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4.1 Introduction

During the 1950s and up to at least the mid- to late 1960s Keynesian economics,

which came to be epitomized by the Hicks–Hansen IS–LM model, was

the dominant force in the development of macroeconomics in terms of both

theorizing and policy prescriptions. As one leading critic of Keynesian economics

has admitted, in the late 1960s the Keynesian model ‘seemed to be

the only game in town in terms of macroeconomics’ (see Barro, 1984). A

central theme of Keynes’s General Theory is the contention that capitalist

market economies are inherently unstable and can come to rest at less than

full employment equilibrium for prolonged periods of time. This instability

was, in Keynes’s view, predominantly the result of fluctuations in aggregate

demand. In the mid- to late 1940s and the 1950s the then-prevailing Keynesian

orthodoxy emphasized real disturbances (notably fluctuations in investment

and autonomous consumption) as the main cause of fluctuations in money or

nominal income, predominantly in the form of changes in real income. To the

early Keynesians, the Great Depression had resulted from a sharp fall in the

level of investment with the associated severe unemployment reflecting a

state of deficient aggregate demand. This contrasted with the earlier quantity

theory of money (QTM) tradition that viewed changes in the money stock as

the predominant, though not the only, factor explaining changes in money


During the 1950s and 1960s, Milton Friedman, more than any other economist,

was responsible for reviving the fortunes of the quantity theory of money.

In 1968 Karl Brunner famously gave the label of ‘monetarism’ to the ideas of

those economists, particularly Friedman, who adhered to the quantity theory of

money. The quantity theory of money is the central plank to monetarism and

this idea is, according to Mark Blaug, ‘the oldest surviving theory in economics’

Blaug et al. (1995). In a reasonably coherent form, the quantity theory of

money stretches back over at least 300 years to John Locke’s Some Considerations

of the Consequences of the Lowering of Interest and Raising the Value of

Money published in 1692 (see Eltis, 1995). However, David Hume’s classic

essay, Of Money, published in 1752, is widely recognized as perhaps the most

sophisticated early statement of the quantity theory of money. According to

Mayer (1980), most of the fundamental propositions of monetarism date back

to this essay. Thereafter, the quantity theory of money was accepted and developed

throughout the nineteenth and early twentieth centuries by many notable

economists, including David Ricardo, Alfred Marshall, Irving Fisher and, at

least up until 1930, Keynes himself. As Blaug notes, ‘Keynes began by loving

it but ended up by hating it’ (see Blaug et al., 1995).

The main purpose of this chapter is twofold. First, to trace the historical

development of orthodox monetarism (see Figure 4.1) beginning with the

quantity theory of money approach (section 4.2) as it evolved from the mid-

1950s to the mid-1960s; through to the expectations-augmented Phillips curve

analysis (section 4.3) which was absorbed into monetarist analysis after the

mid- to late 1960s; finally to the monetary approach to balance of payments

theory and exchange rate determination (section 4.4) which was incorporated

into monetarist analysis in the early 1970s. Second, in the light of this

discussion, to summarize the central distinguishing beliefs commonly held

within the orthodox monetarist school, especially with respect to the role and

Figure 4.1 The evolution of orthodox monetarism

The orthodox monetarist school 165

conduct of stabilization policy (section 4.5) and to reflect on what remains

today of the monetarist counter-revolution.

Before examining the QTM approach to macroeconomic analysis we should

note the key role played by Friedman in what came to be known as the

‘monetarist counter-revolution’ (see Johnson, 1971; Snowdon and Vane, 1996,

1997b). Unlike the majority of economists, Friedman is well known outside

academic circles, a characteristic he shares with Keynes. Together with Keynes,

Friedman has probably influenced macroeconomic theory and policy making

more than any other economist in the twentieth century. This can be attributed

not only to the quality and quantity of his research output, but also to his

artistry and rhetoric in promoting a cause. In recognition of his academic

work, Friedman was awarded the Nobel Memorial Prize in Economics in

1976 for ‘his achievements in the fields of consumption analysis, monetary

history and theory, and for his demonstration of the complexity of stabilisation

policy’. There is no doubt that Friedman’s monetary analysis and his demonstration

of the limitations and dangers of discretionary stabilization policies

in a dynamic and uncertain world have influenced a whole generation of

eminent macroeconomists, most notably Robert Lucas Jr, who freely admits

his intellectual debt to his former teacher whom he describes as a ‘superb

economist’ (Klamer, 1984). Particularly influential to the generation of economists

educated in the USA since the early 1960s was the publication of the

Friedman and Schwartz (1963) volume A Monetary History of the United

States which for Lucas (1994b) played an important, ‘perhaps decisive’, role

in the 1960s debate over stabilization policy. In reflecting on the longevity of

this ‘classic’ text Lucas has commented that it would be the first book in his

suitcase if he is ever invited to Washington ‘for some reason other than

viewing cherry blossoms’. According to Lucas, Friedman was also ‘by far’

his ‘most important teacher’, suggesting that he is sure that he has read

everything that Friedman has ever written (see Lucas, 1994a). In this chapter

we shall explore many of Friedman’s achievements.