The orthodox monetarist school

Introduction
During the 1950s and up to at least the mid- to late 1960s Keynesian economics,
which came to be epitomized by the Hicks–Hansen IS–LM model, was
the dominant force in the development of macroeconomics in terms of both
theorizing and policy prescriptions. As one leading critic of Keynesian economics
has admitted, in the late 1960s the Keynesian model ‘seemed to be
the only game in town in terms of macroeconomics’ (see Barro, 1984). A
central theme of Keynes’s General Theory is the contention that capitalist
market economies are inherently unstable and can come to rest at less than
full employment equilibrium for prolonged periods of time. This instability
was, in Keynes’s view, predominantly the result of fluctuations in aggregate
demand. In the mid- to late 1940s and the 1950s the then-prevailing Keynesian
orthodoxy emphasized real disturbances (notably fluctuations in investment
and autonomous consumption) as the main cause of fluctuations in money or
nominal income, predominantly in the form of changes in real income. To the
early Keynesians, the Great Depression had resulted from a sharp fall in the
level of investment with the associated severe unemployment reflecting a
state of deficient aggregate demand. This contrasted with the earlier quantity
theory of money (QTM) tradition that viewed changes in the money stock as
the predominant, though not the only, factor explaining changes in money
income.
During the 1950s and 1960s, Milton Friedman, more than any other economist,
was responsible for reviving the fortunes of the quantity theory of money.
In 1968 Karl Brunner famously gave the label of ‘monetarism’ to the ideas of
those economists, particularly Friedman, who adhered to the quantity theory of
money. The quantity theory of money is the central plank to monetarism and
this idea is, according to Mark Blaug, ‘the oldest surviving theory in economics’
Blaug et al. (1995). In a reasonably coherent form, the quantity theory of
money stretches back over at least 300 years to John Locke’s Some Considerations
of the Consequences of the Lowering of Interest and Raising the Value of
Money published in 1692 (see Eltis, 1995). However, David Hume’s classic
essay, Of Money, published in 1752, is widely recognized as perhaps the most
sophisticated early statement of the quantity theory of money. According to
Mayer (1980), most of the fundamental propositions of monetarism date back
to this essay. Thereafter, the quantity theory of money was accepted and developed
throughout the nineteenth and early twentieth centuries by many notable
economists, including David Ricardo, Alfred Marshall, Irving Fisher and, at
least up until 1930, Keynes himself. As Blaug notes, ‘Keynes began by loving
it but ended up by hating it’ (see Blaug et al., 1995).
The main purpose of this chapter is twofold. First, to trace the historical
development of orthodox monetarism (see Figure 4.1) beginning with the
quantity theory of money approach (section 4.2) as it evolved from the mid-
1950s to the mid-1960s; through to the expectations-augmented Phillips curve
analysis (section 4.3) which was absorbed into monetarist analysis after the
mid- to late 1960s; finally to the monetary approach to balance of payments
theory and exchange rate determination (section 4.4) which was incorporated
into monetarist analysis in the early 1970s. Second, in the light of this
discussion, to summarize the central distinguishing beliefs commonly held
within the orthodox monetarist school, especially with respect to the role and
conduct of stabilization policy (section 4.5) and to reflect on what remains
today of the monetarist counter-revolution.
Before examining the QTM approach to macroeconomic analysis we should
note the key role played by Friedman in what came to be known as the
‘monetarist counter-revolution’ (see Johnson, 1971; Snowdon and Vane, 1996,
1997b). Unlike the majority of economists, Friedman is well known outside
academic circles, a characteristic he shares with Keynes. Together with Keynes,
Friedman has probably influenced macroeconomic theory and policy making
more than any other economist in the twentieth century. This can be attributed
not only to the quality and quantity of his research output, but also to his
artistry and rhetoric in promoting a cause. In recognition of his academic
work, Friedman was awarded the Nobel Memorial Prize in Economics in
1976 for ‘his achievements in the fields of consumption analysis, monetary
history and theory, and for his demonstration of the complexity of stabilisation
policy’. There is no doubt that Friedman’s monetary analysis and his demonstration
of the limitations and dangers of discretionary stabilization policies
in a dynamic and uncertain world have influenced a whole generation of
eminent macroeconomists, most notably Robert Lucas Jr, who freely admits
his intellectual debt to his former teacher whom he describes as a ‘superb
economist’ (Klamer, 1984). Particularly influential to the generation of economists
educated in the USA since the early 1960s was the publication of the
Friedman and Schwartz (1963) volume A Monetary History of the United
States which for Lucas (1994b) played an important, ‘perhaps decisive’, role
in the 1960s debate over stabilization policy. In reflecting on the longevity of
this ‘classic’ text Lucas has commented that it would be the first book in his
suitcase if he is ever invited to Washington ‘for some reason other than
viewing cherry blossoms’. According to Lucas, Friedman was also ‘by far’
his ‘most important teacher’, suggesting that he is sure that he has read
everything that Friedman has ever written (see Lucas, 1994a). In this chapter
we shall explore many of Friedman’s achievements.