UCL ECON7003 Money and Banking

Lecture 14.

Rise of monetarism.

Limited debate on monetary policy in post-war period.Post-war boom. Post-war consensus. Accommodating monetary policy. Balance of Payments and problems of ‘stop-go’.

Return of macroeconomic turbulence: the debate is revived.Financial deregulation, fiscal expansion, end of Bretton Woods system, inflationary pressures. Stagflation. IMF loan. Rise of monetarism in UK. Note: Macro debate and macro turbulence.

The theory of monetarism.

Phillips curve.

Unemployment and (wage) inflation, 1861-1913.

From Phillips’s 1958 article.

BUT: Labour government of 1974-9 faced:‘Stagflation’.i.e. breakdown of Phillips curve relationship.

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90

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9188

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82

8384

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8792

94

81

Breakdown of the stable Phillips CurveBreakdown of the stable Phillips Curve

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6364

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61

99

9800

01 02

π (%)

u

From late 1960s, negative relationship between u and π no longer evident

Cambridge:

MD = kPY

k is factor of proportionality / ‘Marshallian’ or ‘Cambridge’ k.

Reformulates QTM as theory of money demand.

Keynes:

MD = k(r).PY

Not compatible with QTM.

k not constant – cyclical fluctuations, etc.

Friedman:

MD = k(rB, r1 . . . rn).PY

rB: return on bonds

r1 . . . rn : rates of return (explicit or implicit) on other assets besides bonds.

Restatement of QTM.

Friedman:

Income may fluctuate (cycle, etc.), so how justify concept of stable MD?

Individuals smooth out expenditure:

‘Permanent Income’:

Saving / dis-saving over perceived / expected average lifetime earning.

i.e. MD responds to wealth, as flow > stock variable.

Money demand has a stable relation to wealth, thus defined.

Neutrality of money – LR / SR distinction:

‘Old’ QTM:

ΔM → ΔP only, with ΔY = 0.

i.e. ΔP / ΔM = 1.

Friedman: M is neutral in LR, as in old QTM:

i.e. ΔLRP / ΔM = 1.

BUT: ΔM may have SR effect on Y:

ΔM → ΔP, but also ΔSRY > 0.

i.e. ΔSRP / ΔM < 1.

This SR effect gradually unwinds till we have

ΔLRP / ΔM = 1.

Friedman’s Adaptive Expectations Hypothesis / ‘fooling’ model / effect of SR changes in MS:

Wage-earners’ expectations of movements in P take time to adapt.

P↑ and wage-earners underestimate change.

→ they supply more labour than if they had realised how much their real wage has been eroded by inflation.

Model works symmetrically in reverse / overestimation.

P, Pe

Pe

P

≡ the ‘short run’

‘Natural rate’

‘Old’ classical:

Unique point of equilibrium / self-regulating level.

This is YFE.

Friedman: This is unrealistic.

→ redefined LR sustainable level as ‘natural rate’:

(1) Will always be some u.

At equilibrium / self-sustaining level: ‘natural rate’ – NRU.

(2) NRU is not constant.

Changes with changing labour market conditions.

Monetarism’s optimal MS rule:

Set growth rate of M at same rate as growth of Y.

→ MR equilibrium:

MV = PY

MR: y = ye + classical assumption of V = V

→ P = V/Y.M = const. x M, say κM, i.e. QTM.

π ≡ (P – P-1) / P-1

= (κM – κM -1) / κM -1

= (M – M -1) / M -1

i.e. MR equilibrium:

π = γ, where γ is growth rate of M.

BUT: Problems of CB in controlling MS – review.

CB is not the only player in MS process:

Decisions of commercial banks over deposit creation / excess reserves, etc.

Decisions of NBP affect cash-deposit ratio.

Decisions of borrowers from banks affect interest rates.

Money market equilibrium with monetarist assumptions:

• MS exogenous.

• MD a stable function of income.

MD/P(ye)

MS/P

r

M/PM/P(ye)

MD/P(ye)

MS/P

r

M/PM/P(ye)

Unique point of equilibrium:

MD/P(ye) = MS/P

MS curve super-imposed on MD curve.

With MD at MD0/P (MD

1/P), r rise (fall) without limit.

Keynesianism: r determined in money market.

Monetarism: r undetermined in money market.

Disequilibrium in money market on monetarist assumptions.

MD/P(ye)

MS0/P

M/P

r

MS1/P

r → +∞

r → -∞

MD/P(ye)

MS0/P

M/P

r

MS1/P

r → +∞r → +∞

r → -∞r → -∞

Effects of discretionary monetary policy -- monetarist view.

Discretionary monetary policy → Downward (upward) pressure on r.

→ MS above (below) unique level appropriate to ye

→ y deviates above (below) ye.

