11.1 Milton Friedman and monetarist theory

Milton Friedman's monetarist theory reshaped economic thinking in the mid-20th century. He argued that controlling the money supply was key to managing inflation and economic stability, challenging Keynesian ideas about government spending and fiscal policy.

Friedman's ideas, including the quantity theory of money and the natural rate of unemployment, became influential in shaping monetary policy. His work emphasized the importance of stable, predictable monetary growth and the long-term neutrality of money in the economy.

Monetary Theory

Monetarist Approach to Money and Inflation

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• Monetarism emphasizes the importance of controlling money supply to manage economic stability
• Quantity theory of money establishes a direct relationship between money supply and price levels
• Proposes the equation of exchange: $MV = PQ$
  • M represents money supply
  • V represents velocity of money circulation
  • P represents price level
  • Q represents quantity of goods and services
• Assumes velocity (V) and output (Q) remain relatively stable in the short run
• Changes in money supply (M) directly affect price level (P), leading to inflation or deflation
• Inflation results from an excessive increase in money supply relative to economic growth
• Money supply consists of various monetary aggregates (M0, M1, M2, M3)
  • M0: Physical currency in circulation
  • M1: M0 plus demand deposits and checking accounts
  • M2: M1 plus savings accounts and money market funds
  • M3: M2 plus large time deposits and institutional money market funds

Monetarist View on Economic Stability

• Argues that changes in money supply are the primary determinant of economic fluctuations
• Criticizes Keynesian focus on fiscal policy, advocating for monetary policy as the main tool
• Believes in long-run monetary neutrality, where changes in money supply do not affect real variables
• Supports the idea of a stable demand for money function
• Emphasizes the importance of central banks in controlling money supply to maintain price stability

Monetary Policy

Monetarist Approach to Policy Implementation

• Monetary policy involves central bank actions to influence money supply and interest rates
• Advocates for rules-based monetary policy rather than discretionary interventions
• Friedman's k-percent rule proposes a fixed annual growth rate for money supply
  • Suggests a steady increase of 3-5% per year
  • Aims to provide economic stability and prevent excessive inflation
• Criticizes fine-tuning attempts by central banks, arguing they often lead to instability
• Supports transparent and predictable monetary policy to reduce economic uncertainty
• Emphasizes the long and variable lags in monetary policy effects on the economy

Monetarist Perspective on Employment and Output

• Introduces the concept of the natural rate of unemployment
  • Represents the unemployment rate when the economy is in long-run equilibrium
  • Accounts for frictional and structural unemployment
• Argues that monetary policy cannot permanently reduce unemployment below the natural rate
• Short-term trade-off between inflation and unemployment (Phillips Curve) exists
• Long-run Phillips Curve is vertical at the natural rate of unemployment
• Expansionary monetary policy temporarily reduces unemployment but leads to higher inflation
• Contractionary monetary policy temporarily increases unemployment but reduces inflation

Economic Behavior

Expectations and Decision-Making in Monetarist Theory

• Adaptive expectations theory explains how economic agents form expectations about future events
  • Individuals base their expectations on past experiences and gradually adjust to new information
  • Contrasts with rational expectations theory, which assumes perfect information processing
• Expectations play a crucial role in determining the effectiveness of monetary policy
• Adaptive expectations can lead to a lag in policy effects and contribute to economic cycles

Income and Consumption Patterns

• Permanent income hypothesis explains consumer spending behavior
  • Consumers base their consumption decisions on long-term average income expectations
  • Distinguishes between permanent income and transitory income
• Permanent income represents the expected long-term average income
• Transitory income includes temporary fluctuations or windfall gains
• Consumption patterns remain relatively stable despite short-term income changes
• Implications for fiscal policy effectiveness (tax cuts or stimulus payments)
• Challenges the Keynesian consumption function based on current income