Transcript Lecture XIII

XIII. Monetarism
XIII.1 Introduction
Milton Friedman
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•
•
•
•
1912-2006
Economist, monetarist
1946-1977: University of Chicago
1977-2006: Hoover Institution
Essays in Positive Economics, A
Theory of Consumption Function,
Capitalism and Freedom, A
Monetary History of the United
States (1867-1960) - with Anna
Schwartz, Free to Choose, etc.
• Nobel Prize in Economics, 1976
• Considered as conservative, in
reality liberal economist
• Advisor to President Nixon
Roots and ambitions
• Roots: Quantity Theory of Money
• Ambitions: challenge Keynesianism
– not so much as a theory for a depression period
– mainly the policy conclusions
• Main points of this Lecture:
–
–
–
–
QTM and demand for money
Expectation-augmented Phillips Curve
Monetary approach to BoP and ExR determination
Other characteristics
• Crucial implications for stabilization policies
XIII.2 Demand for money
Previous models (1)
QTM (Fisher version)
• M.V = P.Y – implicit demand function
MD=(1/V).P.Y
• Velocity V assumed constant, supply of
money MS determines stock of money M
• M > MD → price level P↑ and vice versa
• Real interest determined by thrift and
marginal productivity of capital (see LIV,
in particular IV.2.3, loanable funds
interpretation)
Previous models (2)
Keynesian
• Transaction, precautionary (function of Y)
• Speculative, inversely determined by real
interest r
• Interest rate – reward for parting with liquidity
or for not hoarding money
• Speculative motive: there will be always some
preference for cash vis-à-vis other financial
assets (“bonds”)
• Because of uncertainty, demand for money
volatile (unstable) → velocity of money
unstable
Friedman’s demand for money
• Demand for money is a stable function of
limited number of variables

MD
 f WH,r, e , u
P

where WH is total wealth (approximate by
permanent income, see Appendix to this
Lecture), r is real return on other assets, πe is
expected inflation, u represents individual
tastes, preferences and other factors
• Demand of money is higher
– the higher is wealth
– the lower is yield on other asset
– the lower is expected inflation and vice versa
Transmission mechanism
• How do the changes in money stock affect the
real sector of the economy (Y, employment,
etc.)?
• Keynesian (see LVII and VIII): ∆M → ∆r →I → ∆Y
– Important assumption in the background: there is
always substitution between money and other assets
(“bonds”)
• Monetarist
– all individuals maximize utility and reallocate their
wealth among many other assets till marginal rates of
return are the same
– M↑ → marginal return from money↓ → M>MD →
demand for other assets ↑ → their prices↑ →
continues up to the point when all marginal returns
equal
– conclusions: demand for money stable (and stable
velocity V), no obvious relation between change in
money and change in real output, direct impact of
change in money on change in price level
– Quantity theory as a theory of money demand
Empirical evidence
Mixed
• Originally (1950s): Friedman asserted that
interest rate totally insignificant for demand
for money
– Later not confirmed by the data
• 1970s and 1980s: data confirmed unstable
velocity (but a very turbulent period, see later
Lectures), i.e. unstable demand for money
• However, in the long term, demand for money
reasonable stable and link between money
and prices confirmed
• If money influences instability in the
economy, then mainly as a consequence of
fluctuations in the money supply, induced by
the monetary authorities
Today’s assessment
• Changes in money stock are main factor
explaining changes in money income
• If state (Central Bank) decides to control
money supply then actual path of money
income will be different from the situation
when money supply is left endogenous
• Long time lags between money stock
changes and impact on the change of money
income → monetary policy maybe rather
destabilizing
• The money supply should be allowed to grow
at a fixed rate in line with the underlying
growth of output to maintain long-term price
stability
XIII.3 The expectations-augmented
Phillips curve
Inflation and unemployment
USA, 1950-1969
9
8
Inflation (%)
7
6
5
4
3
2
1
0
-1
3
4
5
Unemployment (%)
6
7
Inflation and unemployment
USA, 1970-2000
14
12
Inflation (%)
10
8
6
4
2
0
4
5
6
7
Unemployment (%)
8
9
10
Phillips curve - a wrong concept?
Two 1968 contributions:
• M.Friedman: The Role of Monetary Policy
• E.Phelps: Money-Wage Dynamics and LaborMarket Equilibrium
Original Phillips curve:
• For a period, when long-term average
inflation is zero and workers expect the next
year’s inflation zero as well. This was true
until 1960’s.
• Inflation/unemployment trade-off: not a longterm concept, as there is always some level
of unemployment – a natural rate
(1)
Phillips curve - a wrong concept?
Original Phillips curve: wage
negotiations, when with high
unemployment and expectation of
zero inflation, firms easily find
workers, ready to take a low wage.
Positive inflation expectation: workers
negotiate much harder for higher
nominal wages to keep real wages
unchanged.
(2)
Phillips curve - a wrong concept?
Define expected price as Pe and expected
inflation as
e
P
 P1
e
 
