1. Monetary Theory: Monetarists vs. Keynes
ECO 285 – Macroeconomics – Dr. D. Foster

2. Friedman and the Monetarist View
We can imagine a “market” for money…
--money demand depends on income (mostly) and on interest rates (slightly)
--money supply affects spending directly: MS – Excess MS - AD [PQ in short run]
The Fed buys bonds,
Banks have more reserves,
Banks make more loans,
Spending goes up across economy.
Note MS≡MD.

3. Money and Aggregate Demand
Equation of exchange:
An accounting identity:
Ms * V = P * Q
Quantity theory of money:
(MD = Ms) * V = P * Q
where MD = Ms
Velocity is constant
Q is at full employment
Therefore, changes in M will only change P.
Aggregate Demand for output (AD) can be derived from the demand for money.

4. “Inflation is always, and everywhere, a monetary phenomenon.”
The Money Supply and the Long Run Equilibrium between Aggregate Demand and Aggregate Supply
MS and that increases AD. MS and that decreases AD. P
AS1
Shifts in AD can only change the price level and not real output (nor employment).
“Inflation is always, and everywhere, a monetary phenomenon.”
-Milton Friedman P1
AD1
Q or R-GDP

5. Velocity of M1:
2016 Q4: 5.66

6. Velocity of M2:
2016 Q4: 1.44

7. Velocity of MZM:
2016 Q4:

8. Monetarist vs. Keynesian
What are the initial causes of a recession?
 Money Supply
 Investment
The Fed as source.
Lack of “animal spirits.”
How fast can the economy recover?
Very fast.
Not very fast.
Gov’t as source of disruption.
Market instability.
Markets are quite robust.
May have long-term unemployment problem.
How does monetary policy help?
It has a direct effect on consumer spending.
Works through effects on investment spending.
Very powerful.
Likely ineffective. “Pushing on a string.”

9. Monetarist vs. Keynesian
Should the government aid in the recovery from recession?
No.
Yes.
Use rules.
Use discretion.
Monetary rules will provide the necessary effect.
Fiscal policies, especially gov’t spending are best.
What about increase both government spending and taxes, to maintain a balanced budget?
 Government spending has dubious effects.
 Government spending is the key to success.
 Taxes will slow down economic growth.
 Taxes will be more than offset by  gov’t spending.

10. Keynesian vs. Monetarist Short Run Aggregate Supply
AD1 P
Q or R-GDP
ASLR P1 Q*
AS - Monetarist
The AS is flat in the Keynesian view and steep according to the Monetarists.
AS - Keynes
So, a decrease in the AD will have different consequences in the two theories.
AD2

11. Persistent inflation & inflationary expectations
The Fed tries to reduce unemployment and increase output by MS. This AD.
AS4
AS3
AS2 P
AS5
AD2
AD2
AS1 P4
With a lag, the AS will decrease so all we see is P. P3
The Fed keeps trying, but now no lag in AS. P2
If the Fed stops inflationary expectations will continue to AS, now Q. P1
AD1
Q or R-GDP Q*

12. Keynes & the Paradox of Thrift
Savings role in the economy is negative!
Why? Because income is determined by spending.
If we increase our saving (overall) that means we are decreasing our consumption spending.
C will decrease income/employment/production.
This will C further (the multiplier effect).
As income falls, so to does savings!!!
Why does this happen? In Keynesian model, saving isn’t automatically channeled into investment.

13. Current Problems & Policy Questions
AD’’’
Decreased AD sends us into recession.
Prices
ASLR
ASSR
Fed expands the MS to stimulate economic growth. Doesn’t work. [We also have fiscal policies - G.] P3 P1
Eventually, will there be an overreaction? AD Q’ P2
AD’’
If so, sharply rising AD will lead to high levels of inflation.
AD’
Was Obama a Keynesian?
Q = Real GDP Q*

14. Monetary Theory: Monetarists vs. Keynes
ECO 285 – Macroeconomics – Dr. D. Foster