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		9— The Monetarist Rule



		The purpose of this chapter is to examine the monetarist approach to macroeconomic analysis and discuss a major legacy of monetarism: the monetarist rule that the money supply should grow at a fixed rate equal to the real rate of income growth of the economy.



		By the early 1960s, the Keynesian view of the macroeconomy had become the conventional wisdom, evidence of which was its explicit use as the rationale for the tax cut. Just as the Keynesian view was reaching the peak of its popularity, however, in 1963 Milton Friedman and Anna Schwarz published their book A Monetary History of the United States, 1867-1960 , heralding the arrival of a competing view of the macro-economy that has since come to be known as monetarism.



		Monetarists deplored the way in which disciples of Keynes neglected the role of money, something that Keynes himself had stressed, and placed money at center stage of the macroeconomy, the position it had held in the classical view (see appendix 4.1), which was the conventional wisdom before the Keynesian revolution. In the late 1960s and early 1970s, the monetarist view gained considerable popularity, primarily because during this time the money supply increased dramatically, causing monetarist predictions to be more accurate than those of the Keynesians. Monetarists claim that crowding-out forces are so strong that fiscal actions are completely ineffective, and that only money matters in determining the level of economic activity. Keynesians soon came to agree that money matters and modified their thinking to develop a more eclectic approach. Monetarists, however, insisted that only money matters. This dogmatism, at first very effective as an attention-getting debating tactic, has ultimately been a main reason for the decline of monetarism, as it became evident that several factors in addition to money play roles in the operation of the macroeconomy.



		Upon completion of this chapter you should



		• understand the quantity theory of money;



		• know what is meant by velocity; and



		• understand the rationale behind the monetarist rule.



		9.1— The Quantity Theory



		In the classical school of thought, supplanted eventually by Keynesianism, a prominent role was played by the quantity theory of money, represented by the mechanical formula



		Mv = PQ



		Here, P is the overall price level, and Q is the physical quantity of output produced, so that the right-hand side of this formula is the money value of output, or, equivalently, nominal GDP. The variable M is the money supply, and v is the velocity of money, interpreted as the number of times in a year each dollar of money supply is used to buy a final good or service. This is usually expressed as the number of times the money supply "turns over" in supporting financially the production of output.



		According to this formula, if velocity is constant, a rise in M causes a rise in either P or Q, depending on whether or not the economy is at full employment. This result is easily seen from looking at the formula Mv = PQ. Clearly, the role of money is center stage in determining the level of economic activity. What is not so easily seen is what is going on in the economy to cause this result to hold, the greatest drawback of the quantity theory: it offers no explanation of how an increase in the money supply causes an increase in economic activity. The quantity theory formula seems to appear as gospel without any theoretical justification. Indeed, velocity is defined as the ratio of income to the money supply, making the quantity theory formula a mere tautology. (Take the equation and solve it for v , obtaining v = PQ/M. If this is how v is defined, then the quantity equation becomes true by definition—a tautology!)



		The monetarists reinterpreted the quantity theory as representing an economy's demand for money, and with this reinterpretation they were able to structure an explanation for how an increase in the money supply caused an increase in economic activity. The result is referred to as the modern quantity theory of money, and it is a cornerstone of monetarism.



		9.2— The Modern Quantity Theory



		The original quantity theory formula is rewritten as M = (1/ v ) PQ and is interpreted as a behavioral equation that reflects the economy's demand for money—as nominal income PQ

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