In this article we will discuss about the classical, Keynesian and modern views on monetary policy.
The Classical View on Monetary Policy:
Money, according to the classicists, is a veil. It is neutral in its effects on the economy. It simply affects the price level, but nothing else. An increase in the money supply leads to an increase in the price level, but the real income, the rate of interest and the level of real economic activity remain unaffected.
In the classical system, the main function of money is to act as a medium of exchange. It is to determine the general level of prices at which ‘goods and services will be exchanged. This relationship between money and the price level is explained in terms of the quantity theory of money.
The classical quantity theory of money states that the price level is a function of the supply of money. Algebraically, MV=PT where M, V, P, and T are the supply of money, velocity of money, price level and the volume of transactions (or real total output).
The equation tells that the total money supply MV equals the total value of output PT in the economy. Assuming V (the velocity of money) and T (the total output) to be constant, a change in the supply of money (M) causes a proportional change in the price level (P).
The classicists believed that there was always full employment in the economy. At the same time, they recognised the existence of unemployment in the event of downward rigidity of money wages. Such a situation could be corrected by an expansionary monetary policy.
The process involved is as follows. Suppose the monetary authority increases the money supply, given the velocity of money and the level of real output. With increase in the money supply, liquidity rises with the people who increase the demand for goods and services. This, in turn, raises the price level.
The rise in price level reduces the real wage which provides incentive for employers to expand employment and output towards the full employment level. Thus an expansionary monetary policy is effective in restoring full employment in the classical system.
Keynes did not agree with the classical view that the supply of money influences the price level directly and that the economy always stays at the full employment level. Moreover the classical analysis was related to the long-run where market forces worked the economy towards full employment.
The Keynesian View on Monetary Policy:
In the Keynesian analysis, monetary policy plays a crucial role in affecting economic activity. It contends that a change in the supply of money can permanently change such variables as the rate of interest, the aggregate demand, and the level of employment, output and income.
Keynes believed in the existence of unemployment equilibrium. This implies that an increase in money supply can bring about permanent increases in the level of output. The ultimate influence of money supply on the price level depends upon its influence on aggregate demand and the elasticity of the supply of aggregate output.
In a situation of unemployment, Keynes advocated cheap money policy. So when the supply of money is increased, its first effect is on the rate of interest which tends to fall. Given the marginal efficiency of capital, a fall in the rate of interest will increase investment.
The increased investment will raise effective demand through the multiplier effect thereby increasing income, output and employment. Since the supply curve of factors of production is perfectly elastic in a situation of unemployment, wage and non-wage factors are available at a constant rate of remuneration.
There being constant returns to scale, prices do not rise with the increase in output so long as there is unemployment. Under the circumstances, output and employment will increase in the same proportion as effective demand, and the effective demand will increase in the same proportion as the supply of money. But once full employment is reached, output ceases to respond at all to changes in the supply of money and so in effective demand. An increase in the supply of money beyond the level of full employment would raise the price level in the classical fashion.
What causes the rate of interest to change in the Keynesian monetary policy? In the Keynesian analysis, the rate of interest is determined by the demand for and supply of money. If either the demand for money or the supply of money changes, the equilibrium rate of interest would change.
The supply of money is determined by the monetary authority which is normally fixed in the short-run. In other words, the money supply curve is perfectly inelastic. The demand for money is the desire to hold cash for transactions, precautionary and speculative purposes. Money held for transactions and precautionary motives depends upon the level of income. The speculative demand for money depends upon the rate of interest or bond prices.
It is, in fact, expectations about changes in bond prices or in the market rate of interest that determine the speculative demand for money. Keynes considered only two types of assets in his analysis, money and bonds.
Money does not yield anything explicitly and bonds pay an explicit rate of interest. Therefore, people wish to hold bonds rather than liquid money because interest is paid to bondholders. Keynes held that the demand for money is a decreasing function of the rate of interest.
The higher the rate of interest, the lower the demand for money, and vice versa. This negative relationship between the demand for money and the rate of interest provides a link between changes in the supply of money and the level of economic activity.
Keynes himself proceeded to question the efficacy of his monetary policy under certain conditions. He argued that at a very low interest rate, the demand for money curve becomes perfectly elastic. This is the liquidity trap portion of the demand for money curve which is completely flat.
This means that further increase in the supply of money by the monetary authority cannot reduce the rate of interest. This implies that there will be no effect on investment and income, and monetary policy does not influence economic activity. Given an interest-inelastic investment function, monetary policy will be ineffective in the Keynesian analysis. Thus Keynes believed on the basis of his experience that monetary policy operated under certain limitations.
