previous CHAPTER 15
MONETARIST MONETARY AND FISCAL POLICIES
next

Chapters 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26

Chapter 1
General Economic Concepts
Chapter 2
What is Policy?
Chapter 3
History of Macroeconomic Policies in the United States
Chapter 4
Policy Goals: Maximum Employment
Chapter 5
Policy Goals: Maximum Production
Chapter 6
Policy Goals: Price Stability
Chapter 7
Policy Goals: External Balance
Chapter 8
Subsidiary Policy Goals
Chapter 9
Conflicting Policy Goals
Chapter 10
The Policy Makers
Chapter 11
The Policy Instruments
Chapter 12
The Decision-Making Processes
Chapter 13
The Policy Indicators
Chapter 14
The General Economic Model
Chapter 15
Monetarist Monetary and Fiscal Policies
Chapter 16
Keynesian Monetary and Fiscal Policies
Chapter 17
Debt Management Policies
Chapter 18
Incomes Policies
Chapter 19
Supply Management Policies
Chapter 20
The Long Wave
Chapter 21
Contemporary Issues
"Money does not pay for anything, never has, never will. It is an economic axiom as old as the hills that goods and services can be paid for only with goods and services."

Albert Jay Nock
American Libertarian Author, Educational Theorist, and Social Critic
Memoirs of a Superfluous Man (1943)

"I once met an economist who believed that everything was fungible for money, so I suggested he enclose himself in a large bell-jar with as much money as he wanted and see how long he lasted"

Amory Lovins
American Physicist, Environmental Scientist, and Writer
Climate: Making Sense and Making Money (1997)

  1. Introduction
  2. Say's Law Revisited
  3. The Quantity Theory of Money Revisited
  4. Wealth and Consumption Expenditure
  5. Theory of Portfolio Balance
  6. Determination of National Income
  7. Monetary Policy Implications
  8. Gibson's Paradox
  9. Two Types of Monetarism
  10. Fiscal Policy Implications
  11. Monetarist International Macroeconomic Theory
  12. Summary
    Readings
    Websites
top    I. Introduction

The Monetarist School of economic thought derives from the Classical School of economics. It is based on the stock model of economic activity. It presumes that the behavior of stock variables (assets and liabilities) is more stable and predictable than that of flow variables (income and spending). Furthermore, any disturbances are rectified through changes in the stock variables, while the flow variables adjust passively.

The Monetarist model stands on the same three pillars as the Classical School, namely, Say's Law, the Quantity Theory of Money, and David Hume's Price Specie Flow Mechanism. In addition, the Monetarists have refined the Classical School model with an explicit statement of its underlying assumptions, its use of natural output rather than full employment output, and its use of Portfolio Balance Theory to explain individuals' spending behavior.

The Monetarist model uses a marginal approach like the Keynesian model; however, it does so in the context of portfolio balance theory. Portfolio balance theory and the marginal propensity to consume out of wealth are to Monetarism what the consumption function and the marginal propensity to consume out of income are to Keynesianism. However, rather than relying on stable spending functions to drive economic activity, spending is a passive reaction to portfolio adjustments which are based on marginal utilities and differential prices and rates of return. The balance (or rather imbalance) between the demand for and supply of money, marginal utilities, and relative prices and rates of return are central to spending decisions. Since theorists cannot make interpersonal utility comparisons, Monetarists argue that how and why individuals allocate their money balances among different real and financial assets cannot be known. Therefore, Monetarist policy conclusions generally revert, if anything, to the monetary prescriptives of the Classical school.

top    II. Say's Law Revisited

Say's Law states that the mere act of producting products creates a sufficient amount of demand to buy all of the products which are produced. Like Say, Monetarists assume that man's wants are insatiable and his means to satisfy those wants is limited. To satisfy those wants, individuals will summon all productive resources and make them available for production and the generation of income. The act of producing creates the income necessary to buy all the goods and services produced. Therefore, economies will always tend to operate at full employment — or the natural output level — and produce as much as possible to satisfy all wants.

Assumption #1: Full employment at the natural output level

NATURAL OUTPUT, NATURAL UNEMPLOYMENT, AND INFLATION

adandas
The natural output level is the maximum amount of products that can be produced without inducing an increase in the rate of inflation. It is not full employment output, per se, but rather a modification to the full employment assumption of the Classical School. The natural output falls short of full employment output for three reasons.
  1. Most production processes are subject to the law of diminishing returns. As an economy approaches full employment, diminishing returns to the fixed factor(s) of production set in and marginal costs increase. Businesses ideally like to produce at about 85% of capacity.

  2. Resources are not perfectly substitutable. As an economy approaches full employment, the mismatch between available workers and job vacancies increases. Both employers and job applicants spend more money on search and information techniques to find the right job for the right job applicant and on education and training to raise the skill levels of less desirable workers and shift them to the desired vacancies.

  3. Employers must pay higher wages to attract idle workers receiving government benefits. These rising costs push up prices.
The closer the economy comes to full employment, the faster these costs rise and the faster prices rise. Thus, as the economy produces beyond its natural output and approaches full employment, the rate of inflation increases.

The natural output level is supported by the natural rate of employment; and, given any labor supply, the natural rate of unemployment. The natural rate of employment (Ln) is the amount of labor used to produce the natural output:

Qn = f(Ln) = f(un)

The natural rate of unemployment (un) is the minimum sustainable rate of employment compatible with avoiding an increase in the rate of inflation. Given any labor supply (LT), the natural rate of unemployment is

un = 1 - (Ln/LT)

When the actual level of output (Q2) is below the natural level of output (Qn), Qa < Qn, the actual rate of unemployment is above the natural rate of unemployment, ua > un. If aggregate demand increases from AD1 to AD2, prices remain fairly stable at P1 = P2, because the economy has lots of excess capacity to satisfy the additional demand at the going prices. However, when the actual level of output (Q3) rises above the natural level of output (Qn), Qa > Qn, the actual rate of unemployment falls below the natural rate of unemployment, ua < un, and prices increase at an increasing rate from P2 to P3.

Assumption #2: Wage and price flexibility

Like Say's theory, the Monetarist model is based on a system of relative prices, where the substitution effect is dominant; that is, economic units respond to changes in relative prices by substituting less expensive for more expensive commodities and by producing or selling commodities for markets in which the returns are highest. As long as prices are free to rise and fall, resources will be quickly and efficiently reallocated from markets with declining demand to markets with increasing demand. Temporary gluts in specific markets are possible, but once resources have been reallocated toward the newly desired goods and services, the economy will return to full employment. Long-term gluts or depressions are theoretically impossible.

Assumption #3: No money illusion

The Monetarist model assumes that economic participants have no money illusion. They are not fooled by changes in nominal values or prices. Workers look at their real wages (w/P) and savers look at their real returns (in - pe). If prices rise by 5%, workers demand 5% wage increases and savers demand 5% higher returns to compensate for lost purchasing power. If prices fall by 5%, workers willingly accept 5% wage cuts and savers willing accept 5% cuts in their returns, because purchasing power is not changed.

