Monetarismus

What Is Monetarism?

Monetarism is a school of thought within macroeconomics that asserts that the money supply is the primary driver of economic activity, including inflation and economic growth. Proponents of monetarism believe that by controlling the money supply, a central bank can effectively manage aggregate demand and price stability. This economic theory posits a direct relationship between the quantity of money in an economy and the price level of goods and services.

History and Origin

The roots of monetarism can be traced back to the 16th century with the development of the Quantity Theory of Money (QTM), which linked changes in the price level to changes in the quantity of money in circulation¹⁴. Over centuries, thinkers like John Locke and David Hume contributed to this theory¹³. However, modern monetarism gained significant prominence in the mid-20th century, largely due to the work of Nobel laureate Milton Friedman and Anna Schwartz.

Their seminal 1963 book, A Monetary History of the United States, 1867–1960, argued that changes in the money supply profoundly influenced the U.S. economy, particularly during major economic fluctuations like the Great Depression. ¹¹, ¹²Friedman's restatement of the Quantity Theory of Money in 1956 became a cornerstone of monetarist thinking, emphasizing the importance of a stable and predictable monetary policy.

Key Takeaways

• Monetarism emphasizes the direct link between the money supply and key economic variables like inflation.
• The Quantity Theory of Money is a foundational concept, expressed by the equation MV = PY.
• Monetarists generally advocate for stable and predictable growth in the money supply, often through a monetary rule, to ensure price stability.
• This school of thought suggests that fiscal policy has less impact on long-term economic activity compared to monetary policy.
• Monetarism influenced central bank policies, particularly in the late 20th century, in efforts to combat inflation.

Formula and Calculation

The core of monetarism is often encapsulated by the equation of exchange, a foundational element of the Quantity Theory of Money:

Where:

• (M) represents the total money supply in an economy.
• (V) stands for the velocity of money, which is the average number of times a unit of currency is spent on new goods and services in a given period.
• (P) denotes the general price level of goods and services.
• (Y) signifies the real value of all goods and services produced, often approximated by real gross domestic product (GDP).

In its strictest form, the Quantity Theory of Money assumes that (V) (velocity) is relatively constant or predictable and that (Y) (real output) is determined by real factors like technology and resources, not solely by monetary factors. Therefore, changes in (M) (money supply) are seen as directly proportional to changes in (P) (price level), implying that an increase in the money supply leads to inflation.

Interpreting the Monetarism

Monetarism interprets economic fluctuations primarily through the lens of the money supply. A sustained increase in the money supply beyond the rate of real economic growth is expected to lead to inflation, while a sharp contraction can lead to deflation or recession. Monetarists argue that central banks should focus on maintaining a steady and predictable growth rate in the money supply, rather than discretionary monetary policy adjustments, to achieve long-term price stability. This contrasts with approaches that might emphasize fine-tuning interest rates or reacting to short-term economic data.

Hypothetical Example

Consider a hypothetical economy where the money supply ((M)) is $100 billion, the velocity of money ((V)) is 5, and the real output ((Y)) is $200 billion. Using the equation (MV = PY), the price level ((P)) would be calculated as:

Now, assume the central bank increases the money supply by 10% to $110 billion, and velocity and real output remain constant, as per strict monetarist assumptions. The new price level would be:

In this example, a 10% increase in the money supply led to a 10% increase in the price level (from 2.5 to 2.75), demonstrating the direct relationship monetarism posits between money supply growth and inflation.

Practical Applications

Monetarism has had significant practical applications in how central banks approach monetary policy. During the late 1970s and early 1980s, faced with high inflation, some central banks, notably the U.S. Federal Reserve under Paul Volcker, adopted policies heavily influenced by monetarist principles, focusing on controlling the growth of the money supply to curb rising prices. ¹⁰This period saw a shift away from directly targeting interest rates towards controlling monetary aggregates.

While pure money supply targeting has largely been superseded by other frameworks like inflation targeting, the monetarist emphasis on the importance of money and inflation control remains influential. Concepts such as the potential inflationary impact of excessive money creation, for example through policies like quantitative easing, are still actively debated within financial markets and among policymakers.

Limitations and Criticisms

Despite its influence, monetarism has faced several limitations and criticisms. One significant critique is that it places too much emphasis on the money supply and may overlook the complexities of economic systems, including factors like fiscal policy, technological advancements, or the role of financial intermediaries. ⁸, ⁹Critics argue that the assumption of a constant or predictable velocity of money is often unrealistic, as velocity can fluctuate significantly due to changes in consumer spending habits, financial innovation, or economic uncertainty.
⁷
Additionally, monetarist policies have been criticized for potentially leading to high unemployment rates or recessionary periods if the focus on controlling inflation through tight money supply leads to insufficient aggregate demand. ⁶The relationship between the money supply and economic variables has also been shown to be less robust in empirical studies than monetarists suggest, with mixed results on the direct link between money supply growth and economic activity. ⁵Some criticisms also point out that monetarism's narrow focus might not adequately explain phenomena like asset price bubbles, which are influenced by a broader range of factors beyond just the money supply. ⁴Historical experience, such as the Federal Reserve's experiment with strict money supply targeting from 1979 to 1982, also led to debates about the practical challenges and unintended consequences of pure monetarist approaches.
², ³

Monetarism vs. Keynesianism

Monetarism and Keynesianism represent two fundamentally different approaches to understanding and managing an economy.

While monetarism posits that the private sector is largely stable and government policy, especially monetary, is the main source of instability, Keynesianism emphasizes that the economy can settle at equilibrium below full employment and advocates for active fiscal policy (government spending and taxation) to manage demand and stabilize business cycles. ¹The confusion often arises because both schools aim for economic stability and growth, but their prescribed methods and diagnoses of economic problems differ significantly.

FAQs

What is the main idea behind monetarism?

The main idea behind monetarism is that changes in the money supply are the most significant determinant of the general price level and economic growth in the long run.

Who is considered the father of modern monetarism?

Milton Friedman, a Nobel Prize-winning economist, is widely regarded as the most influential figure in developing and popularizing modern monetarism. His work, particularly A Monetary History of the United States, provided significant empirical support for the theory.

How does monetarism propose to control inflation?

Monetarism proposes controlling inflation by strictly managing the rate of growth of the money supply. The belief is that if the money supply grows at a rate consistent with real economic output, price stability can be achieved.

Is monetarism still relevant today?

While pure monetarism, with its strict focus on money supply targets, is less commonly practiced by central banks today compared to other frameworks like inflation targeting, its core insights regarding the long-term relationship between money and prices remain influential. Discussions about the impact of money creation, fiscal deficits, and the role of the central bank on inflation often draw from monetarist principles.