Monetary Economics: Classical, Keynesian, and Modern Theories

Introduction to Monetary Economics: Principles and Framework

• Context and Objectives:

  • Monetary policy is conducted to achieve specific macroeconomic objectives.
  • Successful conduct of monetary policy is predicated on a prerequisite knowledge of monetary theories.
  • Monetary theories establish the core relationship between Money ($M$), output or quantity ($q$), and prices ($p$).
  • A central postulate of these theories is that changes in the quantity of money influence $q$ and $p$, among other variables.

• The Monetary Policy Framework:

  • The conduct of policy involves selecting a framework requiring instruments, immediate (operating) targets, intermediate targets, and ultimate targets.
  • Monetary theories bridge "missing links" between these policy instruments and the ultimate goals.
  • The framework encompasses theoretical discussions on money supply processes, demand for money, transmission channels, and the role of monetary institutions like the degree of Central Bank Independence (CBI).

Evolutionary Debate on the Role of Money

• Theoretical Schools of Thought:

  • Classical School: Posits that money has no role in influencing real variables; it only influences the price level.
  • Keynesian School: Argues that money influences economic activities through interest rates and expectations.
  • Monetarists: Suggest money affects real variables like output and employment in the short run, but only affects nominal magnitudes in the long run.
  • Neo-Classical and New Classical: Introduce concepts like the Wealth Effect and Rational Expectations ($REH$).

• Conditional Factors:

  • The role of money varies based on whether an economy is large, small, open, or closed.
  • Key determinants include the exchange rate regime, the state of capital mobility, and the stage of economic development.

• Historical Context Shaping Theory:

  • Early 20th Century: Sustained price rises.
  • 1930s: The Great Depression/Recession.
  • 1950s–1960s: The emergence of inflation.
  • 1970s–Early 1980s: Stagflation (simultaneous inflation and stagnation).
  • 1980s–1990s: Financial sector reforms, crises, and innovations leading to CBI and inflation targeting.

Classical Theory: The Quantity Theory of Money (QTM)

• Fisher’s Equation of Exchange:

  • Irving Fisher formalized the theory in the early 20th century (though Jean Bodin linked money and price in the 16th century).
  • The Equation of Exchange: $MV = PT$
  • Variable definitions:
    • $M$: Money stock
    • $V$: Velocity of circulation
    • $P$: Price level
    • $T$: Total volume of transactions
  • Modern variant replacing transactions with real income ($y$): $MV = Py$

• Key Classical Postulates:

  • Direct Proportionality: A direct and proportional relationship exists between money supply and price level: $P = f(M)$.
  • Money as a Veil: Money acts solely as a medium of exchange and does not affect real output or employment.
  • Price Determination: $P = \frac{MV}{y}$. Assuming $V$ and $y$ are constant (or at full employment), as classicists believe full employment is the normal state, any change in $M$ is transmitted directly to $P$.
  • Causes of Inflation: Growth in money stock ($+$), velocity growth ($+$), inflationary expectations ($+$), and real GDP growth ($-$, as it dampens price rises for a fixed $M$).

Classical Dichotomy and the Neutrality of Money

• The Classical Dichotomy:

  • Coined by Don Patinkin (1965), it refers to the separation of the real sector (production and consumption) from the monetary sector.
  • Real variables (output, relative prices) are determined by real factors of supply and demand (labor market, technology).
  • Nominal variables (absolute price level) are determined by the quantity of money.

• Neutrality of Money:

  • Concept coined by Friedrich A. Hayek (1931), dating back to David Hume.
  • States that changes in the money supply affect only nominal variables (prices, nominal income) and not real variables ($y$, employment).
  • If money doubles, price levels and nominal incomes double, but resource allocation remains unchanged.
  • Visual Representation: The Aggregate Supply ($AS$) curve is vertical ($Q^*$ depends on employment $N^*$); $AS$ is invariant with respect to $P$.

• Modern Rejection/Modification:

  • Keynesians and Monetarists reject the dichotomy because prices are "sticky" and fail to adjust in the short run.
  • Most modern economists accept long-run neutrality when equilibrium is restored, but reject it during shock adjustments.

