Indeed if money growth is extremely rapid, then interest rates will often rise as lenders begin to expect higher inflation and demand to be compensated with higher nominal interest rates. But higher nominal interest rates will increase the velocity of circulation, causing inflation to rise by even more than the money supply. This happened in Germany in the s and America in the late s.
Easy money has an even more expansionary effect when it leads to higher interest rates. Now think about the impact of economic growth on inflation. It seems obvious that a booming economy is inflationary, right? At least when interest rates are above zero. And higher nominal spending will tend to boost real output in the short run, because wages and prices are sticky, or slow to adjust.
In the long run, only prices will increase and output will return to the natural rate. Of course both claims are true to some extent, which Friedman acknowledged. In a article, Nelson contrasts the two views:. This view of policy transmission lines up with older expositions of monetary policy transmission—both by monetarists and, it should be stressed, Keynesians like Tobin, —and seems to be implicit in past Bank of England discussions of the connections between monetary policy and the economy see King, This view is not consistent with standard models of monetary policy transmission that have become prevalent in recent decades; indeed, this view has been treated caustically by Svensson , p.
To Svensson, nominal GDP is not useful in monetary policy analysis: while monetary policy certainly affects nominal GDP, nothing is gained by thinking of monetary policy as working via nominal GDP; the reaction of nominal GDP to monetary policy reflects the dependence of prices and output, individually, on variables that are affected by monetary policy. The behavior of nominal GDP is then derived recursively, by the behavior of its two definitional components; nominal GDP does not itself appear in the structure of the model.
Both claims are clearly true. Rather the issue is which modeling approach is the most useful. Policy is appropriate when the output gap is zero and the interest rate equals the natural rate. But how can we estimate the various natural rates? In contrast, Friedman advocated the broad money supply M2 as an indicator of the stance of monetary policy, and some market monetarists favor NGDP futures prices. Friedman won a lot of debates during the s and s because his critique of Keynesian economics was mostly correct.
Keynesians did make the mistake of assuming that rising interest rates meant that money was getting tighter and falling rates meant money was getting easier some still do.
Keynesians did make the mistake of assuming that there was a long run trade-off between employment and inflation. But this seemingly naive and simplistic view of the world won a lot of debates in the s and s. Unfortunately, Friedman was probably wrong about M2 being the appropriate indicator of the stance of monetary policy; the expected rate of growth in NGDP is a more reliable indicator. So Friedman lost some debates in the s. But perhaps targeting 2 year forward expected NGDP would still have been fine.
Back in , some people seemed to think I had something useful to say about the economy. The problem comes when the instrument becomes the policy. It is as bad to have a target for the interest rate some set of short term assets as a M2 growth rate target. I always thought the one-year NGDP targeting approach was too simplistic. In short, by pumping extra money into the system as the Keynesians were prone to doing governments would drive up inflation, risking major economic pain.
Friedman believed that if central banks were charged with maintaining control of prices, most other aspects of the economy — unemployment, economic growth, productivity — would take care of themselves.
While Keynes had asserted that it was difficult to persuade workers to accept lower wages, classical monetarist theory argued otherwise: that lower incomes for workers and lower prices for firms were acceptable in the face of rising inflation.
The growth rate of an economy, argued Friedman, could be determined by controlling the amount of money being printed by central banks.
Print more cash and people would spend more, and vice versa. It also marked an important political departure: whereas Keynes argued politicians should attempt to control the economy through fiscal policy, Friedman advocated giving independent central banks control over the economy using interest rates.
The piece then goes on to examine the successes and failures of the two doctrines over the last fifty years. I always think it important for students to have an awareness of the changing economic conditions and favored policies over the decades, it only helps them to ingrain a deeper understanding of the theory. All gods fail, if one believes too much. The article in full can be found here. He has over twenty years experience as Head of Economics at leading schools.
Keynesians viewed stimulative monetary policy as helping the economy through lower interest rates, which increased spending by consumers and businesses. The two are usually connected, making difficult the disentangling of the two effects. Think of three kinds of assets: physical assets such as business equipment or household belongings; financial assets such as stocks and bonds; and finally money. The portfolio imbalance continues until the value of those other assets rises.
Rising values of physical assets comes from more assets, or higher price tags on the assets, which means the economy is moving forward. Friedman won the battle, and monetary policy was accepted by most economists as a money supply matter. During the recent recession, however some younger members of the profession rediscovered old-fashioned Keynesianism.
Now the Fed is considering trying to pull down interest rates without increasing the money supply. Why consider this sterilized quantitative easing? Some Fed officials with monetarist roots learned the money supply-inflation connection.
They will go for lowering interest rates if the policy does not increase the money supply.
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