Chapter 17

1. Chapter 17 Monetarism © OnlineTexts.com p. 1

2. Monetarism • Monetarism is an economic school of thought that stresses the primary importance of the money supply in determining nominal GDP and the price level. • The "Founding Father" of Monetarism is economist Milton Friedman. © OnlineTexts.com p. 2

3. Characteristics of Monetarism • The theoretical foundation is the Quantity Theory of Money. • The economy and financial markets are inherently stable. • The Fed should be bound to fixed rules in conducting monetary policy. • Fiscal Policy is often bad policy. A small role for government is good. © OnlineTexts.com p. 3

4. The Equation of Exchange • The equation of exchange (a tautology)is the building block for monetarist theory. M x V = P x Y M = money supply P = price level V = velocity Y = real GDP © OnlineTexts.com p. 4

5. The Quantity Theory of Money: The Short Run • Monetarists make a seemingly innocuous assumption that velocity is stable in the short run, or M x V = P x Y where V implies that velocity is fixed in the short run. • Any change in M1 will impact P × Y (nominal GDP). Changes in the money supply are the dominant forces that change nominal GDP. © OnlineTexts.com p. 5

6. The Quantity Theory of Money: The Long Run • Monetarists believe that the economy is always near or quickly approaching full employment because markets work well. • In the long run, output will be equal to potential output, YP. © OnlineTexts.com p. 6

7. The Quantity Theory of Money: The Long Run • In the long run, the quantity theory of money becomes: • 'M' and 'P' are the only variables in this equation that change in the long run. • In the long run, changes in the money supply only cause inflation. © OnlineTexts.com p. 7

8. The Rules vs. Discretion Debate • Monetarists argue that control of the money supply (and, hence, inflation) should not be left to the discretion of central bankers. • They propose a money-growth rule: The Fed should be required to target the growth rate of money such that it equals the growth rate of real GDP, leaving the price level unchanged. © OnlineTexts.com p. 8

9. The Rules vs. Discretion Debate • Keynesians advocate giving central bankers discretion. • They attribute little significance to the Quantity Theory of Money because they believe that velocity is unstable. • Keynesians also argue that the economy is subject to periodic instability, so it is dangerous to take discretionary power away from the central bank. © OnlineTexts.com p. 9

10. Fiscal Policy • Because Monetarist dislike big government and tend to trust free markets, they do not like government intervention and believe that fiscal policy is not helpful. • Where fiscal policy could be beneficial, monetary policy can do the job better. • Automatic stabilizers are sufficient sources of fiscal policy. © OnlineTexts.com p. 10

11. Empirical Evidence of Monetarism • The suppositions of monetarism depend crucially on • the stability of velocity • the efficiency of markets © OnlineTexts.com p. 11

12. Empirical Evidence of Monetarism • Recent evidence suggests that velocity has been unstable and unpredictable since the 1980s. © OnlineTexts.com p. 12

13. Money and Nominal GDP • The lack of correlation between M1 and nominal GDP also depicts the instability of velocity. © OnlineTexts.com p. 13

14. Why did velocity become unstable? • Most economists think the breakdown was primarily the result of changes in banking rules and other financial innovations. • In the 1980s, interest-earning checking accounts altered the demand for money and further blurred the line between transaction and savings accounts. • Also, money markets, mutual funds and other financial assets became substitutes for traditional bank deposits. © OnlineTexts.com p. 14

15. Keynesians vs. Monetarists • Keynesians and Monetarists fought head-to-head in the 1970s. • Most economists conclude that Keynesians won the war, but Monetarists won many battles. © OnlineTexts.com p. 15

16. Keynesians vs. Monetarists:Key Differences © OnlineTexts.com p. 16