Monetarism asserts that monetary policy is very powerful, but that it should not be used as a macroeconomic policy to manage the economy. There is thus an apparent contradiction—if monetary policy is so powerful, why not use it, for example, to create more employment in the economy?
First of all, it should be noted that monetarism was an attempt by conservative economists to reestablish the wisdom of the classical laissez faire recommendation and was an attack on the activist macroeconomic policy recommendations of the Keynesian economists. It is thus helpful to briefly examine the historical background against which monetarism developed as a new school of macroeconomic thought.
The macroeconomic thought dominating capitalist economies prior to the advent of Keynesian economics in 1936 has been widely known as classical macroeconomics. Classical economists believed in free markets. They believed that the economy would always achieve full employment through forces of supply and demand. So, if there were more people looking for work than the number of jobs available, the wages would fall until all those seeking work were employed. Thus, market forces guaranteed full employment. The full employment level of employment resulted in a fixed aggregate output/income. The price level (and thus the inflation rate) was determined by the supply of money in the economy. Since, the output level was fixed, a 10 percent increase in money supply would lead to a 10 percent increase in the price level—too many dollars chasing too few goods. The real interest rate was also determined by forces of supply and demand in the market for funds that could be loaned out. The nominal interest rate was then simply the sum of the real interest rate and the prevailing inflation rate. Classical economists thus had an unwavering faith in the selfadjusting market mechanism. However, it was crucial for the working of the market mechanism that there was perfect competition in the market, and that wages and prices were fully flexible.
Classical economists did not see any role for the government. As market forces led to full employment equilibrium in the economy, there was no need for government intervention. Monetary policy (increasing or decreasing the money supply would only affect prices—it would not affect important real factors such as output and employment. Fiscal policy (using government spending or taxes), on the other hand, was perceived as harmful. For example, if the government borrowed to finance its spending, it would simply reduce the funds available for private consumption and investment expenditures—a phenomenon popularly termed as "crowding out." Similarly, if the government raised taxes to pay for government spending, it would reduce private consumption in order to fund public consumption. Instead, if it financed spending by increasing the money supply, it would have the same effects as an expansionary monetary policy. Thus, classical economists recommended use of neither monetary nor fiscal policy by the government. This hands-off policy recommendation is known as laissez faire.
Keynesian economics was born during the Great Depression of the 1930s. The classical economists argued that the self-adjusting market mechanism would restore full employment in the economy, if it deviated from full employment for some reason. However, the experience of the Great Depression showed that market forces would not work as well as the classical economists had believed. The unemployment rate in the United States rose to higher than 25 percent of the labor force. Hard working people were out in the street looking for nonexisting jobs. Wages fell quite substantially. However, the lower wages did not re-establish full employment.
Economist John Maynard Keynes argued that the self-adjusting market forces would take a long time to restore full employment. He predicted that the economy would be stuck at the high level of unemployment for a prolonged period, leading to untold miseries. Keynes explained that classical economics suffered from major flaws. Wages and prices were not as flexible as classical economists assumed—in fact, nominal wages were very sticky in the downward direction. Also, Keynes argued that classical economists had ignored a key aspect that determined the level of output and employment in the economy—the aggregate demand for goods and services in the economy from all sources (consumers, businesses, government, and foreign sources). Producers create goods (and provided employment in the process) to meet the demand for their products and services. If the level of aggregate demand was low, the economy would not create enough jobs and unemployment could result. In other words, the free working of the macroeconomy did not guarantee full employment of the labor force—the deficient aggregate demand was the cause of unemployment. Thus, if aggregate private demand (i.e., the aggregate demand excluding government spending) fell short of the demand level needed to generate full employment, the government should step in to make up for the slack.
