Good economic policy requires not so much the bravado to implement drastic change as the strength and wisdom to make reasonable trade-offs over the many years it takes to transform a country's standard of living.
Debates in Macroeconomics
(Part C)
by
Charles Lamson
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Inflation as a Purely Monetary Phenomenon
So far we have talked only about nominal output [price level (P) x nominal income (GDP) (Y)]. We have said nothing about how a monetarist would break down a change in nominal output (due to a money-supply change) into a change in P and a change in Y. Here again it is not possible to make a general statement about what all monetarists believe. Some may believe that all of the change occurs in P, and others may believe that at least sometimes some of the change occurs in Y. If all the change occurs in P, and there is a proportional relationship between changes in the money supply and changes in the price level. For example, a 10 percent change in M will lead to a 10 percent change in P if Y remains unchanged. In this case, inflation (an increase in P) is always a purely monetary phenomenon. The price level will not change if the money supply does not change. We will call this view, that changes in M affect only P and not Y, the "strict monetarist" view. There is considerable disagreement as to whether the strict monetarist view is a good approximation of reality. For example, the strict view is not compatible with a nonvertical aggregate supply (AS) curve in the AS/AD model from earlier posts. In the case of a nonvertical AS curve, an increase in the money supply (M), which shifts the aggregate demand (AD) curve to the right, increases both P and Y. Almost all economists agree, however, that sustained inflation---inflation that continues over many periods---is a purely monetary phenomenon. In the context of the AS/AD framework, inflation cannot continue indefinitely unless the Fed "accommodates" it by increasing the money supply. Let us review this. Consider a continuously increasing level of government spending (G) without any corresponding increase in taxes. The increases in G keep shifting the AD curve to the right, which leads to an increasing price level (P). (You may find it useful to draw a graph now.) With a fixed money supply, the increases in P lead to a higher and higher interest rate, but there is a limit to how far this can go. Because taxes are unchanged, the government must finance the increases in G by issuing bonds, and there is a limit to how many bonds the public is willing to hold regardless of how high the interest rate goes. At the point at which the public cannot be induced to hold any more bonds, the government will be unable to borrow any more to finance its expenditures. Only If the Fed is willing to increase the money supply (buy some of the government bonds) can the government spending (with its inflationary consequences) continue. Inflation cannot continue indefinitely without increases in the money supply.  The Keynesian/Monetarist Debate Milton Friedman (Juy 31, 1912 - November 16, 2006) was the leading spokesman for monetarism. Most monetarists, including Friedman, blame most of the instability in the economy on the federal government, arguing that the inflation in the United States encountered over the years could have been avoided if only the Fed had not expanded the money supply so rapidly. Most monetarists do not advocate an activist monetary stabilization policy expanding the money supply during bad times and slowing the growth of the money supply during good times. Monetarists tend to be skeptical of the government's ability to "manage" the macroeconomy. Time lags make it likely that conscious attempts to stimulate and contract the economy make the economy more, not less, unstable. Friedman advocated a policy of steady and slow money growth---specifically, that the money supply should grow at a rate equal to the average growth of real output (income) (Y). That is, the Fed should pursue a constant policy that accommodates real growth but not inflation. Keynesianism and monetarism are at odds with each other. Many Keynesians advocate the application of coordinated monetary and fiscal policy tools to reduce instability in the economy to fight inflation and unemployment. However, not all Keynesians advocate an activist federal government. Some reject the strict monetarist position that changes in money only affect the price level in favor of the view that both monetary and fiscal policies make a difference and at the same time believe the best possible policy for government to pursue is basically noninterventionist.  Most Keynesians agree after the experience of the 1970s that monetary and fiscal tools are not finely calibrated. The notion that monetary and fiscal expansions and contractions can "fine-tune" the economy is gone forever. Still, many believe the experiences of the 1970s also show that stabilization policies can help prevent even bigger economic disasters. Had the government not cut taxes and expanded the money supply in 1975 and in 1982, they agree, the recessions of those years might have been significantly worse. The same people would argue that had the government not resisted the inflations of 1974 to 1975 and 1979 to 1981 with tight monetary policies, they would probably have become much worse. 50 years ago, the debate between Keynesians and monetarists was the central controversy in macroeconomics. That controversy, while still alive today, is no longer at the forefront. For the past four decades the focus of current thinking in macroeconomics has been on the new classical macroeconomics, which is where we turn our attention in the next post.  *CASE & FAIR, 2004, PRINCIPLES OF ECONOMICS, 7TH ED., PP. 652-654* end |
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