MONETARY ECONOMICS
(Hayek, Friedman, Phelps, Tobin, Lucas, Sargent, Kydland, and Prescott)
Hayek
In the field of monetary theory Hayek has many works to his credit. They are: The pure theory of Capital, Prices and production, Monetary Theory and Trade Cycle and Interest and Investment.
His technical writings in Monetary Economics have not received much recognition and praise from his contemporary economists such as Keynes, Hicks and Milton Friedman. However, Hayek’s Monetary Over-investment theory is discussed widely and is being discussed even now in the context of Business Cycles.
Hayek propounded’ additional Credit theory of Trade cycle’. During phases of expansion Banks create Credit and such extension of credit lowers the Market rate of interest below the ‘Natural rate’ of interest. This makes producers to borrow more and invest more. Hayek tries to show how forced saving (credits expansion) changes the structure of production by an artificial increase in investment. This lengthens the process of production and leads to a dis-proportionality between Consumption and Investment, because the new money spent on investment becomes Consumers income and thereby results in increased demand for consumer goods. The rise of consumer goods prices and the consequent fall in real wages means a rise in the rate of profit in the consumer goods industries compared with capital goods production. A fall in real wages will encourage capitalists to substitute Labor for Capital, that is shorten the process of production. The Boom according to Hayek collapses because of the unwillingness of Banks to create credit any further. Investment can be sustained only by voluntary savings and reduced Consumption.
Hayek, rather than Keynes provides an explanation to the 2008 Recession, Carmen, Reinhart, Kenneth Rogoff Lawrence White and Hyman Minsky have argued that financial cycle led to economic volatility. There was evidence of low interest rates leading to financial booms and misallocation of resources. Long booms tended to result in excessive risk taking.
Hayek is a true Liberal. He attacked the trend towards Statism in his work, Road to Serfdom (1944) and the Constitution of Liberty.(1960) Milton Friedman regards Hayek “the Twentieth Century greatest Philosopher of Liberty”.
Milton Friedman
Friedman’s chief contribution is to Monetary Theory. Among his major works in Monetary theories are:
1) Studies in the Quantity Theory of Money and
2) Monetary History of United States (jointly authored with Anna Schwarz).
Friedman had many followers such as Modigliani, Tobin and others. All these persons are known as monetarists. They believe that money matters. Modigliani declares that “we are all monetarists now”.
In the 1960’s the controversy between Monetarists and the Keynesians is widely debated. Both these groups were represented as holding extreme views. Monetarists holding the view “that only money matters” and the Keynesians holding that “money does not matter at all” The bone of contention between the Monetarists and Keynesians is in specifying the precise relationship between money and income. Keynesians have argued that money is merely an indicator; it merely registers a change in income. Monetarists contend that money can be or should be target variable.
To make the points in the controversy clear, let us briefly review the quantity theory of money. Irving Fisher’s quantity theory is known as Equation of Exchange and it is given in equation (1)
(Eqn.1)MV = P.Y
Fisher assumed that velocity of money (V) is highly stable. According to him, money (M), determines nominal income, given by the product of price (P) and output (Y).
In Cambridge (England) economists, Marshal and Pigou stated the quantity theory as a Cash – Balance Equation, given in equation (2).
(Eqn.2) M = k.P.Y
Where k is the cash balance kept as a proportion of income.
Both the versions of the quantity theories of money discussed above are similar, as Velocity of money (V) is equal to 1/k by definition. Rewriting equation (1) we get equation (3)
(Eqn.3)M = P(Y/V)
Where V or 1/k are stable and constant.
Output (Y) is at a full employment level and is treated as constant. Hence, an increase in money supply causes an equi-proportional increase in prices.
