All posts in category Milton Friedman

The Economist comments on Market Monetarism

The Economist has an interesting article on Market Monetarists as well as would the magazine calls “Heterodox economics” – Market Monetarism, Austrianism and “Modern Monetary Theory” (MMT).

I am happy to see this:

“Mr Sumner’s blog not only revealed his market monetarism to the world at large (“I cannot go anywhere in the world of economics…without hearing his name,” says Mr Cowen). It also drew together like-minded economists, many of them at small schools some distance from the centre of the economic universe, who did not realise there were other people thinking the same way they did. They had no institutional home, no critical mass. The blogs provided one. Lars Christensen, an economist at a Danish bank who came up with the name “market monetarism”, says it is the first economic school of thought to be born in the blogosphere, with post, counter-post and comment threads replacing the intramural exchanges of more established venues.” (Please have a look at my paper on Market Monetarism)

There is no doubt that Scott is at the centre of the Market Monetarist movement. To me he is the Milton Friedman of the day – a pragmatic revolutionary. Scott does not always realise this but his influence can not be underestimated. Our friend Bill Woolsey is also mentioned in the article. But I miss mentioning of for example David Beckworth.

One thing I would note about the Economist’s article is that the Austrianism presented in the article actually is quite close to Market Monetarism. Hence, Leland Yeager (who calls himself a monetarist) and one of the founders of the Free Banking school Larry White are quoted on Austrianism. Bob Murphy is not mentioned. Thats a little on unfair to Bob I think. I think that both Yeager’s and White’s is pretty close to MM thinking. In fact Larry White endorses NGDP targeting as do other George Mason Austrians like Steven Horwitz. I have written the GMU Austrians about earlier. See here and here.

And see this one:

“Austrians still struggle, however, to get published in the principal economics journals. Most economists do not share their admiration for the gold standard, which did not prevent severe booms and busts even in its heyday. And their theory of the business cycle has won few mainstream converts. According to Leland Yeager, a fellow-traveller of the Austrian school who once held the Mises chair at Auburn, it is “an embarrassing excrescence” that detracts from the Austrians’ other ideas. While it provides insights into booms and their ending, it fails to explain why things must end quite so badly, or how to escape when they do. Low interest rates no doubt helped to inflate America’s housing bubble. But this malinvestment cannot explain why 21.8m Americans remain unemployed or underemployed five years after the housing boom peaked.”

Market Monetarists of course provide that insight – overly tight monetary policy – and it seems like Leland Yeager agrees.

It would of course have been great if the Economist had endorsed Market Monetarism, but it is great to see that Market Monetarism now is getting broad coverage in the financial media and there is no doubt that especially Scott’s advocacy is beginning to have a real impact – now we can only hope that they read the Economist at the Federal Reserve and the ECB.

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See also the comments on the Economists from Scott Sumner, Marcus Nunes, David Beckworth, Luis Arroyo (in Spanish) and Tyler Cowen.

1 Comment
by Lars Christensen on December 30, 2011  •  Permalink
Posted in Austrian economics, Bill Woolsey, Bob Murphy, Free Banking, Larry White, Leland Yeager, Milton Friedman, MM Research agenda, NGDP Targeting, Nominal Income Targeting, Scott Sumner, Steven Horwitz
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Posted by Lars Christensen on December 30, 2011

https://marketmonetarist.com/2011/12/30/the-economist-comments-on-market-monetarism/

Lorenzo on Tooze – and a bit on 1931

The other day I was asking for comments on Adam Tooze’s book  “Wages of Destruction”. Now our good friend “Lorenzo from Oz” has answered my call. It turns out that he already back in 2009 wrote a review on the book on his excellent blog Thinking Out Aloud.

Here is Lorenzo’s wrap-up:

“Tooze’s book is genuinely revelatory. The purposiveness of Nazi policy, the fears and aspirations that drove it, the limitations it laboured under are all made clear. Hitler was, from first to last, a wilful gambler who knew himself to be such. He was also a consummate political game player who attracted and used people of genuine talent for a purpose that was horrific. That the Nazi economy was a loot economy was not happenstance but the nature of the beast. Genghis Khan with a telephone indeed.”

So far every single review of this book I have read has been positive – I am still hoping to find some time to read it – until then I highly recommend that you all have a look at Lorenzo’s review of the book.

