How Keynesian Analysis Prevailed Over Monetarism
27 June 2017 | Pago Pago, American Samoa
Monetarism is an economic school that stresses the money supply in determining nominal GDP and the price level. The father of Monetarism in the US was Milton Friedman, my teacher and protege. Monetarism is closely aligned with the Austrian school of economics. Monetarism was a theoretical challenge to Keynesian economics that increased in importance and popularity in the late 1960s and 1970s but then collapsed under a mountain of empirical data against it in the 1980s and afterward. In 1969 the Federal Reserve made its operating strategy to be more in line with Monetarist theory, but thereafter they abandoned that strategy in 1982 in favor of Keynes for a number of reasons.
The theoretical foundation of Monetarism is the Quantity Theory of Money which assumes the economy is inherently stable and argues markets work well when left to themselves. Government intervention often times destabilize things more than they help.The Fed should be bound to fixed rules in conducting monetary policy. They should not have discretion in conducting policy because they could make the economy worse off. Fiscal Policy is bad policy. Only a small role for government is good. That is the monetarist view I was taught by Friedman.
Now to understand the problem, realize velocity is the average number of times that the dollar turns over in a given year on the purchase of final goods and services. By assuming that velocity is stable, the quantity theory of money, the core of monetarism, states
M × V = P × Y
where M is the quantity of M2, V is velocity of M2, P is the price level, and Y is real output. As defined, this equation implies it is always true. Some Keynesians, all Monetarists and some other economists accept this equation as valid in the long run (when we are all dead).. The controversy arises because Monetarists make a seemingly innocuous assumption that velocity is stable in the short and intermediate run. Keynesians disagree and argue in the short and intermediate run. V is unstable and not very predictable because of vagaries in saving, hoarding and the distribution of income.
If V is fixed or stable, the equation tells us that any change in M2 will directly impact P × Y. Changes in the money supply are then the dominant forces that change nominal GDP (P × Y). It is not surprising, therefore, that monetarists view control of the money supply as the key variable in stabilizing the economy. Because monetarists believe that markets are stable and work well, they believe that the economy is always near or quickly approaching full employment. ut that isn't true.
Monetarists prefer to take away the discretion of central bankers by forcing them to follow a money growth rule: Monetary policymakers should target the growth rate of money such that it equals the growth rate of real GDP, leaving the price level unchanged. If the economy is expected to grow at 2 percent in a given year, the Fed should require the money supply to increase by 2 percent. Monetarists wish to take much of the discretionary power out of the hands of the Fed so they cannot destabilize the economy.
Keynesians balk at this proposed money growth rule. Keynesians believe that velocity is inherently unstable and they do not believe that markets adjust quickly enough to return us to true full potential output. Therefore, Keynesians attach little or no significance to the Quantity Theory of Money. Because the economy is subject to deep swings and periodic instability, it is dangerous to take discretionary power away from the Fed. The Fed should have some leeway or "discretion" in conducting policy. The Keynesians have won this debate. There has not been serious talk in some time of tying the Fed to a fixed money growth rule.
Monetarists believe that fiscal policy is not helpful. Because Monetarist dislike big government and tend to trust free markets, they do not like government intervention and believe that fiscal policy is not helpful and doesn't work. Excessive government intervention only interferes in the workings of free markets and can lead to bloated bureaucracies, unnecessary social programs, and large deficits. Automatic stabilizers are sufficient to stabilize the economy.
The debate between Monetarists and Keynesians hinges on the stability of velocity and the efficiency of markets. That velocity has been unstable and unpredictable since the early 1980s is the result of empirical research and the Keynesians have prevailed. The monetarist view hinges on the two assumptions described above: the stability of velocity and the efficiency of markets. Both have failed.
Actually, monetarism relies on the predictability of velocity rather than absolute stability, so in the 1970s one could make a case for the short-run quantity theory. However, the 1980s,1990s and 2000s have not been kind to Monetarist assumptions. Velocity has bee highly unstable with unpredictable periods of increases and declines. In such an environment, the link between the money supply and nominal GDP broke down and the usefulness of the quantity theory of money fell into decline. Many economists who were convinced by Friedman and Monetarism in the 1970s abandoned this approach in the mid- to late-1980s. The empirical relationship had simply broken down. Why?
Some economists think the breakdown was primarily the result of changes in banking rules and other financial innovations. Beginning in the 1980's many other means became available to hold and store liquid value that were not M2 and people branched out into those in order to hoard near cash value when savings were greater than real investment. People found that money markets, mutual funds, stocks and bonds as well as other assets were better alternatives than traditional bank deposits. Hence, the relationship between money and economic performance changed because V became unstable and unpredictable.
Most economists conclude that Keynesians won the war and that monetarism was too loaded with anti-government propaganda not supported by research. Keynesians were always convinced of the importance of the money supply in the long run. Most never doubted that. Also, Keynesians have always been more likely to prefer monetary policy to fiscal policy for the short run on minor dips in the economy and fiscal policy for larger economic problems. Monetarists dislike fiscal policy.
Keynesians still view fiscal policy as potentially important for that reason. As a general rule, Keynesians believe that the Aggregate Supply curve is more horizontal than vertical in the short run so stabilization policy can have big impacts on output and employment. Because Monetarists believe that the economy is inherently stable, they tend to view the Aggregate Supply curve as more vertical so discretionary stabilization policy is not as important.
Although differences remain, the debate between Keynesians and Monetarists cooled considerably in the late 1980s. Monetarists could no longer defend a useful relationship between M and nominal GDP except in the very long run. The Keynesians had prevailed.