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Given the compulsions for an accelerated rate of development and the peculiar monetary and financial structure, the principal question is whether monetary policy matters for the economy or not. The various schools of thought have provided diversified answers to this question.
Before the Great Depression of the 1930s, the classical theory, which is based on the assumption of a laissez-faire economy, emphasized the importance of monetary policy. The classical theory did not advocate government intervention. In the classical tradition, money was treated as a veil—determining only the nominal values of macroeconomic aggregates like output—without affecting real economic activity, which was driven by real factors such as capital stock, productivity, and technology.
Thus, money was considered a reflector rather than a regulator of economic activity. The classical view is encapsulated in the well-known equation of exchange:
MV = PY
Where, M is the money supply, P is the general price level, Y is aggregate output, and V is the income velocity of money.
This equation of exchange is an identity or tautology. It states that the total value of payments (MV) must equal the total value of sales (PY). All variables except the price level are determined elsewhere: output in the real sector by non-monetary factors, money stock by policy makers, and velocity by institutional settings.
Under these assumptions, when the money supply increases, individuals attempt to dispose of excess balances. Given a constant velocity and full employment output in the short run, the entire impact of increased money supply is seen in a rising price level, leaving real economic activity unchanged.
In the classical doctrine, the interest rate is a non-monetary phenomenon, influenced by forces of productivity and thrift. According to the classical theory, economic goals like increased output, employment, and price stability can be achieved only through adjustments in the money supply. Hence, monetary policy is considered highly effective in the classical framework.
After the Great Depression in the 1930s, the Keynesian theory brought a major revolution in economic thought. It was based on the theory of effective demand, asserting that there is not always full employment in the economy and that equilibrium can be achieved through various policy interventions.
The Keynesian model acknowledged that wages and prices were not rigid, but argued they did not adjust effectively to clear the labour market. It emphasized the stickiness of money wages and the failure of market participants to perceive real wages accurately. As a result, the labour market does not remain in continuous equilibrium at full employment.
The key proposition of Keynesian monetary theory is that changes in money supply affect the level of economic activity indirectly—through changes in the interest rate and subsequently in real investment.
According to Keynes, the economy is generally below full employment, so merely adjusting the money supply does not ensure increases in output, employment, or price stability.
The Keynesian demand for money had significant implications for monetary policy. Two critical factors for its effectiveness were the interest elasticity of money demand and the initial economic conditions.
Keynesian economics opposed reliance on monetary policy and advocated for fiscal policy as the more influential tool for affecting the real economy. This theory was widely accepted from the post-Depression era until the 1950s.
In the late 1950s, the Phillips Curve emerged, establishing a short-run relationship between inflation and unemployment, reinforcing confidence in Keynesian demand management.
However, during the 1960s, persistent fiscal deficits increased inflationary pressure without corresponding gains in employment. Milton Friedman demonstrated that in the long run, there is no trade-off between inflation and output.
Therefore, Keynesian policies were found ineffective in the long run, disqualifying them as suitable for long-term monetary development strategy.
In the early 1970s, the Monetarist School rose to prominence, suggesting that the economy has a natural level of output and employment determined by capital stock, technology, productivity, and institutional settings.
They argued that the Phillips Curve is valid only in the short run. A key idea was the stability of the money demand function, which implies a predictable velocity of money. If velocity is stable, changes in money stock would result in predictable changes in nominal income.
In the post-1970s, economists like Thomas Sargent and Neil Wallace developed the rational expectations theory. They argued that systematic government intervention through seigniorage cannot have a lasting impact on real output.
In the rational expectations framework, monetary policy affects output only if actions are unanticipated. In the long run, all agents anticipate government actions, nullifying the trade-off between money supply and output.
Hence, money supply cannot influence real output in the medium to long run.
During the 1980s, the New Keynesians reasserted the short-run trade-off between money supply and output by identifying causes of price rigidity—including the efficiency wage theory, insider–outsider dynamics, menu costs, and monopolistic competition.
This theory, with strong microeconomic foundations, acknowledges the need for government intervention. In an imperfectly competitive world, where output is lower and prices are higher than under perfect competition, social welfare is adversely affected without intervention.
Hence, both fiscal and monetary policies have a justified, active role in promoting real economic growth.
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