10. Monetarism

Question 1

Monetary Velocity

Answer 1

The role of money in the economy = its often referred to simply velocity
V = PY/M - where P is the GDP price index, Y is real GDP and M is the money supply.

Question 2

What is the definition of The Quantity Theory of Money?

Answer 2

It asserts that changes in the money supply have a proportional effect on the price level, assuming that the velocity of money and the amount of goods and services produced in the economy remain constant.
The price level is proportional to the money supply.

Question 3

Cross-country evidence on money growth and inflation

Question 4

What were Milton Friedman’s policy recommendations?

Answer 4

Friedman’s monetarist policy called on the central bank to control the supply of money (such as M1) so it grew at a steady low rate. He believed they could do this via controlling the monetary base. This would end up leading to economic stability (nominal GDP rising at a steady rate) and low inflation.

Question 5

What are the three foundations of monetarism?

Answer 5

• Predictable Money Multiplier - They believed that changes in the money multiplier were predictable enough that central banks could adjust the monetary base to control the broader money supply.
• Predictable Velocity - Monetarists didn’t necessarily believe the pure quantity theory, in which velocity was constant, but they did believe velocity was predictable enough to allow central banks to link the growth rate of nominal GDP to the growth rate of the money supply.
• Money and Inflation: For monetarists, inflation “was always and everywhere a monetary phenomenon” and central banks should expect a tight medium-term relationship between money growth and inflation.

Question 6

Why is the money multiplier not stable?

Question 7

Evidence on money growth and inflation in the US and the Euro area

Question 8

What is the behaviour of velocity in the US

Question 9

Evidence on money and inflation across countries at lower rates of inflation

Question 10

What are the reasons why central banks do not apply monetary targeting?

Answer 10

• Uncertain Money Multiplier: While central banks can control the monetary base, the relationship between this base and the money supply is uncertain and depends upon unpredictable behavioural elements in the banking system.
• Uncertain Monetary Velocity: Even if the central bank could control the money supply, the link between this and nominal GDP posited in the Quantity Theory requires that velocity be predictable. In reality, velocity has often been unpredictable.
• Weak Link between Money and Inflation: Stable velocity and long-run monetary neutrality are supposed to lead to a tight relationship over time between inflation and the growth rate of money. In most modern economies, this relationship just isn’t there.