Assumption #4: Real growth depends upon the rate of growth of the resource base

The Monetarist model assumes that natural output is fixed by the amount of resources and and technology and that natural output grows roughly apace with the increase in the factor resource base and changes in technology — maybe 3% per annum — the long-run secular growth rate of output. The Monetarists, therefore, conclude that the private sector is inherently stable and would remain stable, especially, if it were not subject to money supply shocks and interference by the government.

top    III. The Quantity Theory of Money Revisited

The Amount of Money in Circulation Determines the Absolute Level of Prices

The Quantity Theory of Money derives from the Equation of Exchange:

MsV identity PT or MsVy identity PQ.
"In all its versions, the quantity theory rests on a distinction between the nominal quantity of money (Ms) and the real quantity of money (Ms/P). The nominal quantity of money is the quantity expressed in whatever units are used to designate money — talents, shekels, pounds, francs, lire, drachmas, dollars, and so on. The real quantity of money is the quantity expressed in terms of the volume of goods and services that the money will purchase." [Friedman, Monetary Framework, 1, 2]
The real quantity of money is
"...expressed in terms of a specified standard basket of goods and services. That is what is implicitly done when the real quantity of money is calculated by dividing the nominal quantity of money by a price index. The standard basket is then the basket the components of which are used as weights in computing the price index — generally, the basket purchased by some representative group in a base year." [Friedman, Monetary Framework, 1]
A different way to express the real quantity of money is
"...in terms of the time durations of the flows of goods and services the money could purchase; e.g., the number of weeks of a household's average level of consumption that it could finance with its money balances, or the number of weeks of a business's average purchases (or of its average sales or of its average expenditures on final productive services (net value added)) to which its money balances are equal. For the community as a whole, the real quantity of money can be expressed in terms of the number of weeks of aggregate transactions of the community, or aggregate net output of the community, to which its money balances are equal:
Ms/P = kQ.
"The reciprocal of any of this latter class of measures of the real quantity of money is a velocity of circulation for the corresponding unit or group of units.
k = 1/V or V = 1/k.
"In every case, the calculation of the real quantity of money or of velocity is made at the set of prices prevailing at the date to which the calculation refers.
Ms/P = (1/V) Q = kQ
"These prices are the bridge between the nominal and the real quantity of money." [Friedman, Monetary Framework, 1]
Equilibrium

The Quantity Theory of Money assumes that what really matters to individuals is the real quantity of money and that there is a fairly definite real quantity of money that individuals desire to hold under a given set of circumstances. In other words, the demand for real balances is fairly stable and predictable. When the actual quantity of real money balances (Ms/P)a equals the desired quantity of real money balances (Ms/P)d economic participants are in equilibrium and no change will take place. They will continue to generate the same amount of income and output at the same set of prices.

Disequilibrium

Change will only occur when the actual quantity of real money balances is not equal to the desired level of real money balances. If the actual quantity of real money balances (Ms/P)a is greater than the desired quantity of real money balances (Ms/P)d economic participants are in disequilibrium and some change will take place. Individuals will attempt to spend down the excess nominal money balances. In doing so, they will buy other assets. As the excess money balances are spent, economic participants compete against one another for the existing stock of assets. As they compete, they bid up prices. This bidding continues until prices have risen sufficiently to restore actual real money balances to their desired level.

If the actual quantity of real money balances (Ms/P)a is less than the desired quantity of real money balances (Ms/P)d economic participants are also in disequilibrium and some change will take place. However, this time, individuals will attempt to accumulate real money balances. In doing so, they will sell other assets. As economic participants compete against one another to dispose of existing stock of assets, prices will fall. Prices will continue to fall until a sufficient stock of assets is sold to restore actual real money balances to their desired level.

top    IV. Wealth and Consumption Expenditure

Wealth

Wealth (WT) is a measure of the stock of assets at a point in time. It consist of real wealth (Wr) and financial wealth (Wf):

WT = Wr + Wf

Real wealth (Wr) consists of those assets which are tangible and, therefore, consumable. In the limit, real wealth is represented by equity ownership. Real wealth arises from two sources: the stock of human resources (labor) and the stock of nonhuman resources (property):

Wr = Wh + Wn

Human wealth (Wh) is measured in terms of the stream of earnings from employment over time (Ye):

Wh = f(Ye)

Nonhuman wealth (Wn) is measured in terms of the stream of interest, rent, dividend, and other income from property over time (i), both adjusted for price changes:

Wn = f(i, (1/P)dP/dt)

Financial wealth (Wf) consists of those assets which are intangible and, therefore, not consumable. For each financial asset there is an offsetting financial liability.

Consumption Expenditure

The Monetarist model relies on relative prices and stock adjustments. It naturally follows, then, that consumption expenditure is a better measure of household spending than is consumer expenditure. Consumption expenditure is consumer expenditure "smoothed out" over time. It depends on the stock of wealth in each time period rather than the dollar outlay during the period. As long as an asset has some economic life, only a fraction of the asset has actually been consumed. Since only real assets can be consumed, consumption in the Monetarist model is real consumption expenditure, by definition. What is left over is part of net wealth. Because the remaining economic life of goods represents unused consumption or net wealth, production is also "smoothed out" over time. Goods are theoretically only produced as old goods wear out. If saving is not consuming, then both saving and wealth are greater and more stable over time in the Monetarist model, and the Monetarists are correct in stating that consumption is more a function of wealth than of current disposable income.

Lifetime real consumption depends upon the accumulation of real wealth, which, in turn, depends upon human wealth and nonhuman wealth, both adjusted for changes in rates of return and prices:

(C/P)e = Wr = f(Wh, Wn; i, (1/P)dP/dt) = f(Ye, Wn; i, (1/P)dP/dt)

Therefore, real consumption expenditure in any time period depends upon lifetime income, nonhuman wealth, rates of return on financial assets and the prices of goods and services:

(C/P)e = f(y,w; im, ib, ie,(1/P)dP/dt),

where y is income, a surrogate measure for the fraction of total wealth in human form (labor's ability to generate physical and financial wealth); w is the fraction of total wealth in nonhuman form (the fraction of income derived from property); im is the expected nominal rate of return on money (zero for currency, negative for demand deposits with service charges, and positive on negotiable order of withdrawal, SuperNOW, payment order, and share draft accounts); ib is the expected nominal rate of return on bonds (interest ± capital gains/losses); ie is the expected nominal rate of return on equities (dividends ± capital gains/losses); and (1/P)dP/dt is the expected rate of change in prices of goods net of storage and/or maintenance costs (the expected nominal rate of return on real assets). Each of the four rates of return stands for a set of returns, which may be subdivided into narrower classes for more sophisticated analysis of the Monetarist consumption function.

top    V. Theory of Portfolio Balance

The Theory of Portfolio Balance assumes that individuals will hold (or acquire) alternative types of assets such that their total utility (or satisfaction) is maximized.

Total utility is maximized when the marginal utility from the last dollar spent on each asset is equal to the marginal utility of money balances:

MUm = (MU/P)1 = (MU/P)2 = . . . = (MU/P)n

(NOTE: MUm = (MU/P)m for Pm = $1)

Since money is one of many assets individuals can hold in their portfolios, the demand for money depends primarily on the set of relative prices, the existing stock of assets or wealth, and income — the rate at which individuals can accumulate assets:

(M/P)d = f(y, w; im, ib, ie, (1/P)dP/dt; µ).

where y is income, a surrogate measure for the fraction of total wealth in human form (labor's ability to generate physical and financial wealth); w is the fraction of total wealth in nonhuman form (the fraction of income derived from property); im is the expected nominal rate of return on money (zero for currency, negative for demand deposits with service charges, and positive on NOW and SuperNOW accounts); ib is the expected nominal rate of return on bonds (interest ± capital gains/losses); ie is the expected nominal rate of return on equities (dividends ± capital gains/losses); (1/P)dP/dt is the expected rate of change in prices of goods net of storage and/or maintenance costs (the expected nominal rate of return on real assets); and µ is a portmanteau symbol standing for whatever variables other than the above which may the utility attached to the services of money. Each of the four rates of return stands for a set of returns, which may be subdivided into narrower classes for more sophisticated portfolio analysis.

When individuals receive money balances (in the form of money income from wages, interest, rent, and profits, from the sale of assets, or from borrowing), MUm falls relative to the MU/P of other goods:

MUm < (MU/P)1 = (MU/P)2 = . . . = (MU/P)n.

