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The orthodox monetarist school

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The orthodox monetarist school

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Tracing the historical development of orthodox monetarism beginning with the quantity theory of money approach as it evolved from the mid-1950s to the mid-1960s; through to the expectations-augmented Phillips curve analysis which was absorbed into monetarist analysis after the mid- to late 1960s.

Tracing the historical development of orthodox monetarism beginning with the quantity theory of money approach as it evolved from the mid-1950s to the mid-1960s; through to the expectations-augmented Phillips curve analysis which was absorbed into monetarist analysis after the mid- to late 1960s.

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The orthodox monetarist school

  1. 1. The orthodox monetarist school Presentation in Macroeconomics Class University of San Carlos, Cebu City Sept.10. 2016
  2. 2. • Karl Brunner coins the phrase “Monetarism”; Brunner and Alan Meltzer construct the microfoundations of Monetarism, creating a second “camp.”
  3. 3. The quantity theory of money approach
  4. 4. Quantity Theory of Money • The first stage in the development of orthodox monetarism can be traced from the mid-1950s to the mid-1960s, and involved an attempt to re-establish the quantity theory of money approach to macroeconomic analysis
  5. 5. Friedman’s restatement of QTM • Friedman avows that the quantity theory is fundamentally a theory of the demand for money. It is not a theory of output, or of money income, or of the price level. • Friedman regards the amount of real cash balances as a commodity which is demanded because it yields services to the person who holds it. Thus money is an asset or capital good, hence demand for money forms part of capital or wealth theory.
  6. 6. 5 different forms of wealth i. Money ii. Bonds iii. Equities iv.Physical goods v. Human capital
  7. 7. • The present discounted value of expected income flows can be expressed as: W=y/r • Where W is the current value of total wealth, y is the total flow of expected income from the five forms of wealth and r is interest rate. • Friedman expands the detail of wealth and returns to indentify the variety of assets and returns in the potential portfolio: • where P is the price level, rb is the return on bonds, re is the return on equities, ra is the return on real assets, w is the ratio of human to nonhuman wealth (to capture the return on “human wealth”), /r is total wealth, and u is the “portmanteau variable.”       u r wrrrPfM aeb ;,,,,,
  8. 8. An assessment 1. Changes in the money stock are the predominant factor explaining changes in money income. 2. In the face of a stable demand for money, most of the observed instability in the economy could be attributed to fluctuations in the money supply induced by the monetary authorities. 3. The authorities can control the money supply if they choose to do so and when that control is exercised the path of money income will be different from a situation where the money supply is endogenous. 4. The lag between changes in the money stock and changes in money income is long and variable, so that attempts to use discretionary monetary policy to fine-tune the economy could turn out to be destabilizing. 5. The money supply should be allowed to grow at a fixed rate in line with the underlying growth of output to ensure long-term price stability.
  9. 9. The Expectations- augmented Phillips Curve Analysis second stage in the development of orthodox monetarism
  10. 10. • The direction of the monetarist attack against the Keynesian demand management policies and policy- activism changed at the end of the 1960s when Friedman (1968) augmented the basic Phillips curve with the expected rate of inflation as an additional variable determining the rate of change of money wages (Phelps 1967 provided a similar analysis from a nonmonetarist perspective).
  11. 11. Friedman argued that in the long run the Phillip curve is vertical. The vertical long run Phillips curve is located at the natural rate of unemployment. The diagram shows that workers believe that the inflation rate is likely to be 5%. Excess demand may push inflation higher, causing the actual inflation rate to be 9%. Workers expectations of the inflation rate will influence their pay demands.
  12. 12.  At 9% inflation, workers are relatively cheaper. Firms will demand more workers. Demand for labour will crate upward pressure on wages. Unemployment will reduce from A to B.  Workers will eventually recognise that the inflation rate is 9% and will raise their pay demands, causing prices and wages to converge  Inflation at the natural rate of unemployment is zero. At this rate workers may believe that the current rate of inflation will continue in the immediate future. Government may choose to intervene in order to lower unemployment below the natural rate of unemployment. This action may increase aggregate demand through expansionary policies.
  13. 13. • within the orthodox monetarist approach the output– employment costs associated with monetary contraction depend upon three main factors: • first, whether the authorities pursue a rapid or gradual reduction in the rate of monetary expansion; • second, the extent of institutional adaptations – for example, whether or not wage contracts are indexed; and • third, the speed with which economic agents adjust their inflationary expectations downwards.
  14. 14. • The development of orthodox monetarism can be appraised in a positive light, given that it displayed both theoretical and empirical progress over the period of the mid-1950s to the early 1970s. • The reformulation of the quantity theory of money approach (QTM), the addition of the expectations- augmented Phillips curve analysis (EAPC), using the adaptive expectations hypothesis (AEH), and the incorporation of the monetary approach to the balance of payments theory and exchange rate determination (MTBE), generated a large amount of real-world correspondence and empirical support
  15. 15. Summary 1. Changes in the money stock are the predominant, though not the only, factor explaining changes in money income. 2. The economy is inherently stable, unless disturbed by erratic monetary growth, and when subjected to some disturbance, will return fairly rapidly to the neighbourhood of long-run equilibrium at the natural rate of unemployment. 3. There is no trade-off between unemployment and inflation in the long run; that is, the long-run Phillips curve is vertical at the natural rate of unemployment. 4. Inflation and the balance of payments are essentially monetary phenomena
  16. 16. Monetarism has therefore made several important and lasting contributions to modern macroeconomics.
  17. 17. • Thank you.

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