MONETARISM (Tugas 1 English Bussiness)

MONETARISM
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Monetarism asserts that monetary policy is very powerful, but that it should not be used as a macroeconomic policy to manage the economy. There is thus an apparent contradiction—if monetary policy is so powerful, why not use it, for example, to create more employment in the economy?
First of all, it should be noted that monetarism was an attempt by conservative economists to reestablish the wisdom of the classical laissez faire recommendation and was an attack on the activist macroeconomic policy recommendations of the Keynesian economists. It is thus helpful to briefly examine the historical background against which monetarism developed as a new school of macroeconomic thought.
THE CLASSICAL ECONOMICS.
The macroeconomic thought dominating capitalist economies prior to the advent of Keynesian economics in 1936 has been widely known as classical macroeconomics. Classical economists believed in free markets. They believed that the economy would always achieve full employment through forces of supply and demand. So, if there were more people looking for work than the number of jobs available, the wages would fall until all those seeking work were employed. Thus, market forces guaranteed full employment. The full employment level of employment resulted in a fixed aggregate output/income. The price level (and thus the inflation rate) was determined by the supply of money in the economy. Since, the output level was fixed, a 10 percent increase in money supply would lead to a 10 percent increase in the price level—too many dollars chasing too few goods. The real interest rate was also determined by forces of supply and demand in the market for funds that could be loaned out. The nominal interest rate was then simply the sum of the real interest rate and the prevailing inflation rate. Classical economists thus had an unwavering faith in the selfadjusting market mechanism. However, it was crucial for the working of the market mechanism that there was perfect competition in the market, and that wages and prices were fully flexible.
Classical economists did not see any role for the government. As market forces led to full employment equilibrium in the economy, there was no need for government intervention. Monetary policy (increasing or decreasing the money supply would only affect prices—it would not affect important real factors such as output and employment. Fiscal policy (using government spending or taxes), on the other hand, was perceived as harmful. For example, if the government borrowed to finance its spending, it would simply reduce the funds available for private consumption and investment expenditures—a phenomenon popularly termed as "crowding out." Similarly, if the government raised taxes to pay for government spending, it would reduce private consumption in order to fund public consumption. Instead, if it financed spending by increasing the money supply, it would have the same effects as an expansionary monetary policy. Thus, classical economists recommended use of neither monetary nor fiscal policy by the government. This hands-off policy recommendation is known as laissez faire.
KEYNESIAN ECONOMICS.
Keynesian economics was born during the Great Depression of the 1930s. The classical economists argued that the self-adjusting market mechanism would restore full employment in the economy, if it deviated from full employment for some reason. However, the experience of the Great Depression showed that market forces would not work as well as the classical economists had believed. The unemployment rate in the United States rose to higher than 25 percent of the labor force. Hard working people were out in the street looking for nonexisting jobs. Wages fell quite substantially. However, the lower wages did not re-establish full employment.
Economist John Maynard Keynes argued that the self-adjusting market forces would take a long time to restore full employment. He predicted that the economy would be stuck at the high level of unemployment for a prolonged period, leading to untold miseries. Keynes explained that classical economics suffered from major flaws. Wages and prices were not as flexible as classical economists assumed—in fact, nominal wages were very sticky in the downward direction. Also, Keynes argued that classical economists had ignored a key aspect that determined the level of output and employment in the economy—the aggregate demand for goods and services in the economy from all sources (consumers, businesses, government, and foreign sources). Producers create goods (and provided employment in the process) to meet the demand for their products and services. If the level of aggregate demand was low, the economy would not create enough jobs and unemployment could result. In other words, the free working of the macroeconomy did not guarantee full employment of the labor force—the deficient aggregate demand was the cause of unemployment. Thus, if aggregate private demand (i.e., the aggregate demand excluding government spending) fell short of the demand level needed to generate full employment, the government should step in to make up for the slack.
The central issue underlying Keynesian thought was that those individuals who have incomes demand goods and services and, in turn, help to create jobs. The government should thus find a way to increase aggregate demand. One direct way of doing so was to increase government spending. Increased government spending would generate jobs and incomes for the persons employed on government projects. This, in turn, would create demand for goods and services of private producers and generate additional employment in the private sector. Keynesian economists thus recommended that the government should use fiscal policy (which includes decisions regarding both government spending and taxes) to make up for the shortfall in the private aggregate demand to reignite the job creating private sector. Keynesian economists even went so far as to recommend that it was worthwhile for the government to employ people to in meaningless jobs, as long as they were employed.
