The dispute between Monetarism and Keynesianism

A large part of modern monetary economics is characterized as having two views, the monetarist and the Keynesian or fiscalist. The conflicting views on the mechanism as to how money supply affects the general economic activities or income level. Some theorists put the emphasis on a direct relation between the money supply and expenditure. Some economists argue that it is by changing financial conditions particularly the rates of interest, volumes of lending and borrowing that influence of money supply on economic activities can be judged. According to the former school, an increase in the money supply means that some money holders will have excess money balance in their asset portfolios. In the process of restoring equilibrium these balances will be converted into the real goods and services either directly or through the inter mediation of financial institutions. The pressure of demand for
more goods and services will stimulate output and encourage price rises until the value of the output has risen in proportion to the increase in the money supply. Monetary school gives no special emphasis on the rates of interest on the financial assets.

The other school points out that the increase in the money supply will affect cost and the availability of the credit. The superiority of monetary over Keynesian models has not been demonstrated. However, monetary factors are not unimportant; there is no reason to reject the view that changes in the interest rate or the availability of credit. Advocates to monetary approach have not yet shown that the changes in money supply have a reliable and predictable effect on expenditure, even the directions of causation between the money supply and income is at issue.

The most interesting event or a very long time in the real economics has been challenged by a new school of thought called ‘Monetarists’ led by its leader Milton Friedman of Chicago University. A debate continues to exist between one group, which places major stress on fiscal policy as the primary engine of growth and economic stabilizer, and a second group, which feels that money, and therefore monetary policy is the most important primary factor in growth and economic stability.

Monetarism refers to the followers of Milton Friedman who hold that ‘Only money matters’ and as such monetary policy is a more potent instrument than fiscal policy in economic stabilization. Keynesianism refers to the followers of Keynes who believe that ‘Money does not matter’, for economic stabilization, fiscal policy is a more powerful instrument than monetary policy. The difference between Monetarism and Keynesianism can be analyzed as follows:

Theoretical Differences

The monetarists emphasize the role of money in explaining short changes in national income. Friedman and Schwartz have shown that changes in the money supply cause changes in national income. The monetarists believe that all recessions and depressions are caused by severe contraction of money and credit, and booms and inflation by excessive increases in the money supply.

The Keynesians reject the monetarist view that changes in national income are caused solely by changes in money supply. They hold that changes in national income cause changes in the supply of money. The moderate Keynesians still believe such as monetarists that hyperinflation is caused by excessive money supply. On the other hand, the extreme Keynesians hold that non-monetary factors such as investment cause depressions and booms.

Monetarist View

As pointed by the monetarists, the money supply is the ‘dominant though not exclusive’ determinant of both the level of output and prices in the short-run, and of the level of prices in the long run. The long run level of output is not influenced by the money supply. It is dependent on such real factors as technology and the quantity and quality of productive resources. Although factors other than the money supply affect the level of output, employment and prices in the short-run, yet their effects are subordinate to that of the money supply.

A change in the money supply will inevitably affect the price level and output in the short run. But, in the long run, the effect of change in the money supply will be entirely on the price level because the economy is near full employment in that time period and the increase in national income will consist mainly of higher prices. Hence changes in the money supply affect national income directly. This is due to the assumption that the velocity of circulation of money is stable.

The monetarists hold that he rate of interest plays no part in determining the demand for money. The demand for money is the transactions demand for money, which is determined by the level of income. The monetarists believed that the money supply is also not influenced by interest rates. This insensitiveness of both demands for and supply of money is based on the quantity of money. The simplest quantity equation is MV = PQ, where M is the quantity of money, V is its velocity, Q is the number of physical transactions, and P is the price level. Taking PQ = Y, where Y is the national income, the quantity equation becomes MV = Y. As V remains constant, changes in M cause changes in Y.

The monetarist is based on the belief that money is a god substitute for all types of assets such as securities, houses, durable consumer goods etc. Prof. Friedman findings show a ‘stable money demand function’, which implies the demand for money is a stable function of peoples’ income. In other words, the amount of money that the people want to hold is related in a fixed way to their income. If the central bank increases the money supply, it affects interest rates on these different ways:

i) There is the liquidity effect, which causes a very short run reduction in the interest rates. As a result, people will sell securities and their holdings of money will increase. Therefore, there will spend their excess money balances on financial assets on durable consumer goods. This increase in aggregate expenditure on assets and goods will tend to raise output, employment and income. It is called output effect, which will tend to a rise in interest rates because of the rise in output and demand for money resulting from the liquidity effect.

ii) There is the price expectations effect, which occurs due to the expectations of lenders that inflation will continue. They will demand higher interest rates in order to cover the expected inflation rate.

Thus, with the short run liquidity effect bringing a downward pressure on interest rates and both the output and price expectations effects bringing an upward pressure on them, the combined effect will be an increase in interest rates. It will, in turn, discourage investment, and reduce output and employment.

Keynesian View

The Keynesian hold just the opposite views to monetarists about the demand for and supply of money and the aggregate expenditure. Both the demand for and supply of money are highly interest elastic while the aggregate expenditure is not.

They consider the supply of money to be fixed in the short run by monetary authorities. The demand for money also called the liquidity preference is the desire to hold cash. There are three motives on the part of the people to hold cash: transactions, precautionary and speculative demand for money. Money held for transactions and precautionary motives is a function of the level of income, and for the speculative motive, it is a function of the interest rate.