As long as prices remain the same, individuals will spread their money balances over the acquisition of all types of assets — real and financial — according to their utility schedules for real goods and services and their desired returns from financial assets to maximize their total satisfaction. As individuals buy more of the different assets, the marginal utility of additional units declines, while the loss of money balances increases the marginal utility of money balances. When the marginal utility or rate of return from the last dollar spent on all assets is equal to the marginal utility of money balances, the individuals are once again in equilibrium. If individuals have too many real assets, they will buy more financial assets. If individuals have too many financial assets, they will buy more real assets. Once their portfolio of all assets is satisfactory, they will stop spending. Thus, the flow of spending is passive and incidental to the adjustment of their stock positions.

When individuals lose money balances (due to loss of money income, reduced borrowing, or over-accumulation of other assets), MUm rises relative to the MU/P of other goods:

MUm > (MU/P)1 = (MU/P)2 = . . . = (MU/P)n.

As long as prices remain the same, individuals will sell off or divest themselves of all types of assets — real and financial — according to their utility schedules for real goods and their desired returns from financial assets to maximize their total satisfaction. As individuals sell more of the different assets, the marginal utility of additional units rises, while the accumulation of money balances decreases the marginal utility of money balances. When the marginal utility and rates of return from the last dollar spent on all assets is equal to the marginal utility of money balances, the individuals are once again in equilibrium and will stop selling off assets to increase money balances. Thus, the flow of selling is passive and incidental to the adjustment of their stock positions. If relative prices change, individuals will reevaluate the marginal utility from alternative assets, including money balances, and adjust their portfolios accordingly. Again, the flow is passive or incidental to the stock adjustment.

If relative prices change, individuals will reevaluate the marginal utility from alternative assets, including money balances, and adjust their portfolios accordingly. For example, if interest rates fall, then real goods and services will be more attractive than financial assets. Economic participants will sell financial assets, take capital gains, and buy real assets. As they sell financial assets and buy real assets, prices on financial assets will fall, raising their rate of return, and prices on real assets will rise, as marginal utility falls. Participants will continue to make adjustments to their stocks of assets until they are once again maximizing their total utility from the new portfolio of assets. If interest rates rise, economic participants will reverse the asset adjustment process by buying financial assets and selling real assets, until they are once again maximizing their total utility from the new portfolio of assets. In both cases, the flow is passive or incidental to the stock adjustment.

top    VI. Determination of National Income

Short-Run Determination

Aggregate demand depends upon the actual quantity of real money balances in circulation (Ms/P)a relative to the desired quantity of real money balances (Ms/P)d. Suppose the quantity of nominal money balances (Ms) at a given set of prices (P) increases so that the actual quantity of real money balances is greater than the desired real money balances:

(Ms/P)a > (Ms/P)d

Individuals' asset portfolios will be out of balance. They will be holding too many money balances. The marginal utility of holding the actual money balances will be less than the marginal utility from holding other assets:

MUm < (MU/P)1 = (MU/P)2 = . . . = (MU/P)n.

Individuals will try to pay out a larger sum for the purchase of goods and services, securities, repayment of debt, and gifts than they are receiving from corresponding sources. One individual can reduce his excess nominal money balances by forcing someone else to accept them as payment (receipt) for goods, services, securities, debt repayment, gifts, etc. However, as a group, they cannot succeed, because one man's expenditures are another's receipts. The community as a whole cannot spend more than it receives. The attempt to spend down or reduce money balances increases aggregate demand. The increased aggregate demand increases prices and/or output, depending upon the position of the economy relative to its natural level of output.

THE PRODUCTS MARKET IN THE SHORT RUN

adandas
If actual real output (Q1) is less than natural real output (Qn), and aggregate demand increases from AD1 to AD2, real output increases with little or no increase in prices. Portfolios are balanced by decreases in the marginal utilities of the acquired assets as the marginal utility of fewer money balances increases. If actual output is equal to natural output (Qn), and aggregate demand increases from AD2 to AD3, prices increase from P2 to P3 and output increases from Qn to Q3. Portfolios are balanced by decreases in the marginal utilities of the acquired assets and increasing prices as the marginal utility of fewer money balances increases. If aggregate demand continues to increase beyond AD3, prices increase by more than the increase in output and the rate of prices inflation increases. In the limit, at full employment (AS), no additional output can be produced. Portfolios are balanced solely by price increases.

If the reverse were true, and the quantity of nominal money balances at a given set of prices is less than the desired real money balances,

(Ms/P)a < (Ms/P)d

then the attempt to accumulate money balances decreases aggregate demand. Individuals' asset portfolios will be out of balance. They will be holding too few money balances. The marginal utility of holding the actual money balances will be greater than the marginal utility from holding other assets:

MUm > (MU/P)1 = (MU/P)2 = . . . = (MU/P)n.

Individuals will try to sell more goods and services and securities than they are buying. They will try to borrow more than they lend. One individual can accumulate more nominal money balances by forcing someone else to give them up as payment for goods, services, securities, or loans, etc. However, as a group, they cannot succeed, because one man's receipts are another's expenditures. The community as a whole cannot receive more than it spends. The attempt to accumulate money balances decreases aggregate demand. The decreased aggregate demand decreases prices and/or output, depending upon the position of the economy relative to its natural level of output.

If actual real output (Q3) is greater than (Qn), and aggregate demand decreases from AD3 to AD2, prices decrease from P3 to P2 and real output decreases from Q3 to Qn. Portfolios are balanced by increases in the marginal utilities of the divested assets and decreasing prices as the marginal utility of more money balances decreases. If the economy is operating at natural output, a decrease in aggregate demand from AD2 to AD1 causes output to decrease from Qn to Q1 while prices remain relatively stable at P2 (equals P1). Portfolios are balanced solely by increases in the marginal utilities of the divested assets as the marginal utility of more money balances decreases.

Thus, the impact of a change in spending in the Monetarist model changes prices and/or quantity depending on the relationship of actual real output to natural real output. If actual real output is less than natural real output real output will tend to change by more than prices change. If actual real output is greater than natural output, prices will tend to change by more than output changes.

THE STRUCTURAL EQUATIONS FOR THE MONETARIST GENERAL EQUILIBRIUM MODEL
General Equilibrium Y identity E
Causation E = f(Y)
Products Markets Equilibrium Y
P
= C + I or S = Y - C = I
P   P   P     & nbsp; P     P
Products Markets Equations C
P
= f(Y , r)
  P
I
P
= g(r)
P = flexible
Money Market Equilibrium Md
P
= Ms
P
Money Market Equations Md
P
= P . l (Y , r)
        P
Ms
P
= h(r)
General Equilibrium Equation MUm = MU1 = MU2 = . . . = MUn
  p1     & nbsp; p2         & nbsp;    pn

Equilibrium in the products markets occurs when real output (Y/P = Q) is equal to real consumption (C/P) plus real investment (I/P). The flip side of this equilibrium is that real income is equal to real consumption (C/P) plus real saving (S/P). Therefore, the economy is in equilibrium when real saving equals real investment:

C/P + I/P = C/P + S/P

I/P = S/P

(NOTE: The Monetarist model assumes no government and the introduction of government into the economy creates instability.)

THE INVESTMENT-SAVING MARKET

ismodel

Real consumption and real saving depend upon real income (Y/P) and real interest rates (i). Real investment depends upon real interest rates (i). Equilibrium in the products markets occurs where real saving equals real investment. In the diagram above, the general level of prices is fixed, so that equilibrium occurs at interest rate i0 with investment equal to I0 and saving equal to S0.