PS I continue to think that we can learn a lot about the present crisis by studying history. Yesterday I spend some time in the company the Danish central bank governor Niels Bernstein and Polish central bank governor Marek Belka. Dr. Belka brought up the year of 1931. Dr. Belka of course spend time at the University of Chicago in 1980s so he full well understand monetary policy and monetary history. I hope that Dr. Belka will educate his European colleagues about monetary history (he yesterday also referenced Friedman’s and Schwartz’s “Monetary History”). See what I earlier have written on the “Tagic year 1931”.

7 Comments
by Lars Christensen on December 15, 2011  •  Permalink
Posted in Adam Tooze, Anna Schwartz, Economic and monetary history, Lorenzo of Oz, Milton Friedman
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Posted by Lars Christensen on December 15, 2011

https://marketmonetarist.com/2011/12/15/lorenzo-on-tooze/

Friedman should have supported NGDP targeting, but never did

I found yet another gold nugget in David Eagle’s research:

“In 2005 at the WEAI conference in San Francisco, Milton Friedman participated in panel where he strongly endorsed IT. After the panel presentations, an economist from the audience asked Friedman how he thought the Federal Reserve should respond to a broad-based 10% drop in real GDP. After spending some time trying think about what could possibility cause such a drop, Friedman responded by saying that the Federal Reserve should respond with a 10% drop in the money supply. However, immediately thereafter, Friedman inserted, “If you ask a foolish question, you get a foolish answer.””

Eagle continues:
“We disagree with Friedman concerning the foolishness of considering unexpected deviations in real GDP because that is when NIT (NGDP targeting) diverges from PLT (Price Level Targeting). Only by considering such unexpected real deviations can we see the differences in central bank responses under IT (Inflation targeting) or PLT from NIT (which we consider to be the equivalent of Friedman’s k percent rule). According to the new equation of exchange, N=PY, if Y unexpectedly increased while N (Nominal spending) remained as expected, the price level would unexpectedly fall. Under NIT, the central bank would be content to do nothing since N is on target. However, under PLT, the central bank would try to interject funds into the monetary system to try to raise N to match the increase in Y in order to return P to its targeted level. Similarly, if Y unexpectedly decreased while N remained as expected, the price level would unexpectedly increase. Under NIT, the central bank would be content to do nothing since N is on target. However, under PLT, the central bank would try to withdraw funds to try to cause N to fall to match the decline in Y in order that the price level not change.”

Hence, shortly before his dead Friedman indirectly said that he was not in favour of NGDP targeting. In my view that is not overly surprising. At that time official inflation targeting had been a success around the world for more than a decade and Friedman undoubtedly saw it as an vindication of his view that central banks should follow rules. So as always Friedman was the pragmatic revolutionary he simply support the successfully (at that time) version of a monetary rule, but I think that was on purely pragmatic reasons. Furthermore, one have to remember that at that time the primary monetary mistakes in recent history was too loose monetary policy rather than too tight monetary policy so from a pragmatic perspective it made “sense” to support inflation targeting.

As I have earlier argued Milton Friedman also acknowledged that velocity was no longer stable and that probably moved him from the left hand side to the right hand side of equation of exchange. By the way that shows that John Taylor’s use of Friedman to criticizing NGDP targeting by stating that Friedman argued that rules should be instrument rules really does not live up to what Friedman came believe in the final years of his life. Yes, Friedman endorsed inflation targeting, but NOT the Taylor rule (See David Glasner’s excellent critique of John Taylor views here). Furthermore, acknowledging that he did not think that velocity was stable (anymore) really makes it hard to use Friedman as an argument against NGDP targeting. BUT, BUT Friedman nonetheless to the end of his life preferred inflation targeting more than anything else.

Would that have change if he had live to see the Great Recession? I really don’t know and does it really matter? I still consider myself a Friedmanite and to me the best pupil of Friedman around is Scott Sumner!

