Archive for the ‘e488-monetarism’ Category

A Response to Hoover’s “The New Classical Macroeconomics”

Thursday, March 20th, 2008

Chapter 5: The New Monetary Economics

New classicals have brought about criticisms to monetarism, Keynesian monetary theory, and earlier new classical work for not starting with microfoundations.  Prior to Keynes’ General Theory was written in 1936, the distinction between microeconomics and macroeconomics was unknown.  Rather, there was two economic theories that were prevalent during that time–monetary theory (general price levels) and value theory (relative price levels).  A year earlier than the General Theory, John Hicks discussed monetary theory, which he claimed had its roots in value theory.  The difficult discussion dealt with explaining why people held non-interest bearing money when interest-bearing money opportunities were available.  He concluded that these forms (i.e. non-interest) were held to overcome what he termed as “frictions,” or transaction costs and risk.  The early stages of the quantity theory of money is derived from the Walrasian system where all markets clear because price levels adjust to put supply and demand into equilibrium.  It was eventually discovered that price levels (absolute or general) were ultimately determined by the quantity of money in circulation so as long as the velocity of money in circulation was corrected.  From this stemmed discussions of inflation.  Monetarists, such as Milton Friedman, suggested that in the long run, the growth rate of the money supply only affects the general price level instead of the real output of the economy.  Nevertheless, the inflation phenomenon is one in which there is more money supplied than there is money demanded.

Patinkin took the quantity theory of money a step further by starting to explore real price levels. He noticed that economic activity could be carried on at any absolute price level, but money has a value.  Therefore, its value depends on the aggregate price level, and as a result, Patinkin divides through by the price level to discover the real purchasing power of money and incorporates that data into utility functions.  This allows for the fusion of monetary and value theory because the demand for money is defined to be the same as the demand for any other good because it holds a certain utility value.  In addition, the level of absolute prices is determined in conjunction with all relative prices so as long as there is an “anchor” or standard to set those prices (i.e. gold).  However, the principal criticism for Patinkin’s theory is the absence of a distribution effect.  A distribution effect assumes that if an economic agent had an increase in cash balance then he would increase his supply and demand proportionately and the relative proportions remain unchanged.  This also assumes that every economic agent is alike, which means that it wouldn’t matter who received the increased cash balance.

Gurley and Shaw (1960) look at the finance process.  They define money with two out of the three characteristics as did Patinkin–that is, money is the medium of transactions and its demand is assumed to “arise from uncertainty about the timing of receipts and payments.”  The new definition associated with money under the Gurley-Shaw theory is that money can be termed debt.  Therefore, one person’s assets exactly equals another’s debt.  The two would then cancel out.  Looking at money as a means of exchange, it is useful in transactions given the uncertainty.  This uncertainty is what causes the differences in rates of return of portfolios.  Fama’s paper is important because he claims money exists only because of “government-imposed legal restrictions on other financial assets.”  However, I don’t understand his argument with regard to being able to get rid of fiat money if the government introduces it into the economy and the story regarding ingots and government taxation on spaceships (pages 95-97).

Chapter 5 ends with a discussion of banking and finance and how it relates to the Modigliani-Miller theorem.  According to Hoover, the theorem says that “how a firm finances its real activities has no decisions of other economic agents.”  Fama assumes a few things.  One, there are perfect capital markets (i.e. “no taxes, transactions costs, or danger of bankruptcy).  There is also assumed to be rational expectations.  Third, economic agents are concerned with risk-return ratios as they pertain to changes in wealth.  Fourth, firms ‘investment decisions are made independently of the how the investment is financed.  Lastly, economic agents have the same access to capital markets–that is, if a firm can issue a liability, so, too, can an individual agent.  Debt-equity ratios can be altered by a firm, for example, which will change the real opportunities of return by economic agents.  However, to return the economy to the previous state prior to changes in a firm’s finances, economic agents will have to modify their portfolio composition.  Fama concludes his argument by stating that relative prices are independent of any financial portfolios–that is, relative prices are derived from fiat money or commodities and absolute prices (with inflation built in) are independent of financial assets.  The conflicting idea that I don’t comprehend is that a sophisticated and more developed financial system relies on the presence of money because a financial asset is essentially a claim on something else and the conversion of one asset into another form is done through the transaction of money.  The liquidity of money is of utmost importance because of the “lack of necessary connections between the amount of outstanding claims to goods of conversion.”  That is, money tends to become the good in which “accounts are settled and into which financial assets are ultimately convertible.”  Not following the conclusion, Hoover asserts that, in fact, relative prices are not independent of finance.