THE MONEY MARKET

elasticity
Equilibrium in the money markets occurs when the demand for desired real money balances (Md/P) equals the actual supply of real money balances (Ms/P). Since money is one of many assets which economic participants can hold in their portfolios, the demand for real money balances depends primarily upon the set of relative prices, the existing stock of assets or wealth, and income — the means through which economic participants can accumulate assets (Y/P, i). The supply of real money balances depends upon the controls imposed by the central banking authority. The general demand-side equilibrium condition is portfolio balance, where economic participants are in equilibrium when the marginal utility or rates of return from the last dollar spent on all assets is the same. In the money market diagram, equilibrium occurs at ir0 where actual real money balances, Ms0/P, are equal to desired real money balances, Md/P and at ir1 where actual real money balances, Ms1/P, are equal to desired real money balances, Md/P.

Disequilibrium in the products markets occurs if there is a change in the actual supply of real money balances relative to the desired supply of real money balances. This disequilibrium occurs if either nominal money balances change or if the general level of prices of real assets changes relative to the prices of financial assets.

When the actual supply of real money balances rises relative to the desired real money balances, real interest rates fall. Since the Monetarist money demand function is insensitive to changes in the interest rate (MM), a small increase in actual real money balances from Ms0 to Ms1 causes a significant drop in interest rates from ir0 to ir1. At the same time, holding the additional money balances constitutes an increase in saving from S0 to S1. The increase in both real money balances and real saving causes interest rates to fall from i0 to i1 in the investment-saving diagram and from ir0 to ir1 in the money market diagram. This drop in interest rates significantly increases interest-sensitive spending from I0 to I1 in the investment-saving diagram. The increase in investment spending increases aggregate demand from AD2 to AD3 in the products market diagram and prices rise from P2 to P3. As prices rise, the actual supply of real money balances falls.

Individuals continue to spend until prices have risen sufficiently to reduce the actual supply of real money balances to their desired levels. In the short-run, this additional spending has a positive impact on production and output increases from Qn to Q3. The magnitude of this impact, however, depends upon how close the economy is to its natural output (Qn) when aggregate demand increases. As the economy approaches and then exceeds its natural output, the smaller the impact will be on output and the greater the impact will be on prices.

When the actual supply of real money balances falls relative to the desired real money balances, interest rates rise. Since the Monetarist money demand function is insensitive to changes in the interest rate (MM), a small decrease in actual real money balances from Ms1 to Ms0 causes a significant increase in interest rates from ir1 to ir0. At the same time, the loss of money balances causes saving to fall from S1 to S0. The decrease in both real money balances and real saving causes interest rates to rise from i1 to i0 in the investment-saving diagram and from ir1 to ir0 in the money market diagram. This rise in interest rates significantly decreases interest-sensitive spending from I1 to I0. Aggregate demand decreases from AD3 to AD2 and prices fall from P3 to P2. As prices fall, the actual supply of real money balances rises.

Individuals continue to cut back on spending until prices have fallen sufficiently to increase the actual supply of real money balances to their desired levels. In the short-run, this reduction in spending has a negative impact on production. The magnitude of this impact, however, depends upon how close the economy is to its natural output (Qn). If the economy is operating above its natural output, the impact will be smaller on output and greater on prices. If the economy is operating at or below the natural output level, the impact will be greater on output and smaller on prices.

Long-Run Determination

THE PRODUCTS MARKET IN THE LONG RUN

adaslr
In the short-run, output can rise above (Q1) or fall below (Q2) the natural level of output (Qn) — but not for very long. As soon as economic participants see that prices are rising (P1) or falling (P2), they respond by adjusting their behavior to their own expectations of where prices are going.

If prices rise, workers revise upward their expectations of the price level and demand higher wages. If prices rise, savers also revise upward their expectations of the price level and demand higher interest rates. As workers and savers push up their own returns, aggregate supply decreases from AS0 to AS1, prices rise from P0 to P1', and the economy returns to its natural level of output (Qn).

If prices fall, workers revise downward their expectations of the price level and accept lower wages rather than unemployment. If prices fall, savers also revise downward their expectations of the price level and accept lower interest rates rather than sit on idle money balances. As workers and savers push down their own returns, aggregate supply increases from AS0 to AS1, prices fall from P0 to P2', and the economy returns to its natural level of output (Qn).

The Long-Run Adjustment Process Assume that nominal money balances increase from Ms0 to Ms1. The increase in nominal money balances increases actual real money balances from Ms0/P to Ms1/P, because prices remain constant. At the same time, the increase in money balances constitutes an increase in real saving from S0 to S1 (P = constant). The increase in both real money balances and real saving causes real interest rates to fall from i0 to i1 in the investment-saving diagram and from ir0 to ir1 in the money market diagram. This rise in interest rates significantly increases interest-sensitive spending from I0 to I1. As investment increases, aggregate demand increases from AD0 to AD1, prices increase from P0 to P1, and output increases from Qn to Q1.

THE LABOR MARKET

labormkts2
In order to produce more goods and services, businesses demand more labor. As aggregate demand increases from AD0 to AD1, the demand for labor increases from Nd0 to Nd1, labor usage increases from N0 to N1. Unemployment decreases and wages rise from w0 to w1, but the wage increase lags the price increase and real wages fall. This additional employment and output can be sustained only as long as workers are happy with higher nominal wages and ignore the increase in prices which depresses real wages (money illusion).

When workers catch on to the drop in real wages and demand higher nominal wages to compensate for the price increase, the supply of labor contracts from Ns0 to Ns1. Nominal wages rise to w1' as employment falls back to N0. The higher nominal wages increase costs and push up the aggregate supply curve from AS0 to AS1. As the aggregate supply curve shifts up, output falls back to Qn as prices rise to P1'.

As prices rise, actual real money balances decrease from Ms1/P to Ms0/P, real interest rates rise from i1 to i0 in the investment-saving diagram and from ir1 to ir0 in the money market diagram. This increase in interest rates is necessary to compensate for the actual (higher) rate of inflation.

The same thing holds true for a decrease in real money balances. Assume that nominal money balances decrease from Ms1 to Ms0. The decrease in nominal money balances decreases actual real money balances from Ms1/P to Ms0/P, because prices remain constant. At the same time, the loss of money balances constitutes a loss of saving from S1 to S0 (P = constant). The decrease in both real money balances and real saving causes interest rates to rise from i1 to i0 in the investment-saving diagram and from ir1 to ir0 in the money market diagram. This rise in interest rates significantly decreases interest-sensitive spending from I1 to I0. As investment decreases, aggregate demand decreases from AD1 to AD0, prices fall from P1' to P1, and output decreases from Qn to Q2.

When producing less goods and services, businesses demand less labor. As the demand for labor decreases from Nd0 to Nd2, labor usage decreases from N0 to N2. Unemployment increases and wages fall from w0 to w2, but the wage decrease lags the price decrease. This lower level of employment and output can be sustained only as long as workers are happy being unemployed.

When workers catch on to the rise in real wages, they voluntarily agree to work for lower nominal wages. The supply of labor increases from Ns0 to Ns1. Nominal wages fall to w2' as employment rises to N0. The lower nominal wages decrease costs. As the aggregate supply curve shifts down to reflect the decrease in costs, output rises to Q0 as prices fall to P2'.

As prices fall, actual real money balances increase from Ms0/P to Ms1/P, real interest rates fall from i0 to i1 in the investment-saving diagram and from ir0 to ir1 in the money market diagram. This decrease in interest rates is necessary to compensate for the actual rate of deflation.

top    VII. Monetary Policy Implications

Monetary policy is the set of rules used by the monetary authority to manage the amount of money supply in circulation and/or interest rates to influence macroeconomic activity. Monetarists generally concentrate on the amount of money supply in circulation and its rate of growth, because they believe that the linkages between money supply and aggregate economic activity are known, and that the relationships between the policy tools and the macroeconomic goals are stable and predictable in the long run. However, they can also manipulate interest rates to achieve the same desired outcome.

