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A Comparative Static Analysis of Some Monetarist Propositions

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A Comparative Static Analysis of Some Monetarist Propositions A Comparative Static Analysis of Some Monetarist Propositions by ROBERT H. BASCHLE Robert H. Rasohe is Associate Professor of Economics at Michigan State University, East Lan- sing, Michigan. During the 1971-72 academic year, Professor Rasche was a visiting scholar at the Federal Reserve Bank of St. Louis, The following paper evolved out of discussions and seminars with the stafi of this Bank during his visit. The paper is presented in order to foster further discussion of those propositions generally associated with the inonetarist franwwork of analysis. The element of time is a chief cause of those difficul- It would seem that a static analytic framework ties in economic investigation which make it neces- could be developed which could shed some light on sary for man with his limited powers to go step by the theoretical underpinnings of monetarism, although step; breaking up a complex question, studying one bit at a time, and at last combining his partial the mode of analysis is obviously insufficient to cope solutions into a more or less complete solution of with the dynamic propositions which are associated the whole riddle, in breaking it lip, he segregates with this school. Unfortunately the literature is ex~ those disturbing causes, whose wanderings happen tremely scarce. Milton Friedman has set forth a static to be inconvenient, for the time iii a pound called framework, and alleges that the differences between Ceteris Paribus. monetarists and post-Keynesians have to do with as- — Alfred Marshall sumptions about price (and wage) behavior. Mone- The typical textbook approach to macroeconomic tai-ism, he alleges, assumes that the aggregate price analysis is almost completely barren with respect to level is determined in such a way as to clear all what has become characterized as the “rnonetarist markets in the long run. For the short run, he alleges position” on the effects of monetary and fiscal policy that neither the monctarist nor the fiscalist has a actions. These propositions might be summarized as satisfactory theory of the response of real output and follows: the general price level to monetary shocks. Unfortu- (1) the long-nm impact of monetary actions is on nately, Friedman’s excursion into dynamics and dif- ferential equations is difficult, if not impossible, to nominal variables, such as nominal CNP, the 2 general price level, and nominal interest rates; relate to individual market forces. (2) long-mn movements in real economic variables, Thus, the issue remains unsettled. On the one hand, such as output and employment, are little influ- we are left without a clearly specified analytical enced, if at all, by monetary actions; framework for the monetarist approach which can be (3) in the short run, actions of the central bank ex- contrasted with the well-developed static income de- ert an impact on both real and nominal variables; termination model. On the other hand, and even more (4) fiscal actions have little lasting influence on importantly, there is no general model which can nominal GNP, but can affect short-run moveS produce the post-Keynesian model as a particular ments in output and employment; and case, and the monetarist and classical models as al- (5) Covernment expenditrn-es financed by taxes or ternative eases. Such a framework is useful in order to borrowing from the public tend to crowd out, dliscriminate between alternative hypotheses and to over a fairly short period of time, an equal amount of private expenditures.1 construct empirical tests which have the potential to refute one, or both, positions. IThese propositions have been gleaned from Leonall C. Ander- sen, “A Monetarist View of Demand Management: The 2Mjjton Friedman, ‘A Theoretical Framework for Monetary United States Experience,” this Review (September 1971), Ana’ysis,” Journal of Political Economy (March/April 1970), pp. 3-11. pp. 193-238. Page 15 FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1973 This study attempts to develop a general model by consideraUon does not, of course, rule out some ad- 4 examining equilibria which differ by the length of the justment to temporary movements in prices. “run,” This Marshaflian tool should be clearly defined as applying to the behavior which is assumed to he Recently, following the pioneering work of George embodied in the ceteris paribus assumptions: the more Stigler and Armen A. Alehian, considerable theoretical and empirical work on labor market behavior and the behavior which is embodied in ceteris paribus, the 5 Phillips curve has been produced. These studies as- shorter the “run” Traditional macrostatics has been of the Marshallian “short-mn” variety; that is, the real sume that workers do not possess perfect information capital stock has been held constant. This leads to on the wages available to them in return for their labor services, and it is costly for workers to search out some itnforhrnately