The Cambridge Cash Balance Approach

• Theoretical Shift:
  • Unlike Fisher's equation which focuses on total expenditure (velocity), the Cambridge equation focuses on the demand for money (money stock held relating to income).
  • Equation: $M = kPy$
  • Variable definitions:
    • $k$: The fraction of income held as cash balances.
  • Relationship to Velocity: $k$ and $V$ are reciprocals ($k = \frac{1}{V}$).

Velocity of Money ($V$)

• Definition: The ratio of nominal GDP ($P \times y$) to the money stock ($M$).

  • $V = \frac{Py}{M}$
  • It is a positive function of $P, y$ and a negative function of $M$.

• Factors Affecting Velocity:

  • Interest Rates ($+$): Higher rates reduce the demand to hold relative cash for transactions.
  • Consumer Behavior: Priorities for saving ($-$, reduces velocity) vs. spending ($+$, increases velocity).
  • Payment Technology: Fewer barriers to payment increase $V$.
  • Economic Cycles: Recession ($-$); Prosperity ($+$).
  • Government Policy: Increased spending ($G$) increases $V_m$ (velocity of money).
  • Demographics: A younger population correlates with higher $V$.

• Long-term Behavior (U-Shaped Pattern):

  • Low-income countries: Falling velocity due to monetization and spread of commercial banking.
  • Middle-income countries: Relatively constant velocity.
  • Advanced countries: Rising velocity due to financial innovations, sophistication, and money substitutes.
  • Historical Collapse: Velocity collapsed during the Great Depression (1930s) and Global Financial Crisis (2008).
  • Nepal Case (1975–2024): Velocity exhibited significant movement tracking nominal GDP vs. money stock over five decades.

Keynesian Theory and the Keynes Effect

• Core Departures from Classical Thought:

  • Keynes discarded the assumption of flexible wages/prices. He noted prices show downward rigidity and wages are resisted.
  • No automatic tendency for full employment.
  • Introduced the role of expectations and business confidence.

• The Keynes Effect (Transmission):

  • Establishes the link between money supply and output through interest rates ($r$ or $i$).
  • Sequence: $M \uparrow \rightarrow r/i \downarrow \rightarrow I \uparrow \rightarrow Y \uparrow$
  • Aggregate Demand ($AD$) is determined by money income; increasing it raises employment without necessarily affecting price level initially (Keynesian horizontal $AS$).

• The Two Limiting Cases (Ineffectiveness of MP):

  • Liquidity Trap: Interest rates are so low that the demand for money becomes perfectly elastic (horizontal $LM$ curve). Increasing money supply does not lower $r$ further.
  • Interest Inelastic Investment: The investment curve ($IS$) is vertical. Changes in $r$ do not stimulate investment ($I$).
  • Implication: In these cases, Fiscal Policy is superior to Monetary Policy.

Neo-Classical Synthesis and the Wealth Effect

• Counter-Keynesian Argument:
  • Neo-Classicals argued that the economy would return to full employment even in a liquidity trap through price flexibility.
  • Pigou Effect (Wealth Effect): A fall in prices ($P \downarrow$) increases the real value of wealth ($\frac{M}{P} \uparrow$), which boosts consumption expenditure (part of $AD$).
  • Real Balance Effect (Patinkin): Introduced real balances into the consumption function.
  • Result: This shifts the $IS$ curve to the right, restoring output toward $Y^*$ even if money demand is highly elastic.

Monetarist Theory (Milton Friedman)

• Core Maxim: "Inflation is always and everywhere a monetary phenomenon."

• The Role of Money:

  • Rejects that money only affects prices; money demand is stable and predictable.
  • Monetary policy can augment output in the short run ($SR$) due to "Money Illusion" (coined by Irving Fisher, popularized by Keynes) where agents respond to nominal changes.
  • In the long run ($LR$), money is neutral and generates only inflation.

• Crowding Out Effect:

  • Argues that fiscal policy is less effective. In a vertical $LM$ curve scenario (where $M_d$ is unaffected by $i$), expansionary fiscal policy shifts $IS$ only to raise interest rates, crowding out private investment without increasing output. Hence, "Money Matters, Fiscal Policy does not."