The central issue underlying Keynesian thought was that those individuals who have incomes demand goods and services and, in turn, help to create jobs. The government should thus find a way to increase aggregate demand. One direct way of doing so was to increase government spending. Increased government spending would generate jobs and incomes for the persons employed on government projects. This, in turn, would create demand for goods and services of private producers and generate additional employment in the private sector. Keynesian economists thus recommended that the government should use fiscal policy (which includes decisions regarding both government spending and taxes) to make up for the shortfall in the private aggregate demand to reignite the job creating private sector. Keynesian economists even went so far as to recommend that it was worthwhile for the government to employ people to in meaningless jobs, as long as they were employed.
The Roosevelt administration did follow Keynesian recommendations, although reluctantly, and embarked on a variety of government programs aimed at boosting incomes and the aggregate demand. As a result, the Depression economy started moving forward. The really powerful push to the depressed U.S economy, however, came when World War II broke out. It generated such an enormous demand for U.S. military and civilian goods that factories in the United States operated multiple shifts. Serious unemployment disappeared for a long period of time.
Modern Keynesians (also, known as neoKeynesians) recommend utilizing monetary policy, in addition to fiscal policy, to manage the level of aggregate demand. Monetary policy affects aggregate demand in the Keynesian system by affecting private investment and consumption demand. An increase in the money supply, for example, leads to a decrease in the interest rate. This lowers the cost of borrowing and thus increases private investment and consumption, boosting the aggregate demand in the economy.
An increase in aggregate demand under the Keynesian system, however, not only generates higher employment but also leads to higher inflation. This causes a policy dilemma—how to strike a balance between employment and inflation. According to laws that were enacted following the Great Depression, policy makers are expected to use monetary and fiscal policies to achieve high employment consistent with price stability.
By 1950, Keynesian economics was well established. Keynesian macroeconomic thought became the new standard in place of the old classical standard. The birth of monetarism took place in the 1960s. The original proponent of monetarism was Milton Friedman, now a Nobel Laureate. The monetarists argue that while it is not possible to have full employment of the labor force all the time (as classical economists argued), it is better to leave the macroeconomy to market forces. Friedman modified some aspects of the classical theory to provide the rationale for his noninterventionist policy recommendation. In essence, monetarism contends that use of fiscal policy is largely ineffective in altering output and employment levels. Moreover, it only leads to crowding out. Monetary policy, on the other hand, is effective. However, monetary authorities do not have adequate knowledge to conduct a successful monetary policy—manipulating the money supply to stabilize the economy only leads to a greater instability. Hence, monetarism advocates that neither monetary nor fiscal policy should be used in an attempt to stabilize the economy, and the money supply should be allowed to grow at a constant rate. Friedman contends that the government's use of active monetary and fiscal policies to stabilize the economy around full employment leads to greater instability in the economy. He argues that while the economy will not achieve a state of bliss in the absence of the government intervention, it will be far more tranquil. The monetarist policy recommendations are similar to those of the classical economists, even though the reasoning is somewhat different.
A detailed discussion of the key elements of monetarism follows. In particular, an effort is made to explain the theoretical framework that monetarists employ and how they arrive at policy recommendations regarding the use of monetary and fiscal policies.
Based on Richard Froyen in Macroeconomics: Theories and Policies, the key propositions advanced by monetarist economists (in particular, Milton Fried-man) can be summarized as follows.
The above four propositions lead to some key policy conclusions. Based on Froyen, the four monetarist propositions provide the bases for the following two policy recommendations:
First, stability in the growth of money supply is absolutely crucial for stability in the economy. Monetarists further suggest that stability in the growth of money supply is best achieved by setting the growth rate at a constant rate—this recommendation has been termed as the constant money supply growth rule. The chief proponent of monetarism, Milton Friedman, has long advocated a strict adherence to a money supply rule. Other monetarists favor following a less inflexible money supply growth rate rule. However, monetarists, in general, are in favor of following a rule regarding the money supply growth rate, rather than tolerating fluctuations in the monetary aggregate (caused by discretionary monetary policy aimed at stabilizing the economy around full employment). This policy difference from the activist economists (primarily, the Keynesians) is at the heart of the monetarist debate. This component of the debate is known among professional economists as "rule versus discretion" controversy.
