Keynesians vs monetaristsA Granger Causality match

Guy Lion April 2006

Hey Keynes, your [Tax] Cuts

are no uppercut.

Milton, where is your [Money]

Velocity?

I am Clive Granger who

decides Causality

2

Introduction

We will use Granger causality to referee a match in economic theory between Keynesians and monetarists.

Both claim their respective tools are best to manage GDP. We will test which tools better “Granger cause” quarterly

GDP changes.

3

Keynesian economics

John Maynard Keynes (1883 – 1946) stated that a counter-cyclical fiscal policy was effective in managing the business cycle.

This means running a Budget Deficit when the economy is decelerating. And, running a Budget Surplus when economy is accelerating.

Keynes suggested government (net) spending affected aggregate demand without affecting price (inflation).

4

Monetarism

Milton Friedman (1912 - ) stated the Money Supply has a direct impact on economic growth and inflation.

Milton relied on Irving Fisher’s (1867–1947) Quantity Theory: MV = PQ or Money Supply x Velocity of Money = Price x Quantity.

The best way to manage the economy is to target a conservative Money Supply growth and stick to it. This way, you control inflation.

5

Keynesians vs Monetarists fighting stands

Keynesians do not believe monetary variables (M1, M2, M3) affect macroeconomic variables (GDP, CPI). This may be due to change in Velocity of Money being a countervailing force to change in Money Supply. Thus, for them “money does not matter.”

For monetarists, fiscal policies are not effective because interest rate is a countervailing force to fiscal stimulus (the “crowding out” theory). And, because of the Quantity Theory [MV = PQ] Money Supply does have a direct impact on macroeconomic variables (GDP, CPI). Thus, for them “money is everything.”

6

A Budget Deficit proxy variable

Budget Deficit data is annual. That’s a problem. As an alternative we looked at Treasury levels from one

quarter to the next. Disaggregate Interest refinancing from Deficit financing

as shown below.

10 yr rate 10%

DeficitTreasury Increase Interest Deficit financing

levels in T level refinancing financing in %Q1 1000Q2 1050 50 25 25 2.5%

7

Granger Causality review

1. Develop a Base case autoregressive model using dependent variable and its lagged values as independent variable.

2. Develop a Test case model by adding a second lagged independent variable you want to test.

3. Calculate the square of the residual errors for the two models and run a t test (unpaired) to check if the residuals are significantly lower when you add tested second variable. [We will run the non-parametric Mann-Whitney test to observe P value differences].

4. Redo steps 1 through 3, but reverse the direction. By comparing the tests significance or P value, you can see if A Granger causes B more than B Granger causes A.

We will skip step 4 because we are not interested on whether GDP impacts fiscal or monetary policies, but on whether fiscal or monetary policies have a greater impact on GDP.

8

Selecting the lagged variable for GDP

Data source: quarterly data since second quarter 1959 to 3d quarter 2005. Source: BEA (GDP), Flow of Funds (Treasury -> Deficit Financing), Federal Reserve (M2).

Correlation with quarterly GDP

KeynesDeficit Milton

financing M2Spot (0.03) 0.10 Lag 1 Q 0.17 0.17 Lag 2 Q 0.29 0.26 Lag 3 Q 0.15 0.21 Lag 4 Q 0.10 0.14

9

Granger Causality GDP Output

Keynes or Milton Granger causing GDP growthBase Test model

Model Keynes MiltonRegression statisticsMultiple R 0.212 0.361 0.319R Square 0.045 0.131 0.102Adjust. R Square 0.040 0.121 0.092Standard Error 0.008 0.008 0.008Observations 184 184 184

t testAvg. residual square 7.0E-05 6.4E-05 6.6E-05p value 62.8% 75.2%

Mann-Whitney testDifference in avg. rk -4.4 6.4p value 69.4% 56.5%

P values for both test models are too high.

In the Mann-Whitney test, the Milton model is going in the wrong direction. The avg. rank went up. That’s bad.

10

Keynes vs Milton slugfest

Keynes vs Milton. A direct comparison of squared residuals

Keynes Miltont testAverage Square residual 6.41E-05 6.62E-05Difference in " " " -2.12E-06P value 86.5%Confidence Keynes is better 13.5%

Mann-Whitney testAverage rank 179 190Difference in avg. rank -11P value 32.3%Confidence Keynes is better 67.7%

11

Conclusion

[Milton to Granger] I feel tired right now.

Keynes wins by Granger

causing decision.