He wrote, “If we are tempted to assert that money is the drink which stimulates the system of activity, we must remind ourselves that there may be several steps between the cup and the.lip.” The effectiveness of monetary policy depends on first, if the increase in the supply of money reduces the rate of interest provided the demand for money does not become infinite (i.e. perfectly elastic), and second, the reduction in the rate of interest increases investment demand provided it is not inelastic to the rate of interest.
These limitations become more serious during depression and thus monetary policy becomes ineffective. That is why, Keynes favoured investment on public projects during depression. He wrote, “I am now somewhat sceptical of the success of a merely monetary policy directed towards influencing the rate of interest.”
In fact, he advocated supplementing monetary policy with fiscal policy during depression. Recent researches have shown that Keynes was misrepresented by his followers in attributing that he was not a votary of monetary policy.
The Modern View on Monetary Policy:
The modern monetary economists’ reject the Keynesian view that the link between the supply of money and output is the rate of interest. The Keynesian analysis considered only two types of assets: bonds and speculative cash balances, and their allocation depended on the rate of interest which, in turn, resulted in changes in output.
The modern monetary policy is based on the portfolio adjustment process. When the central bank purchases securities in open market, it sets in motion substitution and wealth effects, as the public portfolio consists of a wide variety of assets such as bonds, equities, savings, mortgages, etc. These effects will ultimately increase aggregate money demand and expand output. The transmission mechanism is explained under substitution effects and wealth effects.
The neo-Keynesians widened considerably the portfolio of assets to include not only government securities but also industrial bonds, equities, savings, mortgages, etc. Given this type of portfolio, suppose the central bank engages in open market operation and purchases securities. This will increase the prices of securities, thereby reducing the yield on them. In other words, the holders of securities sell them to the central bank because they get high prices for them.
They now hold more money than they desire. As a result, they try to readjust the structure of their portfolios so as to reduce their money holdings. Suppose they substitute bonds for their excess money balances. The increase in the demand for bonds results in an increase in their market price, thereby reducing their current yield, as interest rate falls. Consequently, the demand for other assets such as equities, consumer durables etc. increases.
When people having surplus money balances purchase equities (shares), their prices rise. As a result, the value of capital of such firms rises above the supply price of such new capital. Such firms are, therefore, induced to increase their demand for more capital equipment, thereby raising output in the capital goods industries.
This will, in turn, spread to the rest of the economy via the multiplier effect. Thus the “neo-Keynesians contend that financial assets are the closest substitutes for money, and that, consequently, increases in the supply of money will have their effect eventually on the level of economic activity by bringing about increases in the output of capital goods industries.”
The monetarists led by Friedman are of the view that excess money balances will be used to purchase not only financial assets but also real assets such as houses, land, consumer durables, etc. So when the Central bank purchases securities and their prices increase and yields fall, the demand for financial and real assets increases. With the increase in their demand, their prices rise. But the rise in the prices of real assets leads to some additional effects.
When the prices of real assets rise, their production is encouraged which, in turn, raises the demand for resources used in their production. Moreover, there is also increase in the demand for services as a result of increase in the prices of real assets. To illustrate, suppose the holders of surplus money balances demand more consumer durables, say cars.
This will raise the prices of existing cars relative to the prices of new cars. Since the new cars are relatively cheaper, their demand will increase which will raise their output, income and employment in the car industry. With the overall increase in the demand for cars, the demand for their services will also increase.
Thus an expansionary monetary policy leads to increase in demand, prices and expenditures for financial and real assets and for services through substitution effect.
The transmission mechanism operates through initial change in interest rates on securities and relative prices of both financial and real assets. These changes lead to the substitution of asset holdings which imply changes in the demand for real assets and services.
There is a lot of controversy between the neo-Keynesians and the Friedmanians regarding the wealth effect. According to the neo-Keynesians when the central bank engages in open market purchasing of securities, it leads to decline in market interest rates.
This produces a wealth effect which results from the fact that at a lower rate of interest the present or the capitalized value of the expected income stream of financial or real capital assets increases. As people feel wealthier, they buy more of all assets in their portfolios, and consequently increase their demand for consumer non-durables.
According to Friedmanians, an open market operation which exchanges money for bonds increases the nominal wealth of society. This is a direct wealth effect. A fall in the rate of interest increases the market value of the existing capital stock, thereby raising the nominal wealth of society. This is the interest-induced wealth effect. Both these wealth effects lead to an increase in net wealth. As a result, individuals buy financial and real assets including consumer durables.
In fact, the extent to which “the combined wealth effects bring up the price of the existing stock of assets relative to the price of new production, they also serve to increase the rate of flow of output of new producer and consumer durables. In addition, the wealth effect may serve directly to stimulate the purchase of consumer non-durable goods.”