What Is Monetarist Economics?
Monetarist economics is a macroeconomic theory asserting that the total amount of money in an economy is the primary driver of economic activity, including national output and the price level. Within the broader field of macroeconomics, monetarism posits that governments can foster economic stability by targeting the growth rate of the money supply. A core tenet of monetarist economics is that fluctuations in the money supply have significant influences on short-run national output and long-run inflation.31
History and Origin
Monetarist economics is largely associated with the work of Nobel Prize-winning economist Milton Friedman, who, along with Anna Schwartz, extensively researched the role of money in economic history. Their seminal 1963 work, "A Monetary History of the United States, 1867–1960," argued that failures in monetary policy by the U.S. central bank, the Federal Reserve, were a primary cause of the Great Depression.
30Monetarism gained considerable prominence in the 1970s, a period characterized by high and rising inflation and slow economic growth (stagflation). F29acing rampant inflation, particularly in the U.S., the Federal Reserve, under Chairman Paul Volcker, adopted policies reflecting monetarist theory in October 1979. V28olcker's measures focused on directly controlling the money supply to combat inflation, a significant shift that led to substantially higher interest rates and ultimately helped bring down inflation, though at the cost of a severe recession. 26, 27The New York Times reported on this pivotal shift, noting Volcker's declaration of a key change in policy. T25his historical period is a testament to the practical application of monetarist principles in battling economic instability.
24## Key Takeaways
- Monetarist economics emphasizes the paramount role of the money supply in determining inflation and nominal Gross Domestic Product (GDP).
*23 It argues that controlling the money supply through monetary policy is the most effective way to achieve economic stability and low inflation.
*22 Milton Friedman, a leading figure in monetarism, advocated for a steady, predictable growth rate of the money supply, often called the "K-percent rule."
*21 Monetarists generally believe that in the long run, changes in the money supply primarily affect the price level, with little lasting impact on real economic output or unemployment.
20## Formula and Calculation
A cornerstone of monetarist economics is the Quantity Theory of Money, often 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 goods and services in a given period)
- (P) = Average price stability level of goods and services
- (Q) = Real output (the total quantity of goods and services produced, often approximated by real GDP)
Monetarists typically assume that (V) is relatively stable or predictable in the long run, and (Q) is determined by real factors like available resources and technology. T19herefore, changes in the money supply ((M)) are seen as directly influencing the price level ((P)).
18## Interpreting Monetarist Economics
Interpreting monetarist economics involves understanding that its proponents see the money supply as a crucial lever for managing economic conditions. If the money supply expands faster than the economy's capacity to produce goods and services, the excess money chases the same amount of goods, leading to rising prices or inflation. Conversely, if the money supply grows too slowly, it can lead to deflation or a recession. Monetarists argue that by keeping the growth of the money supply consistent and predictable, a central bank can provide a stable environment for businesses and consumers, promoting stable prices and sustainable economic growth.
17## Hypothetical Example
Consider a hypothetical economy where the money supply (M) is $100 billion, and the velocity of money (V) is 5, meaning each dollar is spent, on average, five times per year. According to the Quantity Theory of Money, the nominal GDP (P x Q) would be $500 billion ($100 billion * 5).
Now, suppose the central bank decides to increase the money supply by 10% to $110 billion, while assuming the velocity of money remains stable. If the real output (Q) of the economy does not immediately increase, monetarist theory suggests that the average price level (P) would tend to rise proportionally to maintain the equation. The new nominal GDP would be $110 billion * 5 = $550 billion. If real output remained constant, this 10% increase in nominal GDP would translate directly into a 10% increase in the price level, leading to inflation. This illustrates the monetarist view that excessive expansion of the money supply leads to inflationary pressures if not matched by an increase in the production of supply and demand.
Practical Applications
Monetarist economics has had significant influence on the conduct of monetary policy by central banks worldwide. Its insights contribute to the understanding that long-term inflation is fundamentally a monetary phenomenon. C16entral banks often use various tools, such as adjusting interest rates or conducting open market operations, to influence the overall money supply in the economy. W14, 15hile direct money supply targeting has largely fallen out of favor in recent decades in lieu of explicit inflation targeting, the underlying monetarist principle that monetary policy profoundly impacts inflation remains a cornerstone of modern central banking. Milton Friedman himself wrote about the power and potential of money to influence economic outcomes. H13is piece "What Money Can Do," published by the IMF, highlights the fundamental role of monetary aggregates.
Limitations and Criticisms
Despite its influence, monetarist economics faces several limitations and criticisms. A primary critique centers on the assumption of a stable or predictable velocity of money. In practice, the relationship between changes in the money supply and macroeconomic variables has proven to be more complex and less predictable than monetarist theory suggests. C12hanges in financial innovations, consumer behavior, and global capital flows can cause the velocity of money to fluctuate, making it difficult for central banks to precisely control inflation by targeting the money supply alone. T11he Federal Reserve Bank of San Francisco published an economic letter discussing "The Puzzling Decline in the Velocity of Money," illustrating this challenge.
Another criticism is that a strict, rule-based approach to money supply growth, like Friedman's K-percent rule, may lack the necessary flexibility to respond to unexpected economic shocks or severe recessionary periods. C10ritics also argue that monetarism's strong focus on controlling inflation can sometimes come at the expense of addressing issues like unemployment or financial sector instability.
9## Monetarist Economics vs. Keynesian Economics
Monetarist economics and Keynesian economics represent two distinct, often contrasting, schools of thought within macroeconomics. The primary difference lies in their views on the most effective way to manage economic activity.
Monetarist economics, as discussed, emphasizes that the money supply is the chief determinant of economic output and inflation in the long run. Monetarists advocate for the use of monetary policy, specifically controlling the growth rate of the money supply, to achieve economic stability. They generally favor limited government intervention, believing that markets tend toward a stable equilibrium if the money supply is well-managed.
8In contrast, Keynesian economics, developed by John Maynard Keynes, highlights the importance of aggregate demand in driving economic activity. Keynesians argue that fluctuations in demand are the primary cause of economic cycles and advocate for active government intervention, particularly through fiscal policy (government spending and taxation), to stimulate demand during downturns. K7eynesians tend to view the velocity of money as unstable and unpredictable, making direct money supply control less effective.
6While monetarists focus on controlling the quantity of money, Keynesians emphasize manipulating spending. Both theories have influenced policymaking, with governments often employing a mix of both monetary and fiscal tools.
FAQs
What is the primary goal of monetarist economics?
The primary goal of monetarist economics is to achieve economic stability and low inflation by controlling the growth rate of the money supply. M5onetarists believe that stable and predictable money supply growth leads to stable prices and sustainable economic expansion.
Who is the most famous economist associated with monetarist economics?
The most famous economist associated with monetarist economics is Milton Friedman. His extensive research and writings, particularly his work with Anna Schwartz on monetary history, were instrumental in popularizing and developing the theory.
4### How do central banks apply monetarist principles today?
While few central banks today explicitly target the money supply as their sole objective, the core monetarist insight that excessive money growth leads to inflation remains widely accepted. Many central banks now practice flexible inflation targeting, which implicitly recognizes the importance of managing monetary conditions to achieve price stability. They use tools like adjusting interest rates to influence the broader economy.
3### Is monetarist economics still relevant?
Yes, monetarist economics remains relevant. Although some of its strict policy prescriptions, like rigid money supply targeting, have been abandoned due to real-world complexities, its fundamental contributions—such as the understanding that inflation is largely a monetary phenomenon and the importance of a credible monetary policy for price stability—are deeply embedded in modern macroeconomic thought and central banking practices.1, 2