——

See also my earlier post on related topics:

Friedman provided a theory for NGDP targeting
Friedman’s thermostat and why he obviously would support a NGDP target

4 Comments
by Lars Christensen on December 7, 2011  •  Permalink
Posted in David Eagle, David Glasner, Milton Friedman, MM Research agenda, Monetary institutions, Monetary policy rules, NGDP Targeting, Nominal Income Targeting, Scott Sumner
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Posted by Lars Christensen on December 7, 2011

https://marketmonetarist.com/2011/12/07/friedman-should-have-supported-ngdp-targeting-but-never-did/

The Fisher-Friedman-Sumner-Svensson axis

Here is Scott Sumner in 2009:

“People like Irving Fisher had a perfectly good macro model.  Indeed, except for Ratex it’s basically the model that I use in all my research.  But the problem is that these pre-1936 models didn’t use Keynesian language.  And they didn’t obsess about trying to develop a general equilibrium framework. A GE framework is not able to predict any better than Fisher’s models, and is not able to offer more cogent policy advice than Fisher’s model.  Indeed in many ways Fisher’s “compensated dollar plan” was far superior to the monetary policy the Fed actually implemented last October.  (Although I would prefer CPI futures target to a flexible gold price, at least Fisher’s plan had a nominal anchor.)”

I used to think of that Scott mostly was influenced by his old teacher Milton Friedman, but I increasingly think that Scott is mostly influenced by Irving Fisher.

Well of course this is not really important and Friedman undoubtedly was hugely influenced by Irving Fisher. Fisher’s influence on Friedman is excellently explained in a paper by Bordo and Rockoff from earlier this year,

Here is the abstract:

“This paper examines the influence of Irving Fisher’s writings on Milton Friedman’s work in monetary economics. We focus first on Fisher’s influences in monetary theory (the quantity theory of money, the Fisher effect, Gibson’s Paradox, the monetary theory of business cycles, and the Phillips Curve, and empirics, e.g. distributed lags.). Then we discuss Fisher and Friedman’s views on monetary policy and various schemes for monetary reform (the k% rule, freezing the monetary base, the compensated dollar, a mandate for price stability, 100% reserve money, and stamped money.) Assessing the influence of an earlier economist’s writings on that of later scholars is a challenge. As a science progresses the views of its earlier pioneers are absorbed in the weltanschauung. Fisher’s Purchasing Power of Money as well as the work of Pigou and Marshall were the basic building blocks for later students of monetary economics. Thus, the Chicago School of the 1930s absorbed Fisher’s approach, and Friedman learned from them. However, in some salient aspects of Friedman’s work we can clearly detect a major direct influence of Fisher’s writings on Friedman’s. Thus, for example with the buildup of inflation in the 1960s Friedman adopted the Fisher effect and Fisher’s empirical approach to inflationary expectations into his analysis. Thus, Fisher’s influence on Friedman was both indirect through the Chicago School and direct. Regardless of the weight attached to the two influences, Fisher’ impact on Friedman was profound.”

I wonder if Bordo and Rockoff would ever write a paper about Fisher’s influence on Sumner…or maybe Scott will write it himself? I especially find Scott’s “link” to the compensated dollar plan intriguing as I fundamentally think that Scott’s intellectual love affair with “Market Keynesian” Lars E. O. Svensson has to be tracked back to exactly this plan.

PS I am intrigued by the compensated dollar plan (CDP) and I increasingly think that variations of the CDP could be a fitting monetary policy set-up for Emerging Markets and small open economies with underdeveloped financial markets. One day I might get my act together and write a post on that topic.

 

 

 

4 Comments
by Lars Christensen on November 14, 2011  •  Permalink
Posted in Irving Fisher, Milton Friedman, MM Research agenda, Reading recommendations, Scott Sumner
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Posted by Lars Christensen on November 14, 2011

https://marketmonetarist.com/2011/11/14/the-fisher-friedman-sumner-svensson-axis/

Selgin is right – Friedman wanted to abolish the Fed

I guess George Selgin is right  – Milton Friedman at the end of his life had come to the conclusion that the Federal Reserve should be abolished. See for yourself here. This is six months before his death in 2006.

See George’s excellent paper “Milton Friedman and the Case against Currency Monopoly”.

6 Comments
by Lars Christensen on November 8, 2011  •  Permalink
Posted in Free Banking, George Selgin, Milton Friedman
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Posted by Lars Christensen on November 8, 2011

https://marketmonetarist.com/2011/11/08/selgin-is-right-friedman-wanted-to-abolish-the-fed/

Friedman provided a theory for NGDP targeting

A distinct feature of Market Monetarist thinking is that our starting point for monetary analysis is nominal income and that monetary policy determines nominal income or nominal GDP (NGDP). This is contrary to New Keynesian analysis where monetary policy determines real GDP, which in turn determines inflation via a Phillips curve.

