Monetarist

What Is Monetarist?

A monetarist is an economist or school of thought within macroeconomic theory that primarily emphasizes the crucial role of the money supply in determining economic output and the price level. Monetarism posits that fluctuations in the amount of money in circulation are the chief determinants of economic growth in the short run and inflation over longer periods. Proponents of monetarism argue that a steady and predictable growth rate of the money supply is essential for achieving economic stability, and they advocate for central banks to control this rate.

History and Origin

The modern understanding of monetarism is primarily associated with the work of Nobel Prize-winning economist Milton Friedman, who, along with Anna Schwartz, extensively researched the relationship between money supply and economic activity. 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, including being a primary cause of the Great Depression due to the Federal Reserve's failure to offset forces reducing the money stock.

³⁵Monetarism gained significant prominence in the 1970s, a decade characterized by high and rising inflation. A³⁴t this time, traditional Keynesian economic theory seemed to lack effective policy responses to "stagflation" (simultaneous high inflation and low economic growth). M³³ilton Friedman and other monetarists argued convincingly that high inflation rates were directly linked to rapid increases in the money supply, making its control key to effective policy.

³²A major practical application of monetarist principles occurred in 1979 when Paul A. Volcker became chairman of the Federal Reserve. Facing U.S. inflation peaking at 20 percent, the Fed, under Volcker, adopted new operating procedures aimed at controlling the growth of monetary aggregates. T³⁰, ³¹his period, often termed the "Volcker Disinflation" or the "monetarist experiment," involved maintaining high interest rates to slow the economy and combat inflation. W²⁸, ²⁹hile initially leading to a severe recession and unpopularity, these policies successfully brought down inflation.

²⁶, ²⁷## Key Takeaways

• Monetarism asserts that the total amount of money in an economy (money supply) is the primary determinant of nominal gross domestic product (GDP) in the short run and the price level in the long run.
• Central banks should focus on maintaining a stable and predictable growth rate of the money supply rather than actively managing the economy through discretionary monetary policy adjustments.
• Monetarists generally believe that market economies are inherently stable and that government intervention, particularly through fiscal policy, can often be destabilizing.
  *²⁵ A key tenet is the long-run neutrality of money, meaning that in the long run, changes in the money supply only affect prices, not real variables like output or employment.
  *²³, ²⁴ Unstable money supply growth is viewed as a major cause of economic fluctuations, including inflation and recessions.

²²## Formula and Calculation

The core of monetarist thought is often summarized by the Quantity Theory of Money, expressed by the equation of exchange:

Where:

• (M) = Money supply (the total amount of money in circulation)
• (V) = Velocity of money (the average number of times a unit of money is spent on new goods and services in a specific period)
• (P) = Average price level of goods and services
• (Q) = Quantity of goods and services produced (real output or real GDP)

In some interpretations, (Q) is replaced with (Y), representing Nominal GDP, so the equation becomes (MV = Y), where (Y) is the nominal value of output. 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, not directly by money supply. Therefore, changes in (M) primarily lead to changes in (P).

²⁰, ²¹## Interpreting the Monetarist View

From a monetarist perspective, interpreting economic conditions largely revolves around analyzing the growth rate of the money supply. If the money supply grows too rapidly relative to the economy's capacity to produce goods and services, it is expected to lead to inflation. Conversely, if the money supply shrinks or grows too slowly, it can contribute to deflation or slow economic growth and potentially lead to a recession.

¹⁹The monetarist interpretation suggests that policymakers should not attempt to "fine-tune" the economy through frequent, discretionary changes in monetary policy. Instead, they advocate for a rules-based approach, such as a constant money growth rule, to ensure predictability and stability in the price level and overall economic activity.

¹⁸## Hypothetical Example

Consider a hypothetical economy where the central bank decides to significantly increase the money supply by purchasing government securities through open market operations. According to monetarist theory, if the velocity of money remains stable and the economy is already producing near its full capacity, this increase in money will primarily lead to an increase in the general price level.

For instance, if the money supply grows by 10% but real output only grows by 2%, and velocity is stable, the monetarist model predicts approximately an 8% increase in prices (10% money growth - 2% real output growth). This increased money circulating means more dollars chasing the same amount of goods and services, leading to higher prices. In the short term, there might be some temporary boost to employment and output as businesses initially respond to increased demand, but monetarists argue that these real effects are fleeting, and the long-run impact is primarily on inflation.

