Monetary Theory:

ECO 285 – Macroeconomics – Dr. D. Foster

Monetarists vs. Keynes

Friedman and the Monetarist View

We can imagine a “market” for money…

--money demand depends on income (mostly) and on interest rates (slightly)

--money supply affects spending directly: MS – Excess MS - AD [PQ in short run]

• The Fed buys bonds,• Banks have more reserves,• Banks make more loans,• Spending goes up across economy.• Note MS≡MD.

Money and Aggregate Demand

• Equation of exchange: An accounting identity:

• Quantity theory of money:

People hold money for transactions purposes.Velocity (V) is constant, or, at least, stable.Real output (Q) is constant at full employment.

Therefore, changes in M will only change P.

• Aggregate Demand for output (AD) can be derived from the demand for money.

Ms * V = P * Q

MD = Ms = * P * Q

The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply

MS and that increases AD. MS and that decreases

AD.

AD1

P

Q or R-GDP

AS1

P1

Shifts in AD can only change the price level

and not real output (nor employment).

“Inflation is always, and everywhere, a

monetary phenomenon.”

-Milton Friedman

Velocity of M1: 1970 - 2015

Velocity of M2: 1970 - 2015

Velocity of MZM: 1970 - 2015

Monetarist vs. Keynesian

What are the initial causes of a recession? Money Supply Investment

The Fed as source. Lack of “animal spirits.”

How fast can the economy recover?Very fast. Not very fast.

Gov’t as source of disruption. Market instability.

Markets are quite robust.May have long-term

unemployment problem.

How does monetary policy help?It has a direct effect on consumer spending.

Works through effects on investment spending.

Very powerful.Likely ineffective.

“Pushing on a string.”

Monetarist vs. Keynesian

Should the government aid in therecovery from recession?

No. Yes.

Use rules. Use discretion.

Monetary rules will provide the necessary effect.

Fiscal policies, especially gov’t spending are best.

What about increase both government spending and taxes, to maintain

a balanced budget? Government spending

has dubious effects. Government spending is

the key to success.

Taxes will slow down economic growth.

Taxes will be more than offset by gov’t spending.

Keynesian vs. Monetarist Short Run Aggregate Supply

The AS is flat in the Keynesian view and steep according to the

Monetarists.

So, a decrease in the AD will have

different consequences in the two theories.

AS - Keynes

AD1

P

Q or R-GDP

ASLR

P1

Q*

AS - Monetarist

AD2

i1

iMS1

M*Money

MDM

MDK

MS2

MS3

Keynesian vs. Monetarist in the “market” for money

An alternative way to see what is happening to interest rates.

Market rate of interest (i) is determined by MS

and MD. Let the Fed determine

MS.Keynesian MD is more “interest sensitive” than is the Monetarist MD.

It takes a small∆i to get a large

∆MD.It takes a large∆i to get small

∆MD.

Miscellaneous issues concerning the Business Cycle

Persistent inflation & inflationary expectations.

Can we eliminate inflation by AS (short run)?

To eliminate inflation we need to ↓AD.

Keynes and the “paradox of thrift.”

Current problems and policy questions.

Persistent inflation & inflationary expectations

The Fed tries to reduce unemployment and increase output by MS. This AD.

AD1

P

Q or R-GDP

P1

AS1

AD2

Q*

P3

AS2AS3

AD2

AS4

P2

AS5

P4 With a lag, the AS will decrease so all we see is P.

The Fed keeps trying, but now no lag in AS.

If the Fed stops inflationary expectations will continue to AS, now Q.

Can we eliminate inflation by AS (short run)?

No, these policies are “doomed to failure.”

Remember, inflation is a monetary phenomenon,

and caused by shifts in the AD.

• So, what are these policies?

• Wage & price controls

• Tax-based Incomes policies (TIPs)

• Supply-side incentives to boost output.

• Remove barriers that keep wages/prices from falling.

To eliminate inflation we must AD

But, we’ll have to contend with inflationary expectations.

How?

• Gradualism approach

• Going cold turkey

• Indexing

• Wages, mortgage interest rates, taxes …

And, what of the role of government?

Increasing share of GDP & growth is slower, recoveries taking longer. Benefits of G may not be worth the costs.

Keynes & the Paradox of Thrift

• Savings role in the economy is negative!

• Why? Because income is determined by spending.

• So, if we increase our saving (overall) that means we are decreasing our consumption spending.

• This will decrease income/employment/production.

• And, there is a multiplier effect.

• As income falls, so to does savings!!!

• Why does this happen? In Keynesian model, saving isn’t automatically channeled into investment.

Current Problems & Policy Questions

AD

Q = Real GDP

P1

Prices

Q*

ASLR

ASSR

AD’

Q’

P2

•Decreased AD sends us into recession.

AD’’

P3

AD’’’

•Fed expands the MS to stimulate economic growth. Doesn’t work.

•Eventually, there’s an overreaction.

•Sharply rising AD leads to high levels of inflation.

Is Obama a

Keynesian?

Monetary Theory:

ECO 285 – Macroeconomics – Dr. D. Foster

Monetarists vs. Keynes