While Fisher stressed on the demand for money for transactions purpose, the Cambridge economists emphasized on the demand for money as a store of value. Keynes, on the other hand, said that money is demanded for transaction purposes, precautionary purposes and speculative purposes. Keynes observed that the link between money and income is through interest rates. In a liquidity trap situation, in times of a recession investors do not demand money for investment even at low interest rates. This implies that the LM curve is horizontal and changes in the quantity of money do not shift the LM curve. In such cases, monetary policy will have no effect on either the interest rate or the level of income. This explains Keynes argument that money does not matter. Monetarists argue that when the LM curve is vertical, monetary policy has a maximal effect on income and fiscal policy has no effect on income. This explains the monetarists argument that ‘only money matters’. Monetarists use the framework of the quantity theories of money discussed above. The monetarists believe that the income velocity of money is regular, predictable and almost a constant. Hence, they argue that money supply is the main determinant of output. In course of time, both the monetarists and Keynesians gave up their extreme positions in the debate and began to be accommodative to other’s opinion.
In his re-formulation of Quantity theory, Friedman provided a framework for the modern Portfolio approach to the demand for Money. He begins by postulating that money like many other assets yields a form of service to the person who holds it.
Friedman makes the demand for money depend on the real rate of interest on financial assets, the rate of return on nominal money, which is taken to be the rate of change of Price Level, P/P, the real income, Y, the ratio of non-human to human Capital, W and a taste variable, u . Friedman’s demand function for money is:
(Eqn.3) M/P = f (I, ∆P / P, Y, W, u)
The basic difference between Friedman and Keynesians are empirical, not theoretical. Friedman (along with Anna Schwartz) studies the relation between the stock of Money and its changes and the Business Cycles. Friedman suggested that holders of money can be regarded as adjusting the nominal amount of money they demand to their views of their long-term income status (which is a measure of their Wealth), of the long-run level of Prices, and the returns on alternative assets. Neglecting the returns on alternative assets, Friedman and Schwartz use the following equation (4) for empirical analysis:
(Eqn.4) Log M(T) = log .a + log P(T) + b log y (T)
where a and b are numerical constants (or more generally, functions of omitted variables such as returns to other assets). M is money supply and T is time.
They have estimated the money – multiplier or the ratio of percentage change in income to the associated percentage change in the stock of money. For major Business Cycles studied, the Money –multiplier estimate is 1.84.
Monetarists believe that, changes in the quantity of money are the dominant influence on changes in nominal income and, for the short-run changes in the real income as well. According to them money causes business cycles. They argue that stability in the behaviour of money stock would go a long way towards producing stability in income growth. Friedman wants a constant growth rate in money stock. Monetarists believe that the demand for money is a stable function of permanent level of income; hence velocity of money is also stable. As a corollary to constant Velocity any excessive increase in money supply leads to increase in price level and therefore inflation.
Monetarists believe that Fiscal policy on the other hand has a limited effect on GNP of an economy because of the crowding –out hypothesis. The increases in Government spending increases aggregate demand initially. As income begins to rise, the transactions demand for money also increases. With the money stock fixed, increased demand for it results in an upward pressure on interest rates. This causes private investment to decrease substantially. Thus according to Monetarists, increased Government spending leads to decrease in private spending, which is termed as crowding-out. Further monetarists believe in lesser government than more.
Friedman was a true champion of Capitalism. In his Capitalism and Freedom, he writes that the great achievement of Capitalism is not the accumulation of property and wealth but the opportunities it offered to man and woman to extend develop and improve their capacities. Friedman was a true libertarian.
In an articles published in 1958, A.W. Philips indicated on the basis of U.K. data that there was a strong negative relationship between the rate of change of money wages and the level of unemployment. Soon after, it was also argued there was also a significant and stable negative relationship between the rate of change of prices (inflation) and the level of unemployment. Graph depicting inverse relationship between the above two variables is known as Philips curve.
Friedman and Edmund Phelps agree with Philip’s notion of trade-off between unemployment and inflation in the short-run. They assume that prices and wages are flexible. In the long run they argue that un-employment rate will gradually return to the natural rate, and any expansionary policy will only result in higher inflation rate.
