A Stable Demand for Money Function is Necessary for the Success of Monetarism - Term Paper Example

A Stable Demand for Money Function is Necessary for the 'Success' of Monetarism Table of Contents I. Introduction on Monetarism Theory ………..…………………………… 3 II. The Quantity Theory of Money …………………………………………. 3 III. The Measurement of Money Stock ……………………………………… 7 IV. History of Monetarism …………………………………………………... 8 V. UK’s Experience on Monetarism …………………………………...…… 8 VI. Problems that may Arise with the Use of Monetarism ………………….. 10 VII. Conclusion ………………………………………………………………. 10 References ……………………………………………………………………….. 11 Introduction on Monetarism Theory Monetarism theory is part of macroeconomic study which focuses on the effects of the supply of money also known as money stock and central banking. Monetarism started to evolve with Milton Friedman’s quantity theory of money supply. The theory emphasizes the role of money in the economic fluctuations in a way that the economic stability can be achieved through a steady and non-cyclical growth in the money supply. In a situation where there is an insufficient supply of money, the unemployment rate increases. (Turner, 2006) According to monetarism, given that the money supply is facing a steady growth rate, there is a tendency for the economy to meet full-employment equilibrium. Theorists of monetarism take the side that balance between the supply of money and the demand for money is enough to make a country’s economy well and sound. Monetarists strongly believe that changes in the quantity of money in circulation within an economy are the main determinant of the level of national income i and that the central bank should be the one to control the supply of money. It is the central bank that should set a monetary policy and target rates in the growth of money supply while the financial markets should determine the interest rate levels. The Quantity Theory of Money The quantity theory of money of Irving Fisher is represented by the equation MV = PT; wherein M represents Money, V for Velocity, P for the Price Level and T for the Level of Transactions. Based on the old quantity theory that was equated by Newcomb-Fisher, Velocity (V) and Level of Transactions (T) are fixed with the money supply and that supply of money is considered as exogenous. As a rule, the causation will run from left (MV) to right (PT). The increase in money supply will result to an exact proportionate increase in the Price Level (P) since Velocity (V) and Level of Transactions (T) are fixed and money supply (M) is exogenous. Therefore, we can conclude that a sudden increase in the money supply can result to price inflation. This is the main reason why a stable demand for money function is important. Because when M increases given that T and V are fixed; therefore, Money (M) and Price (P) will be greater than the Level of Transaction (T) and Velocity (V). Let us look at the situation wherein the supply of money is more than the demand for money. (See Figure 1 on page 5) The purchasing power of pounds (£) will increase given that there is an excessive supply of money. Therefore, people will purchase more goods if the supply of money is excessive. Likewise, the increase in demand for more goods will then cause the price of goods to increase. When the prices of goods are already high, people will stop buying. On the other hand, when the supply of money is less than the demand for money, people will experience hunger due to lack of money. At this point, the economy is weak causing the unemployment rate to increase. There will be a problem with regards to the available jobs in the market vs. the huge supply of human resources. Given that the supply of money is less than the demand for money, the purchasing power of £ will eventually decrease. (See Figure 2 below) Given that there is a stable demand for money, the supply of money will also be stable in such a way that the demand and supply meets at equilibrium. At this point, the economy is said to be stable since there will be enough jobs for the local citizens, the demand for goods increases, businesses will get to earn profit which will be used for further investments in machineries and other technologies which could create a demand for employment. Therefore, production output increases steadily. In monetarism theory, this economic process moves in a cycle in such a way that the supply and the demand of money meets at equilibrium. The theoretical rationale behind the left-side causation such that the increase in money supply will go at an exact proportionate to the increase in price comes from the Quantity Theory of Money that was explained by Fisher. (History of Economic Thought, 2007b) Let us assume that the nominal income of ‘country A’ is £5 billion. It means that 5 billion worth of goods are produced and sold at £5 each is the same as producing 1 billion goods at the price of £5 each; and/or producing 