Practical Applications

Monetarist ideas have had a profound impact on how central banks conduct monetary policy, even if strict monetarist targeting is less common today. One significant application was the Federal Reserve's strategy under Paul Volcker in the late 1970s and early 1980s, which explicitly targeted money growth rates to combat rampant inflation.

¹⁷While few central banks today explicitly target the money supply due to challenges in measuring and controlling it, many have adopted key monetarist insights. For example, the emphasis on price stability as a primary goal of monetary policy—often expressed as an inflation target (e.g., 2%)—reflects monetarist influence. Centr¹⁵, ¹⁶al banks utilize tools like open market operations, adjusting the discount rate, and setting reserve requirements to influence the availability of money and credit in the economy. These¹⁴ actions, while not always explicitly tied to a strict money supply rule, are based on the understanding that controlling the quantity of money affects economic outcomes. The Federal Reserve, for instance, outlines its primary monetary policy tools used to influence credit conditions and ultimately the economy.

L¹³imitations and Criticisms

Despite its historical influence, monetarism faces several limitations and criticisms:

• Unstable Velocity of Money: A fundamental assumption of monetarism is that the velocity of money is stable and predictable. However, empirical evidence has shown that velocity can be volatile, particularly in modern economies with evolving financial institutions and payment systems. If ve¹²locity is unstable, the direct link between money supply and nominal GDP becomes less reliable, making money supply targeting less effective.
• Difficulty in Defining and Controlling Money Supply: As financial systems become more complex, accurately defining and measuring the "money supply" (e.g., M1, M2, M3) becomes challenging. Furthermore, a central bank's ability to precisely control the growth of broad money aggregates can be limited due to factors like changes in bank lending behavior and public demand for currency.
• ¹¹Short-Run Real Effects: While monetarists emphasize the long-run neutrality of money, the short-run effects of changes in money supply on output and employment can be significant and prolonged, as seen during the Volcker disinflation's recessionary impact. Criti⁹, ¹⁰cs argue that ignoring these short-run real effects can lead to policies that induce unnecessary economic hardship.
• Critique by Keynesian Economics: Keynesians argue that demand for goods and services is the primary driver of economic output, and they contend that monetarism oversimplifies the economy by focusing too narrowly on the money supply. They ⁷, ⁸also emphasize the potential for liquidity traps, where changes in the money supply may have no effect on interest rates or spending.

M⁶onetarist vs. Keynesianism

Monetarism and Keynesian economics represent two distinct approaches to macroeconomic theory, often presenting contrasting views on how economies function and the appropriate role of government intervention.

While monetarism emphasizes the control of the money supply by the central bank to ensure price stability, Keynesianism focuses on managing total spending in the economy through government fiscal measures, especially during recessions. The debate between these two schools of thought has significantly shaped monetary policy and economic thought over the past century.

F⁴, ⁵AQs

What is the core idea of monetarism?

The core idea of monetarism is that changes in the money supply are the primary drivers of economic growth and inflation. Monetarists believe that by controlling the rate at which the money supply increases, a central bank can effectively manage the economy and ensure price stability.

Who is Milton Friedman in relation to monetarism?

Milton Friedman was a highly influential American economist and Nobel laureate widely considered the most prominent advocate of modern monetarism. His research, particularly his work with Anna Schwartz on the monetary history of the United States, provided foundational empirical support for monetarist principles, arguing that fluctuations in the money supply were key to understanding economic fluctuations.

³How does a central bank implement monetarist policies?

In a strict monetarist framework, a central bank would implement policies by targeting a specific, consistent growth rate for the money supply. This involves adjusting its tools, such as open market operations, discount rates, and reserve requirements, to achieve the desired monetary aggregate growth rather than focusing on short-term interest rates.

Is monetarism still relevant today?

While pure monetarist policies (like strict money supply targeting) are rarely implemented by central banks today due to challenges like unpredictable velocity of money, many core insights of monetarism remain highly relevant. The emphasis on the importance of the money supply in affecting inflation and the long-run neutrality of money have been widely adopted into mainstream macroeconomic thought and continue to influence monetary policy discussions, particularly the focus on price stability.¹, ²