In the short run, unemployment could be cut by offering higher money wages to workers. Higher money wages translates into higher prices. But as Edmund Phelps says that “Man is a thinking expectant being”. Soon, workers bargain for money wage increases to offset the fall in real wages experienced. The resulting increase restores real wages but threatens to cause a return of unemployment, as employers shed labor. The economy will recover its equilibrium only when workers expectations are fulfilled and prices turn out as anticipated. Phelps argued that inflation will not settle until unemployment reaches to its ‘natural rate’ (full employment rate). With ‘real-wage bargaining’, the long-run Phillips curve is vertical because there is only one unemployment rate (the natural rate) at which actual and expected inflation match. The only effect of increased demand in the long-run would be to increase inflation for the same level of unemployment.
The monetarists argue that the influence of the money stock is primarily on the price level and other nominal variables. Real variables such as output and employment have time to adjust to their natural levels in the long-run. The natural rates of output and employment depend on real variables such as factor supplies and technology. This is the reason for Supply side economics advocated by Laffer and practiced by Regan and Margaret Thatcher in U.S.A and U.K in 1970’s and 1980’s respectively. In essence supply side economics is concerned with increasing aggregate supply of goods. They argue for policies such as tax-cuts, removing unnecessary regulations, maintaining efficient legal system and encouraging technological progress. Supply side policies combined with sound monetary policies, have succeeded in 1970’s in solving the problem of stagnation in production coupled with inflation – stagflation.
Tobin Model
Tobin agreed with Friedman in the statement that money matters but he disagreed with Friedman’s opinion that money alone matters.
The rationale for the demand for money as an asset, Tobin pointed, lies in its role in reducing the riskiness of general portfolio of assets. In a simplified version of Tobin’s model, there are two assets, Money which is risk less but it has Zero return, and a risky asset, perpetual Bonds, which has a positive expected rate of return. By holding money in his Portfolio the wealth – holder can reduce his Portfolio risk, but at the expense of sacrificing some expected return. Tobin followed the general equilibrium approach in developing his portfolio choice theory. This theory suggested that assets should be regarded as imperfect substitutes for each other, with their differences in expected yields reflecting marginal risks. Tobins portfolio approach has provided a corner stone for specification of financial sector. The whole IS – LM – Classical approach came to be known as Portfolio balance Macro economic approach.
New Classical Approach:
Some macro economists took expectations as static or fixed. Others saw that expectations as adapting to past changes. Muth introduced the concept of Rational expectations in 1961 and the concept is generalized and developed by Lucas. Based on Rational expectations and on imperfect information assump0tion, Lucas developed his supply curve. The implications of Lucas supply curve is first spelt out by Thomas Sargent and Neil Wallace. The approach of Lucas and others is called New Classical approach.
The ‘Rational expectations model’ of Lucas assumes that agents make best use of whatever information is available to them and that expectations are formed in a manner consistent with the way the economy actually operates. Expectations are made subject to forecast error which on average is zero.
The Rational expectations model has the very strong prediction that anticipated monetary policy should have no effect on output, only un-anticipated changes in the money stock increase output. For instance, if people correctly anticipate, inflation, they ask for higher wages as soon as the policy is enacted (or even before). Their demands for higher wages leads to a shift in Labor supply reducing employment and output. Thus, government’s policy becomes ineffective.
Economy reacts to anticipated and un-anticipated changes in the money supply differently. In response to an anticipate change money supply, agents will expect an equi-proportionate change in the price level. Both the actual price level ‘p’ and the expected price level Pe will change in proportion to the change in money supply, the real money supply will remain un-changed, and output is restored to its initial natural level. In contrast, the un-anticipated changes in money supply will have its full aggregate demand and aggregate supply (AD-AS) effects–precisely because an un-anticipated change will not affect expected price Pe. It will however raise the actual price level, thereby stimulates output expansion. Since only unanticipated policy changes have real effects, Demand Management policies are useless.
At first sight, the implication of Lucas model seems to be almost the same as the Classical model. Both models predict policy irrelevance – that neither monetary policy nor fiscal policy can affect the equilibrium level of income in the long-run. The Lucas model is more interesting than the classical model, though, because it allows at least transitory deviations from full-employment. However these temporary deviations are the result of expectations errors and they last only as long as the errors last and that cannot be very long.
