13 Questions To Gauge the Understanding of Your Monetarism College Exam Readiness
Understanding Monetarism through Thought-Provoking Questions and Answers
When Were The Monetary Targets Implemented and Abandoned For The Government?
Figure 3.1 Inflation and the growth rate of M4. Source: DataStream.
Monetarists favor rules versus discretion - whether it should be a money supply rule or an external convertibility rule is more controversial (even among Monetarists). However, the 'correct' approach will vary from country to country.
What Is The Distinction Between The Monetarism Discussed Here And The Political Monetarism?
Confusion should be avoided between the term 'Monetarism' used here and the popular usage which links it to political leaders like Margaret Thatcher and Ronald Reagan. While Mrs. Thatcher claimed to want to use monetary policy to control inflation, her monetary policy was far from what Monetarists recommended (see Chapter 8). Indeed, her government abandoned monetary targeting in 1986. The distinguishing feature of Mrs. Thatcher's ideology was not monetarism but laisser-faire liberalism. She wanted to disengage the government from the economy and, wherever possible free upmarket force. This is discussed further in the last section of this chapter. Let us now look at monetarism in the context of textbook models.
What Textbook Models Best Discuss the Monetarism Theory?
Money in Static Models
Monetarism is first discussed in the context of textbook models; I have no room for a Monetarist interpretation since it has no explicit monetary sector or assets. In Models II and III, the cases identified with monetarism are often called 'Classical' cases.
The orthodox version of the Classical case derives from what can be thought of as a special case of equation (1.9). This special case relates to what is commonly known as 'the quantity theory of money, though in Classical economics, it would be better called "The Monetary Theory of the Price Level.' In modern economics, it is part of the theory of the demand for real money balances. The quantity theory was based on an identity known as the equation of exchange:
MV = pT
Where M is the number of units of money in circulation; V is the number of times per period each unit is used (velocity); p is the average price level per unit transaction; and T is the number of unit transactions per period. This merely says that the value of money paid out in transactions equals the value of goods sold. The theory is achieved by adding the assumption that V and T' are constant, or at least exogenous to the monetary sector. Hence, we have a theory that prices are proportional to the money stock (a gold standard model that was exogenous).
The modern version of the quantity theory is not based on the turnover of money like the equation of exchange but on the average money balances demanded to be held. The primogenitor of the demand for the function is, ironically, known as the Cambridge Equation since it was associated with such famous Cambridge economists as Pigou and Robert- son. The Cambridge Equation says either that individuals hold nominal money balances in proportion to their nominal income or that they hold real money balances in proportion to their real income.
M = kYp (3.2)
Where M is the money stock, Y is income, p is the price level, and k is a constant. By the late 1950s, however, when Friedman tried to provide empirical support in the United States for a relationship similar to (3.3), this equation was no longer part of the apparatus of Cambridge economists. Indeed, it was complete anathema to most of them.
The only differences between (3.3) and equation (1.11) are that income is not presumed to be fixed at its full employment level, and the interest rate is missing here. The implications of this for the IS-LM diagram are straightforward. If we consider the fixed price level case, it is clear in Figure 1.2 that if the demand for money does not depend upon the interest rate, the demand-for-money line is vertical. This means that for each level of the money supply, there is only one income level at which the demand and supply of money will be equal. The implications for the LM curve are shown in Figure 3.2. The LM curve is vertical.
The Real Balance Effect And The Transmission Mechanism May Result In Modern Monetarism Discrepancies. What Are Some Of These Discrepancies?
What Steps Are Involved In Modern Literature?
What Contributed To The Change In Modern Monetarism?
- The lack of dynamics,
- The absence of a supply side to the model,
- The absence of a government budget constraint and
- The inappropriateness of the model to an open economy. The lack of dynamics is particularly crucial since it is now the rate of inflation rather than the price level, which is judged to be important, and expectations come to have a central role in behavior. Consider, for example, the following statement by Laidler.
Which Part Of The Natural Rate Monetarism Hypothesis Is Crucial?
Demand for Money
What Has Led To The Decline In Interest In Monetarism In the UK?
What Challenges Affect Monetarism In The Financial Sector?
What Is The Solution To The Monetarism Challenges Stated Above?
What is the role of Money and Economic Policy in Monetarism?
If There Is No Role of the Local Government in Adjusting Relative Prices, Does It Affect the World's Budget?
Figure 3.3 Money stock and the price level (1963 = 100). Source: DataStream.
The important structural change was the break from gold. This happened piecemeal but was completed by the time the post-Second World War domestic and international monetary system was established. In place of gold in the banking system's reserves were the liabilities of the Treasury and the Bank of England. The fact could not be avoided that monetary policy was now a central policy concern. For twenty years or so, however, monetary policy seemed to take a back seat to fiscal policy.