Hence, to Market Monetarists the split between prices and quantities is not a monetary matter. Monetary policy determines NGDP and that is all that monetary policy can do. While we acknowledge that there is a high correlation between real GDP and NGDP in the short-run the causality runs from NGDP to RGDP and not the other way. In the long run inflation is determined as a residual between NGDP, which is a monetary phenomenon, and RGDP, which is determined by supply side factors.

Milton Friedman came to the same conclusion 40 years ago. In a much overlooked (or should I say a forgotten) article from 1971 “A Monetary Theory of Nominal Income” he discusses this topic. The paper is a follow up on “Milton Friedman’s Monetary Framework” in which Friedman discusses his monetary framework with his critics. I have always felt that he failed to explain what he really meant in his “Monetary Framework”. Friedman seems to have realised that himself and his 1971 try to make up this failure.

Here is Friedman:

“In … “A Theoretical Framework for Monetary Analysis,” I outlined a simple model of six equations in seven variables that was consistent with both the quantity theory of money and the Keynesian income-expenditure theory…The difference between the two theories is in the missing equation the quantity theory adds an equation stating that real income is determined outside the system (the assumption of “full employment”); the income-expenditure theory adds an equation stating that the price level is determined outside the system (the assumption of price or wage rigidity)…The present addendum to my earlier paper suggests a third way to supply the missing equation. This third way involves bypassing the breakdown of nominal income between real income and prices and using the quantity theory to derive a theory of nominal income rather than a theory of either prices or real income. While I believe that this third way is implicit in that part of my theoretical and empirical work on money that has been concerned with short-period fluctuations, I have not heretofore stated it explicitly. This third way seems to me superior to the other two ways as a method of closing the theoretical system for the purpose of analyzing short-period changes. At the same time, it shares some of the defects common to the other two ways that I listed in the earlier paper.”

Hence, Friedman here acknowledges that the problem in the “Framework” papers was that he tried to come up with a monetary theory that followed a Keynesian route from RGDP to prices rather than “bypassing the breakdown of nominal income between real income and prices and using the quantity theory to derive a theory of nominal income”. 

This is something completely lost in modern macroeconomic thinking, which see monetary policy working through a Phillips curve. This is somewhat odd given the weak empirical foundation for the existence of a Phillips curve.

I will not get into the details of Friedman’s model, but I would note that it could be interesting to see how it would look in a rational expectations version.

Back to Friedman:

“I have not, before this, written down explicitly the particular simplification I have labeled the monetary theory of nominal income-although Meltzer has referred to the theory underlying Anna Schwartz’s and my Monetary History as a “theory of nominal income” (Meltzer 1965, p. 414). But once written down, it rings the bell, and seems to me to correspond to the broadest framework implicit in much of the work that I and others have done in analyzing monetary experience. It seems to me also to be consistent with many of our findings. I do not propose here to attempt a full catalog of the findings, but I should like to suggest a number and, more important, to indicate the chief defect that I find with the framework.”

Here Friedman acknowledges that his empirical work for example on the Great Depression is based on a monetary theory of nominal income rather than on a quasi-Keynesian model (like the one he presents in his “Framework”). Any Market Monetarist would of course agree that a monetary theory of nominal income is needed to explain the Great Depression and the Great Recession for that matter. Friedman continues:

“One finding that we have observed is that the relation between changes in the nominal quantity of money and changes in nominal income is almost always closer and more dependable than the relation between changes in real income and the real quantity of money or between changes in the quantity of money per unit of output and changes in prices. This result has always seemed to me puzzling, since a stable demand function for money with an income elasticity different from unity led me to expect the opposite. Yet the actual finding would be generated by the approach of this paper, with the division between prices and quantities determined by variables not explicitly contained in it.”

This empirical result is highly interesting – the correlation between money and NGDP is stronger than between money and prices and income. In that regard it seems odd that Friedman never endorsed NGDP targeting – after all it would be natural to endorse a monetary policy rule that actually is directed towards something monetary policy can determine. However, there is no doubt that Friedman’s 1971 paper clearly provides the theoretical foundation for NGDP targeting. It is only too bad Friedman never came to that conclusion.

