Lesson 12: Monetary Theory and Policy

1. Lesson 12: Monetary Theory and Policy In this lesson we will develop a framework for understanding and evaluating monetary policy. We will place this in the context of the history of economic thought. We will learn about the Classical economists, Keynesian economics, Monetarism and other approaches. Suggested Reading:  RSU Chapter 22, 23, 26, 28, 29. You might also find the following paper of mine helpful � �Inflation, Common Fallacies and Real Issues,� Graduate School of Business Administration, University of the Witwatersrand Fact and Opinion Papers, No. 3, (Second Edition, 1978). (You may download it from http://www.utdallas.edu/~plewin/F&Opaper.pdf) What Remains of Monetarism? R. W. Hafer Economic Review, Federal Reserve Bank of Atlanta Vol. 86, No. 4, Fourth Quarter 2001 (available at: http://www.frbatlanta.org/filelegacydocs/hafer.pdf)

3. Classical Economics and the Role of Money The ascendancy of laissez faire ideas � Say�s Law and the monetary dichotomy Links in the chain Fed ? M ? the Economy M ? GDP; define Q = GDP/P, where P is the (current weight) GDP deflator. M ? PQ. MV = PQ � the equation of exchange �Fisher; M = kPQ � the Cambridge cash balance equation � Marshall. gM = gk + gP + gQ; Monetary growth = inflation + economic growth (+changes in holdings of money); Question: what is the relationship between gP and gQ? If M and Q are approximately constant we have the Quantity Theory of Money. M ?P or gM = gP

4. Crisis and Disillusionment: The Economics of Keynes and Keynesian Economics The prosperous 1920�s in the U.S. and the struggles in the U.K. Keynes, the man and his experiences The presumptions of Harvey Road Scholar, student, civil servant 1914 The Economic Consequences of the Peace Top of Cambridge, top of the world 1930 A Treatise on Money (1930) 1936 The General Theory (1936) The U.S.and the New Deal � Keynes comes to America Keynesian economics � the market system needs help from the government.

5. The Keynesian Message Consumption (savings), Investment and Money (interest rates). A law of Consumption, the paradox of thrift and the danger of stagnation Investment drives the economy, but its so unreliable because it depends so much on expectations A �new� theory of interest rates, its supply and demand for money, not loanable funds, its all about a preference for liquidity and expectations (again) of interest rates transactions, precautionary, speculative motives It all adds up to a story of dangerous potential instability, the story of Ruritania and the wicked witch. So you�ve gotta have the government pay for something, anything � dig some holes and fill them up again.

6. The Keynesian System in Brief � the Static Version�

7. The Keynesian Cross �

8. Derivation of the Multiplier

9. The Phillip�s Curve

10. The Keynesian determination of interest rates

11. The Monetarist Counterrevolution Resistance at the University of Chicago Milton Friedman and Studies in the Quantity Theory of Money Milton Friedman and A Theory of the Consumption Function Milton Friedman and Anna Schwartz A Monetary History of the U.S. (1971). Presidential address and the stagflation of the 1970�s � The Role of Monetary Policy � Nobel Prize It should not attempt the impossible It is impossible to control the real rate of interest It is impossible to permanently reduce the rate of unemployment (NRH) It should do only what is possible and desirable It should control the supply of money to achieve predictable price stability (minimum inflation or deflation). The only way this can be done is through a constant monetary growth rate � this is Monetarism. It�s like driving a boat with a faulty rudder across a lake Monetarism in the spotlight

12. Alternative Theoretical Explanations Keynesianism in retreat � what�s the alternative?!! gP and gQ are not alternatives 1. A monetary disequilibrium theory (Leland Yeager) � Monetarism enriched. 2. A model of rational expectations 3. The Austrian Model of the Business Cycle (Hayek bounces back � Nobel prize in 1974). An increase in Consumption may plausibly imply a reduction in Investment. Investment is an aspect of the Capital Structure (the structure of production) of the economy. If interest rates are wrong, the production structure may be wrong. Misallocation requires costly and difficult reallocation. Which one � maybe a combination of 1 and 3.

13. But why did Monetarism fail? Look at what's gone from Monetarism and what it never had in the first place. Gone since the early 1980s is a stable velocity of money. Gone in recent times is any consensus about just which monetary aggregate counts. Gone is the ability of the Federal Reserve actually to hit a money growth target. Gone is the possibility of even articulating a "monetary rule," let alone actually following one. So what�s left? A strong sense that indeed �money does matter.� Central banking is more art than science A question: can the market help?

14. What�s left of the Phillips Curve?

15. Summing up: Aggregate Supply and Demand

16. The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else.Practical men who believe themselves to be quite exempt from any intellectual influences are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. John Maynard Keynes.