|
(b) Demand for Money
The Monetarist Model begins with the
Cambridge version of the “equation of exchange”:
(9.1) Md
= kPY where the demand for money is a
function of ‘nominal income’, i.e. the P level times real income Y, and
where k is the assumed ‘stable’ or constant proportion of nominal income
held as cash.
Given that k was treated as a constant and
the money supply M was exogenously determined by the monetary authority, the
Cambridge equation could be expressed as a theory of nominal income:
(9.2) M(1/k) = PY, or, alternatively as:
(9.3) MV = PY where V is also assumed to
be constant.
Keynes had assumed that assets or wealth (Wh)
would held either in the form of cash money or other assets, specifically an
homogeneous category called ‘bonds’, i.e. interest earning financial
assets. The key for Keynes in determining how much would be held as cash
and how much as bonds was the interest rate. Put another way, k
would vary with the interest rate (r). If r rose the
speculative demand for money would fall as would transactional demand. If
r fell the demand for cash would rise. Given that k was now
treated by Keynes as a variable rather than a constant the equation of
exchange could not be used to generate a theory of nominal income. It was
this conclusion that the Monetarists contested.
The Monetarist (specifically
Milton Friedman
and his disciples) began by accepting Keynes’ assumption that Wh
could be held either as cash or income earning assets. However, they did
not accept that there was an homogenous category of such other assets called
‘bonds’. Rather they believed that:
(9.4) Md
= L(P, Y, rB,
rE,
rD)
where r was the rate of return:
- on bonds (B) known as the interest rate;
- on equities or company
shares (E) known as dividends plus capital gains; and,
- on durable goods including real estate,
works of art and other physical assets (D) known as appreciation.
According to the Monetarists
any increase in any one of the 3 types of r would result in a decline in the
demand for money but would
be offset by compensatory decreases in one or both of the other rates of return
thereby keeping k stable. For example, when the price of stock equity
went up, the price of bonds would tend to go down.
Three differences can be drawn at this point
between Keynes and the Monetarists:
a) for Keynes the demand for money was
unstable because of changing ‘animal spirits’, i.e. investor confidence.
For the Monetarists, the demand for money was stable, implicitly because the
increase in one kind of r would tend to be matched by a decrease in
another;
b) for Keynes there were different types of
demand for money: transactional, precautionary and speculative. For the
Monetarists, the demand for money was the demand for money as a useful
assets and difference in the types of demand were not material; and,
c) for Keynes, Wh was composed of
cash and a homogenous category of interest earning assets called bonds. For
the Monetarists, there were different rates of return for different
‘financial’ assets, e.g. bonds, equities and durable goods.
Restating the Cambridge equation, the
Monetarist theory of money demand becomes:
(9.1’) Md = k (rB,
rE,
rD)
PY
where k is no longer a constant as in
the Classical Model but
rather a variable dependent on different rates of return.
An increase in any of them will cause k to fall but overall they balance
each other and k remains relatively stable.
For the Monetarist, equilibrium in the money
market exists when:
(9.5) M = Md
k (rB,
rE,
rD)
PY
Given the Monetarist assumption that the
demand for money was stable an increase in the money supply would require
either that PY rise or that rB,
rE,
rD
fall causing k to rise. To the degree that a change in the money
supply results in a change in PY, to that degree, the quantity of money is
important in determining nominal income.
(c)
Theory of Nominal Income
As we have seen under the Cambridge equation
with k as a constant and Ms fixed by the monetary authorities a
theory of nominal income results with:
(9.6) PY = (1/k) M, i.e., nominal income
(PY) is equal to one over k times the money supply.
For the Monetarists, the other factors in
equation 9.5 (rB,
rE,
rD)
were assumed to have little effect on the demand for money approximating a
constant, i.e. money or cash holdings (k) would be nearly constant. The
Monetarist view is shown in
Fig. 9.3 where the LM curve is very inelastic reflecting the assumption
that k is a near constant, i.e., the demand for money is relatively
inelastic with respect to collective changes in rB,
rE, rD
. By contrast, the IS curve is
very interest rate elastic (gentle slope) reflecting the Monetarist
assumption that aggregate demand is very sensitive to changes in interest
rates. This can be contrasted with the Keynesian Model in which LM is
relatively interest elastic while IS is relatively interest rate inelastic (Fig.
9.2). The
LM and IS curves are, of course, shown assuming the price level is
constant. The Monetarist, on the hand, believed that the price level was
variable.
The effect of the Monetarist assumptions –
stable demand for money, interest inelasticity of demand for money, interest
elasticity of investment and savings plus price level variability - on
aggregate demand is shown in
Fig 9.4 where an increase in the money supply results in an increase in
Y and P. In essence, the Monetarist position is that significant change in
nominal income requires changes in the money supply.
Left unanswered is what determines the nature
of the aggregate supply curve and therefore the effectiveness of changes in
the money supply.
(d) Policy Implications
The policy implications of the Monetarist
Model for fiscal and monetary policy are quite different from the Keynesian
Model.
i – Fiscal Policy
Assuming government increases G without
raising T, it must finance the resulting deficit either by printing money or
borrowing on financial markets (Fig.
9.5). An increase in G shifts the IS curve up to the right. Accepting
the Monetarist position regarding the slope of the IS and LM curves then the
shift in IS results in a relatively significant increase in the interest
rate (r0 to r1)
with a very slight increase in Y (Y0
to Y1).
In effect increase government borrowing raises the interest rate causing
private investment to decline (crowding out) thereby minimizing the impact
on Y of increased G. This can be contrasted with the Keynesian Model shown
in
Fig. 9.1.
ii – Monetary Policy
To the Monetarist instability in Y resulted, not as in the Keynesian Model from instability of private
investment, but rather from instability in the growth of the money supply.
Accordingly the best thing that the monetary authorities can do is to
increase the money supply at a relatively steady rate, i.e., by a rule
rather than at the discretion of policymakers. Accepting the Monetarist
assumptions about LM and IS, changes in the IS curve, e.g., increases in G
or X, will have limited effect on Y but significant effects on r and P.
A stable increase in the money supply
will mitigate inflationary pressure without introducing additional
instability (Fig.
9.6). Increases in the money supply also need to be stable because of
imperfect knowledge about aggregate changes in the economy. Thus given current theory
and information it is not possible to accurately predict the future state of
the economy and using discretionary monetary policy to significantly affect
aggregate demand would introduce further instability into the system. Thus
the Monetarist position amounts to an effort to stabilize the economy rather
than affect its growth.
The long and short of it is that the
Monetarist Model calls for limited changes in fiscal policy because it only
crowds out private investment and a steady rate of increase in the money
supply to stabilize rather than manipulate economic growth. The contrast
with the Keynesian position is evident in
Fig. 9.7. In other words, like the Classical Model, the Monetarist
Model calls for minimum government intervention in the economy.
|
