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New Keynesians Vs. Monetarists Page 1 of 3 Monetary and Fiscal Policy Monetary Policy: Alternative Approaches New Keynesians vs. Monetarists Page 1 of 3 Should the Federal Reserve use the money supply as a policy tool? That is, should the Federal Reserve increase the money supply when it wants to stimulate the economy, increasing output and reducing unemployment or should it not? Should it put the money supply on some kind of autopilot and let the rest of the economy adjust to it? These are the two positions that are held by two opposing camps in macroeconomics, the Keynesians and the Monetarists. The Keynesians believe that it makes sense to use the money supply as a policy tool; that is, monetary policy by influencing the interest rate can actually stimulate investment spending and cause the economy to expand. Monetarists, on the other hand, believe that the only influence that money exerts on the economy is an influence on the price level; that is, if the money supply grows too fast, it can spark inflation, and that if the government monkeys with the money supply trying to fine-tune the economy, it will only cause problems, price instability and confusion in the economy that will reduce efficiency. So let’s look closer now at these two positions, the Keynesian position that says monetary policy can do some good in the economy and the Monetarist position that says that the government should maintain a stable money supply and let the rest of the economy adjust to that. Here’s how we can see the difference in these two positions. You’ll remember this equation, called the quantity equation, which is used to explain the quantity theory of money. If you multiply price times output, you get the gross domestic product of the economy. M is the money supply, the total amount of checks and cash available for shopping in the economy. V, the velocity of money, is the number of times the average dollar is spent and re-spent in a year to make all this shopping possible. So if we hold the velocity constant and we imagine that people spend money at a constant rate, then any change in the money supply is going to influence the gross domestic product. Now, the way in which it influences the gross domestic product distinguishes the Keynesians from the Monetarists. Keynesians believe that if you increase the money supply, then, in the short-run at least, you're going to cause the interest rate to fall and stimulate investment spending. The increase in demand in the economy leads factories to produce more, so that real output increases. Now, it’s probably also going to be true in the short-run that the price level is going to go up somewhat as well. So the Keynesians see an adjustment in the short-run with higher prices and higher output, when the money supply in increase. Of course, in the long run, this will go away, because output has to return to fully employment. But, at least in the short-run, an increase in the money supply can cause the economy to expand. The Monetarists, on the other hand, have their roots in classical thinking; that is, wages and prices adjust quickly, they're not sticky, like in the Keynesian story. And if wages and prices adjust quickly, then the economy is always right at the speed limit; that is, if we try to go faster, increasing output beyond full employment, prices and wages rise until the economy is restrained to fully employment. Well, if it’s the case that we’ve always got to be at full employment, then an increase in the money supply immediately creates an increase in prices, with no change in the real economy. This is a really big difference between these two camps, because if you're a Monetarist, you don’t believe that increasing the money supply is going to stimulate output or reduce unemployment or achieve any of these other goals that concern the real economy. Therefore, the best thing you can do for the economy is keep the money supply growing at a constant rate, so as to keep the rate of inflation predictable. Increases in the money supply could throw off the economy by creating unexpected inflation, which then lead to all kinds of problems. Borrowers and lenders get confused, people start spending money faster to try to avoid future inflation, and you get all kinds of inefficiency. So the Monetarists say keep the money supply growing at a constant rate, so as to keep inflation predictable. Now, notice something; the Monetarists would like to have the money supply growing at a rate that reflects the growth rate of real output. That is, if full employment output is growing over time as the population increases and the capital stock accumulates, then you need a certain amount of increase in the money supply just to match the increased money demand. There’s more stuff to buy as the economy grows, so you need more money to make that shopping possible. But if the money supply grows faster than the economy, then the extra money feeds into more inflation. That is, anytime money grows, it’s either making possible more shopping or it’s going to be just pushing up prices. So Monetarists say make the money supply grow at a rate that matches the growth rate of the economy and that keeps the price level relatively constant, or at least predictable. Monetary and Fiscal Policy Monetary Policy: Alternative Approaches New Keynesians vs. Monetarists Page 2 of 3 Now, let's look at this same story told in our aggregate supply – aggregate demand diagram. Here we have the aggregate demand curve and a shift in the aggregate demand curve will represent changes in monetary policy. Suppose the Federal Reserve begins with the economy in a position of long-run macroeconomic equilibrium and tries to stimulate the economy by increasing aggregate demand from AD0 to AD1. Well, what happens in the short-run is, at the original price level we have excess aggregate demand, so the price level begins to rise. And when it rises, we have the usual adjustments; on the demand side, consumer real wealth shrinks, the money demand increases and with it the interest rates, so that investment spending shrinks and foreigners buy their goods elsewhere, because our price level is rising. On the supply side, we’ve got sticky wages and prices, which make the increase in the general price level create a business opportunity in the short-run. Also, companies are confused. They don’t know whether it’s just them or general inflation, so output increases as the price level rises. And, when that happens, the economy is restored to equilibrium with a higher price level P1 and a higher level of gross domestic product Y1. Now, this is the Keynesian view of what happens. The Keynesian view is that the aggregate demand curve shifts outward and pulls the economy temporarily faster than the speed limit. However, what’s going to happen, of course, is that prices are going to start to adjust upward. Because we’re in the region of our diagram that’s beyond full employment, prices are going to start to increase and, as they do, businesses start passing higher costs on in the form of higher prices for goods and services and the short-run aggregate demand curve shifts upwards. This new level, SRAS∞, is where the economy winds up after all the adjustment has occurred. Now, the question that divides Keynesians and Monetarists is “How fast does that curve shift? How rapidly do we adjust back to full employment output?” And the answer depends, of course, on whether people have rational or adaptive expectations. Rational expectations shift the short-run supply curve very quickly as people figure out what’s going on. Adaptive makes it go more slowly. So you can see that rational expectations are closely in line with the thinking of Monetarists. That is, it pulls us right back to our speed limit, whereas adaptive expectations are more in line with Keynesian thinking. That is, we can hang out above full employment longer, because it takes people longer to figure out what’s going on. Also, how quickly can wages and prices actually be adjusted? Are they sticky because of contracts and unions and things like that? Well, sticky wages are more in line with the Keynesians. They believe that unions exert enough power that wages can’t adjust immediately and therefore prices don’t change quickly, whereas Monetarists are a little bit troubled by these sticky wages and prices and therefore they don’t believe that they play that big of a role in the economy. Otherwise, you couldn’t believe that the economy went quickly back to full employment, if you believe that a lot of prices were sticky. So sticky prices and sticky wages and adaptive expectations gives us a view of the world that’s essentially Keynesian. And, in fact, the new Keynesians, the modern Keynesians, have a sophisticated view of the world, in which institutional rigidities, like labor contracts and confusion and the time that it takes people’s expectations to adjust, making people’s expectations effectively adaptive instead of rational. The new Keynesians believe that you can put all those things together and get a convincing story, where the economy can actually go faster than the speed limit when the money supply increases, at least in the short-run. And that the short-run lasts long enough that it makes sense to pursue a policy like this.
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