• The Phillips Curve (Monetarist View):

  • Assuming Adaptive Expectations, there is a trade-off between inflation and unemployment in the $SR$ (movement along $SRPC$).
  • In the $LR$, people correct their expectations; the Phillips curve is vertical at the natural rate of unemployment ($U^*$).

New Classical Theory: Rational Expectations Hypothesis (REH)

• Key Proponents: Muth, Lucas, Barro, Sargent.
• Rational Expectations: Rational people use all available information and do not make systematic errors. They understand the true model of the economy.
• Policy Ineffectiveness:
  • Anticipated Changes: If a money supply change is anticipated, agents adjust prices immediately. The $AS$ curve shifts up, and there is no trade-off between inflation and output even in the short run.
  • Unanticipated Changes (Policy Surprises): Only unanticipated changes (surprises) help augment output temporarily.

Real Business Cycle (RBC) Theory

• Kydland and Prescott (Post-1980):
  • Reject the idea that supply-side variables change only slowly.
  • Output fluctuations (business cycles) are driven by real shocks—technology changes, supply shocks, labor productivity, and natural resource prices—rather than monetary shocks.
  • Money determines the price level, not real output, similar to the original classical model.

Time Inconsistency and Central Bank Independence

• Time Inconsistency (Kydland and Prescott, 1977):

  • Policy makers have an incentive to renege on low-inflation rules to create "surprise inflation" for temporary growth.
  • Rational individuals anticipate this, leading to higher inflation without higher output.
  • Rules vs. Discretion: Rules (one-time decisions) are preferred over discretion (period-by-period decisions) to ensure credibility.

• Central Bank Independence (CBI) and Inflation Targeting:

  • Rooted in the consensus that CBI prevents political pressure to exploit the Phillips Curve trade-off for re-election.
  • Inflation targeting requires transparency, accountability, and the use of a collegial committee to manage "constrained discretion."

Mundell-Fleming Model (Open Economy)

• Core Equations:
  • $IS: Y = A(Y, r) + Nx(Y, Y_f, R)$
  • $R = \frac{e P_f}{P}$ (Real Exchange Rate)
  • $BP: Nx(Y, Y_f, R) + Cf(r - r_f)$
• Monetary Policy Effectiveness:
  • Fixed Exchange Rates + Perfect Capital Mobility: Monetary policy is ineffective; the central bank cannot pursue an independent policy as change in $M$ would force intervention to maintain the peg.
  • Flexible Exchange Rates + Perfect Capital Mobility: Monetary policy is highly effective.

IS-LM and AS-AD Construction

• IS Curve: Derived from the Keynesian cross; downward sloping. Relationship: $Y = C(Y - t(Y)) + I(r) + G + Nx(Y)$.
• LM Curve: Interaction between liquidity preference ($M_d$) and exogenous money supply ($M$). Upward sloping.
• AD-AS Model:
  • AD Curve: Downward sloping due to negative correlation between price level and real money supply ($\frac{M}{P}$).
  • AS Curve:
    • Classical AS: Vertical; level of output is exclusively determined by capital and labor, and is price-invariant.
    • Keynesian AS: Horizontal (extreme sticky price) or positively sloped (short run).
    • $Y = Y_s(\frac{W}{P}, \frac{P}{P^e}, \dots)$
  • Policy Rule: When inflation rises, the central bank raises the policy interest rate to dampen $AD$.

The Fisher Effect

• Equation: $i = r + \pi^e$
  • $i$: Nominal interest rate
  • $r$: Real interest rate
  • $\pi^e$: Expected inflation rate
• Established the relationship where a rise in expected inflation leads to a rise in nominal interest rates. It is derived from the classical dichotomy.

Conclusions

• Long Run: Output depends on real factors. Money determines only the rate of inflation. Policy should focus on a stable environment for productivity.
• Short Run: Money influences output; trade-offs between inflation and employment exist.
• Institutional Structure: CBI is a prerequisite for macroeconomic stability, especially in small open economies where external stability is paramount.
• Fiscal Responsibility: Budget deficits and their monetization are primary causes of instability.