Thursday, 3 December 2009

What happened to the term monetarism?

This is the question asked by Matt Nolan over at the TVHE blog. Matt writes
For example, the term monetarist. In a discussion with my sister and on this post from the DimPost the term “monetarist” was used to describe a relatively right wing outlook about political issues and policy in general. However, this confuses me. My impression was that monetarists at their most narrow are people that believe money supply growth = inflation completely. While more generally a monetarist is someone that believes money supply growth is in some way related to higher long run inflation
Let me say what Milton Friedman thought monetarism was, and he should have known. This comes from "The Counter-Revolution in Monetary Theory", (First Wincott Memorial Lecture delivered at the Senate House, University of London, 16 September, 1970), by Milton Friedman, London: The Institute of Economic Affairs, 1970, pp. 22-26:

LET ME finally describe the state to which the counter-revolution has come by listing systematically the central propositions of monetarism.

1. There is a consistent though not precise relation between the rate of growth of the quantity of money and the rate of growth of nominal income. (By nominal income, I mean income measured in pounds sterling or in dollars or in francs, not real income, income measured in real goods.) That is, whether the amount of money in existence is growing by 3 per cent a year, 5 per cent a year or 10 per cent a year will have a significant effect on how fast nominal income grows. If the quantity of money grows rapidly, so will nominal income; and conversely.

2. This relation is not obvious to the naked eye largely because it takes time for changes in monetary growth to affect income and how long it takes is itself variable. The rate of monetary growth today is not very closely related to the rate of income growth today. Today's income growth depends on what has been happening to money in the past. What happens to money today affects what is going to happen to income in the future.

3. On the average, a change in the rate of monetary growth produces a change in the rate of growth of nominal income about six to nine months later. This is an average that does not hold in every individual case. Sometimes the delay is longer, sometimes shorter. But I have been astounded at how regularly an average delay of six to nine months is found under widely different conditions. I have studied the data for Japan, for India, for Israel, for the United States. Some of our students have studied it for Canada and for a number of South American countries. Whichever country you take, you generally get a delay of around six to nine months. How clear-cut the evidence for the delay is depends on how much variation there is in the quantity of money. The Japanese data have been particularly valuable because the Bank of Japan was very obliging for some 15 years from 1948 to 1963 and produced very wide movements in the rate of change in the quantity of money. As a result, there is no ambiguity in dating when it reached the top and when it reached the bottom. Unfortunately for science, in 1963 they discovered monetarism and they started to increase the quantity of money at a fairly stable rate and now we are not able to get much more information from the Japanese experience.

4. The changed rate of growth of nominal income typically shows up first in output and hardly at all in prices. If the rate of monetary growth is reduced then about six to nine months later, the rate of growth of nominal income and also of physical output will decline. However, the rate of price rise will be affected very little. There will be downward pressure on prices only as a gap emerges between actual and potential output.

5. On the average, the effect on prices comes about six to nine months after the effect on income and output, so the total delay between a change in monetary growth and a change in the rate of inflation averages something like 12-18 months. That is why it is a long road to hoe to stop an inflation that has been allowed to start. It cannot be stopped overnight.

6. Even after allowance for the delay in the effect of monetary growth, the relation is far from perfect. There's many a slip 'twixt the monetary change and the income change.

7. In the short run, which may be as much as five or ten years, monetary changes affect primarily output. Over decades, on the other hand, the rate of monetary growth affects primarily prices. What happens to output depends on real factors: the enterprise, ingenuity and industry of the people; the extent of thrift; the structure of industry and government; the relations among nations, and so on.

8. It follows from the propositions I have so far stated that inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output. However, there are many different possible reasons for monetary growth, including gold discoveries, financing of government spending, and financing of private spending.

9. Government spending may or may not be inflationary. It clearly will be inflationary if it is financed by creating money, that is, by printing currency or creating bank deposits. If it is financed by taxes or by borrowing from the public, the main effect is that the government spends the funds instead of the taxpayer or instead of the lender or instead of the person who would otherwise have borrowed the funds. Fiscal policy is extremely important in determining what fraction of total national income is spent by government and who bears the burden of that expenditure. By itself, it is not important for inflation. (This is the proposition about fiscal and monetary policy that I discussed earlier.)

10. One of the most difficult things to explain in simple fashion is the way in which a change in the quantity of money affects income. Generally, the initial effect is not on income at all, but on the prices of existing assets, bonds, equities, houses, and other physical capital. This effect, the liquidity effect stressed by Keynes, is an effect on the balance-sheet, not on the income account. An increased rate of monetary growth, whether produced through open-market operations or in other ways, raises the amount of cash that people and businesses have relative to other assets. The holders of the now excess cash will try to adjust their portfolios by buying other assets. But one man's spending is another man's receipts. All the people together cannot change the amount of cash all hold - only the monetary authorities can do that. However, as people attempt to change their cash balances, the effect spreads from one asset to another. This tends to raise the prices of assets and to reduce interest rates, which encourages spending to produce new assets and also encourages spending on current services rather than on purchasing existing assets. That is how the initial effect on balance-sheets gets translated into an effect on income and spending. The difference in this area between the monetarists and the Keynesians is not on the nature of the process, but on the range of assets considered. The Keynesians tend to concentrate on a narrow range of marketable assets and recorded interest rates. The monetarists insist that a far wider range of assets and of interest rates must be taken into account. They give importance to such assets as durable and even semi-durable consumer goods, structures and other real property. As a result, they regard the market interest rates stressed by the Keynesians as only a small part of the total spectrum of rates that are relevant.

11. One important feature of this mechanism is that a change in monetary growth affects interest rates in one direction at first but in the opposite direction later on. More rapid monetary growth at first tends to lower interest rates. But later on, as it raises spending and stimulates price inflation, it also produces a rise in the demand for loans which will tend to raise interest rates. In addition, rising prices introduce a discrepancy between real and nominal interest rates. That is why world-wide interest rates are highest in the countries that have had the most rapid rise in the quantity of money and also in prices - countries like Brazil, Chile or Korea. In the opposite direction, a slower rate of monetary growth at first raises interest rates but later on, as it reduces spending and price inflation, lowers interest rates. That is why world-wide interest rates are lowest in countries that have had the slowest rate of growth in the quantity of money - countries like Switzerland and Germany.

This two-edged relation between money and interest rates explains why monetarists insist that interest rates are a highly misleading guide to monetary policy. This is one respect in which the monetarist doctrines have already had a significant effect on US policy. The Federal Reserve in January 1970 shifted from primary reliance on 'money market conditions' (i.e., interest rates) as a criterion of policy to primary reliance on 'monetary aggregates' (i.e., the quantity of money).

The relations between money and yields on assets (interest rates and stock market earnings-price ratios) are even lower than between money and nominal income. Apparently, factors other than monetary growth play an extremely important part. Needless to say, we do not know in detail what they are, but that they are important we know from the many movements in interest rates and stock market prices which cannot readily be connected with movements in the quantity of money.

1 comment:

Philip said...

Take a look at

If the close relationship between what I call corrected M1/GDP and inflation seems as if it has been cooked up, then read The relationship between money supply and other macroeconomic variables

If that sounds unusual you might want to read the analysis at A look at money supply and why it is being wrongly measured