Monetarism

Key Terms
Monetarism: The theory of controlling the supply of money as the chief method of stablising the economy.

Quantitative Easing: The introduction of new money into the money supply by a central bank.
Theory

Key features of monetarism


1) The main cause of inflation is an excess supply of money, in the words of Milton Friedman “too much money chasing too few goods”.

2) Tight control of money and credit is required to maintain price stability.

3) Fiscal and monetary policy are ineffective in controlling AD.

4) The key is for monetary policy to be credible so that people’s expectations of inflation are controlled.


Quantity Theory of Money

Irving Fisher devised the quantity theory of money in the early 21st century.

The theory is based on the equation: M x V = P x Y

  • M = money supply
  • V = velocity of circulation
  • P = price level
  • Y = output

    • Both V and Y are fixed. An increase in the money supply will lead to an increase in inflation.

    Example:

    If money supply is initially £1000 and velocity is 5, output = 5000

  • 1000 x 5 = 1 x 5000

    • If money supply doubles the equation =

  • 2000 x 5 = 2 x 5000


    • Quantitative Easing

    QE may be used if it is believed that inflation is too low or the economy is deflating.

    Process:

    Bank of England purchase assets such as government bonds using newly created money.

    Commercial banks will then have greater liquidity and will be more willing to lend to consumers = higher AD.

    Increase in money supply may also lower market interest rates, reducing inflows of ‘hot money'.

    This may cause a depreciation of the exchange rate and increased UK competitiveness.
    Advantages of Quantitative Easing
    1) Short-term Economic Growth

    An increased money supply should increase spending. AD shifts right = lower unemployment.


    2) Supply-side effects (Long-term Economic growth)

    Quantitative easing should result in increased bank lending. This will mean that businesses more willing and able to borrow money. By drawing together the factors of production, the increase in entreprenerial culture will result in an increase in the productive potential of the economy.

    However QE in the U.K had quite the opposite effect. Bank lending did not increase. This was because instead of passing on the money through lending, banks used much of the £200 billion to restore the amount of liquid capital they owned.


    3) Government Profit

    The Bank of England is currently making a profit on Quantitative easing. The return from the bonds it holds is greater than the interest it pays on reserves.

    For example, in 2010, the Bank of England made £8 billion profit from the Q.E programme. By making a profit the government will face a lower PSNCR and will be able to start paying off some of it's debt.


    4) International Competitiveness

    QE stimulates actual growth (AD) which causes inflation. In addition QE also results in a lower interest rate on borrowing.

    Higher inflaton and lower interest rates will make the £ pound less attractive on the foreign exchange. Traders will sell £ thus causing a depreciation of the currency making exports cheaper and therefore U.K. goods more competitive.
    Disadvantages of Quantitative Easing
    1) Financial Sector Risks

    Inflow of money into commercial banks from quantitative easing may encourage unproductive speculation rather than productive investment. The creation of a speculative bubble and the eventual bursting of the bubble may lead to recession.


    2) Currency manipulation

    Quantitative easing has been a stealth method of reducing the value of the Pound and Dollar. This is unfair to developing markets and may uphold use of protectionism.


    3) Potential Inflation

    Pumping 'new money' into the economy has the potential to be inflationary, if the money supply increases too quickly. QE in the U.K. led to the unintended consequence of a rise in the price of commodities such as oil, leading to cost-push inflation.


    4) Distribution of Income

    QE in addition to low interest rates is argued to have adverse effects on the distribution of income. Savers, such as old people, suffer when the value of their pensions fall. Borrowers on the other hand incur the benefits as low interest rates reduces the amount payed back to the lender.


    5) Social Stigma

    Although not neccesarly the case, QE has been associated with giving money to banks and lining the pockets of bankers. A policy of QE could therefore make the MPC very unpopular with workers.
    Forward Guidance
    This is when the Central Bank announces to markets that it intends to keep interest rates at a certain level until a fixed point in the future.

    The MPC intends not to raise Bank Rate from its current level of 0.5% at least until the LFS measure of the unemployment rate has fallen to a threshold of 7%.

    Bank of Japan in 1990’s aimed to escape its economic doldrums by promising to leave interest rates at zero “until deflationary concerns subside”.


    Advantages of Forward Guidance

    1) Increased Confidence

    By convincing markets that interest rates will stay low for the foreseeable future there will be an apparent increase in stability.

    Increased stability improves confidence. This will result in:

  • Increased consumer confidence = spending
  • Increased business confidence = investment


    • Disadvantages of Forward Guidance

    1) Unexpected shocks

    Unexpected events e.g. a huge decrease in exports and increase in imports may warrant an increase in interest rates. This would destroy confidence and defeat the purpose of forward guidance.


    2) Calculation issues

    The LFS measure of unemployment may indicate that unemployment has increase but does not provide information on whether employment is cyclical or otherwise.

    Interest rates may therefore be raised but the issue of unemployment has not been corrected in the long-run.


    3) Market form their own expectations

    Regardless of the central bank's wish for markets to remain calm and orderly, markets notoriously act chaotically. Financial markets in particular form their own expectations. If a financial market believes that a bubble will occur, then market operators may raise interest rates despite the wishes of the central bank.


    Evaluation of Forward Guidance

    Commitment to low interest rates may not affect banks behaviour.

  • Commercial banks may keep interest rates high because they are short of funds and trying to attract deposits.

  • Markets may feel that although this is what the MPC say they will do, in reality they expect interest rates to change.


    • There is plenty of scope to refine the technique of forward guidance.

  • Publishing meeting transcripts.

  • Releasing detailed forecasts for economic activity.









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