Thursday, February 16, 2012

Another Way of Looking at Things part 2

So using our equation M/P * V(i) = Y we can constrcut a different way of looking at business cycles other than IS-LM-FE, as we have done so far.

With our "monetarist" model, we aren't looking to find the appropriate real interest rate that clears the market for real money balances and loanable funds are full employment. We are instead looking at the real money supply M/P and the "velocity" of that money supply, or how many times each dollar "changes hands" i.e. is used in a transaction in a year.

It stands to reason then, from the above equation, that a decline in Y must either be attributable to a fall in M/P, V, or both. So we need to look at what might CAUSE these variables to decline in value.

Lets start with M/P. A decline in the nominal money supply M would reduce M/P at least in the short run. Theoretically, a decline in the money supply SHOULD lead to a decline in the price-level. But here we come to the fork in the road that divides modern macroeconomists: how QUICKLY do prices adjust? Monetarists and Keynesians say prices are "sticky," as we've seen before. New Classical economists say prices adjust very rapidly, if not instantaneously. For this model, however, we assume prices are sticky. If thats the case, a fall in M will cause a fall in M/P not quickly corrected by a fall in P.

This is, by the way, the basic model Milton Friedman used to describe the Great Depression. He catalogued the fall in the nominal supply of money from 1929-1933 which, in his thesis, combined with "sticky" prices to give us the fall in Y that was the Great Depression. Keep M stable, the story goes, and you stabilize the business cycle.

But lets look at the V(i) term as well. Friedman and most monetarists of his day thought the velocity of money was more or less constant, so that observing M/P was where the action was at. But a decline in the velocity of money is just as able to cause a fall in income Y as a fall in M.

More on this later.

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