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Different School Of Thought Views On Monetary Policy

Info: 2922 words (12 pages) Essay
Published: 27th Apr 2017 in Economics

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There have been many arguments about the effectiveness of the monetary policy. Monetary policy can be said effective in an economy if a change in the money stock have impact on output level, employment, real wages and economic growth and so on. If a change in the money stock supply causes no effect it can be said money doesn’t matter. Hence the objective of the chapter is to view all the different school of thought, outline sources of the monetary policy and to make an empirical literature how monetary policy will stimulate economic growth.



Classical view includes Adam Smith, David Ricardo, William Petty and Stuart Mill believes in the operation of free market economy. They claim that the economy would be self adjusting and no need for government intervention. The view is that the economy would operate at full employment which was mainly explained by say’s law of market “supply always create its own demand”, whenever production take place it immediately generate equivalent factor income. The turnover from the output is used to pay the factor input in terms of wages, rent, profit and interest. According to Pigou, if ever there is any over production, it would be temporary because unemployment implies that labour supply exceed labour demand as a result of which wage rate fall. At lower wage rate more workers and thus eliminating unemployment.

Irving fisher’s equation of exchange is MV = PT

M = Money in circulation

V = Velocity of circulation

P = Average price level

T = volume of transaction

Fisher assumed that money is demanded only for transaction purposes. He further assumed that by keeping V and T constant, any rise in M will raise P by same proportion.

The theory has a limitation and is as follows:

T is assumed to be fixed at full employment level but Keynes study had showed that the economy equilibrium level national income need not coincide with full employment level. So an increase in M given idle resources is likely to lead to increase in output so that T will increase and P may remain unchanged.

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V is not constant. If people expect a rise in prices, spending will increase because V will increase. In addition development in monetary and banking system such as increased use of cheques, debit card affect V.

The value of goods produced in an economy is PT. The amount of money spend is MV. Obviously MV = PT the equation is an identity.


Rate of interestMonetarist argues that the interest rate(r) is determined by the lonable fund theory, i.e. interest rate(r) is determined by demand and supply of loans. According to them (Friedman and Stingler) government policies particularly its monetary policy can have real effect on output and employment in the short run only.






Quantity of lonable funds

According to this theory people have a time preference that is they prefer consumption at present rather than postpone consumption to the future. The supply curve of loans will be upward sloping S as shown in the diagram above. The demand for lonable funds comes from firms willing to invest, households borrowing to buy consumer durables like car, houses etc and the government seeking to finance budget deficits.

Government demand for loans is not very sensitive to a change in interest rates but a rise in interest rate(r) will reduced firm’s and household’s demand for loans and vice versa. Hence the demand curve for loans is downward slopping. The equilibrium rate of interest is at OR and OQ is the quantity.


The theory determine rate of interest in a free market situation. However there are imperfections in the capital market for e.g. all banks are grouped into association of Mauritian bankers.

A substantial amount of saving is done as a matter of habit and custom, independently of interest rate.

In fact people do not save on the basis of the nominal interest rate but rather on real. Thus during a period of inflation real (r) may be low or even negative and people may not save.


According to Keynesians the level of income and employment is determine by the level of aggregate demand (AD). This is different from classical point of view; Keynesian model is demand (AD) which determine how much is supplied. The argument is that if firms finds that they are producing more than being demanded, they will observe an involuntary increase in their stocks of unsold goods and thus to rectify this by cutting back production and laying off workers national income will than fall until reached the value what is produced AD and vice versa.

According to Keynes, (r) represents the price for parting with liquidity. People hold liquid money (cash balances) because of the transaction, precautionary and speculative motives.

Rate of interest






Quantity of money



Monetarists and Keynesians disagree over how interest rate R is determined. Most Monetarists support the lonable funds theory while Keynesians support the liquidity preference theory.

Keynes assumed that the supply of money is determined by the monetary authorities (central banks) and it is fixed in the short run.

D is a systematic part of demand for money in the Keynesian theory as shown in the diagram above. Keynes argues that people hold idle balances rather than income earning assets (bonds) that are there is a high degree of substation between bonds and idle balances.

