1. Lesson 12: Monetary Theory and Policy
In this lesson we will develop a framework for understanding and evaluating monetary policy. We will place this in the context of the history of economic thought. We will learn about the Classical economists, Keynesian economics, Monetarism and other approaches.
Suggested Reading:
RSU Chapter 22, 23, 26, 28, 29.
You might also find the following paper of mine helpful – “Inflation, Common Fallacies and Real Issues,” Graduate School of Business Administration, University of the Witwatersrand Fact and Opinion Papers, No. 3, (Second Edition, 1978). (You may download it from
What Remains of Monetarism? R. W. Hafer Economic Review, Federal Reserve Bank of Atlanta Vol. 86, No. 4, Fourth Quarter (available at:

2. Schools of Economic Thought
The Classical Economists (The Quantity Theory Tradition)
Pre-Smith
Adam Smith (1776); David Hume
David Ricardo James Mill
John Stuart Mill
The Neoclassical Revolution (1871)
The Austrian School (1871)
Carl Menger
Böhm-Bawerk; Wieser
Mises
Hayek
Modern Austrians
Kirzner, Lachmann
Boettke, Horwitz, Roger Garrison, Lewin
Karl Marx
Alfred Marshall – Cambridge school
Irving Fisher - America
Pigou; Keynes
The Keynesian Revolution
Samuelson, Solow, Tobin
The Chicago School (approx – 1990) Monetarism
Milton Friedman

3. Classical Economics and the Role of Money
The ascendancy of laissez faire ideas – Say’s Law and the monetary dichotomy
Links in the chain Fed  M  the Economy
M  GDP;
define Q = GDP/P, where P is the (current weight) GDP deflator. M  PQ.
MV = PQ – the equation of exchange –Fisher;
M = kPQ – the Cambridge cash balance equation – Marshall.
gM = gk + gP + gQ; Monetary growth = inflation + economic growth (+changes in holdings of money); Question: what is the relationship between gP and gQ?
If M and Q are approximately constant we have the Quantity Theory of Money.
M P or gM = gP

4. Crisis and Disillusionment: The Economics of Keynes and Keynesian Economics
The prosperous 1920’s in the U.S. and the struggles in the U.K.
Keynes, the man and his experiences
The presumptions of Harvey Road
Scholar, student, civil servant
1914 The Economic Consequences of the Peace
Top of Cambridge, top of the world
1930 A Treatise on Money (1930)
1936 The General Theory (1936)
The U.S.and the New Deal – Keynes comes to America
Keynesian economics – the market system needs help from the government.

5. The Keynesian Message
Consumption (savings), Investment and Money (interest rates).
A law of Consumption, the paradox of thrift and the danger of stagnation
Investment drives the economy, but its so unreliable because it depends so much on expectations
A “new’ theory of interest rates, its supply and demand for money, not loanable funds, its all about a preference for liquidity and expectations (again) of interest rates
transactions, precautionary, speculative motives
It all adds up to a story of dangerous potential instability, the story of Ruritania and the wicked witch.
So you’ve gotta have the government pay for something, anything – dig some holes and fill them up again.

6. The Keynesian System in Brief – the Static Version 

7. The Keynesian Cross E C+I+G E G C+I I a +I +G C a +I B Slope = c a a Q
C+I+G E G
C+I I
a +I +G C
a +I B
Slope = c a a Q S
I+G Q B’ -a

8. Derivation of the Multiplier
Issues:
The difference between statics and dynamics
Are there forces that offset the multiplier? – for example taxation
What happens at full employment?
The method of government financing G = Taxes + Debt + Money

9. The Phillip’s Curve gP
A Keynesian Tradeoff between Inflation and Unemployment
Unemployment rate

10. The Keynesian determination of interest rates
Ms2
Ms3
Ms1
Liquidity trap i1 i2
Md = LP M

11. The Monetarist Counterrevolution
Resistance at the University of Chicago
Milton Friedman and Studies in the Quantity Theory of Money
Milton Friedman and A Theory of the Consumption Function
Milton Friedman and Anna Schwartz A Monetary History of the U.S. (1971).
Presidential address and the stagflation of the 1970’s – The Role of Monetary Policy – Nobel Prize
It should not attempt the impossible
It is impossible to control the real rate of interest
It is impossible to permanently reduce the rate of unemployment (NRH)
It should do only what is possible and desirable
It should control the supply of money to achieve predictable price stability (minimum inflation or deflation).
The only way this can be done is through a constant monetary growth rate – this is Monetarism. It’s like driving a boat with a faulty rudder across a lake
Monetarism in the spotlight

12. Alternative Theoretical Explanations
Keynesianism in retreat – what’s the alternative?!! gP and gQ are not alternatives
1. A monetary disequilibrium theory (Leland Yeager) – Monetarism enriched.
2. A model of rational expectations
3. The Austrian Model of the Business Cycle (Hayek bounces back – Nobel prize in 1974).
An increase in Consumption may plausibly imply a reduction in Investment.
Investment is an aspect of the Capital Structure (the structure of production) of the economy. If interest rates are wrong, the production structure may be wrong.
Misallocation requires costly and difficult reallocation.
Which one – maybe a combination of 1 and 3.

13. But why did Monetarism fail?
Look at what's gone from Monetarism and what it never had in the first place.
Gone since the early 1980s is a stable velocity of money.
Gone in recent times is any consensus about just which monetary aggregate counts.
Gone is the ability of the Federal Reserve actually to hit a money growth target.
Gone is the possibility of even articulating a "monetary rule," let alone actually following one.
So what’s left?
A strong sense that indeed “money does matter.”
Central banking is more art than science
A question: can the market help?

14. What’s left of the Phillips Curve?gP
Unemployment rate

15. Summing up: Aggregate Supply and Demand
Classicism: Monetarism, RE, Austrianism AS P
Short run/Long run P2 P1
Keynesianism
AD2
AD1 Q Q1 Q2

16. The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men who believe themselves to be quite exempt from any intellectual influences are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back.
John Maynard Keynes.