Finally I should say that Market Monetarists like David Beckworth and Josh Hendrickson are working on developing a modern monetary theory of nominal income determination.

PS Scott Sumner in a recent comment also discuss the relationship between NGDP, prices and quantities in Keynesian and (Market) Monetarist models.

PPS It should be noted that Bennett McCallum in a number of papers refers to Friedman’s 1971 paper when he argues in favour of nominal income targeting. See for example “Nominal Income Targeting in an Open-Economy Optimizing Model”

8 Comments
by Lars Christensen on November 6, 2011  •  Permalink
Posted in David Beckworth, Milton Friedman, MM Research agenda, Monetary policy, MV=PY, NGDP Targeting, Nominal Income Targeting, Reading recommendations, Scott Sumner, Uncategorized
Tagged , , ,

Posted by Lars Christensen on November 6, 2011

https://marketmonetarist.com/2011/11/06/friedman-provided-a-theory-for-ngdp-targeting/

Friedman’s thermostat and why he obviously would support a NGDP target

In a recent comment Dan Alpert argues that Milton Friedman would be against NGDP targeting. I have the exact opposite view and I am increasingly convinced that Milton Friedman would be a strong supporter of NGDP targeting.

Ed Dolan as the same view as I have (I have stolen this from Scott Sumner):

“I see NGDP targeting as the natural heir to monetarist policy prescriptions of the 1960s and 70s…If we look at the textbook version of monetarism, the point is almost trivial. Textbook monetarism begins from the equation of exchange, MV=PQ, where M is money (M1, back in the day), V is velocity, P is the price level, Q is real GDP, and PQ is NGDP. Next it adds the simplifying assumption that velocity is constant. It follows that targeting a steady rate of money growth is identical to targeting a steady rate of NGDP growth.”

Dolan’s clear argument reminded me of Friedman’s paper from 2003 “The Fed’s Thermostat”.

Here is Friedman:

“To keep prices stable, the Fed must see to it that the quantity of money changes in such a way as to offset movements in velocity and output. Velocity is ordinarily very stable, fluctuating only mildly and rather randomly around a mild long-term trend from year to year. So long as that is the case, changes in prices (inflation or deflation) are dominated by what happens to the quantity of money per unit of output…since the mid ’80s, it (the Fed) has managed to control the money supply in such a way as to offset changes not only in output but also in velocity…The improvement in performance is all the more remarkable because velocity behaved atypically, rising sharply from 1990 to 1997 and then declining sharply — a veritable bubble in velocity. Velocity peaked in 1997 at nearly 20% above its trend value and then fell sharply, returning to its trend value in the second quarter of 2003.…The relatively low and stable inflation for this period …means that the Fed successfully offset both the decline in the demand for money (the rise in V) before 1973 and the subsequent increase in the demand for money. During the rise in velocity from 1988 to 1997, the Fed kept monetary growth down to 3.2% a year; during the subsequent decline in velocity, it boosted monetary growth to 7.5% a year.”

Hence, Friedman clearly acknowledges that when velocity is unstable the central bank should “offset” the changes in velocity. This is exactly the Market Monetarist view – as so clearly stated by Ed Dolan above.

So why did Friedman man not come out and support NGDP targeting? To my knowledge he never spoke out against NGDP targeting. To be frank I think he never thought of the righthand side of the equation of exchange – he was focused on the the instruments rather than on outcome in policy formulation. I am sure had he been asked today he would clearly had supported NGDP targeting.

The only difference I possibly could see between what Friedman would advocate and what Market Monetarists are arguing today is whether to target NGDP growth or a path for the NGDP level.

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PS I am not the first Market Monetarist to write about Friedman’s Thermostat – both Nick Rowe and David Beckworth have blogged about it before.

3 Comments
by Lars Christensen on November 5, 2011  •  Permalink
Posted in David Beckworth, Milton Friedman, MM Research agenda, Monetary institutions, Monetary policy, MV=PY, NGDP Targeting, Nick Rowe, Nominal Income Targeting, Reading recommendations, Scott Sumner
Tagged , , , , , ,

Posted by Lars Christensen on November 5, 2011

https://marketmonetarist.com/2011/11/05/friedman%e2%80%99s-thermostat-and-why-he-obviously-would-support-a-ngdp-target/

Milton Friedman on exchange rate policy #6

Gold standard?

