Thursday, February 9, 2012

Another Way of Looking at Things part 1

I normally like to think about the business cycle in term of the IS-LM-FE model described so laboriously below. But lately I've been investigating another apporach taken by Scott Sumner (for one): market monetarism. As well as I can piece together, market monetarism is an udated version of the old monetarism of Milton Friedman: changes in the quantity of money, or the rate of change of the quantity of money, drive the business cycle, i.e. flucations in real output. Let examine how that works.

The workhorse of the market monetarist approach, as near as I can tell, is, surprise! Irving Fisher's Equation of Exchange, which is:

                                                             M x V = P x Q

Where M is the nominal money supply, V is the velocity of money, P is the price level, and Q is real output or real GDP. The equation can be rewritten as:

                                                            M/P x V(i) = Q

Where P is now used to deflate the nominal money supply so as to give the real money supply, and velociy is given as a function of the nominal interest rate which is

                                                          i = r + π e 

Where i is the nominal interest rate equaling the real interest rate plus expected inflation. 

The rewritten form is a bit easier to work with because you can think about the real money supply being multiplied by its velocity to get real income. Less convulted. 

So what about the business cycle? 

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