One should note that while monetarists are adamant about following a money supply rule, they are not so rigid regarding the rate at which the money supply growth rate should be fixed. A general rule of thumb suggests that the money supply should grow between 4 and 5 percent. How do economists arrive at these numbers? It is assumed that the long-term economic growth potential of the U.S. economy is about 3 percent per annum, i.e., the real GDP can grow at about 3 percent. So, the money supply has to grow at about 3 percent just to keep the price level from falling—economists do not like falling prices because they cause other problems in the economy. An inflation rate of 1-2 percent per annum is considered acceptable. To generate 1-2 percent inflation, the money supply must grow at 1-2 percent above the growth rate of the real GDP. In effect, then, to have a modest 1-2 percent inflation, the money supply should grow at about 4-5 percent. The issue of the money supply growth rule will be further clarified when theoretical principles underlying monetarism are discussed later.
Second, fiscal policy is ineffective in influencing either real or nominal macroeconomic variables. It has little effect, for example, on either real output/employment or price level. Thus, the government can't use fiscal policy as a stabilization tool. Monetarists contend that while fiscal policy is not an effective stabilization tool, it does lead to some harmful effects on the private sector economy—it crowds out private consumption and investment expenditures.
The four monetarist propositions discussed in the preceding section, from which the two policy recommendations follow, are supported by theoretical reasoning and support. In general, the theoretical framework employed by monetarist economists is a modified version of classical macroeconomic theory. The modifications were needed to address the Keynesian criticisms of the classical theory and to establish monetarist policy conclusions. Theoretical support for each of the four propositions will be briefly discussed in this section.
This proposition—that money supply has a dominant effect on nominal
income—is the most basic part of the theoretical structure of the
monetarist counterrevolution. Proposition one is based on a key classical
theoretical framework known as the
quantity theory of money.
Classical economists had argued that the quantity (or the supply) of
money determines only price level (a
variables such as output and employment. The quantity theory of money is
used to establish the link between the quantity of money and the price
level, and thus its name simply emphasizes the importance of the quantity
of money. The quantity theory of money was written in the form of the
MV = Py,
is the quantity or stock of money;
is the aggregate price level; y is a measure of the aggregate real
output, say, the gross domestic product; and
stands for the income
of money that is defined as:
Apart from the notion of the velocity of money, the other variables that enter the quantity theory of money are relatively straightforward. Noting that "Py" is nothing but the nominal aggregate output (the value of the gross domestic product at current prices), the income velocity of money can be thought of as the number of times each dollar in the nation's money supply circulates to finance the current nominal income. The velocity, then, is just the turnover rate of money. Necessarily, the income velocity of money is greater than one. The gross domestic product at current prices in 1998 was about $8,200 billion, and a narrowly defined measure of the money supply (called Ml) was about $1,100 billion. These numbers suggested the income velocity of money was approximately 7.5 in 1998.
How does the classical quantity theory of money provide the linkage between changes in the money supply and changes in the price level? In order to translate the equation "MV = Py" into the quantity theory of money, two main assumptions are made. First, it is argued that velocity is constant. Classical economists, in particular Irving Fisher, argue that the velocity of money is determined largely by payment technology and payment habits of the society. For example, frequent use of charge cards, rather than money (such as cash or checks) increases the velocity of money. Similarly, if workers are paid on a weekly rather than a monthly basis, the velocity will be greater. It is however, argued that the foregoing are examples of institutional characteristics, and institutional factors that determine the equilibrium level of the velocity change very slowly. As a result, the velocity of money can be regarded as fixed or constant in the short run.
The second key classical assumption (in fact, an inference of classical macroeconomic theory) was that real output (measured by real gross domestic product) is constant or fixed. As alluded to in the previous sentence and discussed under a brief overview of classical theory, the constancy of real output is a result of classical macroeconomic reasoning, rather than a simple assumption. The fixed output is a result of the full employment level. The full employment of the labor force, in turn, is assured by a set of assumptions about the labor market. In particular, perfect competition, perfect information, and wage/price flexibility always result in the full employment of workers.