In the figure above, the equilibrium interest rate is at R where the demand for money curve D intersects the supply for money M. An increase in money supply from Q to Q1 will shift the supply curve to M1 consequently interest rate fall to R1. Thus as long an economy is below full employment and is not in liquidity trap, an increase in money stock will lead to decrease in interest rate. Since investment is inversely related to interest rate, the lower interest rate will cause investment and hence output to rise.


According to new classical views expansionary monetary or fiscal policy may not be effective in the short run, thus the feature of new classical economists is the rational hypothesis and market clearing assumption. The rational hypothesis states a systematic monetary policy will be anticipated by people or agents. The market clearing is assumed that prices are free to adjust instantaneously to clear market.

Using the assumption of market clearing new Classical economist Lucas (1973) and sergeant and Wallace (1975) believe that the policy irrelevance. Lucas stated that since agents make rational decision and market clear instantaneously, only unanticipated changes in money supply are going to affect output.

Anticipated increase in money will be reflected in higher prices and wage bargains will make wages to be constant. Hence anticipated monetary policy does not have impact on output. This is called Rational Expectation Natural Rate Model and is illustrated below.













AD is aggregate demand and AS is aggregate supply. Initially the economy is in equilibrium at point A with price P0 and income Y*. The impact of an expansionary monetary policy will shift the aggregate demand curve from AD to AD1. Rational expectation on other hand will make AS to shift to AS1. Hence new equilibrium will be at C, output remaining at Y* and price increase to P1. New classical economies believes that it is not possible to increase output in long run thus long run aggregate supply curve will be vertical.

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It is interesting to know how monetary policy affects the economic growth. However there are many various channels of monetary transmission and to understand the relationship between the financial and real sectors in an economy. Hence we will outline how money supply affects economic growth.

Economics theories suggest that high interest rates keep asset prices (bonds, equities and real states) down because a higher rate means a lower percent value of future streams of company earnings. Formula of discount valuation of assets assumes constant growth of dividend.


P =

K – G

P = Price of stock

D0 = Dividend at time T = 0

K = required rate of return

G = Dividend growth rate

Monetary may cause the economy expand by making price of bonds, equities and real state to change and thus interest rates. There can be direct or indirect relationship between asset price (bonds, equities and real state) and monetary policy. Expansionary monetary policy lowers interest rates and thus bonds become less attractive to stock. Demand for higher investment spending which will result growth and employment.

Modigliani’s life cycle model shows how wealth is important (i.e. wealth is a common component of stock). Thus and expansionary policy will raise stock prices thus causing consumption to therefore this will increase investment.

Market operation of the sale and the purchase of treasury bills on the open market by the central banks (CB) can be used as a tool for the economic growth. If the central bank wishes to reduce money supply a contractionary money supply will be used. It will sell treasury bills on the open markets, buyers will pay for these bills by cheques drawn on their accounts of commercial banks which hold it. As a result there will be a fall in cash reserves of the commercial banks which will result in a multiply contraction of bank deposits.

The bank rate also known as the Lombard rate of the minimum lending rate is the rate that the central bank charges on loans taken by commercial banks. Any changes in this rate will have a direct impact on the rate of interest which commercial banks charge on loan to their customers. An increase in the bank rate will lead to a rise in interest rates of loan and hence discourage demand for loans. This put a limit to the growth of bank deposits, hence reducing the growth of money supply and this is viewed by the loanable fund theory by the monetarist views.

For example, when the central bank raises the bank rate, this would imply that commercial bank has to pay more interest when borrowing with the central bank. Therefore as bank lending rate increases, commercial bank also raises their rate of lending. Higher rate would discourage businessmen and industrialist, this would result a reduction in the money supply and this have an impact on aggregate demand. On the other hand a fall in bank rate would make borrowing for loans cheaper, thus encouraging businessmen to borrow and this would lead to an increase in investment and making economic recovery from recession.

Open market consideration on large imports and exports, that is monetary policy can accomplish to induce nominal aggregate demand to grow smoothly and at a non inflationary rate by the use of real GNP multiply by consumer price index (CPI) but a constant growth in aggregate demand constitute more reasonable for monetary authority to maintain fixed exchange.


Many economists and researchers have investigated empirically the linkages between money supply and economic growth. Therefore this section reviews some of the empirical literature relating to the effect of monetary policy on economic growth.