Money Supply Targeting

The linkages between the monetary policy tools — open market operations (OMO), pure quantitative easing (QE), the discount rate (d), and other credit facilities (CFs), like TAF and PDCF — and the macroeconomic goals for money supply targeting are as follow:

(ΔOMO, ΔQE, Δd, ΔCFs) ⇒ ΔB ⇒ Δloans ⇒ Δdeposits ⇒ ΔMs ⇒ ΔAD ⇒ ΔY ⇒ ΔP,ΔQ ⇒ Δu

Assume that the monetary base is B0. When the monetary base is B0, the money supply is Ms0. At Ms0, the money supply is fully expanded and the banks have no excess reserves (Re). If the Federal Reserve wants to stimulate the economy, it can increase the monetary base from B0 to B1 by FOMC authorization to the Manager of SOMA to buy U.S. government securities (OMO) or by Board of Governor approval of district bank requests for a decrease in the discount rate (d) or by opening a new credit facility (CF).

Open Market Operations and Pure Quantitative Easing

THE MONEY SUPPLY FUNCTION

i-rate
         & nbsp;moneys
When the Manager of SOMA buys U.S. government securities or any other type of securities, the monetary base (B) expands and the banks get new reserves. The banks' actual supply of reserves is greater than their desired supply of reserves. Banks get rid of the unwanted excess reserves by making loans. As the banks make loans, they create demand deposits and the money supply (Ms) expands. The banks continue to make loans until all of their unwanted excess reserves have been depleted and their actual supply of reserves equals their desired supply of reserves. When excess reserves are depleted, the money supply (Ms) has expanded by some multiple of the increase in the base from Ms0 to Ms1. The actual multiplier depends upon the definition of the money supply.

Economic participants (households and businesses) now have too much money and not enough other assets. Their actual real money balances exceed their desired real money balances and their asset portfolios are in disequilibrium. They attempt to bring their portfolios of assets into line with their utility schedules by spending down the excess money balances. As they spend the excess money balances on real and financial assets, aggregate demand (AD) increases. When aggregate demand (AD) increases, nominal output (Y) increases.

Monetarists, like their predecessors, the Classical economists, hold the quantity theory of money as "truth." However, they are not so rigorous in assuming that output is always fixed at full employment. Rather they believe that the economy tends to operate at the natural rate of unemployment. At the natural rate of unemployment, the economy is producing its natural real output (Qn = f(un)). The impact of an increase in spending on prices (P) and/or real output (Q) depends upon the relationship of actual real output (Qa) to natural real output (Qn). If the economy is operating below natural output (Qn), the increase in aggregate demand (AD) increases real output (Q) and reduces unemployment (u). If the economy is operating at or above natural output, the increase in aggregate demand simply raises prices (P).

Discount Rate Changes and Introduction of Other Credit Facilities

When the Board of Governors approves district bank requests to decrease the discount rate (d), borrowing at the discount window becomes more attractive. As banks borrow more at the discount window, the monetary base (Ms) expands and the banks get new reserves. The banks' actual supply of reserves is greater than their desired supply of reserves. Banks get rid of the borrowed reserves by making loans. As the banks make loans, they create demand deposits and the money supply (Ms) expands. The banks continue to make loans until all of their unwanted excess reserves have been depleted and their actual supply of reserves equals their desired supply of reserves. When excess reserves are depleted, the money supply (Ms) has expanded by some multiple of the increase in the base from Ms0 to Ms1. Once the money supply has been expanded, the linkage reverts to portfolio balance adjustments by households and businesses to achieve the desired macroeconomic goals (P0, Qn, un).

The Board of Governors can approve the opening of different credit facilities for banks and may approve, in exigent circumstances, credit facilities and loans for non-bank institutions under section 13[3] of the Federal Reserve Act. The Term Auction Facility (TAF) is a credit facility for banks that takes away the stigma of banks' borrowing from the discount window by making a fixed amount of reserves available anonymously to the highest bidder. TAF adds reserves directly to the banking system and the more reserves, the more loans banks can make and the bigger the money supply (Ms) can become. Other credit facilities for non-banks, like PDCF, and loans to non-bank institutions, like AIG, add reserves to the banking system, and automatically create new money supply (Ms) directly from the deposit of loan proceeds by the borrowers into their checking accounts. The latter method is probably the quickest and surest way of increasing the money supply in a weak economy. However, it can only be done under extremely exigent circumstances, when the economy is probably at its worst and no other monetary policy tool has worked.

Interest Rate Targeting

The linkages between the policy tools — open market operations (OMO) and the discount rate (d) — and the macroeconomic goals for interest rate targeting are as follow:

(ΔOMO, ΔQE, Δd, ΔCFs) ⇒ Δiff ⇒ Δis/t ⇒ Δil/t ⇒ ΔAD ⇒ ΔY ⇒ ΔP,ΔQ ⇒ Δu

A change in interest rates influences macroeconomic activity by changing the relative prices of all assets. If the Federal Reserve wants to stimulate the economy, the Board of Governors can approve district bank requests to decrease the discount rate (d) or the FOMC can lower its target for the federal funds rate (iff). The Federal Reserve brings the actual federal funds rate into line with the lower target by authorizing the Manager of SOMA to buy U.S. government securities (OMO).

Open Market Operations and Pure Quantitative Easing

When the Manager of SOMA buys U.S. government securities or any other type of securities, the monetary base (B) expands and the banks get new reserves. The increased supply of reserves lowers the actual federal funds rate (iff). A decrease in the federal funds rate (iff) lowers the banks' cost of funds. The banks can afford to offer more loans at lower interest rates. People and businesses can afford to borrow more at lower interest rates. Loans increase, money supply (Ms) increases, aggregate demand (AD) increases, income (Y) and output (Q) increase, and unemployment decreases (u).

At the same the Manager of SOMA is buying securities, the increase in demand for the securities pulls up their prices and pushes down their yields. Securities are less attractive assets for banks. Banks sell their securities, accumulate reserves, and then make higher interest loans with the excess reserves. Making new loans expands the money supply (Ms). Aggregate demand (AD), income (Y), output (Q), and employment (Le) all increase.

Similarly, when securities prices rise, economic participants (households and businesses) also sell their securities and take their capital gains. Economic participants now have too much money and not enough real assets. Through the portfolio balance and the wealth effects, the change in the relative prices between financial and real assets leads directly to a change in aggregate demand (AD), income (Y), prices (P) and/or output (Q), employment (Le) and unemployment (u), depending on the economy's current deviation from the natural employment level (Qn).

Discount Rate Changes and Introduction of Other Credit Facilities

A decrease in the discount rate (d) will exact the same expansionary influence over income, prices, output, and employment. A decrease in the discount rate decreases the banks' opportunity cost of borrowing at the Federal Reserve to make new loans. Discount window borrowing becomes relatively more attractive and banks increase their borrowed reserves for the purpose of making loans. Once the banks make these loans, the money supply expands and economic participants, who have too much money relative to other assets start spending. In the process, aggregate demand increases and so do income, output, prices, and employment, depending on the economy's current deviation from the natural employment level.

The Federal Reserve can also set the tone for interest rates by auction at TAF or setting the borrowing rate at the PDCF or through one-on-one negotiations with the non-bank borrowers. A loan from the Federal Reserve generally has a lower interest rate than a loan from a bank. The loans through the credit facilities to banks will affect their cost of funds and, hence, their lending rates. However, the rates charged to other non-bank borrowers generally does not have such a direct influence on interest rates.

top    VIII. Gibson's Paradox

Traditional theory holds that an increase in the nominal supply of money increases nominal interest rates. However, as the excess money balances are allocated among all assets to the point where the marginal utility from the last dollar spent on all assets is equal to the marginal utility of money balances, income will rise. Since money is an asset, individuals may decide to hold larger real money balances along with more real goods and other financial assets. If the desired increase in real money balances is proportionately larger than the increase in income, then the demand for money will exceed the supply of money and the net result of an increase in the money supply is an increase in interest rates.

top    IX. Two Types of Monetarism

All Monetarists argue that "money matters and matters much." However, not all Monetarists draw the same conclusions concerning the role of money in macroeconomic stabilization policy.

