1. UCL ECON7003 Money and Banking Lecture 14. Rise of monetarism. Limited debate on monetary policy in post-war period. Post-war boom. Post-war consensus. Accommodating monetary policy. Balance of Payments and problems of stop-go. Return of macroeconomic turbulence: the debate is revived. Financial deregulation, fiscal expansion, end of Bretton Woods system, inflationary pressures. Stagflation. IMF loan. Rise of monetarism in UK. Note: Macro debate and macro turbulence. The theory of monetarism.

2. Phillips curve. Unemployment and (wage) inflation, 1861-1913. From Phillipss 1958 article. BUT: Labour government of 1974-9 faced: Stagflation. i.e. breakdown of Phillips curve relationship.

3. 75 74 80 76 77 79 71 73 70 72 78 90 89 97 96 91 88 95 82 83 84 85 86 93 87 92 94 81 Breakdown of the stable Phillips Curve 69 67 62 66 68 65 63 64 60 61 99 98 00 01 02 π (%) u From late 1960s, negative relationship between u and π no longer evident

4. Cambridge: M D = kPY k is factor of proportionality / Marshallian or Cambridge k. Reformulates QTM as theory of money demand. Keynes: M D = k(r).PY Not compatible with QTM. k not constant – cyclical fluctuations, etc. Friedman: M D = k(r B, r 1... r n ).PY r B : return on bonds r 1... r n : rates of return (explicit or implicit) on other assets besides bonds. Restatement of QTM.

5. Friedman: Income may fluctuate (cycle, etc.), so how justify concept of stable MD? Individuals smooth out expenditure: Permanent Income: Saving / dis-saving over perceived / expected average lifetime earning. i.e. MD responds to wealth, as flow > stock variable. Money demand has a stable relation to wealth, thus defined.

6. Neutrality of money – LR / SR distinction: Old QTM: ΔM ΔP only, with ΔY = 0. i.e. ΔP / ΔM = 1. Friedman: M is neutral in LR, as in old QTM: i.e. Δ LR P / ΔM = 1. BUT: ΔM may have SR effect on Y: ΔM ΔP, but also Δ SR Y > 0. i.e. Δ SR P / ΔM < 1. This SR effect gradually unwinds till we have Δ LR P / ΔM = 1.

7. Friedmans Adaptive Expectations Hypothesis / fooling model / effect of SR changes in MS: Wage-earners expectations of movements in P take time to adapt. P and wage-earners underestimate change. they supply more labour than if they had realised how much their real wage has been eroded by inflation. Model works symmetrically in reverse / overestimation.

8. P, P e PePe P the short run

9. Natural rate Old classical: Unique point of equilibrium / self-regulating level. This is Y FE. Friedman: This is unrealistic. redefined LR sustainable level as natural rate: (1) Will always be some u. At equilibrium / self-sustaining level: natural rate – NRU. (2) NRU is not constant. Changes with changing labour market conditions.

10. Monetarisms optimal MS rule: Set growth rate of M at same rate as growth of Y. MR equilibrium: MV = PY MR: y = y e + classical assumption of V = V P = V/Y.M = const. x M, say κM, i.e. QTM. π (P – P -1 ) / P -1 = (κM – κM -1 ) / κM -1 = (M – M -1 ) / M -1 i.e. MR equilibrium: π = γ, where γ is growth rate of M.

11. BUT: Problems of CB in controlling MS – review. CB is not the only player in MS process: Decisions of commercial banks over deposit creation / excess reserves, etc. Decisions of NBP affect cash-deposit ratio. Decisions of borrowers from banks affect interest rates.

12. Money market equilibrium with monetarist assumptions: MS exogenous. MD a stable function of income. Unique point of equilibrium: M D /P(y e ) = M S /P MS curve super-imposed on MD curve.

13. With MD at M D 0 /P (M D 1 /P), r rise (fall) without limit. Keynesianism: r determined in money market. Monetarism: r undetermined in money market. Disequilibrium in money market on monetarist assumptions.

14. Effects of discretionary monetary policy -- monetarist view. Discretionary monetary policy Downward (upward) pressure on r. MS above (below) unique level appropriate to y e y deviates above (below) y e. All points where y y e are off money market equilibrium. LM is stationary at unique position appropriate to y e.

15. Monetary policy twice damned: IS aspect – review. Monetarism: IS flattish: I highly r-sensitive. Slope represents marginal efficiency of capital. i.e. S-side influences on investment demand. Keynesianism: IS steep. r is only one among many determinants of I. Likely to be relatively minor. Decisions likely to be very LR. i.e. not dependent on SR factors like fluctuations in r.

16. NOTE ALSO: Keynes himself: Un-modellable D-side factors: Mood (investor optimism, pessimism). Expectations. Volatility. Human decisions affecting the future … cannot depend on strict mathematical expectation… the outcome of a weighted average of quantitative benefits multiplied by quantitative probabilities. [We act] choosing between the alternatives as best we are able, calculating where we can, but often falling back for our motive on whim or sentiment or chance.

17. fig GDP Investment Volatility of Investment greater than Volatility of GDP Sloman p. 487, Box 17.6 GDP

18. Monetary expansion r economy moves down IS. Monetary contraction is then implemented as a counter-measure. BUT overshoots y e. Discretionary MP and generation of cycle: monetarist view.

19. Long and variable lags in effects of discretionary monetary policy. impossible to stabilise AD through this means. Expansions and contractions in themselves net to zero. But outcome nevertheless adverse -- economy harmed by instability. Discretionary monetary policy is principal cause of business cycle.

20. O Time Path (a) – without intervention Path (c) – undesired outcome of intervention Path (b) – aim of intervention The intervention has increased the amplitude of the fluctuations! Y Fluctuations and lags

21. Monetarist alternative to discretionary monetary policy: Should be conducted according to a rule. Any rule is better than discretion. Friedmans preference: Constant money growth rule: Growth rate set according to LR growth rate of economy.

22. LR economic growth ΔMS is necessary BUT MS should be set in way that minimises inflationary expectations. Governments cannot be trusted with discretion to do this: they have other motives. Monetary policy should be set by rules that are clearly-identifiable publicly-announced credibly enforceable e.g. in step with the trend rate of growth. Should be administered by a monetary authority independent of government.

23. Non-inflationary increase in MS by CB following MS rule in low-π conditions – preview.

24. Money market: y e to y e determined on S-side. MD increases from M D (y e ) to M D (y e ). CB follows its MS growth rule MS = MD, i.e. superimposed. no upward or downward pressure on r.