What Is Monetarism?
Monetarism is a school of macroeconomic thought that emphasizes the primary role of the money supply in determining economic activity and price levels. As a theory within the broader category of macroeconomics, monetarism posits that changes in the quantity of money in an economy are the chief drivers of inflation in the long run and influence aggregate demand and output in the short run. Proponents of monetarism argue that controlling the money supply is the most effective way for a central bank to achieve economic stability and promote sustainable economic growth.
History and Origin
Monetarism gained prominence in the mid-20th century, largely championed by Nobel Prize-winning economist Milton Friedman and the "Chicago School" of economics. Friedman, along with Anna J. Schwartz, published "A Monetary History of the United States, 1867–1960" in 1963, a seminal work that provided empirical evidence linking the money supply to economic fluctuations. T10heir research argued that the Federal Reserve's mismanagement of the money supply was a primary cause of the Great Depression, rather than a failure of capitalism itself. T9his challenged the then-dominant Keynesian economic theories, which advocated for significant government intervention through fiscal policy to manage economic downturns. F8riedman's influence on economic thought was recognized when he was awarded the Nobel Memorial Prize in Economic Sciences in 1976 for his contributions to consumption analysis, monetary history and theory, and his demonstration of the complexity of stabilization policy.
7## Key Takeaways
- Monetarism asserts that the money supply is the primary determinant of inflation in the long run and a key factor influencing short-term economic activity.
- Central banks, such as the Federal Reserve, should focus on controlling the growth rate of the money supply to achieve stable prices and economic stability.
- The Quantity Theory of Money (MV = PQ) is a foundational equation in monetarism, linking money supply, velocity, price level, and output.
- Monetarists generally advocate for a fixed rule for money supply growth, rather than discretionary monetary policy adjustments.
- Monetarism significantly influenced central banking practices in the late 1970s and early 1980s, particularly in efforts to combat high inflation.
Formula and Calculation
The core of monetarist theory is often represented by the Quantity Theory of Money, which is expressed by the equation of exchange:
Where:
- (M) = The total money supply in an economy.
- (V) = The velocity of money, representing the average number of times a unit of money is spent on goods and services in a given period.
- (P) = The aggregate price level (e.g., as measured by a price index).
- (Q) = The aggregate quantity of goods and services produced, often approximated by real Gross Domestic Product (GDP).
Monetarists typically assume that velocity ((V)) is relatively stable and predictable, and that in the long-run, real output ((Q)) is determined by factors like technology and resources, tending towards its natural level. Therefore, any changes in (M) primarily lead to changes in (P), indicating a direct relationship between the money supply and the price level, or inflation.
Interpreting the Monetarism
Monetarism suggests that stability in the growth of the money supply leads to stability in the economy. When the money supply grows too quickly, it results in inflation. Conversely, if the money supply grows too slowly, it can lead to deflation and economic contraction. The theory implies that policymakers should avoid discretionary interventions and instead adhere to a steady growth rate of money, often suggested to align with the economy's potential for real growth. This predictability, monetarists argue, allows markets and individuals to make informed decisions without distortion from volatile interest rates or unexpected inflation.
Hypothetical Example
Consider a hypothetical economy, "Econoland," where the central bank previously engaged in frequent adjustments to its monetary policy. One year, the central bank rapidly expands the money supply to stimulate economic activity, causing aggregate demand to surge. In the short-run, this might lead to a temporary boost in output and employment. However, under monetarist principles, if the increase in money supply outpaces the growth in real output, Econoland would soon experience rising inflation as "too much money chases too few goods." If the central bank then abruptly tightens the money supply, it could induce an economic downturn, illustrating how unpredictable shifts in monetary policy can create economic instability and contribute to a volatile business cycle.
Practical Applications
In the late 1970s, monetarist principles significantly influenced the monetary policy of the United States. Faced with high and persistent inflation, then-Federal Reserve Chairman Paul Volcker implemented policies aimed at aggressively controlling the growth of monetary aggregates, particularly M1 and M2, rather than directly targeting interest rates. T6his shift in operating strategy was largely successful in bringing down inflation, albeit at the cost of a severe recession. S5imilarly, the British government under Prime Minister Margaret Thatcher also adopted monetarist approaches to curb inflation during this period. A4lthough the direct targeting of monetary aggregates by central banks has largely been abandoned in favor of interest rate targeting, the core monetarist idea that "money matters" and that long-run inflation is a monetary phenomenon continues to inform modern central banking.
3## Limitations and Criticisms
Despite its historical influence, monetarism faces several limitations and criticisms. A significant challenge has been the instability of the velocity of money ((V)). The assumption of a stable velocity is crucial for the Quantity Theory of Money to hold true; however, financial innovation, changes in consumer behavior, and shifts in the financial system have made velocity less predictable over time. T2his unpredictability weakens the direct link between the money supply and the price level, making it difficult for a central bank to effectively control inflation by merely targeting monetary aggregates.
Furthermore, critics argue that the money supply itself is not entirely exogenous (controlled solely by the central bank) but can also be influenced by factors such as bank lending and borrowing by individuals and businesses, making it endogenous. T1his "reverse causation argument" suggests that changes in economic activity can lead to changes in the money supply, rather than solely the other way around. Other criticisms include monetarism's limited capacity to address issues like unemployment in the short term without causing price instability, and its tendency to overlook other factors influencing aggregate demand and prices, such as supply shocks or changes in expectations.
Monetarism vs. Keynesianism
Monetarism stands in contrast to Keynesian economics, the other major school of macroeconomic thought that dominated much of the 20th century. The fundamental difference lies in their approach to economic stabilization:
| Feature | Monetarism | Keynesianism |
|---|---|---|
| Primary Focus | Control of the money supply by the central bank. | Government intervention through fiscal policy (government spending and taxation). |
| View on Stability | Market economies are inherently stable; instability arises from erratic monetary policy. | Market economies are inherently unstable and prone to recessions; government intervention is necessary. |
| Inflation Cause | Too much money chasing too few goods (monetary phenomenon). | Excessive aggregate demand or cost-push factors. |
| Policy Stance | Advocates for rules-based monetary policy (e.g., constant money growth rule). | Advocates for discretionary policy to manage aggregate demand. |
While monetarists emphasize the importance of monetary factors and a more laissez-faire approach to the broader economy, Keynesians advocate for active government management of aggregate demand to smooth out the business cycle and achieve full employment.
FAQs
What is the main idea of monetarism?
The main idea of monetarism is that the money supply is the primary determinant of inflation in the long-run and influences short-run economic activity. It suggests that a stable and predictable growth of the money supply is essential for economic stability.
Who is the most famous monetarist?
Milton Friedman, a Nobel Prize-winning economist, is widely recognized as the most influential figure and leading proponent of monetarism.
Does monetarism still influence economic policy today?
While direct targeting of monetary aggregates has largely fallen out of favor, the core insights of monetarism, particularly the understanding that sustained inflation is a monetary phenomenon, continue to influence modern central bank policies and discussions. Central banks still closely monitor monetary aggregates as indicators of economic conditions.
How does monetarism relate to the Quantity Theory of Money?
The Quantity Theory of Money (MV = PQ) is a foundational equation for monetarism. It posits a direct relationship between the money supply and the price level, assuming that the velocity of money and real output are relatively stable.
What are monetary aggregates?
Monetary aggregates are measures of the total money supply in an economy, such as M1 (currency and demand deposits) and M2 (M1 plus savings deposits, money market accounts, etc.). Central banks historically used these measures to guide their monetary policy decisions.