Monetarists and Keynesians—The Great Debate

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Reproducible Sheets
Monetarists and Keynesians—The Great Debate
One of the great debates in economics is between
the monetarists and the Keynesians.
The Monetarist Argument
The monetarists believe that a proper monetary policy
is the most effective method to smooth out the
business cycle—superior, in fact, to the fiscal policies
advocated by J.M. Keynes, which you studied in
Chapter 10. Milton Friedman, an American professor
of economics, is perhaps the most famous advocate of
the monetarist school of thought. He won a Nobel
prize in economics for his work, basing his theory
around an old equation called the quantity theory of
money:
MV = PQ, where
M = quantity of money in circulation,
V = velocity of exchange, or the number
of times a dollar is used to buy goods,
P = average prices of goods,
Q = quantity of goods and services produced.
Let us return to the Monopoly game in the Chapter
Opener to explain this equation. Remember that each
of the four players in Game A had $10 000, for a total
of $40 000. Thus, M = $40 000. Suppose that, with all
the bidding for properties, each dollar used in the
game was exchanged, on average, five times. Thus, V
= 5. Therefore, M 3 V = $40 000 3 5 = $200 000,
which represents the total dollar output of the game.
If this was a mini-economy, we would say that
figure is its GDP measured in dollars. The other side
of the equation is also the GDP. The price of each
property (P) times the quantity of properties for sale
(Q) represents the GDP at current prices. So far, the
equation represents an identity—each side is the GDP,
so GDP = GDP.
Suppose we double the money in the game, as
happened in Game B. Now, M = $20 000 3 4 = $80
000. Assuming velocity stays the same, then our minieconomy GDP has risen to 5 3 $80 000 = $400 000.
Are the players in the “economy” better off having
more property? Hardly—we see on the right side of
the equation that more money has bid up prices, P, but
has not changed Q, the quantity of properties. The
economy has been inflated, all because of an increase
in M.
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Professor Friedman and his monetarist supporters
argue that velocity is quite predictable, but the quantity
of money is not, causing damaging fluctuations in
GDP that produce boom-and-bust business cycles.
Friedman does not have much faith that central banks
can gauge with any accuracy when the economy needs
a tighter or easier money policy and adjust the money
supply accordingly. According to his research, their
attempts to use such policies have only made things
worse. He calculated that during the Depression of the
1930s, the money supply in the USA fell by one-third,
an effect that prolonged the downturn for years. If this
effect had not occurred, the US economy would have
recovered on its own.
Friedman and other monetarists advocate setting
money supply growth permanently at a slow, steady
growth rate of about 3 per cent. Such a standard would
cause the GDP to rise at the same steady, satisfactory
rate. As for inflation, Professor Friedman said in a
much-quoted statement, “Inflation is everywhere and
always a monetary phenomenon.” In other words,
inflation is always the result of too much money
growth in the economy, caused by unwise policies.
Professor Friedman and the monetarists are fully on
the side of letting the economy adjust on its own to a
stable, predictable money rate growth.
The Keynesian Argument
In Chapter 10, you were introduced to J.M. Keynes’s
theories dealing with fiscal policies. Keynesian
supporters turn the quantity theory around on the
monetarists by arguing that changes in GDP cause
changes in the money supply.
Suppose consumers decide to borrow more
because they are optimistic that the economy will
grow, increasing incomes and employment.
Governments have possibly cut taxes and increased
spending, stimulating the economy. Business borrows
to invest in plant and equipment as they see that
consumers are in a buying mood. The borrowing of
consumers and business expands the money supply.
The point is that the money supply increase does not
occur because the central bank decides to expand it. It
expands because consumers and business decide to
borrow as a result of a growing economy. According
to the Keynesians, the right side of the equation—the
actual output side—causes the change on the left, the
increase in money supply.
Keynesians believe that the economy has basic
weaknesses that will always require government action
© Oxford University Press (Canada) 2003. Permission to reproduce for classroom use restricted to schools purchasing Economics Now.
Reproducible Sheets
Monetarists and Keynesians—The Great Debate
(continued)
to correct. Depressions and recessions are caused by
such factors as a fall in investment spending, which
causes a multiplier effect throughout the economy,
reducing GDP and then lowering the demand for
loans, causing the money supply to fall. They argue
that money and monetary policy should play a
secondary and supporting role to government fiscal
policies, which really drive the economy.
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Who Is Right, the Monetarists or the
Keynesians?
We should be aware that both sides may be
claiming too much. Even if it could be proved that
money growth followed GDP growth, or that GDP
growth followed money growth, it does not necessarily
follow that one caused the other. In Chapter 1, the
fallacy of post hoc ergo propter hoc was introduced: if
A happens before B, then A must have been the cause
of B. “If the rooster crows at dawn, then he causes the
sun to rise.” Probably, the debate between the two
camps will never be resolved.
Questions
1. If there is no change in V, P, or Q, what happens to GDP if M is increased? Is this a real increase in
GDP or an inflated one?
2. Which side supports more government intervention in the economy? Which supports less?
3. In your opinion, which side, the Keynesians or the monetarists, has the best approach to the
economy?
© Oxford University Press (Canada) 2003. Permission to reproduce for classroom use restricted to schools purchasing Economics Now.
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