Monetarist vs. Austrian
Views of the Trade Cycle
The Many Faces of Monetarism
Friedman’s Monetarism:
MV=PQ
with a lag of 18-30 months.
With a mild upward trend in velocity
and Output (Q) growing slowly,
the price level (P) moves with the
money supply (M).
Friedman’s Monetarism:
MV=PQ
with a lag of 18-30 months.
Friedman’s Monetary Rule:
Increase the money supply at a slow
and steady rate so as to achieve
long-run price-level constancy.
--from J. Bradford DeLong’s “The Triumph of Monetarism?”
Journal of Economic Perspectives, Winter 2000.
The velocity of
money became
unstable after 1980.
Friedman’s policy
rule lost its velocity
anchor.
The Federal Reserve
abandoned moneysupply targeting in
favour of interestrate targeting.
Friedman’s Monetarism:
MV=PQ
with a lag of 18-30 months.
The Irony of Monetarism:
The monetary rule that allows the economy to
perform at its laissez-faire best presupposes a
critical piece of intervention (Regulation Q) that
makes the money supply operationally definable.
Friedman’s Monetarism:
MV=PQ
with a lag of 18-30 months.
Greenspan: “We don’t know what money
is, anymore.”
…which explains why the Federal Reserve
switched from money-supply targeting to
interest-rate targeting in the early 1980’s
Friedman’s Monetarism:
MV=PQ
with a lag of 18-30 months.
Note: Q = QC + QI
but the effect of interest-rate changes on
relative movements of consumption and
investment and on the pattern of investment is
no part of the theory.
Friedman’s Monetarism:
MV=PQ
with a lag of 18-30 months.
Inflation is always and everywhere a monetary
phenomenon.
But what goes on in the short-run---during that
critical 18-30 months?
Rising prices create a discrepancy between
the the real wage rate as perceived by the employer
and the real wage rage as perceived by the employee.
The employer sees the wage rate falling w.r.t output prices.
The employee sees—but only belatedly—the falling real wage.
Initially, the employee sees a rising wage rate.
Real wage (employee’s view)
Real wage (employer’s view)
A Theory of Labor-Market Dynamics
Short-Run/Long-Run Phillips Curve Analysis
In response to an
increase in the money
supply, the economy
moves up a short-run
Phillips curve, but the
curve itself shifts as
workers straighten out
their perceptions of
the real wage rate.
The long-run Phillips
curve is vertical.
But note:
A rise in P is prerequisite to a money-induced
boom. That is, P must rise, and then be
differentially perceived, causing Q to rise.
If P doesn’t rise, then there is no boom.
During the 1920s and the 1990s, there was
little or no increase in P. And so, the SR/LR
Phillips curve story doesn’t apply.
The Mises-Hayek theory applies to these two
episodes but Friedman’s theory doesn’t.
According to SR/LR:
Q rises to the extent that P rises.
But MV=PQ suggests that Q rises to the
extent that P does not rise.
Remember, there’s an 18-30 month lag
between increases in M and increases in P.
Also, one of the fundamental propositions of
monetarism is that when M is increased, Q
rises first and P rises hardly at all.
According to Orthodox Monetarism:
Q rises first.
Q rises as a result of P rising.
Q is unaffected in the long run.
The three claims together suggest a selfreversing process (with a flourish):
In the face of an increased money supply, Q
rises as does P, but Q then falls to its initial
level as P becomes fully adjusted to the
higher M. (During the process, labor-market
dynamics can give an extra boost to Q.)
Patinkin’s Model
In response to an
increase in the money
supply, prices are bid up
as people try to
purchase more output.
But with no more output
to purchase, people buy
bonds instead, driving
the rate of interest
below its equilibrium
level.
In the long-run, prices
fully adjust to the higher
money supply and the
interest rate returns to
its initial level.
According to Patinkin:
Q remains at its full-employment level
during the adjustments of the price level
and the interest rate.
More specifically, the interest rate falls and
then rises as the price level becomes fully
adjusted to the higher money supply.
Note that the interest rate is low for a
period of 18-30 months without there being
any effect on the make-up of output.
According to alternative constructions:
The level of employment rises and then
falls as the economy adjusts to an
increase in the money supply, but the
rate of interest remains out of play.
The rate of interest falls and then rises
as the economy adjusts to an increase
in the money supply, but the economy
remains at its full-employment level
throughout the adjustment.
About those alternative constructions:
Suppose each is half right.
The rate of interest falls and then rises
as the economy adjusts to an increase
in the money supply, while at the same
time the level of employment rises and
then falls.
Wouldn’t the increased labor input be
allocated intertemporally in accordance
with a relatively low rate of interest?
Friedman accounts for the M-P lag of 18-30 months:
Holders of cash will…bid up the price of assets. If the extra
demand in initially directed at a particular class of assets,
say, government securities, or commercial paper, or the
like, the result will be to pull the prices of such assets out
of line with other assets and thus widen the area into
which the extra cash spills. The increased demand will
spread sooner or later affecting equities, houses, durable
producer goods, durable consumer goods, and so on,
thought not necessarily in that order…. These effects can
be described as operating on “interest rates” if a more
cosmopolitan [i.e., Austrian] interpretation of “interest
rates” is adopted than the usual one which refers to a small
range of marketable securities.
Milton Friedman (1969 [1961]), “The Lag Effect in Monetary Policy,” in Miltion
Friedman, The Optimum Quantity of Money and Other Essays, Chicago: Aldine.
“The key feature of this process [during which interest rates
are low] is that it tends to raise the prices of sources of both
producer and consumer services relative to the prices of the
services themselves…. It therefore encourages the
production of such sources and, at the same time, the direct
acquisition of the services rather than of the source. But
these reactions in their turn tend to raise the prices of
services relative to the prices of sources, that is, to undo the
initial effects on interest rates. The final result may be a rise
in expenditures in all directions without any change in
interest rates at all; interest rates and asset prices may
simply be the conduit through which the effect of the
monetary change is transmitted to expenditures without
being altered at all….”
Milton Friedman (1969 [1961]), “The Lag Effect in Monetary Policy,” in Miltion
Friedman, The Optimum Quantity of Money and Other Essays, Chicago: Aldine.
“It may be … that monetary expansion induces someone
within two or three months to contemplate building a
factory; within for or five, to draw up plans; within six or
seven, to get constructions started. The actual construction
may take another six months and much of the effect on the
income stream may come still later, insofar as initial goods
used in construction are withdrawn from inventories and only
subsequently lead to increased expenditure by suppliers.”
Milton Friedman (1969 [1961]), “The Lag Effect in Monetary Policy,” in Miltion
Friedman, The Optimum Quantity of Money and Other Essays, Chicago: Aldine.
Friedman’s
Plucking Model
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Monetarist vs. Austrian
Views of the Trade Cycle
The Many Faces of Monetarism