The Roosevelt administration did follow Keynesian recommendations, although reluctantly, and embarked on a variety of government programs aimed at boosting incomes and the aggregate demand. As a result, the Depression economy started moving forward. The really powerful push to the depressed U.S economy, however, came when World War II broke out. It generated such an enormous demand for U.S. military and civilian goods that factories in the United States operated multiple shifts. Serious unemployment disappeared for a long period of time.
Modern Keynesians (also, known as neoKeynesians) recommend utilizing monetary policy, in addition to fiscal policy, to manage the level of aggregate demand. Monetary policy affects aggregate demand in the Keynesian system by affecting private investment and consumption demand. An increase in the money supply, for example, leads to a decrease in the interest rate. This lowers the cost of borrowing and thus increases private investment and consumption, boosting the aggregate demand in the economy.
An increase in aggregate demand under the Keynesian system, however, not only generates higher employment but also leads to higher inflation. This causes a policy dilemma—how to strike a balance between employment and inflation. According to laws that were enacted following the Great Depression, policy makers are expected to use monetary and fiscal policies to achieve high employment consistent with price stability.
THE MONETARIST
COUNTERREVOLUTION
By 1950, Keynesian economics was well established. Keynesian macroeconomic thought became the new standard in place of the old classical standard. The birth of monetarism took place in the 1960s. The original proponent of monetarism was Milton Friedman, now a Nobel Laureate. The monetarists argue that while it is not possible to have full employment of the labor force all the time (as classical economists argued), it is better to leave the macroeconomy to market forces. Friedman modified some aspects of the classical theory to provide the rationale for his noninterventionist policy recommendation. In essence, monetarism contends that use of fiscal policy is largely ineffective in altering output and employment levels. Moreover, it only leads to crowding out. Monetary policy, on the other hand, is effective. However, monetary authorities do not have adequate knowledge to conduct a successful monetary policy—manipulating the money supply to stabilize the economy only leads to a greater instability. Hence, monetarism advocates that neither monetary nor fiscal policy should be used in an attempt to stabilize the economy, and the money supply should be allowed to grow at a constant rate. Friedman contends that the government's use of active monetary and fiscal policies to stabilize the economy around full employment leads to greater instability in the economy. He argues that while the economy will not achieve a state of bliss in the absence of the government intervention, it will be far more tranquil. The monetarist policy recommendations are similar to those of the classical economists, even though the reasoning is somewhat different.
A detailed discussion of the key elements of monetarism follows. In particular, an effort is made to explain the theoretical framework that monetarists employ and how they arrive at policy recommendations regarding the use of monetary and fiscal policies.
KEY MONETARIST PROPOSITIONS
Based on Richard Froyen in Macroeconomics: Theories and Policies, the key propositions advanced by monetarist economists (in particular, Milton Fried-man) can be summarized as follows.
1. The supply of money has the dominant influence on nominal income. Two economic concepts enter this proposition—money supply and nominal income. Money supply can be narrowly defined as the sum of all money (currency, checkable deposits, and travelers checks) with the nonbank public in the economy. The money supply so defined is technically called MI by monetary authorities and economists. Nominal income can simply be understood as the gross domestic product (GDP) at current prices. GDP is thus made up of a price component and a real output component. The current value of the GDP can go up due to an increase in the prices of goods and services included in the GDP or due to an increase in the actual production of goods and services included in the GDP or both.
2. The above proposition then states that the stock of money in the economy is the primary determinant of the nominal GDP, or the level of economic activity in current dollars. The proposition is vague regarding the breakdown of an increase in nominal gross domestic product into increases in the price level and real output. However, the proposition does assume that, for most part, a change in the money supply is the cause of a change in the GDP at current prices or nominal income. Also, the level and the rate of growth of the money supply are assumed to be primarily determined by the actions of the central monetary authority (the Federal Reserve Bank in the United States).
