LECTURE 14. MONETARISM AND THE THEORY OF RATIONAL EXPECTATIONS

1. The evolution of the quantity theory of money. Basic postulates of monetarism

From the 30s to the 70s economic theory and economic policy were dominated by the economic views of Keynesianism. However, in the seventies there was a turn to neoclassical theory, associated with a certain discrediting of Keynesianism due to the development of such processes as "stagflation", that is, the simultaneous increase in unemployment and the price level, which could not be explained within the framework of Keynes's economic theory. The modern version of the neoclassical theory is presented in the form of the theory of monetarism. The theory was called "monetarism" because its main ideas were based on the quantitative theory of money. It must be said that the quantity theory of money is one of the oldest economic doctrines, the origin of which dates back to the sixteenth century, at the time of the formation of the first economic school - the mercantilist school. The quantitative theory of money acted as a kind of reaction to the basic postulates of mercantilism, in particular, to the doctrine so characteristic of mercantilists that money speeds up trade, increasing the speed of circulation, and thereby have a beneficial effect on production.

The thesis about the positive impact of an increase in precious metals in the country was questioned by the English philosophers Locke (1632-1704) and D. Hume (1771-1776), who directly linked the amount of precious metals (means of payment) and the price level, concluding that commodity prices are a mirror reflection of the mass of precious metals available in the country. They argued that the price level on average changes in proportion to changes in the quantity of money, and inflation occurs whenever too much money meets too few goods. To be fair, it should be noted that Hume did not deny the positive impact of “creeping” inflation on economic growth.

In particular, he wrote: “... in every kingdom where money begins to flow in greater abundance than before, everything takes on a new appearance: labor and industry revive, the merchant becomes more enterprising, and even the farmer follows his plow with greater alacrity and attention." However, this industrially beneficial influx of precious metals into the country is of a short-term nature, and, ultimately, the prices of all goods will increase in the same proportion as the amount of metallic money available in the country. And the “price revolution” in Europe that occurred in the sixteenth century, as a result of which, due to the huge influx of gold and silver from America, prices quadrupled, was perceived as irrefutable evidence of a causal relationship between changes in the money supply and the price level.

Hume's ideas were adopted by representatives of the classical trend in political economy, in particular A. Smith, who considered money exclusively as a means of circulation, a technical tool that facilitates exchange and denied it any intrinsic value.

The most rigorous version of the quantity theory of money was put forward by the American economist I. Fisher (1867-1947), who, in his work “The Purchasing Power of Money” (1911), derived his famous equation, which is based on a double expression of the amount of commodity transactions:

▪ as the product of the mass of means of payment and the speed of their circulation;

▪ as the product of the price level and the number of goods sold. I. Fisher's equation has the following form:

MV=PQ,

where М - volume of means of payment;

V - the speed of their circulation;

Р - weighted average price level;

Q is the sum of all goods.

The equation of exchange consists of two parts. The right side (PQ) - "commodity" - shows the volume of goods sold on the market, the price assessment of which sets the demand for money. The left side (MV) - "money" - shows the amount of money paid for the purchase of goods in various transactions, which reflects the supply of money. Consequently, the Fisher equation characterizes the equilibrium of not only the commodity market, but also the money market. Since money is an intermediary in acts of purchase and sale, the amount of money paid will always be identical to the sum of the prices of goods and services sold, that is, this equation is an identity where the price level is directly proportional to the amount of money and the speed of their circulation and inversely proportional to the volume of trade. In an effort to prove the neutrality of factors such as V and Q, Fisher accepts the premise of the neoclassical theory that production is at the point of maximum possible volume, and the velocity of money is a constant value. These assumptions allowed Fisher to argue that in the long run, the development of the economy is determined by real factors (supply factors), and money only affects the price level.

Fisher's version of the quantity theory of money is the most common in American literature. Among European economists, the most popular version of the quantity theory of money is the Cambridge version, or the theory of cash balances, the foundations of which were developed by A. Marshall and A. Pigou. And if Fisher placed the main emphasis on the movement of money as a means of servicing commodity transactions, then the Cambridge school sought to identify patterns in the use of money as income. Her argument is based on the idea of ​​cash balances, which refers to the part of income that a person wishes to keep in cash, that is, in absolutely liquid form.

