Mainstream view, monetarist view, real-business-cycle view, coordination failures are Monetarists say that inappropriate monetary policy is the single most The number of times per year that the average dollar in the money supply is spent is a predictable relationship between the mony supply and nominal GDP (=PQ). Monetarist say that the relationship between the amount of money which . Assume that many households and businesses reduce their spending only because. Monetarists say that the relationship between the amount of money which households and businesses want to hold and the level of national output and income.
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.
- Keynesianism vs Monetarism
Theories and Policies, the key propositions advanced by monetarist economists in particular, Milton Fried-man can be summarized as follows. 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. 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.
Keynesianism vs Monetarism | Economics Help
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.
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. 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. 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. Moreover, the government, by introducing a powerful destabilizing influence changes in the money supplyinterferes 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. 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 percent per annum is considered acceptable. To generate percent inflation, the money supply must grow at percent above the growth rate of the real GDP. In effect, then, to have a modest percent inflation, the money supply should grow at about 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.
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. In general, the theoretical framework employed by monetarist economists is a modified version of classical macroeconomic theory.
The modifications were needed to address the Keynesian criticisms of the classical theory and to establish monetarist policy conclusions. Theoretical support for each of the four propositions will be briefly discussed in this section. This proposition—that money supply has a dominant effect on nominal income—is the most basic part of the theoretical structure of the monetarist counterrevolution.
Proposition one is based on a key classical theoretical framework known as the quantity theory of money. Classical economists had argued that the quantity or the supply of money determines only price level a nominal variablenot real variables such as output and employment. The quantity theory of money is used to establish the link between the quantity of money and the price level, and thus its name simply emphasizes the importance of the quantity of money. The quantity theory of money was written in the form of the equation: Apart from the notion of the velocity of money, the other variables that enter the quantity theory of money are relatively straightforward.
Noting that "Py" is nothing but the nominal aggregate output the value of the gross domestic product at current pricesthe income velocity of money can be thought of as the number of times each dollar in the nation's money supply circulates to finance the current nominal income.
The velocity, then, is just the turnover rate of money. Necessarily, the income velocity of money is greater than one. These numbers suggested the income velocity of money was approximately 7. How does the classical quantity theory of money provide the linkage between changes in the money supply and changes in the price level?
First, it is argued that velocity is constant. Classical economists, in particular Irving Fisher, argue that the velocity of money is determined largely by payment technology and payment habits of the society. For example, frequent use of charge cards, rather than money such as cash or checks increases the velocity of money. Similarly, if workers are paid on a weekly rather than a monthly basis, the velocity will be greater.
It is however, argued that the foregoing are examples of institutional characteristics, and institutional factors that determine the equilibrium level of the velocity change very slowly. As a result, the velocity of money can be regarded as fixed or constant in the short run. The second key classical assumption in fact, an inference of classical macroeconomic theory was that real output measured by real gross domestic product is constant or fixed.
As alluded to in the previous sentence and discussed under a brief overview of classical theory, the constancy of real output is a result of classical macroeconomic reasoning, rather than a simple assumption.
The fixed output is a result of the full employment level. The full employment of the labor force, in turn, is assured by a set of assumptions about the labor market. Once the above two assumptions are made i. More specifically, a money supply change leads to a proportionate change in price level. For example, if money supply increases by 10 percent, price also increases by 10 percent. The reasoning behind this linkage between the money supply and the price level is as follows: An increase in the money supply would lead to an increase in spending by individuals.
However, given that real output is assumed to be constant, the increased spending can only lead to an increase in the price level. This explanation is often summarized as "too many dollars chasing too few goods.
Thus, Fried-man modified the classical quantity of money to allow for variations in real output. Instead, he argues that the velocity can be allowed to change.
However, the changes in velocity are predictable. This complicates the explanation of the linkage between money supply and nominal income somewhat.
Chap 36 Answer Key
If AD decreases in this situation, what will happen to equilibrium output and the price level? Next, imagine that input prices are fixed, but output prices are flexible.
In this case, if AD decreases, what will happen to equilibrium output and the price level? Finally, if both input and output prices are fully flexible, what does the aggregate supply curve look like? To check your answers, review Figures In the immediate-short-run the aggregates supply schedule is horizontal. This is because all prices are fixed input and output prices. If there is a decrease in aggregate demand this will cause output to fall and no change in the price level input and output prices are fixed.
