The money supply and the interest rate, Macroeconomics

Another area where monetarists differ from Keynesians is money supply and interest rates. In the Keynesian analysis with less than full employment level equilibrium, the interest rate is assumed to fall in response to an increase in the money supply. In contrast, monetarists argue that the interest rate may rise. Friedman stresses that interest rates initially decline. He believes, however, that the reduction is only the beginning of the process. With the increase in the supply of money, aggregate demand increases which in turn increases income and thereby increasing the real amount of money demanded. Also, with the increase in aggregate demand, the price level increases, thus reducing the real money supply. Friedman claims that these effects will reverse the initial downward pressure on interest rates in less than a year. After a year or two, these forces will return interest rates to their original levels. Thus, rise in stock of money, instead of having a depressing effect on interest rates, push the interest rates further.

Monetarists also argue that changes in price expectations are slow to develop, however, if the money supply were to increase more rapidly for prolonged periods, prices would increase more rapidly. As people change their expectations about inflation upward, the higher rate of monetary expansion will result in higher interest rates, but not lower interest rates because interest rates first fall and then rise in response to an increase in the money supply. Monetarists believe that interest rates are a poor indicator of monetary policy. On the contrary, many Keynesians believe that interest rates are a good indicator of monetary policy. According to this view, increase in money stocks and a decrease in interest rates implies that monetary policy is expansionary, whereas an increase in interest rates means that monetary policy is rigid and contractionary.

In general, Keynesian analysis shows that a free enterprise economy needs to be stabilized, and since discretionary policy is stabilizing, monetary and fiscal policies should be used to stabilize output and employment. On the contrary, monetarists believe that discretionary monetary and fiscal policy may be destabilizing and thus unnecessary. Since monetarists do not believe in discretionary policy and consider it as potentially destabilizing, they favor steady increase in the money supply as a policy option to minimize fluctuations in income and employment. This policy prescription is in consonance with their belief that the economy tends to adjust until full employment prevails. For this reason they contend that discretionary stabilization policies are, for the most part, unnecessary and unwarranted.


Posted Date: 9/18/2012 7:01:48 AM | Location : United States

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