Sunday, July 28, 2013

A Brief History Of Monetarism Versus Fiscal Policy

Milton Friedman claimed that the Great Depression could have been avoided if the Fed had not let the money supply shrink.  He did not believe that we needed a very active Fed since it was only necessary in his view to have the money supply grow at the same rate as the economy.  Even more importantly, according to Friedman and his conservative colleagues, we did not need a very active government using fiscal policy to moderate the business cycle.  Friedman, after all, was totally opposed to Keynesian theory which supported the use fiscal policy during the Great Depression.  Moreover, conservatives were generally opposed to many of the views expressed by Keynes in his General Theory which was a critique of classical economics.

The recovery of the US economy, that resulted from the military buildup before and during WW ll, provided empirical support for Keynesian theory.  The first battle in the war between monetarists and supporters of Keynes went to Keynes.  The war was not over, however.  Stagflation in the early 70's was difficult to explain with Keynesian theory.  We were not supposed to have inflation during periods of high unemployment.  This led to a compromise between monetarists and supporters of Keynes.  The so called New Keynesian's accepted classically inspired microeconomics as the foundation for macroeconomics, and they viewed monetary policy as the first line of defense against a bad business cycle.  Friedman's monetarism died a natural death but the Fed successfully employed the management of interest rates during the period of that has been called The Great Moderation that began in the 1980's and lasted until the Great Recession.  The management of interest rates replaced the management of the money supply.

The Fed has actively used monetary policy during the Great Recession to reduce interest rates.  Short term nominal interest rates are close to zero and real short term interest rates are negative.  We have reached the zero lower bound in which nominal interest rates cannot fall any further but the economy has been slow to recover.  This has led the Fed to use unconventional monetary policies to manage the economy.  They have not been terribly effective in stimulating the economy, but political resistance to the use of fiscal policy means that it is the only weapon available.  That is why many economists support the Fed's policies despite the arguments by conservatives that they will destroy the economy.  They believe that government policies are responsible for our slow recovery.  If the government would just get out the way, market forces would lead to a strong recovery.  Keynes is dead but Milton Friedman still lives in their economic philosophy.

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