Model Answer
0 min readIntroduction
Monetarism, a school of thought in economics, emphasizes the crucial role of money supply in influencing macroeconomic activity. A central tenet of monetarism is the Quantity Theory of Money, which posits a direct relationship between the quantity of money and the price level. However, the strength of this relationship is contingent upon the stability of money demand. The interest elasticity of demand for money measures the responsiveness of money demand to changes in interest rates. If this elasticity is low, monetarists believe that predicting real Gross National Product (GNP) becomes significantly simpler by solely focusing on the money supply.
Understanding Interest Elasticity of Demand for Money
The interest elasticity of demand for money (Ed) indicates how much the quantity of money people want to hold changes in response to a change in interest rates. It is calculated as the percentage change in money demand divided by the percentage change in interest rates.
- High Interest Elasticity (Ed > 1): A small increase in interest rates leads to a large decrease in money demand. People are very sensitive to interest rate changes and prefer to hold less cash and more interest-bearing assets.
- Low Interest Elasticity (Ed < 1): A change in interest rates has a relatively small impact on money demand. People are less sensitive to interest rate changes and maintain a relatively stable amount of money holdings.
The Link Between Low Elasticity and GNP Prediction
Monetarists, like Milton Friedman, argue that if the interest elasticity of demand for money is low, the demand for real money balances (M/P, where M is money supply and P is price level) is relatively stable and predictable. This stability stems from the fact that changes in interest rates have a limited effect on how much money people choose to hold. The Quantity Equation of Exchange is expressed as: M * V = P * Y, where:
- M = Money Supply
- V = Velocity of Money (assumed constant or predictable by monetarists)
- P = Price Level
- Y = Real GNP
If V is stable (a key monetarist assumption) and Ed is low (making M/P stable), then changes in the money supply (M) will directly and predictably affect nominal GNP (P * Y). Since V is assumed stable, changes in nominal GNP will largely translate into changes in real GNP (Y). Therefore, by observing changes in the money supply, monetarists believe they can accurately forecast real GNP.
Why Low Elasticity Matters
When Ed is high, changes in interest rates can significantly alter money demand, making it difficult to isolate the effect of money supply on GNP. For example, if the central bank increases the money supply, but interest rates rise sharply (due to increased money demand), the impact on GNP may be muted or even reversed. However, with a low Ed, the interest rate effect is minimized, and the money supply changes have a more direct and predictable impact on GNP.
Historical Context & Limitations
The monetarist school gained prominence in the 1970s during periods of high inflation. However, the relationship between money supply and GNP proved less stable in subsequent decades, particularly with financial innovations and changes in the structure of financial markets. The rise of complex financial instruments and deregulation made it harder to control and predict the money supply effectively. The Lucas Critique (1976) also challenged the idea of stable relationships in macroeconomic models, arguing that people's expectations adjust to policy changes, rendering simple money-GNP relationships unreliable.
Conclusion
In conclusion, the monetarist prediction of real GNP based solely on money supply hinges on the assumption of a low interest elasticity of demand for money. This low elasticity ensures a stable money demand, allowing changes in the money supply to directly translate into changes in nominal and, consequently, real GNP. However, the empirical evidence supporting this relationship has been mixed, and the complexities of modern financial systems have challenged the simplicity of the monetarist view. While the theory remains influential, its practical application requires careful consideration of evolving economic conditions.
Answer Length
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