500 million goods at the price of £10 each. (bized, 2007) Using the ‘equation of exchange’ MV = PT; given that the velocity of circulation is 100 and it is stable over a period of time; it means that the supply of money in circulation (1000) changes hands 100 times to buy the output of the economy. Assuming that the number of transactions in the economy is 500, the price level would then be £200; [P = (1000 x 100) / 500]. It means that the average price of each good that goes into circulation is £200. Assuming that there is an increase in the money supply wherein M is equals to 2000. Given that the velocity and number of transactions are stable over time, the price level will now become £400; [P = (2000 x 100) / 500]. In this example, there is an increase of 50% in the price level because of the increase in the money supply. The 100% increase in the money supply resulted to a 50% increase in the price level given that the output produced by the economy remains the same. Therefore, if the money supply increases more that the level of production output, the price level will increase given that there is a stable velocity in the circulation of money. By carefully analyzing the example stated above, it is clear that the supply of money has a big impact over the price level or inflation. It also means that by controlling the supply of money, inflation can be prevented. The Measurement of Money Stock In UK, there are two ways of measuring money stock or the supply of money. These are M0 and M4. M0 is used to refer to the ‘wide monetary base’ or ‘narrow money’ while the M4 refers to ‘broad money’ or ‘the supply of money.’ M0 includes all cash outside the Bank of England plus bank’s operational deposits with Bank of England; while M4 includes all ‘cash outside banks’, cash within the private-sector retail bank and building society deposits, and the cash coming from the private-sector wholesale bank and building society deposits including cash deposits. When we talk about ‘cash outside banks’, we are talking about the money in public circulation and non-bank firms. It is the responsibility of the central bank (such as the Bank of England and the European Central Bank) to increase the money supply whenever it is needed. The central bank can easily increase the supply of money by purchasing government securities from the open market. This increases the available funds of the private banks by loaning through fractional reserve banking. In case the central bank is experiencing ‘tightness’ in the available supply of money, the central bank would produce some money by selling government securities to the open market and by pulling some money back from the private banking sector. This process could either increase or decrease the supply of the government’s short term debts. The control of the central bank over the supply of money enables them to lend out more money to the private banks in a form of debt. The main task of the central bank is to ensure that the growth of money supply is in line with the real GDP growth by targeting some inter-bank interest rate through the open market operations. Monetary problems such as deflation and inflation may arise in case the supply of money is either less or more than the growth of the real GDP respectively. According to Chris Salmon of the Monetary Assessment and Strategy Division of Bank of England, the growth of M4 also known as the broad money is a financial indicator of inflation. Since 1980, the broad money plays a role in UK’s monetary policy framework. (Salmon, 1995) History of Monetarism Due to inflation back in the 1970s, monetarism was widely used in order to solve the problem with the high unemployment rate. People behind monetarism believe that the relationship between inflation and money stock growth is related such that it is the growth in money supply that causes inflation. Monetarism has been “a very powerful intellectual force back in the late 1960s and early 1970s until the late 1970s and early 1980s that it became an economic policy.” (History of Economic Thought, 2007a) UK’s Experience on Monetarism The economic policy in the United Kingdom was changing from time to time. Back in 1970s, monetary policy was treated as subordinate to the income policy. Monetary policy was UK government’s main solution towards inflation. It was between the years July 1972 to June 1976, exchange rate in UK was floating until the pre-monetary period. (Edward, 2000) The monetary system was used in UK some time between July 1976 to April 1979 or prior to the Conservative government election day. (Edward, 2000) The first and second oil price hike in 1973 and 1979 respectively as well as the collapse of the fixed exchange rates caused the economic growth in UK to slow down. (CCE, 2007) The economic down turn in UK resulted to the increase in unemployment, inflation and stagnation. Before 1970, US and UK was using Keynesian policy. Due to the