All points where y ≠ ye are off money market equilibrium.

LM is stationary at unique position appropriate to ye.

MS < MD

IS

MD/P(ye)

MS0/P

M/P

r

MS1/P

r → +∞

r → -∞

r

Y

LM

MS > MD

YNR

MS < MD

IS

MD/P(ye)

MS0/P

M/P

r

MS1/P

r → +∞r → +∞

r → -∞r → -∞

rr

Y

LM

MS > MD

YNR

Monetary policy “twice damned”: IS aspect – review.

Monetarism: IS flattish:

I highly r-sensitive.

Slope represents marginal efficiency of capital.

i.e. S-side influences on investment demand.

Keynesianism: IS steep.

r is only one among many determinants of I.

Likely to be relatively minor.

Decisions likely to be very LR.

i.e. not dependent on SR factors like fluctuations in r.

NOTE ALSO:

Keynes himself:

• Un-modellable D-side factors:

• Mood (investor optimism, pessimism).

• Expectations.

• Volatility.

“Human decisions affecting the future … cannot depend on strict mathematical expectation… the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities.

[We act] “choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance”.

fig

GDP

Investment

Volatility of Investment greater than Volatility of GDPSloman p. 487, Box 17.6

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1978 1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000 2002

GD

P, I

nves

tmen

t (%

ann

ual c

hang

e)

GDP

Monetary expansion → r↓ → economy moves down IS.

Monetary contraction is then implemented as a counter-measure.

BUT overshoots ye.

Discretionary MP and generation of cycle: monetarist view.

MD/P(ye)

MS0/P

M/P

r

MS1/P

r → +∞

r → -∞

MD/P(ye)

MS0/P

M/P

r

MS1/P

r → +∞r → +∞

r → -∞r → -∞

MS < MD

IS

MD/P(YNR)

MS0/P

M/P

r MS

1/P

r ? +?

r ? +?

r

Y

LM

MS > MD

YNR

‘Long and variable lags’ in effects of discretionary monetary policy.

→ impossible to stabilise AD through this means.

Expansions and contractions in themselves net to zero.

But outcome nevertheless adverse -- economy harmed by instability.

Discretionary monetary policy is principal cause of business cycle.

OTime

Path (a) – without intervention

Path (c) – undesired outcome of interventionPath (b) – aim of intervention

The intervention has increased the amplitude of the fluctuations!

Y

Fluctuations and lags

Monetarist alternative to discretionary monetary policy:

Should be conducted according to a rule.

Any rule is better than discretion.

Friedman’s preference:

Constant money growth rule:

Growth rate set according to LR growth rate of economy.

LR economic growth → ΔMS is necessary

BUT MS should be set in way that minimises inflationary expectations.

Governments cannot be trusted with discretion to do this:

they have other motives.

→ Monetary policy should be set by rules that are• clearly-identifiable• publicly-announced• credibly enforceable

e.g. in step with the trend rate of growth.

Should be administered by a monetary authority independent of government.

Non-inflationary increase in MS by CB following MS rule in low-π conditions – preview.

ye0 ye

1 y

IS

MD/P(ye0) MD/P(ye

1)

MS0/P

M/P

r

MS1/P

r

r

LM(ye0) LM(ye

1)

‘Real’ economy is insulated from destabilising effects on r from

within the money market.

ye0 ye

1 y

IS

MD/P(ye0) MD/P(ye

1)

MS0/P

M/P

r

MS1/P

r

r

LM(ye0) LM(ye

1)

‘Real’ economy is insulated from destabilising effects on r from

within the money market.

ye0 ye

1 y

IS

MD/P(ye0) MD/P(ye

1)

MS0/P

M/P

r

MS1/P

r

r

LM(ye0) LM(ye

1)

‘Real’ economy is insulated from destabilising effects on r from

within the money market.

ye0 ye

1 y

IS

MD/P(ye0) MD/P(ye

1)

MS0/P

M/P

r

MS1/P

r

r

LM(ye0) LM(ye

1)

‘Real’ economy is insulated from destabilising effects on r from

within the money market.

Money market:

ye to ye′ determined on S-side.

→ MD increases from MD(ye) to MD(ye′).

CB follows its MS growth rule

→ MS = MD, i.e. superimposed.

→ no upward or downward pressure on r.

ye0 ye

1 y

IS

MD/P(ye0) MD/P(ye

1)

MS0/P

M/P

r

MS1/P

r

r

LM(ye0) LM(ye

1)

‘Real’ economy is insulated from destabilising effects on r from

within the money market.

ye0 ye

1 y

IS

MD/P(ye0) MD/P(ye

1)

MS0/P

M/P

r

MS1/P

r

r

LM(ye0) LM(ye

1)

‘Real’ economy is insulated from destabilising effects on r from

within the money market.