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A Monetarist Model for Economic Stabilization

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A Monetarist Model for Economic Stabilization A Monetarist Model for Economie Stabilization* by LEONALL C. ANDERSEN and KEITH M. CARLSON rji I. HE MONETARIST VIEW that changes in the in curbing excessive growth in total spending, largely money stock area primary determinant of changes because the money stock grew at a historically rapid in total spending, and should thereby be given rate during the four years ending in late 1968. Eco- major emphasis in economic stabilization programs, nomic developments from 1965 through 1969 were in has been of growing interest in recent years. From general agreement with the expectations of the the mid-1930’s to the mid-1960’s. monetary policy re- monetarist view. ceived little emphasis in economic stabilization policy. Presumed failure of monetary policy during the This article develops a model designed to analyze early years of the Great Depression, along with the economic stabilization issues within a framework development and general acceptance of Keynesian which focuses on the influence of monetary expan- economics, resulted in a main emphasis on fiscal ac- sion on total spending. Most of the major econometric tions — Federal Government spending and taxing models have not assigned an important role to the 1 programs — in economic stabilization plans. Monetary money stock or to any other monetary aggregate. policy, insofar as it received any attention, was gen- Furthennore, most econometric models contain a large erally expressed in terms of market rates of interest. number of behavioral hypotheses to be empirically Growing recognition of the importance of money estimated and integrated with each other, because and other monetary aggregates in the determination they are designed to aid in understanding the deter- of spending, output, and prices has been fostered by mination of many economic magnitudes. By compari- the apparent failure of stabilization policy to curb son, the model presented in this article is quite small. the inflation of the last half of the l960’s. Sharply It is designed to provide information on the most rising market interest rates w’ere interpreted to indi- likely course of movement of certain strategic eco- cate significant monetary restraint, while the Reve- nomic variables in response to monetary and fiscal nue and Expenditure Control Act of 1968 was con- actions. sidered a major move toward fiscal restraint. Frank de Leeuw and Edward M. Cramlieh, “The Federal Despite these policy developments, total spending Reserve-MI’I’ Econometric Model,” Federal Reserve Bul- continued to rise rapidly until late 1969, and the rate letin (January 1968), pp. 11-40, and “The Channels of Monetary Policy: A Further Report on the Federal Reserve of inflation accelerated. Those holding to the mone- MIT Econometric Model,” Federal Re~~~erveBulletin (June tarist view were not surprised by this lack of success 1969), pp. 472-91; James S. Duesenberry, Gary Fromm, Lawrence R. Klein, and Edwin Kuh (ed), The Brookings Quarterly Econometric Mode? of the United States (Chicago: aOffering helpful suggestions throughout the study were Rand McNally, 1965), and The Brookings Model: Some Denis Karnosky of this bank, William P. Yohe of Duke Uni- Further Results (Chicago: Rand McNally, 1969); Michael versity and visiting Scholar at this bank, 1969-70, and K. Evans and Lawrence R. Klein, The Wharton Econometric David Fand of Wayne State University. Susan Smith pro- Forecasting Model, 2nd Enlarged Edition (Philadelphia: vided programming assistance and Christopher Babb and University of Pennsylvania, 1968); Maurice Liebenberg, H. Albert Margolis advised on statistical problems. The Albert A. Hirsch, and Joel Popkin, “A Quarterly Econo- authors thank the following for their comments on earlier metric Model of the United States: A Progress Report,” drafts, without implying their endorsement of either the Survey of Cur,’ent Business (May 1966), pp. 423-56; Daniel methods of analysis or the conclusions F. Gerard Adams, M. Suits, “The Economic Outlook for 1969,” in The Philip Cagan, E. Gerald Corrigan, Richard Davis, Ray Fair, Economic Outlook for 1969, Papers presented to the Six- Edgar Fiedler, Milton Friedman and members of the Money teenth Annual Conference on the Economic Outlook at The and Banking Workshop at the University of Chicago, Edward University of Michigan (Ann Arbor: University of Michigan, Gramlieh, Harry C. Johnson, John Kalchbrenner, Edward 1969), pp. 1-26. For a discussion of the role of money in Kane, Michael Keran, Allan Meltzer, Franco Modigliani, these models, see David I. Fand, “The Monetary Theory of George Morrison, David Ott, Joel Popkin, Thomas Saving, Nine Recent Quarterly Econometric Models of the United Roger Spencer, Henry Wallich, Clark Warburton, Manfred States,” forthcoming in the Journal of Money, Credit, and Willms, and Arnold Zellner. Banking. Page 7 ~AL RESERVE SAI?or ST LOUIS - APRIL 1970 The model presented here is the authors’ own ver- net increase in total spending. A change in the money sion of