INFLATION—III More Evidence For Monetary Policy

Press, Volume CIX, Issue 32303, 22 May 1970, Page 18

INFLATION—III More Evidence For Monetary Policy

'By DR MURIEL F. LLOYD PRICHARD, associate-professor of economic history, Auckland University)

In Britain, the Radcliffe Report, 1959, irgued that the Bank of England could exercise io effective control over money supply but this was not important bemuse monetary supply ioes not play a critical •ole in the economy.

What really matters is 'the liquidity position of inancial institutions and of ■rms and people desiring to oend on real resources.” In hort monetary policy does lot matter.

This view has been severely •riticised by Anna Jacobson Schwartz, collaborator with Milton Friedman in the ’mportant publication, “A Monetary History of the United States ’ 1867-1960." Roth are leading figures in the monetarist school in Chicago. Mrs Schwartz contends that the views expressed in the Radcliffe Report are not supported by experience either in the United Kingdom or in the United States. In both countries, she argues, the evidence shows that the quantity of money has a significant influence on the level of economic activity.

Mrs Schwartz illustrated the relationship between changes in the quantity of money and subsequent changes in income (which are, of course, the combination of movements in output and prices) by reference to two recent episodes in United States monetary history. Two Examples First, in 1966: from April, 1966, to January, 1967, monetary policy was contractionary. The quantity of money was not allowed to grow but over the same nine months, fiscal policy was highly expansionary. The government budget showed a 11 billion dollar deficit. Yet from October, 1966, to July, 1967, there was a sharp slowdown in production and in prices. Economists who attached importance to changes in the quantity of money declared that this was inevitable because of ’ the reduction in the money growth rate and despite the expansionary fiscal policy. The second episode began at the end of 1968 when the annual growth rate of money in the United States was reduced from 6.8 per cent to 3 per cent. For the greater part of 1967 and 1968, moneta.y policy was highly expansionary until the drastic reduction, but fiscal policy was greatly contractionary (for example, a heavy surtax on personal incomes) and the huge deficit was transformed into a surplus which continued to early 1969. Again, economists who place importance . on changes in money supply argue that inevitably there was no contraction of economic activity in 1968 or in the first half of 1969, but there would be a slow-down in the second half of 1969. In short, they declared that the effects of a high money growth rate would persist for a period after it is reversed, in raising the level of output and the rate of price rises, despite a highly contractionary fiscal policy. Thesis Supported Mrs Schwartz has also demonstrated that over much longer periods, a closer association has been proved between changes in the quantity of money and those in . money income. Thus the correlation between year-to-year changes in the quantity of money and those in income in the United State? from 1870 to 1963 is .70 and likeI wise for the United Kingdom I (omitting war years) between 1881 and 1967 is .77. I Her thesis is further supported by a study published iin November, 1968, by the

Federal Bank of St Louis in the United States which again demonstrated the close association between changes in money and in income. The authors, Andersen and Jordan, carried out a statistical test of the relative power of fiscal actions and monetary actions to predict quarterly changes in America's gross national product from the first quarter of 1952 through the second quarter of 1968 and they showed that the response of economic activity to changes in monetary supply compared with that of fiscal action is larger, more predictable and faster. The study modestly concluded that “either the commonly used measures of fiscal influence do not correctly indicate the degree and direction of such influence, or there was no measurable net fiscal influence on total spending in the test period.” Thus, various studies regarding monetary actions show that there has been a strong relationship between economic activity and measures of monetary action.

Both United States and United Kingdom experience indicate the existence of this relationship and it is significant that control of the economy through money supply has been rigorously operated in Japan and Germany.

Central Bank's Role

“The Economist” concluded its discussion of the debate ove • money supply as follows. A reasonable seeker after probable truth finds himself emerging with two conclusions. One is that it would be wiser if coutries such as Britain did no. rely so exclusively on tax changes to regulate their economies in future. The other is that central banks should be careful not to lean against the natural trend of interest rates, even temporarily. In determining whether to buy or sell government bonds, the Central Bank should not be influenced by stock market conditions and the price of those bonds. It should be influenced instead by a rule of thumb about the increase or decrease of money supply that it hopes to aim for that year. Usually the best

formula will be to try to increase money supply annually and steadily by a percentage just slightly above the rise in real gross national product at which it is assumed that the country can safely aim (except that any balance of payments deficit should be allowed to decrease interna] money supply by the amount of the deficit). When any government moves its policy in this direction, most economists should welcome the conversion. Thus the retreat from Keynes accelerates. Changes in the money supply are now considered of greater importance than fiscal policy. The debate is important to New Zealand and those who are busy attacking individual firms for price rises in particular, items biscuits canned goods, soap powders, etc., should turn their attention to an analysis of the relationship which undoubtedly exists between changes in the money supply and levels of economic activity. (Concluded)