Research Discussion Paper – RDP 8009 Monetarism: An Interpretation and Assessment

Introduction

Like beauty, ‘monetarism‘ tends to lie in the eye of the beholder, and before it can be assessed it must be defined. Though there have been a number of valuable attempts over the years to specify monetarism's key characteristics, I sha11 not re1y upon them in this essay. Each of them has been heavily conditioned by its time and place of writing, and monetarism has evolved over the years in response to changing circumstances, and in different ways in different places, as new hypotheses have either been developed or absorbed. Thus, I will begin this paper with my own, inevitably somewhat subjective, characterisation of monetarism. In my view, its key characteristics are as follows:

1. A ‘quantity theory’ approach to macroeconomic analysis in two distinct senses: (a) that used by Milton Friedman (1956) to describe a theory of the demand for money, and (b) the more traditional sense of a view that fluctuations in the quantity of money are the dominant cause of fluctuations in money income.
2. The analysis of the division of money income fluctuations between the price level and real income in terms of an expectations augmented Phillips curve whose structure rules out an economically significant long-run inverse trade off between the variables.
3. A monetary approach to balance of payments and exchange rate theory.
4. (a) Antipathy to activist stabilisation policy, either monetary or fiscal, and to wage and price controls, and (b) support for long-run monetary policy ‘rules’ or at least prestated ‘targets’, cast in terms of the behaviour of some monetary aggregate rather than of the level of interest rates.

I. categorises the theoretical core of monetarism as it developed in the 1950s and 60s, II. and III. represent theory developed or absorbed by monetarists since the mid 1960s, while IV. summarises a view of macroeconomic policy issues which, even though it is neither logically implicit in their positive analysis, nor their exclusive property, has remained rather constant among monetarists for the last quarter century.

Before discussing these characteristics of monetarism in detail, let me deal briefly with two propositions that some might feel should be included in the above list. First, on the one hand monetarists have frequently been accused of failing to give any account of the transmission mechanism of monetary policy, and have had attributed to them a belief in some mysterious ‘direct’ influence of money on expenditure; on the other hand they have themselves sometimes referred to a characteristically ‘monetarist model’ of that same transmission mechanism cast in terms of portfolio substitution among a wide variety of assets including reproducible capital, and even perhaps non-durable consumption goods. I believe that this is and always has been a non-issue. The claim that monetarists have failed to specify their transmission mechanism has never been true from the very outset (see e.g., Brunner (1961), Friedman and David Meiselman (1963), Friedman and Anna Schwartz (1963)), and although the mechanism propounded in those papers is a good deal more sophisticated and better grounded in relative price theory than that embodied in the textbook macro models of the 1950s, or in the econometric models of that vintage, there is no essential differences between it and that analysed for example by James Tobin and his associates.

Second, monetarists are often said to prefer ‘small’ to ‘big’ econometric models, and their views about the importance of the quantity of money for the determination of the general price level have undoubtedly led them to take highly aggregated systems seriously. Moreover, early large scale econometric models were not constructed so as to highlight any strong effects of money on economic activity. Monetarists criticised them, as much for being Keynesian, as for being ‘big‘, however. Even so, subsequent developments have clearly shown that ‘big’ models can take on some very monetarist characteristics, while the Albert Ando-Franco Modigliani (1965) and Michael De Prano-Mayer (1965) papers demonstrate that single equation reduced form techniques can as well produce ‘Keynesian’ as ‘monetarist’ results. Empirical analysis of all sorts has been used by both sides in the monetarist controversy, and if there is a method of empirical research more frequently associated with monetarist work than Keynesian, it is not small model or single equation econometrics, but National Bureau techniques of business cycle analysis. Thus though empirical techniques have, in specific instances, provided something to argue about, there seems to me to be no clear dividing line between the statistical methodology of monetarists and their opponents about which one can usefully generalise.