The St. Louis School

The St. Louis School of Monetarists believes that money is all that matters and it is only through the use of countercyclical monetary policy and dynamic changes in the money supply that income cycles are erased. If the economy is contracting, the Federal Reserve should increase the growth rate of the money supply. If the economy is expanding too rapidly, then the Federal Reserve should "step on the brakes" and slow down the growth rate of the money supply. In either case, members of the St. Louis School argue strongly for an active, interventionist Federal Reserve to achieve macroeconomic goals.

The Chicago School

The Chicago School of Monetarists, headed by Milton Friedman, argues that changes in the money supply have such a strong positive effect on income that they should not be used to stabilize economic activity. Friedman and his colleagues believe that erratic growth of the money supply is responsible for the cyclical growth of income. If the Federal Reserve cannot adequately control the growth rate of the money supply through defensive operations, or if its dynamic operations are alternately overly expansionary and restrictive in the application of monetary policy through changes in the money supply, then this "tinkering" will be responsible for erratic growth in income down the road.

Friedman's "Golden Rule" states that the Federal Reserve should keep the money supply growing at a constant rate, consistent with the non-inflationary growth of real output. If the resource base expands about 2% per year and productivity increases about 3% per year, then real output will grow by 5% per year. To obtain non-inflationary, stable growth, the Federal Reserve should keep the money supply growing at 5% per year. Any inflationary tendencies will be the result of changes in velocity:

%ΔMs + %ΔVy = %ΔP + %ΔQ.

If velocity is growing at a 3% rate, then inflation will be 3%:

5% + 3% = 3% + 5%.

If velocity rises by 5%, inflation will rise to 5%:

5% + 5% = 5% + 5%.

If velocity growth falls to 1%, inflation will fall to 1%:

5% + 1% = 1% + 5%.

But even changes in velocity pose no problem for Friedman, who along with Anna Schwartz, has conducted extensive empirical analyses to show that the velocity of the money supply, defined as M2, is fairly stable and predictable over the long-run. If the Federal Reserve keeps the M2 growing at a fairly stable rate of 5% per annum, then the economy will experience long-term, stable, non-inflationary growth. In that is the case, why have a central bank at all??? Friedman would rather replace the Federal Reserve with a robot with no imagination other than to follow Friedman's "golden rule". In the end, this rule is the only monetary policy alternative for members of the Chicago School.

top    X. Fiscal Policy Implications

Fiscal Policy is the set of rules used by the federal government to manage the velocity or circulation of money balances through adjustments in the federal government's budget. The taxing and spending activities of government are really a means for circulating money balances to move them from one point in the economic system to another. In the short-run, this change in circulation causes income, output, employment, and prices to change. When the government increases its spending, it increases the velocity of money balances. When government decreases its spending, it decreases the velocity of money balances. When government reduces taxes, the goal is to get private sector participants to increase the circulation of money balances. When government raises taxes, the goal is to get private sector participants to reduce their circulation of money balances.

In theory, an increase in government spending or a reduction in tax revenues increases the velocity of money balances. This increase in velocity raises aggregate demand, income, output, employment, and prices. A decrease in government spending or an increase in tax revenue reduces the velocity of money balances. The decrease in velocity reduces aggregate demand, income, output, employment, and prices.

In reality, an expansionary budget deficit, whether created by an increase in spending or a decrease in tax revenues, must be financed. The Monetarists argue that how the government finances the deficit is crucial to fiscal policy's affect on income, output, employment, and prices. If the deficit is finance out of existing money balances, then it is not effective because of "crowding out." If it is financed with new money, then any effectiveness is due to the increase in the money supply, not the deficit spending. The latter phenomenon, where new debt is paid for by issuing new money, is called "monetization of the debt."

Borrowing and "Crowding Out"

When the government finances a federal budget deficit by borrowing in the financial markets, it issues securities. As the supply of securities increases from S0 to S1, securities prices fall from p0 to p1. If no new money is created to buy the new securities, the government must compete against households and businesses for the same money balances. As a result, bond yields rise and interest rates in the money markets increase from i0 to i1.

THE BOND MARKET THE MONEY MARKET
bondmktsupply msmodel1

The same effect is observed directly by noting that the government's borrowing is simply an increase in the demand for a fixed supply of money balances, Ms0. As the demand for money increases, from Md0 to Md1, it creates excess demand which puts upward pressure on interest rates and interest rates rise from i0 to i1. Since the government has no borrowing constraints, e.g., cash flow or debt rating constraints, the government can preempt all other borrowers. Thus, what the government wants, the government gets, and other potential borrowers get crowded out of the financial markets. The increase in circulation of money balances by the government is offset by a reduction in the circulation of money balances by private sector participants.

The net result is that income, output, employment, and prices do not change. As the government spends relative prices and the composition of output and employment are changed. As the government borrows and securities prices fall, some money balances will flow into the financial markets. As the government spends, prices on some real assets will rise. This change in relative prices of real assets makes some real assets more attractive and other real assets less attractive. In some markets spending will increase and in other markets spending will decrease. Overall, the decrease in private sector spending will just offset the increase in government spending and there is no change in income, output, employment, or prices. Only if the increase in government spending is not completely offset by a decrease in private sector spending will income, output, employment, and prices increase.

Printing Money and No "Crowding Out"

When the government finances a federal budget deficit by printing money (or by what amounts to the same thing — selling its debt directly to the central bank), it increases the money supply. As the demand for money balances increases from Md0 to Md1, the government creates the necessary money to meet its additional money demand. The money supply increases from Ms0 to Ms1, so that interest rates remain the same at i0.

THE BOND MARKET THE MONEY MARKET
bondmktsupply moneydemandfninstability

When the government sells its securities to a "ready made market", like the central bank, both the supply of and demand for securities rises at the same time. When demand and supply rise in tandem, securities prices remain constant at p0 and yields or interest rates remain constant at i0.

When the government prints money or sells its securities to the central bank, there is no competition for a limited supply of money and there is no "crowding out". The new money balances and their circulation by the government are supported by the continued circulation of the old money balances by private sector participants. The net result is an increase in income, output, employment, and prices, based on portfolio balance. As the government and private sector participants spend, absolute as well as relative prices change and the composition as well as the level of output and employment change, too.

Therefore, a change in government spending or tax revenues changes aggregate demand (through the portfolio balance and the wealth effects), which, in turn, changes income, prices and/or output, and employment and unemployment, depending on the economy's current deviation from the natural employment level. But a change in government spending and/or tax revenues is effective, if and only if, it is accompanied by a change in the money supply. Otherwise, fiscal policy is ineffectual as existing income is simply redistributed through the public sector. Redistribution changes the composition of assets and asset holdings, but not the level of real output or prices, especially as additional spending by the government crowds out private sector spending.

How long an increase in real output can be sustained depends upon the existence of money illusion. If economic participants have money illusion, then this fiscal stimulus may be sustained for a prolonged period of time. If economic participants do not have money illusion, then this fiscal stimulus will be short-lived. It will end as soon as economic participants can get nominal wage increases to restore their real wages to compensate them for higher prices.

top    XI. Monetarist International Macroeconomic Theory

Basic Assumptions

In the Monetarist macroeconomic model, prices are assumed to be flexible. Since the foreign exchange rate of a country's currency is simply another price, Monetarists assume a floating or flexible exchange rate system. Formal devaluations and revaluations are unnecessary as a country's foreign exchange rate responds to the forces of supply and demand.

