Comments on a Molietarist Approach to Demand Management by ROBERT H. RASCHE Robert H. Rasche is Assistant Professor of Economics at the Wharton School of Finance and Commerce, University of Pennsylvania. Tie received a PhD degree in Economics from the Uni- versity of Michigan. Professor Rasehe has been closely involved in the development o/the FRB- MIT econometric model of the United States economy. The author is on leave during the 1971- 72 academic year and is a viiiting scholar at the Federal Reserve Bank of St. Louis. This paper was presented at the Annual Conference of College and University Professors of the Federal Reserve Bank of St. Louis on November 12, 1971. iT. CASUAL reading of the popular discussion of The question is what theoretical framework can stabilization pohey over the past four or five years produce these types of conclusions, and can it be would suggest that the definition of a monetarist was tested? Again quoting the Andersen paper, “monetary firmly established. In the monetarist camp are Milton actions .. .are considered a disturbance which infhj- Friedman, Karl Brunner, Allan Meltzer, and the model enees the acquisition of financial and real assets. Rates of the St. Louis Federal Reserve Bank. Among the of rethrn on real and financial assets and market prices nonmonetarists are Waiter Heller, Gardner Ackley, adjust to create a new equilibrium position of the Arthur Okun, James Tobin, and the large econome- economy; therefore these changes are considered the tric models such as the Wharton model and the FRB- main channels of monetary influence on aggregate MIT model. Sometimes the distinction between the demand.”4 two groups has been summarized in the allegation Thus the monetarist conception of what has been that a monetarist is one who not only believes that called the transmission mechanism is one of monetary money matters, but also believes that money is the 1 disturbances which change interest rates and the rela- only thing which matters, tive prices of real and financial assets. Such changes A close reading of the writings of those associated induce a reallocation of asset portfolios which can in- with both points of view, suggests that distinctions are clude changes in the demand for real assets. Finally, not completely clear at the level of monetary theory. the portfolio adjustments and relative price changes Leonall C. Andersen has characterized the mone- can change the demand for consumables. In an earlier tarist position on stabilization pohcy as holding that article in this Review, Karl Brunner characterizes a 5 “the major impact of monetary actions is ... on long- similar position as the “weak monetarist thesis.” run movements in nominal economic variables such as This construct of the world is apparently one which nominal GNP, the general price level, and market in- is widely accepted among monetary economists today terest rates. Long-run movements in real economic and thus does not discriminate among the monetarist variables such as output and employment are eon~ and nonmonetarist positions. Certainly a whole suc- sidered to be little influenced, if at all, by monetary 2 cession of writings by James Tobin suggests an ex- actions.” On the other hand he admits a clear role planation quite consistent with this view of the trans~ for fiscal policy, if not the eonventiona~stabilization mission mechanism of monetary po1icy.~In fact, An- policy role: “their [fiscal actions] main impact is on dersen admits that he would view his mechanism as 1ong~runmovements of real output In the short “close to the Tobin view, except that it takes into run, fiscal actions exert some but little Iasth~gin- ctonsicleration many more rates of return and market 7 fluence on nominal GNP expansion and, therefore, prices of goods and services.” An examination of the have little effect on short-run movements of output 3 and employment.” ~Ihid., p. 3 (italics are added). ~Kar1 Brunner, “The Role of Money and Monetary Policy,’> this Review (July 1968), pp. 18-19. ‘Walter W. Heller, “Is Monetary Policy Being Oversold?”, in GJames Tobin, “An Essay on Principles of Debt Management,” Milton Friedman and Walter W. Heller, Monetary us. Fiscal Policy (New York: W,W. Norton & Co., Inc., 1969), p. 16. in Commission on Money and Credit, Fiscal and Debt 2 Management Policies (Engiewood Cliff, N.J.: Prentice-Hall Leonall C. Andersen, “A Monetarist Vjew of Demand Man- Inc., 1963) pp. 143-2i8~ and, “A General Equilibrium Ap~ agement: The United States Experience,” this Review (Sep~ proach to Monetary Theory, Journal of Money, Credit and tember 1971), p. 4. 