MonetarismThe Effects of Money Supply Changes on the Real EconomyThe Effects of Fiscal Changeson the Real EconomyOverviewWhat is Monetarism?Friedman’s Restatement of the Quantity TheoryRestatement, ContinuedRestatement, ContinuedRestatement, ContinuedWhat is Monetarism?Expectations-Augmented Phillips Curve and the Accelerationist HypothesisWhat is Monetarism?CGRR Argument 1: Based on PIHCGRR Argument 2: Based on Long & Variable LagsCGRR Argument 3: Based on Money as an InstitutionCGRR Argument 4: Based on Stable Md and VelocityOther ClaimsMonetarismMonetarismGraduate Macroeconomics IECON 309 – Cunningham2The Effects of Money Supply The Effects of Money Supply Changes on the Real EconomyChanges on the Real EconomyLM1rrLM2ISLM1ISLM2?YYKeynesian ViewMonetarist View3The Effects of Fiscal ChangesThe Effects of Fiscal Changeson the Real Economyon the Real EconomyIS1Keynesian ViewMonetarist ViewLMIS1LMIS2rrIS2?YY4OverviewOverview• Milton Friedman⇒ mid-1950s, University of Chicago Neoclassical price theorist⇒ Establish career on PIH and the underpinnings of Marshall’s basic supply and demand model• Chicago School is distinctly neoclassical, with substantial Austrian influence. To oversimplify: Austrians are neoclassical in spirit, with a stronger appreciation of the roles of uncertainty and institutions.• Money and Banking Workshop at Chicago.• Friedman is a self-proclaimed quantity theorist and classical liberal. According to Friedman, “Inflation is everywhere and at all times a monetary phenomenon.” (To the Keynesians, inflation is the result of excess demand for goods and services, and hence arises out of conditions in the real sector.) • Karl Brunner coins the phrase “Monetarism”; Brunner and Alan Meltzerconstruct the microfoundations of Monetarism, creating a second “camp.”5What is Monetarism?What is Monetarism?According to David Laidler (Economic Journal, March 1981, p. 1-2), Monetarism can be characterized by four elements:(I) A ‘quantity theory’ approach to macroeconomic analysis in two distinct senses: (a) that used by Milton Friedman (1956) to describe a theory of the demand for money, and (b) the more traditional sense of a view that fluctuations in the quantity of money are the dominant cause of fluctuations in money income.(II) The analysis of the division of money income fluctuations between the price level and real income in terms of an expectations augmented Phillips curve whose structure rules out an economically significant long-run inverse trade off between the variables.(III) A monetary approach to the balance-of-payments and exchange rate theory. (IV) (a) Antipathy toward activist stabilization policy, either monetary or fiscal, and to wage and price controls, and (b) support for long-run monetary policy “rules” or at least prestated ‘targets’, cast in terms of the behavior of some monetary aggregate rather than of the level of interest rates.6Friedman’s Restatement Friedman’s Restatement of the Quantity Theoryof the Quantity TheoryFriedman, M. “The Quantity Theory of Money--A Restatement.”In Studies in the Quantity Theory of Money, Milton Friedman, editor. Univ. of Chicago Press (1956).According to Friedman, total income (Y) is explained by nominal wealth (W) and the returns (r) that it generates. Explicitly:Y = Wr.If wealth and returns are estimated via expectations of lifelongstreams, then Y is really permanent income. According to the quantity theory, money demand is proportional to the value of nominal transactions, which should be a function of permanent income.7Restatement, ContinuedRestatement, ContinuedFriedman expands the detail of wealth and returns to indentify the variety of assets and returns in the potential portfolio:where P is the price level, rbis the return on bonds, reis the return on equities, rais the return on real assets, w is the ratio of human to nonhuman wealth (to capture the return on “human wealth”), γ/r is total wealth, and u is the “portmanteau variable.”We can simplify this to:Note: at equilibrium, the inflation rate should be equal to the nominal return on the entire (aggregate) stock of real (physical) assets. If individuals do no suffer money illusion, they are not fooled by changes to scale, and f is linearly homogeneous in prices and nominals. ⎟⎠⎞⎜⎝⎛γ= urwrrrPfMaeb;,,,,,⎟⎟⎠⎞⎜⎜⎝⎛π=+−−−+ )()()()()(,,,, YrrPfMeb8Restatement, ContinuedRestatement, ContinuedSo, .This must hold for any value of λ, even λ=1/Y. This implies that:More simply,But since Y=Py,which closely resembles the Cambridge form of the equation of exchange:()YrrPfMebλπλ=λ,,,,⎟⎠⎞⎜⎝⎛π= 1,,,,ebrrYPfYM()YfM•=()PyfM•=.kPyM=9Restatement, ContinuedRestatement, ContinuedThis implies that the cash balances “constant” k, or equivalently, the circular velocity of money V in MV=Py, is really a (stable) function of a few well-defined variables. Interpretation: Over any reasonable period of time, the rates of return in this function will all move together (in “lock-step”). That is, the yield curve maintains a constant shape, even though it may shift up or down. Thus, substitutions among assets are not likely to take place except on the very short run. Therefore, f and k are quite stable, so that the results of the traditional quantity theory still obtain.10What is Monetarism?What is Monetarism?According to David Laidler (Economic Journal, March 1981, p. 1-2), Monetarism can be characterized by four elements:(I) A ‘quantity theory’ approach to macroeconomic analysis in two distinct senses: (a) that used by Milton Friedman (1956) to describe a theory of the demand for money, and (b) the more traditional sense of a view that fluctuations in the quantity of money are the dominant cause of fluctuations in money income.(II) The analysis of the division of money income fluctuations between the price level and real income in terms of an expectations augmented Phillips curve whose structure rules out an economically significant long-run inverse trade off between the variables.(III) A monetary approach to the balance-of-payments and exchange rate theory. (IV) (a) Antipathy toward activist stabilization policy, either monetary or fiscal, and to wage and price controls, and (b) support for long-run monetary policy “rules” or at least prestated ‘targets’, cast in terms of the behavior of some monetary aggregate rather than of the level of interest