Policy Implications: Trade Deficit

Stimulative Monetary Policy

Increasing the rate of growth of the money supply has two major effects on the foreign sector of an economy. First, an increase in the money supply reduces domestic interest rates, taking pressure off the foreign demand for the home country's currency to buy its securities. If anything, money will flow out of the home country in search of higher interest rates abroad. Lower interest rates, ceteris paribus, may start a capital outflow; but the positive effect is that the home country will soon become a net creditor to the rest of the world. Second, the reduced demand for and the increased supply of the home country's currency weakens its exchange rate so that its exports become cheaper and its imports become more expensive. Initially, the terms of trade shift against the home country as the price effect of a devaluation is accomplished more quickly than the quantity effect. Once economic participants are free to renegotiate contracts and respond to the change in relative prices, the quantity effects will reverse the trade deficit (the J-curve).

The negative effect of a stimulative monetary policy is that money balances are increased. This allows residents as will as foreigners to buy more of the home country's goods and services as well as more of its securities. Depending on the current level of capacity utilization, the increased demand for the home country's output will tend to put upward pressure on domestic prices, thus canceling part of the positive effects of devaluation. The impact on the trade balance depends on the net effect of the fall in the value of the home country's currency from an increase in the money supply and the rise in prices from the increased demand for the home country's output. Also, with increased money balances, a portion will flow back into the home country's securities, thus canceling part of the positive effects of lower interest rates. The impact on the capital account depends on the net effect of falling interest rates from increasing the money supply and rising interest rates from increasing money demand. On average, however, the net increase in prices and interest rates should be less than the fall in the foreign exchange value of the currency and in interest rates, because not all of the additional money balances will be spent in the home country.

The effectiveness of a stimulative monetary policy depends on the interest-sensitivity of the money demand function. If the money demand function is interest-insensitive, monetary policy will be effective. A small increase in the money supply will bring down interest rates very quickly. However, if the money demand function is interest-sensitive, then interest rates will not fall very much and monetary policy will not work. Since Monetarists assume an interest-inelastic money demand function, they conclude that monetary policy will be very effective in correcting a trade deficit.

Restrictive Fiscal Policy

A reduction in government spending or an increase in taxes reduces the demand for money, thus reducing interest rates. As interest rates fall, demand for the home country's securities falls. As demand by foreigners for the home country's currency falls, the supply of the home country's currency increases. As money flows out of the home country in search of higher interest rates abroad, the home country becomes a net creditor to the rest of the world. The net effect is a devaluation of the dollar, which makes the home country's exports cheaper and its imports more expensive. Initially, the terms of trade shift against the home country as the price effect of a devaluation is accomplished more quickly than the quantity effect. Once economic participants are free to renegotiate contracts and respond to the change in relative prices, the quantity effects will reverse the trade deficit (the J-curve).

The negative effect of a restrictive fiscal policy is that aggregate demand, income, and employment are reduced. While this restriction reduces the demand for imports, it also reduces domestic demand for the home country's goods and services, thus causing an interim slow down in its economic activity and the possibility of recession only if the quantity effects from the devaluation precede the quantity effects from decreased domestic demand will a recession be averted.

The effectiveness of a restrictive fiscal policy does not depend on the interest-sensitivity of the money demand function. However, to Monetarists it does depend upon the portfolio balance and wealth effects. Fiscal policy has a no direct impact on income, employment, and spending, unless it is accompanied by an equal and direct change in the money supply. Rather it changes the composition of income and asset holdings between the public and private sectors and among nations. In this case, a restrictive fiscal policy should be accompanied by a restrictive monetary policy, but this is counter-intuitive and, what is worse, aggravates the home country's exchange rate and the flow of its output and assets.

Policy Implications: Trade Surplus

Restrictive Monetary Policy

Contracting the money supply (or reducing its rate of growth) has two major effects on the foreign sector of the economy. First, a reduction in the money supply raises interest rates, increasing foreign demand for the home country's currency to buy its securities. At the same time, residents are selling foreign securities and currencies to buy domestic securities. Second, the increased demand for and reduced supply of the home country's currency strengthens its exchange rate so that the home country's exports become more expensive and its imports become cheaper. Initially, the terms of trade shift in favor of the home country as the price effect of a revaluation is accomplished more quickly than the quantity effect. Once economic participants are free to renegotiate contracts and respond to the change in relative prices, the quantity effects will reverse the trade surplus (the reverse J-curve).

The negative effect of a restrictive monetary policy is that money balances are reduced. This forces residents as well as foreigners to buy less and sell more of both the home country's current output and its securities. Increased supply of and decreased demand for the home country's output will tend to reduce the prices of its goods, thus canceling part of the positive effects of revaluation. The impact on the trade balance depends on the net effect of the rising currency from a decrease in the money supply and falling prices from the decreased demand for the home country's output. Also, with smaller money balances, less of the home country's securities will be bought, thus canceling part of the positive effects of higher interest rates. The impact on the capital account depends on the net effect of rising interest rates from reducing the money supply and falling interest rates from reduced money demand. On average, however, the net increase in the home country's prices and interest rates should be less than the rise in its currency and in its interest rates, because not all of the additional money balances will be held in the home country.

The effectiveness of a restrictive monetary policy depends on the interest-sensitivity of the money demand function. If the money demand function is interest-insensitive, monetary policy will be effective. A small decrease in the money supply will raise interest rates very quickly. However, if the money demand function is interest-sensitive, then interest rates will not rise very much and monetary policy will not work. Since Monetarists assume an interest-inelastic money demand function, they conclude that monetary policy will be very effective in correcting a trade surplus.

Stimulative Fiscal Policy

An increase in government spending or a decrease in taxes raises the demand for money, thus increasing interest rates. As interest rates rise, demand for the home country's securities rises. As demand by foreigners for the home country's currency rises, the supply of the home country's currency decreases. As money flows into the home country in search of higher interest rates, eventually the home country becomes a net debtor to the rest of the world. The net effect is a revaluation of the home country's currency, which makes the home country's exports more expensive and its imports cheaper. Initially, the terms of trade shift against the home country as the price effect of a revaluation is accomplished more quickly than the quantity effect. Once economic participants are free to renegotiate contracts and respond to the change in relative prices, the quantity effects will reverse the trade surplus (the reverse J-curve).

The negative effect of a stimulative fiscal policy is that aggregate demand, income, and employment are increased. While this stimulation increases the demand for imports, it also increases domestic demand for the home country's goods and services. Depending on the current level of capacity utilization, the home country's prices may rise. Only if the quantity effects from the revaluation precede the quantity effects from increased domestic demand will inflationary pressures be averted.

The effectiveness of a stimulative fiscal policy does not depend on the interest-sensitivity of the money demand function. However, to Monetarists it does depend upon the portfolio balance and wealth effects. Fiscal policy has a no direct impact on income, employment, and spending, unless it is accompanied by an equal and direct change in the money supply. Rather it changes the composition of income and asset holdings between the public and private sectors and among nations. In this case, a stimulative fiscal policy should be accompanied by a stimulative monetary policy; but this is counter-intuitive and, what is worse, aggravates the home country's exchange rate and the flow of its output and assets.