The Cambridge equation looks like this:

M = k R P,

where М - the volume of the money supply,

R - the total value of manufactured products in physical terms,

Р - the general level of prices for goods and services,

к - Marshall coefficient showing what share of nominal income business entities prefer to keep in the form of cash (cash balances)

The left side of the formula expresses the money supply, given from the outside by the existing monetary system. The right one reflects the demand for money, which is determined by the total nominal income of the members of the society, taking into account what part of this income is stored in the form of cash balances and temporarily withdrawn from circulation. Unlike the Fisher equation, the Cambridge version focuses not on the movement of the money supply, but on the savings in the cash registers of enterprises and individuals. The factors on which the demand for cash balances depends are investigated and two motives for accumulation are singled out: the formation of a fund of circulation funds and the formation of reserves to cover unforeseen needs. Particular attention in the analysis of the movement of the money supply is paid to the principles of income distribution, where the criterion is: on the one hand, the convenience of accumulated cash balances, and on the other hand, the assessment of the victims of lost profits. This "choice at the limit" was further developed in Keynes's theory. However, the conclusions that follow from the Cambridge equation do not contradict the main conclusion from the quantity theory of money: if K and R are constant, a change in the money supply will affect only price changes.

It should be emphasized that the theory of monetarism, like all variants of the quantity theory of money, will be based on the following premises:

▪ the amount of money in circulation is determined autonomously;

▪ the velocity of money circulation is strictly fixed;

▪ a change in the quantity of money has an equal and mechanical effect on the prices of all goods;

▪ the possibility of influence of the monetary sphere on the real process of reproduction is excluded.

The quantity theory of money formed the basis of the policies pursued by the central banks of Western Europe in the twenties of the twentieth century. This policy did not bring the desired results, which to a certain extent explains the turn from the neoclassical theory of money to the Keynesian theory, in which money influences primarily not prices, but employment and production volume. However, in the seventies there was again a return to neoclassical theories, one of the variants of which was “monetarism,” most directly associated with the name of the American economist M. Friedman.

2. Economic views of M. Friedman. Friedman's equation

M. Friedman (born 1912), American economist, world-famous for his book "Research in the Quantity Theory of Money" (1956)

M. Friedman is an adherent of the classical school, sharing one of its main theses - the thesis of non-intervention of the state in the economy. Moreover, unlike representatives of the neoliberal trend, who defend the market from ideological and moral positions, Friedman defends it from a utilitarian position. The argument is as follows: the market acts as a guarantor of freedom of choice, namely, freedom of choice is a condition for the efficiency and viability of the system. It is viable primarily because the free exchange on which it is based takes place only when it is beneficial to both parties. In other words, every trade either makes a profit or does not take place at all; therefore, the total benefit in the course of the exchange increases. The mechanism that ensures the realization of economic freedom and the interconnection of the actions of free individuals is the mechanism of prices.

Friedman draws attention to the fact that prices simultaneously perform three functions: informational, stimulating and distributive. The information function is related to the fact that prices, indicating changes in supply and demand, carry information about the needs for certain goods, about the shortage or excess of resources, etc. This function is extremely important for coordinating economic activity. The second function is to encourage people to use available resources in order to get the most highly valued results in the market. The third function shows what and how much this or that economic entity receives (since prices are also someone's income). All these price functions are closely interrelated, and attempts to suppress one of them negatively affect the others. Therefore, the desire of socialist governments to separate the last function from the rest and force prices to contribute to the realization of social goals, Friedman considered absurd, since, in his opinion, prices provide incentives only because they participate in the distribution of income.

If prices do not fulfill the third function, the distribution of income, then there is no reason for a person to worry about the information that the price carries, and there is no point in reacting to this information.

The efficiency of the economic system and its flexibility depends on the possibility of freedom of individual choice, so Friedman is a supporter of the free market. At the same time, he acknowledges that the "market model" should not reign supreme in society. If an individual entrepreneur is characterized by the orientation of his own efforts to increase profits, then for society as a whole it may not be indifferent to the extent to which all its members have access to a number of benefits that in this society - from the point of view of the cultural, moral , religious and other foundations - are considered absolutely necessary for human life. Such benefits (from the middle of the twentieth century) include primarily education and medical care, as well as a mechanism for the material security of citizens, regardless of the results of their specific activities. Therefore, Friedman, allowing state intervention to provide all citizens with access to these benefits, emphasizes the need to find a compromise between the elements of dictate, inevitable in any intervention, and individual freedom. Friedman accepts government intervention only in forms that least restrict human freedom, including the freedom to spend money. Hence Friedman's recommendations to provide benefits to the poor in cash, not in kind, and the introduction, instead of direct payments to low-income people (whose income does not reach the established minimum level), a system of taxes on personal income, which does not reduce the activity of people to improve their financial situation, since called the system of negative taxes. However, in general, Friedman opposes the excessive expansion of the provision of social benefits, believing that this gives rise to the so-called "institutional unemployment" and "new poverty".