Once the above two assumptions are made (i.e., velocity and real output are fixed), the classical quantity theory of money, given by the expression MV = Py, easily connects the changes in money supply to changes in price level. More specifically, a money supply change leads to a proportionate change in price level. For example, if money supply increases by 10 percent, price also increases by 10 percent. The reasoning behind this linkage between the money supply and the price level is as follows: An increase in the money supply would lead to an increase in spending by individuals. However, given that real output is assumed to be constant, the increased spending can only lead to an increase in the price level. This explanation is often summarized as "too many dollars chasing too few goods."
While monetarists, led by Nobel Prize winner Milton Friedman, initially wanted to use the classical quantity theory of money to explain the linkage between the money supply and the nominal GDP/income, in light of the Keynesian theory and the experience of the Great Depression, they could no longer assume that real output level was fixed. Thus, Fried-man modified the classical quantity of money to allow for variations in real output. However, if velocity is assumed constant, "MV = Py" still means that an increase in money supply will lead to a proportionate change in "Py." Friedman even argues that the velocity of money does not have to be assumed constant. Instead, he argues that the velocity can be allowed to change. However, the changes in velocity are predictable. This complicates the explanation of the linkage between money supply and nominal income somewhat. It no longer means that an increase in the money supply will lead to a proportionate increase in the nominal GDP, because now the velocity can also undergo a change. However, the modified quantity theory of money still links money supply and nominal income. It should be noted that this linkage between money supply and the nominal income does not separate the effects of money on nominal income into changes in the price level (P) and changes in the real output (y). This issue is further dealt with in propositions two and three.
As illustrated above, proposition one does not breakdown a change in nominal output into price and real output components. Friedman argues that, in the short run, both price level and real output increase when the money supply increases. As real output increases, the employment level will change as well, since the increased output has to be produced by a greater number of workers (the level of technology is assumed to remain unchanged in the short run). Monetarists explain the increase in employment and real output as an increase in money supply leads to an increase in price level. However, workers do not ask for increases in nominal wages to offset the price increase, as they are initially unaware of it. However, producers know the increased prices their goods and services are commanding. Thus, from the producers' (employers') point of view, the real wage paid actually falls (i.e., the dollar wage paid remains the same whereas the price level increases). This effectively lowers the cost of hiring workers and they employ an increased number of workers, leading to higher employment and higher real output.
An important implication of this proposition is that a change in money supply does more than influence nominal variables such as price level—it affects real variables such as the employment of labor and real output of goods and services. Monetarists further argue that money, of all the sources of demand in the economy, has the most dominant influence on real variables.
While proposition two deals with the effects of short-term changes in the money supply, proposition three discusses its long-term effects. Crucial to increases in output and employment in proposition two is the decline in real wages paid to workers. However, the decline in real wage was caused due to workers being unaware of the increase in price levels. It is argued that workers cannot remain uninformed about the price level increase, as they pay higher prices for the goods and services they consume. Once workers understand the true extent of the increase in the price level, they will demand an increase in nominal wages (wages in current dollars) to compensate for the increase in the price level. Strictly speaking, they would want nominal wages to increase by the same percentage as the increase in the price level to restore the previous level of their real wage. Once the real wage paid to workers rises to the level it was before the increase in the price level, employers no longer enjoy a cost savings due to lower real wages and, as a result, they cut back labor employment to the level that existed before the price increase. Consequently, the real output level also falls back to the previous level.
The foregoing implies that once enough time passes for workers to adjust their price expectations, the effects of money supply on real variables such as employment and real output evaporate. Does this mean that changes in money supply have no effect on the economy? According to monetarists, this is not the case. The effect is only on the nominal variables—in this case the price level and nominal wage rate, both of which rise proportionate to the initial rise in the money supply. As workers recognize the increase in prices and receive nominal wage adjustments, employment and output levels return to long-term levels, similar to classical fixed output and employment levels. Even as the real variables do not change over the long-term, the increased levels of prices and nominal wages remain.
