Ragbralbur
30-10-2006, 23:56
This is rough outline of a theory I am working on that links the effects of fiscal and monetary policy. Any feedback would be greatly appreciated.
In 1958, A. W. Philips derived what history would come to know as the Philips Curve. It showed that there was a negative relationship between unemployment and inflation. Unfortunately, the curve measured a cluster of years that travelled on a random walk averaging roughly zero inflation. By sheer chance, Philips had charted a system with zero expected inflation. When people began to expect positive inflation in the 1970's, the relationship broke down, and the result high inflation and high unemployment. Philips had the right idea, but his assumption that expectations remained constant created problems with his system.
In 1965, Milton Friedman and Anna J Schwartz completed incorporated the idea of expectations into the Philips model, claiming that pursuing full employment policies will result in the expectation of positive inflation and the acceleration of inflation. This was correct. They advocated keeping the money supply strictly controlled to match money demand through quantity targets. Unfortunately, the monetarist system set quantities based on the assumption that the velocity of money remained roughly constant. Similar to Philips, it was sheer chance that Friedman and Schwartz' analysis held up despite the fact that it does not account for velocity changes.
So what is the velocity of money? Basically, it is the rate at which money moves through the system. Moving through the system, in this case, means an exchange of that money for something the holder values more than the money. If there are many potential transactions in the economy, the velocity will increase. If there are few transaction possibilities, the velocity will decrease. When the velocity of money is high, the money holds more value; it is in higher demand because whoever takes possession of it is more confident in their ability to unload it for a good they desire. Similarly, a sluggish velocity will lower the demand for money. Assuming the money supply is held constant, this will increase interest rates and naturally fight inflation.
Thus, we move to the question of what determines the potential transactions in the economy. The answer is that potential transactions are determined by the degree to which government allows transactions to take place. In a completely free market system, the number of items a consumer can buy is maximized. Following that logic, so too is the velocity of money. In more restricted and regulated markets, the potential transactions have been curtailed, which results in a lower velocity. The result is that government action can create inflationary pressures that require the money supply to be held lower than it would in a free market. In turn, more regulated markets must either experience higher inflation or higher unemployment than less regulated markets, all things being equal.
Therefore, when Friedman said that "inflation is always and everywhere a monetary phenomenon", he wasn't entirely correct, just as Philips wasn't entirely correct when he chronicled the relationship between employment and inflation. So far, monetary aspects have been the best understood contributors to inflation, but it seems they are not the only ones. Each action taken by central authority creates ripples that affect both output and price level, usually to the detriment of both.
I hope to add graphs in the future.
In 1958, A. W. Philips derived what history would come to know as the Philips Curve. It showed that there was a negative relationship between unemployment and inflation. Unfortunately, the curve measured a cluster of years that travelled on a random walk averaging roughly zero inflation. By sheer chance, Philips had charted a system with zero expected inflation. When people began to expect positive inflation in the 1970's, the relationship broke down, and the result high inflation and high unemployment. Philips had the right idea, but his assumption that expectations remained constant created problems with his system.
In 1965, Milton Friedman and Anna J Schwartz completed incorporated the idea of expectations into the Philips model, claiming that pursuing full employment policies will result in the expectation of positive inflation and the acceleration of inflation. This was correct. They advocated keeping the money supply strictly controlled to match money demand through quantity targets. Unfortunately, the monetarist system set quantities based on the assumption that the velocity of money remained roughly constant. Similar to Philips, it was sheer chance that Friedman and Schwartz' analysis held up despite the fact that it does not account for velocity changes.
So what is the velocity of money? Basically, it is the rate at which money moves through the system. Moving through the system, in this case, means an exchange of that money for something the holder values more than the money. If there are many potential transactions in the economy, the velocity will increase. If there are few transaction possibilities, the velocity will decrease. When the velocity of money is high, the money holds more value; it is in higher demand because whoever takes possession of it is more confident in their ability to unload it for a good they desire. Similarly, a sluggish velocity will lower the demand for money. Assuming the money supply is held constant, this will increase interest rates and naturally fight inflation.
Thus, we move to the question of what determines the potential transactions in the economy. The answer is that potential transactions are determined by the degree to which government allows transactions to take place. In a completely free market system, the number of items a consumer can buy is maximized. Following that logic, so too is the velocity of money. In more restricted and regulated markets, the potential transactions have been curtailed, which results in a lower velocity. The result is that government action can create inflationary pressures that require the money supply to be held lower than it would in a free market. In turn, more regulated markets must either experience higher inflation or higher unemployment than less regulated markets, all things being equal.
Therefore, when Friedman said that "inflation is always and everywhere a monetary phenomenon", he wasn't entirely correct, just as Philips wasn't entirely correct when he chronicled the relationship between employment and inflation. So far, monetary aspects have been the best understood contributors to inflation, but it seems they are not the only ones. Each action taken by central authority creates ripples that affect both output and price level, usually to the detriment of both.
I hope to add graphs in the future.