Robert Lucas Jr. and Thomas Sargent argue that existing Keynesian macro economic models cannot provide reliable guidance in the formulation of monetary, Fiscal or other types of policy. While Keynes argued that most unemployment is involuntary, Lucas views unemployment as mostly voluntary. In Lucas opinion, labor supply decision is a choice that each worker makes between labor and leisure. If expected real wages are lower than normal, they take more leisure and wait until real wages rise before working. Suppose, the Central Bank decreases money supply, resulting in decreases in wages and prices. The decrease in money wages is experienced by workers but the decrease in the general price level is not known to the workers. Workers think that their real wages have gone down below their expected wages. They supply less labor and turn down job offers with low wages. Thus, unemployment is explained as a voluntary choice made by workers who are waiting for real wages to rise to its normal level. As workers are rational, their mistake would be corrected in due course. Unemployment is looked at as a temporary disequilibrium that will remedy itself. Just like Friedman, who was Lucas teacher, Lucas also assume market clearing. Lucas approach came to be known as competitive business cycle approach.
Surgent and his co-author Neilwallace have put forward the policy ineffectiveness proposition according to which the Government could not successfully intervene in the economy of attempting to manipulate output. They argued that agents would foresee the effects of monetary expansion, leaving the economy exactly what it was in real terms. What the Government needs a stochastic shock-that is unanticipated change in policy to influence output. Lucas and Edward Prescot are good friends and did collaborative research on dynamic Economics and their joint work is titled Recursive Methods In Dynamic Economics.
Kydland & Prescot:
In the context of Rational expectations Kydland and Prescot have discussed the Time-inconsistent problem in Monetary policy.
Countries such as U.S.A., which follow a modest activist discretionary policy seem to have a bias towards too much Inflation. The Federal Reserve Banks (The Central Bank of USA) had followed during 1970’s a policy of accepting rising inflation for a short-term decrease in unemployment. The preference for short-term gains will be inconsistent with the economy’s long run interests. Finn Kydland and E. Prescot, have drawn our attention to this dynamic inconsistency problem. We know there is a short-run tradeoff between inflation and unemployment given by the short-run Phillips curve. But in the long-run, there is no such tradeoff between the two because of inflationary expectations. While the policy maker may choose the best long-run position for the economy of full employment with zero inflation, the decision maker seeks in the short-run to lower unemployment and slightly higher inflation. It is this split between announced and executed plans that gives rise to dynamic inconsistency problem.
In general an economic policy is said to be time inconsistent when a future policy decision forms part of an optimal plan formulated at some initial date is no longer optimal when considered at some later date.
The inconsistency of optimal plans have led them to argue (in 1977) that Central Bank should obey transparent rules rather than have discretion. They argue for pre-commitment over short sighted policy making. At the Carnegie Rochester Conference on public policy in 1993, John Taylor has observed that we can design rules that have counter cyclical features without at the same time, leaving any discretion about their actions to policy makers. Taylor proposed one such rule, which is discussed in his Macro-economics text book referred in the Appendix.
Amartya K.Sen:
Born, 3rd Nov. 1933 at Santi Niketan, India. He is a non-resident Indian, residing in USA. A.K.Sen is a many sided genius, a poly-math, who distinguished himself in the fields of Economics, Philosophy and Ethics. His principal contribution is to collective choice and Social welfare, which is discussed in this chapter and his other contributions are no less significant. They relate to Famines, Poverty, Inequalities, Entitlements and Capabilities, which are discussed in Chapter 16.
Prof. Sen is a person of many Identities. He is an eminent scholar, best teacher, a leading thinker, an argumentative Indian, a gentleman and a humanitarian.
He is awarded the Nobel prize in Economics in 1998. He received the title of ‘Bharat Ratna’ the highest civilian honour from Government of India.
A Festschrift volume,Choice,Welfare and Development, is brought out in honour of A.K.Sen by his former students and Collegues ( ed.K. Basu et.al,O.U.P.) It contains more details about A.K.Sen’s biographical details and Bibliographical details
May God bless Prof. Sen, in the remaining part of his autumnal life, with sound health, fulfillment and peace.