreign currency (international reserves of foreign currency (international reserves) to stabilize value of domestic reserves) to stabilize value of domestic currency relative to foreign currency.currency relative to foreign currency.

Monetary Approach BOPMonetary Approach BOPFixed Exchange RatesFixed Exchange Rates Key assumptionsKey assumptions

Md/P stable function of limited variablesMd/P stable function of limited variables In long run, Y and L tend to YIn long run, Y and L tend to YNN and L and LNN In long run, monetary authorities can’t In long run, monetary authorities can’t

neutralize monetary impact of BOP neutralize monetary impact of BOP surpluses or deficitssurpluses or deficits

Arbitrage ensures that prices tend to be Arbitrage ensures that prices tend to be equalizedequalized

Monetary Approach BOPMonetary Approach BOP Harry Johnson, “The Monetary Approach to Harry Johnson, “The Monetary Approach to

Balance of Payments Theory” (1972)Balance of Payments Theory” (1972) Three Assumptions: Y = YN; law of one Three Assumptions: Y = YN; law of one

price holds in commodity and financial price holds in commodity and financial markets; domestic prices and interest markets; domestic prices and interest rates are pegged to world levelsrates are pegged to world levels

MMdd = P* f(Y,r); M = P* f(Y,r); Mss = D + R, where D = D + R, where D equals domestic credit and R equals equals domestic credit and R equals international reservesinternational reserves

MMdd = D + R = D + R

BOP AnalyticsBOP Analytics What are the effects of increasing domestic What are the effects of increasing domestic

credit?credit? Increase D means Ms > MdIncrease D means Ms > Md Individuals rid excess balances by buying Individuals rid excess balances by buying

foreign goodsforeign goods Generates BOP deficitGenerates BOP deficit Authorities sell foreign currency for domestic Authorities sell foreign currency for domestic

currency to cover BOP deficitcurrency to cover BOP deficit R falls, Ms falls until BOP deficit eliminatedR falls, Ms falls until BOP deficit eliminated ∆∆D = ∆RD = ∆R

BOP Analytical DynamicsBOP Analytical Dynamics A country experiences persistent A country experiences persistent

BOP deficits and continued loss of BOP deficits and continued loss of international reserves when domestic international reserves when domestic credit growth (∆D/D) exceeds credit growth (∆D/D) exceeds domestic money demand growth domestic money demand growth (∆M(∆Mdd/M/Mdd) due to real income growth) due to real income growth

Policy ImplicationsPolicy Implications There exists automatic adjustments to There exists automatic adjustments to

correct BOP disequilibriacorrect BOP disequilibria Discretionary monetary policy is self-Discretionary monetary policy is self-

defeatingdefeating Domestic monetary expansion in Domestic monetary expansion in small small

open economyopen economy has no effect on dP, r, or has no effect on dP, r, or dY (only foreign reserves)dY (only foreign reserves)

In In large open economylarge open economy, domestic , domestic moentary expansion increases world dPmoentary expansion increases world dP

Monetary Approach BOPMonetary Approach BOPFlexible Exchange RatesFlexible Exchange Rates Frenkel and Johnson, Frenkel and Johnson, The Economics of The Economics of

Exchange RatesExchange Rates, (1978), (1978) With perfectly flexible exchange rates, With perfectly flexible exchange rates,

exchange rates adjust to clear market so that exchange rates adjust to clear market so that BOP = 0BOP = 0

Implies no ∆ in RImplies no ∆ in R Implies ∆D only source of ∆MImplies ∆D only source of ∆Ms s

Therefore, ∆D change ∆MTherefore, ∆D change ∆Ms s and change and change exchange rates and domestic pricesexchange rates and domestic prices

BOP AnalyticsBOP Analytics What are the effects of increasing domestic What are the effects of increasing domestic

credit?credit? Increase D means Ms > MdIncrease D means Ms > Md Individuals rid excess balances by buying foreign Individuals rid excess balances by buying foreign

goodsgoods Excess supply of domestic currency in foreign Excess supply of domestic currency in foreign

exchange markets reduces value of domestic exchange markets reduces value of domestic currencycurrency

Depreciation in currency raises domestic prices, Depreciation in currency raises domestic prices, increasing Mincreasing Mdd and money market equilibrium is and money market equilibrium is restoredrestored

BOP Analytical DynamicsBOP Analytical Dynamics εε = g(M = g(Mss, Y), Y) ∆∆εε = h(∆M = h(∆Mss, ∆Y), ∆Y) Depreciating exchange rate Depreciating exchange rate

occurs when domestic monetary occurs when domestic monetary growth is faster than domestic growth is faster than domestic real income growthreal income growth

Orhtodox MonetarismOrhtodox Monetarism1.1. Monetary growth predominant Monetary growth predominant

factor in explaining nominal factor in explaining nominal income growth.income growth.

2.2. Economy inherently stable and Economy inherently stable and erratic monetary growth is primary erratic monetary growth is primary source of economic instability.source of economic instability.

3.3. No long-run tradeoff between No long-run tradeoff between inflation and unemployment.inflation and unemployment.

Orthodox MonetarismOrthodox Monetarism4.4. Prices and BOP are essentially Prices and BOP are essentially

monetary phenomena.monetary phenomena.5.5. Monetary policy should be Monetary policy should be

guided by a rule; fiscal policy guided by a rule; fiscal policy should be constrained to should be constrained to traditional roles of distribution traditional roles of distribution and allocation.and allocation.

orthodox monetarism

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