Monetarism, a term first used by Brunner in 1968, can be understood in two ways. The first relates to the economic thought that sees in the quantity of money the major source of economic activity and its disruptions (especially inflation), as well as believing that targeting the growth of money supply is the best monetary policy. Secondly, it refers to a large group of economists adherent to these thoughts, lead by Milton Friedman and the Chicago School of economics.

This paradigm, which gained popularity in the 1960s, relates closely to neoclassical economics, believing that free flow of credit and interest rates, as well as a laissez faire attitude is the best way to go, since limited public intervention and a competitive economic system will grant better results than those resulting from Keynesian economics. However, since monetarists consider monetary policy more effective, government control over money supply is required. Also, since monetarists believed in the importance of the quantity of money, the equation of exchange regained popularity.

Monetarists view fiscal policy less effective than monetary policy because of the low interest elasticity of money demand. Therefore, when using the IS-LM model, monetarists consider the IS curve more elastic than the one used by Keynesians, and a LM curve more inelastic. This is the reason why, when using the monetarist’ IS-LM model, public investment created by fiscal policy creates a crowding out effect over private investment, reducing the effectiveness of public spending. However, even though monetary policy is more reliable, its effects may take a while to be noted in the economy, and therefore its implementation can be difficult.

Concerning the Phillips curve, monetarists criticise the money illusion implied in it, which is the basis for the relationship between inflation and unemployment. They believe that, given an unanticipated higher inflation and the subsequent decrease in unemployment, the trade-off shown in the Phillips curve will hold. However this will not be the case when monetary policies are anticipated, implying that the trade-off between inflation and unemployment does not apply in the long run. This is a clear example of the learning process introduced in the Adaptive Expectations hypothesis, firstly formulated (though not under its widely known name) by Irving Fisher in his article “The Purchasing Power of Money”, 1911, and popularized by Phillip Cagan in 1956 and by Friedman, in his paper “The Role of Monetary Policy”, 1968, where he also introduced the concept of natural rate of unemployment, which is the rate that the economy will reach after each movement along the Phillips curve. It must be highlighted that, contrary to New Classical Macroeconomics studies and its Rational expectations hypothesis, monetarists believe that the trade off can be systematically exploited in the short run, as long as each policy is unanticipated.

Given the low effectiveness of fiscal policy as well as the risks of high inflation caused by systematic monetary policies, monetarists defend a commitment by the monetary authorities to steady monetary growth, and reject discretionary and politically driven monetary policies, because of the uncertainty they create.

Generally, if the price of something goes down, we buy more of it. This is down to two effects:

• Income effect: because it’s less expensive, we have more purchasing power because it is a smaller drain on our personal finances.
• Substitution effect: because it offers more utility per unit of money, other alternatives become less attractive.

What Eugen Slutsky managed to do was find an equation that decomposes this effect based on Hicksian and Marshallian demand curves.

Graphically:

Mathematically, it is based on the derivatives of Marshallian and Hickisan demands:

The left hand side of the equation is the total effect- that is, the derivative of x (quantity) respect p (price). It shows us how much the total quantity of x that we consume varies when we change price. The next part is the substitution effect- how much the variation is due to us finding similar options. It is obtained from the derivative of the Hicksian demand with regards price. The right hand side is the income effect, how much changes in our purchasing power affect the amount we consume of a certain good. It is the derivative of the Marshallian demand with regards wealth (multiplied by the quantity).

Whether the SE and the IE are positive or negative when prices rise depends on the type of good:

It is not always possible to tell what the total effect will be- if we are talking about inferior complementary goods, for example, the SE and the IE pull in opposite directions. The TE will depend on which effect is stronger.

Video – Income and substitution effects:

Revealed preference theory is attributable to Paul Samuelson in his article “Consumption Theory in Terms of Revealed Preference”, 1948. Consumer theory depends on the existence of preferences which materialise into utility functions. These utility functions are maximised by consumers subject to a budget restraint. The issue is that it is difficult to accept that individuals really have a definite mathematical formula in mind when choosing between different options. What revealed preference theory does is work backwards to assume that we can deduce these utility functions from consumer behaviour. Analysing these choices leads us backwards to a set of preferences that influences the choices they make. It therefore allows economists to study consumer behaviour empirically.

There are two main axioms to the theory, both based on completeness and transitivity:

WARP (Weak Axiom of Revealed Preference): If A is revealed preferred to B (A RP B), then it must be so in every case. That is, if a consumer ever chooses B, then we must assume that A was previously chosen and that the budget constraint had enough ‘left over’ to allow a consumer to choose B as well.