3. In the short run, money supply does have the dominant influence on the real variables. Here, the real variables are the real output (the real GDP) and employment. The first proposition only alluded to real output—implied in the break up of the nominal GDP into the real and price components. Where does the employment variable come from? Employment is basically considered a companion of real output. If real output increases, producers must generally employ additional workers to produce the additional output. Of course, sometimes producers may rely on overtime from existing workers. But, generally an increase in employment eventually follows an increase in real output. The second proposition, however, is not confined to real output and employment—prices are influenced as well. Thus, the second proposition effectively states that changes in money supply strongly influence both real output and price level in the short run. Proposition two, therefore, provides a break down of a change in the nominal income, induced by a change in the money supply, into changes in real output and price level components mentioned in the first proposition.
4. In the long run, the influence of a variation in the money supply is primarily on price level and on other nominal variables such as nominal wages. Price level is a nominal variable in the sense that a change in price level is in sharp contrast to a change in real output and employment—it does not have the advantages that are associated with the latter two. In the long run, the real macroeconomic variables, such as real output and employment, are determined by changes in real factors of production, not simply by altering a nominal variable, such as the money supply. Real output and employment are, in turn, determined by real factors such as labor inputs, capital resources, and the state of technology. As was indicated in the second proposition, in the short run, a change in the stock of money affects both real output and price level. This, in conjunction with proposition three, leads to the implication that the long-run influence of money supply is only on the price level.
5. The private sector of the economy is inherently stable. Further, government policies are primarily responsible for instability in the economy. This proposition summarizes the monetarist economists' belief in the working of the private sector and market forces. The private sector mainly consists of households and businesses that together account for the bulk of private sector demand, consumption, and investment. This monetarist proposition, then, states that these components of the aggregate demand are stable, and are thus not a source of instability in the economy. In fact, monetarists argue that the private sector is a self-adjusting process that tends to stabilize the economy by absorbing shocks. They contend that it is the government sector that is the source of instability. The government causes instability in the economy primarily through an unstable money supply. Since the money supply has a dominant effect on real output and price level in the short run, and on price level in the long run, fluctuations in the money supply lead to fluctuations in these macroeconomic variables—i.e., instability of the macroeconomy. Moreover, the government, by introducing a powerful destabilizing influence (changes in the money supply), interferes with the normal workings of the self-adjusting mechanism of the private sector. In effect, the absence of money supply fluctuations would make it easier for the private sector mechanism to work properly.
The above four propositions lead to some key policy conclusions. Based on Froyen, the four monetarist propositions provide the bases for the following two policy recommendations:
First, stability in the growth of money supply is absolutely crucial for stability in the economy. Monetarists further suggest that stability in the growth of money supply is best achieved by setting the growth rate at a constant rate—this recommendation has been termed as the constant money supply growth rule. The chief proponent of monetarism, Milton Friedman, has long advocated a strict adherence to a money supply rule. Other monetarists favor following a less inflexible money supply growth rate rule. However, monetarists, in general, are in favor of following a rule regarding the money supply growth rate, rather than tolerating fluctuations in the monetary aggregate (caused by discretionary monetary policy aimed at stabilizing the economy around full employment). This policy difference from the activist economists (primarily, the Keynesians) is at the heart of the monetarist debate. This component of the debate is known among professional economists as "rule versus discretion" controversy.
One should note that while monetarists are adamant about following a money supply rule, they are not so rigid regarding the rate at which the money supply growth rate should be fixed. A general rule of thumb suggests that the money supply should grow between 4 and 5 percent. How do economists arrive at these numbers? It is assumed that the long-term economic growth potential of the U.S. economy is about 3 percent per annum, i.e., the real GDP can grow at about 3 percent. So, the money supply has to grow at about 3 percent just to keep the price level from falling—economists do not like falling prices because they cause other problems in the economy. An inflation rate of 1-2 percent per annum is considered acceptable. To generate 1-2 percent inflation, the money supply must grow at 1-2 percent above the growth rate of the real GDP. In effect, then, to have a modest 1-2 percent inflation, the money supply should grow at about 4-5 percent. The issue of the money supply growth rule will be further clarified when theoretical principles underlying monetarism are discussed later.
Second, fiscal policy is ineffective in influencing either real or nominal macroeconomic variables. It has little effect, for example, on either real output/employment or price level. Thus, the government can't use fiscal policy as a stabilization tool. Monetarists contend that while fiscal policy is not an effective stabilization tool, it does lead to some harmful effects on the private sector economy—it crowds out private consumption and investment expenditures.