To the Keynesians, it is expected about changes in both prices or in the market rate of interest that determine the speculative demand for money. The speculative demand for money is a decreasing function of the rate of interest. The higher the rate of interest, the lower the speculative demand for money, and vice-versa. But at a very low interest rate, the speculative demand for money becomes perfectly elastic.

On the whole, given the level of nation income, the demand for money is a decreasing function of the interest rate. The Keynesians believe that money and financial assets to be goods substitutes for each other. They are highly liquid and yield interest. So, even small changes in interest rates lead to substitution between money and financial assets. A small fall in the interest rate will mean a rise in the price of securities, which will induce people to sell securities and hold more money. The reverse will be case in the event of a small rise in the rate of interest. Thus, the demand for money is highly interest-elastic under Keynesianism.

The Keynesians believe in the existence of unemployment equilibrium. This implies that an increase in money supply can bring about permanent increases in the level of output. The ultimate influence of money supply on the price level depends upon its influence on aggregate demand and the elasticity of the aggregate output.

The Keynesian chain of causation between changes in the quantity of money and in prices is an indirect one through the rate of interest. So when the quantity of money is increased, its first impact is on the rate of interest which tends to fall. Given the marginal efficiency of capital, a fall in the rate of interest will increase the volume of investment. The increased investment will raise effective demand through the multiplier effect thereby increasing income, output and employment. Since the supply of factors of production is perfectly elastic in a situation of unemployment, wage and non-wage factors are available at constant rate of remuneration. There being constant returns to scale, prices do not rise with the increase in output so long as there is any unemployment. Under the circumstances, output and employment will increase in the same proportion as the quantity of money.

But ‘once full employment is reached, output ceases to respond at all to changes in the supply of money and so in effective demand. The elasticity of supply of output in response to change in the supply, which is infinite as long as there was unemployment, falls to zero. The entire effect of changes in the supply of money is exerted on prices, which rise in exact proportion with the increase in effective demand’. Thus, so long as there is unemployment, output will be no change in prices; and when there is full employment, prices will change in the same proportion as the quantity of money.

In the Keynesian transmission mechanism, changes in the money supply affect aggregate expenditure and national income indirectly by changes in interest rate. Suppose the money is increased, it lowers the interest rate which, in turn, increases investment and expenditure thereby supply are transmitted into the level of income: for example, an increase in the money supply causes people to spend their excess holdings of money on financial assets. This means, an increase in the demand for such assets and a rise in their prices. Rise in the prices of assets (securities), brings down the interest rates which, in turn, increase aggregate expenditure, investment and hence income. Thus, according to the Keynesian view, a change in the money supply can only affect aggregate spending and national income first through changes in interest rates, and then only if the aggregate spending is sensitive to interest rate changes.

Policy Differences

Another point of differences between the monetarists and the Keynesians is over the policy prescriptions. According to the monetarists, monetary policy has a greater influence on economic activity than fiscal policy, and fiscal policy is important only making changes in the money supply. On the other hand, the Keynesians emphasize the importance of both fiscal and monetary policy in influencing the economy but they attach more importance to the former than to the later. First, we study the monetarist view on monetary and fiscal policy and then the Keynesian view.

Monetarist View

The monetarists hold that changes in the money supply have a direct influence on aggregate expenditure and thus on income. It can be analyzed an expansionary monetary policy followed by monetarists. To begin, suppose the central bank purchased securities in the open market. It raises the price of securities and lowers the rate of interest. People will, therefore, start selling securities and hold more money. People spend their excess money balances on financial assets and durable consumer goods. Other attracted by low interest rates borrow from banks for expenditure on houses, durable consumer goods, plants and equipment, etc. The forces tend to increase aggregate expenditure and income.

Keynesian View

In contrast to the monetarists, the Keynesians regard monetary policy relatively less effective because of the relative interest inelasticity of aggregate expenditure. In the expansionary monetary policy, the central bank purchases securities in the open market. As a result, the price of securities rises and the interest rate falls. People will therefore, start selling securities in order to hold more money. As the demand for money is highly interest elastic in the Keynesian system, even a small fall in the rate of interest will induce people to sell securities and hold more money.

The controversy between Keynesianism and monetarism can be list out as follows:
(i) Role of MoneyOnly money matters. In other words, only changes in money supply influence the level of nominal income.Money does not matter. In other words, a change in money supply will not change nominal income; it will simply increase the idle cash balance for speculative motive.
(ii) Rate of InterestMoney supply alone should be watched closely because a change in money supply changes aggregates demand directly and not through interest rates.Interest rates are important but the money supply is not. Interest rates affect planned investment and thus national output.
(iii) Monetary PolicyUse monetary policy rule for stabilization.Monetary policy is seldom appropriate.
(iv) Fiscal PolicyFiscal policy is absolutely ineffective because it has no effect on nominal aggregate demand.Fiscal policy is powerful tool, as compared to monetary policy.
(v) Relationship between Money Supply and Price LevelThere is direct and proportional relation between money supply and price level. So, MV = PQThere will be some relationship between price level and money supply through investment and return but not directly proportional relation.
(vi) Economic GrowthMoney supply, demand of money and interest rate can play major role for sustainable economic growth.Government intervention promotes the economic activities because at that condition private sectors are not invested. So, government should promote economic activities.
Similarly, the monetarists advocated that the role of central bank is important whereas Keynesians believed that demand for resources, factor employment, and increase in income then effective demand which increase investment.

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