SARP (Strong Axiom of Revealed Preference): This adds transitivity. If there are only two goods, then it is clear that WARP already defines a consumer’s choice: A over B. However, the SARP adds the idea of indirectly revealing preferences: if A is chosen over B and B over C, SARP and transitivity dictate that A is also preferred to C, so A is indirectly revealed to be preferable to C (A R* C). This drastically reduces the amount of empirical evidence necessary to define consumer preferences.

In the case shown in the figure below, we know that C is indirectly preferred to B (C R* B) because it allows us to reach a higher utility curve. Because C and B define a space (R*), and we know that C, B and A are contained within R*(R*{(C,B)}), then we can say that C RP A RP B, that is, by knowing from observation that C is indirectly preferred to B, we can tell that C is revealed as preferable to A (C RP A) and that A is revealed as preferable to B (A RP B).

If we think of A, B and C as infinitely complex bundles of goods, we can map out all a consumer’s choices. In theory, we can track this backwards to actually build utility functions if we have access to unlimited data. Without actually having to do this, we can aggregate consumer data to reveal general truths about a certain population’s preferences.

Video – Revealed preference:

Characteristics demand theory states that consumers derive utility not from the actual contents of the basket but from the characteristics of the goods in it. This theory was developed by Kelvin Lancaster in 1966 in his working paper “A New Approach to Consumer Theory”.

This approach allows us to predict how preferences will change when we change the options or baskets presented to consumers by studying how these vary according to the change in the characteristics that make them up. With conventional theory, the introduction of a new option meant that we could not reliably predict how this would slot into the consumer’s preference map. However, by relying on a study of the characteristics rather than the goods or service involved, we can predict how changes will affect a consumer’s behaviour without needing to start once again empirically.

This allows us to calculate ‘shadow prices’ for different attributes without having a price for the good itself by associating utility to the characteristics that make up the good rather than the good itself. With these ‘shadow prices’, we can solve utility maximisation problems for baskets or options for which we do not have empirical evidence, as Lancaster demand also lends itself to building utility functions (based on the amount of each type of characteristic rather than the amount of each type of good in a particular basket).

Characteristic demand theory also helps justify the existence of brands. Luxury brands are able to charge a surprice for their products by differentiating themselves from competitors that sell similar goods. In the first diagram, if we suppose that both brands have the same characteristics and are perfect competitors, then we will choose the basket that maximises our total consumption. This means will tend to opt for the cheaper brand, which allows us to reach the highest utility curve: for a given amount of money, we are able to buy either a certain amount of brand 1 (point B) or a certain amount of brand 2 (point A). We choose A since it’s on a higher indifference curve. Point C represents a higher utility curve achieved by a drop in the price of brand 1. However, even though brand 1 got cheaper, we’ll still consume A, since it remains on a higher indifference curve.

In the second diagram, if we look at Lancaster demand, our utility functions will be based on the characteristics that each basket contains rather than on the amount of each type of good. Here, it is no longer ‘all or nothing’- we can allow for convex demand curves that represent our preference for variety in consumption: point C. This time, if the price of one brand drops, we will change our outcome: we can opt for point D.

Video – Characteristics demand:

Price indices are used to monitor changes in prices levels over time. This is useful when separating real income from nominal income, as inflation is a drain on purchasing power. The two most basic indices are the Laspeyres index (named after Etienne Laspeyres) and the Paasche index (named after Hermann Paasche).

Both indices are very similar:

They work by dividing expense on a specific basket in the current period (the sum of p*q for each product in the basket considered when calculating the index) by how much the same basket would cost in the base period (period 0). The main difference is the quantities used: the Laspeyres index uses q₀ quantities, whereas the Paasche index uses period n quantities.

What this translates to is that a Laspeyres index of 1 means that, as the nominator is the same as the denominator, an individual can afford the same basket of goods in the current period as he did in the base period. As the quantities are the same, this just leaves price as a variable, which must remain unchanged. This translates to the concept of compensated variation (CV): by how much do we need to increase an individual’s income in order to offset inflation? This is, at the new level of prices, how much is required to compensate the effect of the price increase? In the top diagram, we see that an increase in the price of good x₁ means a move to a lower utility curve. The compensated variation is the theoretical amount of money the individual would need to maintain their level of utility, putting them back on their original utility curve.