confusing terminology, Most of the traditional analysis from which the “long-run” mone- infonnation on the opportunities available to them. tarist propositions can be gleaned is not long-run Within this framework it is necessary to distinguish analysis in the Marshallian sense. At the risk of add- bet’sveen the nominal wage rate which is aethally of- ing further confusion to the discussion we shall stay fered for labor services at a point in time, W, and the with the traditional short-run definition as the “short wage rate which is perceived by suppliers of labor run,” and compare the results of this model with those services, We. In this paper we employ a wage rate information parameter, X , to relate the perceived of an even shorter run, or “momentary run” model. 1 wage rate to the currently offered rate and an exog- It is well established that a Patinkin-type four enous, or predetermined, component, W,. market model (labor services, commodities, bonds, The relationship we postulate is: and money), under assumptions of complete price flexibility, absence of money illusion, unitary elasticity xl 1—Al We~W (W ) of price expectations, and perfect information on 0 market prices, will exhibit propositions (1), (2), and so the perceived nominal wage rate is a geometric (5) above, in comparison of “short-run” equilibria average of the current wage rate and a predetermined which differ because of a shock to some policy vari- wage rate, presumably based on the history of pre- able.3 However, these analyses have nothing to con- vious wage experience. If the wage information param- tribute to the discussion of propositions (3) and (4). eter, X1, is set equal to 1.0, there is costless informa- tion and the perceived wage rate is the current nom- inal wage. At the other extreme, if Xj is set equal to Basic Elements of Model zero, information about the current wage rate has More than a decade ago, it appears that the assiimp- an infinite price and there is total ignorance of current don of perfect information on prices was implicitly market conditions. relaxed in some of the research work of leading mom This cost of information approach can be extended etarists. Friedman, fi~his work on the demand for to the commodity ma4cet. We assume that households money, distinguished between the current commodity make their consumption and portfolio decisions on the price index, and a longer-run concept which he called basis of their perceived commodity price index, P , the “permanent price leveL’ He argued that: 0 which can differ from the actual commodity price in- -.holders of money presumably judge the “real” dex if information on commodity prices is imperfect amount of cash balances in terms of the quantity of and costly to gather6 Analogous to the case of the goods and services to which the balances are equiv~ wage rate, we postulate a price information parameter, alent, not at any given moment of time, but over X , which relates the perceived price index to the a sizable and indefinite period; that is, they evalu- 2 ate them in terms of “expected” or “permanent” current price index as follows: prices, not in terms of the current price level. This ~MiItonFriedman, ‘The Demand for Money: Some Theoreti~ cat and Empirical Results,” Journal of Political Economy 3 For a derivation of these propositions and a discussion of the (August 1959), pp. 327-351. effects of the presence or absence of government bonds in ~George J. Stigler, “Information in the Labor Market,” Journal the modd, see Don Patinkin, Money, interest, and Prices: An of Political Economy, Supplement (October 1902), pp. 94- Integration of Monetary and Value Theory, 2nd ed, (New 105, and Armen A. Aichian, “Information Costs, Pricthg, and York; Harper and flow, 1965), chap. 10; Robert L. Crouch, Resource Unemployment,” Edmund Phelps et at,, Micro- Macroeconomics (New York: Harcourt, Brace and Jovanovich, economic Foundations of Employment and Inflation Theory 1972), chaps. 6-9; and Franeo Modigilani, “The Monetary (New York: Norton, 1970) pp. 27-52. Mechanism and Its Interaction with Real Phenomena,” Re- 6 view of Economics and Statistics, Supplement (February For simplieity, we assume firms have zero information costs 1963), pp. 79-107. with respect to wages and prices. Page 16 FEDERAL RESERVE BANK OF ST. LOUIS DECEMBER 1973 Table I Equations for the Complete Macroeconomic Model (excluding a Government Sector) Equation Name Market (~1 N’ = Nd (~-,k) Labor demand function 1 (II) Ns=NSE) Labor supply function Labor market (III) Nd = Ne = N Labor market equilibrium condition I Production (or commodity supply) = X~ (IV) (N, K) function (V) c=c(xJ) Commodity demand function for con- sumption (the consumption function) Commodity demand function for in- (VI) I = I (X, r) vestment (the investment function) Commodity market (VII) Total (or aggregate) commodity de- x~c+I mand function Commodity market equilibrium con- (VIII) x = dition Bd (xd, ~ (IX) Bond demand function rP~ r Pe (X) = n~(xs, ~ Bond supply function } Bond market (XI) = Bond market equilibrium condition (XII) = L (xa.
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