Anderson and Jordan (1968) provide an equation for assessing the impact of policies, thus the formulation of a model known as the St Louis model and is as follows:

GNP = α +β1M + β2GE + β3 GR + µ

GNP = Change in the gross national product

M = Money supply

GE = Government expenditure

GR = Change in government revenue

µ = an error term

Anderson and Jordan (1968) make use of the US time series data for the period 1953-1968 and they make the conclusion that both monetary policy and fiscal policy has affected the level of economic activity. The results supported more the monetarist views that monetary policy has greater impact. Thus, Anderson and Jordan recommended that greater reliance should be on the monetary measures than fiscal measures for stabilization.

Krugman (1994), Ljungqvist and Sargent (1998) Morten and Pissarides (1999), Blanchard and Wolfers (2000) among others argued that there are policies that create rigidities which adversely affect the labour market ability to adjust to trade and technological shocks. They emphasizes on the role of education and innovation as a source of endogenous growth.

Schumpeterian model of endogenous growth as develop and studied by Grossman and Helpman (1991) and Aghion and Howitt (1998) build a simple model in which the possible effects of labour market and social welfare policies on both unemployment and growth can be cut off.

According to Bernake and most economic experts when an economy enters into recession, the central bank can take measures to take out the economy from recession by means of injecting money. This way of thinking implies that money pumping can somehow grow the economy. US past evidence shows that lose money policy seems to work from 1960 to 2008 and it took on an average of about nine months before an increases in money supply to cause an increase in the growth rate of industrial production.

Mc Callum (1984, 1985) made study on the rule for monetary that will make control. He made use of four principles for the interaction of nominal and real variables for the design of monetary rule. He put emphasis on qualitative terms of rules began to target path for nominal GNP that grows on average at a constant rate of real output growth. He found that for the United State (US) the approximate figure is about 3 per cent per year. He assumed that a 3 per cent per year would yield an approximate zero inflation rates free from the intervention of the monetary policy. In the 1984 study he made use of the monetary base instrument, variables that can be set by the central bank on a daily basis.

Lucas criticized much more on equations relating to real than nominal variables, e.g. the Phillips curve. There is the issue relating to the natural rate hypothesis which was in boom rate as a result of extremely high unemployment rate which were viewed by Fitoussi and Phelps (1986) and Blanchard and summers (1986) in Europe. The issue is to whether real output is essentially independent of monetary policy. The natural rate hypothesis proved to have a positive result, that is the real output growth is boost up by more rapid growth nominal demand. In fact nominal GNP growth has been rapid in Europe during the 1970’s and 1980’s than during 1950’s and 1960’s yet these most recent period to show high unemployment and reduced in real growth.

Kydland-Prescott (1977) example is used to illustrate a discretionary monetary policy as a result of producing more inflation that would create no additional employment. The use of a specific monetary base as controllable instrument for each period will keep nominal aggregate demand growing smoothly and at a non stationary rate. The rule of monetary base has worked well in the United States (US) over the period 1954-1985.

Carlson (1978) suggest a new modified version of the St Model, he suggested that the equation to be used in the first difference form. Taking into consideration of using an equation in first difference form Carlson, Ubogu (1985) modify the original version of the St Model as follows:

GDPt = αt + β1 Mt + β2 Gt + µ

GDPt = changes in the gross domestic product.

Mt = Changes in the money supply (M2)

Gt = Changes in the government expenditure.

µ = error term.

Ubogu (1985) make use of the new version of the St Model as above using fifteen African countries. He concluded that monetary policy was better to target middle income earners countries While fiscal policy to low income earners countries. David Orsmond (1992) adopted the principles of Ubogu (1985) and applies the above equation in Sub-Saharan countries and made the same conclusion.

Aigbokhan (1991) tested how monetary policy will affect Nigeria making use of the original version of St Louis model. He concluded that in Nigeria fiscal policy was more effective. However monetary policy had negative impact on society. Therefore he implies that Nigeria monetary policy is not so effective for economic stabilization.


In this chapter there has been a review of the theoretical and empirical review. Many researchers have done studies on the monetary policy and economic growth in different countries and has made different conclusion. So the views in Mauritius will be done in the chapter 5 of the dissertation on how the monetary policy will have impact on the Mauritian economy.


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