What we can also see is that the Laspeyres index overestimates this CV: it assumes that inflation has a greater effect than it does. This can be more clearly seen in the bottom diagram. The change in price from P₀ to P₁ leads to a change in the quantity of X consumed from X₀ to X₁. The green rectangle shows the Laspeyres effect associated with this, which is greater than the CV effect. The CS effect, the dark blue trapezoid, shows the loss of consumer surplus associated with the price variation.

A Paasche index of 1 means that the consumer could have afforded the same bundle of goods in the base period as they can now. This can be translated to the concept of equivalent variation (EV): how much income would we have to take away from an individual, at the base price level, to have the same impact on their utility as the inflation between the base period and period 1? That is, if we took the individual’s utility in 2009 at that price level, how much would we have to take away from it to have the same utility as a person on the same income with 2012’s level of prices? Applying the same dynamic we applied to the Laspeyres index, we can see from the top diagram that the Paasche index underestimates the equivalent variation.

We can see this more clearly in the bottom diagram: the consumer surplus is greater than the variation effect, which is in turn greater than the Paasche effect.

If we put this all together, it may be easier to understand each of the effects and understand their downisdes:

These diagramas are simply a combination of the two we saw individually. They help us, however see the differences between both indices. The main downside to these indices is the fact that they do not take into effect substitution effects. When the price of something rises, we tend to consume less of it. Because the Laspeyres index uses base period quantities, it tends to overestimate inflation by assuming that individuals’ income expense is still distributed in the same way. The opposite is true of the Paasche index: because it uses current period quantities, it underestimates inflation.

Therefore, for normal goods, if inflation exists:

Marshallian and Hicksian demands stem from two ways of looking at the same problem- how to obtain the utility we crave with the budget we have. Consumption duality expresses this problem as two sides of the same coin: keeping our budget fixed and maximising utility (primal demand, which leads us to Marshallian demand curves) or setting a target level of utility and minimising the cost associated with it (dual demand, which gives us Hicksian demand curves). We must also look at the Lagrangian functions where we obtain the first derivatives.

This leads us to the main difference between the two types of demand: Marshallian demand curves simply show the relationship between the price of a good and the quantity demanded of it. Hicksian demand curves show the relationship between the price of a good and the quantity demanded of it assuming that the prices of other goods and our level of utility remain constant.  This makes sense when we look at consumption duality: for dual (Hicksian) demand, we maintain a fixed level of utility, and so our level of wealth, or income, must remain constant. We simply cannot be as satisfied if we do not maintain equal purchasing power.

Marshallian and Hicksian demand curves meet where the quantity demanded is equal for both sides of the consumer choice problem (maximising utility or minimising cost). For prices above this equilibrium point, consumer wealth is higher with Hicksian demand curves than Marshallian demand curves, because to maintain utility constant, Hicksian demand curves assume real wealth remains unchanged. Marshallian demand assumes only nominal wealth remains equal. The opposite is true for prices below this point: Marshallian demand assumes that as nominal wealth remains the same but price levels drop (negative inflation), the consumer is better off. Hicksian demand assumes real wealth is constant, so the individual is worse off. This is why Marshallian demand curves are more ‘stable’: they reflect both rent effect and substitution effect. Hicksian demand curves only show substitution effects (utility is constant, therefore rent must remain constant), which means that demand varies with price only because other options become more attractive.

Formally,

For an individual problem, these are obtained from the first order conditions (maximising the first derivatives) of the Lagrangian for either a primal or dual demand problem.

Marshallian demand makes more sense when we look at goods or services that make up a large part of our expenses. Here, the income effect is very large. However, for smaller purchases, we are willing to spend more or less any amount as long as we derive the utility we expect to.

Video – Marshallian and Hicksian demand curves:

Video – Consumption duality:

Cost minimisation is a way of solving the optimisation problem regarding the utility function and the budget constraint, even though the most common way of doing this is by means of utility maximisation.

If we think about it, we don’t normally have a fixed budget for most purchases. We have a certain utility we expect to derive from them and we hope to spend as little as possible on them (but we don’t have a maximum budget).

In this case, it is utility that is fixed as a restriction, and cost that we can play around with. It’s like solving the consumer’s choice problem in a mirror image way to utility maximisation, and is associated with Hicksian demand curves.

The way we resolve this minimisation problem is very similar to utility maximisation, and is also done with a Lagrangian system, since there is a duality in consumption. In this case, we want to minimise our budget for a given utility:

Video – Cost minimisation: