The Orthodox Monetarist School and Stabilization Policy
In conclusion it would be useful to assess the development of orthodox
monetarism and how this school influenced the ongoing debate on the role
and conduct of stabilization policy. The development of orthodox monetarism
can be appraised in a positive light, given that it displayed both theoretical
and empirical progress over the period of the mid-1950s to the early 1970s
(see, for example, Cross, 1982a, 1982b). The reformulation of the quantity
theory of money approach (QTM), the addition of the expectations-augThe
mented Phillips curve analysis (EAPC), using the adaptive expectations hypothesis
(AEH), and the incorporation of the monetary approach to the balance
of payments theory and exchange rate determination (MTBE), generated a
large amount of real-world correspondence and empirical support (see Laidler,
1976). We can therefore summarize the main characteristics of orthodox
monetarism (OM) as:
OM = QTM + EAPC + AEH + MTBE
In contrast to orthodox monetarism, towards the close of this period, in the
early 1970s, the orthodox Keynesian position was looking increasingly degenerative
given (i) its failure to explain theoretically the breakdown of the
Phillips curve relationship and (ii) its willingness to retreat increasingly into
non-economic explanations of accelerating inflation and rising unemployment
(see for example, Jackson et al., 1972).
We can draw together the discussion contained in sections 4.2–4.4 and
seek to summarize the central distinguishing beliefs within the orthodox
monetarist school of thought (see also Brunner, 1970; Friedman, 1970c;
Mayer, 1978; Vane and Thompson, 1979; Purvis, 1980; Laidler, 1981, 1982;
Chrystal, 1990). These beliefs can be listed as follows:
1. Changes in the money stock are the predominant, though not the only,
factor explaining changes in money income.
2. The economy is inherently stable, unless disturbed by erratic monetary
growth, and when subjected to some disturbance, will return fairly rapidly
to the neighbourhood of long-run equilibrium at the natural rate of
unemployment.
3. There is no trade-off between unemployment and inflation in the long
run; that is, the long-run Phillips curve is vertical at the natural rate of
unemployment.
4. Inflation and the balance of payments are essentially monetary phenomena.
5. In the conduct of economic policy the authorities should follow some
rule for monetary aggregates to ensure long-run price stability, with
fiscal policy assigned to its traditional roles of influencing the distribution
of income and wealth, and the allocation of resources. In the former
case, Laidler (1993, p. 187) has argued that the authorities must be
prepared to adapt the behaviour of the supply of whatever monetary
aggregate they chose to control (that is, in response to shifts in the
demand for money resulting from, for example, institutional change)
rather than pursue a rigid (legislated) growth rule for a chosen monetary
aggregate as suggested by Friedman.
The monetarist aversion to activist stabilization policy, both monetary and
fiscal policy (and prices and incomes policy), which derives both from the
interrelated theoretical propositions and from empirical evidence discussed in
sections 4.2–4.4, is the central issue which distinguishes orthodox monetarists
from Keynesians.
Throughout the period 1950–80, a key feature of the Keynesian–monetarist
debate related to disagreement over the most effective way of managing
aggregate demand so as to limit the social and economic waste associated
with instability and also over the question of whether it was desirable for
governments to try to ‘fine-tune’ the economy using counter-cyclical policies.
In this debate Friedman was one of the earliest critics of activist discretionary
policies. Initially he focused on some of the practical aspects of implementing
such policies. As early as 1948 Friedman noted that ‘Proposals for the
control of the cycle thus tend to be developed almost as if there were no other
objectives and as if it made no difference within what framework cyclical
fluctuations take place’. He also drew attention to the problem of time lags
which in his view would in all likelihood ‘intensify rather than mitigate
cyclical fluctuations’. Friedman distinguished between three types of time
lag: the recognition lag, the action lag, and the effect lag. These inside and
outside lags, by delaying the impact of policy actions, would constitute the
equivalent of an ‘additional random disturbance’. While Friedman argued
that monetary policy has powerful effects and could be implemented relatively
quickly, its effects were subject to a long outside lag. Discretionary
fiscal adjustments, particularly in a political system like that of the USA,
could not realistically be implemented quickly. In principle, accurate forecasts
could help to overcome this problem by enabling the authorities to
adjust monetary and fiscal policy in anticipation of business cycle trends.
However, poor forecasts would in all probability increase the destabilizing
impact of aggregate demand management. As Mankiw (2003) emphasizes,
‘the Great Depression and the (US) recession of 1982 show that many of the
most dramatic economic events are unpredictable. Although private and public
decision-makers have little choice but to rely on economic forecasts, they
must always keep in mind that these forecasts come with a large margin of
error’. These considerations led Friedman to conclude that activist demand
management policies are more likely to destabilize than stabilize a decentralized
market economy.
Another important contribution made by Friedman, not directly related to
his theoretical and empirical work on monetary economics, but with important
implications for stabilization policy, is his book A Theory of the
Consumption Function, published in 1957. An important assumption in the
orthodox Keynesian theory of fiscal policy is that the fiscal authorities can
stimulate aggregate demand by boosting consumption expenditure via tax
cuts that raise disposable income (or vice versa). This presumes that current
consumption is largely a function of current disposable income. Friedman
argued that current income (Y) has two components, a temporary component
(YT) and a permanent component (YP). Since people regard YP as their average
income and YT as a deviation from average income, they base their consumption
decisions on the permanent component. Changes in Y brought about by
tax-induced changes in YT will be seen as transitory and have little effect on
current consumption (C) plans. So in Friedman’s model we have:
Y = YT + YP (4.14)
C = αYP (4.15)
If consumption is proportional to permanent income, this obviously reduces
the power of tax-induced changes in aggregate demand. This further weakens
the Keynesian case for activist fiscal policy.
Friedman has also always been very sympathetic to the public choice
literature that suggested that structural deficits, with damaging effects on
national saving and hence long-run growth, would be the likely result of
discretionary fiscal policy operating within a democracy (see Buchanan and
Wagner, 1978). Politicians may also deliberately create instability when they
have discretion since within a democracy they may be tempted to manipulate
the economy for political profit as suggested in the political business cycle
literature (Alesina and Roubini with Cohen, 1997; see Chapter 10).
Although theoretical and empirical developments in economics facilitated
the development, by Klein, Goldberger, Modigliani and others, of the highly
aggregative simultaneous-equation macroeconometric models used for forecasting
purposes, many economists remained unconvinced that such forecasts
could overcome the problems imposed by the problem of time lags and the
wider political constraints. Friedman concluded that governments had neither
the knowledge nor the information required to conduct fine-tuning forms of
discretionary policy in an uncertain world and advocated instead that the
monetary authorities adopt a passive form of monetary rule whereby the
growth in a specified monetary aggregate be predetermined at some stated
known (k per cent) rate (Friedman, 1968a, 1972). While Friedman (1960)
argued that such a rule would promote greater stability, ‘some uncertainty
and instability would remain’, because ‘uncertainty and instability are unavoidable
concomitants of progress and change. They are one face of a coin of
which the other is freedom.’ DeLong (1997) also concludes that it is ‘difficult
to argue that “discretionary” fiscal policy has played any stabilising role at all
in the post-World war II period’ in the US economy. However, it is generally
accepted that automatic stabilizers have an important role to play in mitigat
ing the impact of economic shocks. The debate over the role and conduct of
stabilization policy as it stood in the 1970s is neatly summarized in the
following passage, taken from Modigliani’s (1977) Presidential Address to
the American Economic Association:
Nonmonetarists accept what I regard to be the fundamental practical message of
The General Theory: that a private enterprise economy using an intangible money
needs to be stabilized, can be stabilized, and therefore should be stabilized by
appropriate monetary and fiscal policies. Monetarists by contrast take the view
that there is no serious need to stabilize the economy; that even if there were a
need, it could not be done, for stabilization policies would be more likely to
increase than decrease instability.
Despite its considerable achievements, by the late 1970s/early 1980s, monetarism
was no longer regarded as the main rival to Keynesianism within
academia. This role was now taken up at the theoretical level during the
1970s by developments in macroeconomics associated with the new classical
school. These developments cast further doubt on whether traditional
stabilization policies can be used to improve the overall performance of the
economy. However, monetarism was exercising a significant influence on the
policies of the Thatcher government in the UK (in the period 1979–85) and
the Fed in the USA (in the period 1979–81). Of particular significance to the
demise of monetarist influence was the sharp decline in trend velocity in the
1980s in the USA and elsewhere. The deep recession experienced in the USA
in 1982 has been attributed partly to the large and unexpected decline in
velocity (B.M. Friedman, 1988; Modigliani, 1988a; Poole 1988). If velocity
is highly volatile, the case for a constant growth rate monetary rule as advocated
by Friedman is completely discredited. Therefore, there is no question
that the collapse of the stable demand for money function in the early 1980s
proved to be very damaging to monetarism. As a result monetarism was
‘badly wounded’ both within academia and among policy makers (Blinder,
1987) and subsequently ‘hard core monetarism has largely disappeared’ (Pierce,
1995). One important result of the unpredictability of the velocity of circulation
of monetary aggregates has been the widespread use of the short-term
nominal interest rate as the primary instrument of monetary policy (see Bain
and Howells, 2003). In recent years activist Taylor-type monetary-feedback
rules have been ‘the only game in town’ with respect to the conduct of
monetary policy. As Buiter notes, ‘Friedman’s prescription of a constant
growth rate for some monetary aggregate is completely out of favour today
with both economic theorists and monetary policy makers, and has been for
at least a couple of decades’ (see Buiter, 2003a and Chapter 7).
Finally, it is worth reflecting on what remains today of the monetarist
counter-revolution. As a result of the ‘Great Peacetime Inflation’ in the 1970s
many key monetarist insights were absorbed within mainstream models (see,
for example, Blinder, 1988b; Romer and Romer, 1989; Mayer, 1997; DeLong,
2000). According to DeLong, the key aspects of monetarist thinking that now
form a crucial part of mainstream thinking in macroeconomics are the natural
rate of unemployment hypothesis, the analysis of fluctuations as movements
about trend rather than deviations below potential, the acceptance that under
normal circumstances monetary policy is ‘a more potent and useful tool’ for
stabilization than fiscal policy, the consideration of macroeconomic policy
within a rules-based framework, and the recognition of the limited possibilities
for success of stabilization policies. Therefore, although within academia
monetarism is no longer the influential force it was in the late 1960s and early
1970s (as evidenced by, for example, the increasing scarcity of journal articles
and conference papers on monetarism), its apparent demise can, in large
part, be attributed to the fact that a significant number of the insights of
‘moderate’ monetarism have been absorbed into mainstream macroeconomics.
Indeed, two leading contributors to the new Keynesian literature, Greg
Mankiw and David Romer (1991), have suggested that new Keynesian economics
could just as easily be labelled ‘new monetarist economics’.
Monetarism has therefore made several important and lasting contributions
to modern macroeconomics. First, the expectations-augmented Phillips curve
analysis, the view that the long-run Phillips curve is vertical and that money
is neutral in the long run are all now widely accepted and form an integral
part of mainstream macroeconomics. Second, a majority of economists and
central banks emphasize the rate of growth of the money supply when it
comes to explaining and combating inflation over the long run. Third, it is
now widely accepted by economists that central banks should focus on controlling
inflation as their primary goal of monetary policy. Interestingly, since
the 1990s inflation targeting has been adopted in a number of countries (see
Mishkin, 2002a and Chapter 7). What has not survived the monetarist counter-
revolution is the ‘hard core’ belief once put forward by a number of
leading monetarists that the authorities should pursue a non-contingent ‘fixed’
rate of monetary growth in their conduct of monetary policy. Evidence of
money demand instability (and a break in the trend of velocity, with velocity
becoming more erratic), especially since the early 1980s in the USA and
elsewhere, has undermined the case for a fixed monetary growth rate rule.
Finally, perhaps the most important and lasting contribution of monetarism
has been to persuade many economists to accept the idea that the potential of
activist discretionary fiscal and monetary policy is much more limited than
conceived prior to the monetarist counter-revolution.
In conclusion it would be useful to assess the development of orthodox
monetarism and how this school influenced the ongoing debate on the role
and conduct of stabilization policy. The development of orthodox monetarism
can be appraised in a positive light, given that it displayed both theoretical
and empirical progress over the period of the mid-1950s to the early 1970s
(see, for example, Cross, 1982a, 1982b). The reformulation of the quantity
theory of money approach (QTM), the addition of the expectations-augThe
mented Phillips curve analysis (EAPC), using the adaptive expectations hypothesis
(AEH), and the incorporation of the monetary approach to the balance
of payments theory and exchange rate determination (MTBE), generated a
large amount of real-world correspondence and empirical support (see Laidler,
1976). We can therefore summarize the main characteristics of orthodox
monetarism (OM) as:
OM = QTM + EAPC + AEH + MTBE
In contrast to orthodox monetarism, towards the close of this period, in the
early 1970s, the orthodox Keynesian position was looking increasingly degenerative
given (i) its failure to explain theoretically the breakdown of the
Phillips curve relationship and (ii) its willingness to retreat increasingly into
non-economic explanations of accelerating inflation and rising unemployment
(see for example, Jackson et al., 1972).
We can draw together the discussion contained in sections 4.2–4.4 and
seek to summarize the central distinguishing beliefs within the orthodox
monetarist school of thought (see also Brunner, 1970; Friedman, 1970c;
Mayer, 1978; Vane and Thompson, 1979; Purvis, 1980; Laidler, 1981, 1982;
Chrystal, 1990). These beliefs can be listed as follows:
1. Changes in the money stock are the predominant, though not the only,
factor explaining changes in money income.
2. The economy is inherently stable, unless disturbed by erratic monetary
growth, and when subjected to some disturbance, will return fairly rapidly
to the neighbourhood of long-run equilibrium at the natural rate of
unemployment.
3. There is no trade-off between unemployment and inflation in the long
run; that is, the long-run Phillips curve is vertical at the natural rate of
unemployment.
4. Inflation and the balance of payments are essentially monetary phenomena.
5. In the conduct of economic policy the authorities should follow some
rule for monetary aggregates to ensure long-run price stability, with
fiscal policy assigned to its traditional roles of influencing the distribution
of income and wealth, and the allocation of resources. In the former
case, Laidler (1993, p. 187) has argued that the authorities must be
prepared to adapt the behaviour of the supply of whatever monetary
aggregate they chose to control (that is, in response to shifts in the
demand for money resulting from, for example, institutional change)
rather than pursue a rigid (legislated) growth rule for a chosen monetary
aggregate as suggested by Friedman.
The monetarist aversion to activist stabilization policy, both monetary and
fiscal policy (and prices and incomes policy), which derives both from the
interrelated theoretical propositions and from empirical evidence discussed in
sections 4.2–4.4, is the central issue which distinguishes orthodox monetarists
from Keynesians.
Throughout the period 1950–80, a key feature of the Keynesian–monetarist
debate related to disagreement over the most effective way of managing
aggregate demand so as to limit the social and economic waste associated
with instability and also over the question of whether it was desirable for
governments to try to ‘fine-tune’ the economy using counter-cyclical policies.
In this debate Friedman was one of the earliest critics of activist discretionary
policies. Initially he focused on some of the practical aspects of implementing
such policies. As early as 1948 Friedman noted that ‘Proposals for the
control of the cycle thus tend to be developed almost as if there were no other
objectives and as if it made no difference within what framework cyclical
fluctuations take place’. He also drew attention to the problem of time lags
which in his view would in all likelihood ‘intensify rather than mitigate
cyclical fluctuations’. Friedman distinguished between three types of time
lag: the recognition lag, the action lag, and the effect lag. These inside and
outside lags, by delaying the impact of policy actions, would constitute the
equivalent of an ‘additional random disturbance’. While Friedman argued
that monetary policy has powerful effects and could be implemented relatively
quickly, its effects were subject to a long outside lag. Discretionary
fiscal adjustments, particularly in a political system like that of the USA,
could not realistically be implemented quickly. In principle, accurate forecasts
could help to overcome this problem by enabling the authorities to
adjust monetary and fiscal policy in anticipation of business cycle trends.
However, poor forecasts would in all probability increase the destabilizing
impact of aggregate demand management. As Mankiw (2003) emphasizes,
‘the Great Depression and the (US) recession of 1982 show that many of the
most dramatic economic events are unpredictable. Although private and public
decision-makers have little choice but to rely on economic forecasts, they
must always keep in mind that these forecasts come with a large margin of
error’. These considerations led Friedman to conclude that activist demand
management policies are more likely to destabilize than stabilize a decentralized
market economy.
Another important contribution made by Friedman, not directly related to
his theoretical and empirical work on monetary economics, but with important
implications for stabilization policy, is his book A Theory of the
Consumption Function, published in 1957. An important assumption in the
orthodox Keynesian theory of fiscal policy is that the fiscal authorities can
stimulate aggregate demand by boosting consumption expenditure via tax
cuts that raise disposable income (or vice versa). This presumes that current
consumption is largely a function of current disposable income. Friedman
argued that current income (Y) has two components, a temporary component
(YT) and a permanent component (YP). Since people regard YP as their average
income and YT as a deviation from average income, they base their consumption
decisions on the permanent component. Changes in Y brought about by
tax-induced changes in YT will be seen as transitory and have little effect on
current consumption (C) plans. So in Friedman’s model we have:
Y = YT + YP (4.14)
C = αYP (4.15)
If consumption is proportional to permanent income, this obviously reduces
the power of tax-induced changes in aggregate demand. This further weakens
the Keynesian case for activist fiscal policy.
Friedman has also always been very sympathetic to the public choice
literature that suggested that structural deficits, with damaging effects on
national saving and hence long-run growth, would be the likely result of
discretionary fiscal policy operating within a democracy (see Buchanan and
Wagner, 1978). Politicians may also deliberately create instability when they
have discretion since within a democracy they may be tempted to manipulate
the economy for political profit as suggested in the political business cycle
literature (Alesina and Roubini with Cohen, 1997; see Chapter 10).
Although theoretical and empirical developments in economics facilitated
the development, by Klein, Goldberger, Modigliani and others, of the highly
aggregative simultaneous-equation macroeconometric models used for forecasting
purposes, many economists remained unconvinced that such forecasts
could overcome the problems imposed by the problem of time lags and the
wider political constraints. Friedman concluded that governments had neither
the knowledge nor the information required to conduct fine-tuning forms of
discretionary policy in an uncertain world and advocated instead that the
monetary authorities adopt a passive form of monetary rule whereby the
growth in a specified monetary aggregate be predetermined at some stated
known (k per cent) rate (Friedman, 1968a, 1972). While Friedman (1960)
argued that such a rule would promote greater stability, ‘some uncertainty
and instability would remain’, because ‘uncertainty and instability are unavoidable
concomitants of progress and change. They are one face of a coin of
which the other is freedom.’ DeLong (1997) also concludes that it is ‘difficult
to argue that “discretionary” fiscal policy has played any stabilising role at all
in the post-World war II period’ in the US economy. However, it is generally
accepted that automatic stabilizers have an important role to play in mitigat
ing the impact of economic shocks. The debate over the role and conduct of
stabilization policy as it stood in the 1970s is neatly summarized in the
following passage, taken from Modigliani’s (1977) Presidential Address to
the American Economic Association:
Nonmonetarists accept what I regard to be the fundamental practical message of
The General Theory: that a private enterprise economy using an intangible money
needs to be stabilized, can be stabilized, and therefore should be stabilized by
appropriate monetary and fiscal policies. Monetarists by contrast take the view
that there is no serious need to stabilize the economy; that even if there were a
need, it could not be done, for stabilization policies would be more likely to
increase than decrease instability.
Despite its considerable achievements, by the late 1970s/early 1980s, monetarism
was no longer regarded as the main rival to Keynesianism within
academia. This role was now taken up at the theoretical level during the
1970s by developments in macroeconomics associated with the new classical
school. These developments cast further doubt on whether traditional
stabilization policies can be used to improve the overall performance of the
economy. However, monetarism was exercising a significant influence on the
policies of the Thatcher government in the UK (in the period 1979–85) and
the Fed in the USA (in the period 1979–81). Of particular significance to the
demise of monetarist influence was the sharp decline in trend velocity in the
1980s in the USA and elsewhere. The deep recession experienced in the USA
in 1982 has been attributed partly to the large and unexpected decline in
velocity (B.M. Friedman, 1988; Modigliani, 1988a; Poole 1988). If velocity
is highly volatile, the case for a constant growth rate monetary rule as advocated
by Friedman is completely discredited. Therefore, there is no question
that the collapse of the stable demand for money function in the early 1980s
proved to be very damaging to monetarism. As a result monetarism was
‘badly wounded’ both within academia and among policy makers (Blinder,
1987) and subsequently ‘hard core monetarism has largely disappeared’ (Pierce,
1995). One important result of the unpredictability of the velocity of circulation
of monetary aggregates has been the widespread use of the short-term
nominal interest rate as the primary instrument of monetary policy (see Bain
and Howells, 2003). In recent years activist Taylor-type monetary-feedback
rules have been ‘the only game in town’ with respect to the conduct of
monetary policy. As Buiter notes, ‘Friedman’s prescription of a constant
growth rate for some monetary aggregate is completely out of favour today
with both economic theorists and monetary policy makers, and has been for
at least a couple of decades’ (see Buiter, 2003a and Chapter 7).
Finally, it is worth reflecting on what remains today of the monetarist
counter-revolution. As a result of the ‘Great Peacetime Inflation’ in the 1970s
many key monetarist insights were absorbed within mainstream models (see,
for example, Blinder, 1988b; Romer and Romer, 1989; Mayer, 1997; DeLong,
2000). According to DeLong, the key aspects of monetarist thinking that now
form a crucial part of mainstream thinking in macroeconomics are the natural
rate of unemployment hypothesis, the analysis of fluctuations as movements
about trend rather than deviations below potential, the acceptance that under
normal circumstances monetary policy is ‘a more potent and useful tool’ for
stabilization than fiscal policy, the consideration of macroeconomic policy
within a rules-based framework, and the recognition of the limited possibilities
for success of stabilization policies. Therefore, although within academia
monetarism is no longer the influential force it was in the late 1960s and early
1970s (as evidenced by, for example, the increasing scarcity of journal articles
and conference papers on monetarism), its apparent demise can, in large
part, be attributed to the fact that a significant number of the insights of
‘moderate’ monetarism have been absorbed into mainstream macroeconomics.
Indeed, two leading contributors to the new Keynesian literature, Greg
Mankiw and David Romer (1991), have suggested that new Keynesian economics
could just as easily be labelled ‘new monetarist economics’.
Monetarism has therefore made several important and lasting contributions
to modern macroeconomics. First, the expectations-augmented Phillips curve
analysis, the view that the long-run Phillips curve is vertical and that money
is neutral in the long run are all now widely accepted and form an integral
part of mainstream macroeconomics. Second, a majority of economists and
central banks emphasize the rate of growth of the money supply when it
comes to explaining and combating inflation over the long run. Third, it is
now widely accepted by economists that central banks should focus on controlling
inflation as their primary goal of monetary policy. Interestingly, since
the 1990s inflation targeting has been adopted in a number of countries (see
Mishkin, 2002a and Chapter 7). What has not survived the monetarist counter-
revolution is the ‘hard core’ belief once put forward by a number of
leading monetarists that the authorities should pursue a non-contingent ‘fixed’
rate of monetary growth in their conduct of monetary policy. Evidence of
money demand instability (and a break in the trend of velocity, with velocity
becoming more erratic), especially since the early 1980s in the USA and
elsewhere, has undermined the case for a fixed monetary growth rate rule.
Finally, perhaps the most important and lasting contribution of monetarism
has been to persuade many economists to accept the idea that the potential of
activist discretionary fiscal and monetary policy is much more limited than
conceived prior to the monetarist counter-revolution.
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