However, it was not his worldview that brought Friedman world fame, but the development of a modern version of the quantity theory of money.

In spirit, it is close to the neoclassical, as it implies the flexibility of prices and wages, the volume of production tending to a maximum, and the exogenous (that is, external to the system) nature of the money supply. Friedman's task was to find a stable demand function for money at a constant rate of their circulation.

The demand function for money is close to the Cambridge version and has the following form:

M=f(Y............x),

where Y - nominal income;

х - other factors.

The money demand function proposed by Friedman is the key point of his monetary theory: knowing the parameters of this function, one can determine the degree of influence of a change in the money supply on the dynamics of prices or interest. This, however, is only possible if the function is stable. Friedman insists on this, believing that, other things being equal, the demand for money (the money supply desired by the population) is a stable share of the nominal gross national product, in contrast to the Keynesian model, where the demand for money is unstable due to the existence of speculative moments ( so-called liquidity preference motives). Another fundamental difference between Friedman's views and Keynes's is his belief that the level of the interest rate does not depend on the size of the money supply (at least in the long run). The conditions for the long-term equilibrium of the money market, where there is no place for the rate of interest, are expressed by a well-known equation, which is called the Friedman equation. The equation has the following form:

M=Y+P,

where М is the long-term average annual growth rate of the money supply,

Y - long-term average annual rate of change of real (in constant prices) total income,

Р - the price level at which the money market is in a state of short-term equilibrium.

In other words, with this equation, Friedman wanted to show that in the long run, the growth of the money supply will not affect real volumes of production, and will be expressed only in an inflationary rise in prices, which is quite consistent with the quantity theory of money, and more broadly corresponds to the ideas of the neoclassical direction of economic theory. .

Friedman considers the stability of the movement of the money supply as one of the most important conditions for the stability of the economy as a whole. He proposes to abandon attempts to use monetary levers to influence real variables (the level of unemployment and production) and defines control over nominal variables, primarily prices, as the goals of this policy. Friedman sees the achievement of this goal in following the “monetary rule,” which assumes stable and moderate growth of the money supply within the range of 3-5% per year. These recommendations are directly related to the development of the so-called “lag problem”. Already I. Fischer admitted that the consequences of the state’s monetary policy manifest themselves with a delay. Friedman showed that this delay ranged from twelve to sixteen months and this was a very alarming conclusion, because economists are believed to be able to reliably predict the state of the market no more than a year in advance. In this case, economists' recommendations regarding today's policies will be of dubious value. Therefore, Friedman proposed abandoning a flexible monetary policy, making it a rule to constantly increase the money supply in small and fairly equal (over the years) portions. When establishing the size of such increments, Friedman proposed focusing on two indicators obtained based on the processing of statistical data. This is the average annual increase in the volume of the gross national product (in physical terms) over many years and the average annual rate of change in the velocity of circulation of the money supply. Having made the necessary calculations, Friedman received his recommended growth rate of the money supply of 3-5%. It is easy to imagine that Friedman advocated limiting the excessive discretion of central monetary authorities, believing that any drastic action by the central bank could cause unpredictable consequences.

Another modern version of the classical theory is the theory of rational expectations.

3. Rational expectations theory

In spirit, the theory of rational expectations is a variant of neoclassical theories, as it fully shares its premises, in particular:

▪ rational behavior of economic entities;

▪ completeness of information when forming expectations;

▪ perfect competitiveness of all markets;

▪ instantaneous reflection of new information on supply and demand curves.

These premises of neoclassical theory are well known. What is unexpected is the conclusions drawn from these premises by the representatives of the theory of rational expectations. In their opinion (when accepting the above assumptions), the general reaction of the population to their expectations makes any discrete stabilization policy fruitless. This is well illustrated by the situation, which is interpreted so differently by representatives of the Keynesian trend and monetarism; on the situation of the state policy of cheap money. This policy, within the framework of the theory of rational expectations, will not have any result, since the population is waiting for inflation, enterprises are raising prices, creditors - interest, workers - wages, and as a result, we do not see any real increase in output and employment. Hence the conclusion that a discrete policy only increases instability in society.

For all its logic, the weaknesses of this theory attract attention, some separation from reality, because in reality people are poorly informed, prices are not flexible enough, and there is enough evidence in favor of the impact of economic policy on real gross national product.

Author: Agapova I. I.

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