Monetarist paradox

The Monetarist Paradox is a concept that has its roots in classical monetary economics and runs counter to Keynesian monetary theory. It can be stated as follows: An easy money policy leads (in the long run) to high (nominal) interest rates, and vice versa.

## Contents

* 1 Explanation of the process
* 2 Definition
* 3 Evidence
* 4 Origins
* 5 References

## Explanation of the process

The concept was clearly adumbrated by Milton Friedman by combining the expectations augmented Phillips curve, based on the natural rate hypothesis, with the Fisher equation for the determination of nominal interest rates.  In his Presidential Address in December 1967 to the American Economic Association, he stated, “Paradoxically, the monetary authority could assure low nominal rates of interest - but to do so it would have to start out in what seems like the opposite direction, by engaging in a deflationary monetary policy.”[1]

When the central bank lowers its policy rate, that increases demand through various channels, pushing the economy below the natural rate of unemployment and actual output above its potential. This in turn pushes up inflation.  In response to the rise in inflation, market interest rates will tend to rise due to the Fisher effect.  To prevent further overheating of the economy and to restore demand to a normal level the central bank will then be compelled to raise the policy rate higher than the original starting rate.  Thus the easy money policy which lowered the nominal rate in the short run raised it in the long run, which is the paradox. This fundamental and vital paradox, going back to earlier centuries and that has shaped current central bank policies, should not be confused with other propositions and paradoxes bearing the same name.

## Definition

The term itself was coined by economist Vivek Moorthy in a co authored study of debt stability (2000).[2] This phenomenon has been discussed and/or the expression used in various publications, even earlier (1995,[3] 2004,[4] 2007,[5] 2016[6]).  In correspondence, Milton Friedman stated that, “ I have not myself seen the phrase “monetarist paradox” used to refer to the phenomenon that easy money makes for high interest rates, but it does seem a reasonably apt description”(2005).[7]

## Evidence

The scatter plot below of the average discount rate of select, developed country central banks against the Alesina-Summers[8] index of central bank independence (x-axis) provides strong evidence globally over two decades in favour of the phenomenon. Germany and Switzerland with the most independent central banks that follow tight money policies have the lowest rates in the chart below, while Italy, with the least independent central bank has the highest interest rate.

Source: Vivek Moorthy, October 2016, Economic and Political Weekly, 51(40), 33–39.[6] https://www.jstor.org/stable/44165759 (Refer in case the image is not clear)

## Origins

Prior to Milton Friedman, two leading monetary economists had discussed the process.  First, Irving Fisher in his Appreciation and Interest (1893),[9] citing an anonymous pamphlet from Boston, 1740 of an anonymous Boston tea planter and second Sir Dennis Robertson (1937).[10] Second, Sir Dennis Robertson, formidable critic of Keynes’ liquidity preference theory of interest.  In his review essay of Keynes’ General Theory, Robertson wrote, “Marshall’s explanation of the paradox is given in a famous sentence: “the increase of currency increases the willingness of lenders to lend in the first instance, and lowers the rate of discount. But afterwards it raises prices and therefore tends to increase discount.”

## References

1. ↑ Friedman, Milton (1968). “The Role of Monetary Policy.” American Economic Review, 58 (March), 1–17. Presidential Address to the American Economic Associations, 31 December 1967.
2. ↑ Moorthy, Vivek, Bhupal Singh, and Sarat Chandra Dhal (2000). “Bond Financing and Debt Stability: Theoretical Issues and Empirical Analysis for India.” RBI Department of Economic Analysis and Policy, Development Research Group Study No. 19, June. Sec. I.2.1, Pg. 14, item (iii).
3. ↑ Moorthy, Vivek (1995). “Why Gentlemen Still Prefer Bonds.” The Economic Times, July 24. S. Venkitaramanan, Rejoinder to “Should we Prefer Bonds or Money?” The Economic Times, August 9th.
4. ↑ Moorthy, Vivek (2004). “India’s Primary Deficit and Interest Payments Burden: An Assessment.” Economic and Political Weekly, 39 (26), 2711−2717.
5. ↑ Moorthy, Vivek (2007). “Legacy of Friedman versus Keynes.” Business Line (The Hindu Group of Publications), November 16.
6. ↑ 6.0 6.1 Moorthy, Vivek (2016). “Selective Memoirs: Reserve Bank of India Has Far More Autonomy Than Scrutiny.” Economic & Political Weekly, 51 (October 1), 33–39.
7. ↑ Friedman, Milton (2005). Reply to Letter from Vivek Moorthy, Hoover Institution Library and Archives, Box 161, Folder 11.
8. ↑ Alesina, Alberto, and Lawrence H. Summers (1993). “Central Bank Independence and MacroeconomicPerformance: Some Comparative Evidence.” Journal of Money, Credit and Banking, 25 (May), 151–162.
9. ↑ Fisher, Irving. Appreciation and Interest: A Study of the Influence of Monetary Appreciation and Depreciation on the Rate of Interest with Applications to the Bimetallic Controversy and the Theory of Interest. Publications of the American Economic Association, Vol. XI, No. 4. New York: Macmillan, 1896.
10. ↑ Robertson, D. H. “Mr. Keynes and the Rate of Interest.” The Economic Journal, Vol. 47, No. 186 (June 1937), pp. 294–309, reprinted in Essays in Money and Interest, The Philips Park Press, 1956, Chap. 13, Pg. 170.

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