The last remnants of the global gold standard system died when the Bretton Woods agreement collapsed in 1971, but the notion of a global currency system based on a gold standard occasionally pops up in both general and academic debates, especially in the USA.

Friedman was never any great proponent of the gold standard or other goods-based currency systems. He sees a gold standard system as neither possible nor desirable in a today’s world: undesirable because its reintroduction would imply enormous costs in connection with purchasing gold, and not possible because the “mythology” that surrounded the gold standard in the nineteenth century no longer exists. In the nineteenth century everyone expected changes in the money supply to be determined by developments in the price of gold, and that money and gold were close substitutes. Today, we expect the central bank – not gold – to ensure the value of our money. A reintroduction of the gold standard would require a shift in this perception.

In the nineteenth century the gold standard ensured low (or more correctly no) inflation for long periods of time. On the other hand, prices fluctuated considerably from year to year as gold production rose and fell. According to Friedman this was possible because the goods and labour markets were much more flexible at that time than now. Any attempt to reintroduce the gold standard now would result in exactly the same negative outcomes as a fixed exchange rate policy.

Despite the global gold standard having been abandoned many years ago, most central banks continue to own large amounts of gold. Friedman’s view is that one should fully acknowledge the end of the gold standard system and auction off the gold reserves of the central banks.

This concludes my little series on Milton Friedman’s view on FX policy. See the other posts here:

Milton Friedman on exchange rate policy #1
Milton Friedman on exchange rate policy #2
Milton Friedman on exchange rate policy #3
Milton Friedman on exchange rate policy #4
Milton Friedman on exchange rate policy #5

2 Comments
by Lars Christensen on November 2, 2011  •  Permalink
Posted in Exchange rate policy, Exchange rates, Gold Standard, Milton Friedman, MM Research agenda, Uncategorized
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Posted by Lars Christensen on November 2, 2011

https://marketmonetarist.com/2011/11/02/milton-friedman-on-exchange-rate-policy-6/

Milton Friedman on exchange rate policy #5

The euro – “a great mistake”

The European Monetary Union came into being in 1999, with the euro being introduced at the same time (as “account money”, and in 2002 as physical currency). Milton Friedman was an outspoken critic of this project, and his criticisms can be traced all the way back to “The Case for Flexible Exchange Rates” from 1953. The basic idea behind the euro is that to exploit the full potential of a single European market for goods, capital and labour – the inner market – a single common currency is essential. Friedman opposes this idea, as his view is namely that free trade is best promoted through floating exchange rates when wage and price formation are sluggish.

In Friedman’s eyes the euro area is not an optimal currency area, as the European goods and labour markets are still heavily regulated, and so prices and wages are relatively slow to adjust. At the same time, the mobility of labour between the euro countries is limited – due to both regulations and cultural differences. If this situation is not changed, it will, according to Friedman, inevitably lead to political tensions within the EU that may reach an intensity the European Central Bank (ECB) cannot ignore.

An asymmetric shock to one or more euro countries would require real national adjustment (price and wage adjustments), as nominal adjustments (exchange rate adjustments) are not possible within the framework of the monetary union. In Friedman’s view this would spark tension between the countries hit by the asymmetric shock and those not affected. Thus the euro might actually fan political conflict and the disintegration of Europe – which is in diametric opposition to the founding idea behind the single currency.

For Friedman the euro is not primarily an economic project. Rather, Friedman views the euro as basically a political concept designed to force further political integration onto Europe. Friedman believes that in the long run no country can maintain its sovereignty if it abandons its currency. The integration of the goods, capital and labour markets in the euro member countries is a prerequisite for the euro to function, and according to Friedman this can only happen through further political integration – something he fears will lead to the formation of a European superstate.

Recent developments unfortunately have proven Friedman’s analysis right…

5 Comments
by Lars Christensen on November 1, 2011  •  Permalink
Posted in euro crisis, Exchange rate policy, Exchange rates, Milton Friedman, MM Research agenda, Monetary institutions, The euro, The Great Recession
Tagged , , , , , ,

Posted by Lars Christensen on November 1, 2011

https://marketmonetarist.com/2011/11/01/milton-friedman-on-exchange-rate-policy-5/

The inverse relationship between central banks’ credibility and the credibility of monetarism

A colleague of mine today said to me ”Lars, you must be happy that you can be a monetarist again”. (Yes, I am a Market Monetarists, but I consider that to be fully in line with fundamental monetarist thinking…)

So what did he mean? In the old days – prior to the Great Moderation monetarists would repeat Milton Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” and suddenly by the end of the 1970s and 1980s people that started to listen. All around the world central banks put in place policies to slow money supply growth and thereby bring down inflation. In the policy worked and inflation indeed started to come down around the world in the early 1980.