In the short-run the aggregates supply schedule slopes upward. That is, as prices increase output increases as well. This is because input prices are fixed and output prices can adjust. If there is a decrease in aggregate demand this will cause output to fall and the price level will fall as well unless we assume that prices are rigid downward the ratcheting effect, an assumption made in the previous chapters. In the long-run the aggregates supply schedule is vertical.
This is because all prices are flexible input and output prices. If there is a decrease in aggregate demand this will cause prices to fall and no change in output unless we assume that prices are rigid downward the ratcheting effect, an assumption made in the previous chapters.
According to mainstream economists, what is the usual cause of macroeconomic instability? What role does the spending-income multiplier play in creating instability?
How might adverse aggregate supply factors cause instability, according to mainstream economists? The mainstream view of macroeconomic instability is Keynesian-based and focuses on aggregate spending and its components. Particularly significant are changes in investment spending, which change aggregate demand and, occasionally, adverse supply shocks which change aggregate supply. In the mainstream view, a second source of instability could arise on the supply side.
Wars or artificial supply restrictions boost may increase per unit production costs. What is an efficiency wage? How might payment of an above-market wage reduce shirking by employees and reduce worker turnover?
How might efficiency wages contribute to downward wage inflexibility, at least for a time, when aggregate demand declines? Normally, we could assume that the market wage for the particular type of labor would be efficient, since it is the lowest wage that could be paid to obtain workers in the classification.
Firms may discover, however, that paying a wage that is higher than the market wage will lower their wage cost per unit of output. There are a number of reasons for this possible outcome: First, the above average wage raises the opportunity cost of losing the job and gives workers an incentive to retain their relatively high-paying job.
Worker productivity is likely to be higher and in a sense the higher wage more than pays for itself. Second, motivated workers require less supervision. If the firm needs fewer supervisory personnel to monitor work performance, the overall wage cost per unit of output can be lower. It also gives the firm a better selection of potential workers, since the above-market wage would increase applications.
With a high retention rate and a good pool of applicants, the firm is likely to maintain a more experienced and productive workforce. Efficiency wages are likely to contribute to downward wage inflexibility. Wage cuts may encourage shirking, require more supervising personnel and increased turnover. Wage cuts that reduce productivity and raise per-unit labor costs are self-defeating. How might relationships between so-called insiders and outsiders contribute to downward wage inflexibility? Insiders are workers who retain employment even during recession.
Outsiders are workers laid off from a particular firm and other unemployed workers who would like to work at that firm. Insider-outsider theory suggests that wages will be inflexible downward even when aggregate demand declines.
Employers seem to believe that hiring unemployed workers at a reduced wage is not worth the disruption it could cause the business. Insiders are already trained, know their jobs and may work in teams.
Replacing them with outsiders may cost more than the saving in reduced wages. In the real-business-cycle theory, business fluctuations result from significant changes in technology and resource availability. These changes affect productivity and thus the long-run growth trend of aggregate supply.
The changes in aggregate supply then induce changes in the demand for money, which in this controversial scenario then leads to a change in the money supply, which allows adjustment in output without changes in the price level. The conclusion of the real-business-cycle theory is that macro instability arises on the aggregate supply side of the economy, not on the aggregate demand side as both mainstream economists and monetarists generally say.
Craig and Kris were walking directly toward each other in a congested store aisle. Craig moved to his left to avoid Kris, and at the same time Kris moved to his right to avoid Craig.
Chap 36 Answer Key
They bumped into each other. What concept does this example illustrate? How does this idea relate to macroeconomic instability?
This example illustrates a coordination failure that occurs in macroeconomics when people do not reach a mutually beneficial equilibrium because they lack some way to jointly coordinate their actions.
Expectations of households and business firms can create an undesirable outcome. If individuals expect others to cut spending and anticipate excess capacity, they will cut their own investment and consumption as well.
Aggregate demand will decline and the economy will experience a recession due to self-fulfilling prophecy. Once the economy is depressed, producers and households have no individual incentive to increase spending.
If all participants would agree to simultaneously increase spending, then aggregate demand would rise and real output and real income would expand. Each producer and consumer would be better off.