high inflation and unemployment rate, Jim Callaghan of the Labour government went to the IMF to adopt the monetarist policies in the late 1970s and early 1980s because monetary policy proves to work well under a floating exchange rate regime. (Batini and Nelson, 2005) During this period, the use of pure Keynesian policies was isolated. It was mixed with the monetarism policies to correct the errors in Keynesian policies. “The British experience is one that is full of experiments in monetary regimes and switches in regimes.” (Howard and Johnson, 1982) Monetary targets were set by Mrs. Thatcher after 1979 in order to reign on the government spending. In 1982, this policy failed because inflation increased by 25%. Other non-monetary issues which also contributed to inflation arise. This includes keeping the uncontrolled wage increase in government employees down between the years 1970 to 1971, cuts on income taxes to prevent a wage-price spiral in 1970, increase in unemployment rate and cut on sales taxes in 1971. (Batini and Nelson, 2005) For some time, British economy has been relying on the experimental monetarism. According to Sir Keith Joseph – a British politician back in 1976, monetarism is simply not enough to restore the country’s economy. (Free Life, 1982) Problems that may Arise with the Use of Monetarism Monetarism can be used to solve the problem with inflation. However, with the use of monetarism, there are still many issues that are left unresolved. Since monetarism focuses mainly on the supply of money, other non-monetary issues will be left without a solution. Demand and supply shock can be present due to external factors such as a sudden increase in the population due to migration, a natural calamity which badly affects the production of goods within the affected region, the sudden decline in the demand of goods due to globalization, a terrorist attack causing a sudden changes in the demand and supply of goods and services, etc. The frequent fluctuation in the aggregate demand and aggregate supply curve due to demand and supply shock makes it uneasy to simply control the circulation of money stock. Conclusion Over the years, economic theorists have made up a lot of economic theorist which could possibly help in maintaining a stable economy. Monetarism theory is one of the well-known macroeconomic theories back in the 1970s. Aiming to solve the problem of inflation, UK adopted the theory for some time until it has proven them wrong. Inflation in UK continued to increase despite the use of this theory. Based on the experiments done by UK, monetarism alone is still not enough to solve a country’s economic problem. Monetarism has its own strength and weaknesses just like in other economic theory and each country is facing different kinds of economic problem. Since there are a lot of existing economic theories today, it is always best to continuously study and choose the best economic theory which is suitable to the overall economic problem of a country. Perhaps a combination of one of the existing economic theory could be better than adopting only one economic theory. *** End *** References: 1 Batini, N. and Nelson, E. (2005) ‘The U.K.’s Rocky Road to Stability’ The Federal Reserve Bank of St. Louis. Dated: March 2005 Retrieved: March 23, 2007 < http://research.stlouisfed.org/ > 2 Bized (2007) ‘The State of Monetarism’ Retrieved: March 23, 2007 < http://www.bized.co.uk/ > path: educators 3 CCE (2007) ‘From Keynes to Gordon Brown’ Retrieved: March 23, 2007 < http://www.george.irvin.com/ > path: lecture 4 Edward, N. (2000) ‘UK Monetary Policy: 1972 – 97: A Guide Using Taylor Rules’ Bank of England 2000. ISBN 1368-5562 Retrieved: March 23, 2007 < http://www.bankofengland.co.uk/ > path: publications 5 Free Life (1982) ‘Monetarism is still Not Enough’ Free Life – The Journal of the Libertarian Alliance. Vol. 3: No. 1, 1982 – Article 3 of 6. p. 2 Retrieved: March 23, 2007 < http://www.la-articles.org.uk/FL-3-1-3.pdf > 6 History of Economic Thought (2007a) ‘Milton Friedman and the Chicago School’ Retrieved: March 23, 2007 < http://cepa.newschool.edu/ > path: essays 7 History of Economic Thought (2007b) ‘The Quantity Theory of Money’ Retrieved: March 23, 2007 < http://cepa.newschool.edu/ > path: essays 8 Howard, D. and Johnson, K. (1982) ‘Financial Innovation, Deregulation and Monetary Policy: The Foreign Experience’ In Interest Rate Deregulation and Monetary Policy: Alisomar Conference Sponsored by the Federal Reserve Bank of SanFrancisco. San Francisco: Federal Reserve Bank of San Francisco. pp. 139−181 Retrieved: March 23, 2007 < http://research.stlouisfed.org/ > 9 Salmon, C. (1995) ‘Influences on Broad Money Growth’ Bank of England Retrieved: March 23, 2007 < http://www.bankofengland.co.uk/ > path: publication 10 Turner, E. (2006) ‘The Monetarism Concept’ e-article uploaded: October 6, 2006 Retrieved: March 23, 2007 < http://www.e-articles.info/ > Read More