how monetary and fiscal actions influence the stock, on the other hand, exerts a strong independent economy. Other economists (including those of a influence on total spending. Monetarists conclude that inonetarist persuasion) may prefer to develop certain actions of monetary authorities which result in aspects of the model in a different way. Two such changes in the money stock should be the main tool modifications are presented in Appendix C. The of economic stabilization. Since the economy is con- model is considered open to revision, hut is presented sidered to be basically stable, and since most major at this time with a view to stimulating others to join business cycle movements in the past have resulted in quantifying relationships that are generally asso- from inappropriate movements in the money stock, ciated with the monetarist view. control of the rate of monetary expansion is the means by which economic instability can be minimized. This article is divided into five major sections. A general monetarist view of the response of spending, The theoretical heritage of the monetarist position output, and prices to monetary and fiscal actions is is tile quantity theory of money.8 This theory dates summarized first. Next, the specific features of the back to the classical economists (particularly David model are discussed within a formal framework of Ricardo) in the early 1800’s. The quantity theory in analysis. Statistical estimates of the model’s param- its simplest form is characterized as a relationship eters are presented in the third section. The fourth between the stock of money and the price level. section tests the performance of the model with sev- Classical economists concentrated on the long run eral dynamic simulation experiments.. Finally, by aspects of the quantity theory in which changes simulating the response of the economy to alterna- in the money stock result in changes only in nominal tive rates of monetary expansion, an illustration is magnitudes, like the price level, but have no influ- provided of how the model can be used for current ence on real magnitudes like output and employment. stabilization analysis. The quantity theory of money in its modem form General Monetarist View recognizes the important influence that changes in the money stock can have on real magnitudes in The general monetarist viesv is that the rate of the short run, while influencing only the price level monetary expansion is the main determinant of total in the long run. The modern quantity theory postu- spending, commonly measured by gross national lates that in the short run a change in the rate of product (GNP ) .~ Changes in total spending, in turn, growth in money is followed with a moderate lag by influence movements in output, employment, and the changes in total spending and output, while changes general price level. A basic premise of this analysis in the price level follow with a somewhat longer lag.~ is that the economy is basically stable and not neces- These changes in total spending, output, and prices sarily subject to recurring periods of severe recession are in the same direction as the change in the rate and inflation. Major business cycle movements that of monetary expansion. have occurred in tile past are attributed primarily to large swings in the rate of growth in the money stock. The modern quantity theory still accepts the long- run postulates of its older version. A change in the This view regarding aggregate economic relation- ships differs from prevailing views which consider rate of monetary expansion influences only nominal niagnitudes in the long run, namely, total spending aggressive policy actions necessary to promote sta- (GNP) and the price level. Real magnitudes, notably bility. Monetarists generally hold that fiscal actions, in the absence of accommodative monetary actions, 3 exert little net influence on total spending and there- The classic work on the quantity theory is Irving Fisher, The Purchasing Power of Money (New York: Macmillan, fore have little influence on output and the price 1911). For an extensive review of the quantity theory level. Governsnent spending unaccompanied by ac- literature, see Arthur W. Marget, The Theory of Prices: A Re-examination of the Central Problems of Monetary Theory commodative monetary expansion, that is, financed (New York: Prentice-Hall, 1938), volume II, pp. 3-133. 4 by taxes or borrowing from the public, results in a Many of the ideas prevalent in current monetarist doctrine crowding-out of private expenditures with little, if any, can be found in the writings of Clark Warburton in the 194O’s and early 1950’s. Many of his important articles have been reprinted in his Depression, inflation, and Monetary 2 Ceneral references on the monetarist view are Karl Bmnner, Policy, Selected Papers, 1945-1953 (Baltimore: The Johns “The Role of Money and Monetary Policy,” this Review Hopkins Press, 1966). See also Milton Friedman, (ed), (July 1968), pp. 9-24; David I. Fand, “Some Issues in Studies in the Quantity Theory of Money (Chicago: Uni- Monetary Economics,” this Review (January 1970), pp.
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