P1
and original Phillips curve can be expressed

   e  .u, with  e  0
However, whenever  e  0 , than inflation
might rise, even with high unemployment
no unemployment x inflation trade-off
→

(3)
Phillips curve - a wrong concept?
No permanent inflation/unemployment tradeoff; consequences:
• Permanent positive inflation, which
generates an expectation about a positive
inflation further on;
• Unemployment can not – for a longer period
of time – be kept bellow a certain level, called
natural rate (consistent with full employment
output).
Over time, Phillips curve trade-off disappears.
(4)
Expectations-augmented Phillips curve
Suppose that  0 and, say,    1
than
    .u
e
1
This fits the data for the period even beyond 1970
 well.
rather

Back to more usual notation: u *  0 than
  u  u   -1
*
↔ expectations-augmented Phillips curve

Change of inflation (%)
Change of inflation and unemployment
USA, 1970-2000
5
4
3
2
1
0
-1
-2
-3
-4
-5
4
5
6
7
Unemployment (%)
8
9
10
Short- vs. long-term (1)
• When accepting expectations-augmented P.C.
→ family of original P.C. that shift for various πe
(see graph slide)
• Interpretation for monetary expansion
– starting at natural rates: wage and price inflation and
inflation expectations = 0
– Simplification: productivity growth = 0
• M↑ → excess demand for goods and labor →
prices↑ (faster) and wages ↑, but πe = 0
– money illusion: money wage increase is perceived as
real wage increase and labor supply increases
– In reality, real wage decreases (faster growth of
prices than wages) → demand for labor also
increases → increase of output, decrease of
unemployment ↔ move on existing P.C. → increase
of money wage
• At this stage: actual inflation higher than expected one
Short- vs. long-term (2)
– Increase of nominal wage and zero productivity
growth → π = increase of wage → new expected
inflation πe
• Workers do not suffer from money illusion
any more and press for further nominal wage
increase
– Actual wage increase: original increase due to
lower unemployment + additional increase due to
expected inflation πe
– Horizontal shift of P.C. to the right
– Higher real wage → fall of labor demand → lower
output → return to normal levels of output and
unemployment and to the situation when expected
inflation equals an actual one, but this inflation is
not zero any more
Short- vs. long-run Phillips
curve

W
U = UN
π = πe
U < UN
π > πe
U > UN
π < πe
LRPC
πe

W1
C
B
A
U1
UN
SRPC2
SRPC1
U
Short- vs. long-term (3)
• In the long-run, when economy operating
at normal output and unemployment
– Rate of increase of money wage = expected
inflation, e.g. point C
– One other (but just another one) point A,
where expected inflation = 0
• In the long-run:
– Economy always at normal levels
– Wage inflation = expected price inflation, but
is not linked to unemployment
– LRPC vertical at UN → no inflation x
unemployment trade-off
XIII.4 Monetary approach to
exchange rate determination
Purchasing Power Parity
reminder from LIII
• Suppose that markets (both domestic and foreign) are
fully competitive and prices quickly adjust (monetarists’
position)
• Than prices, when converted into same currency, must
be equal, i.e. PPPxP*=P or
PPP = P/P*
• This definition: absolute PPP
• Relative PPP: percentage change in the ExR between
two currencies is equal the difference in percentage
changes in national price levels
*
• Formally E - E-1  E-1   - 
– where inflation   P - P-1  P-1
• Remark: the expression is good approximation for
small inflation values
Basic relation of monetary approach
• Changes in (absolute) PPP solely determined by changes in
relative price levels: faster domestic inflation → depreciation,
faster foreign inflation → appreciation
• Formally:
MS
P=M L Y,r , P =M
S
*
S,*

