Mac Econ Chap 13 – Monetary Policy Controversy

Chapter 13:

MONETARY POLICY CONTROVERSY

The purpose of this topic is to look at the two alternative explanations of how monetary policy affects economic activity. In Keynesian view, a link exists through interest rates and investment. In monetarist view, the money stock affects the level of purchases directly. The opposing views lead to different recommendations for the appropriate policy to use.

KEYNESIAN VIEW OF MONETARY POLICY

In Keynesian view, the effect of easy money policy is an increase in money supply which causes the interest rate (or cost of borrowing) to decrease. The lower interest rate makes more investment possible. The increase in investment is an increase in aggregate expenditure which has a multiplier effect. The tight money policy works in the opposite direction.

In 1981, the Fed used a tight money policy to slow down inflation. As a result, interest rates reached unprecedented high levels. A moderate recession followed in 1981-82, apparently because of the decrease in investment which was due to the high cost and difficulty of borrowing.

MONETARY POLICY SHORTCOMINGS

In Keynesian view, monetary policy may be very ineffective. Some of the shortcomings come from the asymmetry of the policy, changes in velocity (which may frustrate policies), the uncertainty of investment to be undertaken (especially if not interest sensitive). In addition, a feedback exists in interest rates because interest rates are also costs and affect inflation which decreases wealth and, therefore, consumption.

In most countries of the world, it is generally accepted that monetary policy is adequate for controlling inflation, but is inadequate for economic stimulation. Fiscal policy is considered the appropriate tool for control of economic activity.

MONETARY POLICY ASYMMETRY

The major shortcoming of monetary policy is its asymmetry. That is, a tight money policy is very effective in preventing new loans because excess reserves are reduced, but easy money policy is likely to be ineffective because the additional excess reserves will not be lent out by banks in fear of potential bankruptcies of borrowers during periods of recession. Thus, the recommendation is not to use monetary policy, but fiscal policy instead.

During the great depression of the 1930’s, interest rates dropped below 1%. At this low interest rate, one would think that many businesses would have taken out loans. But this did not happen: the volume of loans also decreased considerably. The reason was that businesses had difficulties staying in business, and banks were afraid to lend them money.

MONETARY POLICY DILEMMA

Monetary policy may be used to either control the money supply or the interest rate. But, both cannot be controlled at the same time. Thus the dilemma. In the past, the dilemma was especially important because the Fed was often responsible for facilitating government borrowing by keeping interest rates low. Such policy would normally be contrary to the goal of inflation control, a major responsibility of the Fed.

The choice between control over interest rates and control of money supply was especially difficult right after World War II. As a result of the war, the government had a large debt and was urging the Fed to keep interest rates low. But the low interest rate policy ran contrary to the need to tighten the money supply and keep inflation down.

MONETARIST VIEW OF MONETARY POLICY

In the view of monetarists, an easy money policy increases the money balances of individuals encouraging them to spend more because individuals maintain a stable relationship between their desired money balances and spending. A tight money policy reduces money balances and curtails spending directly. In monetarist view there is no need for the investment linkage of the Keynesian view presented above.

If the money stock increases, it means that there is more money in checking deposits, which are the largest component of money. If individuals have more money in their checking accounts, they will feel wealthier and will be more willing to spend.

QUANTITY OF MONEY EQUATION

The monetarists rely on extensive empirical verification of the quantity of money equation: MV=PQ, which states that the money stock M multiplied by velocity V equals volume of real output Q multiplied by price level P. They see a causal relation between the volume of transactions and the money stock.

One may recall the circular flow of funds to better understand the quantity of money equation. The sum of everything that has been sold over 12 months is price multiplier by quantity: PQ. What has been sold is also equal to what has been purchased. And that is equal to the average amount of money on hand M multiplied by how many times V that the money amount was used: MV. The two are really one and the same.

VELOCITY

Velocity is the rate of turnover of money. The velocity is believed to be stable by the monetarist because it is a reflection of our society’s desire for security in maintaining a proportion between money balances and spending. This stability appears to exist when broad measures of money stock are used such as M2 or M3.

Each person has some proportion of wealth or income that he/she feels is appropriate to keep in the form of money for unforeseen needs. The proportion is different for different people and depends of each person’s attitude about uncertainty. This attitude does not change much over time, and neither, therefore, the proportion between money balances and spending.

MONETARIST CRITIQUE

The monetarists criticize Keynesian policy recommendations pointing to the misguided monetary policy of aiming at keeping interest rates low (to facilitate government borrowing) which is destabilizing and inflationary. They also focus on the crowding out effect of fiscal policy. The benefit of fiscal policy is the increase in money stock, they say, but it is less wasteful in bureaucratic inefficiency if carried out as monetary policy.

The actions taken by the Fed during the great depression tend to support the monetarist view of a misguided monetary policy. The discount rate was raised in 1931. The required reserve ratio was increased in 1936 and 1937. Finally, the open market operations consisted in selling rather than buying securities by the Fed. All these actions contributed to the severity of the depression.

MONETARIST RECOMMENDATION

The recommendation of the monetarists is to avoid discretionary (and destabilizing) monetary policy, but use, instead, a steady rate of growth of money supply to permit a steady growth of the economy. Fiscal policy should also be limited.

The monetary policy of the 1980’s was inspired by monetarist view and seems to have carried out some of its promises.

When Paul Volker was appointed chairman of the Fed in 1979, he announced that he would concentrate on money growth and not on interest rates. Interest rates reached very high levels in 1980 and 1981. But, inflation was brought under control within 3 years.

VELOCITY INSTABILITY

Keynesian economists reply to monetarist’s view that velocity is unstable. This puts into question the validity of stable money stock growth for economic stability. Their contention seems to be supported when a narrow definition of money supply such as M1 is used. Furthermore, they point out that the quantity of money equation is a tautology and cannot possibly support a direction of causality.

Since the turn of the century, velocity in terms of M1 (i.e. GNP/M1) varied from 2 to 7. During the same time, velocity in terms of M2 (i.e. GNP/M2) remained just below 2 for the entire period. Thus, the statistics support both views of velocity stability and instability.
Advertisements

One thought on “Mac Econ Chap 13 – Monetary Policy Controversy

  1. Pingback: Mac Econ (Lectures) – Big Sea of Knowledge

Leave a Reply

Fill in your details below or click an icon to log in:

WordPress.com Logo

You are commenting using your WordPress.com account. Log Out / Change )

Twitter picture

You are commenting using your Twitter account. Log Out / Change )

Facebook photo

You are commenting using your Facebook account. Log Out / Change )

Google+ photo

You are commenting using your Google+ account. Log Out / Change )

Connecting to %s