Source: Hoover, Kevin D.  1988.  The new classical macroeconomics.  Cambridge, Massachusetts: Basil Blackwell.

A Response to Friedman’s “The role of monetary policy”

Sunday, February 3rd, 2008

Milton Friedman’s article hopes to achieve two things–how can monetary policy contribute to the business cycle and how it should be conducted so that it is the most effective.  Friedman makes the readers aware from the start that Keynes recognized that the monetary policy in place in the 1920s could do little to mitigate the Great Depression because it was a useful tool to stop inflation, but would have done little to curb the recession.  During Keynes time of the Great Depression, he also realized that the liquidity preference for holding money was much higher during times of unemployment, but little could be done in way of monetary policy.  That is where he realized the benefits of government spending to make up for “insufficient private investment” due to the higher interest rates.  It wasn’t until after WWII when monetary policy was realized to be “potent” (as Friedman puts it) because of the inflation sparked by the “cheap money policies.”

In the article, Friedman strongly suggests that the Great Depression, or the Great Contraction as he calls it in this article, was brought on in great part due to the Federal Reserve engaging in deflationary policies, which contracted the money supply by one-third.  Essentially, the Federal Reserve failed to provide liquidity to the banking system.   In Friedman’s era, the role of monetary policy is to promote full employment first and foremost.  Second in the objectives of monetary policy is the prevention of inflation.  However, Friedman feels that the role of the Federal Reserve and monetary policy may be too vast–that is, perhaps the Federal Reserve can’t take on such a big challenge.

Two limitations that monetary policy have a hard time addressing are pegging interest rates for a long period of time as well as pegging unemployment for a long period of time.  Rather than letting the U.S. government pegging war and post-war bonds at a certain price, which turned out to be a mistake, the Fed should engage in open market operations by buying and selling securities.  Of particular concern is a way to keep interest rates low–meaning that the Fed should buy securities to make more money available for banks to loan out.  Friedman recognizes that by allowing the Fed to engage in open market operations, there would be a cyclical adjustment period because as the story goes, if there is more money in the economy, more people will be spending money, which in turn will lead to higher real wages and eventually higher prices.  This would cause spending to decrease and interest rates will have to return to a higher level in perhaps one to two years.  An interesting point that Friedman makes is the country comparison to interest rate levels.  He notes that countries that have higher interest rates have looser monetary policies in place than those countries that have lower interest rates.  This has to do with the fact that outrageous inflation levels have to be curbed by higher interest rates, but in order to achieve those high inflation levels in the first place, the central banking system of that country had to be irresponsible by trying to stimulate growth or “patch up a debt” through the printing of money.  The second limitation that Friedman discusses is the level of pegged unemployment in the long run.  Friedman asks why monetary policy cannot peg the unemployment at a consistent level, say three percent (which is his example).  The reason being is the same reason as pegging interest rates in the long run–in the long run the economy will react to those subsequent policies, but those reactions will be lagged and delayed.  Excess supply or demand will force the real wage rate lower and higher, respectively, than would otherwise be experienced in a state of equilibrium.  (An interesting note about the wage rate is Friedman’s argument regarding minimum wage rates and the strength of labor unions, all of which make the natural rate of unemployment higher than the market would otherwise dictate.)

One thing that Friedman stresses is that monetary policy, though it sounds negative, may prevent money from being a “source of economic disturbance.”  Essentially, the Great Contraction may have occurred on a lesser scale or not at all if deflationary measures weren’t used by the Federal Reserve System.  The second thing that monetary policy can do that will help the economy is to keep it running, to keep it “well oiled.”  That is to say, monetary policy can ensure price stability, which is important for consumers and businesses alike because they will consume more rationally and predictably if the economy is presumed to be stable.  Lastly, monetary policy works as a countermeasure.  For example, if there are presumed federal budget deficits–which means an increased spending–then monetary policy could work to offset the expected increases in inflation.

 When looking at how monetary policy should be conducted, there are two responsibilities: controlling factors in the environment that it can more easily control (i.e. price level) and stay away from those that it has a harder time controlling (i.e. unemployment levels) and avoiding “sharp swings” in policy (i.e. over correcting the market by being too expansionary and too contractionary).  All in all, short of publicly stating a fixed monetary growth, stable monetary policy is needed to promote economic stability.  However, Friedman does recognize the shortcoming, which is sometimes unavoidable–that is, there are other exogenous factors that will influence the domestic economy (i.e. exchange rates, currency markets, and foreign economic trends).

Source: Friedman, Milton.  1968.  The role of monetary policy.  American Economic Review 58 (March): 1-17.  (This can be found in Snowdon’s Macroeconomic Reader.)