As we have seen, fiscal policy was the product of the Keynesian revolution in economic thought. Monetary policy in the two decades after World War Two was largely passive. This arose from the commitment to fix the exchange rate. The connection may not seem obvious, but it is very important. If too much money were circulating in Britain, people would want to spend more abroad on goods or investments. To spend abroad, domestic residents had to buy foreign exchange. The Bank of England had to buy the extra pounds offered with dollars to stop the price of foreign exchange from rising.
In other words, if too much money was generated, the bank had to buy it back with foreign exchange reserves. Hence, even if too much money were 'printed,' this would lead to a loss of reserves and a subsequent policy reversal long before it has caused inflation of prices. In a sense, fixing the exchange rate is a rule controlling the money supply and, in effect, ties domestic inflation to the world economy.
The only monetary problem that governments had was how to finance the budget deficits that fiscal policy required without leading directly to a loss of reserves. The problem arises from the fact that short-term government debt is a reserve asset for the banking system. So government borrowing from banks can lead directly to banks increasing the money supply. This is what is normally meant by the government 'printing" money. Inconsistencies in this policy area were met in the 1960s by the imposition of quantitative ceilings on bank lending, which, in effect, swept the problem under the carpet by inhibiting the major clearing banks and stimulating the growth of uncontrolled 'secondary' banks.
Two separate areas of academic work laid the groundwork for early monetarism; Milton Friedman contributed to both. The first was the demonstration that the aggregate demand for money in the economy was a stable function of a few variables. This underlay the analysis offered on the effects of increasing the money supply. The rule of thumb was that a rise in the money stock would have a transitory effect on output after about a year and a permanent (upward) effect on prices after about two years. Other important ideas were developed in the context of the famous Phillips Curve (see Chapter 7). This had become widely accepted in the early 1960s as it established a stable trade-off between inflation and unemployment. If the government was prepared to accept an increase in inflation, it could achieve a reduction in unemployment. The revised theory, however, held that if unemployment were reduced below what Friedman called the 'natural' rate, this would not lead to stable inflation but ever-accelerating inflation.
The combined effect of these two developments was to reassert the validity of the Quantity Theory, at least in the long run. Expanding the money stock could stimulate employment and output temporarily. Still, ultimately this effect would be reversed (or even more than reversed), and the only lasting effect would be a rise in prices in proportion to the rise in the money stock. However, the relevance of these ideas was not generally appreciated in the United Kingdom in the late 1960s when they hit the academic community because, as we have seen, the money supply was effectively controlled by the commitment to pegging the exchange rate as well as by direct controls on the banks. Indeed, it is ironic to recall that after the election of 1970, an incoming Tory government inherited a balance of payments surplus, a budget surplus, and a controlled money supply. The next three years changed all that in a way that was a little short of disastrous.
Again, a structural change was integral to what followed. There were two important changes in 1971. The first was the floating of the dollar, which was implied by the Nixon speech of 15 August. The second was the domestic reform known as Competition and Credit Control, introduced in September. This removed the direct controls on the banking system and had the effect of allowing the money supply, as measured by M3, to grow at a rate in the order of 25 percent per annum until the end of 1973 (see Figure 3.1, this shows M4 growth which is now the standard broad money series; M3 growth was faster than that of M4 in the 1971-73 period). It should be no surprise that inflation reached about 25 percent in 1975 (the highest level of peacetime inflation in the United Kingdom since the sixteenth century). The reason that this was now possible was that the pound was floating.
Why Did Floating The Pound Have Anything To Do With Competition And Credit Control?
Monetary expansion with fixed exchange rates did not lead to inflation because, as we have seen, the Bank of England would buy back pounds with dollars to stop the exchange rate from falling. Another way to think of this is that tying the value of our money to that of the dollar also ties our inflation rates together within limits. Monetary expansion with floating rates, however, is very different. Since the central bank does not buy back the pounds, people with too many pounds spend them. If the economy is spending more than its income, there is a balance of payments deficit. The value of the pound vis-à-vis the dollar starts to fall. This leads directly to the sterling price of imports rising, and prices in the shops soon follow. Under fixed exchange rates, a monetary expansion leads directly to a reserve outflow. With floating exchange rates, it leads to a depreciating currency and a build-up of domestic inflation as price rises feed through in wage rises and so on.