An important implication of proposition three is that an increase in money supply has no useful effect on the economy, since real variables such as output and employment remain unaffected but prices and wages increase.
The fourth proposition re-emphasizes the monetarists' faith in the private sector and free market. Monetarists rely on a macroeconomic model that illustrates that the private sector of the economy is not prone to massive fluctuations and is inherently stable. On the other hand, the public sector (as reflected by the behavior of the Federal Reserve Bank in manipulating money supply) is unstable. At a more theoretical level, proponents of monetarism argue that investment (a component of private sector demand) is very sensitive to changes in interest rates, whereas the demand for money (the amount of money people want to hold in cash and checkable deposits for various purposes) is not very sensitive to changes in interest rates. While the exact theoretical explanation is quite involved, the preceding assumptions regarding the opposite responses of investment and money demand to interest rates lead to a important theoretical outcome—manipulating the money supply leads to instability in the economy in terms of output, employment, and inflation, whereas changes in the levels of consumption and investment lead to minimal fluctuations in the economy.
A corollary of the foregoing argument involves the third component of aggregate demand, government spending. Aggregate demand is considered to mainly comprise consumption, investment, and government spending. Therefore, like consumption and investment, change in government spending does not trigger large fluctuation in the economy. This also means that fiscal policy in the form of government deficit spending is not very effective in influencing employment and real output in the economy. Monetarists, however, do infer that government deficit spending is not harmless. It leads to increases in interest rates, which reduce private sector spending on consumption and investment—a phenomenon popularly called crowding out.
In sum, the fourth proposition implies that the private sector in itself is stable—instability is introduced by fluctuations in money supply (monetary policy), and fiscal policy, while not causing instability, leads to the crowding out phenomenon.
Monetarist policy recommendations basically assert that the government should not use monetary and fiscal policies to stabilize the economy. This, not surprisingly, sounds like the laissez faire recommendation of classical economists. However, the reasoning behind the policy recommendations advanced by the proponents of monetarism are somewhat different from those used by classical counterparts.
The monetarist policy recommendations have two key aspects—one relates to the use of monetary policy and the other relates to the use of fiscal policy. The four propositions discussed above form the major foundations for monetarist policy recommendations with respect to the conduct of monetary and fiscal policies. The monetarist reasoning behind policy recommendations is briefly discussed below.
With respect to monetary policy, monetarists emphatically recommend that monetary authorities (the Federal Reserve System in the United States) should not use discretionary monetary policy. That is, the nations's money supply should not be manipulated to stabilize or fine tune the economy. The notion of stabilization in turn implies an effort to create stable economic growth with low or no inflation. Such a stabilization policy, if successful, would smooth out the bumps in the path of economic growth—both recessions and booms would be moderated and the economy would grow at a rate consistent with its long-term potential. Monetarists do not believe that the Federal Reserve can conduct a successful monetary policy aimed at stabilizing the economy. They admit that monetary policy does have a dominant effect on nominal GDP (see proposition one). However, monetary policy affects real variables such as employment and real output, whose growth is considered desirable, only in the short-term (see proposition two). In the long term, real output and employment are determined at the equilibrium level, and thus a money supply increase ultimately only affects the price level and inflation, which is not a desirable outcome (see proposition three). Monetarists, therefore, argue that beneficial effects of monetary policy are short-lived and harmful effects prevail. This is one of the reasons monetarists do not recommend using discretionary monetary policies.
Monetarism supporters further argue that the use of discretionary policy destabilizes the economy even further, rather than stabilizing the economy around full employment with low inflation. Monetarists use propositions one and two to support this contention. However, they argue that the monetary instrument is too powerful to be used successfully in stabilizing the economy. Monetary authorities do not have enough knowledge of the way the economy and monetary policy work to use the policy successfully. In particular, they contend that monetary policy affects the economy with long and variable lags. This implies that we do not know exactly when the effects of a dose of monetary policy will show up in the economy. As a result, use of monetary policy can exacerbate the economic fluctuations in the economy, and the resulting instability would be far greater than that found if no monetary policy were used at all.