*
L Y ,r
*



* *
L Y,r  MS L Y ,r
and PPP=
= S,* .
S,*
M
M
L Y,r 
L Y* ,r *


• In another words: in the long run, the ExR (defined as PPP) is
determined by relative supplies of monies and relative demands
for them (relative with respect to domestic and foreign country in
quesiton)
• In the long run, ExR (PPP) reacts similarly to change in money
supplies and to output level as ExR, defined by the short term,
asset approach
• But difference: in asset approach, when interest increases, r,
then ExR appreciates; here the opposite: when r, ExR (PPP)
depreciates - see the ratios above. Why?
Fisher effect and ongoing
inflation(1)
• In most of examples so far: theoretical exercise
with one-time increase in money supply
• Reality: usually permanent change in monetary
policy (at least lasting one)
– Changes in expectations, and both firms and
workers adjust prices, i.e. permanent change in
money growth rate is followed by proportional
change in inflationary rate
• In monetarist, long run view (as in classical
model) this does not change real variables,
including real returns, but changes nominal
interest rate
Fisher effect and ongoing inflation
(2)
Formally:
a. remember interest parity:
b. remember relative PPP:
e
E
-E
*
r=r +
E
Ee  E
 π  π*
E
c. assume the same applies for expected
inflation: E e  E  π e  π e,*
E
d. comparing a. and c. :
r  r *  π e  π e,*
Fisher effect and ongoing inflation
•
Fisher effect: rise in country’s expected
inflation leads to an equal rise in the
interest rate that deposits of its currency
offer; vice versa for a decrease
•
Why PPP depreciates when interest
raises relative to the interest of foreign
currency?
–
Because, due to Fisher effect and the fact
that - as monetarists never assumed - we are
not in the (Keynesian) world of sticky prices,
difference in domestic and foreign interest
equals differences in expected inflation
(3)
Summarizing …
• Monetarist assume that nominal
exchange rates are predominantly
determined by relative money
supplies in domestic and foreign
countries
• Much stronger believe in a speed of
adjustment (long-run “not so long”)
XIII.5 Other basic
characteristics of monetarism
Stable private sector
Keynesians - AD less stable
• Private sector inherently unstable
• Subject to erratic shocks
• mainly: changes in MEI
Monetarists: AD more stable
• Inherent stability
• If unstable, than as a result of un-stability
of money supply
It’s not MEI, but un-proper changes in
money supply what leads to instability of
AD
High level of aggregation
• Expenditures determined by excess
supply/demand of real balances
• Belief in fluidity of capital markets
• Short-term income changes do not
depend on the situation in the
different sectors of the economy
Price level vs. individual prices
Price level – aggregate phenomena,
determined by ADxAS
Pricing decisions in particular
industries – effect on relative prices
only
Keynesian attention to cost
(microeconomic) basis of the pricing
Large vs. small models
• Friedman: do we know enough?
• No need of detailed knowledge of
different sectors
Literature to Ch. XIII
• Thomas Meyer, The structure of monetarism, Kredit
und Kapital 8(1975), pp. 191-215, 292-313. Probably the best,
albeit a bit old overview
• Snowdon, Vane, Modern Macroeconomics, Edvard
Elgar, 2005, Ch.4. Basic text
• Laidler, D., The Demand for Money (4th ed.),
HarperCollins, 1993. Very accessible treatment of different theories.
• Samuelson, P.A., Sollow, R.M., Analytical Aspects of
Anti-Inflationary Policy, American Economic Review,
May 1960. Classical text defining original Phillips curve – worth of
comparing with Friedman’s approach
• Friedman, M. The Role of Monetary Policy, American
Economic Review, March 1968. Basic text on expectationsaugmented Phillips curve and on “natural” values
• Krugman, Obstfeld, International Economics, Ch. 15,
pp. 373-381 PPP and monetary approach to ExR
Appendix: Permanent income
hypothesis
• Milton Friedman (1957)
• Similar as life cycle hypothesis (see your
course on Macroeconomics): current
consumption does not depend on current
income only
• PIH: differentiates between stable,
expected income and one-time
fluctuations
Basic propositions
• In current period, income is
decomposed into permanent and
transitory part
P
Y=Y +Y
T
• Permanent – people expect that this is
going to be their stable income also in
the future (kind of an “average” income)
• Transitory – people know that these are
temporary (random) fluctuations of the
income
Consumption function
• Consumption depends on permanent
income only
C= Y
P
and is proportional to permanent
income
• Average propensity to consume
(APC) is given by a ratio of
permanent and actual income
APC=C Y= Y Y
P
Strength of PIH
• Short-term consumption function uses
wrong data (observed data on income reflect both
permanent and temporary components)
• It can explain a fall of APC at higher
income for short-term consumption
function (APC depends on ratio of permanent and
total income, if income raises in the short-term, it is a
consequence of change in a temporary component,
observed APC falls, but real APC does not change)
• This applies both for cross-sectional
data (for households), and for timeseries (for shorter period of time)
• When using long-term data – income
reflects more permanent component and
APC is constant