The expansionary monetary policy of 1971-73 was accompanied by a major fiscal stimulus following the March 1972 Budget of Mr. Barber, which set the course for the massive budget deficits of the late 1970s. There can be no serious doubts that the policies of the 1971-73 period were irresponsible or incompetent (or both), and Britain suffered from them for at least the next decade. The central Monetarist proposition is substantially borne out by the evidence of this period, as Figure 3.1 (see also Figure 1.2) demonstrates. A massive monetary expansion led to a short-lived boom and, later, rapid inflation. This would have been true with or without the Oil Crisis, which just worsened things. (One of the great myths that survived this time is that the oil shock caused British inflation. West Germany had the same oil shock but did not have inflation above 8 percent. Britain's inflation was undoubtedly dominantly homegrown.)
Another irony of the 1970s experience is that the Labour Government of 1974-79 was the first to admit that the Monetarists were right. The Labour Chancellor of the Exchequer, Denis Healey, introduced cash limits on Government expenditure and money supply targets. In this sense, everybody became a Monetarist for a while. Without fixed exchange rates or the gold standard, there has to be some method for controlling the money supply to avoid runaway inflation. There is still disagreement, even within the Monetarist camp, about how rigid monetary control needs to be. More importantly, perhaps, there is disagreement about how fast ongoing inflation can be brought down by monetary control. Many, including Friedman himself, have argued for gradualism because the very tight policy has real severe effects before it works to control prices. Others like Hayek favor a 'short, sharp shock.'
Monetary policy targets were central to the policy strategy of the Thatcher Government after 1979. A gradual tightening of monetary growth rates was intended to bring down inflation over time. However, the Thatcher Government did not stick to its monetarist strategy for very long. There is continuing controversy as to what extent monetary policy was genuinely the cause of the 1980 recession (see Chapter 12 and Chrystal, 1984). However, in practice, monetary targeting was abandoned by the Thatcher Government in the early 1980s, and partly due to this, inflationary forces were allowed to build up again. (For an extended discussion of the financial innovation of the 1980s and monetary policy problems in the late 1980s, see Chapter 8.) Broad money growth of 15-20 percent per annum was permitted for several years in the mid-1990 (see Figure 3.1). Eventually, money supply targets were replaced by exchange rate targets. However, the exchange rate target had to be abandoned in September 1992 due to speculative pressure.
The reasons for the abandonment of monetary targeting were that the favored measures of money - originally M3 and later M4- ceased to have the same stable relationship with the economy as had existed in 1970 (apparently). Hence, discretion dominated rules in monetary affairs. Unfortunately, judgment has to be good for policy to be good. Such was not the case in the late 1980s.
In 1993 the United Kingdom found itself again in search of a guiding principle for monetary policy, having suffered over 550 percent cumulative inflation in two decades but seemingly having learned very little from experience. Chancellor of the Exchequer, Norman Lamont, adopted guiding ranges of MO and M4 as potential monetary policy indicators. Even though M4 had been abandoned earlier as an indicator because of the instability of its link with the economy (velocity). Meanwhile, the United Kingdom had lurched from the excessive looseness in the monetary policy of 1988 to the excessive tightness of 1990-92. The Monetarist concern that discretionary monetary policy would add to economic cycles rather than smooth them was substantially supported by the UK experience. This is particularly alarming given that the government which delivered these extreme lurches in policy was meant to be sympathetic to monetarism.
Thatcher and Monetarism
The monetarism outlined above can be associated with statements such as, 'There is a stable demand function for money' or 'Inflation is always and everywhere a monetary phenomenon.' It is possible to agree with these and yet disagree with the policies pursued by Prime Minister Margaret Thatcher in 1979-91, though she was commonly labeled 'Monetarist.' Indeed, many true Monetarists doubt that Mrs. Thatcher was a Monetarist. Her government largely ignored its monetary targets even when it had them, abandoned monetary targeting, and rekindled in. Action, and then opted for a very costly exchange rate target. As monetarism aims to achieve a stable monetary environment without recourse to big swings in policy stance, the Thatcher incumbency would score very low in Monetarist popularity polls. The guiding principles of Thatcherism were, in fact, much more closely related to nineteenth-century liberal laisser-faire economics. It is based on a belief in the benefits of the outcome of the working of free market forces, with government participation reduced to a minimum. It is true that many Monetarists, including Milton Friedman, would support the liberal agenda. This is, perhaps, the reason for the confusion of terminology. However, this is the Friedman of Capitalism and Freedom and Free to Choose, rather than the Friedman of Monetary History of the United States and Monetary Trends in the US and UK.
Thatcherism, then, is associated with a particular view about the role of government in the economy. It is the minimalist view of the 'get Big Government off the back of the People' approach, and the "Taxation is theft" view. Questions about the appropriate role of government in a market economy and about monetary institutions and their control are quite separate. The underlying relevance theory to the former is not traditionally regarded as part of macroeconomics. Accordingly, a full discussion goes beyond the scope of this book. Alt and Chrystal (1983) offer an introduction to the main issues.