7Banking (Febniary 1969) pp. 15-29. ~Ibid., p. 4. Andersen, “A Monetarist View,” p. 3. Page 26 FEDERAL RESERVE BANK OF ST. LOWS JANUARY 1972 writings of other nonmonetarist economists will show Most macro-economists will acknowle4ge the valid- similar consistencies with this view of the transmission ity of the price level effect on the LM curve arising mnechanism. Therefore “~veakmonetarism,” as a the- from the specification of the demand for money as a oretical position, does not appear to be a monopoly demand for real balances. Similarly, a specification of of the monetarists. the consumption function in terms of income and wealth as implied by a permanent income or “life- Given this apparent agreement on the theoretical cycle” hypothesis will generate a family of IS curves, basis of the mechanism through which monetary policy one for each level of real wealth1°Once both are con- actions affect the economy, one can question whether structed as functions of the price level, any policy the “monetarist counterrevolution” is more than an action which generates a change in the price level will 1 attempt at product differentiation, such as economists not o~ yhave a direct impact on the IS (fiscal policy) usually associate with monopolistic compelition. A or the LM (monetary policy) etirve, but also will pragmatic view of the discussion suggests that at least cause additional shifts in both curves through the four substantive issues are invoIved~(1) the usefulness changes in the price level, Under these circumstances, of the IS-LM aggregate demand framework for policy simple multiplier calculations do not adequately rep- formulation; (2) the dynamic adjustment of the econ- resent the reaction of the economy to the policy ac6on. omy to a new equilibrium aftei- a policy shock; (3) Accurate policy conclusions cannot be derived with- the mode of conduct of monetary policy; and (4) an out estimates of the parameters of the system. econometric issue of large versus small models. The situation is further complicated when it is as- Limitations of Policy Prescriptions from the sumed that monetary policy can affect the market IS~LMFramework value of assets, such as corporate equities, through induced changes in the rate of return on these assets, A major source of monetarist criticism has been the Then the specification of a consumption-wealth re1a~ use of the IS-LM framework for aggregative policy tionship implies that any change in interest rates will analysis. In this Review, Ronald Teigen has attempted induce a shIft in the IS curve. to defend the IS~LMframework from one monetarist accusation that this framework holds that an increase Teigen has already indicated that it is difficult, if in the stock of money lowers the interest rate and not impossible, to incorporate dynamic phenomenon raises output.8 He demonstrates that with certain such as price expectaUons into the static framework assumptions about the relative speeds of adjustment of this construct,tt Yet, as the monetarists have rightly of various markets, it is possible to show that interest pointed out, adjustments in specified behavioral rela- rates over time ~vi1Ifirst fall and then rise again as tionships have to be made for such expectations under the system returns to a new equilibrium. conditions of anticipated inflation (and particularly when the rate of inflation is anticipated to be At the same time Teigen admits that this framework changing). has ignored price expectations, and in addition, that it is not easy to incorporate price expectations, a dy- It appears that the monetarists have justifiable com- namic phenomenon, into the static frarnewoi-k. This plaints with the policy analysis derived from this appears to sidestep the crux of the monetarist com- framework, which is common to popular macroeco- plaints. Not only does the conventional IS-LM analysis nomic textbooks and past annual reports of the ignore price expectations, but it usually ignores effects Council of Economic Advisers, even if one is pre- from changes in the level of prices. The omission of pared to accept the proposition that there are no deep such price level effects is possible only when the theoretical differences in the transmission mechanism macroeconomic model 5s specified totally in terms of for monetary mid fiscal policy. real flow variables. In sophisticated analysis. such as that of Martin Bailey, price level effec~ of various In many respects the monetarist attack on the IS-LM framework is fighling a “straw man.” Many of kinds arc introduced, and it can be shown that the limitations of this aggregative framework, position of either the IS or the LM curve (in the the highly such as those indicated above, have been attacked in interest rate - real income plane) is dependent upon 9 0 the current price level, ~ It is not I~ecessaryto assume this kind of consumption ftrnc- hon to generate such a family of curves. Price elasticities of ~Rona1d L. Teigen, “A Critical Look at Monetanst Economics,” imports and exports with respect to domestic and foreign this issue of the Review, pp. I9~2O. prices, or income tax functions which have nominal income °Martin Bailey, National Income and the Price Level (New elasticity greater than one, will generate the same effect.