Conclusions

According to the Monetarists, fiscal policy is not very effective in correcting a trade imbalance because it affects the composition of income and wealth holdings rather than the level of income and wealth. Furthermore, the use of fiscal policy to correct a trade imbalance may actually worsen the country's position, if offsetting supply and demand forces leave interest rates unchanged and the country is forced to contract the money supply when it has a deficit and to increase the money supply when it has a surplus.

top     Summary

Monetarist economic theory is a stock adjustment analysis that relies on asset portfolio adjustments by economic participants. In the process of adjusting their portfolios, individuals inevitably buy and sell assets based on the "marginal utility from the last dollar spent" on each asset. Inadvertently, spending on both real and financial assets occurs. Since money is an asset, a change in money balances creates an imbalance in individuals' portfolios that influence macroeconomic aggregates directly. Because the link is direct, any imbalance in individuals' portfolios will give rise directly to changes in income, output, prices, and employment. Therefore, monetary policy is more important than fiscal policy because of its direct impact on aggregate demand.

top    Readings

A Study of Aggregate Consumption Functions. Robert Ferber, National Bureau of Economic Research, New York, 1953

The Monetary Interpretation of History, James Tobin, American Economic Review, 55 Jun 1965: 464-85

Innovations in Interest Rate Policy, Franco Modigliani and Richard Sutch, American Economic Review, 56 Mar 1966: 178-97

A General Equilibrium Approach to Monetary Theory, James Tobin, Journal of Money, Credit and Banking, 1 Feb 1969: 15-29

Monetary vs Fiscal Policy: A Dialogue, Milton Friedman and Walter Heller, New York: W.W. Norton & Co., 1969

Money and the Real World, Paul Davidson, Halsted, New York, 1972

Mr. Hicks and the 'Monetarists', Karl Brunner and Allan H. Meltzer, Economica, 40 Feb 1973: 44-59

Evolution of the Concept of the Demand for Money, Thomas M. Humphrey, Monthly Review (FRBRich), LIX(12) Dec 1973: 9-19

Essays in Positive Economics, Milton Friedman, Chicago: Univ. of Chicago Press, 1974

Milton Friedman's Monetary Framework: A Debate with his Critics, Gordon, Robert J., ed. Chicago: Univ. of Chicago Press, 1974: 1-62

A Keynes-Friedman Money Demand Function, Paul A. Meyer and John A. Neri, American Economic Review, LXV(4) Sep 1975: 610-23

The Monetarist Controversy or, Should We Forsake Stabilization Policies? Franco Modigliani, American Economic Review, LXVII(2) Mar 1977: 1-19

Monetarism: A Historic-Theoretic Perspective, A. Robert Nobay and Harry G. Johnson, Journal of Economic Literature, XV(2) Jun 1977: 470-85

The Structure of Monetarism, Thomas Mayer, W.W. Norton & Co., New York, 1978

Defining Money for a Changing Financial System, John Wenniger and Charles M. Sivesind. Quarterly Review (FRBNY), IV(1) Spring 1979: 1-8

Monetarists and Keynesians, Brian Morgan, Halsted, New York, 1978

A Critique of Friedman's Critics, Lawrence A. Boland, Journal of Economic Literature, XVII(2) Jun 1979: 503-22

Metzler on Classical Interest Theory, John H. Wood, American Economic Review, LXX(1) Mar 1980: 135-48

Two Illustrations of the Quantity Theory of Money, Robert E. Lucas, Jr., American Economic Review, LXX(5) Dec 1980: 1005-14

Monetarist Principles and the Money Stock Growth Rule, Bennett T. McCallum, American Economic Review, LXXI(2) May 1981: 134-38

Monetarism, Keynesian, and New Classical Economics, Jerome L. Stein, American Economic Review, LXXI(2) May 1981: 139-44

Stabilization, Accommodation, and Monetary Rules, John B. Taylor, American Economic Review, LXXI(2) May 1981: 145-49

Monetary Theory, Laurence Harris, New York: McGraw-Hill, 1981

Tobin and Monetarism: A Review Article, Robert E. Lucas, Jr., Journal of Economic Literature, XIX(2) Jun 1981: 558-67

Monetarism is Obsolete, Alan Blinder, Challenge, Sep/Oct 1981: 35-41

Monetary Trends in the United States and the United Kingdom: Their Relation to Income, Prices, and Interest Rates, 1867-1975, Milton Friedman and Anna J. Schwartz, Chicago: Univ. of Chicago Press, 1982

The Role of Fiscal Policy in the St. Louis Equation, R.W. Hafer, Review (FRBStL), LXIV(1) Jan 1982: 17-22

The Short-Run Demand for Money, A New Look at an Old Problem, George A. Akerlof, American Economic Review, LXXII(2) May 1982: 35-39

Cracks on the Demand Side: A Year of Crisis in Theoretical Macroeconomics, Edmund S. Phelps, American Economic Review, LXXII(2) May 1982: 378-81

Monetary Policy and Economic Activity: Benefits and Costs of Monetarism, Andrew F. Brimmer, American Economic Review, LXXIII(2) May 1983: 1-12

Two Types of Monetarism, Kevin D. Hoover, Journal of Economic Literature, XXII(1) Mar 1984: 58-76

An Operational Measure of Liquidity, Steven A. Lippman and John J. McCall, American Economic Review, LXXVI(1) Mar 1986: 43-55

Lessons from the 1979-82 Monetary Policy Experiment, Benjamin M. Friedman, American Economic Review, LXXIV(2) May 1984: 382-387

Monetarist Rules in the Light of Recent Experience, Bennett T. McCallum, American Economic Review, LXXIV(2) May 1984: 388-91

Lessons from the 1979-82 Monetary Policy Experiment, Milton Friedman, American Economic Review, LXXIV(2) May 1984: 397-400

Did Financial Innovation Hurt the Great Monetarist Experiment? James L. Pierce, American Economic Review, LXXIV(2) May 1984: 388-91

International Money and the Real World, 2nd ed., Paul Davidson, St. Martin's Press, 1992

A Fine Time for Monetary Policy? John F. Geweke and David E. Runkle, Quarterly Review (FRBMinn), 19(1) Winter 1995

Inflation and Monetary Restraint: Too Little, Too Late? Nathan S. Balke and Kenneth M. Emery, Southwest Economy (FRBDal), Jan 1995

Evaluating McCallum's Rule for Monetary Policy, Dean Croushore and Tom Stark, Business Review (FRBPhil). Jan 1995.

The Growth Effects of Monetary Policy, V. V. Chari, Larry E. Jones, and Rodolfo E. Manuelli. Quarterly Review (FRBMinn). 19(4) Fall 1995

Long-Term Interest Rates and Inflation: A Fisherian Approach, Peter N. Ireland, Economic Quarterly (FRBRich), Winter 1996

Monetary Policy and Long-Term Interest Rates, Yash P. Mehra, Economic Quarterly (FRBRich), Summer 1996

Monetary Policy Comes of Age: A 20th Century Odyssey, Marvin Goodfriend, Economic Quarterly (FRB Rich), Winter 1997

The Case for a Monetary Rule in a Constitutional Democracy, Robert L. Hetzel, Economic Quarterly (FRBRich), Spring 1997

Monetary Rules, Edward M. Gramlich, The Samuelson Lecture, The 24th Annual Conference of the Eastern Economic Association, New York, New York, 27 Feb 1998

Exercising Caution and Vigilance in Monetary Policy, Roger W. Ferguson, Jr. Distinguished Speaker Series, Federal Reserve Bank of Atlanta, Atlanta, Georgia. 9 Jul 1998

Monetarism, Allan H. Meltzer, The Concise Encyclopedia of Economics, 2002

Neoclassical Economics, E. Roy Weintraub, The Concise Encyclopedia of Economics, 2002

New Classical Macroeconomics, Robert King, The Concise Encyclopedia of Economics, 2002

Rational Expectations, Thomas J. Sargent, The Concise Encyclopedia of Economics, 2002

Tobin's Imperfect Asset Substitution in Optimizing General Equilibrium, Javier Andrés, J. David López-Salido, and Edward Nelson, Journal of Money, Credit and Banking, 36 Aug 2004: 665-90

Friedman's Monetary Economics in Practice, Edward Nelson, Finance and Economics Discussion Series 2011-26, FRB BOG, Washington, DC, Apr 2011

top    Websites

previoustopnext