Central banks were gaining credibility as “inflation fighters” and Friedman was proven right – inflation is indeed always and everywhere a monetary phenomenon. However, then disaster stroke – not a disaster to the economy, but to the credibility of monetarism, which eventually led most central banks in the world to give up any focus on monetary aggregates. In fact it seemed like most central banks gave up any monetary analysis once inflation was brought under control. Even today most central banks seem oddly disinterested in monetary theory and monetary analysis.

The reason for the collapse of monetarist credibility was that the strong correlation, which was observed, between money supply growth and inflation (nominal GDP growth) in most of the post-World War II period broke down. Even when money supply growth accelerated inflation remained low. In time the relationship between money and inflation stopped being an issue and economic students around the world was told that yes, inflation is monetary phenomenon, but don’t think too much about it. Many young economists would learn think of the equation of exchange (MV=PY) some scepticism and as old superstition. In fact it is an identity in the same way as Y=C+I+G+X-M and there is no superstition or “old” theory in MV=PY.

Velocity became endogenous
To understand why the relationship between money supply growth and inflation (nominal GDP growth) broke down one has to take a look at the credibility of central banks.

But lets start out the equation of exchange (now in growth rates):

(1) m+v=p+y

Once central bankers had won credibility about ensure a certain low inflation rate (for example 2%) then the causality in (1) changed dramatically.

It used to be so that the m accelerated then it would fast be visible in higher p and y, while v was relatively constant. However, with central banks committed not to try to increase GDP growth (y) and ensuring low inflation – then it was given that central banks more or less started to target NGDP growth (p+y).

So with a credible central that always will deliver a fixed level of NGDP growth then the right hand side of (1) is fixed. Hence, any shock to m would be counteracted by a “shock” in the opposite direction to velocity (v). (This is by the way the same outcome that most theoretical models for a Free Banking system predict velocity would react in a world of a totally privatised money supply.) David Beckworth has some great graphs on the relationship between m and v in the US before and during the Great Moderation.

Assume that we have an implicit NGDP growth path target of 5%. Then with no growth in velocity then the money supply should also grow by 5% to ensure this. However, lets say that for some reason the money supply grow by 10%, but the “public” knows that the central bank will correct monetary policy in the following period to bring back down money to get NGDP back on the 5% growth path then money demand will adjust so that NGDP “automatically” is pushed back on trend.

So if the money supply growth “too fast” it will not impact the long-term expectation for NGDP as forward-looking economic agents know that the central bank will adjust monetary policy to bring if NGDP back on its 5% growth path.

So with a fixed NGDP growth path velocity becomes endogenous and any overshoot/undershoot in money supply growth is counteracted by a counter move in velocity, which ensures that NGDP is kept on the expected growth path. This in fact mean that the central banks really does not have to bother much about temporary “misses” on money supply growth as the market will ensure changes in velocity so that NGDP is brought back on trend. This, however, also means that the correlation between money and NGDP (and inflation) breaks down.

Hence, the collapse of the relation between money and NGDP (and inflation) is a direct consequence of the increased credibility of central banks around the world.

Hence, as central banks gained credibility monetarists lost it. However, since the outbreak of the Great Recession central banks have lost their credibility and there are indeed signs that the correlation between money supply growth and NGDP growth is re-emerging.

So yes, I am happy that people are again beginning to listen to monetarists (now in a improved version of Market Monetarism) – it is just sad that the reason once again like in the 1970s is the failure of central banks.

15 Comments
by Lars Christensen on October 31, 2011  •  Permalink
Posted in Milton Friedman, MM Research agenda, Monetary institutions, Monetary policy, Monetary policy rules, MV=PY, NGDP Targeting, Nominal Income Targeting, The Great Moderation, Velocity
Tagged , , , , , ,

Posted by Lars Christensen on October 31, 2011

https://marketmonetarist.com/2011/10/31/the-inverse-relationship-between-central-banks-credibility-and-credibility-of-monetarism/

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