Does money supply affect real economic variables such as investment and output (real gross domestic product, GDP) or only the nominal variables such as prices and wages? The monetarists and the Keynesians have been at it since the publication of the General Theory of Employment, Interest, and Money by John Maynard Keynes in 1936.
Milton Friedman, the founder of modern monetarism, famously predicted in the 1970s that both inflation and unemployment would rise if economic planners tried to target ever lower unemployment through discretionary monetary policy by raising money supply, because, in the long run, he argued, the economy would be at potential and prices and wages would rise as a result, but not output, leading to inflation.
The key differentiator of the 1970s experience is that there have been external negative energy supply shocks which led to higher than expected inflation and a recession which led to higher unemployment. Potential growth rate of the economy in the 1970s may have suddenly fallen because of the external negative energy supply shock, otherwise, in the short run without a negative external shock, the economy would have responded as expected to monetary expansion by lowering unemployment further and raising both growth, and inflation if the economy’s output exceeded potential requiring additional labor and capital.
Japan’s experience in both the long run and the very long run over the past two decades presents a puzzle for a monetarist: not only in the short run have real variables such as investment and output not been affected by expansionary monetary policy, but in the long and very long runs money supply has not caused inflation by raising prices and wages. Therefore, Japan’s deflation vindicates the Keynesians because they argue that government intervention through fiscal expansion is needed to lift the economy out of the deflationary mindset to restore growth after which changes to money supply in the short run would affect the economy as expected.
When an economy is left to its own devices in a deep recession or a depression without fiscal expansion to trigger investment, Keynes argued, ever lower interest rates do not provide adequate incentive to market participants to begin to invest because they do not see adequate aggregate demand for their goods and services. At some point, the interest rate targeted by the central bank would be zero (the zero bound as it is known in monetary economics), still unable to change the psychology of the investors.
The period of the financial crisis and the Great Recession of 2007-2009 has been a strong negative shock to the economy. It has once again proved, as had been the case with the Great Depression, that money supply alone cannot recover the economy in a timely manner, including in the short run, in the presence of a shock to investor sentiment, with the recovery taking nearly 7 years to approach near full employment and healthy inflation in the US. Despite an environment of monetary expansion, the reason for the long recovery has been fiscal austerity which was a mistake.
Money supply, except during large negative shocks when government intervention is needed in the form of fiscal expansion, always affects the real variables in the short run as both monetarists and Keynesians agree, and will only affect the nominal variables – prices and wages – in the long run. Most importantly, a monetary rule, contrary to the monetarist view that it always works, however, does not work during shocks to the economy, and discretionary monetary policy from the central bank would be needed as the Great Recession has demonstrated. After all, the monetarist medicine to the US economy dispensed by Paul Volcker from 1979 to 1983 was purely discretionary and had not followed a preset monetary rule, and it behooves to note here that Volcker’s monetarist contraction of money supply had plunged the US economy into a recession altering real economic variables – investment and output – and trading-off, as the Phillips curve says, higher unemployment for lower inflation in the short run.
In the already accommodative monetary policy environment despite very gradual moves to return to normalcy in the US, pro-growth fiscal policies which could bump up the potential growth rates are needed in the Group of Seven (G7) countries to return the global economy to healthy growth and inflation. A stable and gradual transformation of China to a consumption and services-based economy will also certainly help.