Consider, for example, that the economy is in recession and that it is going to come out of recession on its own in three months. However, the Federal Reserve, not knowing when the recession will end, conducts an expansionary monetary policy by increasing money supply to eliminate the recession. Now, suppose that the effects of this monetary policy show up in the economy in six months when the economy has already rebounded and is growing rapidly on its own. The powerful push from the monetary policy could have a negative effect-the economy could overheat, leading to unwanted inflation. Thus, monetarists argue that the monetary authorities, even with good intentions, do not have the knowledge to successfully conduct stabilization using monetary policy. Of course, monetarists also argue that the Federal Reserve is not to be trusted with the manipulation of money supply. They say that the Federal Reserve has made a number of costly mistakes in the past in the conduct of monetary policy. The most infamous example is the decrease in money supply during the Great Depression when the economy needed an increase in money supply to cope with the economic crisis. The proponents of monetarism, therefore, advocate that the Federal Reserve should be kept from tampering with monetary policy—instead of manipulating money supply to stabilize the economy, the Federal Reserve should allow money supply to grow at a constant rate. In other words, the Federal Reserve should follow a rule rather than exercising its discretion. This will keep the Fed from being a source of instability. While monetarists agree that following a rule does not imply that the economy would attain nirvana (a state of bliss in which there are no fluctuations), the economy would experience smaller fluctuations.
Finally, monetarists insist that ultimately, there is no need to stabilize the economy because the private sector is inherently stable (proposition four). It is discretionary monetary policy that introduces instability into the economy. The proponents of monetarism use the inherent stability argument to further strengthen their recommendation of following a constant money supply growth rule.
With respect to fiscal policy, monetarist's policy recommendations are broadly similar to those of the classical economists. The monetarists argue that government fiscal policy (especially deficit spending) is ineffective in affecting employment and real output in any significant manner in either the short or long term (an indirect implication of proposition four). Fiscal policy also does not appreciably influence price level. Thus, on the surface, the conduct of fiscal policy may appear inconsequential. However, monetarists point out that borrowing by the government will lead to an increase in interest rates which, in turn, reduces private expenditures on consumption and investment—government spending crowds out private sector spending. Thus, fiscal policy based on borrowing is not harmless. Increased government spending, financed by printing money, of course, has effects similar to expansionary monetary policy.
Monetarists thus advocate using neither discretionary monetary or discretionary fiscal policy to stabilize the economy—they would like to see money supply grow at a constant rate.
While proponents of monetarism have staged a very vocal and visible attack on the activist policy recommendations of Keynesian economists, they have not been successful in dethroning the Keynesians. One can safely argue that the United States and many other capitalist countries largely follow Keynesian policy recommendations at the current time. In fact, following the Keynesian revolution, the U.S. Congress has enacted laws that commit the U.S. government to promoting high employment consistent with a stable price level. Officially, both fiscal and monetary policies are considered effective instruments of macroeconomic policies aimed at stabilizing the economy through full employment. However, due to the slow speed at which fiscal policy reacts to developments in the U.S. economy, monetary policy has come to shoulder the major burden of stabilizing the economy.
Does this mean that monetarism has completely failed to influence the conduct of macroeconomic policies? Monetarists did fail in having their key recommendation, the constant money supply growth rule, accepted by monetary authorities. However, they have succeeded in driving home the point that manipulating the money supply has powerful consequences and that it can potentially be harmful to the economy. The monetary policy authorities of today realize the limitations of monetary policy. As a result, they do not take rash steps in either direction. The Federal Reserve watches the economy carefully and collects a great deal of information about the state of the economy before taking a major monetary policy action. Thus, monetarists should not be considered as having failed completely—they have succeeded in, at least, adding a note of caution in the conduct of monetary policy.
[ Anandi P. Sahu , Ph.D. ]
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